Tuesday, September 18, 2012

A Bit on Bitcoin

Bitcoin is simultaneously an amazing and very scary technology.  It has a lot of potential, but seems to be doomed to repeat all the mistakes and scams that have been seen in traditional banking.  This guide is for people who are interested in Bitcoin but still wondering about it.

Why use Bitcoin?

In a nutshell, it is essentially internet cash.  This means:

1. It transfers value extremely efficiently worldwide.
2. It is usable for intangible goods like music or video game items.
3. If you are very careful, transactions can be anonymous.

It is quantity limited (more like a commodity then a modern currency) and stored/transferred via a peer-to-peer internet protocol.  This means:

4. It is likely a good long-term store of value.
5. Your ability to spend cannot be "frozen" or otherwise inhibited, other than by depriving you of internet access.
6. The peer to peer nature means that it will be extremely difficult to disrupt, even for large organizations.
7. It can be transferred across borders during times of strife easily since it it possible to hold the "combination" to your bitcoins in your head.

So, if you are looking for a shelter against high inflation, a mechanism to inexpensively pay for goods from China (or other locations), or just want a "rainy-day" nest-egg, then Bitcoin might be for you.

However, please note that Bitcoin is still an experimental currency, so do not purchase more then you can afford to lose!

Is it legal?

This is a strange question because in this world truly "new stuff" is assumed legal and needs to be explicitly declared illegal.  For example, it was not necessary for the Wright brothers to get a pilot's license to fly their airplane and TiVo skirted copyright issues to bring DVR technology to the world without getting a legal ruling a-priori.  

A better question is whether it is likely that Bitcoin will some day be declared illegal.

While there has been no determination of its legal status in any country (edit: looks like an official in Finland affirmed its legality in that country), it is generally considered by lawyers to be legal to hold bitcoins.  Essentially Bitcoin can either be considered a commodity, a currency, or pedantically just a bunch of (uncopyrighted) digital bits!  If a commodity, certainly it is legal to own just like you can buy a bushel of corn.  If a currency, no issue; it is legal in most countries for citizens to hold another country's currency.  And while Bitcoin is not a particular country's currency, in the USA (for example) there are ample instances of corporations issuing currencies, like the Disney Dollar or the Second Life Linden Dollars.

Is Bitcoin a deflationary currency, and does that presage disaster?

Right now, Bitcoin is in fact highly inflationary -- a lot of new coins are being created every year.  However, the inflation rate will decrease as the years go on and eventually stop altogether.

If you are like me, you have been inculcated to believe that a deflationary currency is "evil", causes recessions, and even may have caused the great depression.  Keynesian economic theory claims that a deflationary market causes people to stop consuming to the point where the economy shudders to a halt.  But the "Austrian" school of economic thought questions this gospel for many reasons:

First computer technology is massively deflationary; if you haven't noticed you can read about Moore's law which states that if you just wait a few years, you'll get a much better computer for the same price (or the same one for half price).  And I'm sure people have deferred purchases to wait for the "next great thing" (I know I did).  But did this deflationary environment hamper technology innovation?  In fact, IT technology's contribution to GDP growth in the USA has equaled the contribution of all other sectors combined.

Second, unlike what we learned in school, it is now theorized that the recessions of the 1800's that culminated in the great depression were not in fact caused by the gold standard, but by over-regulation of the currency market.  See this lecture (start a few minutes earlier then the link to get the full picture).

Finally, an argument against a deflationary currency like physical gold is that in practice it cannot represent all other economic activity.  The reason is simply because if the price of gold increased to the point where it DID represent all other economic activity, it would require an infinitesimally small amount to purchase something cheap like a piece of gum.  This amount would be too small to coin!  However, Bitcoin does not have this issue; it is divisible by 8 decimal places today, and in fact a reasonably painless protocol change could extend this by as many more decimals as needed.  Therefore even if all but one bitcoin (or .1 bitcoin, etc) were taken out of circulation, there would STILL be enough to simultaneously represent both the smallest transactions and all the economic activity in the world.

Whether you believe these arguments or not is immaterial -- you need only recognize that Bitcoin is a currency with unique properties; properties that have never been tried before.  Therefore it is not possible to look at prior deflationary currencies and conclude that Bitcoin behave similarly.

Is Bitcoin itself a ponzi or a scam?

Bitcoin has been called a ponzi scheme because a bitcoin has no inherent value (and the early adopters "mined" a lot before others jumped in).  But in fact unbacked paper money also has no inherent value, so are they a Ponzi scheme?  (actually, they often end that way...)

Additionally, while value-store commodities like gold and silver have industrial use (that is, "marginal utility"), the price of these commodities so far exceeds that justified by the intrinsic "marginal utility" value that they might as well have no inherent value.  Is investment in gold and silver a Ponzi scheme?

A Ponzi scheme or other scam is not defined simply by an unfortunate massive loss of value, but by whether the scheme provides or attempts to create any value or provide any service.  Like the Spruce Goose, if it attempts but fails it is not a ponzi or scam -- it is just a mistake.

Bitcoin in fact has tremendous "marginal utility".  It is both a "coin" and a worldwide, free, instant transfer, 10-minute confirm transaction network.  It therefore out-competes other transaction networks like Visa/Mastercard (worldwide but exclusive, 2% fees, instant, 30-60 days to confirm), bank transfer (worldwide exclusive, 25-30 USD + 1-3% currency exchange fees, 2-3 business day transfer, 30-60 day "confirm" with the never-ending low-but-non-zero chance of a "clawback"), and finally Paypal (worldwide exclusive, 2.5% + .30c + 1-3% currency exchange fees)

Additionally, Bitcoin is much easier to get started in then these other systems.  Since no credit is extended, anyone can create a Bitcoin "account" (wallet) instantly and with nobody's permission.

Finally, Bitcoin is/will be very valuable for the purchase of digital commodities like music, video game items, etc.  Traditional transaction networks essentially stop fraud with "chargebacks".  This is the ability to reverse a transaction once the theft is discovered.  The reversal passes through every step of the financial network like a hot potato and ultimately lands on the merchant.  The merchant theoretically has law enforcement follow the purchased goods to the address they are being sent to and arrests whoever picks them up.  But this technique does not work for immaterial items -- the items are not sent to a physical address!  In fact, so much fraud occurs in certain digital commodities that some traditional financial service providers (paypal, ebay) refuse to allow purchases of them.

The genesis of this unfortunate situation  -- that financial networks are forced to use the chargeback mechanism -- is because all the information needed to charge a credit card or access a bank account is passed to merchants and middlemen every single time money is spent.  Therefore many instances of fraud are not the account holders fault but actually caused by some person working in the institution that was paid. 

This is the digital equivalent of storing your money in a safe, but telling every single person you pay your combination and letting them take out the cash!

Bitcoin solves the fraud problem by NOT telling every payee the combination of the safe.  Therefore if someone steals your combination, you have only yourself to blame.  Instead of issuing chargebacks that end up costing the merchant, you must report the loss and hopefully recover your own money when the thief is caught.  Or more likely, responsibly safeguard your combination so your money is not stolen in the first place.

So Why Do I Hear About So Many Hacks and Scams?

In fact, the Bitcoin network and currency has never been "hacked".  It is secured by the same advanced cryptographic techniques that secure your normal electronic bank transfers.  However, online services that use bitcoin have been hacked.  This is equivalent to saying that people have broken into banks and stolen money, but that the money itself has never been counterfeited.  So Bitcoin is thought to be more secure then paper dollars...

But bitcoin is a fledgling currency.  Teenagers from China, hackers from England, and moonlighters in NYC have built currency exchanges.  These people perhaps were not the best choice for the public to entrust with the handling of hundreds of thousands of dollars.  Additionally, one of the features of Bitcoin is that, like cash, it can't be taken back without asking. And, also like cash, it can be used anonymously if care is taken to access the internet anonymously.

These two features are very convenient on a daily basis for legitimate use.  Yes even the "anonymous" feature.  While waiting in line at the checkout counter, have you ever suddenly grown fearful and embarrassed that your credit card would be declined for some reason?  Perhaps you were out to lunch with your boss.  But if you held cash you carry peace of mind, secure in the knowledge that you can pay.  Requiring proof-of-identity (and by extension declining payment from some identities) will always admit the uncertainty that some glitch in the system will halt a perfectly credit-worthy individual's ability to pay.

But the media amplifies the problem.  In fact, to date I've managed to avoid opening accounts with Chinese teenagers, investing in obvious Ponzi schemes, contributing to scams, or losing a single Bitcoin.  It was not hard.  It was obvious from the beginning that money should not be kept on Bitcoin exchanges like they were bank accounts due to "counterparty" risk.  These are not FDIC insured institutions and do not claim to be.  In fact, the great advantage of Bitcoin is that you can easily and safely hold your own money.  So hold it; don't hand it to someone else!

Honestly, given how obvious the scams have been, the real question in my mind is why other people are falling for them.

OK, I'm Convinced.  So How Do I Get And Hold Bitcoins?

You need to start doing your own research now.  But...

Its really easy to get a few Bitcoins in an account on your Android phone (or desktop web browser), but these should be your "spending" account -- like the cash in your wallet, if they are lost you should not be too upset.  Try https://blockchain.info/wallet for one (they also have a great Android app).  Sorry iphone users -- Apple feels Bitcoin threatens their monopoly on phone payments and so have removed all Bitcoin apps from their store.  [Personally, I think you should research this and other heavy-handed Apple tactics, realize that personal choice is more important then incremental convenience and put your iPhone up on ebay...]

Compared to buying a wallet or purse, its a lot harder to buy, take delivery of, and install a secure safe for holding valuables -- and its a lot harder to do the same for Bitcoin.  Well, actually, if you choose to trust just one service, it can be quite easy.  Please research "bitcoin paper wallet" for a primer on the subject.

An intermediate option is to download and use the original Bitcoin client.  This client is capable of storing an encrypted wallet on your computer, and you can back that wallet up.  By the way, you actually only need to back up any wallet once.  The "bitcoin wallet" is actually more accurately described as the key to a safe held on your behalf in a distributed peer to peer network.  That is, if you back up your bitcoin wallet, deposit more coins, and then restore your wallet from the backup you will NOT lose the coins you just deposited -- they are still in the safe, you just restored the file containing the safe's key.

But if you delete this wallet (this key), ALL YOUR COINS ARE LOST (so make backups)!  If you forget your password, ALL YOUR COINS ARE LOST (so don't forget it)!  This is not document "encryption" where if you ask the company that produces the software really nicely they'll crack it open for you.  This is more like if all the energy that the sun will EVER produce was used by the largest, fastest, most efficient computer theoretically possible, the sun would burn out long before it found the key to the safe containing your coins.

On the bright side, this makes it very hard to steal someone's coins.

Good luck Bitcoiner!

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