Bitcoin is a virtual currency, invented by the notoriously secretive Satoshi Nakamoto, allowing transfer for payment of goods and services without physical exchange of Euros or dollar bills in the same manner as one pays with a credit card or banking electronic transfer. Its purported appeal was that it granted untraceable anonymity while offering the protection of strong encryption. On these supposed characteristics, the value of Bitcoin surged to $1142 in late November 2013. Sadly for Bitcoin believers, the past year has seen the value of Bitcoins plummet over 76% and over 33% in the first weeks of 2015 alone as both its purported strong encryption and vaunted anonymity have failed to meet even the lowest expectations.
The Silk Road
Entrepreneurs such as Ross Ulbricht, a 30-year-old Texan physics graduate, rushed into Bitcoin; allegedly founding the Silk Road which was the first website where illegal drugs could be bought and sold under the supposed protection of Bitcoin anonymity. The FBI shut down the Silk Road at the end of 2013 by tracking transactions through the Tor network. Silk Road users have relied on the Tor network, built by the U.S. Defense Department, to shield them from government snooping. It would be unconscionable to laugh.
Mr. Ulbricht had barely had time to meet his cellmates when one Mark Karpeles, who the FBI originally tagged as the Dread Pirate Roberts, leader of the Silk Road, announced that $500M of Bitcoin had simply disappeared into the digital ether from his famed Mt. Gox Bitcoin exchange.
Transactional Malleability
Karpeles’ Tokyo-based Bitcoin exchange claimed that 7% of all Bitcoins in circulation had vanished. This news shocked the true believers of the most famed digital currency as the Bitcoin Foundation has long held out as fact that encryption protocols made it impossible to defraud or bamboozle anyone out of the digital currency. What’s more, Bitcoin practitioners eschewed all forms of insurance which one would expect to be a fundamental characteristic of every wannabe bank or exchange. The proponents of Bitcoin apparently “believed” in the unassailable nature of their product; and as the remaining selling point of Bitcoin was put to flame, its supporters railed against those who saw the apparent flaws in implementation.
Karpeles would claim that a technical flaw in the encrypted wallets holding Bitcoin at his and other exchanges were susceptible to transactional malleability risk, a known flaw in the encryption protocols. With no strong central regulatory authority, wallets holding Bitcoins need not adhere to known standards that would prevent such an exploit. Indeed, this lack of standards was an invitation for an unscrupulous owner of such an exchange, free of even nominal oversight, to magic away its entire Bitcoin inventory. The Yomiuri Shimbun reports that Tokyo Metropolitan Police have concluded that 99% of Mt. Gox losses were due to fraudulent operation by a person familiar with the exchanges operations.
Susceptible to Hackers
At this juncture, Bitcoin has far more similarities to a religion than to a currency. There is an adage in science that if it cannot be measured than it is not known. Sadly, it appears time and again that the major Bitcoin exchanges are unable to measure the simple quantity of what they should own. They don’t know, they merely believe; but no one will be stamping “In God We Trust” on the face of a Bitcoin any time soon.
As 2015 opened, BitStamp, which operates the world’s third largest Bitcoin exchange, lost $5.4M in the encrypted cybercurrency as hackers compromised the company’s “hot wallet” which is where immediate tranactions take place prior to moving Bitcoins to cold storage with supposedly greater security. It was four days after the onset of the hack that BitStamp informed customers that there was indeed a reason that they were unable to complete vital business transactions.
Now, true believers will inveigh on social media against even the mildest of criticisms. But even they must admit that the proponents of Bitcoin are for the most part ill-suited to the task at hand. Many, such as Mr. Karpeles, seem to be in positions of authority through happy accident; evincing few, if any, demonstrable technical skills and would be hard pressed to find employment where technical skills are most needed. Even fewer have any understanding or experience in finance or currency, as only recently have venture capitalist begun to realize that this arena begs for Wall Street experience.
Bitcoin Price Structured to Fall
Even beyond the hackers, DDOS, fraudsters and loss of anonymity, there are aspects to Bitcoin’s structure that would necessitate extreme price caution. Bitcoin transactions require the intervention of Bitcoin miners to insure absence of fraud within the system proper, as it were. Bitcoin miners deploy costly high powered computers to solve complex mathematical formulations that digitally encrypt transactions. The miners are compensated in Bitcoin. The problem is that as more Bitcoins are issued an ever greater investment in computer power is needed to mine Bitcoins.
Here we find similarities to fracking and tertiary oil recovery in an era of falling oil prices. As the value of Bitcoins continues to fall, the breakeven point at which Bitcoin mining is simply no longer profitably at all could be on some near horizon. Indeed, there are several mining companies with debt obligations that have already forced their closure. CoinTerra in Texas defaulted on $4.25M secured notes; CEX.io cloud mining closed after Bitcoin crashed through their $320 breakeven. Without Bitcoin mining, the purchases and sales in the crypto-currency could be very throttled severely.
It would seem that miners could and would demand a higher fee for the Bitcoin transaction as the cost of mining exceeds the value of what is mined. This increased margin demand from miners would erode any cost advantage over a credit card transaction if the seller is forced to raise prices. Anonymity? At this point, a Bitcoin transaction probably sends out a spontaneous FBI invite so costs may be the deciding factor where anonymity exists not.
Hot Wallet Phenomenon
Although Bitcoin is making inroads as a currency and finding more global acceptance, as we’ve pointed out, it has lost the attractiveness of anonymity while gaining huge negatives in perceived risk. And we are now about to witness a two-fold whammy on Bitcoin pricing. The lower Bitcoin exchange rate means that every transaction will, of necessity, put more Bitcoins into vulnerable hot wallets ripe for hackers. As more merchants accept Bitcoins, one best believe that they will demand instantaneous exchange into a safer currency.
BitStamp, again the third largest exchange, forbade access to wallets for days. One would imagine that any hedging strategy by a major merchant accepting Bitcoin for a transaction would place significant selling pressure on the currency as it is improbable that anyone would find comfort with “cold storage” over an immediate conversion to a major currency. In short, the more merchants accepting Bitcoin means increased downward pressure on Bitcoin for the near term, at least.
In Conclusion
Bitcoin remains a very immature, speculative currency absent of the derivative markets and insurance structures that viability demands. The underlying technology, the block chain, is one in which we remain invested. Business models based on fully distributed applications must be customer and purpose driven rather than technology driven, as the very open source nature that one seeks to advantage lowers barriers to entry below comfort levels.
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Joseph Jett
Managing Partner - Jett Capital Management LLC,
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I enjoy following you and reading your articles, but I must take exception at your anti-bitcoin rants, as your passion exceeds your capacity for reason on this subject. The above post is riddled with fallacy and half-truths.
To wit:
1) The price has crashed… if you only consider the last 12 months. A 24+ month chart would show a much different picture. Bitcoin purchased or earned 24 months ago is still up 20X. All currencies are speculative to the degree that they are used for speculation. Finite bitcoin may yet prove to be a better long-term store of value than the most consistently depreciating asset class in the market, infinite legal tender.
2) Anonymity. Bitcoin is only as anonymous as the origin of the email account that created a wallet. As the blockchain is an ongoing ledger it will never be as anonymous as physical cash, bullion, or diamonds. Perhaps that was never the intention of the inventor(s) who have demonstrated an uncanny ability to remain anonymous.
3) Security. When a bank gets robbed halfway around the world, do you stop banking? Whether or not it’s an inside job, the fact remains that poor security at an exchange has nothing to do with the security of the blockchain, which has never been compromised. Banks get robbed daily. A few exchanges get hacked, so what? I’ve earned and spent bitcoin for over 2 years and not once have I used an exchange to interface with the world of fiat currency. A hot wallet is only as secure as the email of the user, and we can agree that email is not truly secure. Bitcoin remains infinitely more secure for online transactions than credit cards. I’m sure that you cut up your credit cards when Target got hacked…
In conclusion, wrist-slitting might best be advised for investment “experts” that didn’t buy in at 25 cents! I’m no expert but I watched it from the time it was trading for 25 cents until I understood it better, when it was trading for $10, 25 months ago. I only wish now that I’d gone all in at the time. The downward pressure on the price over the last year is easily attributable to a few factors; legislative pressure in such bastions of free market enterprise such as China, Russia, and the USA, the FBI liquidating a large quantity of seized bitcoins (see Supply and Demand), the drastically increasing number of mainstream merchants (ie. Microsoft) accepting bitcoins for online sales, and then instantly converting them to cash via such services as BitPay. This has increased the amount of bitcoins being sold rather than held. More of a correction attributable to growing pains than a fundamental flaw in the protocol, which remains intact. You are right that the value of the blockchain technology exceeds the value of bitcoin, but it’s bitcoin that brought awareness of the blockchain to the masses. As the lamestream media continues to demonize it the vast majority (the sheeple) aren’t even sure if bitcoin is legal… Once the smoke clears, I expect that bitcoin will continue to gain acceptance, or even be eclipsed by next generation cryptocurrencies such as darkcoin. Either way, it is sure to continue to be a source of great amusement as it generates such passion from both it’s proponents and detractors. I will remain in between, and I will continue to accept and spend it, neither shunning nor hoarding it. As a merchant the more forms of payments I accept the more times I get paid.
Also transaction malleability is not a “flaw in the encryption protocols”, and mining does not “require an ever increasing computer power.”
Joseph, you are on to something by discussing Bitcoin’s immaturity. I discovered a long time ago that its flaws make it unready for prime time currency use: https://alfidicapitalblog.blogspot.com/2014/02/an-open-message-to-financial-technology.html