I was doing some reading about Bitcoin and considering whether it would be wise to invest in it. From what I could see, I don’t think it would be a good idea yet, and this post explains why.
Before we get into the risks associated with Bitcoin, a quick primer on the concept of this currency would be helpful. Bitcoin is an open-source, de-centralized, digital currency that is mined and not minted. Hidden in large pools of otherwise junk data, blocks of Bitcoin can be computationally mined by comparing the SHA-256 hash of sequence of bits with a known format. Once a block has been discovered, it is broadcast on a peer-to-peer network and recorded in the distributed system along with the time stamp. The principle used to prevent fraudulent claims is based on the Byzantine General’s problem as neatly explained here. The essential result is that the in order to cheat the system, one would need at least 51% of the the total computing resources in the server network.
While it is definitely interestnig to get into the details of how Bitcoin has been implemented, for the purpose of our discussion here it would suffice to note that, in concept, Bitcoin is more like gold than currency in at least two aspects
- It is not “created” by any authority, but is mined from a pool that has an upper limit. So the maximum number of Bitcoins in the system has an upper bound, just as the total gold in this world is limited
- The value of Bitcoins, as of gold, does not come from the backing of an authority but from a general perception that it is valuable.
This also highlights a risk associated with Bitcoin, that follows directly from this similarity. On saturation, it would no longer be possible to get more coins by mining, and so those who are left without Bitcoins at that time (which would likely be a very vast majority) can simply refuse to consider it valuable and switch to other alternatives. Gold at least has an ornamental value that has survived for over a thousand generations, but Bitcoin is just a few bits of data that has absolutely no utility. In this one aspect, it is similar to currency notes which would be pieces of coloured paper if they cease to be recognized as money. The only reason why we can expect currencies to retain value over time is that they are backed by the military power of governments that issue them. (Otherwise, why would anybody still use Dollar?). Since this is not the case with Bitcoin, the risk of depreciation cannot be overemphasized.
Another threat for Bitcoin is from Governments (that are often not led by techies and are always under pressure to demonstrate their pro-poor credentials), who can make Bitcoin transactions illegal because of, among other political considerations, the difficulty in tracking and taxing these transactions. This would lay waste all the computing power that is invested in mining Bitcoins, and ruin those who built up a fortune in this currency. Since Bitcoin transactions are irreversible, it is tough to deal with fraudsters (as in the case of a shop that does not deliver after making payment). Since this mode of payment is not ratified by any government, it would be difficult to get legal recourse either.
Apart form this, there are technical risks such as sizable computing resources on the network being compromised, breaking the security features of the system. Early on, when the resources in the network are less, controlling more than half of it is not impossible, considering what hackers have achieved in the past. So, with all the uncertainties involved, one should at best invest only a very small fraction of their funds in Bitcoins now. For geeks, it might pay off to do a bit of mining and for gamblers, trading in Bitcoins might bring some gains in the short term. But for the serious investor or businessman who wants to switch to Bitcoin as a transaction currency, I don’t think it would be a wise choice before it is ratified by at least a few major Governments
Spread the love