Bitcoins are not digital greenbacks

by lsparrish4 min read19th Apr 2013163 comments


Personal Blog

Should you probably donate a bitcoin to your future self?

Bitcoin has been in the news a bit lately. In case anyone hasn't been following recent events, its price hit $266 per coin, toppled to $50, and then climbed back to a rate which has been between $80 and $140.

This goes to show its high volatility at the present time, which means that any individual trade you make will be something of a gamble with a noisy, hard-to-predict outcome. You could be buying in right before a boom or a bust. Buying and then selling at random intervals will probably cost you more money than you make, due to transaction fees. Trying to outsmart the market in the short term with nothing but your own human instincts and powers of induction will probably cost you even more money because Markets are anti-inductive. The most realistic way of making much money with bitcoin -- sans owning your own exchange, having skill and resources for serious technical analysis, a faster-than-usual trading bot, or fantastic luck -- is if you can determine that the current price is very poorly calibrated relative to its future value, and if you buy and hold very long-term.

Market swings constitute a psychological attack, assuming you know and care about them, so employing the buy-and-hold strategy can be more difficult than it looks. However, as it happens, you can render bitcoins almost purely unspendable (i.e. impossible to transfer via the network) for a finite period of time as a technical matter. You could for example create a brainwallet based on a lengthy memorized passphrase with a random value appended to it. The larger that appended value, the (exponentially) greater the amount of processing time needs to be spent to find out what it contains. Having access to the memorized passphrase gives you the overwhelming advantage over a brute force attacker, whereas the appended random value immunizes it against dictionary attacks. (Todo: Find or write a program for this. Prove it works, and move some of my bitcoin holdings to a wallet requiring a day or more to unlock.)

Early adopters with moderate crypto skills could thus have a distinct advantage compared to the average investor and realistically hope to beat the market on that basis if mere human psychology and resistance against short term panic-selling is the fundamental constraint. So that's one consideration that could play to our advantage. Assuming, that is, that bitcoin is worth taking seriously to begin with, and not just a matter of geeky fun.

The question that matters for that consideration (the one that differentiates long term speculation on bitcoin from various speculative bubbles in gold, real estate, tulips, etc.) is this: Of all the possible worlds, where is the probability mass concentrated with respect to the future of bitcoin, in terms of how it will actually be used? Is there an overwhelming tendency for bitcoin to fail and be replaced by other things (e.g. other cryptocurrencies, or fiat dollars) -- or is it actually likely (in at least the minimal sense of "not overwhelmingly unlikely") to turn into a major store of wealth in coming decades?

I rather think it is the latter. But first, let's consider what I believe to be the strongest argument against it, which unpacks to three parts:

  1. Deflation. Bitcoin will never be more than 21 million coins strong due to the production rate going down by half every 4 years. That implies that it will always deflate, i.e. there will be less available to buy as time goes on.
  2. Volatility. This is the natural result of deflation. As scarcity increases, people buy out of the speculative belief that value will rise forever. They fear to spend because really, who wants to have bought a million dollar pizza? Eventually, when enough of the value is due solely to this belief in future growth, people abruptly begin to sell, and the bubble bursts.
  3. Distrust. Currency requires trust. Volatility decreases trust. If bitcoins continue to be volatile, because of deflation, which is built into the system, it cannot be trusted well enough to compete with more stable currencies -- and will therefore eventually die out.

Taken together, this seems like a pretty good knock-down argument. It apparently implies, as a matter of basic economic law, that some other cryptocurrency must win over it in the long term, and/or that fiat money will retain its dominance. But the thing to notice is that it's not so effective against bitcoin as a massive store of wealth per se, so much as a currency that will be directly used, in a manner directly analogous to how government-backed monetary units are used. Non-currency forms of wealth which serve some other purpose can safely handle quite a bit more volatility, because their value is not dependent on being trusted as a currency, but rather as a value storage mechanism.

Here is the general scenario that I think holds more probability mass than bitcoin-as-a-traditional-currency, and yet works as a fairly realistic alternative to bitcoin-as-a-flop:

  • Bitcoin will fall out of circulation as a currency because of its relative volatility.
  • Nonetheless, alternate currencies will be built into the blockchain.
  • These alternate currencies will be designed for stability, instead of deflation.
  • Mechanisms for trading alternate currencies for bitcoins will be part of the protocol.
  • Rather than a currency, bitcoin plays a role as a scarce, fungible, stabilizing commodity.
  • The ease of turning it into these successful alternate currencies gives it the ability to outcompete traditional options like gold.

Can this be done? Consider the following more specific scenario as an example:

  1. Alice puts 100 bitcoins in a currency wallet denoted "dollars".
  2. Alice withdraws 10,000 of a currency called "dollars" from an associated address.
  3. The network knows that there are 100 times as many dollars as bitcoin, and makes a note of this.
  4. The network will not allow Alice to withdraw bitcoins from the currency wallet until she replaces the dollars.
  5. Bob puts 99 bitcoins in a currency wallet also denoted "dollars"
  6. Bob withdraws 10000 dollars from it.
  7. In the event that Alice replaced her dollars and withdrew her bitcoins quickly, the network recognizes this as valid. But in the event that she did not, the dollar is recognized as having more value and the network will not permit Bob to withdraw that amount unless he has 101 bitcoins in the wallet.

This is just one example I've come up with, and may not be the best. Various other schemes are possible. (For example, it could be possible for any dollar-owner to convert them back to bitcoin, as opposed to the person who originally minted them.) What the various possible models for doing this have in common is that they allow you to set up currencies which dynamically increase and decrease in supply, depending on how much bitcoin people are willing to invest into them, and how badly people want bitcoins back later on.

A competing scenario to the above would be one in which a better-optimized cryptocurrency protocol implements this, or some other stability-prone algorithm and thus outcompetes the volatile, easily manipulated, "primitive" bitcoin protocol in use today. I used to think I could just jump on the bandwagon when this comes around, maybe strategically sell someone a pizza and end up a millionaire.

However, I've somewhat lost faith in that possibility of late because I realized that bitcoin is much more powerful than it seems, and is capable of substantial self-modification if needed for compatibility with a newer and better system. The only thing locking us to the current protocol is the degree to which bitcoin-owning miners find it in their best interests to continue to use it as it is. A competing algorithm that makes bitcoins more valuable without violating existing expectations would probably not be hard to get people to update to.

Another thing that makes me think bitcoin will tend to self-improve to the point of winning against competitors is that at least some people with substantial assets in bitcoin form are likely to be very proactive in defense thereof. Assuming they remain committed to the long game, and are able to acquire sufficient short-term wealth to pursue their goals, they can do a number of things to defend it against the various plausible attacks: Hiring programmers to improve the client software and render it less hackable, hiring lobbyists to protect it against regulatory interference, employing botnets to attack competitor currencies, slowing down or preventing transactions that appear to be going through anonymizing laundries that could be associated with tax-dodging and illegal drugs, and so forth.

So it seems to me like owning at least one bitcoin and holding onto it for long-term purposes is probably a good idea.

Personal Blog