Matt O'Brien: The scam called Bitcoin

Bitcoin is not a currency, it's a tech stock, says Matt O'Brien. Photo / AFP

Sometimes it's hard to tell whether Bitcoin is more like Ponzi scheme or a pyramid scheme.

Whatever it is, though, it isn't a currency. It's a tech stock. Each Bitcoin is really a share in a system that seems to make it cheaper to transfer things online - money, stocks, bonds, even the deed to your house - by cutting out the middleman. Well, kind of. Bitcoin doesn't remove the middleman so much as replace him with middlemen who don't make you pay much, but make society as a whole do so instead. Is this progress?

It's supposed to be. Ever since the early days of the Internet, people have been trying to figure out how to transfer money online without having to go through the financial system.

The problem, though, is if I send you money, how do you know I haven't already spent it or sent it to somebody else? You don't.

So the only solution has been to have a trusted third-party, like a bank, sit in between us. I send the money to the bank, it verifies that I actually have this money to send, and then it sends it on to you, all for a 2 per cent fee, of course.

Miners

Bitcoin's breakthrough is to have a decentralised network of "miners" sit in between us instead. Now, remember, these miners are trying to win new Bitcoins by solving computationally taxing math problems. The clever part, though, is that in the process of doing so, they also create a public ledger of every single Bitcoin transaction, what's called the blockchain.

That includes every Bitcoin that's ever been won, every Bitcoin that's ever been used, and every Bitcoin that's ever been transferred. So now we don't need a bank to know that I have the money I'm sending to you, and that I'm only sending it to you. The miners confirm all this. And the best part is that instead of having to pay the bank myself to do this, the system pays the miners in new Bitcoins.

The question, though, is how you get people to mine Bitcoin to begin with. Sure, you can tell them that Bitcoin is digital money they can use to buy things online, but they already have money they can already use to buy things online. And while merchants would be more than happy to save the 2.5 per cent they pay in credit card transaction fees, customers are a lot more more blasé since they don't pay them directly.

People buy Bitcoins because they think the price will go to infinity and beyond once everybody uses them, but they don't spend their own Bitcoins because they think the price will go to infinity and beyond once everybody else uses them. And so nobody uses them.

Exclusive

The answer, then, was to do what makes anything popular: make it exclusive. Specifically, Bitcoin limits the total number of coins that will ever be created to 21 million. Now, for Bitcoin's first year and a half, as Nathaniel Popper documents in his page-turning history Digital Gold, there were still be only a handful of people, if that, mining it. But that began to change when libertarians, who were convinced, just convinced, that the Federal Reserve's money-printing would mean the doom of the dollar, discovered Bitcoin and its non-inflatable money supply. A boom was born.

But what made people mine Bitcoins is what has kept them from spending Bitcoins. Think about it like this. Bitcoin's finite supply means that its price should go up, and keep going up. So if you have dollars that are losing a little value to inflation every year and Bitcoins that are gaining it, which one are you going to use to buy things with?

The question answers itself, and it raises another. Why would this ever change? Unless you can't buy something online with dollars - like drugs - you'd always want to use your dollars instead. Buying things with Bitcoin would be like cashing out your Apple stock in 1978 to go grocery shopping even though you have plenty of actual cash lying around.

Catch-22

The catch-22 is people buy Bitcoins because they think the price will go to infinity and beyond once everybody uses them, but they don't spend their own Bitcoins because they think the price will go to infinity and beyond once everybody else uses them. And so nobody uses them. But if nobody uses them, then the price will stay stuck at something a lot less than infinity let alone beyond.

So the Bitcoin faithful have tried to not only convert people, but also convince them to martyr themselves, financially speaking, for the crypto cause. It goes something like this.

Hey, do you want to hear about the future? It's a digital currency called Bitcoin that lets you spend or move your money online without paying any fees.

Sounds great. How does it do that?

Well, Bitcoin saves you money by making transactions irreversible.

So ... if I get scammed, I got scammed? There's nothing I can do about it?

Yes.

OK, but is it at least easy to use?

The thing is, I don't actually use it. I just hoard it. I'm waiting for some greater fools to push up the price by using theirs.

Oh.

Yeah. So you should buy some Bitcoins and use yours.

I'll get back to you on that.

Avoid fees

But Bitcoin is good for something other than redistributing wealth from one libertarian to another. That's transferring money, or anything else for that matter, online. "The design supports a tremendous variety of possible transaction types," Bitcoin's shadowy inventor Satoshi Nakamoto wrote back in 2010, including "escrow transactions, bonded contracts, third party arbitration, multi-party signature, etc."

So anytime you need to send any kind of financial asset or agreement to somebody else, you can send it along with a Bitcoin and, through the beauty of the blockchain, avoid having to pay a lot of fees. That's why Wall Street banks are looking into whether they can buildmtheir own blockchains to cut costs before their competitors do.

And while sending money is cheap within the US, it's not not across international borders - the average transfer fee, according to the World Bank, is 7.5 per cent. It's not hard to imagine, in other words, that Bitcoin could claim a big chunk of the $500 billion remittance market, although the difficulty of actually getting the physical cash to people in developing countries is still a significant hurdle.

Wait a minute, though. How does the blockchain cut costs again? Remember, instead of you paying the bank a fee to process a transaction, the Bitcoin system pays miners new coins to do so. Then these transactions get added to the list of all others in the public ledger, the blockchain.

Pollution

But anytime it seems like you're getting something for nothing the costs are probably just being hidden. What are those costs? Well, Bitcoin mining is a pretty expensive business. Even the most specialised computers, which mine Bitcoins and only mine Bitcoins, require a lot of energy.

So much so that Bitcoin miners have set up shop in far-flung places like Iceland where geothermal energy is cheap and Arctic air is cheaper still - free - for them to run and cool off their machines at the lowest possible price.

OK, but why should we care that Bitcoin miners have big energy bills? They're the ones paying them, after all. Well, for the most part. The problem is the price you pay for energy doesn't include the cost we all pay for pollution. So energy-intensive businesses that are paying less than they "should" for it can generate environmental spillovers on everyone else, or what economists call negative externalities.

Once you take this into account, it's not clear how much Bitcoin is really cutting cost so much as shifting them. Specifically, it turns your transaction costs into our pollution costs. Now, Bitcoin might still lower costs overall, but the calculus isn't as simple as it appears if you only add up the benefits.

It's not clear what Bitcoin is or what it will be, but it is clear what it's not. It's not a currency. People don't set prices in Bitcoin and, for the most part, don't buy things with it either. The only function of money it comes close to performing is as a store of value, but it doesn't even do that well.

Even though it seems like Bitcoin prices should go up and up and up, it hasn't for a year and a half now. In fact, Bitcoin's $225-a-coin price is 80 per cent less than its December 2013 peak. That said, Bitcoin might be a better way to send things online - or at least its technology, the blockchain, might - but, again, that depends on how much energy it takes to run the network. In the meantime, though, Bitcoin is still a little bit of a Ponzi - or is it a pyramid? - scheme that its libertarian early adopters are trying to cash in on.

The future might not belong to Bitcoin, but it should to its technology.