Are Bitcoins Valuable?

By: Miles Pringle

May 2018

Yes, because people have agreed to use them; however, bitcoins are rarely used in everyday legitimate transactions. Most of the value in bitcoins comes from pure speculation as investors trade in bitcoins and bitcoin futures as an investment tool. How valuable are bitcoins? On April 18, 2018, the value of one bitcoin was approximately $8,000, more than a 650% increase from around $1,200 dollars a year earlier; although that is less than half its high of $19,000+ on December 16-17, 2017.

The volatility of bitcoins, and the fact that few vendors accept them and that many banks/governments have banned them to some extent, render bitcoins useless for everyday transactions. It is hard to buy groceries when the money in your e-wallet varies dramatically from the time you walk into the store to the time you get to the checkout line. Also, even if bitcoins were accepted by the grocery store, you couldn’t pay with an actual bitcoin coin (can you make change for my $8,000 coin?). What is being accepted by a few vendors is a fractional interest in a bitcoin, e.g. .0001%. Thus, there is an entire secondary market of instruments evidencing interests in bitcoin.

So, what is a bitcoin actually? It is a unique set of data (“a chain of digital signatures”[i]) that interacts with and is transferred via a public ledger, referred to as the “blockchain.” As explained in the original white paper outlining bitcoins, a coin is transferred by the owner “digitally signing a hash of the previous transaction and the public key of the next owner and adding these to the end of the coin.”[ii] The purpose of the currency, at least as stated in the original white paper, is to address internet-based commerce’s reliance on “financial institutions serving as trusted third parties to process electronic payments.” The key difference is that the blockchain serves to document the transfer of currency rather than a bank and a payment processor.  

How are bitcoins created? By “mining” them, which “involves compiling recent transactions into blocks and trying to solve a computationally difficult puzzle.”[iii] The person who solves the puzzle first gets the newly created bitcoin. Importantly, the reward for mining is reduced over time which will “result in a total release of bitcoin that approaches 21 million.” Said again, there is an artificial limit on the number of bitcoins which has no relation to the value of bitcoins.

The fact that there is a limit on the amount of bitcoins means that they can never replace government backed currencies. As we are well aware, the supply of money typically grows over time. If it grows too much, there is inflation which may destroy the economy. If it grows to little or shrinks, it can no longer can serve as a viable means of transaction and may well destroy an economy. “Deflation slows economic growth. As prices fall, people put off purchases. They hope they can get a better deal later. … Massive deflation helped turn the 1929 recession into the Great Depression. As unemployment rose, demand for goods and services fell.”[iv]

The explanation as to why bitcoins are capped appears to be that the limit approximates naturally occurring commodities like gold. However, even when our economy was tied to the gold standard, it never strictly limited the amount of currency in circulation. Congress continually changed the ratio of dollars to gold in order to meet the need for more currency (e.g. $1 = 2o.z. to $1 = 1o.z.). Even in ancient times, when gold was literally the currency, kings and emperors would mix gold with other metals in order to lower the amount of gold in individual coins so that they could have more coins in circulation. Market forces have always driven the amount of currency in the economy. Thus, bitcoins are more analogous to a commodity than a currency.

While the blockchain tracts the movement of bitcoins, everyday purchases using interests in bitcoins are tracked in secondary markets. For example, you can purchase your interest in a bitcoin on a bitcoin exchange, such as Coinbase, a California based company which raised more than $200 million dollars from large investors such as BBVA, USAA, and the New York Stock Exchange. Your Coinbase account can be used to make online purchases through Shopify, a Canadian based payment processor traded on the New York Stock Exchange with 2017 revenue of more than $580 million.

I hope you find the irony here as humorous as I do. Bitcoin was created to circumvent the banks and other payment processors for internet transactions. In order to do that you need an account with an investment bank and a merchant account with a third-party processor. Neither the investment bank, nor the processor are subject to the examinations and compliance scheme for depository banks. Also, your bitcoin account is not insured up to $250,000 by the FDIC.

Another problem with bitcoin is its relation to unlawful behavior. We are well aware that bitcoin is often the currency of choice for criminals like hackers, drug dealers and human traffickers. Additionally, cryptocurrencies like bitcoin are inundated with fraud schemes banned decades ago in more traditional exchanges.  Nicholas Weaver, a researcher at the International Computer Science Institute at UC Berkeley, points out that “bitcoin exchanges are unregulated entities that allow all sorts of things that are outright frauds. For example, in a regular stock exchange, you’re not allowed to trade with yourself because that’s price manipulation. But that’s a regular occurrence on these cryptocurrency exchanges.”[v]

Coinbase, referenced above, is not without its complaints. In January of this year there were almost 900 complaints regarding Coinbase made to the Consumer Financial Protection Bureau.  “More than 400 complaints were categorized as ‘money was not available when promised,’ a fairly fundamental issue for any financial account.”[vi]

There are other real-world concerns with bitcoin, such as it takes a lot of energy to mine for bitcoins and maintain the blockchain. The algorithm used to mine is so complex that computers must guess parts of the equation. The rational for the complexity is that no one can dominate the mining process, but the power needed to create each bitcoin requires as much electricity as the average American household burns through in two years.[vii] All told, the energy consumed by the entire bitcoin network is “estimated to be higher than that of the Republic of Ireland… That’s commensurate with CO2 emissions of 20 megatonnes – or roughly 1m transatlantic flights.”[viii]

So yes, bitcoins are valuable today. You may want to invest in some if you are willing to navigate a highly volatile and fraud-swamped market. Will bitcoin become the currency of the future? No. Will another cryptocurrency become more widespread? Probably. Will any cryptocurrency replace government-backed currencies? Not anytime soon.

©PRINGLE® 2018

This Article was originally published in Oklahoma County Bar Association’s Briefcase Vol. 51 No. 5 in May 2018.

[i] Satoshi Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System”, published October 31, 2008, available at https://bitcoin.org/bitcoin.pdf (last accessed April 18, 2018).

[ii] Id; Also, “Hash” is “a mathematical process that takes input data of any size, performs an operation on it, and returns output data of a fixed size… A common use of this kind of hash function is to store passwords.” See Faife, Corin, “Bitcoin Hash Functions Explained”, published February 19, 2017, available at https://www.coindesk.com/bitcoin-hash-functions-explained/ (last accessed April 18, 2017).

[iii] Investopedia, “Bitcoin Mining”, available at https://www.investopedia.com/terms/b/bitcoin-mining.asp (last accessed April 19, 2018).

[iv] Amadeo, Kimberly, “Deflation, Its Causes and Why It's Bad: Deflation Threatens You More Than Inflation”, The Balance, updated April 11, 2018, available at https://www.thebalance.com/what-is-deflation-definition-causes-and-why-it-s-bad-3306169 (last accessed April 19, 2018).

[v] Illing, Sean, “Why Bitcoin is bullshit, explained by an expert: It turns out cryptocurrencies and blockchains have a few problems”, Vox, published April 11, 2018, available at https://www.vox.com/conversations/2018/4/11/17206018/bitcoin-blockchain-cryptocurrency-weaver (last accessed April 19, 2018).

[vi] Detrixhe, John, “Coinbase’s customer complaints more than doubled in January”, Quartz, published March 05, 2018, available at https://qz.com/1220367/coinbases-customer-complaints-more-than-doubled-in-january/ (last accessed April 19, 2018).

[vii] Popper, Nathaniel, “There Is Nothing Virtual About Bitcoin’s Energy Appetite”, The New York Times, published January 21, 2018, available at https://www.nytimes.com/2018/01/21/technology/bitcoin-mining-energy-consumption.html (lasted accessed April 19, 2018).

[viii] Hern, Alex, “Bitcoin’s energy usage is huge – we can't afford to ignore it”, The Guardian, published January 17, 2018, available at https://www.theguardian.com/technology/2018/jan/17/bitcoin-electricity-usage-huge-climate-cryptocurrency (last accessed April 19, 2016).