I may be a techie, but I’m also a slow adopter of new technologies. I used OS/2 long after the rest of the world moved on. I didn’t get my first DVD player until they stopped making VCR tapes, and I still don’t have anything blu-ray. If it works, I use it. But I’ve been bit too many times by brand new technologies that are buggy or surpassed by their competitions. For example, I do not install the latest-greatest patches until other people have installed them and the patches are known to not cause catastrophic failures. (If I criticize a company or industry for being too slow to adapt, then they have to be very slow to adapt.)
For the last few months, I have had a wide variety of people ask me about Bitcoin. What is it, how does it work, what are the risks. These questions have been coming in steadily since the end of last year — before the recent Bitcoin problems. I guess it took a while, but Bitcoin has finally hit mainstream and regular people want to know about it.
Shortly before the whole “Mt.Gox vanished” issue, I had been interrogated by two groups of people in the banking industry. They have had an increase in customer inquiries regarding Bitcoin. Each group asked me the same initial question: “Why do you think about Bitcoin?” Each time, I gave them the same two-word answer: Stay away. Then I would follow it up with a detailed explanation. (One of the banks were so grateful for the discussion with me that they sent me a very nice thank-you card.)
How it works
For people who don’t know about Bitcoin, consider this a very superficial and high-level description. Bitcoin is a digital currency. There are no physical coins or paper money.
Bitcoin isn’t tied to “the gold standard” or any national currency. The price is based strictly on demand. As a result, the value can fluctuate wildly. But in my opinion, this really isn’t any different than the stock market. Stocks may fluctuate wildly based on nothing more than speculation and demand. I don’t view this as a reason to avoid Bitcoin.
(For people who get confused with my capitalization, I’m using ‘Bitcoin’ to refer to the concept and ‘bitcoin’ to reference an amount of currency.)
People can exchange bitcoins like money or trading cards. People can exchange bitcoins for goods or service. When all is said and done, you need some way to exchange bitcoins for a state-run currency. This controls the actual value. If you want to buy in, I will happily take your dollars and give you what we agree to be an equivalent amount in bitcoins. If you want to cash out, I can take your bitcoins and give you money. Since the value is based on demand, the exchange rate is really whatever someone thinks they can get.
Pieces of Eight
The next question is usually “how do people get bitcoins?” There’s really two ways: buy them or mine them. (People can also ask for donations. But I’m ignoring these handouts.)
The easy way to get bitcoins is to find someone who has bitcoins and pay them real money for some of this digital currency.
The alternative is mining. Bitcoin mining is an easy concept but is neither straightforward nor easy. Conceptually, there’s a mathematical problem that can be solved, but solving it takes time. After your computer solves the problem (which could take weeks or months), you receive some bitcoins for your effort. (The work is performed on a block of data. Each completed block currently pays something like 25 bitcoins.)
Because the work is extremely time-consuming, lots of people may work together on a single block. These groups of workers are called pools. By joining a pool, you are likely to get paid faster. However, since the 25 bitcoins need to be distributed between all of the pool members, you are likely to only receive a fraction of a bitcoin. (25 bitcoins at an exchange rate of $600 per bitcoin is $15,000. If there are 100,000 members in the pool and everyone does an equal amount of work, then you might get around 15 cents for your assistance.)
The ability to generate bitcoins means that no centralized entity controls the market and there is a limited supply of bitcoins. The supply is limited to the speed of the miners and how fast the newly mined bitcoins are introduced into the open market. This also leads to some of the volatility. If a miner hordes their bitcoins, it could drive up the price. If they release a flood of bitcoins, it could lower the value.
Fortunately, you can always get a piece of something. Like the stock market and most currencies, you don’t need to work in whole values. I can own 1.213 shares of stock in a company. Fractions of a US dollar include quarters (25%), dimes (10%), nickels (5%), and pennies (1% of a whole dollar). Similarly, you can own a fraction of a bitcoin. Bitcoins can be segmented into really tiny fractions. Even if the price for a full bitcoin is $800, I can still buy a fraction of a bitcoin for $5.
At first glance, mining for bitcoins sounds pretty easy. You download a program to do the mining, go to bed, and in the morning you will have money. Right?
I have a spare computer and decided to try do some bitmining. Getting started is anything but easy.
- The first thing you need is a digital wallet to hold your bitcoins. Bitcoin.org lists a few options. However, none of these are easy to use. (Virtually no documentation and poor user interfaces.)
After first configuring my wallet, I should have a zero balance. However, I could not check my balance until the wallet synchronized with the Bitcoin cloud. The software I am using started by saying that I had over 200 weeks worth of data to synchronize. It took nearly 24 hours to complete, but when it finished I could see my current balance: $0.00.
As far as I can tell, Bitcoin requires synchronizing against every transaction since “day 1″. Right now, it takes about 24 hours to be ready to start using Bitcoin… and everyday it will take a little longer for someone to start up from scratch because there are more transactions to synchronize. (This seems like really poor long-term planning.)
- After you get your wallet configured, you need to setup an account with one or more pools. They require your public bitcoin account identifier. My bitcoin wallet has that value, but it wasn’t trivial to find. The pools that I joined also require me to create a ‘worker’ account within my ‘pool’ account. I still don’t understand exactly what that is or how to use it, but I set it up.
- You’re going to need some bitcoin mining software. Again, there are lots of options, but none have documentation or clear instructions for configuring and running. I downloaded 4 different ones, and only managed to get one of them to work. The other 3 say “no device found” or similar errors. I guess they want some kind of hardware acceleration that I don’t have or don’t know how to enable.
The mining software also wants the login information for my pool membership. (I couldn’t tell if they wanted the main account or the worker account. I tried the worker account and it is running, so I hope I configured it correctly.)
The good news is that I think I finally got it working. At least, my computer looks busy and says it is processing 32 khash/s (32,000 hashes per second — that’s probably considered slow; I switch from ‘scrypt’ to ‘sha256d’ and am getting 18,536 khash/s). The bad news is that I won’t know if it is actually working until I (hopefully) see a few slivers of bitcoin in my account.
This entire experience reminds my of my blog entry on Open Source Sucks. Lack of documentation, hard to use software, poor usability, and lots of forums with incomplete assistance. I’m a techie and I nearly gave up.
What’s the opposite of anonymous?
A lot of people refer to bitcoins as an anonymous currency. Then again, a lot of people in the bitcoin community say it is not anonymous. The fact is, they are both right.
With regular banking transactions, it is relatively easy to see who owns an account and even where the money comes from. Bank auditors can even follow the money trail. If you pay for something with a credit card, then an auditor can identify your bank account that paid off the credit card, how the credit card was used, and even what store you shopped at. Since sales receipts identify items purchased, the trail even shows the auditor what you bought. As long as you use current bank and credit services, it is really difficult to stay anonymous.
If you want anonymity, then you use cash. Cash removes the transaction history. The auditors may know that you withdrew $200 in cash from an ATM or that you deposited $500 in cash, but they don’t know how the money exchanged hands or what was purchased. Was your $500 deposit just you putting back your earlier withdraws, or was it payment for something?
With Bitcoin, the transaction histories are public information. We can see that a bitcoin was transferred between accounts. We can even trace a sliver of bitcoin back through the transaction history and identify every account that ever touched it. However, you cannot easily tell who owns an account or what was traded in exchange for the bitcoin transfer. The account owner and purpose of the exchange is unidentified.
To reiterate, banking permits you to track accounts, transfers, and purchases. Cash allows you to watch the endpoints (accounts) but not the exchanges. And Bitcoin permits watching the transfers but not the exchanges or the account owners. In this regard, Bitcoin is great in that it offers a third option for money management.
Too good to be true
Excluding the hard-to-use software, Bitcoin looks like a great system. The value is no riskier than the stock market, no central government manages it, and it gives you a way to watch transactions without identifying what was traded or who it was traded between. So why don’t I like Bitcoin?
- No FDIC. In the United States, bank accounts are insured by the US Treasury. If the bank gets robbed, I do not lose anything. Even with credit cards, I’m only liable for the first $50 in fraudulent charges. But with Bitcoin? There is no insurance. You assume all risk. If someone steals the password to your virtual wallet, then you will lose all of your money and you will have no recourse.
- Lost Wallet. Your Bitcoin wallet is cryptographically protected by a password. If you forget your password, then you will lose everything in your wallet. (No reminder hints, no backdoors, no administrative resets.) Similarly, if your hard drive crashes and takes your only copy of your wallet, then you lose everything.
This is very different from the banking and cash currency world. If I don’t remember my bank account number, the banker can look it up. If I lose my credit card, the credit card company will quickly issue me a replacement. And if my cash burns up in a house fire, I can show the ashes to the Department of Treasury and they will replace every bill. (First they verify that the ashes account for the claimed amount of currency.) But if I lose my bitcoin wallet? It’s gone.
- Central Hubs Vanish. As I understand it, your bitcoin wallet doesn’t actually hold any currency. Instead, it holds a claim ticket. Specifically, it holds the cryptographic key pairs needed to spend the currency. The actual currency is held elsewhere — in the blockchain (which contains the transaction history). A copy of the blockchain is stored on every client, which is why the initial synchronization takes so long.
Some people like to store their wallets in an outsource hub. So… what happens if the places holding the currency vanishes? Well, you’re out of luck. In this regard, Bitcoin can be a lot like storing your money in somebody else’s mattress.
The only good news here is that there is some redundancy. If a single hub vanishes, like when Mt.Gox vanished, the redundancy ensures that money does not evaporate. (It does nothing to stop theft, but does stop losing the main blockchain.)
- No Transfer Delay. Bitcoin promotes this as a benefit. Let’s say you want to transfer money from the US to the UK. With cash, you would need to mail it (expensive and takes at least 24 hours). With bank transfers, you’re looking at a few days. But with Bitcoin? The transfer is measured in minutes. This is because there are no banking regulations and every transaction is authenticated and nonrepudiated (you authorized it and you cannot deny authorizing it).
The bad news is, if you accidentally transfer the wrong amount ($1000 instead of $10.00 — forgot the period, oops) then the money is gone. Period. No delay.
The problem gets worse if the seller decides to not ship the item. You have no recourse to get your money back. With a bank transfer or credit card transaction, you can report the fraud and they can recover the funds. With cash and a receipt, you have legal recourse. But since Bitcoin is not a recognized currency, you might be on your own.
As I understand it, it is this lack of transfer delay and inability to recall funds that led to the closings of the Mt.Gox and Flexcoin central hubs. There’s also been reported thefts at other hubs, like Poloniex. Details of the thefts are just beginning to trickle out. But at a high level, someone managed to get whatever they needed to authenticate bitcoin transfers. Then they initiated transfers. Since there is no delay and no recall, the money was immediately stolen. 750,000 bitcoins from Mt.Gox (about $446 million) and 896 bitcoins from Flexcoin (about $600,000). Right now, I haven’t seen anything that says these thefts are related.
If the compromises happened at the hubs, then Bitcoin has a fundamental flaw. The cryptocurrency is supposed to require a cryptographic challenge that uses the credentials only found in your bitcoin wallet. However, there may be another explanation. Recently there has been malware that attempts to steal your bitcoin wallet. This could easily lead to large thefts is someone with a large number of bitcoins gets infected.
- Evaporation. Even though there are people mining bitcoins right now, there are a finite number of bitcoins. There will come a day when bitcoin mining won’t be needed because every bitcoin will be found.
The problem is, people lose bitcoins. If you forget your wallet’s password, the currency is lost. If you throw out an old hard drive and forgot that it contained $7.5 million in bitcoin, then the bitcoins are lost. With a government’s mint, they can account for shrinkage due to loss and print up more money as needed. But the total number of available bitcoins is only going to shrink. This will drive up the price of bitcoins and force people to use smaller and smaller fractions of bitcoins.
- Laundering. The anonymity that Bitcoin provides is ideal for money launderers. You convert your dirty money to bitcoin (through an unsuspecting middle-man who happily exchanges bitcoins for cash), transfer the money around, and then cash out with untraceable currency. It’s really no surprise to me that the drug bazaar Silk Road was caught with $3.5 million in bitcoin.
Of course, if bitcoin is only used for transfers related to illegal activity, then it makes bitcoin users suspect. So the illegal-activity bitcoin community needs regular people to use bitcoin for non-illegal purposes. This gives their illegal activity anonymity by hiding among the general population.
- Competing Technologies. I know a guy who invested a lot of money into laserdisc and betamax, only to have both technologies never take off. By the same means, Bitcoin is not the only digital currency available. There are dozens of competing technologies here. The real question becomes: which will survive and which will vanish? Like the stock market, you don’t want to be heavily invested when it crashes from $800 per bitcoin to a penny stock. (It would be like investing real money in Second Life, only to have the game drop out of popularity.)
- Experimental. I think this is the most important aspect that everyone seems to ignore. Bitcoin is an experimental technology. Why would anyone invest more than a few real dollars in bitcoin? Major investments into an experimental technology is nothing except an extremely high risk.
Show Me The Money!
Bitcoin does have interesting benefits, but I see it as too high risk for any kind of serious investment. People who want to invest are better off playing the real stock market. And people who want anonymity are better off with cash.
If this write-up didn’t completely scare you away from using Bitcoin — or if it did scare you and you want to get rid of your bitcoins — then feel free to send me a bitcoin donation.
Update 2014-03-08: I have rewritten part of the central hubs section, thanks to a few of the people who have left comments with corrections.