By Tim Hardy
You cannot talk meaningfully about bitcoin unless you understand that when we talk about it we are in fact talking about two different things.
Very crudely, bitcoin is both a unit (which may be money) and a networked platform controlling and tracking the movement of those units.
Most people just focus on the electronic money aspect but bitcoin is first and more interestingly a platform. It is a peer-to-peer network with no central authority. It is governed by protocols encoded in the reference implementation of the software and these protocols are maintained by the consensus of all of its participants. Bitcoin acts as a distributed notarisation system and participants collectively maintain a cryptographically verifiable, auditable public record of contracts of ownership known as the blockchain. At present, those contracts of ownership are almost exclusively for the units known as bitcoins but they can potentially be for more than this.
One bitcoin (XBT) acts as a fungible, verifiably countable, divisible, durable, rare and transferable unit. By design, it has the potential to act as a medium of exchange and as a store of value. Without needing the involvement of an institutional actor like a bank, the bitcoin network itself validates transactions and prevents double spending. If Alice has 1 XBT that she uses to pay Bob for web design services she cannot then pay Carol the same 1 XBT for marketing costs. People hope that bitcoins can exist as a means of payment that is outside the formal banking system and which free floats against traditional money and is not backed by anything. So far, it has proved very successful as a currency in the shadow economy. Extreme volatility however is the biggest threat to more widespread acceptance. At present, buying and selling bitcoins carries significant risk with no guarantees or protection if anything goes wrong. Extreme volatility is a function of illiquid markets so it is possible that the problem will be solved naturally with time if the exchanges mature.
Bitcoin relies on public key crytography and uses the Elliptic Curve Digital Signature Algorithm (ECDSA) both to create bitcoin addresses and to validate transfers between bitcoin addresses in transactions. The act of validating these cryptographic signatures and appending confirmed transaction records to the blockchain in a record known as a block is known as mining. By design, a new block is added every ten minutes. To maintain this rate, the difficulty of mining is constantly adjusted. As more computing power is dedicated towards mining, the rate has steadily increased; if fewer resources were used to mine, the rate would decrease. All miners compete to be the one to append the next block. The prize for doing so is both a fixed reward (currently 25 bitcoins) and the right to keep any transaction fees in that block.
The fixed reward is the only way bitcoins can be created. The reward is halved at regular intervals to control the supply and the total eventual number of bitcoins is capped at 21 million. Around 12 million are already in existence although a significant number of these may be unspendable if early experimenters no longer have access to their private keys.
Unlike national currencies, bitcoins are not backed by state entities. There will be no bailout after a bitcoin crash. Likewise, no government can print more bitcoins to buy itself out of debt. This may in part explain the emotional appeal of bitcoins although economists would argue that economies function better when they have managed monetary policies so digital currencies will never be more than a complement to traditional money. Bitcoin is perhaps more like a local currency such as the Brixton pound than traditional money although it is an international one. E-gold was a similar idea – that failed – but that was backed with gold. Bitcoin is not backed by anything. It is effectively the world’s first glocal fiat currency: a money for the internet community.
Optimistic estimates place the potential monetary value of a single bitcoin as something relative to the value of precious metals (of which like bitcoin there is a finite amount) or to the value of the current electronics payments and remittance markets of which bitcoin could in theory seize a significant percentage thanks to its very low transaction fees. Such figures are huge but based on wishful thinking. More conservative estimates such as John Woo’s Merrill Lynch / Bank of America report puts the current estimated value at $1300 while noting the many dangers. The most probable value sadly is zero.
The value of bitcoins is based not entirely on the valuation of participants in the exchanges but on the consensus of miners that bitcoins have value so that they are willing to accept bitcoins as payment. There is obvious some relationship to the exchange value as mining has fixed costs in terms of hardware and operating costs in terms of electricity that must be met but hopefully those investing in mining are taking a longer perspective that smooths out some of the day-by-day volatility.
Nonetheless, the current value on the unregulated exchanges is driven by wild speculation, open market manipulation and the volatility that comes from poor liquidity. As I write, the market has dropped by a quarter on news that Baidu has stopped accepting bitcoins. It is not impossible that it will have entirely recovered by tomorrow morning. Daily swings of 10% are about as stable as the currency gets. Those who warn that the 9000% increase this year has all the signs of a speculative bubble are completely right. However, those who sneer that bitcoins are simply arbitrary trading tokens like tulips whose value depends on what people are willing to pay for them on the exchanges are missing something.
The utility of the bitcoin network itself has value. Where this is factored in people’s estimates is hard to tell.
Bitcoin definitely attracts the delusory thinking and mania associated with asset bubbles and this is enhanced by the echo chamber effect of internet discourse. Bitcoin has significant weaknesses and many opportunities to fail ahead of it and is far more vulnerable to attack by a determined and well resourced opponent than many believers are willing to concede. A significant crash could lead to a catastrophic loss of faith from which it cannot recover if those maintaining the network abandon the project. An alternative cryptocurrency could gain market dominance although I must note that this is highly unlikely to be one of the many current “alts” popping into existence which hope to profit from bitcoin’s halo effect. Most likely, the best innovations will just be quietly absorbed into the already existing machinary of global finance as bitcoin itself is tamed, regulated and allowed to quietly senesce. Bitcoin’s continued success as a peer-to-peer currency with no central bank operating outside capital controls and regulation seems impossible.
The near future of bitcoin, however, contains some fascinating possibilities. The next release of the reference bitcoin client will allow users to associate up to 80 bytes of arbitrary data with their transactions: “we imagine that most uses will be to hash some larger data (perhaps a contract of some sort) and then embed the hash plus maybe a little bit of metadata into the output.” (Core Development Update #5). Combined with the already existing but little used ability to make n-of-m multisignature transactions, this change allows two parties to ringfence funds for a project in a transaction that could include a hash of the contract and not to release the bitcoins until the contract end conditions are met. This may require a third party who cannot personally access the funds to adjudicate in the event the two parties are unable to agree but this third party could be a piece of software if the outcome involves public data. Professor Edward Felten of Princeton is currently leading a team of academics to design a prediction market free of centralized authority using the bitcoin platform, a project that will presumably take advantage of such mechanisms.
Another recent innovation is the ability to embed time-based contracts into transactions that allow, for example, someone to offer wireless access or access to a website for a trickle of tiny micropayments with no need to use a third-party payment provider. Paying people a fair fee for their work or covering the hosting costs of a website without having to run adverts is made possible if these ideas gain traction.
For more on contracts in bitcoin, watch Mike Hearn at Bitcoin 2012:
Public excitment and cynicism over the monetary value of bitcoin units obscures the really interesting potential for innovation in using bitcoin as a platform. Even if bitcoin itself eventually vanishes (which I fear is the mostly likely outcome, even though I would love to see it succeed) the ideas and experiments it will create will have a lasting effect on how people organise and negotiate agreements and open up new ways of managing identity, reputation and trust without the need for third parties or institutions.
Whenever people talk about bitcoin, remember that the real value is not in bitcoin as a currency. It is in the possibilities a peer to peer, verifiable public record like the blockchain creates. I have no idea what the future holds but I hope it survives for a least a few more years as we have barely begun to explore its potential.