Thursday, July 14, 2011

Bitcoin

What is the future of bitcoins? In the short term, I see one major opportunity: point-of-sale terminals. In the medium term, I see one major potential problem: deflation. In the long term, I believe that some sort of hybrid Bitcoin system will take hold that allows for variable inflation rates.

What is Bitcoin? You can download a Bitcoin program at www.bitcoin.org. This program creates a digital wallet for you with a balance of 0.00 BC (bitcoins). To fill up your wallet you can do one of 2 things. You can either buy bitcoins from someone in exchange for some good or other currency, or you can mine your own bitcoins. Don't bother trying to mine though if you don't have at least a high end graphics card, it's not worth the electricity costs. I personally have mined around $0.50 equivalent in bitcoins over the course of a few weeks. Not much, but for me it's about the idea not so much the money.

One immediate opportunity that I see and would love to get involved with is a point-of-sale (POS) terminal. Veriphone makes POS terminals, and these can apparently be programmed in C/C++. Unfortunately, you have to be accredited to be officially allowed to make applications for them, and I'm too cheap to do that so I can't. These terminals could be set up to process Bitcoins through custom-made smart-cards loaded with a private key. A smart card costs less than $1USD, so this should be feasible. I imagine that stores could request their Veriphone terminals to be loaded with a Bitcoin program. Alternatively, someone could make their own POS terminal to process Bitcoin transactions. If I was a store owner, I think that I would like to have a physical device that sits on my counter and accepts Bitcoin cards. I don't like the idea of using a computer or smartphone to process a transaction, which is unfortunately the only way to do things right now. The hardware should be physically there, but again that's just my opinion. A bitcoin POS terminal doesn't currently exist, so it's a great opportunity for someone!

Deflation? Well, there are only ever going to be around 21 million bitcoins in existence because the mining that myself and others are doing is becoming more and more difficult. Some people have argued that this could lead to a deflationary spiral, where hoarders hold their bitcoins hoping that they will gain value, and as a result nobody buys anything until eventually nobody is using the currency anymore. It's difficult to say for sure whether or not this will happen, but I do see it as a major threat. A bigger threat I see to Bitcoins is more fundamental.

To me, the idea that anyone can mine the currency into existence (and secure everyone else's transactions Bitcoins the process) isn't necessarily the only way for a cryptocurrency to exist. The way US dollars are created is that the Federal Reserve buys US Treasury Bonds on the free market. In other words, they create a dollar by backing it with a promise to pay it back with 5% interest per year. That is not currently the case with Bitcoins. There is no free-market buying of securities to ensure the long-term stability of Bitcoins. On the one hand, this means that Bitcoins are completely decentralized, which is attractive to many. On the other hand, the inability to dynamically grow and shrink the money supply is a serious limitation to the potential upside. I believe that Bitcoin would be much more effective if it could expand the money supply quickly (or contract if need be). Since Bitcoin cannot expand/contract the money supply dynamically in response to pressures and can only grow at an arbitrary predetermined rate, it is missing a key piece of the recipe for success.

I predict that a future cryptocurrency will allow for dynamic inflation rates to be set by users in a peer-to-peer network. If a user or group sets the inflation rate too high, they will eventually go belly-up. If the inflation rate is too low, that person or organization will get out-competed by more aggressive growers. It's actually very similar to what is happening now, just without a bunch of bankers and politicians determining the correct rates and bailing out their "too-big-to-fail" friends. It could be a nice future, one where 40% of the economy is not based on the financial sector, but is instead based on real things.

I think that this is an exciting time to be witnessing these thought experiments in finance turn into multi-million dollar ideas.

At this time, the value of all the Bitcoins in existence is: $95.4 Million USD

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