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.
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?
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.
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.
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!
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.
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?
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*