Bitcoin Demystified (did I just pay $50 for a latte?)

bitcoin

Myth: Bitcoins are not as secure as US Dollars

Credit cards and financial account passwords are compromised everyday – whether by outright theft, hidden scanners or cameras that surreptitiously steal numbers, or hackers – causing millions of dollars in loss.

Counterfeit paper money is an ongoing problem. And if the bank robber asks for small bills at the teller window, he will likely get to spend them.

The Bitcoin “serial number” is registered and encrypted. Bitcoins can only be created solving complex cryptography problems in a competitive domain. It used to cost in electricity to mint a Bitcoin than they were worth. I doubt true now. And the cost to mine is dropping with electronic hardware (ASIC and FPGA) mining solutions.

Myth: Bitcoins markets are run by criminals and cater to criminals

If you don’t have the computer skills to mine Bitcoins, you must buy them through an exchange. Years ago, MtGox was the only option. Registration requires levels of identify verification as well as verification of funding sources. Trading on Mt. Gox is imperfect and randomly closed. On the other hand US stock markets have relatively narrow trading hours while BitCoins are traded 24×7.

Exchanges can be frozen or even shut down by government authorities. The use of Bitcoin markets to trade illegal goods or fund illegal activities is a valid concern. The FBI shut down TheSilkRoad and arrested the organizer. The news produced a brief 20% drop in BitCoin value, which became the buy opportunity of the year. The FBI isn’t going to dump Bitcoin accounts needed for a trial years in the future. The US government restricted Bitcoin usage on digital payment sites like Dwolla The Chinese government has made similar moves recently. On the other hand, a lot of people lost money when the US Government shut down online gambling sites, e.g. PokerStars and FullTiltPoker. Comments by government officials this week portend a positive environment for Bitcoin and other digital currencies. See Bloomberg news

A number of BitCoin exchanges and marketplaces have been funded in the last few months. Most of these are backed by Tier 1 venture capital funds with deep pockets and a long-term horizon.

  • BitInstant (New York): Platform for instantaneous Bitcoin transfers.
  • Bitpay (Atlanta): Lets customers of businesses ranging from software-makers to auto dealerships make payments in Bitcoin, then transfers cash to those merchants.
  • Coinbase (San Francisco): Makes a “virtual wallet” that lets users buy Bitcoin and pay for goods and services with it.
  • CoinLab (Seattle): Backed by Silicon Valley investor Tim Draper. Recently tried teaming with leading Bitcoin exchange Mt. Gox; the partners, however, are now in court.
  • Lamassu (New Hampshire): Has developed an ATM to instantly turn dollar bills into Bitcoin.
  • OpenCoin (San Francisco): Cofounded by E-Loan’s Chris Larsen, it has created a payment system to transact various currencies, including dollars, Bitcoin and a new alternative, Ripple.
  • Tradehill (San Francisco): Runs a Bitcoin exchange that competes with Britain’s Bitstamp, Russia’s BTCE and Tokyo-based Mt. Gox, among others.

If exchanges make you nervous, simply use them for conversions, then store your BitCoin in a personal secure, encrypted wallet. I use BitCoin-Qt.

Fact: Digital Money is here to stay

When is the last time you saw someone write a check in the grocery store, especially someone under 60? Today’s kids will shop with their smart gadget, not with a credit card and certainly not with folding money as my grandfather called it.

Bitcoin has advantages for micropayments (the smallest unit of payment is 1 Satoshi = 0.00000001 BTC) and that amount can be transferred at no cost. Independent artists could sell content for fractions of a penny without losing the $0.30 + 3% that Paypal charges.

Bitcoin is the first digital currency to gain a foothold. But it could be supplanted by something better. There is a gold analogy with respect to Bitcoin – the more that is mined, the harder it gets to mine more. Gold costs $300 per ounce to mine which sets a base value. Bitcoins mining essentially has half-life. About half of the maximum possible Bitcoins (21,000,000) has been mined. The remaining 11 million will be fully mined by 2017. This has several implications.

The US M1 money supply is ~$2.5T. In simple terms replacing M1 dollars with M1 Bitcoin equivalent would equate to a value per Bitcoin of $100,000. Most goods would be priced in mBitCoins or uBitCoins which sounds awkward. (1 MicroBitCoin = 10 Satoshi’s if you’re keeping score).

BitCoin software is open source. What if the US Treasury began minting DigitalCoins under a derived scheme, that combined US Government money management with the cyber protection advantages of BitCoin. Would Mt. Gox stand a chance?

Did I just pay $50 for a latte?

Success of Bitcoin hinges on the use of the digital currency for buying and selling legal goods and services. The price gyrations of the last few months make that a daunting challenge. Similar to the problems with runaway inflation, how much does an item really cost if the dollar basis is fluctuating by 30% to 90%. And that leads to the second problem – lack of merchants that accept BitCoin. At the end of the day, the rent has to be paid in dollars (or the local currency).

What is needed is a more efficient marketplace. Farmers hedge against price drops in crops on the Futures Market. Traders hedge again stock drops (or pops) with options. If people can make money regardless of the price movement direction, the forces that accelerate bubbles are diminished.

Full Disclosure

I gave my nephew a BitCoin for his 14th birthday. He sold it to buy an XBox One. I hope it doesn’t turn out to be a $50,000 game box.