Tuesday, December 3, 2013

Bitcoins will fail. Part 2

My previous entry talked about what bitcoins are. I admit I am fascinated by how they work technology wise and I have been following it for years. Finance wise though, I think they fail to be a sound and secure financial instrument.

Bitcoins are safe. Everything else around it is not
Bitcoins themselves are very safe. They are encrypted and transferred between two trusted clients. However the encryption only protects access and editing of files inside the encryption, inside the bitcoin. It provides no protection of the bitcoin itself.  As long as a user has to convert their bitcoin into another currency to get its value in purchasing other things then there is a vulnerability; the exchanges.
Just last month there were three $1 million thefts from exchanges.  This is the weak link in trading and getting economic value out of bitcoins and all the thieves know it. Keep in mind how bitcoins have an ownership change. 1 wallet sends the bitcoin to another then both of them tell the entire network it has occurred. When you sell a bitcoin on an exchange there is a wallet at the exchange that you have your bitcoin in and it transfers it to another wallet on that same exchange. If the exchange is buying and selling bitcoins it has to be involved in the process. The only way this can occur that I am aware of is if the wallets are controlled by the exchange and you are given access to the wallet.

There is no rule however that says you have to be the one initiating the bitcoin transference. In the linked article above, one exchange just shutdown and kept the bitcoins. They can then transfer from the wallet they control to their own. Both wallets update the network and everyone is in agreement on who the owner is. Some users are openly admitting they stole the coins because why not, there is nothing that can be done to stop them.
In reality you never own a bitcoin. The wallet owns the bitcoin. A person doesn't even own a wallet its a matter of who is controlling the wallet at any given point in time.

Exchanges aren't the only access point that is vulnerable. There is the connection between you and your wallet that can be denied on your own computer through malware. If encryption protects the editing or manipulating of the bitcoin from being copied and created then a second layer of encryption can protect the first encryption. So one day you go to access your wallet and an encryption key is requested to access your wallet. Oh and a helpful popup appears saying if you want to know what the key is you had better get to a second wallet and transfer a bitcoin to the listed wallet address. If not then the wallet is deleted. Remember that nobody can just create bitcoins but nobody said that a software file cannot be deleted. Or lost on a hard drive computer crash for that matter.

Anonymity is a double edged sword.
One of the big selling points of bitcoins is that its anonymous and its nobody's business but yours and the person you are sending the bitcoin to. This also means that if a bitcoin is stolen there is no way to prove it. You cannot go to the police and tell them that John Smith stole your money and you want it back. The entire bitcoin world is in agreement that its no longer your bitcoin.

Remember the whole part about the government cannot track or regulate bitcoins? That also goes for them sticking up for your rights. When cash is in a bank and its robbed or the bank goes bankrupt the FDIC (Federal Deposit Insurance Corporation) steps in and replaces your cash because its just cash and not unique.The value is just replaced. For protection of stock brokers closing shop we have a similar protection with the SIPC (Securities Investors Protection Corporation). These entities insure that there can be no fraud that will hurt the individual. There are undo buttons to reverse transactions. This is what also allows credit cards to work. Yes you can have your identity stolen and someone run up credit card bills but in the end, the system is intended to get everything reversed eventually and for you to not be left with having a financial loss.

Bitcoins are software so theoretically it can be changed and edited to allow a black list of bad bitcoins that are not accepted. Now you have a problem of a central authority making decisions of what bitcoins are good and what are not which goes against the idea of what bitcoins are.

Bitcoins are still software
A bitcoin's history is public record from the moment its created to the current date. Each time it changes wallets its recorded across the whole network so that everything is legit. Bitcoins also go out to 8 decimal points. Wallets can be created at any time and people can have multiple ones.
Do you see the problem with this as far as the network becoming bloated and bogged down?
Wallet #255,327 sends bitcoin #3,425,854.04938593 to Wallet #3,994,329. Now given enough time this Satoshi (part of a bitcoin) will get passed around that it's trail gets larger and larger for everyone to verify that its latest transaction was legit. The more popular bitcoins get the more bloated the system and slower it will become.

Currencies have to have faith
It is faith in reversing wrongs and being protected that is one of the reasons fiat currencies work. A person can have the sense of freedom that when they use their credit card or spend their dollar it will be accepted by the merchant. They can also feel secure that if their identity or credit card is stolen and used that they are not left responsible for the damage. The damage can be undone. It may take time and isn't full proof but that is the intent of the electronic dollar system.

Currencies have to have stability
This is perhaps bitcoins greatest weakness imo as to why it will never be a successful currency. A currency needs stability and faith on its expected purchase power. That's why the Federal Reserve is careful not to have deflation at all and only a little inflation. This way day in day out people have a general idea of what a dollar can be used for and thus make plans, investments, and informed decisions about their spending habits.

Bitcoins on the other hand changes 30% or more of its value... in one day. It would be like walking into the grocery store to buy that steak for $10 being told sorry it costs $16 today. But come back at the end of the week and it will cost $7. Compound that out several digits and now the bitcoin system has some major problems.

The upward shift in purchase power causes hording. That is speculation on my part but let me ask you this. I remember bitcoins going down to $0.01. A year ago bitcoins were going for about $20-$30 or so. A month ago they sell for $600. Today they are over $1,000. Are you going to trade your bitcoin for a good or service like you would a currency or are you going to hold it to sell later when it appreciates. Talk to Laszlo Hanyecz who did the first online bitcoin transaction back in May 2010. 10,000 bitcoins sent to another person and the other guy paid for a delivered pizza to his house spending $25. That is ten million dollars in today's value. In 3 years time.

This is an asset not a currency. Bitcoins might have value as an asset to convert into dollar profit. That is of course if you can maintain control of your bitcoins vs the dangers I listed above.
I freely admit I am no expert on bitcoins. I have never controlled one and probably never will. To me, there is too much risk and not enough reward via guarantee. However we have historic precedence of what happens without regulation of a currency and regulation of markets or even asset class mania.

Disclaimer: The investments and trades discussed are not recommendations for others. I am not a financial planner, financial advisor, accountant, or tax adviser. The financial actions I talk about are for my own portfolio and money and only suited for my own risk tolerance, strategy, and ideas. Copying another person's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.


  1. Very thought provoking series. On the balance of probabilities, there is every likelihood that bitcoins will fail and be worthless. It's not easy feat standing up a new payments system. I do think there is a very real chance that their value will eventually stabilize and not be subject to these recent manic swings, that won't be for some time to come. In the meantime, the real question is whether merchants will see latent value in accepting them as a form of payment, if they can remediate to cash. If the answer is yes, there could be real viability, if not, then as an alternate store of value is the best that BTC can hope for,

    1. Bitcoins do have a chance to mature and stabilize at some point very similar to the market for tulips.
      I think you are approaching bitcoins well.... with a small position to try things out. I don't see that harm in that and hope it works out for you.

  2. Thanks for writing these articles, I now feel I have a better understanding of bitcoins. Sort of seems like an electronic precious metal (it's finite), but with a lot more inherent problems from both the security and currency adoption standpoints.

    1. An electronic precious metal is pretty accurate as I think the same type of investor goes crazy for them. The anti-establishment anti-fiat hope the world burns type of person who instead of wanting to learn how our existing system works, dreams of a new system where they have the power.
      Both gold and bitcoins are an asset and a tool. Nothing more.