Bitcoin: what is it good for?

by Stubborn Mule on 4 May 2013 · 20 comments

Bitcoin has been a hot topic in the news over the last few weeks.

The digital currency has its adherents. The Winklevoss twins, made famous by the movie Social Network after suing Mark Zuckerberg for allegedly stealing the concept of Facebook, now purportedly own millions of dollars worth of Bitcoins.

It also has its detractors. Paul Krugman has argued that the whole enterprise is misguided. Bitcoin aficionados are, he writes, “misled by the desire to divorce the value of money from the society it serves”.

Still others cannot seem to make up their mind. Digital advocacy group, Electronic Frontier Foundation (EFF) accepted Bitcoin donations for a time, but became uncomfortable with its ambiguous legal status and shady associations, such as with the online black market Silk Road, and decided to stop accepting Bitcoin in 2011. A couple of years on and the EFF’s activism director is speaking at a conference on Bitcoin 2013: The Future of Payments.

Recent media interest has been fuelled by the extraordinary roller-coaster ride that is the Bitcoin price. In early April, online trading saw Bitcoins changing hands for over US$200. At the time of writing, prices are back below US$100. As with many markets, it’s hard to say exactly what is driving the price. Speculators, like the Winklevoss twins, buying Bitcoins will have helped push up prices, while reports that Silk Road has suffered both a deflation-driven collapse in activity and hacking attacks may have contributed to the down-swings.

Bitcoin (USD) prices

Although not obvious on the chart above, dramatic price movements are nothing new for Bitcoin. Switching to a logarithmic scale makes the picture clearer. After all, a $2 fall from a price of $10 is just as significant as a $40 fall from a price of $200. The 60% fall from $230 to $91 over April has certainly been dramatic. But back in June 2011, after reaching peak of almost $30, the price fell by 90% within a few months.

Bitcoin price history (log scale)

The volatility of Bitcoin prices is orders of magnitude higher than traditional currencies. Since the start of the year the price of gold has been tumbling, with a consequent spike in its price volatility. Even so, Bitcoin’s volatility is almost ten times higher. The chart below compares the volatilities of Bitcoin, gold and the Australian dollar (AUD).

Historical volatility of Bitcoin

A week or so ago, armed with this data, I was well advanced in my plans for a blog post taking Bitcoin as the basis for a reflection on the nature of money. I would start with some of the traditional, text-book characteristics of money. A medium of exchange? Bitcoin ticks this box, with a growing range of online businesses accepting payment in Bitcoin (including WordPress, so not just underground drug sites). A store of value? That’s more dubious, given the extremely high volatility. It may appeal to speculators, but with daily volatility of around 15%, it’s hard to argue that it is a low risk place to park your cash. A unit of account? Again, the volatility gets in the way.

That was the plan, until a conversation with a colleague propelled me in a different direction.

She asked me what this whole Bitcoin business was all about. Breezily, I claimed to know all about it, having first written about Bitcoin two years ago and then again a year later. I launched into a description of the cryptographic basis for the operation of Bitcoin and went on to talk about its extreme volatility.

I then remarked that when I first wrote about it, it was only worth about $1, but had since risen to over $200.

“So,” she asked, “did you buy any back then?”

That shut me up for a moment.

Of course I hadn’t bought any. What gave me pause was not that I had missed an investment opportunity that would have returned 20,000%, but that I was so caught up in the theory of Bitcoin that it had not occurred to me to see what transacting in Bitcoin was actually like in practice. So I resolved to buy some.

This turned out not to be so easy. While there are many Bitcoin exchanges, paying for Bitcoins means jumping through a few hoops. Perhaps because the whole philosophy of Bitcoin is to bypass the traditional banking system. Perhaps because banks don’t like the look of most of them and will not provide them with credit card services. Whatever the reason, your typical Bitcoin exchange will not accept credit card payments. Many insist on copies of a passport or driver’s licence before allowing wire transactions, neither of which I would be prepared to provide.

Eventually I found BitInnovate, which allows the purchase of Bitcoin through Australian bank branches. Even so, the process was an elaborate one. After placing an order on the site, payment must be made in person (no online transfers), in cash, at a branch within four hours of placing the order. If payment is not made, the order is cancelled. Elaborate, but manageable, and no identification is required.

But before I could proceed, I had to set myself up with a Bitcoin wallet. As a novice, I chose the standard Bitcoin-Qt application. I downloaded and installed the software, and then it began to “synchronise transactions”. This gets to the heart of how bitcoins work. As a purely digital currency, they are based on “public key cryptography”, which is also the basis for all electronic commerce across the internet. The way I make a Bitcoin payment to, say, Bob is to electronically sign it over to him using my secret “private key”. Anyone with access to my “public key” can then verify that the Bitcoin now belongs to Bob not me. Likewise, the way I get a Bitcoin in the first place is to have it signed over to me from someone else. In case you are wondering what one of these Bitcoin public keys looks like, mine is 1Q31t2vdeC8XFdbTc2J26EsrPrsL1DKfzr. Feel free to make Bitcoin donations to the Mule using that code!

In this way, rather than relying on a trusted third party (such as a bank), to keep track of transactions, the ownership of every one of the approximately 11 million Bitcoins is established by the historical trail of transactions going back to when each one was first “mined”. Actually, it’s worse than that, because Bitcoin transactions can involve fractions of a Bitcoin as well.

So, when my Bitcoin wallet told me it needed to “synchronise transactions”, what it meant was that it was about to download a history of every single Bitcoin transaction ever. No problem, I thought. Two days and 9 gigabytes (!) later, I was ready for action. Now I could have avoided this huge download by using an online Bitcoin wallet instead, but then I would have been back to trusting a third party, which rather defeats the purpose.

The cryptographic transaction trail may be the brilliant insight that makes Bitcoin work and I knew all about in it theory. But in practice, it may well also be Bitcoin’s fatal flaw. Today, a new wallet will download around 10 gigabytes of data to get started, and that figure will only grow over time. The more successful Bitcoin is, the higher the barrier to entry for new users will become. I suspect that means Bitcoin will either fail completely or simply remain a niche novelty.

Still, it is an interesting novelty, and despite the challenges, I decided to continue with my investigations and managed to buy a couple of Bitcoins. The seller’s commission was $20 and falling prices have since cost me another $20 or so. So, I am down on the deal, but, as I have been telling myself, I bought these Bitcoins on scientific rather than investment grounds.

Of course, if the price goes for another run, I reserve the right to change my explanation.

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{ 18 comments… read them below or add one }

1 Danny Yee May 5, 2013 at 12:37 am

10 gigabytes, holy moly! I was expecting some overheads here, but that’s really a bit excessive. How are retail Point of Sale applications running over old modems supposed to handle bitcoin transactions?

2 Stubborn Mule May 5, 2013 at 8:06 am

@Danny for the forseeable future, I believe all PoS applications will continue to be provided by banks, or other trusted 3rd parties. Under that scenario it is conceivable to get Bitcoin (or something similar) working at the shopfront: the 3rd party would maintain all the transaction history and the shopfront merchant’s PoS is just authenticating itself to the 3rd party and providing the specific transaction information. Still, I would be surprised to see Bitcoin arriving at a bricks and mortar retailer near me.

3 Mark L May 5, 2013 at 9:19 am

I think the distinction between trust in a third-party globally and many Bitcoin owners trusting many third-parties locally is important here. Yes, if I don’t trust anyone, I’ll need to synchronise myself and deal with the data transmission. But perhaps I’m willing to trust someone close by to do this part for me. If so, the data transmission issue can be postponed much longer than otherwise. Technology improvements will also postpone it.
Of course, eventually the data will be so big, no-one can handle it. Before that point, Bitcoin will have to come up with a way of destroying Bitcoins as part of the mining process for Bitcoin 2.0.

4 Stubborn Mule May 5, 2013 at 11:17 am

@Mark I agree. I would, however, distinguish between trusting a 3rd party for merchant services and trusting a 3rd party to provide wallet services.

Both services already exist today. BitPay is an example of the former, Blockchain an example of the latter.

In the case of a merchant service provider, just like banks do today, the service provider maintains an account on your behalf and, while you can accept Bitcoin, you may have your account immediately credited with, say, AUD. Whether at a shopfront or online, you are still taking the transactions and using the service provider to manage the back-end.

Online wallet providers, on the other hand, have your secret key and anyone could be making payments to your account, which the provider siphons off, without you being aware of what is going on. While these services may all be quite trustworthy, it feels like a more significant level of trust is required.

@Danny I double-checked and realised I exaggerated slightly: my Bitcoin wallet has actually swollen to 8.9G not 10G.

5 Stubborn Mule May 5, 2013 at 11:19 am

@Mark and I suppose my point is that I believe a significant number of true Bitcoin believers will never trust a 3rd party to host their wallet. When you visit the “official” Bitcoin wallet information page, there are warnings about all of the web wallets. I suspect that will put many people off.

6 Stubborn Mule May 5, 2013 at 11:22 am

@Mark, I should add that I have some sympathy with Krugman’s view. Money is a social construction and the idea that one can ever have a fully functional form of money that does not involve some form of trust among a social group or network (whether that be a state or some looser coalition) is a pipe dream.

7 zebra May 5, 2013 at 11:50 am

Mule – I suspect that the difficulty in arranging transactions is a deliberate attempt to put off online credit card fraudsters. Anything which can be bought with a credit card and then exchanged for cash or something easily sold online is bound to be a magnet. Especially as the transactions are untraceable. I noticed something similar recently buying US iTunes cards online – it seemed to be unnecessarily complicated, the maximum amount was limited and I was barred from one site for doing nothing more than trying to buy with two different cards. Even when I did manage to do it it took several days.

8 dan May 6, 2013 at 10:05 am

As long as Bitcoin has that amazing volatility, I reckon all its good for stimulating blogposts, podcasts, and the occasional wet dream for econogeeks and technowonks.

Nobody can use a currency where its value is so uncertain.

I can recommend this: http://www.npr.org/blogs/money/2013/04/09/176688096/episode-450-bitcoin-goes-to-the-moon

And I think Henry Blodget called it right, when he said that Bitcoins are the “perfect bubble”: http://au.businessinsider.com/bitcoin-is-the-perfect-bubble-2013-4

See also: http://au.businessinsider.com/why-bitcoin-speculators-laugh-at-anyone-who-calls-it-a-bubble-2013-4

9 Stubborn Mule May 6, 2013 at 9:17 pm

@dan all good grist to the Bitcoin mill! It’s fascinating, but as you say, with that level of volatility it simply can’t be useful. Either the volatility will have to reduce or Bitcoin will only exist as a novelty if at all.

10 Stubborn Mule May 7, 2013 at 2:56 pm

Now it seems that the global head “emerging payments” at MasterCard has dismissed Bitcoin as a fad for geeks.

11 Simon Rumble May 7, 2013 at 5:50 pm

I’m sure the gigabytes problem will be resolved. Perhaps the ledger can be checkpointed. The volatility is an issue but there are already merchant services that will immediately cash out a BTC transaction to fiat and automatically translate prices.

Volatility also makes for some interesting algorithmic trading options. I’m currently playing with Goxtool doing a balancing strategy to slowly build some coin from volatility.

Oh and a small tip in your wallet if you wanna fire up the client.

12 Danny Yee May 7, 2013 at 6:55 pm

So, looking at my personal sample of bitcoin users, use is driven largely by geek curiosity… Can we build a currency out of that?

13 Dan May 7, 2013 at 7:35 pm

Sure you can build a currency out of geek curiosity: http://www.dandwiki.com/wiki/SRD3e:Money

But even in a world of dodecahedral dice currency and valuation are problematic: http://www.svincent.com/MagicJar/Economics/GenericCurrency.html

14 Stubborn Mule May 7, 2013 at 8:06 pm

@Simon. You might be right about checkpointing…although I am not sure how agreement to make the change would be reached.

I hadn’t come across Goxtool before. Looks interesting. What payment mechanism have you used to settle with Mtgox?

Fired up my wallet, but didn’t find a tip: did you use 1Q31t2vdeC8XFdbTc2J26EsrPrsL1DKfzr

15 Stubborn Mule May 7, 2013 at 10:37 pm

The FT has reported that the CFTC is considering regulating Bitcoin. Exchanges may be treated as “money service businesses” and be subject to controls to restrict money laundering.

16 Simon Rumble May 9, 2013 at 6:25 am

@Mule I use Technocash to pay Mt Gox. Their fee isn’t brilliant but then I can exchange at a rate of my choosing.

Tip will probably take a bit to get there. I didn’t include a mining fee and on small transactions that can take a long time to get confirmed.

Re “money service businesses”, I believe the only official statement in Australia was something along the lines of no regulation of digital currencies unless the currency is backed by precious metals. (See http://www.smh.com.au/it-pro/business-it/paypal-eyes-bitcoins-disruptive-potential-20130501-2isa4.html ). That will change as it starts getting used more.

A critical use case is cross-border transactions like guest worker remittances. Western Union and Paypal have enormous fees, huge spreads on cross-currency rates and a terrible reputation for freezing funds. If BTC-local currency can be sorted, it will be very attractive in that space. I wonder if Hawala dealers are already using it to balance their ledgers?

17 Chris Vernon November 19, 2013 at 2:57 pm

I hope you’ve kept your BitCoins Mr Mule! What do you think of today’s events and Bernanke’s words? Fascinating stuff.

18 Stubborn Mule November 19, 2013 at 10:47 pm

I think Bernanke was quoting Blinder rather than making the statement himself. Still, amazing prices! I have sold enough of my (small) Bitcoin holding to get back the money I put in and will leave the rest in for what will probably be a bumpy ride.

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