Crypto Concerns

Thoughts on existing limitations with Bitcoin-like cryptocurrencies

Posted on February 9th, 2015

After spending some time thinking about cryptocurrencies, I have developed
some opinions on where things are headed. I could be wrong, and these views will no doubt evolve over time, but I hope there is some reason in them. Cryptocurrency is fascinating, and definitely has a role to play in the future; the questions are what role and when.

I’ll start by talking about Bitcoin and the Blockchain, and then move on to
the Stellar payment infrastructure in a subsequent post, which I currently find promising. I’ll assume basic knowledge of how Bitcoin works. For a quick overview, see my [earlier post](/economics/2015–01–17-bitcoin.html) or related resources.

It’s probably not news to you that Bitcoin’s price has been somewhat volatile. It is after all a novel currency. Two questions arise: is volatility a problem, and will Bitcoin’s price stabilise?

If we’re hoping for a currency for trade of goods and services, and we assume the value of US dollars and other traditional currencies is relatively stable for the foreseeable future (at least through the transition to digital currencies), volatility is very much a problem. If I buy a can of soda today for the equivalent of USD 1 in Bitcoin, I will be upset tomorrow if it turns out I spent USD 100, or even USD 2 retrospectively.

On to the second question: will the price of Bitcoin, or another cryptocurrency with limited and predictable supply stabilise? To answer this, it’s worth conducting a thought experiment in monetary theory. Suppose we live on an island where everything is traded in seashells. What’s the rough value of a seashell, in terms of something (there are no US dollars to compare to)? The relative price of goods and services will determine their relative value to each other, but how much is one seashell worth? In other words, how is the base price of a coconut set. It could be 10 seashells, after which all other products could derive their own price. What stops it from being 5 seashells? One perspective is that, subject to limited distortions like human psychology, politics, employement etc., the absolute level of prices (not relative prices) will be largely determined by the supply of seashells. We have to be very careful when describing the supply however. Is it simply the absolute number of seashells? What’s the supply we care about?

If a Bitcoin were a real currency that could be traded for any good or services, disregarding other currencies its value could be in the millions of current USD. Even if we take into account other currencies (which then take a share of the money supply pie), Bitcoin’s theoretical value could be astronomical. This is what so many cryptocurrency speculators are betting on.

If someone could snap their fingers and have Bitcoin jump to this value; if all goods and services (or an agreed upon subset) could be traded for Bitcoin; if people could agree on what market the currency underpins, then there is no reason Bitcoin couldn’t reach some equilibrium value. The problem is the path there.

Given a more or less fixed supply, and no clear path to stability, I have serious doubts as to whether Bitcoin will transition to being a real currency for trade. Of course, it could find niche applications (i.e. machine-to-machine rapid trading), but vanilla trade is unlikely to be one of them.

Perhaps some new innovation will address the limitations mentionned, but for the moment both Bitcoin and the Blockchain have significant flaws (despite their admitted brilliance). A path to price stability for Bitcoin is unclear or implausible, restricting it to niche use cases. As for the Blockchain, it has yet to address the paradox of distributed security and scalability.

I remain optimistic about cryptocurrencies. The promises of decentralisation and digitisation are, amongst others, extremely appealing. Hopefully by being critical of existing issues, and creative in addressing them, we’ll find the inevitable path forward.

Further thanks are due to my brother and close friends, for listening to me think out loud, and for providing wise feedback.

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