Why Bitcoin won’t replace centralized currencies

    6/2/13 

      Bitcoin recently has gotten a lot of press, and, being a geek who is interested in money, I have spent quite some time exploring the usage of this currency. In the time that it took for me to familiarize myself with it, set up a trading account and a wallet, and get everything in place, bitcoin went from $40 USD, to $200, then down to $50 and back to $115. This kind of volatility, and the steps I had to go through to acquire a wallet and purchase the btc, caused me to realize that in its current incarnation, bitcoin is only a realistic option for tech savvy geeks who have a need to keep their funds away from prying eyes. If you don’t have high level tech resources and a need to protect your money from bank or government scrutiny, then bitcoin will probably fail to replace national currencies for you.

What is bitcoin?

Essentially, it is a cryptocurrency unit without physical presence that you can keep in a virtual ‘wallet’. You have three ways of acquiring bitcoin. You can trade in fiat money like US Dollars for bitcoins on a marketplace, such as Mt Gox. Alternately, you can become part of bitcoin’s minting system, called ‘mining‘, and receive currency in exchange for the time and resources it takes to process the validation hashes that form the bitcoin commerce system. The third way is to sell goods or services and get paid in btc. In every case, you receive a string of encrypted digits. These bits of data represent an amount of btc, a date of issue and an address of origination. You can then turn around and make payments as you would with Paypal or similar services.

How bitcoin works.

The integrity of the currency rests on a massive peer-to-peer network. This network of servers and computing nodes has the duty of validating and keeping an ever-expanding ledger of transactions since the on-lining of bitcoin, called the blockchain. It also processes security hashes to secure the ledger blocks and the transactions kept within, and it creates more hashes for the issuance of new bitcoin units. The current implementation provides for a maximum of 21 million bitcoins to exist at all times. There will never be more bitcoins and, as wealth is generated, the value of btc relative to fiat currency should increase. Because the units are digital, they are divisible indefinitely, thus you could eventually buy a pack of gum for .0000199 btc.

Taking the above purchase, your software wallet would generate an encrypted transaction record which holds the amount, date and recipient address of the counter party. This information is then broadcast across the network, validated by a number of live nodes to create a consensus of authenticity, and subsequently added to the blockchain. This blockchain is what protects against forgery; you cannot theoretically re-issue the same bitcoin amount again. It would require tampering with the records of most of the peer network in order to alter this consensus process. This is made computationally unrealistic by pitting the would-be attacker’s processing power and network resources against that of the rest of the network. You can read more about this in the bitcoin white paper.

It appears that the concern for forgery was a focal point when engineering the backbone for bitcoin. When you receive or send a payment, the information is appended to your wallet. These are essentially number strings that you can take out off-line on a memory key, or even print out as a hard copy. You can add these numbers to another wallet later on as a string of numbers that authenticate a unique amount of bitcoin. There is no indicator of money ownership other than the data being in your possession. Consequently, when you send a payment, the recipient sees the amount and a wallet address that is anonymous. If you go to blockchain.info, you can see all the bitcoin transactions being processed by the network in real time. A relaying IP address is attached, a wallet address, a date and an amount. That is about it. There is seemingly a lot of privacy built into the record keeping, and the IRS would have to snoop at the IP traffic layer in order to monitor transactions.

Theoretically, the portability of the currency and the built-in anonymity are attractive if you want to move funds under the nose of the authorities, for whatever reason. As long as you have the means to install a wallet system anywhere, carrying money around is just a matter of taking numbers with you, whether printed or on a digital file, and plugging them back into your new wallet installation. You can do this in two ways, but both have huge caveats. You could run your own wallet client software on your computer or mobile device, and issue payments from it. This is the more complicated approach, but also is the approach that offers the most privacy and independence. The alternative is to sign up for a third party wallet, that keeps your bitcoin data on a server somewhere in the cloud, accessible anywhere you have an Internet connection. These wallets also have handy smartphone apps to facilitate conducting business in bitcoin, usually for a fee. More on the two approaches later.

What makes bitcoin appealing.

Public Domain: First off, there’s no national government, central bank, business cartel, or army backing the safety and value of bitcoin. The currency was developed by a shadowy group of individuals, or perhaps just one guy, working under pseudonym. Apparently, the dev ‘team’ has since announced that it moved on to other projects. So the current consensus is that there is no central authority, the system is self organizing and running through a vast network of peer nodes distributed worldwide. The latter are motivated by the ability to use the currency and to generate btc for their time and effort. Being a cynic, this raises so many questions for me. For instance, what happens when problems arise and someone needs to correct the system? Check out the Wikipedia entry for bitcoin here. A major security flaw was exploited in 2010 to create billions of fake bitcoin. Fixing this involved amending code, and changing the fraudulent entries in the blockchain. From what we know of the system, this had to require some special access and major orchestration. I have a hard time believing the devs simply created bitcoin for purely altruistic motives, decided to keep their identities unknown, and then moved on from the entire thing. Clearly, this whole narrative is fabricated. With what little we know, the reality of bitcoin’s infancy lies somewhere between an NSA lab and a heroic group of white hats fighting to free the world from institutionalized theft.

Regardless, bitcoin has been successfully used to pull money away from government authorities for a while now. You can even buy contraband online using btc. Check out the Silk Road. It’s like eBay and the Mos Eisley Cantina had a lovechild.The integrity and reliability of the currency is kept by the efforts of the community. Currencies rise and fall with end-user confidence, and bitcoin’s acceptance says more about the growing mistrust in governments and banks than it is an endorsement of its intrinsic strengths. Why switch to bitcoin at all if you feel your currency is stable and your money safe where it is? The only other reason would be to reduce transaction costs. And admittedly, even Paypal fees are starting to look expensive these days. (By the way, I recommend Dwolla as an alternative.)

Portability. Bitcoin is the perfect vehicle for smuggling capital, evading taxation, and hoarding. You can carry and hide vast sums in a piece of silicon no bigger than a fingernail. As long as there is a network of users, bitcoin promises this money can be spent anonymously worldwide. The recent surge in price of btc was attributed to the dramatic loss of confidence in European banks, and rightfully so, when you consider the outright plundering of deposits that took place recently in Cyprus. This is a clear example of a desire to evade oppressive government control of private money.

Impossible to forge. Time will tell how resistant the currency is to forgery. For now we can take it for granted that bitcoin won’t lose value through forgery, or runaway issuance of new notes. This is definitely a strong point of bitcoin’s implementation.

What makes bitcoin scary.

Public Domain: This is the flip side that I touched upon earlier. Because bitcoin’s popularity is inversely related to that of national fiat currencies, there is always the possibility that governments will meddle in the functioning of bitcoin. And there are so many ways to do this. While it is true that bitcoin is impervious to some types of manipulation that fiat currencies enable, there are technology based disruptions and legal restrictions that come to mind. And if a significant amount of wealth is available in the form of bitcoin, it will certainly attract the greedy or the needy. Use your imagination.

 Point of origin: I am also very skeptical about bitcoin’s origin. Linus Torvalds developed a free OS that revolutionized server-side computing. Sure he wasn’t alone in pushing Linux, but he didn’t need to hide his true identity. Why don’t we know who wrote bitcoin? ‘They’ didn’t do anything incriminating, and given the status of the currency after 4 years of existence, there is little reason for reprisal against the so called Satoshi Nakamoto, from anyone. So why the anonymity? It’s very, very fishy to me. I’d imagine the creator of a system that could leave a huge mark in history would want his name recognized. The anonymity only suggests an alternative agenda; to cover a less palatable reality.

What if bitcoin is a P2P system engineered by, say, the World Bank; a sinister “problem-reaction-solution” scheme really designed to rein in gray and black markets, and we are just playing into their hands by adopting the system? As with your email, you are being told that bitcoin carries a measure of privacy over the Internet. But how do you know for sure? You NEVER will. Impossible. Because every transaction is tracked, we could be building a huge ledger of everything we buy and sell and who we deal with, only to be accessed by the entire alphabet soup of government entities in ways that are not disclosed to the public. Call me paranoid if you want, but if I slip someone a Benjamin, at least there is no record of anything being done. Could this be the single currency system the NWO has put in place to eventually replace all others? Because all transactions are processed through a centralized system (albeit massively distributed), any transaction could be disallowed by IP address or wallet address. But I digress.

Reliability: While bitcoin draws its strengths from the digital medium, the latter also imparts weaknesses. The entire system is so dependent on technology that it creates many points of failure. Most can be mitigated, but there’s enough fallibility to make one pause. No transaction is possible if your wallet loses power. Hardware failures could cause you to lose your wallet data. Sure, you can print out your bit coin and keep them on a piece of paper, but who will take that in an exchange? At some point you need to go through the entire system to complete the accounting.

There is one entrepreneur who had the clever idea to embed a memory chip into a physical coin. This chip is charged with an amount of bitcoin and this way can be physically traded. These are more collectors’ items, as you can only be certain of the bitcoin value once you break the seal and enter the numbers into your wallet. There may yet be a way to create a more physical bitcoin trading experience, but in this case, why not make it simpler and use pieces of silver or gold?

Also, while the protocol has strong authentication, it is still vulnerable to lots of forms of theft through hacking wallet devices and man-in-the-middle attacks. All in all, as a user of a technology-based money without institutionalized insurance, you are on your own to ensure your money is safe and sound at all times. You will need to be very savvy technically in order to avoid scams, malfunctions, and software exploits of your devices when you run your own wallet. If you chose to go the route of a third party wallet service, then you are entrusting your money to a business that is essentially a high-profile hacking target that the government can subpoena and has no FDIC coverage whatsoever. In short, you are dispensing with all the advantages bitcoin has to offer and taking on potentially more liabilities than you would by keeping your money in a bank. And what would be the point of that?

Scalability: Imagine that bitcoin took off because of worldwide loss of confidence in banks and governments. How would the peer-to-peer network that legitimizes bitcoin handle explosive growth? What would this mean for the individuals such as myself who installed the full wallet client? My computer does not just hold my bitcoin, it also processes transactions and keeps a live copy of the blockchain for others to refer to. I am one of those who make bitcoin possible as a medium of exchange.

Assuming a linear algebra model such as y=mx+b, we can derive linear projections of the blockchain’s growth.

I downloaded the entire blockchain on April 11th in order to set up a test bitcoin wallet on my PC. The download amounted to a sizable 7 Gb. This includes a record of all the Btc transactions made to date. Every time you launch the wallet application, it downloads the latest transaction blocks to update the blockchain. As of the latest update on 5/28/13, the wallet database was up to 9.2 Gb. This gives us two data points for our linear growth model. Also, we make the assumption that our intercept, the value of the blockchain size at x=0 (where x= life of bitcoin in days), is also zero, since it started without transactions and should be negligible. The blockchain starting date we will assume is January 1, 2009. If you look at the Blockchain statistics here, you will notice that the Blockchain doesn’t actually grow until late 2010, and that the parabolic curve clearly depicts exponential growth, but bear with me and my basic math skills.

To recap:

-1/1/2009: blockchain start date = 0mb (x=0 days, y=0 megabytes)

-4/11/2013: x=1561 days, y~ 7000 mb

-5/28/2013: x= 1608 days, y= 9200 mb

To calculate the slope of our model, we solve using : m=(y1-y2)/(x1-x2). Plugging our numbers will yield: m=(7000-9200)/(1561-1608)= -2200/-47= 46.8 (mb/day).

This assumes we stay at the current daily transaction rate, which is roughly 50k daily transactions in btc worldwide. Again, please go here to see the chart for daily transaction rate and make up your own mind as to where it could be headed. For bitcoin to really be a globally accepted currency, I would consider a hundredfold increase in daily transactions, because what is 5,000,000 daily transactions in a world populated by 7 billion? It represents a less than 1% acceptance if there are 7,000,000,000 money transactions every day, or 1 per person. Yet at 5m daily transactions, the blockchain would grow by 4,680 mb/day if we base on the current blockchain growth. I must point out here that the white paper for bitcoin mentions provision for pruning the blockchain, but doesn’t explain how it could be done without removing records and allowing double-issuance of coin. If you were to take a paper ledger and tear off pages from it, how can you keep the whole record required to track down your money in real time? Until I am shown proof that this problem is already solved, I’ll assume the blockchain will continue to grow untrimmed as it has since the past three years.

So we are already contemplating potential data increases only manageable by server clusters in a collocation. You can pretty much forget about maintaining your full client wallet on your home computing device. It would require an ever growing growing computer budget JUST to run a network node, with demands more appropriate for today’s data centers than home computing environments. It’s not an economically realistic scenario, and most would fall back on the lightweight wallet system. This means that the network’s integrity would require such vast resource commitments that a system of compensation will certainly have to come into place for the upkeep of blockchain network nodes.

Naturally, computing power keeps on increasing, and so we would have to take this into account. Still, one look at the parabolic charts on the blockchain site indicates that my calculations are probably way too conservative.

Also, as bitcoin usage widens, the incentives to defraud the system become bigger. I love it when Apple fans smugly point out that Mac OS has much fewer malware plaguing it than poor old Windows. They use it to underscore Apple’s supremacy, blatantly ignoring that hackers get much more reward for hacking the operating system that covers 75% of the planet. Well, the same would go for bitcoin. If a couple billion users turn to bitcoin daily, black hats all over the world will be salivating at the potential gains to be made. Without the fraud protection framework provided by institutions such the government-bank cartel, bitcoin is a wild west that one ventures into on their own.

And, of course, governments will also want to rein in the bitcoin system if it becomes big enough. You are deluded if you think the IRS and Fed will allow bitcoin to grow unregulated. What’s worse, ‘They’ could seem to be keeping their hands off the whole thing, but all the while having their fingers in the pie already and we wouldn’t even know it.

Lack of physical presence: Where do you slip bitcoins to a stripper? How are rappers gonna make it rain? I guess I’m a dinosaur but there are some things you need a good physical medium for… Come up with your own examples.

In closing, bitcoin is to fiat money systems what Neo was to the Matrix, a rogue warrior standing against centralized manipulation. But as bitcoin’s usage grows, so will the need for centralized oversight and protection. And by then we will have gone full circle. Bitcoin only exists because people want to evade centralized control of their money. It is a telling sign that we citizens of the world be willing to brave the dangers of a cryptic new technology and abandon the comfort of our familiar financial systems that still arguably carry some currency protection, in order to make our money safer…

If anything, bitcoin addresses a need created by these uncertain times rather than providing a long term foundation for sound money. The attempt to bypass the classic institutionalized currency system by creating a peer-to-peer tech-based system is elegant, but not without its own dangers. It doesn’t really promise anonymity on a grand scale and it doesn’t provide insurance from theft or failure of the service that holds your wallet. It works great in its current size, because it is mostly left alone by governments. And it doesn’t look as good as a gold coin. Don’t bet the house on it. And instead of trying to free your money from the scary Matrix we live in, why not go in and change its agents?

Raphael

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