A long-shot investment idea with an attractive potential upside

I’ve recently discovered BitCoin. It is a monetary system with active exchanges into/from USD, AUD, GAU, INR, CNY, SLL, BGN, PLN, EUR, CLP, and (thankfully) CAD. Today, one BitCoin (BTC) is roughly eight dollars (USD). The market capitalization is $56, 053, 200, assuming each coin is worth eight US dollars. BitCoin has been compared to Bittorent, commodities markets for precious metals, and non-physical, traditional, fiat currency (i.e. numbers in a bank). BitCoins are divisible to the eighth decimal position. Of particular interest: there is no central issuing authority, only a global network of users and open-source cryptographic software connecting users in a peer-to-peer network. This network, at its current size, has incredible computational power which is used to secure transactions. As it grows, it becomes more secure and gains in speed. The software, which is developed in an open-source environment, can be revised as one pleases. The most popular new versions are posted on a central website. They become popular after being scrutinized by a global pool of nerds, each of whom would love to destroy confidence in a particular version by pointing out a fatal flaw/impropriety. An individual should be worried about using software that is not widely accepted because it might contain a piece of code that grants others access to your BitCoins. The network as a whole is not likely to be compromised by such software because the network will not verify a transaction that violates the methodologies instituted by earlier versions of the software (e.g. for preventing double-spending or counterfeiting).

What makes BitCoin of pressing interest to investors is that the algorithms at work reward early adopters because it supplies BitCoins more freely to begin with and, if all goes to plan, these plentiful BitCoins belong to the relatively small group of early adopters. Some have reportedly made returns sixty times the value of their principal investments (returns convertible into ordinary currency).

Also, the value of BitCoins have taken a hit in the last month or so due to a widely publicized hack into one of the exchanges. The value on that exchange plummeted to near-zero for a short-time, during which the exchange shut down all trading and rectified the situation, after which the value of BitCoins on that exchange returned close to its original. The value of BitCoins on the other exchanges did not change very much, during this episode. But media attention later drove the price down significantly. This was followed by a report of someone’s personal store of BitCoins being stolen by a hacker. This sounds frightening, but it is easily avoidable by using ordinary encryption software or storing your coins on one of the exchanges (provided it is not hacked). Ultimately, the lessons learned are that one is safest to keep one’s BitCoins on one’s own computer under a decent amount of encryption (this is really easy and free). Backup an encrypted copy on a free service like dropbox, and you won’t have to worry about loss from theft or fire. Given that it is encrypted, even if someone hacks into “the cloud”, your information is encrypted and so it is safe. These sorts of precautions are similar to those ordinarily taken with cash, jewelry, gold, etc.,. These precautions, however, are safer, cheaper, and easier. These lessons were not appreciated by the media, so the value of BitCoin has dropped significantly. But the trading volume is still high and the currency has been stable since it dropped, suggesting that it has a large degree of resilience. Also, as with any small stock, BitCoin is volatile. The hope, then, is that it will recover from this low point, become more widely adopted and much less volatile in the years to come. As an investment with some risk but huge potential payoff, the expected utility is through the roof. (This surely fits the investment strategy propounded by the philosophically astute investor/Professor/media-personality Nassim Nicholas Taleb.)

A little about the BitCoin mechanism: New coins are generated as a side-effect of policing calculations performed on the computers of willing parties in the network. Two years ago, your personal computer could do enough work that you might just generate some coins, which you would then own. Now, new coins tend to be generated by people who actually purchase specialized computers with cooling mechanisms, etc., that are dedicated to this policing work; they hope to recoup the costs of their computers in BitCoins and make a profit. The rest of us get BitCoins by trading real money on an exchange. The last sale price is listed together with the lowest offer to sell and the highest offer to buy.  Whenever these meet, a sale is made. One can follow these exchanges regularly, looking for good prices, or just pay the current market price get on with one’s life. With some BitCoins in hand and the free software on your computer, you open a “wallet” on your computer. This wallet gives you a number. (To be especially certain of your anonymity, generate a new number for each transaction.) All you have to do is tell the exchange service that you want n BitCoins (or a fraction thereof) sent to that number. This begins the transaction.

[Note: This paragraph may be skipped. I try to explain the mechanism, but I don't fully understand it and may be off on a few points.]  There is a publicly posted record of the transaction and a generated key that you receive, which is, in effect, your money. When you spend your money, you will use this key to generate a new key for yourself corresponding to your number of BitCoins minus what you transferred (the old key is now useless to you). You also post a public record of the transaction going forward and send a private key to the recipient. Verification occurs on the network by determining from the public record what your original (and now useless) key was based on the information you posted going forward. This is not trivial; rather, it is a brute-force decryption that can only be performed by the very large network. The result shows that you had access to the money you just spent because the public network now knows your old key and can use it to decrypt your old wallet. Nothing is known about your new wallet because your own program independently writes the key for it. These brute-force decryption tasks are actually performed on bundles of transactions, not just yours; these bundles are called `blocks’. The public record is the output of each block, given as input a vast number of transactions. Usually, a transaction is considered fully verified six blocks after it is performed, so long as it is not called into question by any of the intermediary blocks. This technique is what makes BitCoin revolutionary as a reliable, uncrackable, and distributed system for tracking transactions.

Here are three objections to the use of BitCoin as an investment vehicle followed by responses:

First Objection

BitCoin would be disruptive to traditional banking systems if widely adopted. Governments that are influenced by the banking establishment (i.e. every government) will try to put BitCoin out of business one way or another.

Response

Yes, governments will likely respond negatively to BitCoin. But, they have limited abilities to combat the rise of BitCoin. Like Bittorent, governments cannot take peer-to-peer systems offline unless they turn off the internet (this would be much more disruptive to the economy and the banking system by extension). Instead, governments might attempt to enforce anti-BitCoin legislation, making it illegal for vendors to accept BitCoins as payment. This could be effective against using BitCoin at your local grocery store, but would require unlikely international cooperation to enforce such prohibitions against international purchases using BitCoin. Regardless, the black-markets of every country will continue to use BitCoin in place of cash where convenient (e.g. for untraceable payments on shipments of illegal goods). Worst-case scenario: Governments reduce BitCoin to the currency of choice for illicit economic activity and BitCoin investment becomes an investment in “Global Crime and Political Protest Inc.”.

Second Objection

The current interest in BitCoin is akin to the buzz that over inflates the IPO of a small tech company that lacks a proven strategy for generating revenue. This is because there are many enthusiasts who love the idea of a decentralized currency and many investors who understand the benefit to early adopters that is hardwired into the system; but there are not yet many vendors accepting BitCoins and these vendors appear to be activists, not serious businesses. This suggests that the price of BitCoins is set by speculation alone rather than by its facilitation in the trade of valuable goods and services.

Response

The list of online companies accepting BitCoins is a poor indicator of the extent of trade using BitCoin because there are many local jobs paid in BitCoins and, alas, there is the black market. Further, BitCoins have only been discussed in the media for the last month or two. It is early yet growth in terms of people holding BitCoins is exponential, following curves that, if persistent, would cover the earth’s population in three years (“BitCoin is the Economic Singularity”, The Economic Future, 7 June, 2011). Moreover, BitCoins offer irresistible benefits to practically everyone. Consider:
  1. You can send money globally much like you send e-mail; banks no longer facilitate these transactions and can no longer insist on ridiculous service-charges.
  2. You can send money to anyone who has access to the internet in ten minutes or less with nearly absolute anonymity and a mathematical guarantee that the transaction will succeed. This beats a $40 bank charge for a transaction taking two-three business days. This also avoids taxation/tariffs imposed by local governments. Moreover, you don’t need to have a special bank-account with monthly fees granting you the “privilege” of paying $40 to do this. Neither do you need to yell at the bank-agent who misspelled your name and wired your money to some netherworld from which it can be retrieved in two-three more business days only after re-entering your bank-account number and re-spelling your name for five different agents on the phone, each of which spoke with you only after putting you on hold for an average of twenty-minutes.
  3. You can send money to any relatives you may have who live in a developing nation and are geographically removed from such things as banks and ATMs. All they need is access to the internet (cell-phones now provide this in very remote areas) and some form of digital storage like a flash-drive. People in such communities already use cell-phone minutes as a form of currency, so it would seem to be an easy switch to BitCoins.
  4. As an investor, you can hold some of your cash-reserves in BitCoins. You need not worry about the inflation concomitant with the current practice of printing traditional money in excess to pay down government debts: Bitcoins can only be generated according to a predetermined and regular process and, thus, are immune to this form of inflation. Moreover, the rate at which new BitCoins enter the market decreases over time at a predictable rate even as the population grows; this implies that the currency exists in a deflationary environment owing to which the currency has a tendency to appreciate in value. What a change from traditional currency that must be invested in order to counteract inflation.
  5. Most people keep the majority of their assets in intangible forms that they may access only by dealing with some profit-seeking organization. One of the appeals of holding gold is that you can keep it in a safe in your house, handle it, etc.,. BitCoins are strings of numbers and letters (decryption keys) that are practically tangible in the sense that the owner(s) alone have access to the relevant strings. These can be encrypted and backed up to prevent loss and theft. But the owners can also do whatever they want with the codes (including erasing them, which is a way to destroy the currency). Unlike gold, however, one can divide BitCoins and spend portions of them as desired without relying on a weighing scale. The power is back in the hands of the owners, not the banks, and this is not at the expense of security, immobility, or the usual inflationary losses of value unmatched by interest payments (recall that BitCoins tend to appreciate in value even when left in your sock-drawer for decades).
  6. Online vendors will be pleased that by accepting BitCoins they are paid almost instantaneously yet do not have to give a cut of their profits to an intermediary service. Street vendors need only have a web-enabled cell-phone to perform credit-card-like transactions (however, the ten-minute verification issue will have to be addressed).
  7. Bitcoin transactions are irreversible. So landlords will be happy to receive deposits and rent payments in BitCoin rather than cheques that can bounce and be cancelled.

Third Objection

 Like Netscape, Yahoo search, and MySpace, many promising internet companies with huge market capitalizations have been taken out by competitors offering superior services or integration with established products. Bitcoin may soon find a superior competitor and one’s investment in BitCoins will be wiped out.

Two Responses

Hand-Waving Version:  Like any investment, you ought to keep an eye on the competition and get out of your bets when they look like they are going sour.
Pumper Version: In a peer-to-peer setup, the larger the network, the safer and faster the transactions. Users will always opt for the largest network for this reason. BitCoin has a head-start, and is already being reported about in major media outlets. Further, concerns about competitors with superior qualities of service are ungrounded. If a competitor also offers services, it is likely to be a centralized monetary system (like the Linden dollars of Second-Life, which can also be traded for USD, but are issued at the whim of the owners of the video-game company and thus are not immune to hyperinflation and financial manipulation). As a peer-to-peer system, anyone can design a pleasant user-interface or provide a service that eases the less technically adept into the system. Crucially, these are independent of the actual monetary system. Thus, it is unlikely that an investor will have to worry about competition and follow the Darwinian response.
[[Update: Aug 22,2011] My response might be immature. In any market that tends towards monopoly or oligopoly, the first player has a significant advantage. The network of bitcoin users depends on the software running on each computer in the network. Users will be loath to switch software if it involves moving their money from BitCoin to a different e-currency, but they will if the alternative is sufficiently more attractive — the required benefits of switching for the early adopting BitCoin community might not be that great. One problem with BitCoin development is that many changes would affect real people’s real money. Experimentation with the basic economic processes of BitCoin is not feasible because people will not run new BitCoin software that jeopardizes the safety of their savings; such experimentation would require the introduction of a new currency. As I’ve indicated, only one peer-to-peer currency is likely to be widely adopted, and it already seems that BitCoin is that currency. But experimentation with virtual currencies that have no value in USD is still possible, and is in fact actual: Freecoin.com poses a competing development platform for playing around with alternative implementations of bitcoin-like peer-to-peer currency. The objectives of its developers are to continue investigation into this style of currency without attempting to implement any actual currency(ies). Large changes to the system are acceptable because no-one has skin in the game. It seems likely that something will develop from their work (or work elsewhere) that could supplant BitCoin. But not tomorrow. So, see my Hand-Waving response.]

Links:

To the minute values by exchange: http://www.bitcoincharts.com/markets/
Short description of how it works: http://ironwolf.dangerousgames.com/blog/archives/1105
A slightly longer description of how it works and potential weaknesses: http://blog.ezyang.com/2011/06/the-cryptography-of-bitcoin

 

9 Responses to “A long-shot investment idea with an attractive potential upside”

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    Very nice post, it helps put to rest a lot of the objections towards bitcoins while staying fairly unbiased.

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