Bitcoin is so hyped up that I can’t even distinguish whether it has reached the highest level of hype possible — Game of Thrones level hype.
Lots of people are hoarding it. This encourages more people to hoard it. This pumps up the price. That’s all good as long as there is a decent justification for this herd behavior. If it is just a bunch of greedy mindless sheep wanting to cash in, then bitcoin will collapse — just as it has already collapsed in 2013 after the infamous Mt. Gox exchange got shut down.
So before you start investing your money in this digital gold, why don’t you give me a few minutes to understand the pitfalls here.
How does bitcoin work?
This is a simplified, partial explanation that anybody should be able to understand. If you understand the behind-the-scenes of the technology you may skip this section.
The bitcoin protocol utilizes many physical machines (nodes) scattered throughout the globe. Each node holds a copy of a blockchain. A blockchain, as it sounds, is simply a list of virtual blocks chained together in a very secure way. By secure I mean that if information in any block is maliciously tampered with, then the whole chain becomes invalid. Each block contains a list of transactions that were done with bitcoin. By looking at the blockchain history, one can find how many bitcoins came into his controlled address, or how many were spent out of it, thus determining how many bitcoins he owns.
A user performs a transaction by broadcasting from his wallet to all the nodes in the network. Some nodes in the network, called miners, attempt to add the transaction to a block they create. This block will contain all of the transactions they have received in the current period. In order to create the block they have to solve a hash function, a computationally hard problem that has an easily verifiable solution. It is just like a mathematical problem that you struggled with in high school, but given the solution you can just plug it in and see if it satisfies the equation. A miner that creates the block, by solving the hash function quickly enough, sends it to the rest of the network. The other nodes in the network can verify whether the block and its transactions are valid. If all goes well they accept the block. The miner that created the block is rewarded with a predetermined amount of bitcoins plus fees. This gives an incentive to try to mine a block before the competition. Solving the hash function forces each miner to have computational power, thus preventing them from spoofing up fake machines and attacking the network (Sybil Attack). This protection mechanism is called Proof of Work.
Why does bitcoin have value?
I am aware of two use cases for bitcoin:
- An investment asset that is expected to appreciate in value.
- A digital currency that will act as a medium of exchange.
Why does it suck as an investment asset:
You are probably thinking to yourself, “What is wrong with you?”
Many people have made insane, sci-fi returns from bitcoin investments. That is true, and there is even a very good chance that bitcoin will yield phenomenal revenue in the upcoming years. However, I argue that a trustworthy asset is something you should be able to hold on to for decades, and even pass to your offspring when you finally decay into dust. Bitcoin, like any other asset, has value because you can find someone who would like to buy it. Its demand mostly stems from the faith that people have in it. A broad consensus grants it value.
Let’s compare bitcoin to gold, just because many people like to do so. Unlike gold, bitcoin holds no intrinsic value. Over 50% of the gold in the world is directed to jewelry and industrial use. That means that even if for some intangible reason all gold investors will sell their holdings, gold trade will not cease.
There are items that have no real intrinsic value but people will unload their dollars on them because they hold value for them. For example postage stamps occasionally get sold for millions (http://mashable.com/2014/06/17/stamp-auction-20-million/#XKzqp_DhbOqw). Stamps hold purely sentimental value. They are relics of history, exhibiting miniature art. Turning back to bitcoin, it is hard to imagine people immersing themselves in the experience of opening a digital wallet and observing the digits proclaiming the amount of coins they hold. Surely people pay lots of money for interesting things like virtual gems (https://venturebeat.com/2008/08/05/apple-wake-up-or-grow-up-a-99999-iphone-app-that-does-nothing-launches/), but would you honestly consider this an investment?
Imagine someone knocking on your front door and offering you a stone for sale. He will proclaim that the stone has no utility but people may buy it from you later for a higher price. For how long would you be willing to keep that stone? Wouldn’t you be afraid that someday people will wise up and stop buying it?
Now imagine a doomsday event that will result in a world wide distrust of bitcoin. It might be an arbitrary drop of the price, an attack on the network, a bug, or anything else I can’t quite imagine right now. After investors ditch bitcoin, who promises they will come back to it? Perhaps some improved altcoin with great marketing will bury bitcoin after the doomsday event….
However, if more people will start doing business with bitcoin, if it will become a de facto medium of exchange, then attempts to replace it will encounter resistance. It seems like this process has started. Unfortunately, bitcoin sucks as a currency, and so it will fail to receive universal adoption.
Why bitcoin sucks as a currency?
- Energy waste:
First of all because of Proof of Work. Miners consume enough energy to power all of Lebanon. Energy that could have been used by more than 1.5 million households is being directed to solve useless hash functions. This is excruciatingly wasteful.
Words can’t describe how horrible this is.
Some claim that this is good because bitcoin is being backed by electricity. No! Proof of Work power consumption is for solving bitcoin’s security issues (preventing the spoofing up of virtual machines that transmit malicious transactions) and has nothing to do with its value. It is comparable to saying that if you drill for gas at sea, and you send warships to protect your rigs then the warships are backing up the gas value, rather than just protecting your operation from attacks. Proof of Work is simply an extremely wasteful method to protect the blockchain.
2. Politics:
The bitcoin community is currently split. There are two dominant camps. The Core camp led by the developers of the most popular bitcoin node, “Bitcoin Core”. They are the rascals that continued the development and maintenance of bitcoin after the anonymous creator, Satoshi Nakomoto, vanished.
The other camp is the Miners camp. This camp is led by companies operating large quantities of mining nodes such as the Chinese Bitmain. They created Bitcoin Cash (or “Bcash” if you are a core supporter), by splitting (forking) the original bitcoin blockchain.
Each camp wants to change the bitcoin protocol according to its own whims and interests. You can find lots of political backlash on reddit and plenty of “fake news”. The objective of this is to sway bitcoin users to adopt a certain version of bitcoin. This process can be presented in a positive, democratic light. Two parties are in competition over the bitcoin users’ heart. So they go on a campaign explaining why their version of bitcoin is better for the people while actually catering to their own agenda. Just like most modern democracies!! Not the ideal solution, but a pretty good one.
There is a caveat however… When a certain party decides to fork the blockchain (split it into 2 coins), they either advertently or inadvertently affect the original coin. For example, when the miners created Bitcoin Cash (or Bcash) from bitcoin, a general recommendation came out to avoid transacting. There was a fear that transactions of the new coin may be replayed on the original coin. Protection measures were implemented to avoid such problems. Yet, there was a day where bitcoin exchanges froze their activity just to be on the safe side! People in general abstained from committing transactions until it was clear that the fork was successful. After a few days everything went back to normal.
Another fork that is scheduled for November is known as Segwit2x (don’t mind the weird name). Unlike Bitcoin Cash (Bcash — some people feel strongly about the name), this fork will have no protection, or an intentionally deficient protection, from replay attacks. The people behind this fork claim that Segwit2x is an upgrade of bitcoin and the users should stop using the original bitcoin, thus adding proper protection is redundant. Objectors to this fork are labeling it as an attack on the original chain. One thing is certain, you don’t want your currency to be disrupted like that. It isn’t too bad if bitcoin is just an asset, but now we are discussing bitcoin as a replacement to fiat currency. Imagine that you are brokering a huge deal and suddenly you can’t perform transactions safely. Or maybe you simply just want to go shopping and now you can’t. The problem is that anyone can fork the bitcoin chain and cause disruptions. This could have an adverse effect on a bitcoin based economy.
3. Latency, fees, and scalability:
In order for bitcoin to replace fiat money each transaction must be fast and cheap (or better yet, free). Today, this is clearly not the case. A transaction confirmation time may vary between minutes to hours, instead of taking a few seconds. The miner fee you pay also varies, but can cost a few dollars for transactions of a few dollars…
However, we are debating whether bitcoin can become a feasible currency in the future. Well, no one can predict the future, but currently it seems that there is no decent plan to make bitcoin scale. In fact there is a consensus among devs that blockchains are not scalable! There are all sorts of patches that can scale bitcoin a bit like increasing the block size (advocated by the miners camp), or creating a network of payment channels that are processed outside of the blockchain (advocated by Core). Neither of these solutions can make the bitcoin protocol scale in the magnitude needed for it to become a global currency. We already have non blockchain crypto coins that have better scalability than bitcoin. Still even they may not be scalable enough and a newer generation of cryptocurrencies may have to emerge. Bitcoin is today’s king because it was the first to claim the throne. But it doesn’t have the justifiable power to hold onto the throne. Eventually it will be replaced.
4. Security
Bitcoin’s whole protocol isn’t as secured as you believe it is. Don’t worry, your precious bitcoins are safe as long as your private key is secure. What is unsafe is the possible rerouting of traffic... Remember, bitcoin nodes communicate via the internet. There are known weaknesses of the internet that can enable attackers to redirect traffic to wherever they choose (google BGP hijacking attacks). Attackers can isolate bitcoin nodes, drop transactions, and mess with miners. Consider the following case: https://www.wired.com/2014/08/isp-bitcoin-theft/. There is still no known solution to this issue.
5. Volatility
Running an economy on a currency with a purchasing power that fluctuates like a Six Flags’ roller coaster will simply not work out. The claim that some bitcoin proponents have that the price will eventually stabilize with mass adoption is not backed up by anything. Let us, for the sake of the argument, assume the best case scenario where mass adoption occurs. I remind you that there is a limited hard capped supply of bitcoins that can be mined (this is just how it is). In such a case the bitcoin value will keep on spiraling up, because there is a limited supply and demand will only increase. This hyper-deflation will adversely change the economic incentives for investments and trade, thus decreasing social cooperation. People would be less likely to spend money in the present, if in the near future they could get the same product for less.
Conclusion:
I have demonstrated that bitcoin value as an asset may greatly depends on its utility as a currency. Since it sucks as a currency, it also sucks as an asset, hence it sucks and will eventually fall. Do note that this will take time so currently investing in bitcoin is fine.
