Will Bitcoin be another failed global eCurrency?

Memeburn already ran an article on Bitcoin before, where Matthew Stone brought us up to speed on this new crypto-currency that seems to be taking the world by storm. Stone voiced some concerns about governmental clampdown on the new currency, and not without good reason.

Firstly, at its anarchic root, Bitcoin robs government of its control over currency generation and its ability to track transactions. This has major implications in terms of controlling inflation within a country. Furthermore, the anonymity afforded by Bitcoin has strong tax implications. Ultimately, having capital tied up in BitCoins makes it incredibly difficult for the government to audit individuals and companies for tax purposes. Trading goods and services using BitCoin will ultimately make it difficult to assess the general well-being of a nation’s individual economy. All of these things are very disturbing for economists and governmental bodies.

But can government really succeed at cracking down on Bitcoin users? Stone mentions that previous attempts at eCurrency have failed, or at least have struggled, for precisely this reason. However, a major difference between Bitcoin and all other previous attempts at eCurrency is the decentralised nature of Bitcoin technology. Without an individual transaction handling company to point a finger at, it becomes a nightmare for any government to even attempt to gain control over the technology.

Indeed, the first thing that generally comes to mind when you hear the word P2P is music and film piracy. Both the music industry and the film industry have poured billions of dollars into trying to fight P2P filesharing. Have they succeeded? The jury is still out on that, but I’m pretty certain that torrents for the latest movies and albums are aplenty on the internet to this day.

Napster started its legal battle with the music industry in 2000, and a decade later P2P file sharing still abounds. In fact, with many of the P2P filesharing networks, the only way to get on top of them is to actually go after the people who share the torrent information in the first place — the Pirate Bays and their ilk. With Bitcoin, it gets even harder, the only way to prevent it is to stop people from advertising that they will trade in Bitcoins. That’s a pretty big job, and very difficult to enforce. While Bitcoin could eventually become illegal, it won’t stop people using it. I have met perfectly respectable businessmen who feel nothing about downloading a few music albums using eMule or any of the bittorrent clients.

There are much bigger concerns over Bitcoin’s survival. The first is adoption. While proponents tout the fact that Bitcoin is already used by quite a number of online businesses, this number is in its hundreds at a generous estimate, and we’re talking about a global currency. If BitCoin really has any chance of survival, more people need to start using it.

To be fair, the Bitcoin network is currently processing over US$100 000 in transactions per hour, and that figure is rapidly growing. From that, I guess one can infer that there is a healthy uptake of the currency, but compared to any other currency, this is only a drop in the ocean. This sort of criticism is easy to level at Bitcoin, but supporters are quick to parry any attacks on this new currency.

On one forum, a Bitcoin supporter quickly points out that while Bitcoin may not be ideal for every type of transaction, it is ideal for use in geographical locations where alternative online payment facilities are simply not available to every user.

He states, “Paypal froze the accounts of 3rd world Kava farmers, who discovered that they could sell their crops directly to consumers over the internet. If the Kava farmers were using Bitcoin, this would not have happened. The 3rd world Kava farmers need Bitcoin more than people living in affluent countries who already have adequate banking and payment processing services.”

Another user in the same forum points out, “Proponents of Bitcoin should keep an eye on countries with unstable currencies and actively promote Bitcoin in those markets as protection against governments that are destroying wealth by printing money.”

These optimistic supporters of Bitcoin believe that although Bitcoin is unlikely to become a mainstream currency, the benefits of using it will definitely appeal to people in developing countries, and that this will help to drive its adoption. I am not so sure, but I have been wrong about a lot of things in the past.

Something that I haven’t quite worked out yet, is that while Bitcoin relies on its builtin scarcity to control deflation, its value will naturally increase as more people start trading using the currency. The problem that emerges is that it becomes harder and harder to pay small amounts using the currency. Right now, a single coin is worth 8.35 USD.

This means that you can’t really buy anything in the currency for anything under this value. As Stone explains in his article, there should never be more than 21-million coins in circulation. There are more than 6-million coins in circulation at the moment, with a current estimated worth of over US$40-million USD. The USD exchange rate for Bitcoins has increased by a hundredfold over the last eight months (from six cents to over six dollars), and by tenfold in Bitcoin prices in the last six weeks.

For a global currency, that’s not a lot of coins, but we’re dealing with some big values. Ultimately, the value has to continue increasing until it is impossible to buy anything with a value short of a few hundred dollars. It seems to me that this builtin mechanism to control deflation may ultimately be a hindrance to Bitcoin adoption.

Maybe I’ve got something wrong here, and I certainly don’t want to start bashing this technology before its had a chance to prove itself, but the only solution that I see is that a sub-currency will have to be created to account for smaller denominations, perhaps running alongside Bitcoin. I’m sure some bright minds have already burned up some cycles thinking about this, and I would be really glad if someone could explain how this might be solved.

Another relatively small problem that Bitcoin faces is that the protocol keeps a provenance record built into each coin. That means that you can track the history of a coin’s exchanges. There is a concern that coins could grow pretty big over time as more and more exchanges take place. This will mean that storing them will use up plenty disk space, and the network will ultimately slow down due to the additional overhead.

That doesn’t sound too encouraging, but it also raises another concern. While Bitcoin is touted as an anonymous protocol, and it is essentially very good at this since no personal information is exchanged, there is a trace of all of the exchanges that have been made with any coin. I think back to the AOL Search History debacle that took place in 2006.

In this case, search history results were leaked for a large number of AOL users. AOL initially responded by saying that no personally identifiable information was leaked, unique identifiers were used for each user to track preferences. The result was that through plenty of backward engineering and cross-referencing hackers and even the New York Times were able to eventually isolate and locate individual users responsible for the searches.

Let’s consider a Bitcoin scenario, if I pay for a regular service using Bitcoin, and then decide to buy a naughty treat for my significant other. The same unique identifier is used in my coin history. Over time, my identifier is going to build up a profile of the types of exchanges that I make, and in time it should be possible to work out who I am based on my profile and a lot of other research. Sure, this problem exists with all sorts of internet exchanges, and it is unfair to slam Bitcoin for this possibility. Certainly, some users have presented unique ways to help mitigate this traceability, but I see the coin history element as something that may become a problem in the future.

There have been many other deeper criticisms of Bitcoin than I have laid down, and it is clear that it is a technology that is starting to make waves. While I have raised some of my concerns over its survival, I am not against the technology. In fact, I would love to see it blossom. Even if it does not succeed, it will change the way that we think about currency in the future.

The real future of Bitcoin will really come down to how quickly it is adopted, and the evidence shows that people are not shy to use it. As it starts to gain adoption, I believe we will see a huge improvement in the exchange of goods and services on the Internet and it will massively open up the global market in a way that has never been seen before.