A comprehensive critique of the weaknesses of Bitcoin

Sebastiano Scròfina (republished from Quora):

“Bitcoin has many advantages over the traditional currency system but it is undermined by two major security weaknesses that make it technically unreliable on the long run, and by at least three major economic weak points that will prevent it from ever becoming a real currency.

At Kakigarden we’re developing a solution that is immune from those issues, and in our opinion some important things to improve are:

1) Majority attacks

As I outlined in 2010 answering How can Bitcoin be hacked?, Bitcoin can indeed be hacked. It’s a beautiful concept but it’s not secure. It can be exploited, which means it will. It’s just a matter of time.

2) Social attacks

The scarcity of Bitcoin is not a real, hardcore scarcity such as the scarcity of gold or platinum. It’s just defined in some lines of code. Those lines can be changed, Bitcoin can indeed be inflated and loose all of its appeal. There is a variety of ways in which this can happen in practice. More scarily, there is hardcore economic evidence that doing so would actually benefit Bitcoin as a currency (see below). Again, if it can, it will. It’s just a matter of time.

3) Still centralized, not really P2P

Bitcoin is not really P2P. The amount of currency is decided by a central authority (the community), while the truth is defined by what 50%+1 of the nodes believe to be the truthful block chain. As always with centralization, these two weak points are also the easiest single points of failures to exploit.

4) Deflation and liquidity trap

In economics, a liquidity trap happens when people are unwilling to invest and keen to keep their assets “under the pillow”. That’s exactly the trap Bitcoin is falling in and will fall in. It was actually designed for it. Bitcoin is a deflationary currency, which means it’s worth more and more as time goes by. Sounds good ? It did to the developers, but it actually isn’t. In Gresham’s terms Bitcoin is good money, while inflated central banks’ money is a bad one. What would you spend first ? The bad money, because you want to get rid of it, and keep the good one for yourself. The only exception to this are illegal businesses who don’t have any alternative to Bitcoin, or people where central banks have failed or are failing (as Somaliland or Zimbabwe). This means that, with the aforementioned exceptions, Bitcoin is not actually a currency as it appears to be, but rather a digital store of value that can be used as a currency.

5) Government intervention

As soon as the US government will rule against Bitcoin, which could happen sooner than we think, all US businesses will be forced not to accept Bitcoin. Maybe even running the client could be deemed illegal. This will trigger drops in BTC value because the expectations for Bitcoin as a currency will drop. As other governments will follow, as it already happened with Napster and file sharing, the use of Bitcoin will be more and more restricted to criminals and illegal activities, and people where central banks have failed or are failing (as Somaliland or Zimbabwe).

6) No lock-in

As soon as a better p2p currency comes along, people can sell their BTCs and jump on the other system. This means that as soon as a better alternative comes along, there will be an incentive to be the first to abandon Bitcoin, while the last ones will be heavily penalized: they’ll have to sell their Bitcoins for a fraction of the price they bought them at. Think of bank runs: what happens usually is that the bank closes until panic has stopped. Here there’s no bank, so what’s gonna happen when the run starts ? If you own Bitcoins, keep your eyes open.

7) Lack of intrinsic value

The current value of BTCs is artificial. Bitcoin is in a bubble because more than 90% of people who buy BTCs with USD or other currencies are speculators. They don’t buy Bitcoins because they need them, but because they expect somebody will need them in future. And you know what ? This is very risky, because Bitcoin has no intrinsic value. This means that as soon as it is hacked, or government intervenes, or a better alternative comes along, the value of Bitcoins can drop to zero. Yes, that’s right: zero. That’s the intrinsic value of a digital signature. Gold has an intrinsic value: it’s needed for a lot of real uses, which guarantees you that however bad the gold market goes, you’ll never loose everything. Bitcoin doesn’t.

8) Friction

You can’t buy Bitcoins with Paypal. You can’t convert Bitcoins to Paypal. The value of Bitcoin fluctuates enormously every day. All this means there is friction for the average person and the average business to use Bitcoins as a currency instead of the dollar. Again, only who’s got no alternatives is really driven to use Bitcoin (see above).

9) Speculation

Remember how George Soros broke the British Pound ? Currencies don’t belong only to the domain of economics, but also to that one of politics. And that’s why central banks have policies. If a speculator like Soros comes along with their massive buying power, they can start to use their power to do politics on the Bitcoin community, and there’s no Bitcoin authority that can react. For example, a speculator can enter slowly in a massive quantity, and then sell enough and fast enough to trigger panic in the community and push Bitcoin owners to panic sell (something similar already happened in Bitcoin’s “black friday” on June 10th). Such attack could be politically motivated, or financially (to buy after the price drop). Who knows ? Who cares ? Bitcoin has no protection against those types of attacks. And remember: this can happen with any commodity or precious metal, but they do have intrinsic value at least. Bitcoin doesn’t have the safety net of real goods, nor the one of fiat currencies.

10) Anonymity

Bitcoin is not anonymous. As one of the lead developers already pointed out, it’s fairly easy to track people down unless they don’t take extreme precautions.

11) Speed

Transactions take minutes, or even hours, to be confirmed. Given it’s electronic and not physical, this slowness is a bit of a paradox.

12) Fractional reserve

Bitcoin doesn’t stop middlemen from practicing fractional reserve banking, thus inflating the currency at their own benefit. In fact, this is probably what will happen and what could partly relieve its deflationary nature.

This is the tip of the iceberg. There is much more to the future p2p currencies (objective value vs subjective value, scarcity vs abundance, etc), but I feel this is a concise enough answer to the question, specifically focused on Bitcoin’s immediate weaknesses rather than what the mid-term future of currency might look like.

In conclusion:

As I said, think of Bitcoin as the Napster of central banking and banking as we’ve known them. Bitcoin represents probably just 1% of the coming currency revolution. The future p2p currencies will have to solve Bitcoin’s technical and economical flaws, and totally redefine economics. Contrary to what most economists (from Mill to Schumpeter) believe, currency is not a neutral veil, but indeed the very matrix of how we interact, trade and live as a species. As every language influences the way one thinks, currency influences the way one behaves. Mainstream currency is the most powerful and spoken language on our planet, and in the next decade it’s going to be totally redefined by the Internet. The next generation will have a hard time trying to understand what economics was to us.”

5 Comments A comprehensive critique of the weaknesses of Bitcoin

  1. AvatarZbigniew Lukasiak

    I came to a similar conclusion – but for me the lethal attribute of the bitcoin system is its wastefulness. It burns a lot of electricity for timestamping transactions to prevent double spending. By my, very crude, estimates this is currently about half a million dollars a month worth of electricity (http://forum.bitcoin.org/index.php?topic=28780.0) – and it will need to grow in proportion with the total market cap of the bitcoin economy – because this is what defines the security strength of the system (this is an arms race situation).

    With a central server this could be done with trivial computing cost but this would obviously make the system vulnerable to attacks on that central server. I am convinced that there can be a compromise solution – but this is just an intuition.

    By the way:

    ad 7 – Every money is a kind of bubble – people accept it not because they need it’s intrinsic value – but rather because they expect other people to also accept it. This could be the definition of money. Nick Szabo’s ‘Shelling out’ essay (http://szabo.best.vwh.net/shell.html) is where I found this thought well crystallized after reading similar intuitions at the bitcoin forum.

    ad 9 – All this relies on people ‘panicking’ – but maybe people can just learn not to do that? Solving this problem by pure market forces is one of the novelties bitcoin brings – this is what would make it an interesting experiment if it worked in a longer term.

  2. AvatarAmin

    1) At this point an attack is for all practical purposes impossible. The bitcoin network has significantly more hashing power than the fastest 500 supercomputers combined. This means that only a very few parties are even theoretically capable of mustering the resources to take over the network, and that number decreases every month.

    2) Social attacks could never succeed in destroying bitcoin because those who don’t agree with the protocol change will simply not download the altered software, thus ensuring the continuation of the 21 million capped bitcoin protocol.

    3) Bitcoin is completely decentralized in that no node is a permanent or vital element of the network. That 50%+ of the hashing power defines the truthful block tells us nothing about how that hashing power is distributed and thus is not relevant to the question of whether the currency is centralized.

    4) Deflation leading to a liquidity trap is self-correcting in a free market, as lower spending leads to less use as a currency, which leads to the value dropping and the currency coming out of deflation.

    That is why gold was used for so long in trade despite being deflationary, and only ceased being used when governments began penalizing its use in numerous ways (e.g. levying a capital gains tax value on its appreciation versus inflationary national currency, requiring taxes be payable in national currency, limiting subsidies like deposit insurance to the national currency).

    5) The government cannot ban bitcoin without shutting down the internet. It’s peer-to-peer.

    6) Bitcoin has a huge first mover advantage. Another p2p currency will likely have no significant advantage to bitcoin, and will have none of the existing branding and merchant/software base.

    7) No digital currency can have intrinsic value, but where gold has intrinsic value, digital currency can be sent across the world instantly.

    8) Bitcoin’s use and value has increased despite the friction, and the friction is decreasing with time as new exchanges open up .

    9) Speculators cannot attack the value of assets, they can only anticipate it. George Soros didn’t break the Bank of England, he correctly predicted the Bank of England wouldn’t be able to maintain the peg. Any speculator that attempts to move the market is risking losing enormous amounts of money. In fact, trying to move the market from where it naturally belongs is how the Bank of England lost so much money to Soros and other speculators who correctly bet on its price settling at its natural, below-peg, value.

    10) A digital currency existing on a peer-to-peer network cannot be wholly anonymous. Pseudonymity is the most anonymity it can give.

    11) The speed can be sped up through third party processors, and in any case, transactions can be assumed to be safe instantly with very low risk of them not confirming, due to the enormous cost and planning that a fraudster would have to go through to pull off a double spend.

    12) Fractional reserve lending will not inflate the supply of bitcoins because there is no lender of last resort, with the ability to create money, that mitigates the risks for fractional reserve lenders. This makes it like the gold standard era, where those who engaged in fractional reserve lending were subject to bank runs, which kept the money supply limited.

    Bitcoin is nothing like Napster. Napster had a central server that the government shut down. Bitcoin is a pure p2p currency.

  3. Avatarjaromil

    Not well informed, but nice try.

    Lacks references and broader knowledge of less known p2p currencies. Flaws in BTC are known indeed.

    I srsly doubt you can be the one providing a better design, stay humble and keep an eye on the CCC. Hacker communities will write this chapter in history.

    ciao

  4. Avatartom pooler

    The Arabic community tried a similar initiative with a virtual Dinar exchange. That community might have some lessons to pass on to the P2P effort. I believe the virtual gold based Dinar was an initiative some 8 or 9 years ago.

  5. Avatarsebastiano scròfina

    @Zbigniew
    I agree, it’s unfortunate that a lot of electricity is being wasted in this process.

    @Jaromil
    I love the inspiration behind of Bitcoin, and I believe we need not one but a wealth of solutions to address the money issue. I’m doing my best in this regard, and I see from you’re website that you’re doing it, too. Committed people like you are what’s needed, I believe.

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