Some questions about Bit Coins

There has been a lot of interest regarding bit coins (http://en.wikipedia.org/wiki/Bitcoin) recently. Basically it is an internet based currency that some are claiming is the wave of the future.  A big reason for the recent interest is the parabolic rise it has experienced this year. It started the year around $13 and got to $260 at some point in the last few days before plunging to $100 and going back up to $160. Still an over all 12 fold rise. Quite impressive I must say. I received an email from a friend as well as my Dad with each asking how they can get hold of this digital Gold so to speak. This remind anyone of the Dot com mania of the late 1990s? Or the real estate bubble that followed it?

It is not my intention to pan or praise this currency. Just to investigate it? How does it stack up as a currency. I will confess that I do not know much about how digital currency works. But I simply wish to raise some questions that I believe must be answered before anyone wished to buy Bitcoins. Keep in mind that I am talking about people who wish to hold bit coins the way they hold dollars, euros or gold. For transactions and as a store of value. If your intention is to speculate in bitcoin, then I will be of little help. I don’t speculate. I’m the worst speculator in the world. My timing is spectacularly and consistently atrocious. So without much ado, let us raise some questions about Bit coins.   

Rarity
A big reason why Gold is such a good currency is it’s relative rarity. This is why Iron is not money. Iron is too abundantly available in nature. On this count Bit coins are a good currency. Apparently only 21 million bit coins will ever be released into perpetuity. Thus a bit coin has the advantage of rarity. But that does not mean that Digital currency itself has the advantage of rarity. The Bit coin network was created by a bunch of people. Another bunch of people are perfectly capable of creating another digital currency network called the Byte coin. So here are my questions

1. What prevents competitors from flooding the market with their own digital currencies and destroying the rarity of BitCoin?
2. Why are there no viable competitors up to this point? To be sure , there is a competitor called the ripple network (http://en.wikipedia.org/wiki/Ripple_monetary_system). But this begs another question. Why did the BitCoin network take off and not the ripple network?

If it so happens that creating a Digital currency network is not all that difficult, then Bit coins will crash as the rarity is no longer there.

Ease/Difficulty of Inflating the currency
Gold has an advantage over paper currency in the sense that it is very difficult to inflate, i.e. it is very difficult to bring new Gold into the market. Gold mining is expensive. To buy an ounce Gold costs only twice of what it takes to mine it. Not so with paper money. Paper money can be created at a whim and negligible cost compared to it’s face value. That is why paper money is so prone to inflation. On this count bit coins come up trumps. There will not be more than 21 million Bit coins created. Thus if BitCoin is the only digital currency that will ever be created, then bit coin is the perfect currency. Even better than Gold. But I suspect that it is not all that difficult to create other digital currency networks. The proliferation of other currency networks also has an inflationary effect. Thus I repeat my question from the last para
1. What prevents competitors from flooding the market with their own digital currencies and thus inflating the Digital currency system?
2. How do new bit coins come into existence?
3. How much effort is needed to bring new bit coins into existence? In terms of man hours? In terms of computing power? In terms of materiel? In terms of bit coins already in existence?

Intrinsic Value
Critics of Bitcoin have pointed out that a bitcoin has no intrinsic value and is thus useless. This, I believe, is unfair. Paper money also has no intrinsic value. Gold also has an intrinsic value (if industrial applications are considered) that is far lower than it’s market price. The intrinsic value of Gold is it’s use as money. Same with BitCoin. This, incidentally is where Platinum, silver and palladium score over Gold and bit coins. Their intrinsic value is at par with their value as money.

Incorruptibility
Gold is a noble metal. It does not rust or react with a lot of other elements. It can be stored safely without damage for hundreds of years. Paper money by contrast is very easy to damage by fire, water, earth or air. On this count, the question is
How easy or hard is it to corrupt or damage a bit coin?

Forgery and detection
Gold is forged in several ways, i.e. by iron pyrites (Fool’s Gold), mixing with other metals, making huge bars of Gold with an iron core etc. But in general a common man can detect forgery/purity with simple methods like pumice stones, density tests etc. This is where Gold scores over platinum. You pretty much need an expert to detect a platinum forgery. As for paper money, no comments! So the question for BitCoin is
How easy or difficult is it to forge a bit coin? How easy or hard is to detect the forgery. What is the forgery Vs detection effort ratio? A good currency is hard to forge and the forgery easy to detect.

Divisibility
This is why eggs and tennis rackets are not currency. What if you only want to spend half an egg? Gold is minutely divisible as is a bit coin. A bit coin is divisible into 100 million units. Good!

Decentralized control
The only reason national currencies are money is that if you refuse to accept them in return for goods and services you will be arrested. Their use is not voluntary. It is compulsory. Only national government are allowed to issue currency. If you try to issue your own currency, you will be treated worse than a child molester. Not so with Gold. Anyone can mine Gold and the acceptance of Gold is purely voluntary. No one is ever jailed for refusing to accept Gold. Same with Bitcoins. Anyone can mine them. There is no law to prevent you from mining bit coins. There is no law forcing you to accept bit coins. So on this count bitcoins win.

Other questions
1. What is public key cryptography?
2. What sort of cryptography is Bit coin using? How does that work?
3. What sort of people/organizations/hardware have a natural advantage in mining bit coins?
4. What limits the rate of current bit coin generation given infinite manpower and computing power?
5. Can the network be hacked/manipulated? Instances of fraud?
6. How does one lose a bit coin?

Conclusion
It is too early to bring the verdict on bit coin. It seems a perfect currency except when looked at from one angle. What are the barriers to entry for other Digital currency such as Byte Coin? This is the million Bitcoin question! If the barriers to entry are high, then Bitcoin is very viable. I will myself go out and buy some. But if they are low, as I suspect, then it is best to wait and watch. I mean if some anonymous guys can create a digital currency network like Bitcoin, how hard could it be for several competitors to come up with their own versions? My advice. Don’t buy. Just wait and watch.

Speculative question: Is it possible to design a Digital currency with intrinsic value? What would that value be?
1. Computing power?: Nah! too inflationary!
2. Internet bandwidth?: Naah! Too inflationary
3. *Your guess here*

Advertisements

About masculineffort

A Man should be able to change a diaper, plan an invasion, butcher a hog, conn a ship, design a building, write a sonnet, balance accounts, build a wall, set a bone, comfort the dying, take orders, give orders, cooperate, act alone, solve equations, seduce a woman, analyze a new problem, pitch manure, program a computer, cook a tasty meal, fight efficiently, die gallantly. Specialization is for insects.
This entry was posted in Digital Currencies. Bookmark the permalink.

4 Responses to Some questions about Bit Coins

  1. Peter Šurda says:

    You pose interesting questions. I think that in general, they have been addressed by someone already. Maybe you can read my master’s thesis, I think it’s pretty good on the basics.

    The reason why a “competitor flood” is an unlikely scenario is due to the network effect. Just like you can’t flood the market with new languages and expect people to switch over from, say, English. In network goods, you’d typically expect a small number of dominant players. New Bitcoin competitors would need to either provide a significant technological improvement, or a higher liquidity. I’m not saying it’s impossible, but it’s difficult and at the moment I don’t really see a competitor, with a minor exception. The only realistic competitor I see is Ripple, because it contains some fundamental differences. Whether it will compete or complement Bitcoin though it’s early to say. For the time being I lean towards Ripple being a complement to Bitcoin.

    Bitcoins are produced by using computing resources. The supply is designed to be inelastic by defintion and produced competitively, so when more computer power is put into Bitcoin production, the variable production costs rise, and vice versa. This allows an equilibrium, where marginal production costs follow the market price.

    On a theoretical level, Bitcoin is as hard to damage as, say, the English language, i.e. impossible. But there are practical issues with implementations and various hypothetical attack vectors, so if you are not careful, you might end up “damaging” your coins in the sense that it might become impossible to use them.

    On a theoretical level, Bitcoin is also unforgeable, but that’s true about gold too. Gold is defined as atoms with 79 protons in the nucleus, and that can’t be “forged”. What can happen is that someone might trick you into accepting something as if it was gold even though it does not consist of atoms with 79 protons in the nucleus, because the resources required to verify the number of protons in macro-objects are, at the moment, prohibitive. Nanotechnology could change that, but we’re not there yet. Bitcoin, on the other hand, is defined through its mathematic properties, and computers can very easily and at low cost verify if what you’re being presented really is a Bitcoin. There are still practical difficulties and attack vectors, but people are working on making it easier and more secure, and even with the attack vectors, the potential forgery (such as a double spend) is revealed very quickly, within minutes/hours.

    You can read about PKI on http://en.wikipedia.org/wiki/Public-key_cryptography , I provide a simplified account in my thesis. Bitcoin PKI is based on the ECDSA algorithm. This is considered very secure by cryptographic researchers.

    Advantage in mining have people who can get ASICs and/or who can get cheap electricity. ASICs are only available for general public in small quantities, because the production only started recently, however, you can preorder some and hopefully get them within a couple of months. You may still be able to use less efficient mining equipment, I think it is still profitable to use GPUs at the current prices, but your profit margin won’t be as high.

    The production of Bitcoins is defined through an inelastic production function, and it has a difficulty variable that automatically adjusts to the computing power. This is, in principle, unbreakable, because of two factors: you can’t manipulate the time (so everyone can verify based on the current date and time how many Bitcoin should there be), and the function is convergent, so even if everything breaks, you still have a hard limit on the total number of produced coins.

    There are attack vectors possible, and it is possible to conduct fraud, however these are of limited applicability and mostly only occur when people are not careful. Entrepreneurs are working on making it easier for people to secure their own Bitcoins. Bitcoin also allows for replacing of other financial functions through cryptography, such as decentralised escrow, uncollateralised lending or smart property, but these are not fully usable yet. These additional functions would provide security on a level that has never been possible before in the whole history.

    You can lose bitcoins by losing the public key. So make sure you have backups, and that noone beside you can access your private key. As I said above, innovative solutions are being developed to make it easier for normal users to secure their bitcoins. Just give it a couple of years and you’ll be amazed.

    I hope the answers are satisfactory, there are plenty of resources on the web that also provide information. For economic analysis, you can visit my blog (which I see you already did). Please excuse typos, I’m not checking my writing as this is not supposed to be an academic publication.

  2. Pingback: Bitcoin: Is inflation of Digital currency systems possible? | masculineffort

  3. Pingback: BitCoin: State interference | masculineffort

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s