Bitcoin is an electronic currency based on a piece of software that allows for the collaborative adoption and use of electronic bits of information as money. We have been keeping track of bitcoin since 2009, starting with this post by Michel Bauwens: Bitcoin: new open source P2P e-cash system. In June last year I reported that bitcoin was now available in a public beta release, pointing out a fact that seemed somewhat strange at the time: Bitcoin was going to have no more that 21 million coins in existence – ever. See Bitcoin P2P Cryptocurrency now in public beta.
Considering that rather inflexible limitation of bitcoin issue policy to respect a maximum of 21 million coins, I commented on the currency in this article, expressing my doubt that the currency could live in the real world.
Unfortunately the developer of bitcoin has set a maximum of bitcoins to ever be created, which will make this currency highly deflationary. The more users that will want to use bitcoin, the more they will have to compete for the use of a limited amount of coins. Coins will become worth more and more, meaning less bitcoins will buy more product. Those who will profit from this deflation are going to be the “first come” users, those who created bitcoins when it was still relatively easy.
I believe bitcoin is an interesting proof-of-principle for a user-generated currency, yet it is not a currency that can guarantee price stability. Because of the fixed total amount of coins to be created, the currency cannot be adapted to a growing market.
Others have focused on the rather energy intensive amount of calculations needed to keep track of, and to gradually create, all those 21 million coins. That was reported on here on this site in two articles: A serious problem with BitCoin: it wastes energy and Is Bitcoin a Rube Goldberg machine?
Now Michel has pointed me to Timothy Lee’s blog Bottom-up. Timothy, in two articles, discusses another set of problems with bitcoin. In his first article (The Bitcoin Bubble) Lee questions whether bitcoin has a chance of being adopted over the resistance of established currencies like the US dollar.
The fundamental demand-side problem is that it’s not clear why anyone would want Bitcoins—which are, after all, just entries in a database—in the first place. The obvious retort is that the same objection could be made of any fiat money system. The value of a fiat currency like the dollar is a matter of social convention: it’s valuable to me because other people will accept it as payment for stuff I want to buy. Theoretically, if you persuaded everyone that dollars were worthless, this would become a self-fulfilling prophesy. Conversely (the argument goes) all we have to do to make Bitcoins a “real” currency is to persuade some people that it’s valuable. And apparently, the creators of Bitoin have already succeeded in this task.
But dollars have at least two advantages over Bitcoins. The obvious difference is that the United States government requires taxes to be paid in US dollars. Since federal taxes represent a significant fraction of most peoples’ income, they will continue to demand dollars even if they prefer another currency for day-to-day transactions.
The more subtle difference has to do with network effects and transaction costs. Dollars underpin the American economy in essentially the same way that the TCP/IP protocol underpins the Internet. The original choice of a medium of exchange was arbitrary, but people needed to pick something and once the dollar was chosen it acquired tremendous momentum. Convincing Americans to switch to a currency other than the dollar is roughly as futile as convincing the Internet to switch to a protocol other than TCP/IP, and for the same reasons.
In a second article, Timothy Lee argues that even the limit of 21 million bitcoins ever to be brought into existence, which is a fundamental feature of the currency’s code base, is not as inviolable as it might seem. In Bitcoin’s Collusion Problem, there is a very clear explanation of how the currency works. I am quoting it here as the best short and to-the-point explanation that I have seen so far.
The Bitcoin peer-to-peer network can be thought of as a giant, shared accounting ledger. Whenever someone makes a Bitcoin transaction, the record of this transaction is submitted to the various nodes in the network. At fixed intervals, each node bundles up all the transactions it has seen into a data structure called a “block” and then races with the other nodes to solve a difficult mathematical problem that takes the block as an input. The first node to solve its problem (the problem is randomized in a way that gives each node a roughly equal chance) announces its success to the other nodes. Those nodes verify that all the transactions in the new block follow all the rules of the Bitcoin protocol, and that the solution to the mathematical problem is correct. (verifying solutions is much easier than finding them) Once a winning solution is found, all nodes then treat the transactions encoded in the winning node’s block as new entries in the global transaction register.
The system has a clever incentive system: each node is allowed to insert a fixed reward (currently 50 Bitcoins) for itself into the block it is working on. If it “wins” the race for a round, then this reward becomes part of the official transaction history. Effectively, the winner of each race gets to “mint” some Bitcoins for itself as a reward for participating in the transaction-verification process. The creator of the Bitcoin protocol established an expoentially decreasing schedule of rewards. If this schedule is followed, no more than 21 million Bitcoins will ever be issued.
But that limit – says Lee – is not carved in stone. The users themselves could band together and – spurred on by a desire to make more coins – could split off a large part of the bitcoin ecology from the group running the original program, essentially creating a fork, a bitcoin clone.
The limit is a social convention baked into the BitCoin software. If a rogue node tries to give itself a larger reward than the protocol allows, the other nodes are supposed to reject its proposed block. But that only works if most nodes are enforcing the rules. If Bitcoin became a “real” currency, nodes would face a tremendous temptation to collude in order to give themselves larger rewards.
If a group of nodes colluded to change the rules (say, awarding themselves 100 Bitcoins rather than 50 for “winning” a round), the result would be a “fork” of the Bitcoin network. Nodes that enforced the original rules would reject blocks with the higher rewards, effectively expelling them from their network. The “rogue” nodes would recognize one another’s blocks, and would effectively establish a second, rival Bitcoin network. Theoretically, these different networks could continue in parallel indefinitely, but it’s likely that relatively quickly one of them (probably the larger one) would come to be regarded as the “real” Bitcoin network and cash spent on the other network would become worthless.
So the question is whether it would be possible for a critical mass of nodes to collude to change the rules. And I think the obvious answer to this question is yes, for two reasons…
Well obviously, there is more to an electronic currency capable of replacing our current money system than meets the eye. It will be interesting to see where the bitcoin saga will lead us next, and what other systems may be laying claim to the distinction of having changed the currency landscape forever.