Sunday, October 12, 2014

The Problems I Have With Bitcoin

I have some problems with Bitcoin that cause me some concern for its long-term usage. These concerns are not about the immediate viability of the cryptocurrency. For now, I think Bitcoin is the right innovation for the modern world. However, there are some shortcomings that concern me.

Lost Bitcoins


If you lose your wallet information, let's say your dog ate the paper on which you wrote your keys, or maybe he ate your hard drive, then you have no way of accessing that lost Bitcoin, nor anybody else for that matter. This means that they are stuck on the ledger forever, never to be traded again.

With a few million Bitcoin in circulation, this doesn't sound like a big deal, a few Bitcoin here and there. However, over time, these lost Bitcoins can add up, reducing the overall availability of Bitcoin for use. Things seem to be working more or less OK for the moment, but, if the ultimate goal is to get all 8 Billion people on Earth using Bitcoin for commerce, there already aren't enough. So, we are doomed to deal in smaller and smaller fractions of Bitcoin as they get hoarded and/or lost over time. It's going to get ridiculous when you are paying 0.000005121 for a cup of coffee.

Fixed Bitcoin Supply


Speaking of hoarding, that's another problem. One of the reasons why we have a Federal Reserve is that there wasn't enough gold to go around. If you have a mortgage on your farm to pay, you need people to buy your crops. If there is not enough cash in circulation, then your customers don't have the cash to pay you. The problem we had with gold was bank runs. There wasn't enough gold at banks to satisfy depositors' claims. Therefore, there wasn't enough money for people to use to pay their debts. It may have been their money on accounting ledgers, but there wasn't enough cash for them to pull from A to put into B. Silver was added to the money supply, but even that was eventually abandoned.

With Bitcoin, we do not have to worry so much about bank runs as there is no bank; but, hoarding can be problematic. Let us say that you somehow end up with 1 million Bitcoin, through savvy trades and good, ethical business practices. That leaves fewer Bitcoin in the pool, which is non-inflationary. Because you control so many coins, the price for Bitcoin goes up because there are fewer around for transactions. So, as the price goes up, your Bitcoin hoarding starts to pay off in higher valuations. You just have to sit on it and watch the value go up. What is your incentive to trade? It warps the value of Bitcoin.

With gold, we had some increase in the supply. Even today, several hundred tons of gold are mined each year throughout the world. So, the present supply of gold is limited, but, does slowly increase over time. With Bitcoin, there is an increase in the supply, up until the the 21 million Bitcoin limit. After that, the only way to provide access to the 21 million bitcoin to all the billions of people on earth is to use fractional reserve banking. Without that, we face deflation.

There are arguments in favor of deflation, but most Economists are trained in inflationary economies and wouldn't know how to deal in a world where deflation is the norm. This is why we have spent trillions of dollars propping up the stock market. Not only are Economists ill-equipped to reimagine the world in a deflationary economy, the public is completely unable to deal with the prospect of decreasing salaries and values for the goods they want to sell, even though they would be just as well served in the long run.

For the moment, we are spared some of the problem with Bitcoin deflation thanks to mining introducing new Bitcoins intothe system.

The Blockchain Size


The Bitcoin blockchain is around 9 GB at this time. This is with a few million geeks occasionally transacting back and forth among themselves. What happens when you scale Bitcoin to 8 billion users making several transactions per day? How large can the blockchain grow? What happens when it reaches 1 TB? 10 TB? Presumably, storage is getting cheaper (deflation) and processing is getting more powerful. But, still, there are practical considerations to keep in mind when pushing and pulling that much data around. Imagine trying to launch a node when the blockchain reaches 1 TB; how long would that take to synchronize?

What do we do with the blockchain in 50 years? 100 years? We are going to require centralized machines to handle transactions because participation will be out of reach for the average user. We are already seeing this with mining pools. You as an individual have little opportunity to successfully mine Bitcoin compared to the big players. Things will only become more competitive as the Bitcoin mining reward gets smaller and smaller and the necessary resources for mining increase in computing demand.

Conclusion


As stated at the opening, I am a fan of Bitcoin. I like what it does. However, I have some reservations about its long-term viability. Specifically, what concerns me is the fixed Bitcoin supply, which is impacted by lost Bitcoins and some of the same problems gold faces as a currency, namely hoarding. However, even gold has some degree of inflation as it continues to be mined.

I think that cryptocurrencies should include some degree of inflation to make up for coin loss and to counter some of the problems with deflation. For this reason, I like NXT and Blackcoin because they employ "minting" to slowly and predictably introduce new currency. I think 1% is too low, because people breed faster than that; but, it's a move in the right direction.

Bitcoin may be a bridge that takes us to the next level of cryptocurrency. I think it is a great start; but, we should be looking for a next generation option.
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