I’m with Felix

by Stubborn Mule on 16 February 2014 · 4 comments

FT blogger Felix Salmon and venture capitalist Ben Horowitz have very different views of the future of Bitcoin. Salmon is a skeptic, while Horowitz is a believer. A couple of weeks ago on Planet Money they agreed to test their differences with a wager.

Rather than a simple bet on the value of Bitcoin, the bet centres of whether or not Bitcoin will move beyond its current status, as a speculative curiosity, to serve as a genuine basis for online transactions. The test for the bet will be a survey of listeners in five years’ time. If  10% or more of listeners are using Bitcoin for transactions, Horowitz wins. If not, Salmon wins. The winner will receive a nice pair of alpaca socks.

I have been fascinated by Bitcoin for some time now and have a very modest holding of 1.6 Bitcoin. Nevertheless, I believe that Felix is on the right side of the bet. I have no doubt that the technological innovation of Bitcoin will inform the future of digital commerce, but Bitcoin itself will not become a mainstream medium of exchange.

Volatility

Only days after the podcast, the price of Bitcoin tumbled as MtGox, the largest Bitcoin exchange in the world, suspended Bitcoin withdrawals due to software security problems. Sadly, this means my own little Bitcoin investment halved in value. It also highlights how much of a roller-coaster ride the Bitcoin price is on. As long as Bitcoin remains this volatile, it cannot become a serious candidate for ecommerce. It is just too risky for both buyers and sellers. Horowitz acknowledges that the Bitcoin market is currently driven by speculators, but is confident that the price will eventually stabilise. I doubt this. Even during its most stable periods, the volatility of Bitcoin prices is far higher than traditional currencies, and has been throughout its five year history.

Bitcoin drop

The Ledger

One of the key innovations of Bitcoin is its distributed ledger. Everyone installing the Bitcoin wallet software ends up downloading a copy of this ledger, which contains a record of every single Bitcoin transaction. Ever. As a result, there is no need for a central authority keeping tabs on who owns which Bitcoin and who has made a payment to whom. Instead, every Bitcoin user serves as a node in a large peer-to-peer network which collectively maintains the integrity of this master transaction ledger. This ledger solves one of the key problems with digital currencies: it ensures that I cannot create money by creating copies of my own Bitcoin. The power of the ledger does come at a cost. It is big! On my computer, the ledger file is now almost 12 gigabytes. For a new Bitcoin user, this means that getting started will be a slow process, and will make a dent in your monthly data usage. A popular way around this problem is to outsource management of the ledger to an online Bitcoin wallet provider, but that leads to the next problem.

Trust Problems

A big part of the appeal of Bitcoin to the more libertarian-minded is that you no longer have to place trust in banks, government or other institutions to participate in online commerce. In theory, at least. If you decide to use an online Bitcoin wallet service to avoid the problem of the large ledger, you have to trust both the integrity and the security capability of the service provider. The hacking of inputs.io shows that this trust may well be misplaced. Even if you have the patience and bandwidth to maintain your own wallet, trust is required when buying or selling Bitcoin for traditional currency. There are many small Bitcoin brokers who will buy and sell Bitcoin, but invariably you have to pay them money before they give you Bitcoin, or give them Bitcoin before you get your money. Perhaps the big exchanges, like MtGox, should be easier to trust because their scale means they have more invested in their reputation. But they are not household names, the way Visa, Mastercard or the major banks are. Growth of commerce on the internet has been built on trust in the names providing the transactions more than trust in the technology, which most people don’t understand. I would be very surprised to see the same level of trust being established in the Bitcoin ecosystem, unless major financial institutions begin to participate.

The Authorities

But will banks jump onto the Bitcoin train? I doubt it. Not because they are afraid of the threat to their oligopoly—most bankers still only have the vaguest idea of exactly what Bitcoin is, or how it works. What they do know is that virtual currencies are attractive to criminals and money launderers. Last year saw the FBI crackdown on Liberty Reserve, followed by the crackdown on the underground black-market site Silk Road. More recently, the CEO of one of the better-known Bitcoin exchanges was arrested for money-laundering. In the years since September 11, the regulatory obligations on banks to ensure they do not facilitate money laundering have grown enormously. The anonymity of Bitcoin makes it hard for banks to “know their customer” if they deal with Bitcoin and as law-enforcement increases its focus on virtual currencies, providing banking services to Bitcoin brokers becomes less appealing for banks. When I bought my Bitcoin last year, I used the Australian broker BitInnovate. For several months now, their Bitcoin buying and selling services have been suspended and, I’m only guessing, this may be because their bank closed down their accounts. To become a widely-accepted basis for commerce, Bitcoin will necessarily have to interface effectively with the traditional financial system. At the moment, the prospects for this don’t look good.

For these reasons, I think Felix has a safe bet, and can look forward to cosy feet in alpaca socks. But, even if Bitcoin does not become widely accepted, its technological innovations may well revolutionise commerce anyway. Banks around the world can adopt ideas like distributed ledgers and cryptographically secure, irrevocable transactions to make the mainstream global payments system more efficient.

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{ 4 comments… read them below or add one }

1 MarkL February 16, 2014 at 9:34 pm

I’m with Felix too. The energy costs of Bitcoin mining guarantee severe deflation if circulation keeps growing: http://spectrum.ieee.org/computing/networks/bitcoins-computing-crisis
Cheers,
Mark

2 Ramanan February 17, 2014 at 9:36 am
3 zebra February 17, 2014 at 12:47 pm

Given how myself, and everyone else in the bank I work for, has to be recertified annually for the “know your customer” compliance training, to detect and prevent fraud and money laudering, I can’t see how any regular financial instituion could legally undertake transactions which involved bitcoins as a currency. I don’t even “meet a customer” let alone get to know them.

4 ᙇᓐ M. Edward Borasky (@znmeb) February 17, 2014 at 1:19 pm

Horowitz (and Andreessen) are not “believers”. They are *investors*, specifically, venture capitalists who have invested in Coinbase, a startup active in Bitcoin services. Their “belief” amounts to advocacy for Coinbase, marketing for Coinbase and presumably advising the founders. They win (and win big) if Coinbase wins. Belief has nothing to do with it – they’ve closed a deal and are doing everything they can to assure Coinbase wins, including betting alpaca socks with “skeptical” members of the press.

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