Bitcoin? Ask an IT guy

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The past months Bitcoin has been in the news many times. There were some very good items and many very bad. When Bitcoin became more widely known, many of the bigger news agencies decided to consult an expert on the subject, usually a professor in economics or a known economist. I was amazed by their poorly thought out comments and often just plain wrong arguments and objections against Bitcoin as a currency. It seems there are a few reasons for this. Some didn’t research the subject (“Yeah, looks like a bubble to me so that’s probably what it is”), they don’t understand it or they approach it from an economic point of view based on preconceptions about what a currency should be. Maybe some are concerned about the potential consequences for the financial system. Well, they should be because the technology behind Bitcoin can be very disruptive to the way our economy works.

So, if you want an unbiased opinion about Bitcoin from someone who knows what he’s talking about, don’t ask an economist, ask an IT guy. According to BTC China, China’s largest Bitcoin exchange, 92% of its users are male, 93% are younger than 40 years old, 90% have a bachelor’s degree or higher and most work in the IT industry. Those are the people that know Bitcoin, not some retired economist who has only seen a price chart.

In this article I won’t explain the basics about Bitcoin. So if you’re new to Bitcoin I suggest you pay a quick visit to http://Bitcoin.org/en/ which explains in a simple way what Bitcoin is, how it works and what the benefits are for individuals, businesses and developers. For a price chart and market information I recommend BitcoinCharts.com.

In this article I will address the comments and objections I heard and read which are wrong or (in my opinion) put into a wrong perspective: 

bitcoin accepted here

 

You cannot trust a cryptographic currency

You don’t need to trust a cryptographic currency. This is one of the fundamental properties of Bitcoin. Instead of trust, everything is based on cryptographic proof which includes secure ownership, verification of transfers and prevention of double-spending. Fiat currencies rely on trust: central banks must be trusted not to debase the currency (history proves otherwise), banks must be trusted to hold and transfer your money (but hardly keep reserves and create credit bubbles) and protect your privacy. Bitcoin protects your privacy by cutting out the middleman and decentralized distribution keeps fees to a minimum since there are no overhead costs.
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Bitcoin price fluctuations make it unstable and therefore unsuitable as a currency

This is a typical chicken-or-egg case. In order to become stable Bitcoin must be widely adopted, but to be adopted as a currency it must become stable. Don’t forget Bitcoin has existed for only four years and has only received world-wide attention since October 2013. This sudden attention and popularity has caused the price of Bitcoin to soar and fluctuate wildly because of speculation.

In the long term however the excitement will pass. Even with the current wild fluctuations it is possible for a business to accept Bitcoin without too much risk. Let’s say I want to buy a poster online, which would be about $15 and the merchant accepts Bitcoin. I don’t really care about the price in Bitcoin as long as it is pretty close to the value in Dollars. The thing that matters here is that I can exchange my Dollars to Bitcoins timely and the merchant can do the same with his Bitcoins to Dollars. Bitcoin provides a quick (almost instant) and secure transaction and a high level of privacy. This is how businesses currently implement Bitcoin without a big risk on fluctuations. By the time the price stabilizes and Bitcoin is widely accepted it won’t be necessary exchange them for another currency at all.
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Bitcoin can never become an accepted currency because it is not backed by a central bank or government

This objection is mostly made by economists and it’s based on the preconception that only a government can provide trust and guarantee the value of a currency because of its reserves. This is indeed the case with fiat currencies, exactly because the government controls the currency and can influence its value. The principle of backing by the government is irrelevant with Bitcoin because its value is based on demand (not supply) and market acceptance only.

Market acceptance is key, not government backing. Here’s a recent example to illustrate this. There was some panic selling after the Chinese government banned financial institutions from using Bitcoin on 5 December. All media were screaming “crash!” after the price went down almost 30% but neglected to mention the price stabilized after a few hours to about 10% below that day’s high. As this guy on reddit formulates it: “Breaking: Largest most authoritarian government in the world manages to slightly inconvenience Bitcoin for an hour or so”. Now, on 6 December China’s largest search engine Baidu announced it stopped accepting Bitcoins, closely followed by China Telecom, causing the Bitcoin price to drop almost 50% in 1 day and eventually stabilizing around 30% below the previous day’s mean price.
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The Bitcoin price crashes all the time. This is bad.

It depends how you look at it. If you bought 10 Bitcoins for $1000 and a day later the price drops to $600 that’s bad. For you. Let’s change perspective to the bigger picture. When the price goes up quickly, like it has in the past months, many people invest in Bitcoin hoping for a big return. For a currency this is bad since it drives the price up even further and prevents spending. When the price eventually crashes many will cash out on their investment to prevent a loss or take a profit. Big players can even cause a crash by dumping many Bitcoins in the market. This drives down the price and increases liquidity. This in turn lowers the barrier for new people to enter the market, creating a bigger and more stable system which is slightly more robust since it takes more people to sell out at the same time to cause a crash. These crashes, or rather corrections, are positive for the market as a whole.
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How can I pay for cheap products if a Bitcoin is worth $1000?

Bitcoin is divisible in 8 decimals. So even if a Bitcoin would be worth $1 million you could still pay in the equivalent of cents. It is inconvenient though to work with 8 decimals. You could easily transfer 0.00006 instead of 0.000006 and pronouncing it (“that’ll be zero point zero zero zero zero zero 6 Bitcoin”) is even more inconvenient. So there must be an agreement on how to name e.g. 1/1000 Bitcoin (milli-Bitcoin or mBTC). Some initiatives are already being taken. Bitcoinity recently decided to use mBTC as their default Bitcoin unit. The smallest unit (0.00000001 Bitcoin) already has a name: a Satoshi, named after Bitcoin creator’s pseudonym Satoshi Nakamoto.
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Bitcoin is not safe because it’s been hacked

Bitcoin itself has never been hacked. Some exchanges and websites accepting Bitcoin were hacked and Bitcoins stored in accounts on those websites were stolen. Bitcoin itself cannot be hacked as long as the majority of computing power is not controlled by someone or some group trying to attack the network. I’ll try to explain without getting too technical.

All transactions ever made are stored in a distributed public ledger called the blockchain. Everyone who has Bitcoins stored in a wallet on their PC has a copy of that ledger (which also functions as a network node). Every 10 minutes a new block is added to the chain, which cannot be modified without recalculating the block. The network always accepts the largest chain. As long as the majority of computing power is controlled by honest people, the honestly calculated chain will grow faster than and outpace any competing dishonest chain. To modify a past block, an attacker would have recalculate that block and all blocks after it and then catch up with and surpass the blockchain calculated by the honest nodes.

Anyone can run a program on their PC to calculate the next block. To compensate for increasing hardware speed the difficulty of the calculations adjusts itself to the total amount of computing power so that on average a new block is calculated every 10 minutes. Otherwise someone with fast enough hardware would be able to outpace the network and modify the blockchain.

To give you an idea about the computing power you would need to outpace the network: currently the global Bitcoin computing power (almost 7 million GH/s) is 256 times faster than the top 500 supercomputers combined! To have a chance at outpacing the network you would need at least this amount of computing power. The required amount of energy would be more than 100,000 MWh per day, presenting you with a daily electricity bill of $16 million.

In order to send Bitcoin to someone you need their public address and your own private key (which is stored in your wallet) with which the transaction is signed. A transaction is valid only if the signature is correct. So even if someone manages to outpace the network, he cannot change someone else’s transaction without knowing the private key. And since all previous Bitcoins ever produced are already recorded in the blockchain (and cannot be double-spent) that person can only undo a previous transaction he recently made himself. It is not possible to create Bitcoins out of thin air.
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Bitcoin can be used for illicit transactions

So does cash. Illicit transactions are part of the economy. However, the full transparency of the transaction history makes it possible to trace illicit transactions. You can always follow the money, as this guy illustrates by chasing 96,000 Bitcoins stolen from Sheep Marketplace. Bitcoin therefore is not anonymous, but pseudonymous. Once you link a Bitcoin address to your identity by exchanging Bitcoins for another currency or by buying something online you are no longer completely anonymous.
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Bitcoin transactions aren’t reversible

This is correct. Once a transaction is made there is no way to reverse it other than the other party sending you Bitcoins back. In the current system financial institutions act as mediators, which increases transaction costs. The possibility of transaction reversal also increases the risk of fraud, which is calculated into the fees. Merchants carry the biggest risk here, while buyers are overprotected. If goods are ordered with a stolen credit card, the card company will charge-back the payment and the merchant loses both his goods and money. Buyers will always be refunded by the card company if they’re ripped off and can easily get away with charge-back scams. Merchants must be wary of their customers so they require them to provide more personal information then they actually need for the transaction, infringing your privacy. Unlike credit cards which can be stolen, compromised and used for fraudulent charge-backs, Bitcoin doesn’t rely on third parties for security, privacy and trust.

But let’s say you do not trust a certain merchant with whom you haven’t done business before. You can of course use an escrow service, but this means you have to trust a third party with your funds. The Bitcoin protocol supports multi-signature transactions, which means the payment will only be made if more than one person approves. Most common is a 2-of-3 transaction where there is a third party arbitrator. The payment will only be made if 2 of the 3 persons approve the transaction. If the transaction goes smoothly both seller and buyer agree and the payment will be made. If something goes wrong they can both agree to send the funds back to the buyer. If they don’t agree they appeal to the arbitrator who investigates and decides who deserves the funds. The transaction can only be made once and the arbitrator never owns the funds and cannot transfer the funds to himself. The arbitrator will likely charge a fee, but only if a dispute is filed. This means most transactions have no fee and fees are only charged to those who make use of arbitration instead of being spread out evenly among everyone (like credit card fees). Because the transaction requires 2 of 3 signatures, if both parties agree the arbitrator is not doing a good job or charges too much, they can easily transfer the funds to another address and setup a new multi-signature transaction with a new arbitrator. Fraud is much more difficult compared to credit cards, where it is possible for a fraudulent merchant to get away with theft or a fraudulent buyer to get away with a charge-back scam. The money can only be spent once, to the buyer or the seller but not to both, and possible fraud is investigated by a third party before a transaction is made.

Although the Bitcoin protocol supports it, executing multi-signature transactions currently is complex and technical. No Bitcoin program supports it in a user interface yet, but this feature is in development.

Update: Bitrated is now offering a free interface for multi-signature transactions on its website and a marketplace for arbitration services.
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Bitcoin has a deflation problem

Since the supply of Bitcoin is limited it is assumed that the value must keep rising to accommodate a growing economy. I will start describing Bitcoin with the quantity theory of money.

M * V = P * Q

M: Money supply
V: Velocity of money
P: Price level
Q: Quantity of production (GDP)

The deflation argument based on this formula is that if the money supply (M) is fixed and the economy (Q) grows, the price (P) must drop (or the value of Bitcoin must go up). However it is incorrectly assumed that the velocity of money (V) is constant. When the price (P) drops, people will postpone spending and start hoarding, decreasing the velocity (V). The current hoarding is a logical consequence of the expected growth (Q) combined with a limited supply (M) which will continue until the price stabilizes when the Bitcoin economy (Q) reaches a fitting size. By then hoarding won’t be profitable anymore and the velocity will increase. In a mature Bitcoin economy it is not the price level (P) adjusting to growth (Q), but the amount of Bitcoin used in spending (V) adjusting to growth (Q).
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Bitcoin can be used for money laundering

This is another fallacy like the illicit transactions argument. There are many methods for money laundering using both cash and electronic payments. Casinos are used for money laundering and we’re not closing them because of it. Banning Bitcoin because it can be used for illegal activities in spite of its benefits is like banning cars because they can kill people.

However, the possibility for money laundering can be seen as positive as well. It allows evading capital controls, which is one of the reasons Bitcoin is so popular in China. There is enormous wealth in China, but it is very difficult getting it out of the county. Bitcoin facilitates unrestricted world-wide transfer of wealth.
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Bitcoin is a bubble

The Bitcoin price has been soaring lately and in the short term it can indeed be seen as a bubble. However dismissing Bitcoin by saying it is just a bubble you ignore its promising long-term potential, its benefits and how it can disrupt the economy and the current financial system. Of course Western Union will call it a bubble; Bitcoin cannibalizes on their profit. The same goes for central banks who see their control over the economy slip away should Bitcoin become generally accepted.

Bitcoin it still young and when the hype subsides and acceptance grows the price will stabilize. The price will however need to continue to rise in order to reflect the value of the economy it eventually represents, since the total amount of Bitcoins is limited to 21 million. Let’s say the current total value of the Bitcoin economy would equal 5% of the world’s gold reserves, which has a value of $450 billion. Currently 12 million Bitcoins have been produced. The implied value of one Bitcoin would then be $37,500.

A positive aspect of the Bitcoin “bubble” is that the higher market cap enables larger transactions. Moving $1 million worth of Bitcoin is problematic with a market cap of only $10 million. You would be trying to move 10% of the entire market. Good luck finding that much liquidity in a reasonable amount of time. You would also be taking a big risk if you wanted to sell your Bitcoins and there aren’t enough buyers. The current Bitcoin market cap is about $9 billion, so moving $1 million shouldn’t be too problematic. For bigger investors and companies to enter the market though the price must rise to expand the market.
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China has banned Bitcoin

This is not true. The Chinese government has banned financial institutions from using Bitcoin so they won’t get into financial trouble should Bitcoin crash again. It is a risk protection measure for the financial sector, not a discouragement of using Bitcoin. There is no other form of Bitcoin regulation. Trading Bitcoin and using them for transactions is still perfectly legal. Second, China has qualified Bitcoin as a commodity instead of a currency. Because of that Bitcoin can be used for transactions. If Bitcoin was qualified as a currency you would not be allowed to use it for transactions because the Yuan is the only legal currency in China. This is important as it implies support for further development of the Bitcoin economy in China.
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Bitcoin has no real value

First I want to make something clear about real or “intrinsic” value. Government issued, or fiat money (from the latin fiat: “it shall be”) has no intrinsic value since the value is not contained in the money itself. Fiat money has value because the government says so. But it’s intrinsically useless, backed by intrinsically useless government reserves which it can print at will.

So what gives a currency its value if not the government, or the central bank, or legal status? In the end it’s because we all accept it as a means of exchange and we trust the financial system supporting the currency. Bitcoin advocates along with many businesses and organizations have come to realize the Bitcoin network is a superior payment system and Bitcoin has excellent properties as a monetary unit. It is both a medium of exchange and a store of value. This in turn is what gives Bitcoin its value as a currency. It is the market which determines whether Bitcoin has value, not a government declaration. The monetary value however is only one aspect. The underlying blockchain technology has many more potential applications that will give value to Bitcoin and other cryptocurrencies.
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Priceless

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Sources and further reading

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