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Will the bitcoin bite the dust?

by Kevin Rafferty

It was one of the runners-up for the word of the year 2013 as chosen by Oxford Dictionaries; it has received a partial blessing from Ben Bernanke, the chairman of the U.S. Federal Reserve — but a warning from U.S. law enforcement agencies.

At one point it soared in value by 10,000 percent during 2013 until China’s central bank dealt a blow to its fortunes.

Financial authorities, not to speak of economists, are sharply divided on whether the bitcoin is the currency of the Star Trek future or an empty promise with nothing to back it, so that it will and should fade away.

Hearings before the U.S. Senate in November illustrated the concern about virtual currencies, and particularly bitcoin. The title of the hearings was the “risks, threats and promises” of virtual currencies. Committee chairman Sen. Tom Carper set the scene by saying that “Virtual currencies, perhaps most notably bitcoin, have captured the imagination of some, struck fear among others and confused the heck out of the rest of us, including me,” he said.

He expressed his worry that virtual currencies could facilitate the sale of “weapons, child pornography, and even murder for hire services.”

Worry about use of bitcoins for illegal activities burst into the open with allegations about the underground website Silk Road, sometimes described as the Amazon.com of illegal drugs, which used bitcoins as the currency of choice. In October, the FBI raided and shut down Silk Road and arrested Ross William Ulbricht on suspicion of drug trafficking, soliciting murder, facilitating computer hacking and money laundering.

At the Senate hearings, a posse of officials from the Secret Service, the Justice Department and the Treasury’s financial crimes enforcement network boasted how they had successfully investigated crimes where bitcoins or other virtual currencies had been used, citing the busts of Silk Road and also eGold and Liberty Reserve.

Mythili Raman, acting assistant attorney general at the justice department’s criminal division, pointed out that since every transaction of every bitcoin is recorded, that constitutes a trail of evidence. She claimed that “Cash is still probably the best medium for laundering money.” She added, “Many virtual currency systems offer legitimate financial services and have potential to promote more efficient global commerce.”

Bernanke’s letter to the Senate committee cited 1995 testimony by Alan Blinder, then the vice chairman of the Fed. Bernanke summed up Blinder saying that “while these types of innovations may pose risks related to law enforcement and supervisory matters, there are also areas in which they may hold long-term promise, particularly if the innovations promote a faster, more secure and more efficient payment system.”

After Bernanke’s testimony and the comments of Raman about the “legitimate” potential of virtual currencies were published, the price for just one bitcoin soared by more than $200 and briefly touched $900, itself a testament simultaneously to the dream and the nightmare of the currency.

Volatile is too calm a word properly to describe the vicissitudes of the bitcoin from a lowly $12 at the start of last year. Even after touching $900 the bitcoin fell to $500 overnight, then jumped to $745, before continuing on a roller-coaster ride. It galloped past the $1,240 mark, meaning that anyone who had bought at the low at the start of the year and sold at the high would have gained 10,000 percent.

Alas for the currency, China’s central bank put a dampener on the party by declaring that the bitcoin carried risk and told financial institutions not to trade it. To prove the point, about risk, the bitcoin plummeted by 30 percent in response to China’s warning. It is not a currency for widows or orphans or even for ordinary people who want a store of wealth or medium of exchange. How can you trust its value in the face of these wild fluctuations?

Bitcoin is virtual cash. It has its origins in 2008 in a mathematical project by someone called Satoshi Nakamoto, assumed to be a pseudonym for one or more people with mathematical and strong free-market views.

Unlike traditional currencies issued by central banks, bitcoin has no issuing government authority. Nakamoto published a paper setting out the virtues of bitcoin as “a peer-to-peer electronic cash system” that “would allow online payments to be sent directly from one party to another without going through a financial institution.”

This appeals to market purists. The currency owes no obligation to a government. Its transfer is instantaneous, without the delay or the costs of going through banks. It does not have the physical presence or the storage or carrying costs of gold or silver or shells or stones, which have been used as real money in history.

Bitcoins are mathematically generated in a process called “mining” as the computers go through number-crunching tasks. But the system was set up so that it becomes increasingly difficult to mine bitcoins, and the maximum total number has been set at 21 million, so there is no way that a national or multinational central bank can come in and issue new bitcoins and thus devalue the currency.

The mathematically pure logic of having the market set the rate even leads some supporters to hope that the rise of the bitcoin could lead to the death of governments.

But the recent volatility could lead to the death of bitcoins. In the financial blog Naked Capitalism, Wolf Richter amusingly speculates that the U.S. authorities may be encouraging the volatility as a way of killing the virtual currency without getting their hands dirty by banning it.

Imagine if you buy a house in bitcoins, sign the contract when one coin is worth $100 but then have to pay up when the bitcoin has gone to $900, quite a loss.

On the other hand, if you sign the deal just before Christmas when the bitcoin has already fallen to $675, and only pay when the virtual currency plummets as some pundits predict to $10, you have a bargain if you are the buyer. But it is too risky, and that is the problem, with no central bank to smooth the fluctuations or no lawyers or courts to appeal to.

Nakamoto and others have stressed the trust built into the bitcoin system, which means you cannot cancel or have someone mediate a transaction if it goes wrong or you change your mind. And that’s precisely why banks and governments — when they behave themselves — are needed, to supply trust and a remedy when something goes wrong in the form of a false bill of goods or defective items.

The volatility of bitcoins is reminiscent of other mania down the centuries for gold or land or even tulips. But at the end of the day when the mania crashed, the losers had some physical possession to console themselves with: a tulip looks good and may cheer you up for its short life.

Even if your bitcoins soar in value, you cannot see them; if your bitcoins crash, you have no physical asset. Is the pain of loss only virtual or real?

Kevin Rafferty is a professor at the Institute for Academic Initiatives at Osaka University. He served on the World Bank staff in Washington from 1997 to 1999.

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    And cue the bitcoin fanboys outrage. no one else’s opinions are valid. Bitcoins Rule!!