Bitcoins, a Crypto-Geek Ponzi Scheme

post_logo

Now that U.S. Senators Charles Schumer and Joe Manchin are advocating a crackdown on Bitcoins (a peer-to-peer electronic currency), the mainstream media is starting to pick up on the story.  Our informed readers here have probably heard something about the issue by now, but may be wondering what the heck these things are.  There has been much debate about whether bitcoins are a legitimate digital currency or an Internet era scam, so we will examine the issue of in an effort to make some sense of it.

Bitcoins were created by an anonymous person, purportedly from Japan, going by the name of “Satoshi Nakamoto.” On the surface, bitcoins are one of the first successful implementations of a digital currency created independent from any government or central bank and therefore is resistant to government control.  Bitcoins are championed by cyber libertarian/anarchists who want people to be able to spend money as they deem fit.  There is evidence that bitcoin currency is having some success in these endeavors but the currency is primarily used for anonymous dollar-denominated trading and speculators.  More specifically, bitcoins are used as an anonymous payment scheme for activities prohibited by government.  For example, bitcoins could facilitate the following activities:

  • Allowing people to donate money to WikiLeaks without worrying about the U.S. Government shutting down their PayPal accounts
  • Allowing American citizens to gamble online using foreign gambling sites and bypass a U.S. Government ban on online gambling or the transfer of funds to offshore gambling sites
  • Allowing people to buy illicit drugs online through anonymous online services like “Silk Road” (like eBay for drugs)
  • Tax evasion.  Income paid in bitcoins is nearly as untraceable as cash exchange and the bitcoins can be converted instantly to cash to minimize volatility.

Bitcoins have the following characteristics that ensure its success:

  • Bitcoins work in a decentralized peer-to-peer environment
  • Bitcoins can only be spent once per owner and the transactions are verified by bitcoin peers running the open source bitcoin software
  • Every bitcoin transaction is logged in a global peer-to-peer registry
  • Bitcoins can be generated by anyone running bitcoin “mining” software but the difficulty is increasing exponentially as time goes by and as more people attempt to generate bitcoins
  • The maximum number of bitcoins that can be generated will only be allowed to approach 21 million.

The Bitcoin Bubble

The bitcoin supply limit is designed to guard against currency inflation and avoid situations where governments print out more money while devaluing existing currency.  The problem is that a limited supply will become outstripped by demand, creating hyper deflation.  While deflation (the increase in currency value) sounds like a good thing, it is highly unstable because a currency that rockets in value must come crashing down at some point.

Sure enough, the bitcoin bubble has inflated 483-fold in a span of just over 8 months from October 1 2010 to June 9 2011.  Even more surprisingly,  bitcoins have skyrocketed 9667-fold from a value of $0.003 to $29 since it began dollar-denominated trading in April 2010.  See the chart below generated by BitcoinCharts.com.


Source – BitcoinCharts.com Creative Commons

That means anyone who jumped in at the beginning in April 2010 and bought $1000 worth of bitcoins would theoretically have $9.6 million in bitcoins.  That certainly sounds like a tempting bet, but be warned that it’s only a matter of time until the bubble pops and the value corrects itself to a tiny fraction of its peak.  Collecting that $9.6 million today might be very tricky, and the bitcoins will probably have to be sold off gradually because any attempt to sell a large number of bitcoins for dollars could trigger a massive sell-off and rapid devaluation in price.

Exponentially Higher Benefits for Early Bitcoin Miners

There was another way to obtain bitcoins, but those days are long over.  In the early days of bitcoins before they could be had for fractions of a penny, computer geeks with fast graphics processors designed for high end gaming could generate their own bitcoins through a process called “mining.”  Since the pool of bitcoin miners were few in the beginning and they all had a statistically equal chance of gaining a bitcoin if they had equivalent computing hardware, it was relatively easy to generate bitcoins.  So easy in fact that nearly 3 million bitcoins were generated in 2009 — 13% of the total number of bitcoins allowed.  The number of people sharing those 3 million bitcoins were relatively few, because not many people (even hardcore computer and information technology geeks) read cryptography mailing lists.

So who were the folks that knew about bitcoins in 2009 and had the first crack at getting a significant fraction of those 3 million bitcoins?  It was the cryptography geeks.  More specifically, the developers who wrote the first bitcoin mining software probably paid themselves by having the first crack at generating bitcoins with almost no competition.  It would also be no surprise if one of those developers were the actual person behind the fictitious character “Satoshi Nakamoto” (who actually may or may not be Japanese).  I agree with those who bet that he or she is not Japanese, as assuming that identity would only make it harder for him or her to be tracked down.

Conveniently Anonymous

We can effectively think of “Satoshi Nakamoto” as being on top of a Ponzi scheme.  But unlike physical world Ponzi schemes where the creators almost always end up in jail, the creator of bitcoins is anonymous and went out of his way to use anonymous email accounts through TOR networks to anonymously publish a whitepaper on bitcoins.  The next wave of speculators who bought early into the bitcoin scheme and/or tried to generate their own bitcoins at a much slower pace (but still much higher than today) were the next tier in the scheme and they can probably walk away with some nice earnings if they pull out before the bubble bursts.  At this late stage when the mainstream news is reporting on bitcoins, we have speculators trying to buy in at extremely high valuations hoping to sell to the “greater fool”.

Can Bitcoin Survive After the Bubble Bursts?

It’s only a matter of time when bitcoin value comes crashing down to earth and when that happens, does that spell the end of bitcoins?  Given the fact that there will still be demand for an anonymous currency transfer scheme and people will still want to gamble online and buy illicit drugs online, it’s quite possible that bitcoins (or some derivative technology) can survive after a massive bubble correction.  Someone could publish a proposal to gradually add more supply to balance demand and so long as a critical mass of the world’s bitcoin users go along with it, the deflation problem might be solved.  But by that time, a lot of people will have lost their shirt trying to get rich quick with bitcoins.