Bitcoins and Commerce

Stephen DeAngelis

May 23, 2014

If you’ve paid much attention to financial news over the past few months, you can’t help but have heard about Bitcoins. You might also have asked yourself, “What the heck is a Bitcoin?” Brian Dodson provides the following explanation from “Bitcoin’s main page”:

“Bitcoin uses public-key cryptography, peer-to-peer networking, and proof-of-work to process and verify payments. Bitcoins are sent (or signed over) from one address to another with each user potentially having many, many addresses. Each payment transaction is broadcast to the network and included in the blockchain so that the included bitcoins cannot be spent twice. (The blockchain is the distributed record of all transactions involving bitcoins.) After an hour or two, each transaction is locked in time by the massive amount of processing power that continues to extend the blockchain. Using these techniques, Bitcoin provides a fast and extremely reliable payment network that anyone can use.”

From that description you understand that a Bitcoin is a kind of currency. Dodson warns, however, “Bitcoins may have absolutely no intrinsic value (… a good property for a currency), but they do have a strictly defined intrinsic scarcity.” [“Pros and cons of a mature Bitcoin economy,” Gizmag, 13 March 2014] The scarcity to which Dodson refers involves the fact that the Bitcoin system has built into it an upper limit of 21 million Bitcoins (between 12 and 13 million are currently in circulation). Dodson further explains:

“Each transfer from A to B is accompanied by a digital signature generated using the private key of A. While everyone can verify the signature using A’s public key, only A can generate a valid digital signature with which to transfer ownership of Bitcoins. Ultimately, the ownership of Bitcoins is defined by the series of transactions in which they have been involved. This distributed knowledge is the heart of the Bitcoin system.”

If you still find that explanation a bit confusing, perhaps the following video will help.

If you are still confused, the team at Choice Loans has put together an interactive guide that has everything you need to know about Bitcoin — with articles, videos, and applications on how it works and how to accept it as a payment option. One member of the Choice team, Pete Smith, informed me that companies like Overstock, eBay, Virgin, and Yelp are all accepting Bitcoins now as payment. So the question Dodson asks is: “Will a transition to some form of intrinsically stable cryptocurrency be made in the future?” Concering that point, Dodson is relatively optimistic. “It seems a natural path,” he writes, “given our drive toward a culture of information.” He then asks the natural follow-on question, “Will Bitcoin itself be that currency?” Concerning Bitcoin, he is not so optimistic. He writes, “Personally, I doubt it. While Bitcoin is an important experiment, I suspect we will have a number of lessons to learn about cryptographic currencies before actually adopting one.”

Dodson is not alone in his skepticism about the future of Bitcoins. Louis Basenese, a former Wall Street consultant and analyst, calls Bitcoins an “insidious currency scam.” [“The Exact Date for Bitcoin’s Final Crash to $0.00,” Wall Street Daily, 27 February 2014] For that reason, he was not at all surprised when “one of the most prominent Bitcoin exchanges, Mt. Gox, disappeared.” Basenese asserts that Bitcoin holders can’t say they haven’t been warned. He explains, “Back in April 2013 – in an incredibly tragic twist of irony – Mark Karpeles, Chief Executive of the now-defunct Mt. Gox, said, ‘If you buy Bitcoins, you should [keep] in mind that the value could be zero the day after.’ Well, thanks to you, Mr. Karpeles, that day has officially arrived.” Even the Bitcoin website warns:

“The price of a Bitcoin can unpredictably increase or decrease over a short period of time due to its young economy, novel nature, and sometimes illiquid markets. Consequently, keeping your savings with Bitcoin is not recommended at this point. Bitcoin should be seen like a high risk asset, and you should never store money that you cannot afford to lose with Bitcoin. If you receive payments with Bitcoin, many service providers can convert them to your local currency.”

These warnings remind me of ads for medications that list all of the potential side effects that could result from taking them and you end up wondering why you would want to ask your doctor about them as the ads recommend. Obviously, Basenese doesn’t recommend investing in Bitcoins; however, cryptocurrencies do have their proponents. For example, Lata Nott writes, “Given that they are immune to direct government manipulation and don’t rely on banking institutions, the currency might be especially beneficial to the developing world, bringing financial services to billions of people without access to banks and credit cards.” [“Bitcoins: A Primer,” TMT Perspectives, 9 January 2014] And she notes that “Ernst & Young recently postulated, it is not necessary for Bitcoin to replace normal currency in order for it to have a future.” Michael Novogratz, CIO of the Fortress Investment Group and a former Goldman Sachs partner, is positively bullish over the prospects of Bitcoins. [“Investor Mike Novogratz Has A Very Simple Argument For Why He’s Bullish On Bitcoin,” by Rob Wile, Business Insider, 5 May 2014] One of the reasons that Novogratz is so optimistic about Bitcoin’s future is that a lot of smart people are involved in the movement. He told Bloomberg Television’s Stephanie Ruhle:

“There are in best estimates somewhere 30,000 individual programmers working on Bitcoin. My college roommate lives down in Barbados. He was the smartest guy that we went to school with. He full time works on derivatives of Bitcoin. So there’s this open source community where there’s huge brain power, let alone all the VC money that’s going in. And so from Marc Andreessen and his company to Benchmark … there’s lots of smart money going in. I’ve never seen a small project with more human capital going into it, and so I kind of want to bet just on that alone.”

Wile notes that “Ruhle pressed [Novogratz] on whether Bitcoin could simply flame out” and he “responded by saying it would lead to the ‘democratization of finance.'” He explained:

“I think you’re going to see things like peer-to-peer lending. … The Internet disintermediates large players and I think Bitcoin is just one of the threats that the finance industry the way we know it has coming against it.”

In March, the Fortress Investment Group “became the first Wall Street company to declare an investment in Bitcoin.” [“Fortress rolls Bitcoin stash into $150m hedge fund,” by Stephen Foley, Financial Times, 19 March 2014] Although Fortress’ actions appears to offer support for Bitcoin’s future, Foley reports, “The fund has told prospective investors that it expects to reduce its holdings of Bitcoin in favour of investments in promising start-up companies.” With the collapse of Mt. Gox and the indictment of Bitcoin Foundation Vice Chairman Charlie Shrem, Basenese asserts, “Bitcoin’s days are numbered.” That hasn’t stopped Cameron and Tyler Winklevoss, the brothers famous for suing Facebook’s co-founder, Mark Zuckerberg, from starting their own Bitcoin fund. [“Winklevoss Twins to List Bitcoin Fund on Nasdaq,” by Rache Abrams, New York Times, 8 May 2014] Abrams reports that the Securities and Exchange Commission remains wary of Bitcoin and that it “issued a warning to investors about Bitcoin, saying that it created new ‘concerns’ for investors.”

Frankly, I don’t know whether Basenese or Novogratz or the SEC is correct. My cautious side tells me that Basenese’s advice is probably the best to follow in the near-term. He cites ex-Federal Reserve Bank examiner, Mark T. Williams, who insists, “The problems at Mt. Gox are not isolated; they are systemic to the Bitcoin industry.” However, in the long-term, Novogratz’ position — that the financial sector is going to become more democratized — may prove to be accurate. Cryptocurrencies have a lot to offer if the all of the bugs can be worked out.