01 Jun 2011

Bitcoin: You Too Are Mortal

As is perhaps evident from some of my other posts, I’m kind of a sucker for alternative currencies. A couple of years ago I watched the trainwreck that was the demise of 1MDC, a ‘currency’ that was backed by EGold (which was itself shut down in 2009). And then there’s the sad saga of the Liberty Dollar, which in retrospect probably would have avoided a lot of legal trouble if it had been called the ‘Liberty Peso’ or something a bit less official.

Liberty Dollars and EGold (and its spawn, e.g. 1MDC) were, until recently, arguably the high-water marks for private currencies in the U.S., in modern times anyway. However, both of them suffered crucial flaws: they were built around centralized institutions which created single points of failure. When they eventually aroused the attentions of the authorities – as any private currency is likely to do – they were pretty quickly taken down.

In the case of someone holding physical Liberty Dollars this wasn’t really catastrophic, since they still had the coins. (Even morons who bought them at terribly inflated prices might have come out ahead, due to the run-up in commodities prices in the last few years, if they held out long enough.) However, “holders” of EGold were right out; they had to wait until mid-2010 to be able to get their money out, and then only by identifying themselves.

One would not have been faulted for thinking that the idea of private currencies, existing in parallel to government-backed ones, was finished.

But it’s instructive to consider why EGold was designed the way it was, with a centralized architecture. If we give its developers any benefit of the doubt at all, they must have realized this was a gaping vulnerability. But it was a necessity for two reasons:

  1. They wanted to back their currency with a physical commodity, namely gold.

  2. They wanted to be able to make money on it.

The point I’m (rather laboriously) making my way around to, is that neither of these are true for all private currencies, and Bitcoin in particular seems to avoid them.

Bitcoins aren’t backed by anything. Unlike EGold and Liberty Dollars, both backed (either directly or indirectly) by gold, Bitcoins aren’t backed by anything. They have exactly zero intrinsic value. While that makes them rather volatile, it also means there’s no warehouse full of metal to be inconveniently seized.

Second, there doesn’t seem to be much in the way of a profit motive behind Bitcoin’s development. Both Liberty Dollar and EGold seem, on their face, to be money-making ventures for those behind them. Liberty Dollars were sold, at a premium above their intrinsic value, by NORFED; EGold charged management fees, presumably in excess of its costs to have some gold bars stored in a vault. PayPal, which is admittedly not a private currency, makes money via transaction fees. All of those models require a centralized architecture in order to generate revenue.

Bitcoin’s architecture eliminates the potential for a Bitcoin, Inc. IPO, but in doing so it is significantly more difficult to shut down.

One area where Bitcoin seems to remain vulnerable is in its convertibility to traditional currencies, especially USD. Although it’s possible in theory to ‘bootstrap’ a currency (particularly one with a fixed number of tokens) that’s not convertible – someone would need to jump in and start pricing goods in it, and in doing so imbue the currency with real-world value – but it’s certainly a lot easier if you can move value back and forth from other currencies.

Currently there are several public Bitcoin markets, including Mt. Gox, the largest, Bitcoin Exchange, which is a forum for person-to-person transactions, and BitcoinExchange.cc, which just strikes me as shady (maybe it’s the .cc TLD).

Even at Mt. Gox, buying Bitcoins is not a straightforward process. You can’t just whip out your Visa and buy $100 worth of Bitcoins at the going rate; instead, you have to go through one of several intermediaries who handle the USD side of the transaction, moving money into a Mt. Gox account, and then you can use the money to buy Bitcoins. It’s not that much worse than setting up an account with a brokerage (and the fees and minimums are much lower!), but it’s not like the Foreign Exchange desk at the airport.

This is where I’m a bit concerned that the whole Bitcoin concept could get in trouble. Right now, the value of Bitcoins – which are backed by nothing, other than a mathematical guarantee that only a certain number can be ‘minted’ – has built into it an assumption about the ease of converting them into USD and other currencies. If the ability to convert Bitcoins to USD or other currencies was suddenly suspended, I suspect you would see a very sharp drop in the value of Bitcoins. In doing so, it might erode confidence enough to render it useless or insignificant as a currency.

Exactly how this plays out will be very interesting in the months and years ahead. The U.S. government took significant amounts of time to bring the axe down on EGold and Liberty Dollars, so the lack of immediate action shouldn’t be taken to indicate any change in attitude towards private currencies. If and when something does happen, my bet is that it occurs at the BTC/USD/EUR/etc. exchange points. We’ll see.

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