The Coming Collapse of Bitcoin?

In 2008 the entire world was beginning to panic as our global financial systems teetered ever so close to total meltdown. Major banks were either failing or near failure, and the entire house of cards seemed to be one 10-of-Clubs away from becoming a meaningless flat stack in the middle of the table.

There was a growing distrust of banks, Wall Street, and our entire monetary system. We had allowed the wrong powerbrokers to gain control and business and industry were collapsing all around us. Visions of the Great Depression and its soup lines were haunting us, like a reoccurring nightmare, causing us to rethink our every move.

Many ideas were percolating in the background, but for one, the timing was perfect. Indeed, it is during the worst of times that we, as humans, often do our best work.

So it was in this collapsing chaos where people were grasping desperately for even the slightest ray of hope when on November 1st in 2008 a mysterious paper appeared on an obscure cryptography listserv describing details for a new digital currency called bitcoin.

It was from this seemingly innocent birthing chamber that this piece of monetary-replacement technology would begin its three-year rollercoaster journey, a journey with great lessons for our future.

Mystery Surrounding the Founder

The original Bitcoin architecture was formulated by Satoshi Nakamoto, a person no one has every met. The mystery surrounding Nakamoto seems to have been a key component to its viral success.

In an online profile, he claimed to be living in Japan, but his email address was from a free German service. Google searches for his name turned up nothing; it was clearly a pseudonym.

None of his fellow cryptography junkies had heard of him. But over the next few months he would become the Keyser Söze of digital currency.

Bitcoins are essentially “mined” using CPU processing from individual computers. The faster your system, the quicker you can “mine” a bitcoin. There are technically a finite number of “coins” to be mined, so the more a person works at it the more wealth they create.

Nakamoto himself mined the first 50 bitcoins—which have come to be known as the genesis block—on January 3, 2009. For the first year, his breakthroughs remained part of a tiny group of early adopters. But slowly, word of bitcoin spread beyond the limited world of cryptography.

Other than the clear libertarian tone of his writings, Nakamoto said very little about who he was or where he’d come from. His communications had been limited to a few key insiders using the secret Internet found inside the Tor network, a system designed to protect online anonymity.

To explain this further, Tor is a network where data is encrypted and re-encrypted multiple times, then sent through successive Tor relays, each one of which decrypts a “layer” of encryption before passing the data on to the next relay and ultimately the destination. This reduces the possibility of the original data being unscrambled or deciphered along the way.

Throughout 2009 and 2010, Satoshi Nakamoto wrote hundreds of posts in perfect English, helping to guide bitcoin into a life of its own. He limited his online statements to technical discussion of his source code and only brief commentary on other topics.

At one point Bitcoin users proposed it be used as an underground funding channel for Wikileaks but Nakamoto rejected the attention it would bring, stating, “The project needs to grow gradually so the software can be strengthened along the way. I make this appeal to Wikileaks not to try to use bitcoin. Bitcoin is a small beta community in its infancy. You would not stand to get more than pocket change, and the heat you would bring would likely destroy us at this stage.”

Then, in April, 2011, Kanamoto sent a note to a developer saying that he had “moved on to other things” and to “deemphasize trying to find out who he was.” He has not been heard from since.

“Trough of Disillusionment” or Total Collapse

The value of bitcoins, a “cryptocurrency” that some believed would overtake some traditional currencies, has recently plummeted across all of its exchanges – to a level where it now costs more to “mine” them than they are worth.

The value of bitcoins on one of its main exchanges, MTGox, has collapsed since mid-June from a high where it was trading at the equivalent of about $30 per “coin” almost to parity now.

The black line = the closing price for Bitcoins on the MTGox Exchange where they are traded;
the red and green lines = volumes of coins sold and purchased.

A recent article in Wired Magazine explains the rise and fall this way:

“Through 2009 and early 2010, bitcoins had no value at all, and for the first six months after they started trading in April 2010, the value of one bitcoin stayed below 14 cents. Then, as the currency gained viral traction in summer 2010, rising demand for a limited supply caused the price on online exchanges to start moving. By early November, it surged to 36 cents before settling down to around 29 cents. In February 2011, it rose again and was mentioned on Slashdot for achieving “dollar parity”; it hit $1.06 before settling in at roughly 87 cents.”

“In the spring, catalyzed in part by a much-linked Forbes story on the new “crypto currency,” the price exploded. From early April to the end of May, the going rate for a bitcoin rose from 86 cents to $8.89. Then, after Gawker published a story on June 1 about the currency’s popularity among online drug dealers, it more than tripled in a week, soaring to about $27. The market value of all bitcoins in circulation was approaching $130 million. A Tennessean dubbed KnightMB, who held 371,000 bitcoins, became worth more than $10 million, the richest man in the bitcoin realm.“

Today the value of a bitcoin is slightly under $2.50. Does this sudden drop mean the currency is about to become extinct?

Bitcoins are, in fact, just very long strings of numbers that are “produced” by a processor-intensive calculation that requires increasing amounts of computing power to create them. There is also a limit to how many can ultimately be produced, according to the algorithm used to generate them. So far, less than 7.5 million bitcoins have been produced. This represents about one-third of the total potential for “mined” bitcoins.

As Charles Arthur states in The Guardian, “With the value of bitcoins dropping so low, and the computing power required to produce them growing steadily, it is becoming uneconomic to generate more except through the use of hacked computers in “botnets”. Although there has been anecdotal evidence of their being used to generate bitcoins, many botnets are hired out on a commercial basis to send spam or host phishing websites – and that may be more profitable, directly, than creating the currency.”

Others point to a rash of bitcoin-related businesses posted for sale as a clear indicator of its ultimate demise.

But the true believers find hope in Gartner’s Hype Cycle.

The Gartner Hype Cycle is based on a theoretical technology-adoption-and-maturation curve that begins with a “technology trigger,” ascends to a “peak of inflated expectations,” collapses into a “trough of disillusionment,” and then climbs a “slope of enlightenment” until reaching a “plateau of productivity.” Using this theory, bitcoin is beginning to climb its way out of the trough, as people learn to value the infallible code and discard the human drama and wild fluctuations that surround it.

Anonymous Money

Much of the value in using bitcoin is the fact that it’s untraceable – anonymous. As a result of this feature, underground marketplaces such as Silk Road have begun to spring to life.

A June 1st article in Gawker titled “The Underground Website Where You Can Buy Any Drug Imaginable” explains it best:

Silk Road, a digital black market that sits just below most Internet users’ purview, does resemble something from a cyberpunk novel. Through a combination of anonymity technology and a sophisticated user-feedback system, Silk Road makes buying and selling illegal drugs as easy as buying used electronics—and seemingly as safe. It’s Amazon—if Amazon sold mind-altering chemicals.

Here is just a small selection of the 340 items available for purchase on Silk Road by anyone, right now: a gram of Afghani hash; 1/8th ounce of “sour 13” weed; 14 grams of ecstasy; .1 grams tar heroin. A listing for “Avatar” LSD includes a picture of blotter paper with big blue faces from the James Cameron movie on it. The sellers are located all over the world, a large portion from the U.S. and Canada.

But even Silk Road has limits: You won’t find any weapons-grade plutonium, for example. Its terms of service ban the sale of “anything who’s purpose is to harm or defraud, such as stolen credit cards, assassinations, and weapons of mass destruction.”

Getting to Silk Road is tricky. The URL seems made to be forgotten. But don’t point your browser there yet. It’s only accessible through the anonymizing network TOR, which requires a bit of technical skill to configure.

Lessons for the Future

Currencies like bitcoin are much more about their usability than their hordability. Its single feature, being anonymous, insures a unique usability feature that will give bitcoin lasting value. But it’s functionality as an anonymous currency is directly related to its price stability. So losing the valuation spikes is a good thing.

Every step taken by law enforcement to curb illegal activities will be met with another ingenious shift in how deals are transacted. With cash becoming ever more traceable, drug dealers have evolved from offshore banking to various forms of stored-value cards to the most secret currency so far – bitcoin.

However it’s only a matter of time before the anonymity of bitcoin will be compromised and users can be traced.

One of Nakamoto’s primary breakthroughs in creating bitcoin was solving the double-spending problem. A digital dollar is nothing more than information. Gone are the metal and paper of generations past.

But with digital money, what’s to prevent someone from copying and pasting it as easily as a chunk of text, “spending” it as many times as they want? Our answer traditionally has been to use a central clearinghouse to keep a real-time ledger of all transactions—ensuring that, if someone spends their last digital dollar, that they can’t then spend it again. The ledger prevents fraud, but it also requires people in a position of trust to administer it.

Bitcoin did away with the need for a third party clearinghouse by publicly distributing the ledger, what Nakamoto called the “block chain.”

He also devised an ingenious strategy to determine who gets to create new bitcoins with cryptographic mining puzzles. By increasing the workload on “miners” exponentially over time, he has insured scarcity. With only 21 million bitcoins possible and an entire world wanting to use them, the demand will theoretically continue to fuel a good market for them.

Over time, however, something better will come along.

Mexican artists who paint images of dogs playing poker on velvet canvases are also counting on a certain kind of demand for their limited inventory of artwork. But artists have very little recourse in limiting the supply of their paintings and invariably, over time, supply will always outstrip demand.

Bitcoin is also fiat money, currency based on trust. Most currencies around the world are fiat currencies, not backed by gold or precious metals.

National currencies though, have legal structures and systems to help protect their value. In the U.S. we have layers of trust incorporated into our currencies – our towns and cities honor it, our counties and states use it, and the federal government mandates it. This layering of systems helps insure durability.

Currencies are people-based systems that require human interaction with it. Without people, currencies become meaningless.

Bitcoin, in its current state is not a currency with universal acceptance or appeal. People are hard-pressed to find apartments that will accept bitcoins for their rent, grocery stores that will accept it to buy food, or a DMV that will allow you to buy plates for your car.

There is also no system in place for recovering lost or stolen bitcoins. As a digital currency, it can be hacked, pilfered, erased, or corrupted. Can a bitcoin system be built to be durable enough to survive over time?

As a way to legitimize its existence, new systems could be developed for bitcoin creation. Instead of using it primarily for the trade of black-market goods and services, large reserves could be awarded as prize money to incentivize major scientific advances. As an example, if 10 million bitcoins were awarded to the winners of the DaVinci Institute’s Eight Grand Challenges or to the winners of an X-Prize competition, it would be viewed as a positive force, offering hope for humanity. Rather than the currency of choice for members of WikiLeaks or Occupy Wall Street, the image could be reframed around finding cures for cancer and diabetes, as well as stopping hurricanes and earthquakes.

Once it begins to stabilize, and the supply of bitcoins expanded many fold, it could be used as a trade reference currency, used to write cross-border contracts when national currencies have become too volatile. As an example, if a company in the U.S. writes a contract to buy a ship load of computers from Thailand six months from now, rather than framing the contract around a national currency, the contracted price could be calculated in terms of bitcoins.

In it current iteration, bitcoin has been relegated to the nefarious underbelly of society, appealing to niche groups of Libertarians and social anarchists. But for all its limitations, bitcoin remains a major milestone in our transition from national currencies to global currencies. It also serves as a guiding light for transitioning from labor-intensive systems to automated systems.

The legend of bitcoin is far from over. In fact, with a little tweaking, it could very well be only beginning.