Viewpoint: Why Bitcoin Is Going Gangbusters and Why It Matters

By Samee Zafar; Edgar, Dunn & Company

The Bitcoin system offers a virtual “crypto-currency” based on an open source computer program developed in 2009. The currency is decentralized and anonymous. So anonymous that its creator used a pseudonym to hide his identity and has now completely disappeared from the face of virtual Earth.

Many have exhausted the available management vocabulary to describe it as a “killer app,” a “major disruptive technology” and a “powerhouse” that “lowers barriers to entry.” Already analysts trained in the field of quantitative finance are propounding theories on how to measure the “intrinsic value” of Bitcoin. They point to its soaring value and a little bit of incomprehensible magic that needs to be explained with incomprehensible equations. The price of a bitcoin went erratically upward earlier this year, then down in apparent free fall, before steadying itself and then zigzagging, like a high performance aerobatic plane experiencing engine trouble.* Surely, there must be the natural economic forces of supply and demand acting on its unpredictable trajectory. Where is the demand coming from?

Who Wants It?

The demand for bitcoins arises from a number of very different sources. These overlap, of course, but to make sense of Bitcoin’s rocketing popularity, let’s look at who uses it and why.

1. Monetary Freedom Fighters:

In the forefront of those who support Bitcoin are the true believers.

For them a virtual currency that is anonymous and not backed by a central authority is at the heart of an ancient good, the teachings of the founding fathers, an inalienable right and all that good stuff.

These enemies of monetary tyranny are the digital libertarians—who believe in the powers of cryptography to win in this battle for individual liberties. Contrary to any misleading images of libertarians you may be entertaining, of long-haired, rebellious, tattooed anarchists, these guys are smart and successful idealists who are motivated by a particular political philosophy and a world view that not everyone finds comprehensible or pragmatic.

2. Disillusioned and Desperate: The second group is made up of those who have something to lose. These are the people whose savings are under threat from recent bank failures and economic crises in markets, such as Cyprus. People in other markets anticipating a Cyprus-like future also are interested in the Bitcoin system as a means of preserving their distressed deposits.

Decentralized currency on a server somewhere in Siberia is better than money in an account which could be accessed by a bankrupt government as and when needed.

3. The Undesirables: One of the places bitcoin is said to be used often is the famously secret Website Silk Road where, allegedly, contraband items were bought and sold, money is laundered and a whole host of illegal stuff is available for sale except, allegedly, items that could “harm others” (although apparently drugs were available). People who participate in these activities have a special interest in Bitcoin, which is their currency of choice.

4. Gamers and Gamblers: This is a very big deal. The multibillion-dollar market for online gaming and gambling is important. People who play perfectly harmless entertaining games online or gamble, pay with their credit cards, bank accounts or prepaid vouchers. But the great thing about online gambling with bitcoins and pocketing your winnings is that no one needs to know about anything at all.

5. Speculators and Entrepreneurs: The market price of bitcoins is highly volatile, fertile ground for those who want to get in to make a fast buck. Bitcoins also offer opportunities to entrepreneurs.

Businesses have appeared overnight offering to store bitcoins for their customers or process transactions for them. There also are those who operate large computers to generate new bitcoins.

Other creative business concepts are being developed every day, including the Bitcoin ATM project championed by someone called Jeff Berwick, whose other ambition was to create a libertarian expat haven in Chile, until he realized that an ATM is “hardware” and therefore, “any government, anywhere, can just come and take it away.”

So Where’s the Problem?

Besides the fact that the Bitcoin system is currently in service of some, shall we say “niche” uses, there are problems on the supply side, too. The open source program that generates bitcoins rewards the use of computing processing power (solving “complex” mathematical problems and confirming Bitcoin transactions). Transactions are added to a decentralized transaction log, called the block chain, every 10 minutes or so. The system is based on distributed computing involving thousands of “nodes” and needs no central authority to back it up. The lack of a central authority is a plus in the eyes of those who inherently distrust the role of such entities in monetary systems.

But what about the role of the guarantor of last resort in times of acute crises? There is no one who would bear the ultimate responsibility for system failure or provide some form of guarantee in times of unexpected economic crises.

The threat of regulation is always a real one. Regulators tend to be conservative, more interested in public protection rather than monetary freedom and are likely to take an adverse view of any anarchic, self-regulated system where there are multiple points of failure but no central control.

Bitcoin enthusiasts will tell you it’s an elegant system—an open source computer program spewing out value at a managed predetermined rate limiting the supply, unlike the debasing of real money through quantitative easing practiced by tyrannical central banks. There is an obvious analogy to the mining of gold and other precious metals.

The details and the underlying algorithms of mining bitcoins are so arcane and so fiendishly complex that they are not properly understood even by Bitcoin developers and die-hard enthusiasts.

So what if the system screws up like any other system? What if there is a massive fraudulent attack by sophisticated hackers using algorithms of an even higher order than the so-called “unbreakable and impregnable” self-sustaining loops of the Bitcoin-distributed servers? And even if all goes smoothly and the Bitcoin system succeeds to represent a stable digital currency, what would prevent a clutch of clones from entering the market and diluting the demand? The only way to avoid such a fate is to achieve widespread acceptance and usage, but that’s highly unlikely until we all start dumping our cards and bank accounts en masse and retailers start accepting bitcoins globally. 

With Us or against Us

The possibility of something going wrong in the process of electronic monetary genesis or somehow someone getting through to compromise the integrity of the system leads Bitcoin enthusiasts to start hammering into our heads the extreme improbability of such an event. If you continue this line of questioning, you run the risk of being labeled one of those who “just doesn’t get it.” The world seems to be divided into two zones: The developed world—those who get it—and the developing world, those who don’t. Only a few avenues are open for debate with enthusiasts. You are allowed to discuss certain weaknesses, such as loss of value if bitcoins are lost or stolen, the threat of regulation, problems of system scalability and lack of merchant acceptance. But at the risk of exposing your ignorance, you may not question the complexities of Bitcoin supply and demand or the underlying crypto-technology. 

Conclusion

You don’t need to be a rocket scientist to understand that the current rate of conversion offered for bitcoins has appreciated because of factors that have no bearing on its underlying value as a payment mechanism. It may yet grow to be an alternative cyber-commodity or a standard safe haven for distressed deposits—provided it survives serious hacker attacks in the future—but, at this stage, it’s difficult to see Bitcoin as an alternative currency for the connected world that will provide value to a majority of people.

Yes, people still buy gold as an investment and they’ll buy bitcoins, too. If Bitcoin manages to become wildly successful, it’s likely that several similar currencies will appear alongside it. The focus of hackers all across the globe will then surely turn to these anonymous stores of virtual value rather than to traditional account-based payments.

 Samee Zafar is a director in Edgar, Dunn & Company’s London office. He has advised some of the largest financial services organizations in Europe and North America on competitive strategy, operations and technology. His expertise covers retail banking, card issuing and acquiring, as well as online and mobile payments. He can be reached at [email protected].

Click here to read a counterargument on the pros of Bitcoin.

*This article was written for the Fall issue of Pay Magazine before bitcoin value shot up to $1,000.