Thursday, June 27, 2013

Bitcoin: Is it a Legitimate Currency?

I've known about Bitcoin for a couple years, and in hindsight, I should have acted on it and bought a few.  The recent price surge early in 2013 from a few dollars to its peak to $260, and subsequent crash to its current level of $100 is prima facie evidence that Bitcoin is a legitimate currency, traded in a market exchange.

In previous eras, items as diverse as seashells and tally sticks (animal bones and wood) have been used as currencies, as well as gold and silver for the past 6000 years.  It is well established that during World War II, cigarettes and whiskey bottles were used as currencies.  Enterprising soldiers in Iraq and Afghanistan knew the value of cigarettes amongst the troops.  Cigarettes have been currencies in prison systems for decades.  Where cigarettes are banned in prisons, postage stamps have been the currency of choice.  Certificates and paper currencies have enjoyed monopolies by government decree, but they've certainly had competitors along the way, including black market exchanges.

One Bitcoin aficionado reminded me that toilet paper was a valuable asset during the Serbian-Croatian war.  So to suggest that Bitcoin is not a legitimate currency is naive and wrong-headed, mainly because it has already been in use for three years running, but also because many other seemingly odd items have been used throughout monetary history.

Hard assets bugs may cringe at the thought of Bitcoin as a currency competitor to global paper currencies, but they also miss the point that Bitcoin is supplementary to precious metals, even if it is not a direct competitor to gold and silver as currencies.  Whether it has also contributed to the recent plunge in gold and silver prices is debatable, but its standing as a legitimate alternative currency isn't.

From that perspective, Bitcoin is a DIRECT competitor to gold and silver--at least in this nascent stage of its existence.  Before gold bugs throw tomatoes, I emphasize this observation realizing that gold and silver have NO competition as sustainable and durable MONEY in the long run.  The existential debate of money vs. fiat currency is of wider scope, and can be searched throughout other blog entries.

When currencies collapse, the issuing empire collapses.  That is not debatable, as history shows a 100% correlation for those inevitable outcomes.

My Bitcoin enthusiasm was fueled by my attendance at informal Bitcoin meetups in San Francisco and Sunnyvale since 2012.  What raised my antenna was the presence of representatives from Paypal and VISA at one of the meetups last spring.  That's when I knew these multi-billion dollar financial behemoths had an eye to the future, a world of minuscule transaction costs competing against the industry-standard 3% spread.

In the mean time, gold and silver prices remain undervalued, because there are competing, fiat currencies which the masses still have confidence in, despite their pervasive and persistent devaluations.  Holders of said currencies will eventually discover the ravages of a currency collapse in a "When Money Dies" scenario <click here>.

Trust is being slowly eroded in those fiat currencies, and while some currency dissidents will naturally migrate to gold and silver, a growing minority are choosing Bitcoin and other virtual currencies out of necessity (they have low savings) or by choice (they typically are also anarcho capitalists).  Anarcho capitalists are technologically savvy, libertarians, and prefer the pseudo-anonymity of virtual currencies.  They respect the sovereignty of the individual in a non-aggressive fashion.

The outcome of Bitcoin appears binary:  Bitcoin and other virtual currencies will become wildly successful, as they gain traction and become more mainstream.  Or they will collapse, due to a variety of variables, including security breaches and predatory cannibalism.  I'm betting on the former, as virtual currencies are competitive and cooperative simultaneously.  For instance, Ripple may be a competing currency, but it also legitimizes the virtual currency infrastructure--a validation of Bitcoin.  Dilution and unfettered proliferation are the major concerns there, but the growth of participants will outstrip the growth of currency units.

One pro-Bitcoin talking point superimposes its current adoption trajectory to the early stages of the internet, when a dial-up connection was the only choice.  Another anecdotal observation is Bitcoin infrastructure courses are now offered at Stanford University, the world's preeminent educational institution for technology entrepreneurship.  Google Ventures and Andreesen Horowitz invested in the aforementioned OpenCoin's Ripple.  Peter Thiel led a round of financing for TransferWise.  The list of venture capitalists funding virtual currency ventures is a Who's Who of silicon valley tech titans.

Bitcoin's decentralized infrastructure doesn't immunize it from government shutdown, but it at least provides some protection.  Similarly, the demise of Napster did not precede the end of file-sharing.  To the contrary, it ushered in the subsequent proliferation of BitTorrent, due to its decentralization.  Both have peer-to-peer protocols which provide collateral "forking" should some branches get shut down or become polluted.

With Prism NSA surveillance exposed, there is no doubt that Bitcoin's pseudo-anonymity is being monitored by the government.  The Department of Homeland Security seized Mt. Gox’s Dwolla account.  Mt. Gox users can no longer use the popular Dwolla as a funding option.  A drug dealer was recently raided by law enforcement via the Silk Road marketplace.  The benevolence of the Bitcoin community assisted in bringing justice to dirty money, instead of sheltering the perps.  Integrity and peer pressure enhance the Bitcoin marketplace.

The biggest concern for the viability of Bitcoin is the preservation of Bitcoin's cryptography, the protection of a Bitcoin user's wallet.  A black hat intruding the security of cryptographic constructions would crash Bitcoin with lethal force, inflicting more damage than any government agency could.  Having said that, its 256-bit encryption is virtually impossible to crack.  Again, the operative word is "virtually".  The one constant is the security arms race will continue to escalate exponentially.  Having said that, the computing power needed to hack Bitcoin's encryption is mind-boggling in today's world.

But then again, this tech icon made this prediction:
"No one will need more than 637 kb of memory for a personal computer—640K ought to be enough for anybody," Bill Gates, Microsoft, 1981.
Bitcoin coders are some of the sharpest in the world, and will do everything in their power to protect the sanctity of its encryption.  The element of trust needs to be in place, much like trust is inherent in fiat currencies.  Hopefully, that trust isn't violated with Bitcoin, as it has with our financial overlords via currency debasement and re-hypothecated theft.  And that Bitcoin advocates aren't re-introduced to the phrase "counterparty risk."

To this gold bug, I do not dismiss Bitcoin's role in competitive currencies.  But long-term, Exter's pyramid <click here> still rings true on gold's store-of-value function.  Precious metals will remain the fundamental foundation of sound money.

Will that prevent Bitcoin--or other virtual currencies, from gaining acceptance?  Absolutely not.  It's legitimate.  It's growing in stature and influence.  It's backed by some of the brightest coders and forward-thinking corporations.  It's decentralized.  It's global--beyond national borders.  It usurps government oppression.  It's fungible.  It's adaptable. It's community-based.  It carries low transaction fees.  And the 21 million unit cap preserves scarcity.  That's enough incentive to buy a few--just in case.

Perhaps libertarian gold bug Ron Paul summed it up best in this interview:
"To tell you the truth, it's little bit too complicated. If I can't put it in my pocket, I have some reservations about that. But it has been designed in the free market. If it is a means of exchange, it would not ever be illegal. You shouldn't regulate it in the free market, but I do not think it fits the definition of money, which has been around for 6000 years.

People want to see something they can know what it is, they can define it, touch it and put in their pocket. If you do not have a computer and someone running the computer and calculations, you don't have it. I am not a big supporter of that, but I am not opposed to it. I admit, I do not fully understand what is going on with it."

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