Bitcoin: A currency whose time has not come

If anybody needed confirmation that Bitcoin is a bubble waiting to burst, consider this: It took seven years since it started trading for it to cross the $1000 threshold, which it did in January this year. Four months later, in May, the price surged through the $2000 level. By August, it broke the $4000 barrier and … well, you get the picture. It takes ever less time to go through each successive $1000 level. Just after 1am London time this morning, it broke the $10,000 threshold for the first time. Thirteen hours later, it reached an all-time high of $11,434 and less than six hours later it was way back down, at just above $9000.

If you draw a daily chart of Bitcoin moves, this is a trend which will not show up. But these are the sort of market movements that are hard to resist – everyone loves a good boom, and before too long it is a pretty safe bet that there will be a bust from which there is no coming back. Aside from the fact that any asset which rises at such a speed almost inevitably comes crashing down again, there are numerous ironies associated with Bitcoin which make it unsuitable to be the great alternative to central bank controlled cash that its proponents claim.

Consider the fact that its initial popularity was derived from those who believed the best form of protection against an imminent collapse in civilisation was to live in a remote cabin in the woods with plenty of tinned food and a well-stocked armoury. The theory ran that central bank cash would soon become worthless as societies collapsed and alternative forms of money would come into their own. There is just one snag. Bitcoin is an electronic token which exists only on a computer. In the event that civilisation were to collapse, who would be there to keep the lights on – or more pertinently, generate the electricity required to ensure that Bitcoin could continue to be traded?

To understand why all this is an issue, we need to go to the heart of what Bitcoin is. It was designed as a peer-to-peer electronic cash system to cut out the conventional banking system. In order to make this work, transactions between holders of Bitcoin are recorded on a digital ledger known as the blockchain. In a conventional banking system, the ledger is a record maintained by the banks. To bypass this step, a ledger technology was created in the form of an electronic file which records all transactions in sequence, so we can see how title to Bitcoin passes from one holder to the next. In the absence of a centralised record keeper, it is important to ensure that people are not cheating (i.e. claiming to own Bitcoin to which they are not entitled). This is done by timestamping each transaction and linking it to each previous timestamped transaction in the form of a chain. In this way, we can trace back all transactions – there are no secrets.

But transactions are only added to the chain after a complex proof-of-work algorithm has been solved. Due to the transparency of the system, falsifying the current transaction would require falsifying all previous transactions, and because the proof-of-work algorithm is computationally onerous, there is little incentive to cheat – it is simply too expensive in terms of time and transaction costs. So once you solve the cryptographic puzzle and all users agree the solution is valid, one iteration of the proof-of-work algorithm suffices to ensure the blockchain is valid. Bitcoin comes into the equation because those who maintain the blockchain, and do the complex calculations, are rewarded by payment of Bitcoin. An additional complication worth knowing is that the supply of Bitcoin is limited to 21 million, and almost 80% of all coins likely to come into existence have already been created. Moreover, miners get progressively lower rewards for each block they “mine.”

Having completed that diversion, it raises two issues. First, the electricity requirements to run the blockchain and mine Bitcoins are enormous. Because of their increasing scarcity, miners have to expend more energy to generate each additional Bitcoin – it is an energy-inefficient process. Currently, this activity consumes as much electricity as the Turkmenistan economy and estimates suggest that by 2020 it could consume as much as Denmark. Second, the real bonus of the system is that the blockchain is applicable to a wider range of activities than Bitcoin. The real reason why Bitcoin has surged this year is that investors have been bringing blockchain-related products to market via initial coin offerings. But the Ethereum network, which is an open-source, blockchain-based platform designed for a wider range of applications and in which the digital currency (Ether) is derived as a by-product of the verification process, has been one of the fastest growing currencies this year.

Policymakers have taken note of the recent bubble with the BoE’s Jon Cunliffe reassuring the public in a radio interview this morning that it is too small to hurt the wider economy. Indeed, the global market cap of all digital currencies currently stands at $283 billion – less than 0.5% of world GDP. But central bankers have taken note of digital currencies and have been thinking about central bank controlled cryptocurrencies for quite a while (I will deal with this another time). I do believe that there is a future for digital currencies – it’s just that I don’t believe Bitcoin is the vehicle to take them forward.