by David Orrell
Bitcoin’s artificially high mining costs, which serve as a security feature to deter tampering with the blockchain, were perhaps also intended to emulate gold. As discussed in chapter 6, Adam Smith equated the cost of gold with the labor required to procure it, so gold money is in a sense backed by mining labor. With Bitcoin’s proof-of-work protocol, human labor is replaced with the labor of computers and the electricity needed to power them. Bitcoin price and mining costs are coupled. If the price spikes too high above costs, then miners will mine more coins, which will increase supply and drive down the price; and as mining technology improves, costs go down, but the system makes fewer coins available to mine, which drives up the price. (When the number of bitcoins reaches its cap, mining of new coins will come to an end, so the existing coins will be backed, we suppose, by historic computer labor.) One of the criticisms of gold is the environmental damage and waste caused by mining, and the same can be said of Bitcoin; proponents will argue this is the cost of maintaining a secure network.
Bitcoin’s exchange rate is volatile in part because much of the trading is speculative and does not involve the purchase of actual goods and services.22 This volatility is not of direct concern to people who use bitcoins only as an intermediary for money transfers; however, it is certainly a headache for people like merchants. Volatility should reduce with time as the currency becomes more widely accepted, and this appears to be happening at a fairly quick pace—so much so, that even some of the people involved with the development of Bitcoin were surprised (see the section “Bitcoin: An Insider’s Audit”). As one of the authors of this book, Chlupatý, found out, in Berlin, dubbed the world’s Bitcoin capital, one could even live entirely on this currency in 2014, from renting a place, through getting a meal or a cup of coffee, to buying collectibles. Berlin business owners from Kreuzberg, the very heart of it all, say they mostly save the bitcoins they earn today, liking Bitcoin’s philosophy, its rebellious antiestablishment feel, and its potential to disrupt the status quo, and hoping for the best to happen tomorrow. They both fear the currency’s gradual shift toward the mainstream and, on a certain level, wish for it.
Money 5.n
While Bitcoin is by far the leading cybercurrency, it may not represent the last word on cybercurrency design. Competitors include so-called proof-of-stake altcoins such as the Paris-based NeuCoin, launched in July 2015, which rewards miners based on holdings rather than proof-of-work. As NeuCoin’s founders point out in a white paper, Bitcoin miners currently earn in aggregate about $1 million a day, which works out to about $10 per transaction.23 Users don’t notice this, because transaction fees average only 5 cents. The remaining $9.95 comes from the new coins awarded to miners, and most of this is swapped out of Bitcoin to pay for expenses such as electricity. Mining rewards are set to decline as fewer new coins become available in the future, so total transaction fees will have to go up to compensate. The idea is that the sum value of transactions should increase enough to keep fees low.
NeuCoin, which is focusing initially on microtransactions such as tipping for online services, gets around this potential problem in another way, by simplifying the mining process and rewarding miners with new coins based on the number they hold (effectively an interest payment). Miners are motivated to secure the system because they will be substantial holders of the currency. Some coins are also granted to new or existing users or companies that adopt the currency. The process is overseen by three nonprofit foundations located in the Isle of Man, which are ultimately controlled by NeuCoin users on the basis of one vote per coin. The idea is to distribute coins strategically to encourage widespread adoption—while the Greeks and Romans used the army, NeuCoin is going for gaming, music, and video sites, with ads such as: “Go ad-free today for 10 NeuCoins. Click here to get 20 free.” The money supply will therefore expand, rapidly at first and then more slowly, with a long-term target of 3 percent per year. Whether NeuCoin will succeed remains to be seen, but it and other competitors may well give the champ a run for its money.
Bitcoin’s key technology, the blockchain, can also be used for purposes other than tracking coins. The company Ethereum, for example, has developed a software platform that uses the blockchain to certify digital contracts, powered by its own Bitcoin-like currency called ether (symbol Ξ, as in Ξther).24 When we asked a representative from the firm at a Bitcoin conference to show a useful application, he pointed at his T-shirt, which displayed a few lines of code describing a decentralized drop box for large files. The file to be saved is broken up and distributed to multiple computers owned by different users. The owner can then redownload the file by making a micropayment in ethers. It doesn’t sound that exciting, until you think of the massive quantities of underutilized but potentially valuable storage space that could be tapped, instead of building more data centers in Iceland or wherever.
In principle, anything that can be represented mathematically can be implemented using the language, from voting systems to derivatives contracts to stock markets to ownership of physical assets such as cars, houses, and gold. Trading expensive items usually involves middlemen such as real estate agents or brokers to verify the identity of each party and make sure the transaction takes place properly. But if the ownership of the goods is tied to a digital token and verified through the blockchain, then the assets can be tracked and traded in the same way as bitcoins.
The blockchain has, for example, been proposed for the music industry as a way to keep track of artists’ royalties, which are currently handled through a notoriously labyrinthine procedure involving layers of middlemen.25 In other areas, the problem is not so much middlemen but the lack of a functioning system at all. As the Peruvian economist Hernando de Soto points out, billions of people around the world are excluded from the formal economy because there is no “public memory” of who owns what—which means among other things that they have no collateral for loans.26 One answer—currently being tested in Honduras, one of the poorest countries in Latin America—is to build a secure land registry based on an enlarged version of the blockchain.27 The trust that the blockchain gives Bitcoin can be generalized to any type of contract or document that would usually require a third party such as a lawyer. The distinction between money, things, and information becomes increasingly blurred.
In fact, with the much-vaunted Internet of Things, things could start to pay one another. An appropriately configured washing machine could order laundry detergent, negotiate the price, monitor the shipment, and alert the owner by phone, tracking everything on the blockchain as it went.28 A self-driving car could set itself up as a taxi service.29 Toasters and dishwashers will presumably be owning their own bank accounts and doing some speculation in derivatives on the side. And so on.
The endless possibilities are being explored in fintech hubs around the world, from Sydney to Tel Aviv, from London’s Silicon Roundabout (situated around the Old Street Roundabout) to Zug’s Crypto-Valley (described as a Swiss mecca for fintech because of its open legal environment).30 A number of start-ups are being supported by investors such as BitAngels, whose cofounder Michael Terpin believes at least 10 percent of the world’s e-commerce could be done over the blockchain, and the $4 billion venture capital firm Andreessen Horowitz, whose Marc Andreessen coinvented the first widely used Internet browser, Mosaic.31 And in a replay of the “coder versus suits” dynamic that fueled the PC revolution in the 1970s, the equally revolutionary appeal of Bitcoin has not been lost on large financial companies such as JP Morgan and technology firms such as (yesterday’s upstart) Apple. Even Goldman Sachs described Bitcoin as part of a “megatrend” that will shape the future of finance and backed it up by making a major investment in the Bitcoin company Circle.32 In 2015 it also filed a patent application for its own cybercurrency, dubbed SETLcoin, which uses the blockchain to execute transactions involving financial assets such as stocks and bonds.
What will emerge from these financial laboratories remains to be seen, but the world of money is
experiencing a greater wave of innovation than at any time since someone first transcribed an IOU onto a clay tablet.
Bitcoin: An Insider’s Audit
Marek Palatinus, a freelance programmer, is well known in the Bitcoin community. He is creator of the Bitcoin mining pool concept and a core programmer of TREZOR, the world’s first hardware bitcoin valet. He was also one of the victims of a publicized cyberattack in 2012 during which hackers stole bitcoins worth roughly $228,000. Despite—or perhaps because of—this, Palatinus remains loyal to the development of this cryptocurrency.33
AUTHORS: In less than two and a half years, Bitcoin’s value spiked from approximately $100 to $1,000, dropped back toward $200 and then grew to the current $400 level. How do you view speculations with this currency?
PALATINUS: Bitcoin as a technology is simply a tool that can be used in a number of ways. One is as money, another is for speculation. For me personally Bitcoin is not about speculation but I do not think it will harm it. It helps stabilize it and determine its market value. Bitcoin is a relatively new tool, and people are still looking for a stable price level at which it could find itself with respect to regular currencies such as the dollar.
AUTHORS: But could significant volatility not harm its exchange rate?
PALATINUS: People certainly look at this a lot; it is in a way a reflection of confidence in the system. If they do not understand a technology, then they observe how much faith others put in it. Bitcoin has as a result died a hundred times already, which is why every time it fell markedly articles started to appear about its failure. Nevertheless its volatility is slowly declining, which confirms that the more people speculating or trading, the smaller the fluctuations.
AUTHORS: Bitcoin’s exchange rate fell five percent after bitcoin community legend Mike Hearn, a former senior software engineer at Google who left the company in 2014 to focus on bitcoin development stated at the start of 2016 that “bitcoin has failed,” pointing out that the cryptocurrency faces technological collapse. What is your view?
PALATINUS: There are two factions in the Bitcoin community and each has its own view of what bitcoin is. It is a tool that works according to some principles but how it is used is really up to people. According to Mike, Bitcoin should be a transaction method for regular spending. The second faction claims that it should be a rare digital commodity that either quotes a value or around which other tools are created. I believe that in the long run the second option is more advantageous than a hugely inflated blockchain.
AUTHORS: Going back to the idea of bitcoin’s technical failure: Do you think it is possible that it will encounter an irresolvable technological problem?
PALATINUS: Of course this can happen. On the other hand, with each new day, it is less and less probable for a truly major mistake to appear in the technological arena. But Bitcoin can fail in the sense that it will not fulfill the expectations of the general public.
AUTHORS: Another crucial issue raised lately has been the concentration of power. Mining is supposedly currently dominated by several Chinese entities, two of which control more than 50 percent of the hash power. What is your take on this?
PALATINUS: Centralization is in this sense under way. I consider this a problem but not a fatal one. China is today a technological superpower and mineries there are more accessible and cost at least 20 percent less. Intended decentralization is thus interrupted by physical borders, which has nothing to do with bitcoin as such. The market is simply skewed due to the fact that there are few producers, that they do not compete with each other and that they are connected to large Chinese farms. But in principle nothing prevents natural competition from fixing this as time passes.
AUTHORS: What if an entity without economic interests (in profits) but one interested in controlling bitcoin tries to enter the game? There are, for example, speculations about secret services, scared of cryptocurrencies, of their disruptive potential. What happens then?
PALATINUS: Of course, with an essentially unlimited budget, one can gain a monopoly or control. In the end this is about the degree of likelihood. I think it is possible but I am not sure it is probable.
AUTHORS: In the past two years signals indicating that bitcoin and the technology it depends on have attracted mainstream attention have been multiplying. Large banks such as Goldman Sachs are buying up startups that use the blockchain principle to develop various products and services. Is this shift towards the mainstream—or its interest—positive or negative for Bitcoin?
PALATINUS: It is without a doubt excellent PR for Bitcoin, it legitimizes the technology. This is because many people want to know if politicians, well-known companies, and the like approve of something. But I must add that in my opinion corporate blockchain use is nonsense. This is just buzz, an effort to show that they are keeping an eye on things and going with the times. As far as I know, no bank has introduced so much as an app or even functional concept indicating what blockchain should be used for.
AUTHORS: And what is your opinion about the fact that the Chinese central bank is mulling launching its own cryptocurrency while certainly having a different motivation than global commercial entities?
PALATINUS: Issuing a decentralized currency with controlled circulation seems strange to me. I do not believe that China would let people mine their own currency, that it would not want control. In such a case, it makes no sense. Blockchain has huge overhead, which ensures decentralization. If someone issues a cryptocurrency that they want to control, all they have is an expensive technology.
AUTHORS: Predicting further development is of course very difficult in the case of young and organically growing projects such as bitcoin. But let’s try anyway: Where do you see Bitcoin in five years, technologically and, shall we say, ideologically?
PALATINUS: In terms of technology the protocol is in place and current discussions indicate that it will not change easily. But I think that various startups and services able to use the technology will emerge around the existing model. This means various sidechain technologies, that is, opportunities to create your own blockchains, currencies, which enjoy the same security as the main bitcoin blockchain. In terms of ideology, I think Bitcoin will be demystified within a few years in part thanks to how often we now talk about blockchain. People will simply get used to the fact that it is here and that there is no need to fear it.
Veni-check, Vidi-check, Vici-pending
So how does the future look for Bitcoin in particular? As Palatinus hints, the result will depend not just on technology but also on the interplay of social, political, and economic forces. There are myriad possibilities, but as we peer into the virtual tea leaves, three of the more extreme scenarios are as follows.
Napstercoin
Bitcoin becomes yet another short-lived star that turns into a black hole; some of its principle shall be carried on by other tools and projects, but this currency per se will run its course. In this Napster-like scenario, Bitcoin would cause a massive industry shake-up, of the sort that led to Apple’s iTunes, and then fulfill the adage that “the revolution devours its children.”
The main attraction of Napster was not just the fact that it was free but that users could access a huge and decentralized catalogue of digital music. Apple iTunes offered a similar catalogue, but now it was centralized. It also had a simple and elegant interface, which users were willing to pay to use. Some of the moves done by big players, including Apple, indicate that they might be thinking the same approach can work again. Apple Pay basically turns a phone into a standard credit card. While its technology relies on credit card infrastructure and is creaky compared to Bitcoin, to the consumer it might make little difference. And given Apple’s design brilliance and its ability to partner with Visa, Whole Foods, or Disney, the advantage seems to be clearly on its side. Apple will take a hefty cut of the payment charges and enjoy access to consumer data previously monopolized by banks.
However, one must not forget that “the Apple ecosystem is a closed
system that does a tremendous job at retaining customers but leaves it vulnerable to the innovation of open source projects. This is a flaw that Google’s Android has exploited brilliantly and profitably,” as the investor and author Brian Kelly argues.34 Perhaps this time around the mainstream will enable the revolutionary feature to establish itself—in early 2015, Google announced that it was testing a new system known as Plaso that allows Bitcoin payments. Which leads us to the next scenario.
Supercoin
Bitcoin (or an improved version thereof) becomes an established parallel currency that functions alongside fiat moneys and other legal tenders including a handful of cybercurrencies. Enjoying its momentum, it grows in size until it becomes a challenge to the status quo just by the virtue of its sheer existence. If it succeeds in this way, Bitcoin could prove disruptive for not only authoritarian regimes such as China but also standard liberal democracies. “The politicians are still not fully aware of the destructive potential the Bitcoin has vis-à-vis their power,” says Jaroslav Brychta, chief economist at brokerage X-Trade Brokers and a staunch supporter of the Austrian school of economics.35 The banks’ focal role in the economy is given by their monopoly over the system of payments, but if Bitcoin goes mainstream anyone could make payments and handle other financial operations without a bank account. “At that point, bank deposits would be meaningless. And once you take away deposits from the banks, if they cannot take deposits and multiply them, it is game over,” concludes Brychta.