Bitcoin

Money

A fiat money requires only three properties: a) it is hopefully nearly impossible to counterfeit, b) a large enough group of people is willing to accept it as an intermediary barter vehicle for all sorts of goods and services. c) it does not allow double (or more) spending. In other words, a coin once spent can not be spent again by the same person.

The first & third properties are necessary to establish the second one. In fact, if the currency could easily be counterfeited or multi-spent its value would be destroyed. The third property results from the unique identity of each coin or note.

The necessity of properties a) & c) required throughout history that fiat money be guaranteed and issued by some government. In fact, governments have the unrestricted power to issue & enforce laws, therefore they can have strong enforcement of unique IDs & anti counterfeiting laws.

With the advent of modern computation this is no longer the only way to guarantee these mandatory properties. In fact, modern cryptographic algorithms can guarantee the unique ID & non falsification of any kind of document, certificate or proof. Therefore, it was a matter of time before a form of computer based money would be introduced. Bitcoin is such a computer generated money.

Bitcoins have also the following attractive properties;

BTC Is Disruptive

The following quotes from comments on a HBR Bitcoin Article capture the full disruptive impact of the bitcoin system.

Jason Serafin

The Bitcoin system is a new system that does not fit in the classical ideas of what currency is. There is nothing to compare it to and that is why it is so brilliant. A deflationary currency may have been "bad" with classical currencies but the same limitations on those currencies do not apply to bitcoin such as the decentralized control and how easily it is to create smaller units for trade. So the short answer is that no one knows how Bitcoin will perform as a currency yet and anyone claiming to know is being foolish. We are blazing new trails here and I think that is awesome.

Fred Wemberly

People that keep seeing Bitcoin as just one thing, a currency, are missing the larger picture. Bitcoin has inherent value as another tool of the network. It will end up being the ultimate networked tool.

But Bitcoin is other things also. And in the end, it's the internet itself, monetized.

Bitcoin is:

1. a currency
2. a distributed and verifiable public ledger
3. a peer-to-peer payment processing network
4. a triple-entry accounting system
5. a store of wealth
6. a cryptosignature creation and verification device
7. a personal offshore bank account
8. a distributed timestamp server
9. the network, monetized

http://peculium.net/2013/03/24...

wtpayne

I agree. Bitcoin provides a distributed cryptographic infrastructure that might yet find it's greatest utility outside of it's current use as a currency. (Namecoin DNS is a good example of this sort of thing).

The most remarkable thing that Bitcoin does is create a mechanism for "proof-of-ownership" in a decentralised, peer-to-peer way.

If you wanted to, you could store tokens in the transaction record that would enable you to tie the ownership of a particular bitcoin to another physical asset or informational right, represented by that token.

The token could confer access or voting rights for example, rights that could then be bought and sold in an informal, peer-to-peer, over-the-counter market.

Bdancer

Very well thought out. If bitcoin does not become the Internet currency because of some flaw not recognized at this point, then something even more sophisticated will take its place. It will truly change the world and will completely change government too.

Florian Bvsch

Bitcoins are disruptive, designed to be disruptive. They turn every principle and business built around currencies and exchange of value on its head. It is a grand experiment. Perhaps it will fail, or maybe it will succeed. The cost of ignoring it however can be unlimited.

How Bitcoin Works

Bitcoin uses hash algorithms in a number of ways to insure users' privacy and prevent both counterfeiting and double spending. In particular,

"BitCoin uses the SHA-256 hash algorithm to generate verifiably "random" numbers in a way that requires a predictable amount of CPU effort. Generating a SHA-256 hash with a value less than the current target solves a block and wins you some coins." (Emphasis added).

The key point is that "solving" a block means constructing a block whose header, when hashed, produces a hash that is lower than the target but is the closest "guess" about the target. Thus the bitcoin network can adjust the average number of hashes required to close-guess the target. This adjustment of the target is done by the network to tune the required computation rate (network hashrate) so that a block is created roughly every ten minutes regardless of the growth of the network hashrate.

How bitcoin works supplies many more details on how bitcoin achieves all the requirements mentioned above. See also: (Transferring Bitcoins)

Additional details on how bitcoin works are supplied by the protocol specification

Finally, the most recent decentralization & attack proofing improvements are embodied in the getblocktemplate mining protocol

Resolution

The resolution power of the bitcoin is very large indeed, as Wikipedia states "Each bitcoin is subdivided into 100 million smaller units called satoshis, defined by eight decimal places."

This implies that, while the present BTC to dollar conversion rate is about $100, it does NOT mean that the long term BTC money base is limited to just 21 x 10**6 (21 million BTCs) times $100, that is 2,100 million $ or 2.1 B$ which clearly would be insufficient to handle even a .1% of WW money flows.

Bitcoin can accommodate the WW money flows by simply increasing its value and that of its subdivisions. For example if the satoshi were to appreciate to one cent, then the maximum money flow that could be accommodated by the bitcoin system would be 21 million x 1 million dollar = 21 Trillion dollar or 21T$! This would be quite adequate to handle all the present day WW money flow. The corresponding valuation for the bitcoin would then be, an astounding one million dollars per bitcoin.

Potential BTC Appreciation

One can get some idea of the potential BTC's appreciation by estimating the world wide monetary basis and estimating the fraction that could be BTC based. As the two graphs in:

GDP vs St Louis Adjusted Monetary Basis

Monetary Base % vs GDP for US EU & Japan

show, at present time, the US monetary basis is about 20% of GDP. This is, as the St. Louis Fed Graph shows, a very high percentage. I.e the economy is, at present very unleveraged. If we use this figure on a world wide basis then the monetary base for the world should be around (80/5) T$. If bitcoin is assumed to reach 10% of the WW monetary basis it should amount to 1.6T$. this would correspond to BTC's valuation of 1.6T$/11 x 10**6 = 1.6 x 10**12/11 x 10**6 = 1.6 x 10**6/11 = $145,000

Again referring to the St. Louis graph, in boom times when leverage is very large, the money base can shrink to less than 5% of GDP, correspondingly the valuation of BTCs would be 1/4 if we assume the same WW GDP. That is, about $ 36,250. Even if bitcoin takes over only .1% of WW money's flows it still would reach astronomical values between $14,000 to $ 3,635 per bitcoin!

However, it is far from certain that bitcoin can grab even one thousandth of the WW money's flows. First of all, a lot has to happen to build the confidence in the currency and a dependable infrastructure to support it.

In addition, as the next sections will show, bitcoin has a fundamental flaw which will probably prevent its adoption as WW currency for all, but a restricted range of, mostly illegal, activities.

Bitcoin's Fundamental Flaw

The "intrinsic" value of a currency can be calculated as the value that causes the money supply to be of a size adequate to support the related economy. In other words, if M is the money supply (number of coins), and v is the money's velocity (in numbers of turns per unit time) and B the value of an individual coin then, in the average, it must be true that:

GBP = v*M*B

Where GBP stands for Gross Bitcoin Product. In the bitcoin case we know precisely the value of M, we can know the value of B from the MtGox quotations, but we have no knowledge of v the money velocity. We can guess estimate by equating it to the US dollar's velocity. This estimate will tend to be on the high side, at least for the time being, of limited bitcoin commercial acceptance.

An additional difficulty for bitcoin is that, differently from conventional fiat currencies, it is strongly deflationry. For instance, if bitcoin were to support the entire world economy with a maximum of 21 million coins its value could be as high a 1 million dollars per bitcoin, if v = 5 turns per year, or 1/4 million if 20 turns per year are assumed.

This srong deflationary characteristic causes bitcoin to be both a financial asset and a currency. These two aspects are in conflict since the former will cause a tendency towards a (very) low money velocity or, what is the same, for the currency to have a high dormancy. In other words people will be very reluctant to spend it. While no dependable statistics are available it has been estimated that 60% of bitcoins are not circulating.

Therefore, the actual size of the bitcoin economy would be given by:

GBP' = v*M'*B = v*.4*M*B = v*M*.4*B = v*M*B'

Where B'= .4*B (about $40) is the "intrinsic" bitcoin value justified by its currency role. The remainder (about $60) arising from its role as a [libertarian] financial asset.

There has been a lot of discussion whether bitcoin may be a bubble. The clear fact is that asset markets have positive price feedback and consequently are unstable and prone to form financial bubbles

Besides this instability, the strong deflationary nature of bitcoin will prevent it from achieving acceptable fluidity in markets that do not have a strong requirement to escape government control and oversight. That is, illegal and criminal activities and special situations, such as, the recent Cyprus government confiscations of private banking assets.

One can estimate an upper "intrinsic" value for the bitcoin if one can estimate the size of the WW Crime GDP which states:

"Well, for the first time ever, the UN in conjunction with the World Bank have given an official estimate of the size of the global criminal GDP. Yuri Fedotov, head of the UN Drugs and Crime Office (UNODC) stated that organised crime from which Odessa is certainly not immune, and Afghan heroin trade, which Ukraine will send personnel to attempt to manage, accounts for $2.1 trillion. $2.1 trillion is 3% of global GDP. If it was a country, it would be in the top 20 economies on the planet.

It is the first ever official UN global guesstimate regarding the serious and organised crime economics. The figures are based on 2009 statistics."

Accordingly the upper intrinsic value of bitcoin could be $ 30,000 at 5 turns/year or $ 7,500 at 20 turns per year. These are still respectable targets. However, the figure of 3% of WW GDP for illegal activities is far from proven and there is no knowledge of what percentage of such activities would embrace the bitcoin economy.

On the other hand, it is quite easy to fix the bitcoin system so that it is no longer strongly deflationary and therefore can be attractive to legitimate activities.

In fact, bitcoin could be turned into a fabulous, world wide, currency for the Internet age by simply tying the mining difficulty to the value of a suitable basket of fiat currencies and commodities, in such a manner that its money supply will automatically adjust in line with the growth of the bitcoin economy so that the price of the bitcoin versus the basket will stay, on the average constant.

Copyright Ugo O. Gagliardi 2013