Bitcoin’s Appeal and Flaws Simply Explained
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The most powerful notion drawing people to Bitcoin is simple, an individual user can control possession and spending of their own currency, without relying on a bank, credit card company or central payment processor. In that sense, it is a peer-to-peer payment solution.
Bitcoin supporters dislike central authorities, including central banks who control monetary policy. The distain extends to corporations who control a segment of the economy; the way a few credit card companies control consumer payments.
Bitcoin represents not only cutting out powerful companies like Visa and American Express from transactions between two parties, but on a philosophical level, it leaves hope for those who want less government or centralized control in their daily lives and monetary policy.
National central banks make policy decisions to print money, set benchmark interest rates, wholesale lend to financial institutions or bailout companies that are too big to fail. Those decisions often lead, over time, to inflation and a decrease (in relevant terms) to a currency’s purchasing power.
A currency that experiences inflation will have less purchasing power the longer you hold it. In 1940, $1.00 bought twenty bottles of Coke. Today, it may not even buy a single bottle.
Inflationary national currencies disproportionally impact people who hold cash and cannot afford (or choose not) to hold assets like real estate, stocks and bonds that may appreciate in value, beyond the rate of inflation. The rich, (who hold assets that appreciate in value beyond the rate of inflation) get richer, the poor (holding what little cash they have, with decreasing purchasing power), get poorer.
While there are certainly good reasons for central banks to make decisions that lead to inflation, Bitcoin’s creator, Satoshi Nakamoto, wanted to remake the rules. He envisions a currency that did not need banks or credit card companies, nor an authority or organization that could control monetary policy, set benchmark interest rates or print more currency. Nakamoto not only wanted to rid of a central bank in his currency, he wanted no authority capable of making monetary policy for Bitcoin.
For that reason, Bitcoin’s software code only allows a total of 21 million coins to ever be minted and put into circulation.
Minting New Bitcoin
More important than the limited supply of Bitcoin is the way in which new supply is created. Instead of a central bank decision to put more currency into supply, users can mint or ‘mine’ new Bitcoin by putting their computers, or designated computing processors, to work verifying transactions on the Bitcoin network. These users are then rewarded with small amounts of new Bitcoin, proportional to the amount of computing power they contribute to the network.
Parties on the network also pay a small amount of Bitcoin to have their transactions (i.e. sending and receiving Bitcoin) confirmed. With present conditions, 25 new Bitcoins are produced or ‘mined’ every 10 minutes, which should result in a full supply of all 21 million Bitcoin by about 2140.
Nakamoto’s brilliance, to attract participants, was to offer incentives to replace the roles of traditional payment processing companies and central banks. Miners are not only issued new Bitcoin to replace central banks printing money, but they also receive Bitcoin for using their computing power to confirm transactions on the public ledger; a process normally undertaken by payment processing companies in credit card transactions.
Bitcoin advocates like to say that ‘code is now law’. That is, Nakamoto’s code governs the currency and not a central bank.
Once 21 million Bitcoin are in circulation, many expect the value of the currency to increase, not deflate, simply because you cannot mine or issue additional coins. Of course, that position presumes demand and usage of Bitcoin does not dwindle. The argument goes, if demand for Bitcoin increases, and supply stays the same, presumably the price goes up.
Public Ledger, Private Parties
In traditional banking, transactions are kept private between banks and the transacting parties. There is no master transaction log of all payments which is a public record. Bitcoin does the opposite. Bitcoin posts all transactions to a public ledger that anyone can view, but keeps the identity of the participants private.
Ledger transactions are recorded using unique codes (letters and numbers) which anyone can view online. Of course, once a public ledger address or ‘wallet address’ becomes associated with an individual, it becomes easy to track the history of that individual’s payments. So, the power Bitcoin’s anonymity feature relies on parties taking their own measures to stay anonymous, like Nakamoto.
An Anonymous Founder
To add to the intrigue, Nakamoto remains anonymous. Nakamoto’s commitment to anonymity goes in hand with his or her commitment to ensuring no single individual or central authority represented the currency, let alone controlled it.
More compelling and impressive is the fact Nakomoto’s has not touched millions of dollars worth of Bitcoin many conclude he must hold as a result of early mining operations. This has led some to believe Nakamoto is either fantastically sound in his conviction to Bitcoin, dead, or worse, lost his private keys.
A Boost from the Criminal Underworld
The partial anonymity function of Bitcoin gave way to its adoption by criminals. The most notorious example is the now defunct Silk Road, which many compared as the eBay or Amazon of online drug and firearm sales. Silk Road brought buyers and sellers of illegal goods together from all over the world and combined an escrow service with Bitcoin to facilitate transactions. It has been estimated that as much as $1 Billion dollars in trade, in the form of Bitcoin, was processed on Silk Road.
The demise of Silk Road, whose domain and website were seized by the US government in October 2013, led to the public trial of Ross Ulbricht, who the US justice system concluded was the libertarian mastermind behind the site.
It is safe to assume that in addition to Silk Road, Bitcoin was adopted by other criminal operations as a means of transferring value without relying on banks or meeting in person to exchange cash.
Bitcoin’s early adoption arose, in part, from facilitating illegal trade, similar to the way Napster rose facilitating copyright infringement.
The demise of Silk Road drew a lot of public attention for Bitcoin, which ironically, likely led to more mainstream adoption from 2013 onward.
To summarize, Bitcoin’s appeal comes primarily from (i) there being no central authority controlling the Bitcoin network; (ii) the code limiting circulation to 21 million coins; and (iii) a public ledger of transactions, but the anonymity (with exceptions) of its participants. Whether or not Bitcoin sees continued adoption as a means of storing or transferring value, it remains a fascinating economic experiment.
Central Points of Failure
Bitcoin relies on traditional banking systems to purchase or trade money in and out of the currency. That process is typically done by cryptocurrency exchanges like Binance, Coinbase, Kraken and many others.
One of the most famous early exchanges was Mt. Gox, which ended in bankruptcy proceedings following the theft of over 700,000 Bitcoin in early 2014. At the time of the theft, the coins held by Mt. Gox were valued at approximately USD $560 million, with each coin trading at roughly USD $800. Mt. Gox highlighted that Bitcoin exchanges served as a central point of failure.
Ironically, with the value of Bitcoin going on to trade at over USD $18,000, the Mt. Gox bankruptcy trustee, who recovered 200,000 Bitcoin from the company’s coffers, held it long enough to see the dollar value now exceed what users owned on the platform at the time of its demise. Still to this day the Mt. Gox trustee continues to liquidate the remaining coins to pay out claims from people who held funds on the platform. In fact, many believe the trustee’s liquidation has played a role in driving Bitcoin’s price down at various points.
This leads to the great irony of Bitcoin adoption and the ‘Catch 22’ proponents face in the mass adoption of Bitcoin. That is, to buy Bitcoin, many rely on a bank to wire fiat funds to an exchange. Many banks and credit card processors now refuse to facilitate transactions in which funds are sent to a Bitcoin exchange, and governments are requiring ‘know your customer’ rules be imposed on Bitcoin exchanges.
In the early days of Bitcoin, exchanges did not require you to confirm your identity, and while some still do not, they face the scrutiny of regulators and the uncertainty of the wrath of governments being imposed to shut them down.
As a result, the partial anonymity feature of Bitcoin is quickly lost when you are trading the currency on an exchange, with your identity fully known to the exchange and your transactions, in which you remove Bitcoin from an exchange, are posted to a public ledger. Governments with subpoena power over centralized exchanges can relatively easily match your identity to public ledger transactions and trace funds up the chain.
Exchanges have also become subject to court orders requiring that transaction data for thousands of account holders be shared with tax authorities like the Internal Revenue Agency in the United States.
There is no doubt that at least until mass adoption is achieved, exchanges will remain crucial for driving adoption and allowing people to acquire Bitcoin. At the same time, exchanges charge fees, create central points of failure for theft, government regulation and oversight, which ironically is, in-part, what Bitcoin’s creator hoped to avoid.
With cutting fee hungry centralized payment processors and banks out of traditional money transfers being a main benefit of Bitcoin, it is hard not to see the irony of the growth and power of centralized exchanges, who charge similar fees and are now valued in the billions of dollars.
However, proponents of Bitcoin also argue that central exchanges are a necessary evil to drive adoption and give exposure to non-technical users. In the meantime, there is no doubt that the impressive growth of exchanges has made them appear to be more and more like the institutions Nakamoto wanted to cut out of economic transactions between two parties.
Private Keys and the Custody Issue
The technical nature of Bitcoin has also been a barrier to entry for many users. To be the true owner of a given number of Bitcoin, a user is assigned a private key, forming a long sequence of letters and numbers. To use those keys, display your Bitcoin balance and process transactions, users must have a software or hardware wallet. Some also elect to store their private keys offline in “cold storage” written down and locked away for safe keeping. For a novice user, those options can be daunting.
It is difficult for people to trust that any portion of their wealth is safely stored in a sequence of letters and numbers whether it is recorded in a software or hardware wallet provided by a third-party or written down and locked away somewhere.
This has led to central exchanges playing a role in holding or taking custody over Bitcoin and providing a smoother user experience to buy, sell and trade Bitcoin. Central exchanges like Coinbase do not provide their users with their own private keys.
Instead, they take custody of keys and simply display your Bitcoin balance in your account with them. While you can still freely trade and transfer your Bitcoin to anyone with a public wallet address, you never do so with your own private keys. Many argue you lose the real power and benefit of actually holding your own funds if you rely on a central exchange. Central exchanges also present the ability for regulators, tax authorities and litigants to seek account seizure orders and freeze balances, detracting from the economic freedoms Bitcoin represents.
The reality is that for non-technical users, custody of Bitcoin with a large organization such as Coinbase makes a lot of a sense, at least at the moment.
Not everyone is comfortable storing large portions of wealth in sequence of letters and numbers which could be lost, stolen or forgotten about. Others equally have difficulty trusting the makers of software and hardware wallets. But then again, not everyone was comfortable putting Visa numbers into websites in 1999.
It may also be that the majority of people prefer a central exchange being accountable for their funds and have no concerns about account seizure within the realm of established law. That is, not everyone holds libertarian views where they desire to exist outside the realm of legal systems and government authority.
As large investors and institutions enter the space, it is safe to assume that few will be willing to hold custody of their own Bitcoin and will gravitate towards institution like Coinbase, who are increasingly being regulated and even seeking out regulatory approval to obtain custody licences and insure deposits. However, with regulation and insurance comes the cost of compliance and, in turn, more fees for users.
Again, the irony is hard to hide. Nakomoti’s vision was for a currency that removed the need to trust or rely on central organizations, such as banks, to process payments. The rise of Coinbase and others is evidence that many will gravitate towards relying on what they perceive to be the most trust worthy institutions to store their wealth, allowing users to at least take legal action in the event funds are lost or stolen.
Having a superior user experience and removing the complications of managing private keys plays a role as well.
Understanding the complications users face in holding and storing their own private keys leads to the obvious problem of what happens when you lose your private keys. Or worse, what happens in the event you die, without a plan in place for your keys.
The answer is simple, your Bitcoin is gone, for good.
In that instance, you (actually your estate) will be left wishing you had some central authority, who held custody of your coins and was subject to wills or estates laws to facilitate your coins being passed on. With an institution like Coinbase holding custody of your Bitcoin, like any other assets, courts can likely deal with their orderly distribution in the event of death.
Bitcoin hasn’t really proven to work for daily consumer transaction as e-cash. With the inability to print new Bitcoin beyond 21 million coins, and its significantly fluctuating price, few people actually want to use Bitcoin to buy goods. There is too great a risk the dollar value of a user’s Bitcoin spent will fluctuate even from the time a transaction is agreed to, to the time it is processed, or goods delivered. Price fluctuations also make pricing goods and services in Bitcoin difficult.
The best cautionary tale is the now famous Bitcoin pizza purchase. In 2010 a programmer purchased two large Papa John’s pizzas for 10,000 Bitcoins, worth about $30 at the time. Today, those same Bitcoin are worth about USD $60 million.
With such cautionary tales, people are hesitant to spend Bitcoin for daily transactions. Equally, vendors are hesitating to accept Bitcoin because the chance of a rise in value is equaled by the prospect significant drops in value. So instead, people turn to Bitcoin as a speculative investment to hold, not a currency to spend.
Some have argued it is possible for Bitcoin to become a better use case for peer-to-peer e-cash when its price, relative to sovereign currencies, fluctuates less. In the meantime, the price fluctuation has given rise to a number of so-called ‘stable coins’, or cryptocurrencies that are intended to represent national currencies capable of being programmed into smart contracts. A topic for another day.
The other main factor dissuading Bitcoin’s usage as a peer-to-peer e-cash solution is the unpredictable transactions fees on the Bitcoin network. Fees payable to miners to process transactions go up when there is large demand on the network and the blocks being mined are full. This had led to alternative currencies or ‘Alt-Coins’ trying to change block sizes and mining parameters.
In addition to price fluctuations and transaction fees, Bitcoin has been plagued by concerns it just cannot scale. When the network is overloaded with transactions, not only do fees rise, but transactions are processed slower as they wait to enter the blockchain and be confirmed by miners. It is simply not feasible to buy a coffee with Bitcoin if a transaction takes 20 minutes to confirm. Nor will vendors adopt Bitcoin if there is even a small chance a transaction may take 20 minutes in the future.
Layer Two and the Lighting Network
Some believe the fix for slower and costlier transactions comes from placing a second layer on top of the Bitcoin network; the lightening network.
In its simplest terms, the lightening network, being developed by Lightening Labs, proposes to open payment channels off the Bitcoin network, allowing people to exchange coins back and forth and only occasionally settle those transactions on the main Bitcoin blockchain.
In essence, the proposal is to remove smaller transactions off the Bitcoin blockchain to reduce the number of transactions and implement faster payment channels “off-chain”. These off-chain transactions would then be fast enough to buy goods and services in real time. In the meantime, while the Lightening Network is still under development, Bitcoin’s use case as peer-to-peer e-cash appears to be limited.
The Securitization of Bitcoin
The evolution of Bitcoin trading has also led to a futures market and the securitization of Bitcoin. Banks and investment firms continue to make submissions to regulators for the approval of a Bitcoin exchange traded fund or investment products which hold Bitcoin. This pushes Bitcoin further down the path to a speculative investment or store of value tantamount to digital gold, and not a peer-to-peer e-cash.
Of course, some view the securitization of Bitcoin as banks hijacking the currency and pushing it further away from its founder’s intentions. More troubling, the securitization of Bitcoin may allow for investment banks to sell more Bitcoin than are actually in circulation, diluting the argument that a limited supply will drive Bitcoin’s price upward.
For great insight into the securitization of Bitcoin, listen to Caitlin Long’s interview on the Off The Chain podcast by Anthony Pompliano: