Hacking Startups

Jun 25 2013

What is Bitcoin good for? Not Silk Road.

Bitcoin is uniquely suited for applications where capital mobility is critical. Other applications are largely spurious.

There are several proposed advantages of cryptocurrencies in general and Bitcoin in particular:

  1. Anonymity
  2. Store of value
  3. Medium of exchange
  4. Investment
  5. Irreversibility
  6. Independence from any government policy
  7. Freedom of capital movement

We examine and compare, for each of these purposes, as potential alternatives, several existing currencies and stores of value:

  1. Dollar cash
  2. Gold
  3. PayPal
  4. Dollars in a domestic bank
  5. Dollars in an offshore bank
  6. Land
  7. Shares

Anonymity

Widespread confusion about the potential anonymity of Bitcoin is understandable. Theoretically, cryptocurrencies can provide stronger anonymity assurances than alternatives (see, e.g., Zerocoin). However, Bitcoin provides no anonymity, not by design and not in implementation. Transactions are globally visible and traceable; they can be tied to specific people when money is spent on tangible purchases. True, you could stuff some Bitcoins into a pseudonymous wallet for a while without being traced. You can also open a PayPal account without verifying it and get some money into it.

The benchmark is not whether you can anonymously receive money, but whether you can anonymously spend it.

If all you worry about is being able to anonymously receive, I have a better idea: ask to be paid in empty eggshells and have them deposited in the closest body of water. You’ll never get to them, but that only improves security.

Store of value

Bitcoin is also an exceedingly poor store of value compared to gold or land.

Gold has remained a relatively stable store of value for the last five thousand years.  Land has even appreciated, largely due to population increase.

Given how long these trends have continued, it is likely that they will continue for at least some fraction of the time that they have already continued. I do not recommend gold as a store of value, but it sure beats Bitcoin, which has a much shorter track record, much higher historic volatility, and much more uncertain future.  It is only reasonable to use Bitcoin as a store of value if your time horizon is a few months; that is to say, never.

Medium of exchange

Bitcoin has no real advantages as a medium of exchange.  It is not faster than credit cards or wire transfers remotely and the difference in fees is largely due to the fact that banks provide additional services—most importantly, various forms of protection from fraud and theft. In person, cash works better.

Investment

The investment function of Bitcoin is similar to store of value, but distinct. While Bitcoin is an exceedingly poor store of value, it may be, for the right market participant, a good medium for speculation. Whether you are such a person depends on your sophistication as an investor.

A simple benchmark question is: Do you have more than a billion dollars under management?

No? Well, pal, then you are meat for those who can move the market. Given that Bitcoin is a small market in total, the trading trends will be for the conceivable future dominated by manipulation.

See also below on the effect of zero supply elasticity.

Another category of trader for whom Bitcoins can be great for speculation is an insider. (Un)fortunately, most insider knowledge about Bitcoin (a bug or perhaps future criminal prosecution of large exchanges or software makers) will need an effective way to take a short position. Due to counterparty risk, Bitcoin today does not offer a good way to short itself. This is an area that a different cryptocurrency could address, perhaps through an inherent mechanism of futures contracts settlement.

Irreversibility

Many tout irreversibility of Bitcoin as an advantage. Both cash and gold, however, have a very comparable extent of irreversibility.

Perhaps the most important point missed here is that reversibility is a feature, not a bug. Markets vastly prefer settlements reversible in case of theft or fraud; these protections increase consumer uptake.

Liability limits on credit cards enabled their use on the Internet despite initial consumer fears. Credit card issuers have improved reversibility by lowering the legally mandated $50 liability limit to $0 on most cards, further increasing uptake.

Consumers don’t want to lose the contents of their accounts with no recourse because of a security breach on their computer. Reversibility protects them, and they want it.

Independence from any government policy

Here is where we are starting to get somewhere. Government could pass all sorts of laws regulating or even prohibiting Bitcoins, but it lacks technical means of just grabbing them like it can with contents of domestic bank accounts (think Cyprus) or devaluing like with cash (think everywhere).

However, gold has all the same properties here that Bitcoins have, and is a vastly better store of value. (Again, I do not recommend you take any position on gold, and in particular I would not go long at the time of this writing. I am simply pointing out that it is an existing alternative structured similarly to Bitcoins and just plain better for the stated purpose.)

Note that both gold and Bitcoins are better at this than cash, which can be simply declared invalid, domestic bank deposits, which are in even far greater danger, or something useful, but also highly visible, like real estate, farmland, or other large tangible assets. Gold and Bitcoins can be made illegal, and population can be ordered to hand them over, but the order does not implement itself, like with voiding cash, and is not trivial to implement, like seizure of domestic bank funds. And, obviously, offshore banks are domestic banks in a different jurisdiction. The practical ease of affecting physical gold and Bitcoins with policy is comparable. Bitcoins can be hidden using physical and also steganographic means, whereas gold does not benefit from steganography; in practice, however, this difference is small, unless one wants to move the store of value. Which brings us to freedom of capital movement.

Freedom of capital movement

Finally! Bitcoins are like an offshore bank in the Internet crypto jurisdiction.

Once some local currency or other form of value is in Bitcoins, no technical means can stop the capital from leaving an oppressive regime for any other place.

While Bitcoins may be subject to all sorts of dangers in the longer term, the move does not take long, and if other alternatives are not available (e.g., it is illegal to carry gold or cash out or make wire transfers out of a country), Bitcoin transfer can only be stopped at the point where the value is converted into Bitcoins.

Zero supply elasticity means higher volatility

Bitcoin has a unique and undesirable property of having no supply elasticity. More gold can be mined and more dollars can be printed, but Bitcoins get minted on schedule that ignores demand. Zero supply elasticity means an inherently higher price volatility compared to gold or dollars.

Rarely considered attacks

A security assessment is always relative to a threat model, so I will enumerate here a few insufficiently considered attacks on the Bitcoin ecosystem:

  1. Make Bitcoins and any dealings with them illegal. Treat them legally as the money laundering equivalent of child pornography. Pursue any exchanges, cutting off their transfers and attempt to seize deposited funds; make creating, offering, and running Bitcoin software illegal.
  2. Simply have more than 50% of total compute capacity and rewrite history to confiscate other people’s Bitcoins. Current system capacity is about 150 Thash/s. Current best price of mining hardware is about 50 Mhash/s/$. That’s just $3M worth of hardware. Given the total valuation of Bitcoin, this is highly unstable (due to the temporary nature of availability constraints of ASIC miners) and will change in future, but even then, you can always spend the total valuation of Bitcoins for the ability to rewrite history. Even at graphics card efficiency (1.5 Mhash/s/$), this is still only $100M, potentially profitable even for simple theft. Even at current point of equilibrium (~$1B), this is laughably easy for a large government agency with crypto expertise.
  3. Quietly pressure Bitcoin software makers to do nefarious, but seemingly innocuous things, like purposefully insert bugs that allow for a fork. There already was a fork.
  4. Adopt Bitcoins for normal finance purposes, but with a few protocol changes that will evolve gradually. Final result will be no better than current banking system in terms of government control, but each step will be relatively benign. An easy way to start is to provide limited reversibility to be able to offer fraud and theft protection.
  5. Fork the ecosystem rather than the record of transaction history. Release a different, and slightly better currency. E.g., a version of Zerocoin that is not Bitcoin-compatible. Rinse, repeat.

Conclusion

Bitcoins are great if you need to do a small move of capital (something of personal scale for an average person) that you can’t do otherwise. Once the move is complete, exit the Bitcoin position.

If you are a cryptocurrency researcher, a fruitful and challenging area, besides the obvious anonymity, are built-in derivatives, particularly futures and leverage.