The FAQs: What You Should Know About Bitcoin
Dec 29, 2017 0:12:27 GMT -5
Post by PrisonerOfHope on Dec 29, 2017 0:12:27 GMT -5
The FAQs: What You Should Know About Bitcoin
DECEMBER 27, 2017 | Joe Carter SHARE
CURRENT EVENTS
DO CHRISTIANS NEED TO KNOW ABOUT BITCOIN?
The best answer to this question is probably, “Some do, most don’t, but we all may in the future.”
When I first started researching bitcoin for an MBA project in 2012 the price was $15 per “coin,” and it was of interest mostly for ideological and technological reasons. This year the cryptocurrency reached an all-time high of $19,796 per bitcoin on December 17 (though it has dropped again, and at the time of this writing is $15,850) and it has garnered increased interest as “investment” opportunity.
It’s this economic angle—especially the morality of speculation—that makes bitcoin of interest to (some) Christians. Are Christians who buy bitcoins gambling with God’s money? Are they hoping to sell an object with no intrinsic value to someone more greedy or gullible in the hopes of getting out before the bubble pops?
In a future I’ll address these questions and others related to the ethics of speculation. But in this article I’ll present the information about bitcoin in a relatively straightforward manner to help believers make the determination for themselves.
This is a long article, and most people will not need to read all of it. If you’re only mildly curious about bitcoin I’d suggest reading the sections marked as “simple” explanation and the section “What is bitcoin? (The economic explanation).”
WHAT IS BITCOIN? (THE SIMPLE TECHNOLOGICAL EXPLANATION)
Bitcoin is network-based digital currency that is created and exchanged electronically. Although the currency exists entirely online, it can be used to purchase non-virtual goods and services. Because it is a purely peer-to-peer version of electronic cash, bitcoin allows online payments to be sent directly from one party to another without going through a financial institution.
WHAT IS BITCOIN? (THE DETAILED TECHNOLOGICAL EXPLANATION)
The founder of the world’s most successful cryptocurrency has a name but no identity. In 2009, a computer programmer using the pseudonym Satoshi Nakamoto (Satoshi means “reason” in Japanese) self-published a nine-page paper explaining how a digital currency could be created that would eliminate the need for centralized third-party financial institutions.
In most forms of e-commerce, a third party acts as a mediator between the buyer and the seller for the purpose of electronic funds transfer. This mediation not only increases the transaction costs but also the ability to reverse the payments allows the financial institution to have the last word on any transaction. Although this function is necessary for the current trust-based system of online commerce, it conflicts with a core value of the super-secretive Nakamoto: absolute privacy. As Nakamoto explains:
With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.
What was needed, according to Nakamoto, is an electronic payment system based not on trust but on cryptographic proof. Such a system would allow “any two willing parties to transact directly with each other without the need for a trusted third party.” Without a third-party mediator, the buyer and seller could remain completely anonymous, exchanging goods and services without having to disclose any private information about each other.
The problem with such an approach is that with most digital cash schemes, it is possible to spend a single digital token twice. Unlike physical token money such as coins, the act of spending a digital coin does not remove its data from the ownership of the original holder. Another means is needed to prevent double-spending. Nakamoto’s ingenious solution to the double-spending problem was to use a proof-of-work system as both an initial currency distribution mechanism and also a measurement against double-spending.
Proof-of-work (POW) systems were originally designed by computer scientists as a means of preventing network service abuses, such as spam or denial-of-service attacks. The system requires evidence that some time-bound function has been completed (generally solving a computation that requires processing time by a computer) before access to the network will be granted. In 1999, computer scientist Hal Finney developed the concept of the “bread pudding protocol.” Just as stale bread can be repurposed to create a new foodstuff (e.g., bread pudding), a POW solution can be repurposed for other uses, including the creation of a digital token. Such repurposed POWs—or RPOWs—form the basis of cryptographic proof for Nakamoto’s bitcoin system. Bread pudding isn’t the most inspiring metaphor for a currency, though, so the users of bitcoin refer to the creation of new currency as “mining.”
WHAT IS BITCOIN? (THE ECONOMIC EXPLANATION)
Why are bitcoins considered valuable?
Most global currencies are fiat money—money that has value only because of government regulation or law. Fiat money is not convertible by law into anything other than itself, such as gold or silver, and has no fixed value in terms of an objective standard—its value can fluctuate based on numerous economic factors.
In contrast, commodity money is a medium of exchange that may be transformed into a commodity, useful in production or consumption. Commodity money can be based on minerals (e.g., gold or silver), found objects (e.g., shells or stones), or consumer goods (e.g., ramen noodles in prison). Although it was the dominant medium for exchange for more than 2,000 years, commodity money has fallen out of favor because of it limits the scope for monetary policy and other actions that alter the value of money.
Bitcoins are a form of commodity money. Technically, bitcoins have no intrinsic value, since they are nothing more than digitized “bits” created by a laborious process on a decentralized network of computers. But because the supply is limited (they are rare commodity not easily produced) and their use is recognized as a medium of exchange, they are assigned a value by their users. What bitcoins are worth is solely determined by what people believe they are worth.
Is bitcoin still a cryptocurrency?
Not really. A cryptocurrency is a digital asset designed to work as a medium of exchange that uses cryptography to secure its transactions, to control the creation of additional units, and to verify the transfer of assets. Bitcoin has become the most popular mainstream cryptocurrency by ceasing to be a form of currency (i.e., a medium of exchange). Sure, you can still technically buy some goods and services with bitcoin. But because it is prone to deflation you’d be foolish to do so.
Deflation, a decline in the general price level, occurs when the price of goods and services declines relative to a specific measure. The value of the goods and services themselves does not have to decline for deflation to occur; all that is required is for the value of the currency itself to increase. This is exactly what has occurred for the entire existence of bitcoin.
Because of its deflationary nature, bitcoin is a terrible form of currency. For example, in 2010, a developer named Laszlo Hanyecz traded 10,000 bitcoins for two Papa John’s pizzas. At the time the bitcoins were worth about $40. Today, those coins would be worth $1.7 million. Anyone who bought anything with bitcoins prior to 2017 is likely regretting their purchase.
It bitcoin a tech stock?
Definitely not. There are several ways that stocks are valued, but most of them are based on the assumption that the underlying company has or will have future earnings that will either justify the rise in price or will lead to a distribution of dividends to shareholders.
While bitcoin sometimes acts like a stock (i.e., it can be traded on exchanges, is subject to technical analysis, and so on), there is no company underlying bitcoins—only a blockchain. Bitcoin will also never have earnings, though it currently pays out a form of “dividend” to bitcoin miners.
Is bitcoin the “new gold”?
Bitcoin is like Gold 2.0, Tyler Winklevoss says.
No, it’s not. While bitcoin appeals to many of the same people who once preferred gold as an investment vehicle, bitcoin has few similarities to the precious metal. For starters, bitcoin is a a commodity currency that acts like a “fiat currency,” similar to the U.S. dollar. Gold is commodity money because the price of gold is backed by . . . gold. Gold is also an actual physical asset that has some use for real-world applications. Bitcoin is an intangible asset whose monetary value solely depends on how much hard currency people are willing to exchange for it.
Additionally, gold has the advantage of being a long-term illusion: gold is valuable because for thousands of years we humans have convinced ourselves that gold is valuable. Bitcoin and other cryptocurrencies have a long way to go before they can create a similar “money delusion.”
Is bitcoin a wealth redistribution system?
Yes, it is. The question is what type of wealth redistribution system. The most generous take is that similar to Valentin Schmid, who contends that bitcoin “favors risk takers, innovators, savers, and people who are curious and persistent enough to learn new technology as well as history.” Those people, who jumped on the bitcoin train early enough “will be richly rewarded and their purchasing power will increase.”
That’s certainly true to some extent, since 40 percent of bitcoin is held by about 1,000 people. As the price of bitcoin increases, the value of the holdings of these early movers is rising almost exponentially. The key for them is when to unload bitcoins for hard currency and collect the wealth that has been accumulating to them. When they do (and they can even collude together on the timing since bitcoin isn’t subject to financial regulations) the bitcoins held by the late movers will be worth much, much less than they bought them for (as many people discovered the week before Christmas).
Another, less congenial, term for this is a ponzi scheme. The price of bitcoin is currently rising based solely on the idea that the price will rise even further. And as long as there are “greater fools” to bid up the price of the cryptocurrency, the price will continue rise. Eventually, though, when there are no more fools left, the bubble will pop—and thousands of people will have lost real money.
Is bitcoin a speculative bubble?
Yes, almost assuredly. Financial bubbles involve outsized growth in the price of an asset beyond its true value. Bitcoin has no intrinsic value, so why do people hold it as an asset? Because they think it can be sold an even higher price in the future (see: greater fool theory). As economist John Cochrane explains:
f the price [of an asset] is greater than zero, either people see some “dividend,” some value in holding the asset, beyond its cash payments; equivalently they are willing to hold the asset despite a lower expected return going forward, or they think the price will keep going up forever, so that price appreciation alone provides a competitive return. The first two are called “convenience yield,” the latter is a “rational bubble.”
“Rational bubbles” are intriguing, but I think fundamentally flawed. If a price goes up forever, eventually the value of bitcoin must exceed all of U.S. wealth, then all of world wealth, then all of interplanetary wealth, then all of the atoms in the universe. The “greater fool” or Ponzi scheme theory must break down at some point, or rely on an irrational belief in the next fool. The rational bubbles theory also does not account for the association of price surges with high volatility and high trading volume.
The fact that bitcoin is a speculative bubble, though, does not mean that it will pop anytime soon. As long as the people who hold the most coins—the “bitcoin whales”—think there are greater fools who will bid up the price, the bubble is likely to last a long time.
How does bitcoin work? (The simplified explanation)
In order to use the bitcoin system, a user installs a “wallet” on their computer or mobile phone. Once installed the wallet generates a bitcoin address (similar to an email address) that allows the user to send and receive payments. Bitcoins are divisible to 8 decimal places yielding a total of approx. 21×1014 currency units. This allows a person to spend a fraction of a bitcoin. Unlike standard e-commerce and money transfer system, bitcoin transactions are irreversible.
Bitcoin can also be traded like a stock on a online cryptocurrency trading platforms, such as Coinbase or Bitstamp.
How does bitcoin work? (The more complicated explanation)
A bitcoin is merely a chain of digital signatures attached to a transaction log. In the first transaction of the system, Nakamoto’s computer program (which is open source and distributed across a peer-to-peer network) created 50 bitcoins. When Nakamoto spent some of the coins, it created a new transaction that subtracted the amount from his account and credited it to the recipient’s. All such transfers entail the owner digitally signing a hash (a numerical value created by an algorithm) of the previous transaction and providing the public key for the encryption to the next owner. Both items are then added to the coin’s transaction log. A payee can verify the signatures to verify the chain of ownership, which prevents double spending of the same coins.
This transaction—and all subsequent exchanges—is distributed to the entire network for verification. Collections of transactions, known as “blocks,” are deemed valid when another computer on the network creates a transaction log for it that matches the previous blocks. To prevent the falsified logs from being accepted, the system must provide a means of verification that is prohibitively costly to any individual user, but relatively cheap for the network as a whole. As explained in The Economist:
This is done by making it into a forced-work task, which involves using the valid blocks and the new transactions to generate a digest consisting of 256 bits (i.e., any number between 0 and 2256). The task is complete when the system’s algorithm spits out a hash value below a preset target (like 11 in the example above). The target is set so that the puzzle is solved by someone on the network, and a new block approved, every 10 minutes. To keep this rate constant as the network’s ranks swell and its combined computing power grows, the target is lowered in order to make generating a value below it harder. (Conversely, if the network were to shrink, it would get easier again.)
As a reward for providing the computing power necessary to validate the logs, the first user whose computer finishes the RPOW task is rewarded with a set number of new coins. This is how new bitcoins are added to the money supply. Because blocks are created at a steady average rate (about every ten minutes), 300 new coins were added to the system every hour for the first four years (210,000 blocks). The system is designed so that the minting rate will decrease by half every four years. In 2012 the number of new coins issued per block dropped to 25 coins. In 2017, the rate will be 12.5, and so on, until the total supply plateaus at 21 million coins around the year 2030.
WHAT ARE THE ADVANTAGES OF BITCOIN?
The advantages of using bitcoin are mostly ideological. There are four main groups of people who are attracted to the bitcoin system:
1. People who are obsessed with privacy.
2. People who despise the government, fiat money, and/or the Federal Reserve System.
3. People interested in online experiments and/or peer-based innovations.
4. People interested in economic speculation.
Of course such a list isn’t exhaustive, and there is much overlap between the groups. But the nature of the system makes it appealing to such groups precisely because this was the intent of its founder.
Almost nothing is known about Satoshi Nakamoto, the man (or woman) who devised both the concept and the original bitcoin program. The name is Japanese, but there is no Japanese version of the bitcoin program. Nakamoto has also not written a single line of Japanese either in his code or in his sparse online writings. After starting the bitcoin project in 2007, his involvement tapered of in late 2010. He has not been heard from since.
As to his political motivations, the only clue is a message he left on a cryptography mailing list. In response to a claim that the bitcoin system would be “socially useful and valuable,” Nakamoto wrote: “It’s very attractive to the libertarian viewpoint if we can explain it properly. I’m better with code than with words though.”
The intent and motivations of the founder are usually of no concern when evaluating new technologies. However, the case of peer-based systems such a bitcoin, they can be a useful starting point for understanding how the project will evolve and its likelihood of success. Crowd-sourced technology projects are often driven as much by political and social concerns as they are with economics. Bitcoin is a prime example. The system is cumbersome, limited in use, and has many economic disadvantages (which we’ll discuss in the next section) that far outweigh—at least for the common user—any advantages. The primary motivation for advancing the system is to advance concerns common to cyberlibertarians: online privacy and a disdain for fiat money.
The concerns of some privacy enthusiasts, however, have less to do with political abstractions of liberty than with a desire to have their financial transactions hidden from the view of law enforcement. For example, the website Silk Road made headlines a couple of years ago for becoming the first online marketplace for illicit drugs to accept the digital currency.
Although users of bitcoins can remain anonymous, they aren’t untraceable. As Jeff Garzik, a member of the bitcoin core development team, told Gawker.com, “Attempting major illicit transactions with bitcoin, given existing statistical analysis techniques deployed in the field by law enforcement, is pretty damned dumb.” Ironically, drug users who thought they were using bitcoin to conceal their transactions are likely making it easier for the DEA to collect a database of their purchases.
However, buying drugs is not the only government-avoiding activity that bitcoins help facilitate. They can also allow American citizens to gamble online using foreign gambling sites and bypass a U.S. government ban on online gambling or the transfer of funds to offshore gambling sites. The currency also allows people to avoid taxes and can facilitate donations to groups targeted by federal agents. Bitcoin users, for instance, can provide money to groups like WikiLeaks without worrying about the U.S. government shutting down their PayPal accounts.
Most people who used to exchange bitcoins, though, were (presumably) not using their money to buy psychedelic mushrooms from Canada or play online blackjack in Antigua. Many were simply enthusiastic and supportive of a system that allows them to put their monetary theories into practice.
Today, few people are using bitcoin to buy goods and services, and most of the exchanges are from buyers and sellers interested in speculation (i.e., selling bitcoins to people who think the price will rise even higher).
WHAT ARE THE DISADVANTAGES OF BITCOIN?
For people who are not obsessed with anonymity and are not waiting for the United States to return to the gold standard, the reasons for avoiding entering the bitcoin market are numerous:
1. Convertibility – Whereas other currencies are convertible into other financial instruments (dollars to checks to certificates of deposit, and so on) and through numerous third-party services (e.g., Visa, PayPal, Citibank), commodity currencies like bitcoin can only be exchanged for fiat currencies—and then only through an online exchange. Indeed, unless your computer is working overtime on bitcoin mining, the only way to acquire the currency is to buy it from one of the online exchanges.
These exchanges are completely unregulated and are subject to problems that do not affect other financial markets. For instance, in 2011 the largest bitcoin exchange, MTGox, had a security breach that resulted in the theft of nearly 500,000 bitcoins (worth about $9 million at the time and $8 billion today). The theft caused the value of bitcoins to crash from $17.50 to one cent before the market was able to recover.
2. Instability – The MTGox breach—and the subsequent market crash—taught bitcoin owners a harsh lesson about commodity currencies: they can be wildly unstable. Over the eight-month span from October 1, 2010, to June 9, 2011, the market value of bitcoins skyrocketed 9,667-fold from a value of $0.06 to $29.
The rate had dropped in 2012 and at the end of last year a bitcoin was worth only $13.51. Last week, though, bitcoins were trading as high as $19,790 before plummeting back to around $16,000. Anyone who had bought $1,000 worth of the coins in October 2010 would have $1.2 million worth of bitcoins. However, the convertibility problem would make it nearly impossible for the bitcoin “whales” to extract all of their earnings without crashing the market and devaluing the entire currency. A gradual sell-off over an extended period of time would be necessary to take advantage of the increase in valuation.
Still, being the seller of the overvalued currency is preferable to being the buyer. The Winklevoss twins, millionaires famous for their legal battle with Facebook, claim to own around 1 percent of all bitcoins currently in existence (around 108,000). They began buying the currency in 2012, making some early bitcoin holders very rich (current values of their holdings: about $1.7 billion).
Indeed, the only way to ensure that you make a profit (or at least not lose money) is to have bought bitcoins in 2009: Three million bitcoins—13 percent of the total number of bitcoins that will ever be created—were minted that year. Few people, mainly readers of cryptography mailing lists, were even aware of bitcoins then and so were able to acquire a disproportionate share of the currency. Somewhere on the planet, economically savvy hackers (including, perhaps, Satoshi Nakamoto) are making a fortune by slowly selling off their digital currency.
3. Limited protection against fraud – Satoshi Nakamoto made it a point to make bitcoin transactions non-reversible. But this is one of the primary features that encourage people to trust e-commerce systems. If you know that your money is lost and can’t be returned if you are scammed, you are less likely to trust buyers online. This has the effect of dampening trust in all merchants, not just the fraudulent ones, and reducing the desire to exchange money in a virtual setting.
4. Limited sources for goods and services – Once you acquire bitcoins, what can you spend them on? Mostly online services, such as software, tech support, and webhosting—services that can easily be paid for using current e-commerce systems like PayPal. Few offline merchants today currently accept the virtual currency. Although it may change in the future, the lack of places to buy goods and services limits the usefulness of the currency as a medium of exchange.
5. Waste of capital and resources in creating the currency — As Jordan Ballor asked,
[W]hat does a bitcoin block represent in terms of actual human utility? I worry too that this is a system that relies parasitically on real-world resources, e.g. coal which provides a large part of the electricity, which is used to run computers so that they can then in turn “mine” something entirely virtual.
This is similar to Adam Smith’s concern about the fundamental foolishness of relying on gold and silver currency:
The gold and silver money which circulates in any country, and by means of which, the produce of its land and labour is annually circulated and distributed to the proper consumers, is, in the same manner as the ready money of the dealer, all dead stock. It is a very valuable part of the capital of the country, which produces nothing to the country. The judicious operations of banking, by substituting paper in the room of a great part of this gold and silver, enable the country to convert a great part of this dead stock into active and productive stock; into stock which produces something to the country. The gold and silver money which circulates in any country may very properly be compared to a highway, which, while it circulates and carries to market all the grass and corn of the country, produces itself not a single pile of either. The judicious operations of banking, by providing, if I may be allowed so violent a metaphor, a sort of waggon-way through the air, enable the country to convert, as it were, a great part of its highways into good pastures, and corn fields, and thereby to increase, very considerably, the annual produce of its land and labour.
6. Bitcoin is a prone to deflation and speculative bubbles — Deflation, a decline in the general price level, occurs when the price of goods and services decline relative to a specific measure. The value of the goods and services themselves do not have to decline for deflation to occur; all that is required is for the value of the currency itself to increase. This is exactly what has occurred for the entire existence of bitcoin.
WHY DOES BITCOIN MATTER?
If the experiment as a currency is unlikely to succeed, then why should anyone bother paying attention to bitcoin? The reason can be found in another, more successful, completely pernicious, online venture: porn.
“The internet was completely funded by porn,” Greg Fitzsimmons said at the 23rd annual adult entertainment industry awards. He was only half-joking. The pornography industry drove or boosted many of the web’s most useful innovations—live chat, streaming video, online payment systems—as well as the popularity of fast connections. As Christians we should recognize that the moral and social destruction of online pornography has been incalculable. But genre has also been a driver of innovation in many areas of information technology.
Similarly, the types of people interested in the bitcoin experiment—highly motivated, tech-savvy—are likely to spark new cutting-edge methods, technologies, or policies that will change e-commerce, security, and online privacy. For example, the African diaspora—nearly 140 million Africans live abroad—has become such a major source of foreign income that it now outstrips foreign aid sent by Western donors. Unfortunately, about $7 billion a year never makes it into the relatives’ accounts because of high bank fees. Bitcoin or other crytocurrencies may pave the way for future transfer methods that circumvent the current system of exorbitant transaction costs, allowing more money to be transferred directly to needy family members.
As a currency, the story of bitcoin is likely to become nothing more than a footnote in obscure economic journals. However, the cryptocurrency’s legacy on information technology and peer-to-peer based trust systems may be as significant. The question we Christians must ask is whether it is wise stewardship to fund the growth of a system in which thousands of people will eventually lose real, significant wealth in the hope that it might lead to such innovations.
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DECEMBER 27, 2017 | Joe Carter SHARE
CURRENT EVENTS
DO CHRISTIANS NEED TO KNOW ABOUT BITCOIN?
The best answer to this question is probably, “Some do, most don’t, but we all may in the future.”
When I first started researching bitcoin for an MBA project in 2012 the price was $15 per “coin,” and it was of interest mostly for ideological and technological reasons. This year the cryptocurrency reached an all-time high of $19,796 per bitcoin on December 17 (though it has dropped again, and at the time of this writing is $15,850) and it has garnered increased interest as “investment” opportunity.
It’s this economic angle—especially the morality of speculation—that makes bitcoin of interest to (some) Christians. Are Christians who buy bitcoins gambling with God’s money? Are they hoping to sell an object with no intrinsic value to someone more greedy or gullible in the hopes of getting out before the bubble pops?
In a future I’ll address these questions and others related to the ethics of speculation. But in this article I’ll present the information about bitcoin in a relatively straightforward manner to help believers make the determination for themselves.
This is a long article, and most people will not need to read all of it. If you’re only mildly curious about bitcoin I’d suggest reading the sections marked as “simple” explanation and the section “What is bitcoin? (The economic explanation).”
WHAT IS BITCOIN? (THE SIMPLE TECHNOLOGICAL EXPLANATION)
Bitcoin is network-based digital currency that is created and exchanged electronically. Although the currency exists entirely online, it can be used to purchase non-virtual goods and services. Because it is a purely peer-to-peer version of electronic cash, bitcoin allows online payments to be sent directly from one party to another without going through a financial institution.
WHAT IS BITCOIN? (THE DETAILED TECHNOLOGICAL EXPLANATION)
The founder of the world’s most successful cryptocurrency has a name but no identity. In 2009, a computer programmer using the pseudonym Satoshi Nakamoto (Satoshi means “reason” in Japanese) self-published a nine-page paper explaining how a digital currency could be created that would eliminate the need for centralized third-party financial institutions.
In most forms of e-commerce, a third party acts as a mediator between the buyer and the seller for the purpose of electronic funds transfer. This mediation not only increases the transaction costs but also the ability to reverse the payments allows the financial institution to have the last word on any transaction. Although this function is necessary for the current trust-based system of online commerce, it conflicts with a core value of the super-secretive Nakamoto: absolute privacy. As Nakamoto explains:
With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.
What was needed, according to Nakamoto, is an electronic payment system based not on trust but on cryptographic proof. Such a system would allow “any two willing parties to transact directly with each other without the need for a trusted third party.” Without a third-party mediator, the buyer and seller could remain completely anonymous, exchanging goods and services without having to disclose any private information about each other.
The problem with such an approach is that with most digital cash schemes, it is possible to spend a single digital token twice. Unlike physical token money such as coins, the act of spending a digital coin does not remove its data from the ownership of the original holder. Another means is needed to prevent double-spending. Nakamoto’s ingenious solution to the double-spending problem was to use a proof-of-work system as both an initial currency distribution mechanism and also a measurement against double-spending.
Proof-of-work (POW) systems were originally designed by computer scientists as a means of preventing network service abuses, such as spam or denial-of-service attacks. The system requires evidence that some time-bound function has been completed (generally solving a computation that requires processing time by a computer) before access to the network will be granted. In 1999, computer scientist Hal Finney developed the concept of the “bread pudding protocol.” Just as stale bread can be repurposed to create a new foodstuff (e.g., bread pudding), a POW solution can be repurposed for other uses, including the creation of a digital token. Such repurposed POWs—or RPOWs—form the basis of cryptographic proof for Nakamoto’s bitcoin system. Bread pudding isn’t the most inspiring metaphor for a currency, though, so the users of bitcoin refer to the creation of new currency as “mining.”
WHAT IS BITCOIN? (THE ECONOMIC EXPLANATION)
Why are bitcoins considered valuable?
Most global currencies are fiat money—money that has value only because of government regulation or law. Fiat money is not convertible by law into anything other than itself, such as gold or silver, and has no fixed value in terms of an objective standard—its value can fluctuate based on numerous economic factors.
In contrast, commodity money is a medium of exchange that may be transformed into a commodity, useful in production or consumption. Commodity money can be based on minerals (e.g., gold or silver), found objects (e.g., shells or stones), or consumer goods (e.g., ramen noodles in prison). Although it was the dominant medium for exchange for more than 2,000 years, commodity money has fallen out of favor because of it limits the scope for monetary policy and other actions that alter the value of money.
Bitcoins are a form of commodity money. Technically, bitcoins have no intrinsic value, since they are nothing more than digitized “bits” created by a laborious process on a decentralized network of computers. But because the supply is limited (they are rare commodity not easily produced) and their use is recognized as a medium of exchange, they are assigned a value by their users. What bitcoins are worth is solely determined by what people believe they are worth.
Is bitcoin still a cryptocurrency?
Not really. A cryptocurrency is a digital asset designed to work as a medium of exchange that uses cryptography to secure its transactions, to control the creation of additional units, and to verify the transfer of assets. Bitcoin has become the most popular mainstream cryptocurrency by ceasing to be a form of currency (i.e., a medium of exchange). Sure, you can still technically buy some goods and services with bitcoin. But because it is prone to deflation you’d be foolish to do so.
Deflation, a decline in the general price level, occurs when the price of goods and services declines relative to a specific measure. The value of the goods and services themselves does not have to decline for deflation to occur; all that is required is for the value of the currency itself to increase. This is exactly what has occurred for the entire existence of bitcoin.
Because of its deflationary nature, bitcoin is a terrible form of currency. For example, in 2010, a developer named Laszlo Hanyecz traded 10,000 bitcoins for two Papa John’s pizzas. At the time the bitcoins were worth about $40. Today, those coins would be worth $1.7 million. Anyone who bought anything with bitcoins prior to 2017 is likely regretting their purchase.
It bitcoin a tech stock?
Definitely not. There are several ways that stocks are valued, but most of them are based on the assumption that the underlying company has or will have future earnings that will either justify the rise in price or will lead to a distribution of dividends to shareholders.
While bitcoin sometimes acts like a stock (i.e., it can be traded on exchanges, is subject to technical analysis, and so on), there is no company underlying bitcoins—only a blockchain. Bitcoin will also never have earnings, though it currently pays out a form of “dividend” to bitcoin miners.
Is bitcoin the “new gold”?
Bitcoin is like Gold 2.0, Tyler Winklevoss says.
No, it’s not. While bitcoin appeals to many of the same people who once preferred gold as an investment vehicle, bitcoin has few similarities to the precious metal. For starters, bitcoin is a a commodity currency that acts like a “fiat currency,” similar to the U.S. dollar. Gold is commodity money because the price of gold is backed by . . . gold. Gold is also an actual physical asset that has some use for real-world applications. Bitcoin is an intangible asset whose monetary value solely depends on how much hard currency people are willing to exchange for it.
Additionally, gold has the advantage of being a long-term illusion: gold is valuable because for thousands of years we humans have convinced ourselves that gold is valuable. Bitcoin and other cryptocurrencies have a long way to go before they can create a similar “money delusion.”
Is bitcoin a wealth redistribution system?
Yes, it is. The question is what type of wealth redistribution system. The most generous take is that similar to Valentin Schmid, who contends that bitcoin “favors risk takers, innovators, savers, and people who are curious and persistent enough to learn new technology as well as history.” Those people, who jumped on the bitcoin train early enough “will be richly rewarded and their purchasing power will increase.”
That’s certainly true to some extent, since 40 percent of bitcoin is held by about 1,000 people. As the price of bitcoin increases, the value of the holdings of these early movers is rising almost exponentially. The key for them is when to unload bitcoins for hard currency and collect the wealth that has been accumulating to them. When they do (and they can even collude together on the timing since bitcoin isn’t subject to financial regulations) the bitcoins held by the late movers will be worth much, much less than they bought them for (as many people discovered the week before Christmas).
Another, less congenial, term for this is a ponzi scheme. The price of bitcoin is currently rising based solely on the idea that the price will rise even further. And as long as there are “greater fools” to bid up the price of the cryptocurrency, the price will continue rise. Eventually, though, when there are no more fools left, the bubble will pop—and thousands of people will have lost real money.
Is bitcoin a speculative bubble?
Yes, almost assuredly. Financial bubbles involve outsized growth in the price of an asset beyond its true value. Bitcoin has no intrinsic value, so why do people hold it as an asset? Because they think it can be sold an even higher price in the future (see: greater fool theory). As economist John Cochrane explains:
f the price [of an asset] is greater than zero, either people see some “dividend,” some value in holding the asset, beyond its cash payments; equivalently they are willing to hold the asset despite a lower expected return going forward, or they think the price will keep going up forever, so that price appreciation alone provides a competitive return. The first two are called “convenience yield,” the latter is a “rational bubble.”
“Rational bubbles” are intriguing, but I think fundamentally flawed. If a price goes up forever, eventually the value of bitcoin must exceed all of U.S. wealth, then all of world wealth, then all of interplanetary wealth, then all of the atoms in the universe. The “greater fool” or Ponzi scheme theory must break down at some point, or rely on an irrational belief in the next fool. The rational bubbles theory also does not account for the association of price surges with high volatility and high trading volume.
The fact that bitcoin is a speculative bubble, though, does not mean that it will pop anytime soon. As long as the people who hold the most coins—the “bitcoin whales”—think there are greater fools who will bid up the price, the bubble is likely to last a long time.
How does bitcoin work? (The simplified explanation)
In order to use the bitcoin system, a user installs a “wallet” on their computer or mobile phone. Once installed the wallet generates a bitcoin address (similar to an email address) that allows the user to send and receive payments. Bitcoins are divisible to 8 decimal places yielding a total of approx. 21×1014 currency units. This allows a person to spend a fraction of a bitcoin. Unlike standard e-commerce and money transfer system, bitcoin transactions are irreversible.
Bitcoin can also be traded like a stock on a online cryptocurrency trading platforms, such as Coinbase or Bitstamp.
How does bitcoin work? (The more complicated explanation)
A bitcoin is merely a chain of digital signatures attached to a transaction log. In the first transaction of the system, Nakamoto’s computer program (which is open source and distributed across a peer-to-peer network) created 50 bitcoins. When Nakamoto spent some of the coins, it created a new transaction that subtracted the amount from his account and credited it to the recipient’s. All such transfers entail the owner digitally signing a hash (a numerical value created by an algorithm) of the previous transaction and providing the public key for the encryption to the next owner. Both items are then added to the coin’s transaction log. A payee can verify the signatures to verify the chain of ownership, which prevents double spending of the same coins.
This transaction—and all subsequent exchanges—is distributed to the entire network for verification. Collections of transactions, known as “blocks,” are deemed valid when another computer on the network creates a transaction log for it that matches the previous blocks. To prevent the falsified logs from being accepted, the system must provide a means of verification that is prohibitively costly to any individual user, but relatively cheap for the network as a whole. As explained in The Economist:
This is done by making it into a forced-work task, which involves using the valid blocks and the new transactions to generate a digest consisting of 256 bits (i.e., any number between 0 and 2256). The task is complete when the system’s algorithm spits out a hash value below a preset target (like 11 in the example above). The target is set so that the puzzle is solved by someone on the network, and a new block approved, every 10 minutes. To keep this rate constant as the network’s ranks swell and its combined computing power grows, the target is lowered in order to make generating a value below it harder. (Conversely, if the network were to shrink, it would get easier again.)
As a reward for providing the computing power necessary to validate the logs, the first user whose computer finishes the RPOW task is rewarded with a set number of new coins. This is how new bitcoins are added to the money supply. Because blocks are created at a steady average rate (about every ten minutes), 300 new coins were added to the system every hour for the first four years (210,000 blocks). The system is designed so that the minting rate will decrease by half every four years. In 2012 the number of new coins issued per block dropped to 25 coins. In 2017, the rate will be 12.5, and so on, until the total supply plateaus at 21 million coins around the year 2030.
WHAT ARE THE ADVANTAGES OF BITCOIN?
The advantages of using bitcoin are mostly ideological. There are four main groups of people who are attracted to the bitcoin system:
1. People who are obsessed with privacy.
2. People who despise the government, fiat money, and/or the Federal Reserve System.
3. People interested in online experiments and/or peer-based innovations.
4. People interested in economic speculation.
Of course such a list isn’t exhaustive, and there is much overlap between the groups. But the nature of the system makes it appealing to such groups precisely because this was the intent of its founder.
Almost nothing is known about Satoshi Nakamoto, the man (or woman) who devised both the concept and the original bitcoin program. The name is Japanese, but there is no Japanese version of the bitcoin program. Nakamoto has also not written a single line of Japanese either in his code or in his sparse online writings. After starting the bitcoin project in 2007, his involvement tapered of in late 2010. He has not been heard from since.
As to his political motivations, the only clue is a message he left on a cryptography mailing list. In response to a claim that the bitcoin system would be “socially useful and valuable,” Nakamoto wrote: “It’s very attractive to the libertarian viewpoint if we can explain it properly. I’m better with code than with words though.”
The intent and motivations of the founder are usually of no concern when evaluating new technologies. However, the case of peer-based systems such a bitcoin, they can be a useful starting point for understanding how the project will evolve and its likelihood of success. Crowd-sourced technology projects are often driven as much by political and social concerns as they are with economics. Bitcoin is a prime example. The system is cumbersome, limited in use, and has many economic disadvantages (which we’ll discuss in the next section) that far outweigh—at least for the common user—any advantages. The primary motivation for advancing the system is to advance concerns common to cyberlibertarians: online privacy and a disdain for fiat money.
The concerns of some privacy enthusiasts, however, have less to do with political abstractions of liberty than with a desire to have their financial transactions hidden from the view of law enforcement. For example, the website Silk Road made headlines a couple of years ago for becoming the first online marketplace for illicit drugs to accept the digital currency.
Although users of bitcoins can remain anonymous, they aren’t untraceable. As Jeff Garzik, a member of the bitcoin core development team, told Gawker.com, “Attempting major illicit transactions with bitcoin, given existing statistical analysis techniques deployed in the field by law enforcement, is pretty damned dumb.” Ironically, drug users who thought they were using bitcoin to conceal their transactions are likely making it easier for the DEA to collect a database of their purchases.
However, buying drugs is not the only government-avoiding activity that bitcoins help facilitate. They can also allow American citizens to gamble online using foreign gambling sites and bypass a U.S. government ban on online gambling or the transfer of funds to offshore gambling sites. The currency also allows people to avoid taxes and can facilitate donations to groups targeted by federal agents. Bitcoin users, for instance, can provide money to groups like WikiLeaks without worrying about the U.S. government shutting down their PayPal accounts.
Most people who used to exchange bitcoins, though, were (presumably) not using their money to buy psychedelic mushrooms from Canada or play online blackjack in Antigua. Many were simply enthusiastic and supportive of a system that allows them to put their monetary theories into practice.
Today, few people are using bitcoin to buy goods and services, and most of the exchanges are from buyers and sellers interested in speculation (i.e., selling bitcoins to people who think the price will rise even higher).
WHAT ARE THE DISADVANTAGES OF BITCOIN?
For people who are not obsessed with anonymity and are not waiting for the United States to return to the gold standard, the reasons for avoiding entering the bitcoin market are numerous:
1. Convertibility – Whereas other currencies are convertible into other financial instruments (dollars to checks to certificates of deposit, and so on) and through numerous third-party services (e.g., Visa, PayPal, Citibank), commodity currencies like bitcoin can only be exchanged for fiat currencies—and then only through an online exchange. Indeed, unless your computer is working overtime on bitcoin mining, the only way to acquire the currency is to buy it from one of the online exchanges.
These exchanges are completely unregulated and are subject to problems that do not affect other financial markets. For instance, in 2011 the largest bitcoin exchange, MTGox, had a security breach that resulted in the theft of nearly 500,000 bitcoins (worth about $9 million at the time and $8 billion today). The theft caused the value of bitcoins to crash from $17.50 to one cent before the market was able to recover.
2. Instability – The MTGox breach—and the subsequent market crash—taught bitcoin owners a harsh lesson about commodity currencies: they can be wildly unstable. Over the eight-month span from October 1, 2010, to June 9, 2011, the market value of bitcoins skyrocketed 9,667-fold from a value of $0.06 to $29.
The rate had dropped in 2012 and at the end of last year a bitcoin was worth only $13.51. Last week, though, bitcoins were trading as high as $19,790 before plummeting back to around $16,000. Anyone who had bought $1,000 worth of the coins in October 2010 would have $1.2 million worth of bitcoins. However, the convertibility problem would make it nearly impossible for the bitcoin “whales” to extract all of their earnings without crashing the market and devaluing the entire currency. A gradual sell-off over an extended period of time would be necessary to take advantage of the increase in valuation.
Still, being the seller of the overvalued currency is preferable to being the buyer. The Winklevoss twins, millionaires famous for their legal battle with Facebook, claim to own around 1 percent of all bitcoins currently in existence (around 108,000). They began buying the currency in 2012, making some early bitcoin holders very rich (current values of their holdings: about $1.7 billion).
Indeed, the only way to ensure that you make a profit (or at least not lose money) is to have bought bitcoins in 2009: Three million bitcoins—13 percent of the total number of bitcoins that will ever be created—were minted that year. Few people, mainly readers of cryptography mailing lists, were even aware of bitcoins then and so were able to acquire a disproportionate share of the currency. Somewhere on the planet, economically savvy hackers (including, perhaps, Satoshi Nakamoto) are making a fortune by slowly selling off their digital currency.
3. Limited protection against fraud – Satoshi Nakamoto made it a point to make bitcoin transactions non-reversible. But this is one of the primary features that encourage people to trust e-commerce systems. If you know that your money is lost and can’t be returned if you are scammed, you are less likely to trust buyers online. This has the effect of dampening trust in all merchants, not just the fraudulent ones, and reducing the desire to exchange money in a virtual setting.
4. Limited sources for goods and services – Once you acquire bitcoins, what can you spend them on? Mostly online services, such as software, tech support, and webhosting—services that can easily be paid for using current e-commerce systems like PayPal. Few offline merchants today currently accept the virtual currency. Although it may change in the future, the lack of places to buy goods and services limits the usefulness of the currency as a medium of exchange.
5. Waste of capital and resources in creating the currency — As Jordan Ballor asked,
[W]hat does a bitcoin block represent in terms of actual human utility? I worry too that this is a system that relies parasitically on real-world resources, e.g. coal which provides a large part of the electricity, which is used to run computers so that they can then in turn “mine” something entirely virtual.
This is similar to Adam Smith’s concern about the fundamental foolishness of relying on gold and silver currency:
The gold and silver money which circulates in any country, and by means of which, the produce of its land and labour is annually circulated and distributed to the proper consumers, is, in the same manner as the ready money of the dealer, all dead stock. It is a very valuable part of the capital of the country, which produces nothing to the country. The judicious operations of banking, by substituting paper in the room of a great part of this gold and silver, enable the country to convert a great part of this dead stock into active and productive stock; into stock which produces something to the country. The gold and silver money which circulates in any country may very properly be compared to a highway, which, while it circulates and carries to market all the grass and corn of the country, produces itself not a single pile of either. The judicious operations of banking, by providing, if I may be allowed so violent a metaphor, a sort of waggon-way through the air, enable the country to convert, as it were, a great part of its highways into good pastures, and corn fields, and thereby to increase, very considerably, the annual produce of its land and labour.
6. Bitcoin is a prone to deflation and speculative bubbles — Deflation, a decline in the general price level, occurs when the price of goods and services decline relative to a specific measure. The value of the goods and services themselves do not have to decline for deflation to occur; all that is required is for the value of the currency itself to increase. This is exactly what has occurred for the entire existence of bitcoin.
WHY DOES BITCOIN MATTER?
If the experiment as a currency is unlikely to succeed, then why should anyone bother paying attention to bitcoin? The reason can be found in another, more successful, completely pernicious, online venture: porn.
“The internet was completely funded by porn,” Greg Fitzsimmons said at the 23rd annual adult entertainment industry awards. He was only half-joking. The pornography industry drove or boosted many of the web’s most useful innovations—live chat, streaming video, online payment systems—as well as the popularity of fast connections. As Christians we should recognize that the moral and social destruction of online pornography has been incalculable. But genre has also been a driver of innovation in many areas of information technology.
Similarly, the types of people interested in the bitcoin experiment—highly motivated, tech-savvy—are likely to spark new cutting-edge methods, technologies, or policies that will change e-commerce, security, and online privacy. For example, the African diaspora—nearly 140 million Africans live abroad—has become such a major source of foreign income that it now outstrips foreign aid sent by Western donors. Unfortunately, about $7 billion a year never makes it into the relatives’ accounts because of high bank fees. Bitcoin or other crytocurrencies may pave the way for future transfer methods that circumvent the current system of exorbitant transaction costs, allowing more money to be transferred directly to needy family members.
As a currency, the story of bitcoin is likely to become nothing more than a footnote in obscure economic journals. However, the cryptocurrency’s legacy on information technology and peer-to-peer based trust systems may be as significant. The question we Christians must ask is whether it is wise stewardship to fund the growth of a system in which thousands of people will eventually lose real, significant wealth in the hope that it might lead to such innovations.
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