Review: The virtual bubble of bitcoin

May 15, 2015

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The age of ultralow interest rates has created an ideal environment for speculative excesses. Since the U.S. Federal Reserve set the monetary lever close to zero in 2008, bubbles have appeared in several asset classes, from contemporary art (think $58 million for Jeff Koons’ “Balloon Dog”) to rare earth minerals. Yet none of these bubbles has been quite as dramatic, nor excited such widespread interest, as bitcoin, the digital currency whose value soared by over 5,000 percent during the course of 2013.

In “Digital Gold”, Nathaniel Popper, a New York Times reporter, tells the bitcoin story from its inception to the current day. Since its peak in December 2013, bitcoin’s market price has declined by more than 80 percent. For anyone who missed the digital comet which blazed across the financial world, we are talking about a fiendishly clever piece of cryptographic software, launched in 2009 by a mysterious figure, who goes by the name of Satoshi Nakamoto. This “disruptive technology” is described succinctly by an early adherent as “a peer-to-peer, network-based digital currency with no central bank and no transaction fees”.

The wonder lies in bitcoin’s code, which to date has proven robust against hacker attacks. The software is ingeniously designed to reward members who maintain bitcoin’s digital ledger, known as the “blockchain”, on the network. Computers which successfully record transactions receive a small number of freshly minted bitcoins.

As bitcoins have climbed in price – they first transacted at five cents apiece in 2010 and peaked above $1,200 some three years later – the “miners”, as they are called, have ever stronger incentives to bring more computing power into the bitcoin system. At the same time, bitcoin’s rarity is guaranteed by the software which both regulates the pace of new issuance and caps the total eventual circulation at 21 million units.

The protocol has many admirers. Popper describes its more fanatic followers as experiencing “ecstatic moments of conversion to the bitcoin cause”. True believers are often given over to Utopian thinking. Bitcoin has been described as the most important new technology since the internet; as having the potential to change forever the way we do business; and, according to one fervid follower, having the capacity to “bring us closer to freedom in our lifetime”.

Bitcoin burst forth into the world at a fortuitous moment. The “digital gold” was welcomed by people who feared that hyperinflation would come out of the Federal Reserve’s money-printing. The Occupy Wall Street mentality was sympathetic to a currency which existed outside of the corrupt banking system. Libertarians, outraged by the “WikiLeaks blockade” – when Washington forbade banks and credit card companies from dealing with the online whistleblower – were attracted by bitcoin’s anonymity. After the government of Cyprus confiscated bank deposits, BusinessWeek magazine pronounced that “bitcoin may be the global economy’s last safe haven”.

It also helped that Silicon Valley emerged from the Great Recession in robust financial health and eager to use new technology to smash Wall Street’s battered defences. Bitcoin is a currency designed for the age of social networks. Venture capitalists in Palo Alto, including Netscape founder Marc Andreessen, and tech entrepreneurs such as Wences Casares, a central figure in Popper’s story, carried the bitcoin torch to Silicon Valley. The Winklevoss twins of Facebook fame were among the early high-profile investors.

In contrast to the lofty ideals, the reality of bitcoin’s early years has been decidedly grubby. The early adopters of the cryptocurrency did include a Massachusetts farmer who accepted bitcoins in exchange for alpaca socks. However, the main appeal was to drug dealers and other peddlers of illicit wares on the online Silk Road marketplace.

Popper narrates a glorious black comedy involving Silk Road founder Ross Ulbricht, who allegedly offered to pay an online drug dealer to assassinate a blackmailing hacker. Naturally, the fee for the murder was to be paid in bitcoins. Ulbricht was later imprisoned for his Silk Road activities, but prosecutors were unable to prove that an actual murder took place, or even whether the proposed victim ever existed in person. A virtual murder mystery.

Bitcoin has yet to bring nirvana to the world of finance. In fact, the digital currency has encouraged the worst financial excesses. Bubbles often appear in asset classes which have a good story to tell, are limited in supply and difficult to value. Bitcoin turned out to be a perfect speculative plaything, its market price rising and falling with the number of related tweets.

The digital currency has been massively hyped and frequently ramped. The SEC has even prosecuted a bitcoin Ponzi scheme – the Bitcoin Savings & Trust – although critics would argue that bitcoin itself is a giant pyramid scheme. There have been numerous cases of fraud and several scandals. When the dominant bitcoin exchange Mt. Gox closed down in April last year, hundreds of millions of dollars’ worth of clients’ bitcoins went missing.

Still, the bitcoin bubble wasn’t all bad news. The runup in the market price stimulated investment and much experimentation in the bitcoin world. Despite the bursting of the bubble, the lurid scandals, and the fact that the online currency still attracts few legitimate transactions, bitcoin retains a passionate following. There are the naysayers, of course, who point to lingering security concerns and the lack of government acceptability. Economists question whether money based on an asset, whether gold or this digital simulacrum, is really the answer to our financial woes.

When it comes to bitcoin’s prospects, Popper sits somewhat on the fence. This is forgivable. No one knows – although there is smart money behind the blockchain technology, independent of its future as a digital currency. Whatever transpires, bitcoin’s brief history provides one of the most compelling stories in the long and inglorious history of finance, from the Dutch tulips to the current day. And in Popper it has found a worthy chronicler. Bitcoin may be inherently speculative, but ”Digital Gold” is a sound investment.

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one bitcoin is divisible up to 8 decimal places.

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