5 Oct 2014

Bitcoin Couples a Great Idea With a Bad Idea

(Disclosure: I work for Google, which has invested in Ripple.)

Bitcoin couples a great idea (a new way of transferring money) with a bad idea (a new currency).

The part that’s great is the distributed public ledger to record and authenticate transactions, bypassing the banks and the financial institutions, whose modus operandi is to impose themselves as middlemen in every transaction and extract a bit of the money flowing through. There’s no reason to pay a few percentage points of every transaction in the economy to these assholes.

Not only are these fees higher than they need to be, but they are amazingly non-transparent. When I use my debit card abroad, for example, Citibank charges me $2.5 plus a foreign currency markup of 4%, plus a service tax. And this is for debit card transactions abroad. If I want to receive money in my account from a source abroad, there’s a charge for that as well, which is a fixed amount + a certain percentage of the money being transferred, subject to a minimum and a maximum. And these fixed amount and percentage vary with the amount being transferred.

When the financial sector plays these dirty games to overcharge us, and making it so complex and non-transparent that we have no idea how much we’re paying, innovation that sweeps these jerks out of the way is overdue.

That’s all great.

The bad part is a new currency, also named Bitcoin, perhaps confusingly. Nobody wants a new currency. People care about buying products and services. A currency is only a means to that end. No one cares about Bitcoin as a currency any more than they get excited about paying two 50 rupee notes instead of one 100 rupee note. Given that there’s no gain from adopting a new currency, people will stick with the currency they use, and not switch over.

As an analogy, if the designers of email had taken this point of view, they’d insist that emails be in Esperanto rather than English or another language that people actually use in the real world.

If any new product is to be adopted, it has to offer concrete real-world advantages to its adopters. A new currency doesn’t.

Not to mention that Bitcoin is a bad currency since it’s so volatile, more than real currencies, and even eight times more than the American S&P 500 stock market index. It’s hard to work with a currency that keeps fluctuating wildly. Your Bitcoins may drastically lose value, and if you’re a shop that accepts Bitcoins, you’ll have to keep increasing and reducing prices as measured in Bitcoin. If a currency is to be useful, it should have a stable value, since things are measured relative to it. It’s like a kilogram. You couldn’t buy things weighed in kilograms if the kilogram itself kept fluctuating.

The other person is that Bitcoin is deflationary, and the total number of Bitcoins that can exist is capped at 21m. This further increases volatility: as more people use Bitcoin, the value of each individual Bitcoin will go up, due to simple demand-and-supply logic. And knowledge that that will happen causes speculators to hoard Bitcoin in the hope of selling it later to make a profit. This further increases volatility [1], making it bad as a currency.

So, Bitcoin is a great idea (the distributed public ledger), coupled with a bad one (a new currency).

Fortunately, multi-currency networks like Ripple and Stellar are being created, which let you use real-world currencies like dollars. After all, the technology is independent of the unit used. There’s no reason the distributed public ledger can’t track dollars if it can track Bitcoins.

[1] Ideally, the value of each individual Bitcoin should have been capped, rather than the number. Whenever the price of 1 Bitcoin exceeds the cap, new Bitcoins are created in sufficient quantity to bring it back down to the cap.

For example, the cap could have been set as 1 dollar as of Jan 2009 (which is when Bitcoin was released). As Bitcoin becomes popular, and its value goes up beyond 1 dollar, new Bitcoins should be created in sufficient quantity to bring its value down to 1 dollar. The only catch here is that the dollar itself inflates over time, so you should exclude that by measuring the value of Bitcoin in 2009 dollars, rather than today’s dollars.

You can’t prevent the value of Bitcoin from going below the cap, but you can prevent it from going above. This will reduce volatility, making Bitcoin a more useful currency than it is now. Unfortunately, Bitcoin was not designed that way.

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