Thursday, April 11, 2013

The Bitcoin crash, hoarding behavior and alternatives

I’ve been following Bitcoin for the last couple years and while I’m positive about some of the ideas that have come out of from Bitcoin, I think the long term value of a Bitcoin as it exists today is zero.

I like the idea of using computational power to establish consensus on transaction and using transaction fees as computational rewards for participating in the consensus.

What will make Bitcoin difficult to use as a transactional currency is that there is no way to control hoarding behavior. With “old style” currencies, if there is too much demand for cash, a central bank can simply create more in order to keep value of the currency stable. In addition, a constant (but low) rate of inflation encourages people to use their money, rather than stick it under their mattress.

Since Bitcoin has a fixed number of units, a spike in demand will create a feedback loop where hoarders push up the price, and more hoarders appear because they want to make money off the spike. Eventually enough people cash out and creates an avalanche where everyone tries to exit at the same time. Unfortunately the design of Bitcoin does not allow for arbitrage to keep the price locked to any fixed target.

If this keeps repeating, people will start looking for an alternative, and if there is another bitcoin-like system that has better “escape valves”, my guess is that eventually people will switch to that instead and the value of Bitcoin would go to zero.

What could a more stable system look like? Perhaps it could be inspired by the success of ETFs (Exchange Traded Funds). For example, a bank (or group of banks) could create a redeemable Bitcoin backed by a currency (or other basket of assets). It would work almost exactly the same as bitcoin today, with the exception that an arbitrageur could take a large block of bitcoins and redeem them for real assets (if the price was too low) or deposit the assets in a trust to create a new block of coins if the price were too high. Normal users would just trade coins with each other, and the arbitrageur would keep the price stable, just as it happens with ETFs today.

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