April 4, 2014

Two-sided Bitcoin

Bitcoin’s “Achilles’ heel (or saving grace, depending on how you look at it)” is not being a recognized global currency.

In the years following the 2008 financial meltdown, there was a massive move away from anything with speculative value: derivatives, stocks, bonds, you name it. Many investors, doubtful of world currencies and the credit of the troubled governments issuing them, even went a step further and reallocated capital to gold. Now, gold certainly has its merits. Since its value is determined by the market and no single entity can “print” gold for personal use, as the U.S. Treasury can with the dollar at the instruction of the Fed, there is an added layer of financial protection for those who own it. On the other hand, it’s clunky. As a physical asset, it has to be stored, protected, and kept track of, all of which wastes money over time. Well, in the age of technical innovation, these drawbacks have been circumvented by the advent of cryptocurrencies, tenders which only exist online and are protected by a community of hackers who agree on a common code to enable exchange of these currencies, while making it impossible for anyone to hack the system. The most successful of these cryptocurrencies is Bitcoin, whose supporting development community has grown exponentially and whose total value now exceeds $1.5 billion. All of this raises the question: Is Bitcoin the new and improved gold?

In the Bitcoin system, one uses an electronic account number that can instantaneously exchange virtual currency with any other in a matter of keystrokes. The currency’s main advantage, just like gold’s, is that its value is independent of the financial stability of any one country. However, this is a two-faced coin. The flip side is that since its value isn’t pegged at some constant ratio to a recognized asset or traded commodity, the market price of a Bitcoin is determined in a vacuum, which can potentially lead to wide fluctuations. Gold has been around for a long time, so even though its price is not supported by anything else of recognized value, like a constant ratio of gold ounces to Subway sandwiches, the price of gold falls within a narrow expected band. In contrast, Bitcoin is but a five-year-old baby with unpredictable interactions between supply and demand.

In this relationship, it’s not the supply side that’s the problem. Bitcoins are generated by computer “miners,” which use brute force to solve algorithms randomly issued by a server. When one of these computers solves the algorithm, after billions and billions of calculations documented by a “proof of work,” it is awarded a Bitcoin. The more Bitcoins are created, the more difficult they become for the miners to create. As more and more computers have been turned into Bitcoin miners, mining for Bitcoins has become more expensive than the electricity needed to keep the computers running; the only remaining Bitcoin miners are actually machines that have been maliciously hacked to do so by a third party that can deposit the earned Bitcoins in its own account without having to foot the utility bill, and even that’s going out of style.

The real threat to stable prices is the demand. As more and more companies have begun accepting bitcoin as a valid medium of exchange over the past 24 months, its price has grown steadily to meet the need for increased circulation, as is only natural. Then, in November of last year, financial speculators (primarily Chinese banks) unleashed a roller coaster of volatility, quintupling the price of a Bitcoin in a matter of months, followed by a half-price crash, followed by another rise to near-record highs. While this may be good for Wall Street gamblers—or whatever the Chinese equivalent is, since mainstream investment groups have so far been unwilling to touch Bitcoin with a 10-foot digital pole—this type of volatility is no good for those actually using Bitcoin as intended. Imagine running a business which accepts Bitcoins but purchases supplies with dollars, and then learning the day after you’ve been paid in Bitcoins that due to a crash they can only be traded in for half as many dollars as before. No good. As of now, there have been more booms than busts so few have suffered, but the uncertainty of future prices weighs heavily on the credibility of Bitcoin as a legitimate global currency.

Closely related to Bitcoin’s claim to legitimacy is its Achilles’ heel (or saving grace, depending on how you look at it) of not being a recognized global currency. That is, no government authority regulates it. Whereas it takes paperwork, credibility, and approval from the government to set up a bank, pretty much anyone can declare herself a Bitcoin trader. One such trader was Mt. Gox, a Japanese Magic-The-Gathering-turned-Bitcoin-Exchange that last month reported a hack that resulted in $350 million in missing Bitcoins and promptly filed for bankruptcy. Of course, all financial institutions are under constant risk of attack, but the lack of regulation means that depositors are left completely unprotected. Mt. Gox, the largest in its field, offered no written insurance or assurances on a user’s account, and any lawsuits are impractical since they would have to be filed under international law. This is because, again, these exchanges are not monitored internally by local governments since Bitcoin is not recognized as a real currency.

If Bitcoin is to quickly become a currency on par with mainstream currencies such as the dollar, governments need to recognize that the advantages of cryptocurrencies mean that they are here to stay, despite any growing pains. It is important to recognize that government regulation of Bitcoin isn’t anathema to the economic benefits of its open-source principles, foremost of which is that new Bitcoins are issued predictably and automatically, rather than at the behest of a government that might have bills to pay. But what about imposing regulations on Bitcoin exchanges such as insurance mandates and solvency-ratio floors? Stability is something Bitcoin desperately needs, and if it is to become more than just a speculative asset, someone outside the free market will have to provide it. The more governments recognize Bitcoin, the more businesses will start accepting it alongside their country’s currencies, and the more stable Bitcoin prices will become as they become pegged at the quoted ratios to the goods sold by these businesses. The outcome? The first truly global currency. The dollar was a reasonable post-WWII substitute, but we’re in the 21st century now. Unless you’re only as tech-savvy as your grandparents, it’s worth the effort to jump on the tech train.

David Grossman is a first-year in the College.