Tuesday, February 18, 2014

A Skeptic Looks at Bitcoins

One of my rules for evaluating potential investments is how well I understand them. Unless I have developed a basic understanding of the investment and its attendant risks, I’m not willing to invest in it. No amount of written and verbal advice given by “experts,” is sufficient to overcome my need to understand. After all, these selfsame experts are the ones who have missed numerous bubbles.

The value of Bitcoins is market-based, determined by supply and demand. Supply is purportedly regulated by the software. There are currently approximately 12.4 million bitcoins, and the programming calls for a maximum of 21 million. That means the currency is designed to inflate almost 70%, but at ever-slower rates until finally reaching the 21 million maximum.

Bitcoins, unlike gold or silver for example, have no industrial use; they have no intrinsic value. They are like wampum: they are only worth what two people in a transaction agree they are worth. Humans do not have a great record at determining monetary worth when something has no intrinsic value. This is not a 21st century problem, as evidenced by the tulip bulb craze in the early 17th century. Even when something has intrinsic value (gold, silver, real estate), we humans often go hog wild—or conversely can’t see the value in the dirt below our feet.

To summarize, bitcoins have no intrinsic value and are programmed to inflate. That does not sound like a winner to me. But wait, there’s more! In addition to the inherent risks of buying with no intrinsic value, bitcoins contain exogenous risks as well.

Unfortunately, I have very little clue—and, if they are honest, no one else does either—what the exact characteristics of those risks are.

For example, what prevents those “in charge” of the open source coding from deciding to increase the number of available bitcoins past the current 21 million limit, continuing to inflate the currency? I’m sure those in charge insist it can’t happen. But it is certainly a real risk, and I can’t quantify it.

How secure is the system from hackers? I have a firm belief that if humans made it, other humans can break it. This theory applies to more than just the system that creates new bitcoins according to a predetermined schedule. How safe is your bitcoin account? If someone raids your bank your loss is covered (up to certain limits) by the bank or their insurance. Will the same hold true for your digital bitcoin wallet? Who pays those insurance costs? How secure is the insurer? I have no clue.

If the value of bitcoins stabilizes so that its conversion to traditional currencies is primarily determined by inflation in the traditional currency, it would make bitcoins a perfect inflation hedge. That would have utility. However, with a maximum of 21 million of the little critters—and at a recent price of $628—total currency in circulation will max out at a bit over $13 billion. The world’s annual output of goods and services is something north of $70 trillion. US Debt—the world’s “safe” place for parking money—is over $17 trillion.

So there we have it: an entity with no intrinsic value, a currency guaranteed to inflate 70%, with lots of potential risks for which there are no guarantees. Investing in bitcoins sounds to me like making a bet based on the greater fool theory.

Does that mean we should ignore bitcoins all together?

No. They might soon have transactional value. Right now if someone in the U.S. buys one of my novels or my bridge book and uses a credit card, I pay the transaction costs. Using my Square credit card reader, the fees are 2.75% if I swipe a credit card and 3.5% if I enter the transaction manually. Square doesn’t work for foreign transactions.

If someone comes up with a methodology that reduces my transaction fees and allows for instant conversion of bitcoins back to U.S. dollars so I don’t have a currency risk, I’ll adopt in a flash. And since bitcoins are not individual country centric, I could use them abroad without the foreign transaction fees charged by most credit cards.

Bitcoins may be the opening salvo over banks’ and credit card companies’ bows. Technology continues to attack the value of intermediaries—those people and corporations that stand between buyer and seller. If entrepreneurs find a way to reduce the necessity of intermediaries and their attendant transaction costs, it will have major ramifications.

When people first used the internet to exchange messages, most had no clue how dramatically the internet would change the way we do business. The same may be true with bitcoins, and venture capitalists are already making their bets. It is too early to tell how this will all turn out, but it’s too important to ignore.

While I’m waiting to see how that turns out, I won’t be holding bitcoins. Too much risk.

~ Jim


  1. Jim, you CAN use bitcoins to buy some things; Amazon and Target now accept them: http://barkbks.me/1biAQ8w

    And you can buy them at ATMs, too: http://barkbks.me/1gB1rNV

    I first found out about them when we headed into Canada on a day trip while we were up in Bellingham to look at Western Washington University. I read somewhere that you can buy partial units at this ATM in Vancouver, BC and that it was a popular tourist attraction.

    I do agree with you on your points about the risk. I've never been an "early adopter" when it comes to investments and I like to know what I'm investing in. But Bitcoins are something to watch, just as you say.

    I also remember reading somewhere that the Fed has concerns about their legality... but that was sometime over the summer. Perhaps it's been resolved by now?

    1. I did not mean to imply that you could not buy bitcoins or use them to purchase things. I know that you can. But to what purpose? As soon as you buy the thing you are subjected to market risk without an apparent equivalent benefit -- unless, of course, you want anonymity, which is attractive for illegal pursuits (which I'm sure none of my readers would engage in!).

      As for legality -- and rest assured, I am not providing legal advice -- my understanding is that used for legal purposes with whatever required reporting goes along with the transaction that they are legal. ~ Jim

  2. Thanks, Jim. I've been watching Bitcoins as they developed and never fully understood the risks and benefits. Your article makes it very clear. I think I'll watch from a distance until I see a real benefit for me.