Bitcoin Disadvantages Explained: Volatility, Criminality and Technical Issues

All text © 2013 Erik A. Steiner

Wake Up and Smell the Tulips…
The Bitcoin bubble WILL burst – but when?

Money evolved as a means of facilitating
transactions in goods and services (Bruner,
2011).


Prior to the evolution of money, individuals
had to make sure they had something to
trade in kind for the goods and services they
were missing in order to survive.

The prevailing economic system was Barter.


Trade was inaccurate, complex, clumsy and
easily susceptible to fraud.
Trade was only possible when two sides to a
transaction each wanted what the other
had on offer and in roughly equally-valued
quantities.

Humanity needed a viable solution.
Humanity needed a medium of exchange
that could facilitate transactions and resolve
the inefficiencies of barter.


Various materials , typically metals – gold
and silver, served in this role over the
millennia, however their value fluctuated
wildly, and transporting metals is not trivial.


Essentially,

Money was
created as a
convenient
unit of exchange
to facilitate trade.

For MONEY to be EFFECTIVE, it has to fulfill
three roles:
1) Provide a medium of exchange
2) Provide a unit of account that can
facilitate valuation, calculation and
storage
3) Avoid the inefficiencies of barter


(Ferguson, 2008)


According to Ferguson (2008), money must
have SIX defining characteristics:
1)
2)
3)
4)
5)
6)

Availability
Affordability
Durability
Fungibility
Portability
Reliability

From here we arrive at –

Steiner’s Ten Characteristics of Currency


In order to serve as a viable means of exchange and to maintain a stable value,
a currency must be:

1) Commonly appraisable
2) Easily comprehendible
3) Conveniently storable
4) Efficiently transactable
5) Widely available
6) Globally affordable
7) Inherently durable
8) Quantitatively Fungible
9) Effortlessly Portable
10) Universally Reliable
Based on Ferguson (2008), Bruner (2011) and others.

Moneytime…
So, what is Bitcoin??
Bitcoin is a virtual, distributed, encrypted,
partially open source P2P network based
currency with a proprietary accounting and
trading system.


The algorithm used to produce bitcoins,
released by an unknown individual or group
by pseudo name “Satoshi Nakamoto,” uses
iterative artificial intelligence algorithms to
create increasingly difficult “puzzles.”
Encryption algorithms are open-source and
are continuously improved by a growing
developer base with an inherent interest in
hack-proofing the system (maintain and
increase value!).
Creation, accounting and trading are welldefined by the original algorithm.


How are Bitcoins created?
Bitcoins are created by running proprietary
software on increasingly expensive
hardware such as the Adafruit miner
pictured here. Hardware must be installed
on more and more powerful computers to
work.

Principles of Bitcoin Creation
Bitcoins are created by solving mathematical
problems, or “puzzles.” Puzzles can be
solved running a software program, called a
“client,” on proprietary hardware such as
the Raspberry Pi by Adafruit pictured on the
previous page.


By solving a puzzle one creates a “Block.”
Once you succeed in creating a “Block” it is
registered in the “Blockchain” which is a
public transaction ledger, and you earn a
specified number of Bitcoins as a reward for
your effort.

Image: Bitcoin mining setup

The Ingenious “Satoshi Nakamoto”
Algorithm

Image: Bitcoin mining setup


Nakamoto’s algorithm was preprogrammed
with ingenious features tailored to
propagate Bitcoin production and build hype

1) The number of Bitcoins awarded for
each Block halves at intervals estimated
to be four years (but not known to be
four years): used to be 50, now 25.
2) It currently takes about 10 minutes to
mine a block (mine=create)
3) As the network grows stronger – the
algorithmic difficulty increases
4) Therefore, the time to solve a block will
INCREASE as the associated REWARD will
decrease
5) However if hype continues to build
around Bitcoin the externally applied
value associated with Bitcoin will
continue to grow – motivating
additional mining efforts


Just like during the Gold Rush – whomever is
smart enough to set up store and sell equipment
is guaranteed a handsome payoff.

Evaluating Bitcoin as a viable currency
based on Steiner’s Ten Characteristics of Currency:


1)
2)
3)
4)

Commonly appraisable – no – value fluctuates wildly
Easily comprehendible – no – highly technical and abstract
Conveniently storable – yes – digital, ~zero storage costs
Efficiently transactable – yes and no – currently inexpensive to transact, but
difficult to locate willing partners
5) Widely available – no – known among the literati but far from widespread
6) Globally affordable – no – production costs and valuation increasing quickly
7) Inherently durable – no – hackable and susceptible to virii and other
computer and network issues
8) Quantitatively Fungible – yes – infinitely divisible (e.g. Satoshi 1x10-6 bitcoin)
9) Effortlessly Portable – yes – can be transported digitally
10) Universally Reliable – no – highly unreliable

Advantages – in Favor of Bitcoin:


• A “fixed supply” - theoretically estimated at 21 million units (however
infinitely divisible i.e. “fungible” – could also be construed as advantage)
• Non-regulated – alternative to government controlled currencies
abused through monetary policies
• Portable – inexpensively and easily moved, transported, transacted
• Decentralized – managed by the network, the proletariat, the common
man; appeals to anti establishment types
• Cheap - Very low transaction costs – but forecast to increase with time;
fees also independent of amount: large transactions especially cheap
• Fast - Facilitates rapid transactions – international transactions in
minutes rather than hours
• Private – relatively anonymous to transact (but can be hacked)
• Popular – currently enjoying mostly increasing value due to public
hype; however also useful in countries with problem-plagued national
currencies


Bitcoin Disadvantages I – just the simple issues…:
• Volatile –value fluctuates wildly, therefore difficult to appraise at given
point in time
• Instable - has to be stable in order to function as currency in the global
financial system; people not willing to use unstable currency
• No predictable stored value – not backed by anything tangible,
traceable or recognizable: a basic requirement for currency
• Speculative – lacks intrinsic value as an investment and derives value
mostly from the expectation others will indeed accept as payment
• Not resilient – e.g. $US and gold – and enough other stable alternatives
exist
• International – all the disadvantages of the euro amplified by globality
• Unregulated – while anti-establishment individuals are attracted to the
wild nature of the Bitcoin, also means it cannot be controlled – cannot
be stabilized through a crisis!


Bitcoin Disadvantages II –the technical:
As a digital virtual entity created by running software on a distributed
network, Bitcoin is inherently susceptible to hacking and other Internet
maladies…:
• Bitcoin is theoretically protected by highly advanced cryptographic
algorithms but at heart use of the “wallet” hinges on a private key, a
complicated type of password but similarly susceptible to hacking.
• The creation of Bitcoins is controlled by a sophisticated algorithm
which is supposed to control the creation of additional currency - but it
had already been hacked to create an unlimited number of Bitcoins.
• Exchanges are numerous and distributed – but frequently fail, taking
down Bitcoin owners with them. In one study (Steadman, 2013), 18 of
40 exchanges closed within the span of three years.
• Bitcoin mining botnets and trojans, malware and the hijacking of
mining networks are the unfortunate reality – leading not only to theft
of existing Bitcoins but also to the creation of undocumented “currency”
and possibly destroying exchanges and rerouting transactions.


Bitcoin Disadvantages III–the criminal:
Bitcoin is taking a larger and larger role in facilitating criminial and antiestablishment activities.
• Bitcoin is closely associated with illegal purchases the world over – primarily
used to purchase illegal drugs and finance online gambling
• According to the Economist, Bitcoin has been popular because of “its role in
dodgy online markets” (Economist,2012)
• Silk Road, a Bitcoin exchange specializing in the drug trade , shut down by FBI in
2013 (Forbes, 2013)
• The Washington Post labelled Bitcoin “the currency of choice for seedy online
activities” (Chen, 2011)
• CNN called Bitcoin a “shady online currency” (CNN, 2012)
• “…online gambling accounts for a huge portion of Bitcoin activity” (Wyher, 2013)
• “…online gun dealers use Bitcoin to sell arms without background checks”
(Smith, 2013)
• Bitcoin is inherently anti-community – success of an unregulated virtual
currency may curtail conventional taxation and limit communal development and
support for national needs
• Bitcoin enables anonymous monetary transfers between politicians and
influential individuals or corporations
• Bitcoin can facilitate untraceable hiring of mercenaries and assassins
• Bitcoin can facilitate money laundering
• Bitcoin is being used to circumvent international sanctions – for example by
Iranians.


So what to make of Bitcoin?
• Clearly virtual currencies have inherent advantages that are worth
exploiting, however, controls must be put in place in order to create a
reputable currency people will trust
• At the present time Bitcoin is being hyped by speculators, antiestablishment types – and the merchants of Bitcoin mining hardware –
all of whom have vested interests in perpetuating the Bitcoin scheme
• Rumor is that Bitcoin’s unknown founders have set aside 25% to 30%
of Bitcoins in circulation and therefore can exercise control over the
Bitcoin economy (hence not really as independent as proponents
believe)
• Adoption of Bitcoin-like currencies by the establishment may lead to
anarchy as such systems are driven by greed and will circumvent current
taxation systems and practices
• Essentially while the production of Bitcoins is asymptotically limited to
21 million units, not only are those units infinitely divisible, but an
unlimited number of similar currencies could be created – tomorrow
• In a highly influential article Krugman (2013) argues that Bitcoin
algorithmic structure coupled with the “currency’s” deflationary bias
incentivizes hoarding – market will not be fluid enough to facilitate trade
• Low transaction costs are not a sustainable competitive advantage


What if I were to tell you…it’s all part of a sophisticated Ponzi scheme?
• The disadvantages delineated in the previous slides, economical,
technical, legal and downright criminal should be enough to keep any
sensible layperson away from Bitcoin…but, wait, there’s more…
• As I’d pointed out earlier – no one knows who or what “Satoshi
Nakamoto” is. With the most basic requirement from currency being
trust – how can anyone hope to base an economy on technology that is
completely dissociated from its founders?
• Imagine, for example, that Bitcoin may be an economic trojan
horse funded and distributed by Al Queda or some other terrorist
or clandestine organization??
• Probably not… (not smart enough…) but • The algorithm had been constructed to maximize potential gain from
the mining operation itself!
• Ingeniously, the algorithm requires more and more computing
power to keep producing less and less Bitcoins.
• Theoretically, because of the asymptotic nature of the production
curve – production will never stop…
• In parallel, more and more will be spent with the hardware
providers to mine Bitcoins…


Bitcoin – No Real Economic Viability
• To be effective, a truly global virtual currency would have to be created
by an international organization, perhaps by The World Bank or by a
subsidiary thereof to encourage trust among future users.
• In any event the creators would have to be known, respected and
trusted entities – and from historical experience, even then we may not
be protected from fraud and deception.
• Economically, something like Bitcoin is not a step forward but rather a
step back; it does not introduce more efficiencies into the global
financial system but rather deficiencies – after all, in the current
economy to be useful to anyone Bitcoin first has to be traded for
something else. Hence, more transactions and more costs – not less.
• In a Ted presentation by one Paul Kemp-Robertson it had even been
compared to primitive forms of payment such as Berkshares and “Ithaca
Hours” or even…Starbucks Stars… (Kemp-Robertson at Ted, June 2013)


Good morning, Mr. Ponzi…
• Clearly the ingenious inventors of Bitcoin have taken a page from Ponzi
• By creating continuous and increasing demand for the required
hardware the individual or group responsible is reaping the most
rewards from planting the seeds for this scheme
• Demand for hardware increases as :
• The time required to mine a block increases
• The network grows – driving greater algorithmic complexity
• In parallel the rewards for mining decrease
• The entire scheme is set up so that – theoretically – mining never
ends, because of the asymptotic nature of the production curve
(see next slide)
• As long as the scheme manages to survive – and it has been built to
appeal to enough groups with diverse interests so that it just may carry
on for a while – the value of a Bitcoin continues to increase, pushing the
entire scheme forward ever faster…as incremental adoption meets a
relatively fixed supply of Bitcoin, prices have nowhere to go but up.
The anonymous inventors continue to profit as long as the scheme
survives.
As long as they can remain anonymous – they have no downside.

Source: https://en.bitcoin.it/wiki/File:Total_bitcoins_over_time_graph.png


The Asymptotic Bitcoin Production Curve

Virtual Currency – An Idea whose Time has Come.
Bitcoin is an important experiment along the path to a true virtual
currency, but thus far its development is a hazard to most whom are
involved – and to many who are not.


A noted academic writes, “(Bitcoin)…represents the sharpest ever
refutation of the efficient markets hypothesis,” and “…perhaps the finest
example of a pure bubble [emphasis mine].” (Quiggin, 2013)
It may be a while before a viable virtual currency rears its head. In the
meantime, I’d advise to be cautious, and, yes, to wake up and smell the
tulips…


Bibliography
Bruner, Christopher M. (2011). “The Changing Face of Money”. Review of Banking and Financial Law, V.30, p. 383-406.
Chen, Adrian (1 June 2011). "The Underground Website Where You Can Buy Any Drug Imaginable".
The Economist (29 September 2012). "Monetarists Anonymous".
Ferguson, Niall. (2008). The Ascent of Money – A Financial History of the World.
Forbes (25 October 2013). "FBI Says It's Seized $28.5 Million In Bitcoins From Ross Ulbricht, Alleged Owner Of Silk Road".
Krugman, Paul (14 April 2013). "The Antisocial Network". New York Times.
Lee, Timothy B. Lee and Hayley Tsukayama (2 October 2013). "Authorities shut down Silk Road, the world's largest Bitcoin-based
drug market".The Washington Post.
Quiggin, John (16 April 2013). "The Bitcoin Bubble and a Bad Hypothesis". The National Interest.
Sanati, Cyrus (18 December 2012). "Bitcoin looks primed for money laundering". money.cnn.com. CNN. Retrieved 18 October
2013.
Smith, Gerry (15 April 2013). "How Bitcoin Sales Of Guns Could Undermine New Rules". huffingtonpost.com.
TheHuffingtonPost.com, Inc.
Steadman, Ian (26 April 13). "Study: 45 percent of Bitcoin exchanges end up closing". Wired.
Wyher, Tommy (19 October 2013). "The Rise and Rise of Bitcoin". The Huffington Post. Thehuffingtonpost.com, Inc.

This presentation was strung together by
Erik Steiner.


My interest in Bitcoin stems from my
ongoing research into failure –
personal, corporate, institutional.
Having had the opportunity to
experience the dot.com bubble
firsthand and then three ensuing global
financial crises, I was deeply intrigued
by the Bitcoin phenomenon and moved
to create this presentation.

Most of my ramblings online
are on the subject of failure.
Please check out:
Twitter stnr_on_failure
Pinterest Anatomy of failure
Linkedin Anatomy of failure
Blog Steiner on Failure

Comments? erik at steiner.co.il
To connect:
http://www.linkedin.com/in/eriksteiner
All text © 2013 Erik Steiner. Images from various sources.

Bitcoin Disadvantages Explained: Volatility, Criminality and Technical Issues

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