Monday, December 16, 2013

The Case for Bitcoin

I have taken an interest in bitcoin for several years now and when I first starting looking into it, pretty much no one else had heard of the digital currency and it was hard to find any useful information about it. So I got myself a bitcoin wallet and started to play with it.

Recently I've seen a great deal of ill-informed commentary on the subject such as this article by Louis Cammarosano that was linked on Peter Creswell’s blog. While Peter posted this response from guest blogger Paul Van Dinther, I don’t think the response goes nearly far enough in addressing the issues that have been raised, so I’ve decided to do my own post on the subject to destroy some of the myths that are surrounding bitcoin.

Bitcoin is a digital currency, not a payment service like PayPal. A currency is an artificial store of value. A currency can be based on a physical commodity, like gold, but even where this is the case the currency itself is artificial. Currencies do not have to be based on physical commodities and, in fact, almost all currencies in the world today are what is known as “fiat” currencies, meaning they are backed by law rather than by any physical commodity.

Bitcoin, you might be surprised to hear, is a commodity-based currency. What is the commodity that it is based on? Well, this is where things get a little complicated. It is based on a digital commodity that is the result of a complex computation. Like any physical commodity such as gold, the digital commodity requires physical effort to extract it. The physical effort in this case is the computing power required to calculate the next unique number in a sequence that is a bitcoin. One of the reasons that bitcoins are increasing in value is that new coins are getting harder to extract. In 2009 a bitcoin could be “mined” using a personal computer in about two weeks. Now it takes about a year and a half. This is because there will only ever be 21 million bitcoins and more than half of them have already been found.

The beauty of bitcoin is in that complex computation or algorithm that reveals the next coin. The algorithm is a cryptographic formula and, like most cryptography, it is extremely difficult to calculate one way but very easy to validate the outcome of the calculation the other way. Think of multiplying two prime numbers together - even two relatively large primes are quite easy to multiply especially if you have a calculator, but it is very difficult to do the reverse – factorising a very large product. Because it uses a cryptographic algorithm, bitcoin satisfies two security requirements - it is very difficult to hack (i.e. forge a valid bitcoin) and very easy for anyone to check whether any one bitcoin is valid. I won’t go into the details of how the algorithm actually works but it is sufficient to say that the worldwide network of bitcoin wallets effectively “votes” on which is the next valid coin in the sequence. You can probably forge a bitcoin if you knew what you were doing but within an hour of spending it (the time taken for a bitcoin to propagate to nearly every wallet in the world), everyone would know it was fraudulent.

But what if you were able to hack the algorithm itself so that your fraudulent coins were always recognised as the valid ones? That is possible, but over the several years that have passed since bitcoin was invented by the pseudonymous Satoshi Nakamoto, the collective minds of the world’s greatest hackers and, more importantly, some of the world’s leading mathematicians have not been able to reverse engineer the problem. 

So let’s examine each of the arguments that Louis Cammarosano makes against the digital currency. He claims that bitcoin has no intrinsic value but, as Paul Van Dinther points out, neither substantially does gold. The latter is worth what it is because of its rarity and the effort of mining it, not because it has some limited industrial uses in electronic circuits and to coat visors.

Cammarosano’s next argument against bitcoin is his contempt for “early adopter smugness”, a fairly hypocritical objection from someone who calls bitcoin a “faith-based/emotion backed currency”. He says you must believe in bitcoin in order to ascribe value to it. He admits the same applies to the US Dollar and all other fiat currencies. But, as I have said above, bitcoin is actually a commodity-based currency and its value is dependent on the rarity of the commodity, and this puts it above the US Dollar and all other major Western currencies.

He says it is “not really anonymous” because you can trace the trades through the physical delivery of goods that are purchased. Yes, of course you can as the founder of the drugs trading site, Silk Road, recently discovered. Bitcoin is certainly more anonymous than US Dollars and other mainstream currency transactions that must now be declared to the US government under its nefarious FATCA law (of which I have recently blogged).

He says bitcoins are “not limited in supply” because the 21 million bitcoins can be subdivided infinitely. This means that bitcoin can endlessly deflate and can still be used to purchase small value items, and actually this is a highly desirable attribute of a currency and one that we haven’t seen in Western currencies since they were gold-based in the early 20th century.

He says there is “no customer service if something goes wrong,” unlike “PayPal, Visa, MasterCard, and AMEX services that will refund their users’ money if a transaction goes wrong.” But of course his examples are not currencies but rather payment services, and good luck to you getting your value back when the US Dollar tanks as it is soon to do. And he is wrong on the point that bitcoin holdings are uninsurable.

Finally, he says bitcoins can be stolen or lost or even manipulated in value. He is correct in that the coins are only as secure as the digital wallet they are kept in and that big players like governments could manipulate the market value of bitcoins. But is he seriously saying that these attributes don’t apply to every other currency in the world?

In conclusion, the only risk I see with bitcoin is that the algorithm might be broken, but this gets less likely the longer it exists unbroken and while I am not totally convinced it will remain forever impregnable (e.g. who knows what quantum computers could do?), I think bitcoin is already a viable alternative to the fiat currencies of thieving governments who continually debase their value. 


Syndrum said...

Great post! I've been heavily into Bitcoins for quite some months now but commodity-base explanation put things into a useful perspective.

One point: I'm assuming it's possible to adjust the code to later on if necessary, but as far as I'm aware bitcoins currently can only be subdivided into 8 decimal points. That would create a limited supply.

Kiwiwit said...

Yes, I understand that is a limitation of the current wallets, not the bitcoin algorithm itself.