Bitcoin: Myths, Mania and Monetary Gain

 We know how passionate the debate around bitcoin, and more broadly cryptocurrencies, is. Here, we will try to step back and take stock of the situation.

 

Timeline

 

  1. The first bitcoin was originally released on January 9, 2009 by an individual or group called Satoshi Nakamoto.

  2. November 2010: Market capitalisation exceeds 1 million USD.

  3. December 2010: First mobile transaction.

  4. April 2011: Bitcoin passes parity with euro and sterling pound.

  5. June 2011: The Great Bubble of 2011; bitcoin exchange rate plummets to nearly 10 USD, just four days after its peak at 31.91 USD.

  6. March 2013: Bitcoin market cap reaches 1 billion USD.

  7. April 2013: Bitcoin reaches 266 USD.

  8. May 2013: First bitcoin ATM unveiled.

  9. August 2013: Germany recognised bitcoin as a private money.

  10. November 2013: Bitcoin is worth 1000 USD.

  11. December 2013: China bans bitcoin.

  12. January 2015: Bitcoin is worth 170 USD.

  13. June 2016: Bitcoin reaches 770 USD.

  14. November 2017: Bitcoin reaches 10000 USD.

 

Now that you have in mind the history of bitcoin, it seems essential to take some of the most received ideas on this burning topic and try to discern the true from the false.

 

Bitcoin is anonymous

 

Everything that happens in the bitcoin world is trackable. Thanks to the way that the algorithm is structured, every bitcoin-based transaction is logged in the blockchain. But individuals are hidden behind their bitcoin addresses which are not tied to the identity of users.

Some exchanges require their users to verify their identities. Moreover, using large datasets (including addresses used to deposit or withdraw money to or from an exchange or wallet service, publicly exposed donation addresses, or addresses simply used to send bitcoin to someone when using a real identity), it is possible to cross-check information, and this leads to “reidentification”. However, there are ways to improve one’s anonymity, for instance, using cryptocurrencies dedicated to confidentiality (Coinjoin).

 

Bitcoin is used for illegal purposes

 

Bitcoin, as all currencies is used for illicit purposes. Some websites accessible through Tor browser like Silk road (which has been closed in 2013) are based on bitcoin. Cash is still the best way to launder money.

 

Bitcoin is a bubble

 

“A bubble is an economic cycle characterized by a rapid escalation of asset prices followed by a contraction.” (Investopedia). What is interesting in the bitcoin is that institutional investors did not come first. Most of the early adopters are more techies than people interested in financial markets. But does that mean that it is not a bubble?

 

When comparing bitcoin growth with other substantial market moves, we can see that it is truly unique.

 

 

In that respect, it is not logical to speak about a “bubble that would never burst” regarding bitcoin. Usually, a bubble bursts when investors start panicking because they realise that the asset they hold is not as valuable as once thought.

 

Nevertheless, it does not make sense to justify a bubble just because of the volatility. The following diagram exposes gold volatility through the years compared to bitcoin volatility.

 

 By looking at these astonishing variations, we can conclude that bitcoin is a bubble and will burst one way or another, but we do not know when and it does not mean that this will be the end of bitcoin. We can imagine that it will trade closer to its production costs (around $1000-$1500) which is the best valuation we can have at present.

 

Will Bitcoin replace fiat currencies?

 

The bitcoin market capitalisation is close to $300B and is $400B for the 100 most prominent cryptocurrencies. Monetary aggregates (all the money supply) for the Eurozone reach $14000B and pretty much the same amount for the USA. Another impressive figure to note is the total global market capitalisation (the value of all stocks, in all companies, in all countries): more than $80000B. Simply put, the global stock market cap is more than 200 times the cryptocurrencies market cap. So even if it could, the way would be very long before it has any importance in the economy to replace fiat currencies.

Plus, and this is tied to the following received idea (bitcoin will be adopted by financial institutions and governments), states want to be in control of their currency (through central banks) and will have difficulties letting bitcoin overcome their power. This is why it is plausible that Russia and China (which already prohibited ICOs and bitcoin for financial firms) will ban bitcoin totally and introduce their own cryptocurrency.

 

How financial institutions and governments approach the currency

 

Just a week ago, CBOE and CME, Chicago’s two most common derivatives exchanges announced that they would begin trading bitcoin futures contracts on December 18. Many people think it is the sign that bitcoin is supported by the financial industry including some of the most significant investment banks in the world. However, since this announcement, most of the financial institutions said they would not immediately allow their customers to trade (e.g. JPMorgan, Citigroup, Société Générale, etc.). Others like ABN Amro or Goldman Sachs will clear futures contracts for some clients only after implementing strict standards that will make transactions very difficult. Only small brokers like Interactive Brokers will allow their clients to trade bitcoin futures contracts right away under specific conditions.

It should be kept in mind that banks offer financial products based on the demand of their clients and this does not necessarily mean that they genuinely believe it is “the currency of the future”.

About governments, we can observe that in most countries, it is legal to buy, hold, sell and pay with cryptocurrencies (there are some exceptions including Morocco, Bolivia, Ecuador, Kyrgyzstan...) but it does not mean that bitcoin is recognised as a proper currency. Today, bitcoin is not seen in the same way as the GBP, Euro or USD; this is why it is not concerned by many legislations. The second official authorities start to see bitcoin as a valid currency, it will probably establish strict regulations at the same time.

It is hard to see how bitcoin would take the leadership as a way of payment. As a matter of fact, high volatility, high transaction costs and transaction throughput time do not support its adoption.

 

The Blockchain

 

The blockchain is a public and accessible ledger recording all transactions. Bitcoin has its own blockchain; a new block containing all the transactions’ information is added every 10 minutes on the blockchain in a linear chronological order. Every computer connected to the mining activity is a node and possesses a copy of the blockchain. It is accessible via websites such as https://blockchain.info/.

Blockchain’s innovation is that it allows trustless transactions; individuals do not need to trust the second party nor the intermediary (such as banks) in the trade.

Bitcoin is one of the many application of blockchain, such as the process of recording all the non-currency related transaction contracts. It can be used for many other applications like identity verification (ex: Onename).

 

So, what is bitcoin?

 

Thus, bitcoin was initially thought to be a virtual currency transacted via the internet in a decentralised trustless publicly accessible system called blockchain where transactions are recorded. When releasing it in January 2009, pseudonymous Satoshi Nakamoto wanted "a new form of money that combines BitTorrent peer-to-peer file sharing with public key cryptography". The number of bitcoin is limited to 21 million; the algorithm will release the last one in 2040. Thus, like gold or other precious metals, it is a finite entity. The process of bitcoin creation is called mining: individuals use their computing power to check, authenticate, record transactions in a “block” uploaded on the blockchain. By doing this, miners release new bitcoins at the same time. They get rewarded with transaction fees and bitcoins, automatically. Bitcoin mining consumes power at an annual rate of 32TWh, about as much as Denmark which involves critical costs and impact on the environment.

Thanks to the algorithm behind it, any fraud attempt will be rejected by the consensus of users mining it.

Bitcoins are kept in a virtual wallet, offered by various companies. Unlike other cryptocurrencies, bitcoin is pseudonymous, not anonymous.

Bitcoin value chain is composed of software developers, miners, exchanges, merchant processing services, web wallet companies, and users/consumers.

 

Traditional currencies have three functions; medium of exchange, unit of account and store of value. Technically, bitcoin could do all of this. However, because of the current volatility, it does not fulfil any of these functions. Few vendors accept it, and it does not reflect any value since its price is continuously evolving; thus no one would keep their wealth being invested in bitcoin.

The other cryptocurrencies are working with the same core principles, on a separate blockchain.

 

The Blockchain is a push technology in which users give only relevant information to the network. Usual credit card transactions are done under pull technologies, implying that all personal information is consistently given to the parties involved in the operation.

 

Limits

 

Bitcoin has several flaws. First, paying with bitcoins involves high transaction costs. Nowadays it is unrealistic to purchase all day items with it.

Since it is not regulated, it is highly responsive to the country’s decisions regarding its use. When a nation decides to legalise or prohibit it, it directly impacts on bitcoin’s price. Thus, it is highly exposed to speculation.

 

Moreover, bitcoin is limited by its transaction throughput capacity, namely 3.3 to 7 transactions/sec. This is caused by bitcoin’s blockchain’s maximum block size of 1MB. This limit was established to prevent miners from creating large spam blocks. Visa typically allows 2000 to 10 000 transactions/sec.

Furthermore, these transactions can take at least 10 minutes to be authenticated and registered in blocks by miners, whereas Visa transactions take seconds at most. This latency is a significant handicap to the use of bitcoin.

 

Against the common belief, the fact that bitcoin is encrypted does not imply that it is secured; the elliptic curve cryptography standard used by bitcoin is crackable.

There are two situations in which all the system would crash; if a group of miners controls more than 50% of the computing power, they would be able to prevent new transactions from being confirmed and freeze the system. Also, if a price drop causes the bitcoin to plunge under miners’ remuneration rate, miners would stop their activities and transactions will not be able anymore.

 

Conclusion

 

As a conclusion, what is fascinating is the technology behind cryptocurrencies, i.e. the blockchain; its possibilities are endless. Unfortunately, most of the argumentation of bitcoin supporters relies on the blockchain and not on a proper analysis of this new financial asset. A significant part of the people is buying bitcoin because of the current trend which is seemingly one of speculation.

Bitcoin is the first of its kind and has driven the creation of hundreds of other cryptocurrencies. Maybe one of them will rival traditional currencies, yet it is very difficult to tell. Therefore, it is likely that Bitcoin is not the currency of the future, but the future of currencies.

 

*Evolution of the price of the bitcoin (Coinbase) from November 11 to December 12. Due to very high volatility, it is likely that this number is already outdated when you will read these lines.

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