Undercover Economist

Boom or bust for bitcoin?

Bitcoin appeals to libertarians on the basis that governments cannot arbitrarily make more of it

In a moment, I’ll gaze into the crystal ball and foretell the future of the world’s most famous cryptocurrency, bitcoin. I should first explain what’s happening now.

It was developed in 2008 by an unknown programmer or programmers. Confusingly, bitcoin is both a payment technology and a financial asset. The asset called bitcoin has no intrinsic value but it has a market price that fluctuates wildly. Like digital gold, it appeals to libertarians on the basis that governments cannot arbitrarily make more of it.

The payment technology called bitcoin is what you might get if you ran the Visa network over a peer-to-peer network of computers. In case that description doesn’t help, it’s a way of sending money anywhere in the world but instead of relying on the authority of a financial intermediary such as Visa or Western Union, it uses a decentralised network to verify that the transaction has occurred. The record of all previous transactions is called the blockchain; it, too, is stored on a decentralised network. The entire process relies on cryptographic techniques to prevent fraud, which is why bitcoin and other currencies like it are called cryptocurrencies.

This may all seem very esoteric but the internet was esoteric once and it turns out to have become important. So what lies ahead for bitcoin?

Here’s one scenario.

Bitcoin has enjoyed many booms and busts in value, and later in 2015, the price surges again. This will be the biggest yet, drawing more and more people into the market. As the dotcom bubble and railway mania proved, even revolutionary technologies can be overvalued; with Bitcoins selling for $2,000, $5,000 and eventually $10,000 each, nemesis is around the corner.

The first sign of trouble will be the scams. A recent research paper by computer scientists Marie Vasek and Tyler Moore identified almost 200 bitcoin scams, in which about 13,000 victims lost $11m. Such scams will only become more common as the stakes become higher and the pool of naive investors deeper. Soon they will be the stuff of mainstream consumer rights phone-ins.

Arguably, scams are a sign that Bitcoin has matured — after all, nobody proposes abandoning the dollar because con artists like to be paid in dollars. But they are just a foretaste of what is to come — Bitcoin will be gutted by predatory monopolists.

The Bitcoin system has always relied on a crowd of people putting their computers to work verifying transactions and writing them into the blockchain, a task which costs money and energy. In a rather confusing analogy with gold, these people are called “miners” and they are compensated in Bitcoins, of course. Yet there is a basic inconsistency at the heart of this system, as the economist Kevin Dowd has observed: Bitcoin mining needs to be done by a decentralised crowd but is more efficiently done by large arrays of computers owned by a few players. Or possibly just a single one.

Even today, Bitcoin mining is a game for the big boys. As the Bitcoin mining industry becomes a tight, self-serving oligopoly, the stage is set for Bitcoin counterfeiting on a massive scale. In 2018, 10 years after the invention of Bitcoin, the system collapses under the weight of its own contradictions.

It’s an intriguing story — but of course, it is just a story. We could give it a name: “BitCon”.

. . .

If you don’t believe that, I have another story for you. The title is “Daisy Chains”. Throughout 2015 and 2016, the price of Bitcoins continues to collapse. Speculators lose interest and some of the big miners sell off their computers at a heavy loss. The spotlight moves elsewhere but the true believers in the power of decentralised blockchain processing continue to develop the system.

Bitcoins aren’t the only things that can be transferred using a peer-verified network, after all — you could transfer the digital lock to a smart car; or a financial contract, with pay-offs and penalties automatically adjudicated and paid for by the blockchain. The question is whether the effort of doing all this is more efficient than the current centralised systems using interbank payments.

The answer is yes but only in certain circumstances. A blockchain is a ledger of every digital transaction ever made on the system. This proves far too unwieldy for a universal means of payment. Yet specialised niche systems evolve: by 2018, block-chain processing is common for remittances; by 2019, block-chain processing pays for and controls self-driving taxis. You can even download an out-of-the-box blockchain app for your local babysitting circle — or your prostitution ring. Blockchain approaches don’t replace Western Union and Visa everywhere but they squeeze margins and make inroads for certain applications.

The only disappointment for the true Bitcoin enthusiasts is that Bitcoin itself, the currency that started it all, fails to catch on. Most people prefer a trusted brand. When a standard of value is used on these disparate blockchain processes, the most popular by far is “FedCoin” — more commonly known by its correct name, the US dollar.

Two stories about the future, and most likely neither one will come true. These are interesting times for cryptocurrencies.

Written for and first published at ft.com.