Why Bitcoin Doesn't Behave Like Money

Besides Bitcoins, “the only other currency I know that drug dealers take is $100 bills,” says market strategist Nicholas Colas. But the way Bitcoins are engineered makes them more useful as an asset like gold, not a currency. Here are three signs that Bitcoins are transforming from something that drug dealers hoard into something that we all use to buy groceries.

“When drug dealers and smugglers use your currency, it's a stamp of approval," says Nicholas Colas, Chief Market Strategist at ConvergEx Group, which builds software for hedge funds, brokerages, and asset management firms. "These are people who are very serious about their money. They're not on the bleeding edge of anything. They're the most conservative people on the planet.”

The story of the rise of Bitcoin is a fascinating, confusing tale full of apparent paradoxes which we've been tracking in detail here. Why are sketchballs on Tor-accessible markets like Silk Road so willing to accept Bitcoin despite its volatility? Can it actually compete with traditional forms of money? And why can’t just anyone create a decentralized currency?

To date, Bitcoin’s infamy comes from the anonymity it allows in transactions--it’s nearly impossible to trace and tax--but there are economic imperatives driving its popularity as well. Dealers may believe that it will hold its value better than other exchangeable currencies.

“It's not that Bitcoin is getting expensive, it's that everybody fears that all the other currencies are getting cheap,” says Colas. He believes currency sharks are buying Bitcoins not because their intrinsic value is rising, but because the value of every other medium of exchange seems to be dropping.

“If they didn't think there was going to be a good way to spend it, they would probably buy gold,” says Eli Dourado, Research Fellow with the Technology Policy Program at George Mason University’s Mercator Center. He believes that the same speculation on behalf of the drug dealers may also be driving Bitcoin’s use as a hedge against the ongoing debt crisis in the Eurozone. “They've got to be picking Bitcoin because they think the exchange opportunities will be there in the future.”

If true, the hedging activity would classify Bitcoin less as a form of money and more as a new asset class--something akin to gold, which doesn’t work as well in daily life as extant currencies, but serves well as a long-term store of value that can eventually be converted back into money. Still, there are signs this is changing.

Bitcoin Becomes Money

Many commenters on a recent Hackernews thread on the subject noted that Bitcoin shows similarities to commodities like gold or silver in that it fluctuates with more volatility than the Consumer Price Index, but still holds value relatively well. Says user disintermediate:.

The best you could hope for would be a similar volatility to a commodity like gold or silver. So products and services will never be priced in Bitcoin while there is a better alternative like the dollar which is relatively stable.

There’s a lot of truth to that. Although you can buy some goods and services directly with Bitcoin, it would be nearly impossible to create a CPI for it. There just aren’t enough merchants listing prices in Bitcoin to create a basket of goods. Unless you fill that basket with drugs.

That doesn't mean it will always be that way. For Bitcoin to be considered money in the traditional sense, it must function in three ways:

  1. It must be a reliable store of value. Bitcoin's history of wild price fluctuations have lead some to question its value as an investment vehicle, but its recent use as a hedge against currency fluctuations suggests that it is a starting to fulfill this function.
  2. It must be freely exchangeable for goods and services, a function called medium of exchange. Right now, you can freely trade Bitcoin for other currencies, but only a few merchants will accept it directly in exchange for goods. If the market for Bitcoin expands, it will increasingly take on this role.
  3. It must be a unit of account. At the most basic level, this means that its holders must believe that one Bitcoin will always equal one Bitcoin. That sounds straightforward, but given its decentralized system, there's no guarantee that this will always be the case. It's unlikely, but if a hacker were able to manipulate the blockchain to convince the network that each existing block is worth one tenth of one Bitcoin rather than one, it would fail at this function.

Despite at least partially fulfilling all three roles, Bitcoin still doesn't behave like money. The reason why may be simply that people are waiting to see how it matures. How will we know when it reaches this point?

Three Signals Bitcoin Is Acting Like Money

Whether it fulfills its role as an asset or a new form of money, trust in the stable value of the Bitcoin is paramount, and right now Colas says it’s far too volatile to be accepted by the mainstream. For that to happen, Colas is looking for three signals that Bitcoin is ready for prime time:

  1. A mechanism to short-sell Bitcoin. Exchanges are just now starting to support Bitcoin loans to enable margin trading. If these features catch on and larger exchanges (principally Mt. Gox) start to adopt them, Colas believes the market will be much healthier.
  2. Whether the Bitcoin ecosystem survives an onslaught of attacks sure to head its way as the value of the currency increases. “The bigger problem Bitcoin faces from cyber security standpoint is how safe are these wallets, especially the online wallets? As the value grows it becomes more and more lucrative to target them with real breaches, not just DDoS attacks,” says Dourado.
  3. A 30- to 60-day slowdown in volatility, which depends largely on Bitcoin remaining secure, since the total quantity of Bitcoins grows at a fixed rate.

What Could Go Wrong?

Plenty, including security compromises and ham-handed attempts at regulation on the part of governments. But Bitcoin has factors working in its favor. For one, its engineers have solved the “double spend” problem that usually accompanies a decentralized currency; let’s say you complete two electronic transactions at the same exact time, which party gets the money? Explains Gwern.net:

If we avoid the problems of centralization and resolve on a decentralized system, we face a different but equally severe set of problems: without centralization, in a distributed system in which no party has veto power (and any party can be anonymous or a mask for another party), how and who decides which of 2 conflicting transactions is the real transaction? Must a distributed system simply allow double-spends, and thus be useless as money? No. The under-appreciated genius of Bitcoin is that it says that the valid transaction is simply the one which had the most computing power invested in producing it. Why does this work? In the Bitcoin distributed system, there are many good parties at work producing new transactions, and they will independently latch onto one of the two competing transactions produced by an attacker and incorporate it into future transactions; the amount of computing power necessary to out-invest those other parties quickly becomes too enormous for any one entity to invest. Within hours, one transaction will be universal, and the other forgotten. Hence, Bitcoin is an acceptable cypherpunk currency: it is decentralized, parties participate out of self-interest, and it is economically infeasible to attack Bitcoin directly.

Deflationary pressure is another trap. While deflation might seem like a good thing at first--it increases your buying power before prices adjust--it could be death for a nascent currency. As user delowe puts it:

Deflation makes it more profitable to do nothing than to invest. When this happens, people react by not spending money. The market [for the currency] dies.

Deflation has other non-optimal effects too; it causes debt to grow in relative value, meaning that borrowing activity slows, and it can force employers to lower your salary to maintain profit margins.

But the market for Bitcoin is not in danger of deflation, say some experts, because no one (yet) seems to use it as a medium for loans or salary payment. Indeed, the vast majority of Bitcoins are hoarded, not exchanged--at least for now.

[Image: Flickr user JD Hancock]