Outline

Bitcoin: the term conjures up $$$ in the eyes of anyone that’s talking about it lately.

Starting at an exchange rate of about $1000 at the beginning of this year, and varying wildly since then, the cryptocurrency has picked up steam in the past few months, rocketing past psychological barriers with abandon, trading at the $18000-$20000 range for a few months before falling back to its current levels, at about $6000 or so. With price swings extreme enough for investors to flee and take cover had it been occuring on any other equity, commodity or currency, it is fascinating to see human nature in action in keeping this party going, as they say in the Bitcoin communities, to the moon.

As with any trending topic where everyone suddenly is an expert and has a word to say about it, I’m throwing in my hat as well. In this post, I argue that bitcoin and other cryptocurrency efforts are at best an expensive regression to the mean, and at worst, an expression of human greed.

My Personal History With Cryptocurrency

My experience with Bitcoin is a bit of a sad postscript. I came across the cryptocurrency in 2009, when I was quite excited by the prospect of contributing my spare CPU cycles to the BOINC project. So, I downloaded the Bitcoin miner, a small Windows program, expecting it to look as cool as the BOINC client, and started running it on my old HCL laptop that was running on a Celeron processor. Having seen BOINC and the pretty visualizations it generated (which was also part of the draw to the project in the first place), it was quite a bit of a letdown to see a small MFC Forms window running on a corner of my desktop, showing no details except for a small statusbar message that said how many coins had been mined so far. It didn’t take long for me to get bored of it and just delete the whole thing; but if I remember correctly, I was disappointed that it was taking forever for the number to go up from zero to one, and I didn’t see the point. To think that the few BTC that I mined and threw away would be worth a few tens of thousands of dollars… **wince**

Blockchains and Cryptocurrencies

What are blockchains? An illustrated guide to a blockchain.

• Double-spend protection

Bitcoin in Depth

A summary of the design of bitcoin. Key points:

• Limits to total #btc -> deflationary, as coins go out of circulation
• Mining - rewards for validating blocks
• Btc language

Criticism

What are the gotchas. Analysis behind the current goings-on.

• Blocksize - limits speed of txn processing
• BTC centralization - sybil attacks
• What happens after mining?

Future Prospects

What’s going to happen in the future. What will go away, what will stay? Why I’m optimistic about blockchain Why I’m optimistic about Storj and IPFS Why I’m optimistic about Ethereum

• What I’m going to cover in this post? What am I not going to cover?
  • Bitcoin is a forerunner of a general class called crypto-currency tokens built on Blockchain
  • Blockchain is a distributed transaction log maintained by a network of computers that contains validated transactions between entities represented by addresses. The machines in the network validate these transactions and add them to the blockchain; the differences exact nature of this validation, and the reward mechanisms for these network of computers for performing these validations gives rise to the wide variety of cryptocurrencies and crypto-tokens we see today. However, utility of the blockchain isn’t limited to cyrptocurrencies and token sales only; any system that has a transactional nature that requires a fault-tolerant and consistent transaction log benefits from a blockchain system.
  • While the technical design of blockchains and cryptocurrency systems is fascinating, not going ito details.
  • Instead, going to talk about bitcoin in particular in terms of its design flaws (see my defacto disclaimer about opinions), and more fascinating aspect, of human motivations, emotions and behavior.
  • Also going to address other cryptocurrencies, ICOs and where they stand, and also about the underlying technology, blockchain
• Psychology of people changes depending upon their stake
  • Key insight is the above.
  • Your stance depends upon how invested you are.
  • Of course, I’m also subject to the same bias - since I identify with the human race (nice try, robot)
  • Filter bubbles help increase the concentration of this
  • We are wired to resist/ignore evidence to the contrary - scientific method isn’t really followed by humans driven by emotion
  • Wise quote: got rid of investments when shoeshine boy started giving stock tips.
  • Hard to change a man’s mind when his salary depends upon it.
• Why I’m skeptical about Bitcoin
  • So, where do I stand? I’m a skeptic of bitcoin. But I see huge potential in the underlying technology.
  • Skeptical about bitcoin for the following reasons:
    • Motivation of txn verifiers:
      • Miners won’t let coin value go down. Why would they? Mining makes them money! At this point, miners are still in bidness since their realized profits > costs. A miner today can sell btc on an exchange to cover their op costs, which is still very much in real dollars. However, op costs are increasing all the time, and if the difficulty increases sufficiently (due to the #participants or getting closer to the 21 million limit) or the price goes down (because of some macroeconomic event or regulation), there’ll be a time when profits < costs, at which point the miner is motivated to shut down business and take out all the remaining profits. So what happens when that happens? Everyone takes out their money including the miner, massive selloff happens, run on the bank, price falls, people get desperate, and the avalance gathers speed - a classic bubble burst.
      • Let’s say btc is all mined. No more BTC. what’s the reward for a miner now? Charge txn fees? Why would they continue validating txns? Two scenarios: BTC is at a high point when mining ends. Miner holds fuckton of btc. Two possibilities: either hold these btc cos value is high, or sell them. You’re still runnig the miner, which at this poitn is just validating txns, so you are burning a lot of money in op costs. So either you have to sell your btc or start charging txn fees. If op costs are less than sum txn fees, you accumulate btc; if op costs are greater than sum txn fees, you’ll need to sell your mined btc to cover op costs. In the latter case, the business isn’t profitable anymore; makes the most sense to sell off all the mined btc, sell all the mining infra, make a pretty penny, and go settle down in a tropical island sipping Mai Tais; in the former case, you accumulate more btc, further constricting supply and further driving up the demand for the remaining available liquidity, further decreasing your motivation to get rid of your btc.
    • BTC behaves like a store of value. While BTC supporters and proponents claim that bitcoin is meant to be a medium of exchange, its design encourages hoarding. Especially given the current exchange rate, people believe in the greater fool theory: either demand will keep going up, and hence bitcoin will keep appreciating in value, so they can sell at any point for a higher rate, or that it will hold its value, allowing them to keep their money locked away in bitcoin. This store-of-value behavior is due to the limits built into the design; the finite supply ensures that the total number of bitcoins in circulation only stays constant or goes down (similar to gold getting locked up in safes around the world, thereby increasing demand for the metal).
    • Liquidity in the market
      • So miners aren’t motivated to part with their btc as long as their op costs are in fiat currency, and the price of btc > op costs. So are other ‘investors’ in btc who aren’t in the market for making btc a great medium of exchange but are in there to hold until they can sell it off to someone else at a higher price. In either case, hold seems to be the primary strategy (or sell after a certain threshold of profits have been made, forgoing higher profits in the future); this limits the actual number of bitcoin transactions that happen purely as currency. What happens when most bitcoins are removed out of the market? The remaining bitcoins that are available for sale go up in price, due to the demand. The reduced liquidity also calls into question the entire claim that bitcoin is intended to be used as a medium of exchange. Of course, btc is infinitely divisible; but why would anyone want to use a currency that
    • Outright bubble
      • What’s inherent value? If you consider btc as gold, it’s the cost of mining the gold, plus the demand for it as an industrial raw material. The trading value however incorporates market sentiment: belief in general that the price will go up, and this drives demand. The same goes for any company stock: the trading price incorporates its current and future projected cash flows; this is usually above the book value, which is the inherent value of the stock (ie. how much will that one stock get if the company were liquidated at the moment). Since the creation of btc involves a lot of electricity and waste heat management, the cost spent on mining that btc is equivalent to the resources expended on doing the computation. At the moment, this cost stands at ~$800-$1500, depending on where you mine. However, the price of btc is at $15000+, which indicates that the market believes that demand for btc will grow astronomically (in the case you look at btc as a store of value), or that btc will become defacto currency to the point where a few bitcoins can buy a house (in the case you look at btc as a security).
    • Inherent limits of Bitcoin design choices:
      • 21 million limit ensures value of btc only goes up, which encourages ‘saving’. Once again, txns are essential for a currency; otherwise its a store of value. People not parting with their btc only says they are treating it as a store of value, moving excess cash into it.
      • 1 MB block size limits txn rate. Run on the bank case - network can’t process txns, people start bidding lower, price falls, bubble bursts. A significantly large order, or a selloff due to regulation is enough to get this started.
      • The txn rate limit also encourages larger txns.
• Why I’m optimistic about Blockchain