Talking about BitCoins: What they are, what they can be and what they probably cannot be

During the past two years – especially through the last year – Bitcoins have become a relevant discussion within the modern world and currency markets. Born out of a desire to surpass problems created by the fractional banking system, Bitcoins  and other digital crypt-currencies, seek as their ultimate objective to become a main-stream means of exchange to compete with regular banking. On today’s article I want to talk to you about Bitcoin but more than that I wish to go above the role of “supporter or detractor” and look at Bitcoins from a very rational perspective. Through the following paragraphs I will talk about Bitcoin’s objective characteristics, what it is, what it isn’t what it can be and what it definitely cannot be. As with almost everything in life there are disadvantages and advantages to Bitcoin, problems that prevent it from ever reaching certain goals and advantages that make reaching other goals extremely easy.

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As many of you may already know Bitcoins are a form of crypto-currency, created by the solution of an encryption algorithm through computational brute-forcing and kept alive by the sharing of a transaction chain used by all Bitcoin users to carry out, record and validate transactions. I am not going to get very technical about Bitcoins here – as it is not my main objective with this article – so you can read more about Bitcoin’s technical aspects here. The main important characteristics of Bitcoin anyone should be aware of are that it’s anonymous (wallets – digital programs where Bitcoins are kept – are not tied to an identification), it’s decentralized (there is no central issuing or controlling authority) and it’s limited (total number of Bitcoins is limited to 20 million and the rate of generation is also limited). From these characteristics we can make some deductions about what Bitcoins can and cannot be, based on what we know about macroeconomic and what Bitcoin actually resembles within our monetary system.

First of all, Bitcoin is very different from traditional Fiat money. This is not bad or good for Bitcoin but it depends on its ultimate purpose. Bitcoins will never grow to replace the US dollar and the overall monetary system because Bitcoins suffer from terrible problems in this regard that deter it from becoming an effective large scale replacement for money as we know it. Among these problems the most important is probably supply. When a population grows exponentially the monetary supply needs to grow in the same manner in order to accommodate the expanding demographics (basic macroeconomics). If a population grows but the monetary supply remains constant, there is an implicit deflation that stimulates accumulation and makes lending simply impossible. If the economy functioned based on Bitcoins it would be impossible to carry out large projects or start many new businesses because borrowing would be extremely hard. The interest people charge for borrowing would be very high as it would have to exceed the gain expected from deflation. Then to gain that interest would be even harder because as time passes the value of goods or services being sold depreciates in values.

Another important deterrent from becoming a real replacement for fiat would be distribution. Bitcoin has naturally created an environment where some players have a naturally large stake over the distribution of coin. About 85% of Bitcoins are held by 1% of the wallets, meaning that the Gini coefficient of Bitcoins (a measure of inequality) is really high. If Bitcoin would become a replacement for the USD not only would you have to compete to get something that inherently deflates in nature over time but you would also need to get it from a very small segment of the population. A world where Bitcoin is the main means of exchange would be a world where a few would control a large majority of the wealth.

Now the above doesn’t mean that I am against Bitcoin, I just see that from a macroeconomic perspective it is not rational to expect it to ever replace Fiat. What can Bitcoin be then? The best exercise we can do is look at Bitcoins and see what they resemble in our economic environment. Bitcoins are held primarily by a few, are inherently deflationary and can be bought and sold between users. From this I would say that Bitcoins best resemble company stocks because these are also limited, held largely by some stock-holders but can also be exchanged freely among users. We could therefore say that buying a Bitcoin is alike buying a share (buying equity) within the “Bitcoin company”. You are making a bet that the Bitcoin company will increase in value as a function of time.

But what does the “Bitcoin company” do? It’s a money exchange business (think something like Western Union). The Bitcoin company obtains its value from the ability it gives users to perform currency exchanges from one place in the world to another, almost entirely for free. This is the place where Bitcoin can really shine and a place where the value of a Bitcoin is practically irrelevant for the end-user. If Bitcoin derives its value from serving as a means of moving currency between countries at practically no cost, then I don’t care if a Bitcoin is worth 100 or 10,000 USD because I just want to exchange X quantity I have for Bitcoins and then immediately exchange them back to another country’s currency. In the same manner as I don’t care what the value of the Western Union stock is when I perform a money exchange I also don’t care what the value of Bitcoin (the stock value of the “Bitcoin company”)  is if my sole goal is to exchange a currency between one country and another.

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The “Bitcoin company” still has lots of challenges to face, including regulation and managing anonymity (which can encourage things like money laundering) but as a means to exchange money I don’t see a reason why it cannot be a long term sustainable premise. However I don’t see it ever replacing fiat, because it is structurally not adequate to play the same role as money does in the current economic system and demographic climate. Bitcoin simply does not fit the macroeconomic requirements needed to do what money does under out current system (which not only serves as a mean of exchange and store of value but also as a means to economic expansion and debt creation).  It is although interesting to consider whether a crypto-currency that can really replace fiat can be created, I would say that it can but it needs to be a much more complex proposition than the current Bitcoin implementation.

If you would like to learn about my work and how you too can create your own algorithmic trading systems please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)

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2 Responses to “Talking about BitCoins: What they are, what they can be and what they probably cannot be”

  1. Crawford says:

    The assumption made are that all crypto currencies are limited in supply or that only one crypto currency is possible (Bitcoin), but in reality that is not the case. The beauty of crypto currencies is that they can be reinvented to overcome problems with existing currencies.

    Do you have a reference for the 85% of currencies are in 1% of the wallets? I’m really interested in that statistic. One big problem that currencies have to overcome right now is that special hardware is manufactured to mine the currency. This basically eliminates the average joe from participating. This is why Scrypt coins were created, but they to may soon have hardware that will outpace any average mining computer.

    Also while the coins are anonymous from the standpoint that the wallet is not attached to identification, the transactions are very traceable effectively making it very difficult to stay anonymous. It would make long distance petty crime easier just because no law enforcement agency has the resources to trace those individuals down.

    • admin says:

      Hi Josh,

      Thanks for posting :o) I know that all crypto currencies do not have a limited supply, I was just mentioning that in this article as it pertains to Bitcoins (as the article is about Bitcoin and not crypto currencies in general). I however agree with you in that they can be reinvented as well, it would be very interesting to see a crypto currency with the true potential to replace fiat currencies.

      About the Gini coefficient for bitcoin, there are several sources. Here are a few (businessInsider, stackexchange). I also agree with you that the evolution of mining hardware carries a significant problem for this type of currencies, it encourages the accumulation of Bitcoin by people who can afford better technological solutions. The concept of mining can probably be improved to make it fair and impossible for this type of Gini coefficient extremes to happen, however this requires significant changes to the current concept of mining.

      I agree that anonymous right now does not mean untraceable, especially if you want to convert those coins back to fiat. However in a world where a crypto currency would replace fiat there must be a way to trace back everything to somebody (company, individual, etc) because otherwise it would become very easy to launder money and carry out illegal transactions. While there is a link to fiat this is no problem (As all fiat is in theory traceable in the global financial system) but once we’re in a “crypto only” system (if ever) tracing usage is fundamental for law enforcing.

      Thanks again for your comments Josh :o)

      Best Regards,

      Daniel

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