Is Bitcoin’s bubble finally bursting?

Bitcoin is a digital currency based on some fancy cryptography that is designed to facilitate anonymous transfers, and resist regulation by government.

A Bitcoin is essentially a claim on a string of numbers (that take the place of a physical coin) that can be bought and sold. There are exchanges that will convert between bitcoin and other currencies, and even some merchants who will take bitcoin in cash.

The idea of an anonymous digital currency itself is not new. David Chaum proposed the concept of electronic cash and developed a scheme in the 1980’s. Chaum’s currency proposals never did really get off the ground, but his keynote address at the first World Wide Web conference had a major impact on the development of the Web.

Bitcoin itself is largely based on hashcash, a ‘proof of work’ scheme proposed by Adam Back in the 1990’s as a way to stop spam. The idea behind hashcash was to increase the cost of sending email to the point that spam became uneconomic by requiring each sender to perform a quantity of computational make-work.

Before the rise of Bitcoin in 2009, the most successful scheme of this kind was E-Gold, which operated from 1996 until it was shut down by the Secret Service in 2007. E-Gold tapped into the libertarian ideology of anonymous cash, but their technology fell far short of the rhetoric. E-Gold wasn’t really anonymous, and wasn’t even located outside US jurisdiction. The company was registered in St. Nevis and Kitts, the datacenter was located in Florida. The idea that E-Gold somehow operated outside the scope of US regulation was a spectacular example of self-delusion by their management.

Computer generated Bitcoin via Shutterstock

Computer generated Bitcoin via Shutterstock

E-Gold wasn’t an anonymous currency as such, it was an exchange that allowed customers to transfer ownership of gold between them. Which was sufficient to allow its use as a means of avoiding government controls on money transfers. When the system was shut down, some of the largest complaints came from Iran, where citizens had been using it to evade US sanctions, and were left unable to access the money in their accounts.

The E-Gold episode had two curious aspects. One is that the exchange was permitted to operate for so long, when it was obvious that it was operating illegally. In my work stopping Internet frauds, I would meet Secret Service, FBI and Postal Inspectorate officers on a regular basis, and the conversation would almost always turn to the ongoing mystery of why the scheme was allowed to keep running.,,The authorities did not act until their hand was forced by the collapse of ‘Solid Investment,’ a Ponzi scheme that had made extensive use of E-Gold to conceal money movements.

Another mystery is the sentences that the perpetrators received. Instead of 10 years in jail and a $500,000 fine, the CEO received 300 hours community service, six months home detention and a $200 fine. It is difficult to imagine that one of two things didn’t happen. Either the organizers of the exchange coughed up some very valuable information as part of their plea bargain, or the cooperation with the authorities had begun long before the exchange was finally shut down.

Many people in my field suspected that E-Gold was allowed to operate because the Fed preferred to have the money laundering activity happening in a flawed exchange, than see the rise of a genuinely anonymous electronic cash system. If so, the concern was justified. The rise of Bitcoin came hard on the heels of the collapse of E-Gold, and Bitcoin’s promise of anonymity is backed by some real cryptography.

If I had had the good sense to ignore the libertarian ideology surrounding the launch of Bitcoin, I might have bought a thousand bucks worth when the coins were fetching $0.02 each. Such a stake would be ‘worth’ $6.25 million today. Who knows what Bitcoin might be worth tomorrow? The answer could be $250 or it could be $0.00. Nobody knows because Bitcoin is a currency without any intrinsic value. Unlike a government minted currency, you can’t use Bitcoin to pay taxes or pay fees for government services. Unlike bank issued scrip, there is no promise to redeem Bitcoin in gold or specie.

This lack of intrinsic value had initially led me to dismiss Bitcoin as broken. But I now understand that it is the real genius of the scheme, as it allows the value of Bitcoin to soar as long as there are more punters eager to throw money into the expanding bubble. In effect Bitcoin replaces both the E-Gold system and the Solid Investment Ponzi scheme in one stroke.

The Bitcoin bubble is even better than a Ponzi scheme or a mere stock bubble as there is no expectation against which the performance of Bitcoin need to be measured. The ‘value’ of Bitcoin will increase for as long as there is more demand to buy than to sell. As long as the value of Bitcoin appears to be increasing in value (or at the least not losing value), Bitcoin users are encouraged to keep part of their funds in Bitcoin.

Another factor that encourages Bitcoiners to keep their money in the system is the sheer difficulty of transferring money in and out. This is largely due to US government actions that have shut down many of the ingress and egress portals in the Bitcoin ecology. Barclays Bank in the UK and the Dwolla money transfer service have already closed the accounts of Mt Gox, the largest Bitcoin exchange. The lowest cost means I could find of transferring $1,000 into MtGox from the US would cost me at least $50, possibly more (the sites are not exactly transparent about fees). Allowing for another 5% overhead to transfer money out, Bitcoin is an expensive way to move money.

If Alice offers to pay $20,000 in BitCoin to Bob for his crack cocaine, the actual value of the Bitcoins themselves does not matter very much to either party as long as Bob is reasonably confident that it won’t drop too much before he can redeem his coins for cash. Traditional money laundering techniques such as buying and selling valuable goods can easily eat up more than half of the amount transferred. BitCoin does not need to be perfect to gain users, it just needs to be a little more efficient than existing options.

As far as the use of Bitcoin as an exchange medium is concerned, the nominal price of the coin does not matter except to the extent that the current price of about $125 makes it impossible to use BitCoins to buy a hamburger. But not to worry, the Bitcoiners insist, we can make change! What they don’t mention is that once change is added into the system, the cryptographic proofs of anonymity that the system purports to offer become faith based.

You can watch Bitcoin transactions in real time at blockchain.info. Some of the transactions are quite high value.

Bitcoin-live-transactions

 

In the last hour (as of this writing) there were ten trades over $50,000, one of which was for $669,999.05. Just what is the economic activity that is driving all these trades? Given the cost and inconvenience of transferring money into and out of the BitCoin system, one might be tempted to presume that much if not most of the economic activity is criminal.

Many of the customers left with money stranded in E-Gold accounts lived in Iran. Last year the administration ratcheted up sanctions against Iran to an unprecedented level, attempting to sever Iran’s connections to the international banking system. These sanctions have limited effect on the government, which can make alternative arrangements, but the private sector is left to fend for itself. Bitcoin provides the Iranian merchant class with an escape mechanism.

As with E-Gold, the question is not whether US authorities will act, but when, how and whether the action will be effective.

The first blows have already been struck as the Department of Homeland Security has begun legal action against the Dwolla payment service, pressuring them to stop Bitcoin transfers to Mt. Gox. US currency reserves held by Mt. Gox were also seized for failing to register with the Financial Crimes Enforcement Network.

On Wednesday, DHS moved against the Costa Rica based ‘Liberty Reserve’, another anonymous payment transfer scheme, that also served as a means of transferring money into and out of the Bitcoin system. Arthur Budovsky, the founder of Liberty Reserve was already on the run from a five year prison sentence, reduced to probation, for his involvement in an E-Gold like scheme called Gold Age.

The DHS began its action against the gold-based exchange schemes from the bottom up, taking out the small players like Gold Age before the raid on E-Gold. It seems likely that enforcement action against the Bitcoin system is following the same pattern.

Bitcoiners assure me that their system is government proof, but I have heard the same arguments about crypto-anarchy for years, and law enforcement has won every single time the theories have been tested.

Rolling up the Bitcoin system would be more difficult than the action against E-Gold and Liberty Reserve, but not impossible. If all else fails, DHS can ask Congress for legislation. It is unlikely that any member apart from Rand Paul would object. The raid on Liberty Reserve provides DHS with an excellent pretext for legislation, and that may well have been one of the reasons for the timing.

If DHS does not act soon, Bitcoin might become too widespread to be stoppable. Iran is holding its presidential election on June 14th, and there are several important national days before that. The end for Bitcoin might be coming quite soon.

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