Beware the Bitcoin

You have no doubt heard about Bitcoin and Blockchain. I will do my best to translate what I have learned into English. Wish me luck! Bitcoin can be thought of as one product, for example a Model T Ford is a product.Blockchain can then be thought of as the invention of the car. Bitcoin is just one specific kind of “car” or Blockchain. The invention of the car revolutionized our lives and long gone was the need for horse and buggies or oxen and carts. The proponents of Blockchain feel that this new technology will also permanently change our world.

Bitcoin, the product, has two main components. First, it was designed to be used as a currency. Ideally, the creator envisioned Bitcoin replacing money as we know it. Second, Bitcoin acts as a “store of value”. For example, if you were to put $1 million Canadian Dollars under your mattress, you would be storing that value. (although I would argue poorly)

Why do we need a new currency? There are many interesting arguments for why, but I will stick to the one practical reason I have seen. When we use paper currency we walk up to the fruit stand and buy some apples and give the vender a $5 dollar bill. However, what if the apples are in another city or country? We could get in our car and drive the money there but that is not realistic. Insted we use a third party to complete the transaction. Today, we are pretty comfortable sending money around the world through either a bank or maybe using Mastercard or Visa. We trust Visa will not steal our money and so does the apple vendor. This trust allows us to do business with people we have never met. What Bitcoin does is remove the third party. The software is very complex but the short version is that it allows two people who have never met to know that neither party can cheat them in an agreed upon transaction, thereby eliminating the need for a third party. Bitcoin’s second feature is that of a “store of value”. This feature is best thought of when compared to gold. Just like gold, Bitcoin was designed so there is a limited amount. (21 Million Bitcoins if I remember correctly). Bitcoin is getting more and more expensive to create, just like gold is more and more expensive to mine. In fact, the creators wanted it to be thought of as gold so much that they call the “creation” of another Bitcoin “mining”. The theory being that it will hold its value or go up over time and thereby protect your value because it is a scarce resource, like gold.

Now that we have a basic understanding of Bitcoin I have a few comments. First, using Bitcoin as a replacement for our actual currency seems very doubtful to me as it is currently operating. The transactions can take up to 10 minutes to settle and you MUST be connected to the internet or you literally have no money. Visa and Mastercard process tens of millions of transactions in the time bitcoin might process a few hundred, the cost to process ONE bitcoin transaction is 20 to 30 times more than Visa or Mastercard. The price of Bitcoin is very, very volatile which makes it harder to do large transactions or plan. In short, there are significant issues here.

Second, using bitcoin as a store of value and comparing it to gold. This seems to be what people are actually TRYING to use Bitcoin for right now. More people are buying bitcoins than are selling so the price had been rising. Although it did fall about 36% in a two week period. There are significant problems here as well. Because bitcoin is designed to be anonymous there is some speculation that Bitcoin has been used to hide all kinds of illicit money. Any one from North Korea, to Russian Oligarchs to corrupt foreign officials can hide money in Bitcoin. If this is true, this is not who I would like to put my belief in.

The biggest problem with the “store of value” argument is that it relies solely on belief. Someone else has to believe it has value or it will literally drop to 0. It is, after all, just software. If there is no buyer of the next bitcoin it becomes worthless. Why would there be no buyer? Think back to our car analogy. There were hundreds of car manufacturers over the last 100 years. Most went out of business or were bought by the companies we think of today. This is the very early days of blockchain technology. If someone comes out with a better, safer, faster, cheaper product, how long do you think Bitcoin will have “value”? If you do a quick google search there are currently 1,381 blockchain type currencies that have already been created and more coming.

Gold can be traded as a gold bar, or a gold coin, or a smaller gold coin, or even a tiny sliver of gold. Bitcoin is software, it could be divided up into a Billionth of a bitcoin. That means that, in a way, there is unlimited Bitcoin.

There are some very interesting and useful applications of the Blockchain technology. For example, we all assume the person at land titles is not going to erase our name off our house title and write in their own name. Unfortunately, this does actually happen in some very poor countries. With Blockchain, you would eliminate the need for land titles and fraud would be almost impossible. It is also possible we could use this kind of technology for trading stock certificates instead of having to go through the Toronto Stock Exchange.

Because Bitcoin calculations were designed to get increasingly complex every time a new coin is created it now takes the energy output of a small country just to create one more bitcoin. This is going to get dramatically worse, by design. This alone could be enough of an impediment to halt its use.

Governments do not like hidden wealth or tax leakage. So far, all major industrial nations have stood by and observed. They will not stand by forever, once governments feel there is significant tax leakage expect them to act.

In short, Blockchain is a very interesting technology but there are many problems to be worked out and we likely haven't seen the best uses of it yet. Anyone predicting the price of Bitcoin is doing no more than you could, making a wild guess.