I’m going to assume you know the basics about bitcoin. If not, Brad Plumer’s recent summary on Wonkblog is as good a place as any to start.
On Wednesday, the value of a Bitcoin dropped by 28% against the dollar. On Mt. Gox, the largest Bitcoin exchange, the virtual currency started the day at $234 per BTC, rose to $263 by noon, and then over the next six hours, shed more than 50% of its value, plummeting to $136 before rallying briefly to close at $168. After a day of carnage, the currency had shed nearly all its gains since Monday.
If you’re keeping score, Bitcoin both doubled and halved its value in three days. That’s an insane amount of volatility for anything, much less a currency - but that’s not surprising, because Bitcoin is pretty shitty as a currency. It’s a lot better as a transaction network, though. I’ll explain more below, but first, I want to talk about bitcoin as a currency.
Bitcoin as Currency
Among bitcoin’s biggest issues, and the one that’s caught the most attention, is that it’s inherently deflationary: There’s a fixed number of bitcoins that will ever be “mined” and the rate at which they’re “mined” is diminishing. That means that, if economic activity continues to grow (and all that’s required to satisfy that is for the population to grow), an increasing amount of trades will have to be conducted using a fixed pool of bitcoins. That means two things: first, the relative “cost” of each transaction in bitcoin goes up as time goes on, and, following that, the relative value of bitcoins goes up the longer you hold them, which means the structure of bitcoin heavily incentivizes holding bitcoins, not spending them (all of this is textbook deflation, and why deflation tends to be a very bad thing for economies).
Aside from the well-known deflation problem, the crypto-coin has several issues, most notably with the “crypto” part: for all the hype around bitcoin’s privacy, it’s staggeringly vulnerable to attack via network analysis. Every bitcoin transaction is logged in the Bitcoin Transaction Graph - this is how transactions are validated, and why you can’t just copy and spend the same bitcoin twice. The full transaction graph is publicly available — it has to be to fulfill its purpose. That means that, unlike cash, gold, or any other non-digital means of transaction, every single bitcoin transaction is fundamentally public. The identities of the parties are not necessarily known, but there’s a huge body of work on de-anonymizing individuals based on network relationships, and the fact that the entire record is public gives a huge trove of data for analysis. One such analysis by two professors at The Weizmann Institute of Science in Israel was able to collapse several different accounts and identify large transactions despite efforts on the parts of the participants to obfuscate the source and destination of the funds.
The purely-digital nature of Bitcoin presents another avenue of attack — hacking, via malware or just bad software design. This is fundamentally the same attack that hard currencies suffer from - the equivalent of mugging or armed robbery - except the digital world has not fully embraced the level of security the physical world has. This isn’t fundamentally a problem with Bitcoin, but it’s a fundamental problem of the medium bitcoin relies on, so it’s a problem for bitcoin. Back in 2011, Mt. Gox, the largest bitcoin exchange, was hacked, and nearly $9M in bitcoin were stolen - a sum that ranks among the largest bank robberies in history, though I suspect it required less effort than most actual robberies. Again, this isn’t a problem with bitcoin per se, but the state of internet security is pretty poor, and bitcoins are utterly untraceable once stolen.
The Nature of Bitcoin
So, bitcoin sucks as a currency. That doesn’t mean it’s useless. While it’s somewhat vulnerable to network analysis, bitcoin still functions well as an anonymous medium of exchange that’s basically impervious to regulation. A bitcoin wallet can be created anonymously, transactions between entities don’t require any documentation other than the source and destination accounts and the amount to be transferred (and this can be heavily obfuscated), and the connection between the digital currency and the real exchange of goods or services need not be made explicit. In other words, if you want to make a very discreet payment to someone, Bitcoin is a stellar choice.
As much as anything, Bitcoin reminds me of Tor, the anonymity network - Tor started as a DARPA project to enable secure government communication. It was opened up to the broader community for two reasons: first, if only government agents use the network, it’s obvious someone’s a government agent if they’re using the network; second, the network’s speed and reliability are improved the more it’s used.
Bitcoin’s origins are not explicitly DARPA, but its history is certainly a bit eyebrow-raising: In 2008, a man nobody ever heard of posted a research paper to a cryptography board describing a functioning crypt-currency, which he called Bitcoin. He was active in the community for the birth of the bitcoin network, but disappeared not long after. Nobody has managed to track down the original author, who called himself Satoshi Nakamoto, and the origin of the paper remains unknown. What remains is a surprisingly well-designed functioning digital currency that can be used for anonymous transactions between individuals.
Bitcoin as a Hawala
This, I think, is what Bitcoin was designed for, and what its ultimate goal is: Bitcoin is not a 21st century currency, it’s 21st century Hawala, a network which can facilitate transactions across long distances without any real records. In a Hawala, two individuals who want to exchange money work out the details of their transaction, and then go to brokers who handle the actual exchange between themselves based on a longstanding relationship and the promise that their debts will be settled eventually. The two individuals interact only with the brokers, so the transaction itself is almost entirely off the records. The original Hawala networks in the Middle East date back to the 8th century, and the Hawala style of financial network is still prominent in North Africa, the Middle East, and Southeast Asia - prominent enough that the US Treasury Department considers them a serious money-laundering vector in the region.
In this light, bitcoin’s vulnerability to network analysis becomes less of an issue. While it’s possible to trace transactions between individuals, in a hawala structure the individual transactions between members aren’t capturing the trades the network is facilitating, they’re settling outstanding balances across the aggregation of those trades. You can know all the members of the network and all the flows between them without being able to determine what those exchanges actually represent. This makes it much, much more difficult to map hawala activity to real world identities - there’s no one-to-one mapping between offline events and the recorded transactions, so cheap means of social network analysis are rendered ineffective.
Given the structure of Bitcoin - its ill fit as a currency, its anonymity-like features, and its immunity to practical regulation - as well as its own cryptic history, my guess is this is the ultimate purpose of Bitcoin: Bitcoin is not intended to replace standard currency, it’s designed to facilitate transactions that shouldn’t be taking place, transactions that demand at least deniability, if not outright secrecy. A true Hawala-type network requires longstanding trust-based relationships, but Bitcoin gets around that by encoding trust chains in the currency itself. It’s a way of bootstrapping the sort of anonymous transaction networks that older and more deeply-rooted communities have always created, and doing so among people who don’t have the shared ties to create trust networks on their own.
Bitcoin is a very interesting phenomenon. It’s a darling of the crypto-anarchist community, and with good cause, but it’s not interesting as a currency - it’s fatally flawed for reasons economists defined decades ago. Instead, it’s interesting for what it allows: frictionless, anonymous, untraceable transactions between any two entities, regardless of social, ethnic, business, or historic ties. That’s bitcoin’s real power, that’s what it was designed for, and I suspect that’s what it’s really being used for. The recent price volatility is interesting, but it speaks more to how little of the currency is being used as an actual medium of exchange than it does any real market movements. The real action in Bitcoin is all happening behind closed doors.