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(Virtually) The strongest currency

Jun 09 2011 00:00 Simon Dingle

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In debate, currency is very similar to religion. Sane conversations soon head south as the lunatic fringe takes over. What starts out as a civil talk about standards and reserves soon degenerates into an argument about gold and the US dollar. Money talk is crazy talk. Because – let’s face it – money is a crazy business. But what if we could go back to the drawing board and design an inherently better currency?

In part, that’s the goal of Bitcoin – a new, alternative currency taking the online world by storm. It’s being actively traded via Internet-based exchanges. A digital mining community has sprung up to develop the currency and an ecosystem of goods and services providers is already accepting it as tender.

So what is Bitcoin? Is it viable? And should you be thinking about it? My conclusion, having researched the currency, is that you should at least read on. Bitcoin has been around since 2009. The reason it didn’t hit the news two years ago is because it was purposefully kept secret at first. The father (or mother) of Bitcoin is a mysterious character known as Satoshi Nakamoto. Nobody knows if it’s an individual’s real name or something made up.

Whoever Nakamoto is, or isn’t, the foundation for Bitcoin is smart and required sophisticated mathematic modelling and advanced development in computational algorithms. Bitcoin is referred to as a “crypto-currency”. The network that supports it uses complex encryption so everything – from the units of the currency itself to the supporting transactional system – is very secure. More secure than any current transactional systems or conventional currencies can be.

While traditional monetary systems attempt to build security around basic units of currency, Bitcoin builds security into the money itself. Bitcoin was designed from the ground up to be decentralised. The currency can’t be controlled by any government or single institution. Instead, it’s powered by a distributed network of computers on the Internet.

Anyone who uses Bitcoin adds their computer to an international grid network that forms its transactional system. Your computer becomes a node in that system when you start exchanging Bitcoins. It contains transactional data of the currency, which is imprinted into every node. In that way Bitcoin uses peer-to-peer connections to build a global transactional system that can’t be stopped without turning off the Internet.

That’s the primary difference between Bitcoin and fiat currencies that only have value due to either regulations and laws. But Bitcoin derives its value from a decentralised network.

But there’s more to value than that. A currency must be accepted for trade of goods and services, or be based on a resource – such as gold – in order to have value. Indeed, if you ask the Bitcoin community where the currency gets its value from you’ll be told it has value because it’s already accepted as payment by many providers.

The other side of the Bitcoin value debate is how it’s generated – which is currently a key point in discussing any currency, given our less than ideal global status quo, when most things hinge on the US dollar. And we’ve seen the consequences of that over the past two years. The greenback is a shoddy currency in terms of value, which isn’t stopping it being bought up to hedge against its own demise… and back to my point about the sanity of current global markets.

The US dollar is controlled by the US Federal Reserve, which can also print more of the money. So one organisation is empowered to make key decisions about the entire global economy.

However, the Bitcoin is generated by computers running complex calculations. And that’s where things become really interesting. When you download the Bitcoin software to your computer a digital wallet is created on your hard drive. That’s essentially an encrypted file that stores your Bitcoin balance. That file can be backed up like any other.

But you can also use your computer to generate Bitcoins. When in that mode your computer’s spare processing capacity will be used to conduct calculations that are fed back into the Bitcoin network. Nobody knows exactly what those calculations are for, but the consensus seems to be they’re progressing the encryption mechanism for the currency.

Every time a new mathematical problem is solved, the node, or computer, that solved that problem is rewarded with 50 Bitcoins. A block is created on the network and work begins on solving the next problem. As the problems are solved they become more complex – so the next block becomes more difficult to achieve.

In its early days a single Bitcoin user with his PC could realistically expect to solve blocks and get coins every now and then. But that process – known as “mining” – has become more demanding on computer resources, so you require a pretty substantial super-computer if you expect to make any real money from generating Bitcoins. Some miners are using graphic processors (GPUs) because they’re better equipped to solve mathematic problems than a computer’s CPU; others are investigating the use of more powerful computer architectures.

The mining community is now massive and had generated more than 6,2m Bitcoins by the beginning of May this year. That number will grow at a slowing pace over the coming years until around 2040, when it’s expected a final limit of 21m units of currency will be reached. At that time more blocks could be created or a decimal shift could be used to adjust the availability of Bitcoins.

Given they’re generated by increasingly powerful computer processing it’s been suggested the underlying value of the currency is in the cost of electricity to power computers over the network. But leaders of the growing Bitcoin community dispute that. Bitcoin’s website – www.bitcoin.org – states: “It’s a common misconception that Bitcoins gain their value from the cost of electricity required to generate them. Cost doesn’t equal value: hiring 1 000 men to shovel a big hole in the ground may be costly but not valuable. Also, even though scarcity is a critical requirement for a useful currency it alone doesn’t make anything valuable. For example, your fingerprints are scarce but that doesn’t mean they have any exchange value.”

I decided to track down Bitcoin miners and discuss their prospects with them. What I soon learned was many of them are less interested in getting rich and more in volunteering their time and computers to furthering the currency’s development, which they see as a worthy cause. However, many are very serious about making money and have formed mining pools that collectively generate Bitcoins and share them according to contributed computational power.

I also spoke to one Bitcoin miner in Pretoria who has to date managed to generate only one coin but is active in answering questions and solving problems with the community. A tracking site for Bitcoin traders showed more than 100 active in SA – and those are only the traders who sign up to the tracking service. There are definitely many more playing the game.

Obtaining real names from the community is tricky. Bitcoin is designed to be anonymous. When you pay someone in Bitcoins you give them a string of numbers and letters: your Bitcoin address. That encrypted string contains the information their computer needs to send the currency to you.

The actual transaction itself is verified by the network of millions of computers that all carry the DNA (for lack of a better word) of transactional history. They don’t require your name, location or any other information about you. You can also generate new strings all the time and some Bitcoin traders tell me they generate a new string for each transaction, making it impossible to track them down.

There are many good reasons why identities should be protected in distributed computing systems and it’s a debate we don’t have space for: suffice to say, laundering would be one of the bad reasons, while the good reasons mostly involve ethics and necessity in some countries.

Another South African trader I spoke to online said it was tricky to buy Bitcoins because most traders are in the US and will only allow you to buy Bitcoins via EFT or cash transactions. They don’t like accepting PayPal because it’s too easy to reverse transactions, claiming no goods or services were received. He (or she) trades via a US bank account.

There are also concerns in the community about exchange control regulations in SA that have long crippled our ability to conduct business online, depending on who you speak to. At the time of writing the value of one Bitcoin was just more than US$8,45. It was at around $7,20 to the Bitcoin when I began my research in earnest a week ago and was at 1:1 with the US dollar in February. As an investor, that kind of growth looks too good to be true. Perhaps it is.

One of the most active exchanges for Bitcoin is called Mt Gox (www.mtgox.com), where Bitcoin traders meet and set up transactions. Another site of interest is Bitcoin Charts (www.bitcoincharts.com), where the currency can be tracked.

One of the only viable arguments I’ve heard against the Bitcoin currency was from an economist posting anonymously to a discussion group, who pointed out the system could lead to runaway deflation of the currency, referred to as a “deflationary spiral”.

That’s been widely debated by the trading community and a study on the subject has been posted online. The study suggests Bitcoin won’t be subject to deflationary spiralling because it’s fundamentally different from fiat currencies.

The study reported: “The key difference is that people don’t foresee a fixed cost (unit amount) that they must pay with Bitcoin. If the value of the Bitcoins they own increases, then any future cost will take a proportionally smaller amount of Bitcoins. There isn’t any fixed incentive to holding Bitcoin other than speculation.”

It adds: “If the economy that uses Bitcoin grows, the per-unit value of Bitcoin proportionally increases also. Everything is the opposite of the fiat fractional reserve banking system (because Bitcoin isn’t a debt but an asset). Bitcoins only deflate in value when the Bitcoin economy is growing.”

At the crux of the argument is that elaborate controls are in place to ensure Bitcoin generation slows with time: unlike fiat currencies, where more can be generated at will. The absolute, mathematical control of Bitcoin protects against many of the problems encountered with traditional currencies and runaway debt cycles.

You can already buy and sell goods for Bitcoin, its community grows every day and there are some serious traders investing in the currency – even if they won’t tell me who they are. So to write off the idea of Bitcoin would be short-sighted. For now it’s meeting its goals and support is mounting. Things are also happening rapidly – as they tend to do online.

If nothing else, Bitcoin is an interesting experiment and provides good food for thought about currency, central bank reserves, resources and financial systems. It answers a dichotomy of economics by being both tightly controlled but decentralised. It might become a niche system for online payments and displace PayPal. Or it could grow to become something much more than that. Either way, it would be silly to ignore it.

PLAY, PLAY MONEY

It’s a game

ECONOMICS TEXTBOOKS tell us money is any object or record that’s generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are: a medium of exchange, a unit of account, a store of value and, according to Wikipedia, occasionally in the past a standard of deferred payment. Any kind of object or secure verifiable record that fulfils those functions can serve as money.

Fiat money is without intrinsic use value as a physical commodity and derives its value by being declared by a government to be legal tender. The money supply of a country or currency zone consists of currency (banknotes and coins) and bank deposits.

Bitcoin isn’t money because it’s not a medium of exchange and its creation isn’t rooted in economic activity. True, it’s accepted by some as tender: but who? How big is the community that would rather have Bitcoins in exchange for selling a T-shirt than US dollars? Are major companies signing up for Bitcoin accounts?

The creation of the Bitcoins by individual computers is analogous to a central bank using the printing press to create new money. Ideally, money should be created through credit creation backed by economic activity. However, it’s true that the US Federal Reserve has been printing money in an effort to get banks to lower their interest rates. At least there’s method in the Fed’s madness: the Bitcoin process of using your computer’s spare processing capacity to conduct calculations that are fed back into the Bitcoin network simply doesn’t make sense from an economics perspective.

Every time a new mathematical problem is solved, the node (or computer) that solved that problem is rewarded with 50 Bitcoins. A block is created on the network and work begins on solving the next problem. As the problems are solved they become more complex, and so the next block becomes more difficult to achieve.

It just seems as if this is an ever-slowing method of printing money, with no view to interest rates or the real economy. That’s unlikely to catch on in a big way. Central banks still have a role to play and computer-generated money is more of a sophisticated computer game than anything else.

GRETA STEYN


The golden alternative

Bring back the gold standard

CALL ME CONSERVATIVE if you must, but I’d far rather own Krugerrands than rely on some digital entry on my laptop generated by a process I’m never going to understand. Gold has been the traditional store of value for thousands of years as well as being the recognised international monetary asset between 1870 and 1914, when almost all the world’s major countries operated on a gold standard.

The metal fell increasingly out of favour with the onset of the First World War due to the restrictions sticking to a gold standard placed on the ability of countries to “print” the money needed to finance that conflict. Gold was subsequently famously dismissed by economist John Maynard Keynes as “a barbarous relic”.

However, in the upheaval following the global financial crisis of 2008 there are increasing demands that gold be reinstated as a monetary asset. And it’s not just the usual suspects – the “gold bugs”, “guns, gold and god brigade” plus sundry conspiracy theorists – who are now pushing for that. None other than World Bank President Robert Zoellick has suggested a modified global gold standard is needed. Zoellick says a new, co-operative monetary system is needed that should “consider employing gold as a reference point of market expectations about inflation, deflation and future currency values”.

The easiest way to achieve that would be to include gold as a component of the special drawing rights created by the International Monetary Fund. Gold could be combined with a basket of other major currencies, such as the euro and China’s renminbi to provide a viable alternative to the use of the US dollar as the world’s reserve currency.

What’s driving the resurgent interest in gold is, of course, the collapse of the greenback against other major currencies. Hand in hand with that goes the rising concern among savvy investors about the spectre of a major renewed burst of inflation in the United States and other major world economies.

Paul Walker, CEO of British metals research consultancy GFMS, put it succinctly at a recent presentation in Johannesburg when he commented: “A gold price approaching US$1 500/oz sends a very simple message to the policy makers, which is: we don’t believe you.”

What investors are increasingly unhappy about is the huge creation of debt – trillions of dollars worth – by the US and other major economies attempting to stave off a major economic recession with, apparently, little regard for the inflationary consequences.

Walker said: “Central banks have consistently shown an unwillingness to grasp the nettle of this problem. What the rising gold price is saying is that central banks have failed on their interest policies. There’s clearly not the political will to tackle those problems and, for as long as those problems remain in place, then I’ll be bullish on gold.”

Another gold “guru” I follow closely – Martin Murenbeeld, of DundeeWealth Economics – put it the following way in a recent report. “We’ve all graduated to trillions of dollars. But think about it: where does such money come from? Indeed, where does the IMF get $155bn to help Greece? The answer is that all such money comes from governments who must borrow it directly in the market or from the central banks who must ‘print’ it. My point is: the greater the need for financial support… the greater the pressure to ‘print’.”

You can’t “print” gold. You have to mine it or buy it from above ground stocks, over which the owners are becoming increasingly possessive. Even some central banks – notably belonging to various emerging economies – have begun buying gold.

BRENDAN RYAN

 
online purchasing  |  bitcoin  |  online trading
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