Thoughts About Bitcoin

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Bitcoin has been a wild ride.

In 2010, one Bitcoin was worth $0.01, rising to $200 in 2013. It then fluctuated between $200 and $1,000 from 2013 to early-2017, until exploding to $17,500 in mid-December, 2017. As of February 9, 2018, the price had fallen to $8,400.

Bitcoin is a decentralized, electronic currency that is created by computers “mining” for Bitcoin on the blockchain, which is a public ledger of the history of all Bitcoin transactions. When a new transaction occurs, computers on the Bitcoin network process the transaction by solving a complex algorithm, which updates the blockchain to reflect this new transaction. The computer that solves this algorithm first is rewarded with a Bitcoin. The algorithms are designed to become progressively harder to solve, which slows the creation of new Bitcoins. The total amount of Bitcoins to be created is capped at about 21 million. They can then be traded for goods or services, or bought and sold on Bitcoin exchanges.

I am skeptical that it will replace dollars on a widespread basis for a few reasons. First, given the complexity of the algorithms, it takes a massive amount of energy to process a transaction on the blockchain. A widely-cited estimate suggests that Bitcoin-mining consumes the same amount of energy in a given year as the entire nation of Denmark. Another estimate suggests that processing a transaction on the blockchain uses the same amount of energy as a typical house does in a week, which is 5,000 times more energy than is required to process a credit card transaction. These exact numbers are in dispute; but it is clear that Bitcoin requires a great deal of energy to function.

Second, since it is created by this decentralized mining process, if someone loses his Bitcoins, the Bitcoins are gone forever. That is, if someone’s computer hard drive fails, or if someone loses his Bitcoin “key,” there is no way to recover the lost Bitcoins. It’s estimated that between 2.8 million and 3.8 million Bitcoins are lost forever.

Third, a currency’s value must be stable in order to serve as a form of payment, but the price of Bitcoin is fluctuating wildly. Buyers will be reluctant to spend Bitcoin if they anticipate the price could sharply rise. The first Bitcoin transaction was made in 2010 – for two pizzas that sold for 10,000 Bitcoin, which is the equivalent of $84 million today. Sellers will be reluctant to accept Bitcoin if they think the price might crash. Currently, three Bitcoins could buy a new car. A car seller might be reluctant to accept payment in Bitcoin if there is a chance the price crashes to $1,000.

What is fueling the rise in Bitcoin’s price? I think it is a combination of people using it in illegal transactions, people buying it who are convinced that the collapse of the dollar is imminent, and people buying it in anticipation of future price increases. I suspect the third reason is the predominant reason. This seldom ends well.

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