Wake Up and Smell the Tulips… The Bitcoin bubble WILL burst – but when?

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Money evolved as a means of facilitating transactions in goods and services (Bruner, 2011). Prior to the evolution of money, individuals had to make sure they had something to trade in kind for the goods and services they were missing in order to survive.

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The prevailing economic system was Barter. Trade was inaccurate, complex, clumsy and easily susceptible to fraud. Trade was only possible when two sides to a transaction each wanted what the other had on offer and in roughly equally-valued quantities.

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Humanity needed a viable solution. Humanity needed a medium of exchange that could facilitate transactions and resolve the inefficiencies of barter. Various materials , typically metals – gold and silver, served in this role over the millennia, however their value fluctuated wildly, and transporting metals is not trivial.

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Essentially,

Money was created as a convenient unit of exchange to facilitate trade.

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For MONEY to be EFFECTIVE, it has to fulfill three roles: 1) Provide a medium of exchange 2) Provide a unit of account that can

facilitate valuation, calculation and storage

3) Avoid the inefficiencies of barter

(Ferguson, 2008)

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According to Ferguson (2008), money must have SIX defining characteristics:

1) Availability 2) Affordability 3) Durability 4) Fungibility 5) Portability 6) Reliability

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From here we arrive at –

Steiner’s Ten Characteristics of Currency In order to serve as a viable means of exchange and to maintain a stable value, a currency must be: 1) Commonly appraisable 2) Easily comprehendible 3) Conveniently storable 4) Efficiently transactable 5) Widely available 6) Globally affordable 7) Inherently durable 8) Quantitatively Fungible 9) Effortlessly Portable 10) Universally Reliable

Based on Ferguson (2008), Bruner (2011) and others.

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Moneytime… So, what is Bitcoin?? Bitcoin is a virtual, distributed, encrypted, partially open source P2P network based currency with a proprietary accounting and trading system. The algorithm used to produce bitcoins, released by an unknown individual or group by pseudo name “Satoshi Nakamoto,” uses iterative artificial intelligence algorithms to create increasingly difficult “puzzles.” Encryption algorithms are open-source and are continuously improved by a growing developer base with an inherent interest in hack-proofing the system (maintain and increase value!). Creation, accounting and trading are well-defined by the original algorithm.

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How are Bitcoins created? Bitcoins are created by running proprietary software on increasingly expensive hardware such as the Adafruit miner pictured here. Hardware must be installed on more and more powerful computers to work.

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Principles of Bitcoin Creation Bitcoins are created by solving mathematical problems, or “puzzles.” Puzzles can be solved running a software program, called a “client,” on proprietary hardware such as the Raspberry Pi by Adafruit pictured on the previous page. By solving a puzzle one creates a “Block.” Once you succeed in creating a “Block” it is registered in the “Blockchain” which is a public transaction ledger, and you earn a specified number of Bitcoins as a reward for your effort.

Image: Bitcoin mining setup

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The Ingenious “Satoshi Nakamoto” Algorithm

Nakamoto’s algorithm was preprogrammed with ingenious features tailored to propagate Bitcoin production and build hype

1) The number of Bitcoins awarded for each Block halves at intervals estimated to be four years (but not known to be four years): used to be 50, now 25.

2) It currently takes about 10 minutes to mine a block (mine=create)

3) As the network grows stronger – the algorithmic difficulty increases

4) Therefore, the time to solve a block will INCREASE as the associated REWARD will decrease

5) However if hype continues to build around Bitcoin the externally applied value associated with Bitcoin will continue to grow – motivating additional mining efforts Im

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Just like during the Gold Rush – whomever is smart enough to set up store and sell equipment is guaranteed a handsome payoff.

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Evaluating Bitcoin as a viable currency based on Steiner’s Ten Characteristics of Currency: 1) Commonly appraisable – no – value fluctuates wildly 2) Easily comprehendible – no – highly technical and abstract 3) Conveniently storable – yes – digital, ~zero storage costs 4) Efficiently transactable – yes and no – currently inexpensive to transact, but

difficult to locate willing partners 5) Widely available – no – known among the literati but far from widespread 6) Globally affordable – no – production costs and valuation increasing quickly 7) Inherently durable – no – hackable and susceptible to virii and other

computer and network issues 8) Quantitatively Fungible – yes – infinitely divisible (e.g. Satoshi 1x10-6 bitcoin) 9) Effortlessly Portable – yes – can be transported digitally 10) Universally Reliable – no – highly unreliable

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Advantages – in Favor of Bitcoin: • A “fixed supply” - theoretically estimated at 21 million units (however infinitely divisible i.e. “fungible” – could also be construed as advantage) • Non-regulated – alternative to government controlled currencies abused through monetary policies • Portable – inexpensively and easily moved, transported, transacted • Decentralized – managed by the network, the proletariat, the common man; appeals to anti establishment types • Cheap - Very low transaction costs – but forecast to increase with time; fees also independent of amount: large transactions especially cheap • Fast - Facilitates rapid transactions – international transactions in minutes rather than hours • Private – relatively anonymous to transact (but can be hacked) • Popular – currently enjoying mostly increasing value due to public hype; however also useful in countries with problem-plagued national currencies

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Bitcoin Disadvantages I – just the simple issues…: • Volatile –value fluctuates wildly, therefore difficult to appraise at given point in time • Instable - has to be stable in order to function as currency in the global financial system; people not willing to use unstable currency • No predictable stored value – not backed by anything tangible, traceable or recognizable: a basic requirement for currency • Speculative – lacks intrinsic value as an investment and derives value mostly from the expectation others will indeed accept as payment • Not resilient – e.g. $US and gold – and enough other stable alternatives exist • International – all the disadvantages of the euro amplified by globality • Unregulated – while anti-establishment individuals are attracted to the wild nature of the Bitcoin, also means it cannot be controlled – cannot be stabilized through a crisis!

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Bitcoin Disadvantages II –the technical: As a digital virtual entity created by running software on a distributed network, Bitcoin is inherently susceptible to hacking and other Internet maladies…: • Bitcoin is theoretically protected by highly advanced cryptographic algorithms but at heart use of the “wallet” hinges on a private key, a complicated type of password but similarly susceptible to hacking. • The creation of Bitcoins is controlled by a sophisticated algorithm which is supposed to control the creation of additional currency - but it had already been hacked to create an unlimited number of Bitcoins. • Exchanges are numerous and distributed – but frequently fail, taking down Bitcoin owners with them. In one study (Steadman, 2013), 18 of 40 exchanges closed within the span of three years. • Bitcoin mining botnets and trojans, malware and the hijacking of mining networks are the unfortunate reality – leading not only to theft of existing Bitcoins but also to the creation of undocumented “currency” and possibly destroying exchanges and rerouting transactions.

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Bitcoin Disadvantages III–the criminal:

Bitcoin is taking a larger and larger role in facilitating criminial and anti-establishment activities. • Bitcoin is closely associated with illegal purchases the world over – primarily used to purchase illegal drugs and finance online gambling • According to the Economist, Bitcoin has been popular because of “its role in dodgy online markets” (Economist,2012) • Silk Road, a Bitcoin exchange specializing in the drug trade , shut down by FBI in 2013 (Forbes, 2013) • The Washington Post labelled Bitcoin “the currency of choice for seedy online activities” (Chen, 2011) • CNN called Bitcoin a “shady online currency” (CNN, 2012) • “…online gambling accounts for a huge portion of Bitcoin activity” (Wyher, 2013) • “…online gun dealers use Bitcoin to sell arms without background checks” (Smith, 2013) • Bitcoin is inherently anti-community – success of an unregulated virtual currency may curtail conventional taxation and limit communal development and support for national needs • Bitcoin enables anonymous monetary transfers between politicians and influential individuals or corporations • Bitcoin can facilitate untraceable hiring of mercenaries and assassins • Bitcoin can facilitate money laundering • Bitcoin is being used to circumvent international sanctions – for example by Iranians.

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So what to make of Bitcoin? • Clearly virtual currencies have inherent advantages that are worth exploiting, however, controls must be put in place in order to create a reputable currency people will trust • At the present time Bitcoin is being hyped by speculators, anti-establishment types – and the merchants of Bitcoin mining hardware – all of whom have vested interests in perpetuating the Bitcoin scheme • Rumor is that Bitcoin’s unknown founders have set aside 25% to 30% of Bitcoins in circulation and therefore can exercise control over the Bitcoin economy (hence not really as independent as proponents believe) • Adoption of Bitcoin-like currencies by the establishment may lead to anarchy as such systems are driven by greed and will circumvent current taxation systems and practices • Essentially while the production of Bitcoins is asymptotically limited to 21 million units, not only are those units infinitely divisible, but an unlimited number of similar currencies could be created – tomorrow • In a highly influential article Krugman (2013) argues that Bitcoin algorithmic structure coupled with the “currency’s” deflationary bias incentivizes hoarding – market will not be fluid enough to facilitate trade • Low transaction costs are not a sustainable competitive advantage

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What if I were to tell you…it’s all part of a sophisticated Ponzi scheme? • The disadvantages delineated in the previous slides, economical, technical, legal and downright criminal should be enough to keep any sensible layperson away from Bitcoin…but, wait, there’s more… • As I’d pointed out earlier – no one knows who or what “Satoshi Nakamoto” is. With the most basic requirement from currency being trust – how can anyone hope to base an economy on technology that is completely dissociated from its founders?

• Imagine, for example, that Bitcoin may be an economic trojan horse funded and distributed by Al Queda or some other terrorist or clandestine organization?? • Probably not… (not smart enough…) but -

• The algorithm had been constructed to maximize potential gain from the mining operation itself!

• Ingeniously, the algorithm requires more and more computing power to keep producing less and less Bitcoins. • Theoretically, because of the asymptotic nature of the production curve – production will never stop… • In parallel, more and more will be spent with the hardware providers to mine Bitcoins…

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Bitcoin – No Real Economic Viability • To be effective, a truly global virtual currency would have to be created by an international organization, perhaps by The World Bank or by a subsidiary thereof to encourage trust among future users. • In any event the creators would have to be known, respected and trusted entities – and from historical experience, even then we may not be protected from fraud and deception. • Economically, something like Bitcoin is not a step forward but rather a step back; it does not introduce more efficiencies into the global financial system but rather deficiencies – after all, in the current economy to be useful to anyone Bitcoin first has to be traded for something else. Hence, more transactions and more costs – not less. • In a Ted presentation by one Paul Kemp-Robertson it had even been compared to primitive forms of payment such as Berkshares and “Ithaca Hours” or even…Starbucks Stars… (Kemp-Robertson at Ted, June 2013)

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Good morning, Mr. Ponzi…

• Clearly the ingenious inventors of Bitcoin have taken a page from Ponzi • By creating continuous and increasing demand for the required hardware the individual or group responsible is reaping the most rewards from planting the seeds for this scheme

• Demand for hardware increases as : • The time required to mine a block increases • The network grows – driving greater algorithmic complexity

• In parallel the rewards for mining decrease • The entire scheme is set up so that – theoretically – mining never ends, because of the asymptotic nature of the production curve (see next slide)

• As long as the scheme manages to survive – and it has been built to appeal to enough groups with diverse interests so that it just may carry on for a while – the value of a Bitcoin continues to increase, pushing the entire scheme forward ever faster…as incremental adoption meets a relatively fixed supply of Bitcoin, prices have nowhere to go but up.

The anonymous inventors continue to profit as long as the scheme survives.

As long as they can remain anonymous – they have no downside.

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The Asymptotic Bitcoin Production Curve

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Virtual Currency – An Idea whose Time has Come. Bitcoin is an important experiment along the path to a true virtual currency, but thus far its development is a hazard to most whom are involved – and to many who are not. A noted academic writes, “(Bitcoin)…represents the sharpest ever refutation of the efficient markets hypothesis,” and “…perhaps the finest example of a pure bubble [emphasis mine].” (Quiggin, 2013) It may be a while before a viable virtual currency rears its head. In the meantime, I’d advise to be cautious, and, yes, to wake up and smell the tulips…

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Bibliography

Bruner, Christopher M. (2011). “The Changing Face of Money”. Review of Banking and Financial Law, V.30, p. 383-406.

Chen, Adrian (1 June 2011). "The Underground Website Where You Can Buy Any Drug Imaginable".

The Economist (29 September 2012). "Monetarists Anonymous".

Ferguson, Niall. (2008). The Ascent of Money – A Financial History of the World.

Forbes (25 October 2013). "FBI Says It's Seized $28.5 Million In Bitcoins From Ross Ulbricht, Alleged Owner Of Silk Road".

Krugman, Paul (14 April 2013). "The Antisocial Network". New York Times.

Lee, Timothy B. Lee and Hayley Tsukayama (2 October 2013). "Authorities shut down Silk Road, the world's largest Bitcoin-based

drug market".The Washington Post.

Quiggin, John (16 April 2013). "The Bitcoin Bubble and a Bad Hypothesis". The National Interest.

Sanati, Cyrus (18 December 2012). "Bitcoin looks primed for money laundering". money.cnn.com. CNN. Retrieved 18 October 2013.

Smith, Gerry (15 April 2013). "How Bitcoin Sales Of Guns Could Undermine New Rules". huffingtonpost.com.

TheHuffingtonPost.com, Inc.

Steadman, Ian (26 April 13). "Study: 45 percent of Bitcoin exchanges end up closing". Wired.

Wyher, Tommy (19 October 2013). "The Rise and Rise of Bitcoin". The Huffington Post. Thehuffingtonpost.com, Inc.

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My interest in Bitcoin stems from my ongoing research into failure – personal, corporate, institutional. Having had the opportunity to experience the dot.com bubble firsthand and then three ensuing global financial crises, I was deeply intrigued by the Bitcoin phenomenon and moved to create this presentation. Comments? erik at steiner.co.il To connect: http://www.linkedin.com/in/eriksteiner

This presentation was strung together by Erik Steiner.

Most of my ramblings online are on the subject of failure. Please check out: Twitter stnr_on_failure Pinterest Anatomy of failure Linkedin Anatomy of failure Blog Steiner on Failure

All text © 2013 Erik Steiner. Images from various sources.

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