Bitcoin has arrived, it seems. Not only has the price of Bitcoins soared above $15,000, repeatedly recovering from sharp drops along the way, but financial markets are now treating Bitcoin and other cryptocurrencies as legitimate financial assets. Most recently, the Chicago Mercantile Exchange has announced that it is about to launch a Bitcoin futures contract.
Paradoxically, however, these developments have undermined the very proposition that is supposed to give Bitcoin its ultimate value. As the name cryptocurrency implies, Bitcoin was intended not as a speculative asset but as a free-standing currency to compete with, and ultimately replace, government-issued currencies like the US dollar. While the price of Bitcoin has surged, its use as a currency has stagnated, or even declined.
At the core of the cryptocurrency proposition is the idea of the blockchain, a distributed ledger in which updates are made by a consensus of a large number of independent contributors. In the case of Bitcoin, two kinds of updates are needed. New bitcoins are created by “proof of work”, that is the production of an easily verified solution to a complex mathematical problem. The energy used in this process, and the fact that the work done in the calculations is of no value in itself, have been the subject of much criticism.
The other kind of updates to the ledger, those that make it work as a currency, take place when Bitcoins are transferred from one person to another in exchange for goods and services. The blockchain ensures that these transactions can be verified, even though there is no central authority keeping track of them and no physical evidence of their occurrence.
The problem is that the mining tail is wagging the Bitcoin dog. So much effort is going in to the profitable activity of mining bitcoins that the system is dominated by these updates. As a result, using Bitcoins for their intended purpose as a currency is slow and costly. A Bitcoin transaction can take hours, or even days, to be confirmed and a typical fee is as much as $7.
Recently the gaming platform Steam announced that, because of these fees, and the volatility of the currency, bitcoins would no longer be accepted as payment. This is a striking instance of a much bigger problem. Nearly a decade after its introduction, and with nearly $100bn in market capitalisation, a list of all legitimate merchants willing to accept Bitcoin fits comfortably on a single web page.
If, for example, you would like to use Bitcoin to buy a beer, your options are limited to two venues, one in London and one in Sydney. An Australian vendor recently made headline news by offering to accept Bitcoin as payment for his house. To put it bluntly, a merchant accepting payment in Bitcoins is not making a business decision but staging a publicity stunt.
Of course, much of the appeal of Bitcoin is that it can be used for transactions where secrecy is desired, including drug deals and money laundering. The recent upsurge in the price of Bitcoin reflects its massive popularity in China, where people have lots of reasons to seek to hide transactions from the authorities. But that in turn creates a vulnerability.
Over 80% of all Bitcoin mining takes place in China, much of it organised in a relatively small number of “pools”. If the Chinese government took control of these pools, it would control the entire ledger and could change it in any way it wanted. Of course, that would require willingness to undertake large scale seizures of computers and the use of force to compel co-operation. But the Chinese government has ample force at its disposal, and a demonstrated willingness to use it against any perceived threat.
So, a bet on Bitcoin involves a lot of faith in the continued tolerance of the Chinese government for a currency with a professed objective of undermining existing states.
Like most financial bubbles, Bitcoin begins with a claim to have invented a new way of doing business. If people lose faith in that claim, the entire edifice is merely a record of some pointless calculations. At the moment, there’s little evidence to support the idea that Bitcoin will ever become a usable currency.