03 June 2013

Future Bitcoin: Currency for Better World – or Not?

[NB! It’s a long essay. If you don’t want to read it all, just skip the rest and move to the “Short version of the long story” in the end. Then turn back to the beginning and read my reasoning.]

More recently, there has been a lot of “noise” around bitcoin (BTC), defined on its official website as “an open source P2P digital currency”. Bitcoin has got notable (mixed) media attention; bitcoin start-ups have started to attract VC funds; bitcoin enthusiasts seem to be gathering around the world; bankers and central bankers are paying attention. Wow. That’s a buzz!

Popularity of bitcoin among its enthusiasts and die-hard fans builds on the well-known issues of the current monetary system which:
(a) is centralized and based on “fiat money”, i.e. supervised by governments and central banks that have taken the authority (and responsibility) to control the money supply;
(b) is heavily reliant on the banks that can and from time to time do fail, causing losses both for the depositors (in first order, amounts above the guaranteed deposits) and for the tax payers (when banks are being bailed out or kept on the artificial life support);
(c) has no privacy, that is a banker can see every transaction of her or his customer.

Apparently, many people do not like the idea of being controlled and monitored by the “money masters”. Instead, they (we) want a monetary system that is: secure, decentralized, based on worldwide consensus, politically neutral, and protecting individual rights and freedom. That’s what die-hard fans of bitcoin believe this crypto-currency* to be; that has been the basic promise to the bitcoin enthusiasts.

Yet bitcoin is not fit to live up these noble expectations and promises. I’m not talking about the technology which in one or another way is going to change the financial industry. (Banks would just love certain technological advantages that bitcoin offers; they’d just love this dedicated developers like technological visionaries who are developing bitcoin infrastructure.) I’m talking about the conceptual design of the monetary system in the “bitcoin economy”, and the interactions between bitcoin economy and the world of finance as we know it.

Another major cause of concern is of course legal aspect. Obviously this kind of initiatives and financial innovations are intervening to the aims and tasks and potentially also the authority of central banks and governments. Obviously too, a new and immature currency with bitcoin features is attractive for guys with skewed motivations. I will not go into details with this; it’s more for the lawyers to analyze. Just to note: my guess is that venture capital is going to reconfigure bitcoin in a way that it is generally in line with the legislation.

Before going to the discussion points, I’d suggest beginning with a brief introduction to bitcoin.

Distinctive features of bitcoin

I’ll skip detailed descriptions which can be found from its official website, incl. references that it provides to further resources. I simply highlight the distinctive features of today’s bitcoin that I think are important to remember throughout the whole story.

The conceptual difference of bitcoin (and bitcoin-based crypto-currencies) is its decentralized nature, at least in theory. There is no central bank and no other formal organization to regulate the supply of base money. Instead, supply of base money is written into the code: it is programmed to increase according to a pre-determined schedule until the total number of bitcoins reaches 21 million by around 2040. (Source: Bitcoin Wiki)

The closely related distinctive feature of bitcoin is its open source technology: it’s not secret and on principle, everyone (assuming relevant skills) can access the source code and further develop it – or develop another currency based on bitcoin (as some have done alreay).

Managing bitcoin transactions and technical issuance of bitcoins is carried out collectively by the network. Thus, online payments in bitcoins are performed from peer-to-peer. That is money is being transferred from the virtual wallet of one person to the virtual wallet of another person with no intermediary in the middle.

Bitcoin enables pseudo-anonymous online payments, even if full anonymity requires special efforts such as implementation of the bitcoin’s new cryptographic extension called zerocoin.

As we shall see, some of these distinctive features may only be of a temporary nature...

For the starters, venture capitalists who put their money into the bitcoin start-ups, suggest abandoning bitcoin’s inherent anonymity.

Defining bitcoin supply IS an issue.

Bitcoin’s fixed supply (21 million coins) is an issue which makes bitcoin unsuitable for becoming the base currency of any growing economy. It is good that new money cannot be just “printed” at the discretion of some authoritative body, but it is a problem if deflationary nature of money encourages hoarding cash and discourages people from entrepreneurship. (I’m keeping in mind honest entrepreneurship, not bitcoin scam, speculations, black markets, pyramid schemes and other controversial ventures where margins can be sky-rocketing.)

For the illustration, today there are ca. 11.2 million coins “mined” (source: Blockchain -> Charts); suppose, the total number of bitcoin users is 500,000 (just a guess estimate which may well range from 100,000 to 1 million; the real number is very difficult if possible at all to figure out) which means that there are 22.41 bitcoins per user. By around 2040, all bitcoins ought to be in circulation; let’s assume that bitcoins become widely accepted and that the total number of users grows from five hundred thousand to five hundred million by that time; this leaves only 0.04 bitcoins per user. Ok, by that time there are over 2 quadrillion atomic units of bitcoins (each bitcoin is formed from 100 million smaller units called satoshis), so the number of bitcoins in circulation as such is not an insurmountable problem. At the same time, for each user being able to purchase the same amount of goods and services, the value of bitcoin had to go up by more than 500 times with less than 30 years. One may argue for a different number (assuming different numbers of users, and taking into account the effects of lost coins, economic growth, introduction of the fractional reserve system by the bitcoin banks etc.), but the fact remains: the system is very deflationary, and thus it makes much more sense to simply hold (virtual) cash than to invest it into developing new products and services. In my illustrative calculation, an IRR of 20% for a project wouldn’t be enough even if investment were completely risk free.

While hard limit to the money supply is an obvious flaw, we have to ask: “Is 21 million bitcoins indeed this hard limit as implied on bitcoin-related websites?” In fact: no. From the talks with the bitcoin developers it so turns out that the limit can be changed if the majority of the bitcoin network agrees. It’s just that the decision to “print” more bitcoins requires consensus of the many people. Who would make the proposal to change money supply and how the needed consensus would be reached? What is the anchor to the bitcoin supply in that case? I do not know (but I do think, that it has to: a) take into account population size, and b) enable economic growth) – no one does. These are still crucial open questions which may completely change the whole "monetary policy" in “bitcoin economy”, and thus also views on bitcoin price trends.

Flaws of the current financial system are being imported to the “bitcoin economy”.

One of the things that bitcoin promoters are saying in these days in order to convince people to join the movement, is that banks are broke and cannot be trusted. It’s the same argument that the “gold bugs” are making. Indeed, banking system IS being kept on artificial life support, and both tax payers and bank creditors are set to take (further) losses, either directly or in an indirect and less obvious way. (For an example, download slides about the current standing of European banking sector from the FRXmarket.) What an unpleasant “surprise” though that bitcoin start-up founders are “importing” crucial flaws of the current financial system to the “bitcoin economy”.

Indeed, when browsing bitcoin start-ups in the AngelList and looking around in the internet, one finds a number of bank-like ventures (one is even called “The Bank of Bitcoin”) and other types of virtual financial institutions that take or intend to take deposits and lend money in bitcoins, and/or provide investment banking services, and/or introduce various derivative instruments including sorts of derivatives that were a significant contributor to the still ongoing Great Recession. 

I wonder if it has ever occurred to these innovators that by doing so, they are:
  • creating the very same hated fractional reserve system and the problem of debt being created without corresponding increase in the money supply;
  • making things overly complex and confusing from day one;
  • basically building the same flawed financial system for the virtual currency, only without the supervision and back-stop of a formal central bank.
I also wonder if some bitcoin bankers are building banks in the unregulated virtual world, because they are not able to do so in the regulated “real” world.

In any case, bitcoin is not a solution to crucial problems in the financial system. Crises and crashes will be inherent also to the bitcoin economy (and presumably, they would become more frequent even if smaller as bubbles popped faster). Let’s be clear in this: bitcoin is not (debt) free money.

The question still remains: what a sound financial system should look like? For one thing, one has to get rid of the mechanisms that are creating debt without creating money.

The way how “bitcoin economy” is being built, is not the way you’d build a better world.

If you wanted to create a new world that is based on consensus, and protecting individual rights and freedom, you’d probably not make money its center from the start. Instead, you’d build it around initiatives like Let’s do it! World and projects deriving from this already pretty big non-profit "start-up". 

Ok, a better world would probably need money and some sort of financial system too. Even if focusing on the financial side of affairs, you’d avoid maintaining and further increasing inequalities between rich and poor by creating a direct two-way link between the old and the new economy. You’d avoid giving rich people better chances to accumulate wealth in the new economy simply because they have more venture capital and because they can afford taking more speculative risks (e.g. simply buy more of the new money for their old money). Instead, if the aim is to build a fairer word, you’d disentangle new money from the old money from the start; you’d enable an equal starting point for everyone in the new economy. (How to run two parallel economies with the very same people so that unfair inequalities from one economy would not be imported to another is of course a good question.)

To be fair, bitcoin helps to change the existing power patterns at least somewhat. It gives lucrative opportunities for a group of people that would best be described as money conscious tech guys (and maybe to their families and friends). Similarly, old financiers and policy makers will most probably lose if they don’t keep up with the developments in technology. This way, old power patterns can be changed at least in certain extent.

Yet again, if bitcoin start-up founders accept venture capital, VC-s will shape the “bitcoin economy” as they want it to be, and re-configure bitcoin as needed. As summarized by the ConvergEx Group Chief Market Strategist Nick Colas: “It's in the hands of the VCs now.” (Source: Business Insider, “Here's Why Venture Capitalists Want To Make Bitcoin The 'Next Big Thing'”, 23 April 2013)

Last but not least on this point: you’d not start a better world with spreading misleading information. For example, you’d not say that the hard limit of bitcoins is about 21 million, if it actually has to be changed for bitcoin to become something more than a marginal speculative sort of over-the-counter derivative.

What about buying bitcoins?

I do not know about you, but here is why I do not buy them at this point – except maybe an insignificant amount for experimentation:

(a) To me, the price of bitcoin (ca. 130 USD at the time of writing) simply doesn’t make sense. It may be a layman’s reasoning, but when I compare what I can do with 130 USD or 100 EUR vs what I can do with 1 BTC then clearly 130 USD or 100 EUR has more value to me. (This may be different for you if you want to buy a specific product or pay anonymously or are making frequent payments to those who use or accept bitcoins. Yet that’s rather an exception.) I’m looking at the current price as far too high also because I do not believe that today’s bitcoin, purely due to its economic properties, has a future greater than a highly speculative alternative currency. (I may change this view if bitcoin’s economic properties are revised.)

(b) As revealed in the “Quantitative Analysis of the Full Bitcoin Transaction Graph” by Dorit Ron and Adi Shamir in October 2012 (based on data up to 13 May 2012), 78% of bitcoins are “stashed under digital mattress”, i.e. they are accumulated to the addresses that only receive and never spend. Furthermore, the researchers found that total number of bitcoins received by most entities is negligible: for the analyzed time horizon, balance of almost 97% of all entities was less than 10 BTC's and accordingly, there were only 78 entities with current balance larger than 10,000 BTC's. Ok, the paper is a bit old and probably contains some estimation errors, but the issues of thin market and heavily concentrated bitcoin holdings into a few hands are very real. This means that the price of bitcoins can be easily manipulated by a handful of individuals. (I cannot say for a fact that it is, but it can be. It can also be that a handful of entities/individuals with large bitcoin holdings are waiting for opportunities to cash out without causing a market crash and their own paper profits to disappear; such opportunities would arrive for them if new money flows into bitcoins.) Even though I find it disturbing, some professional speculators might like the bitcoin market precisely because it is thin and it doesn’t take that much to manipulate it.

(c) It is way too disturbing that some of the top promoters of bitcoin are at the same time undermining it with highly controversial acts and/or clearly conflicting interests. Some of them appear to be involved into the development of digital currencies that are competing with bitcoins. (For a further reference, you might want to do background research about the claims in this angry blog post: “The Bitcoin Foundation is TOXIC and must dissolve, plus a call to action,” published in 19 May 2013. Sorry if it's removed by the time you try to access it; the author of the post might be viewed as controversial too. I haven’t done any thorough research on this by myself, but after some “googling”, the smell of it alone is enough to keep me away from buying bitcoins at this stage.)

(d) Hackers continue abusing bitcoin for their profit. There is still a real risk of losing everything to a criminal intruder.

What about venture capitalists who are investing into bitcoins though? Reportedly, for a big group of investors, bitcoin seems to be anything but a bubble. Well, what I’m reading out from their communications is that bitcoin investors are investing into anything around bitcoin but bitcoin itself.

They are investing into the bitcoin technology (and technologies based on the original bitcoin technology), and lots of ways to play around with it; they are investing into the people developing related technologies; they are investing into a new era of currencies (which may well have quite different economic properties than the present bitcoin, but be still based on the bitcoin technology with little modifications) as more efficient systems are likely to replace current ones even if cash doesn’t disappear; they are investing into the potentially huge market size – and the market for enhanced bitcoin technologies may well be more matured tech companies that want to introduce or improve their own virtual money, or (maybe I’m jumping a bit ahead with this, but it seems a very logical development) large financial institutions that need innovations (their current system of money transfers is slower and more expensive) but are unable to attract innovators otherwise than via the “food chain” of venture capital.

The fact that bitcoin technology may be available at bargain does not automatically mean that the price of bitcoin is reasonable. Buying bitcoins because venture capitalists are investing into the companies in the bitcoin ecosystem is not quite an argument in itself.

Short version of the long story

In conclusion:
  • Bitcoin is not the currency of a better world; in that sense, it is going to disappoint its enthusiasts.
  • Future bitcoin would be quite different from the current one.
  • A re-configured bitcoin and/or its descendants – whatever their names will be – have good chance for becoming a disruption. Yet the “disruption” is much smaller and quite different from what the die-hard bitcoin fans and enthusiasts would like to believe.

Here is why: 
  • Current economic properties of bitcoin make it unfit for becoming an important currency. Supply of bitcoins is an issue.
  • Bitcoin start-up founders are importing crucial flaws of the current financial system to the new “bitcoin economy”.
  • Bitcoin doesn’t considerably change the shape of global wealth pyramid; it doesn’t reduce the present inequalities due to its entanglement with the current monetary system.
  • Venture capital has started to re-configure bitcoin. Thus, it is very likely that digital currencies based the enhancements of bitcoin technology will survive. But these new currencies are different bitcoins.
  • In several respects, bitcoin technology, present and yet-to-be developed, would benefit the financial system. Ironically enough for the bitcoin enthusiasts, today’s financial institutions may well become the exit strategy for the angel investors and VC firms investing into the bitcoin start-ups.
  • A better world you’d build differently… and yeah, the financial system for a better world would be much more boring as “fun of money games” would be taken away.

Last but not least: future, however likely, is not pre-determined. Vital bitcoin community** can change it. I’m curious to see if some of my points will have an impact to the emerging “bitcoin economy”.

* I use the expressions “digital currency”, “crypto-currency” and “virtual currency” as synonyms, even if for tech guys the meanings of “digital”, “crypto” and “virtual” may not be exactly the same. 
** If you haven’t done so already, attend some of the related events, and you see what “vital” means.


  1. Very cool to see a poutsch embed at the bottom of this very interesting blog post!

  2. Bitcoin being limited at 21 BTC was never a problem. Saying that a deflationary system prevents people from investing is like ignoring for example that the IT industry can't produce because the prices are always falling down. Inflation, otherwise is a real problem, since it takes money's value and people are discouraged to save, which is essential to any economy.

    Forget Keynes and read more Mises and Hayek.

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  4. This is designed to be reached by the year 2040. A where to spend bitcoin unit or BTC can be divided into 100 million units in trade operations. These smaller units are known as satoshis