Bitcoin’s 3 Fatal Design Flaws

This Saturday I’m giving a talk in a panel debate on Bitcoin at the O2. I’ve been asked to be the critic of an  alternative currency that has some very enthusiastic fans.

For those that don’t know, Bitcoin is a digital currency (known as a cryptocurrency) that is not issued by governments or banks. Instead the currency uses some complicated programming to limit the amount of money that can be created. Only 21 million Bitcoins will ever be created, and there is no  human decision maker who can influence that. For advocates of the currency, this is a major advantage, as it prevents the abuse of the power to create money. It is easy to see why this would be so appealing – after all, we have recently seen the damage that can happen when commercial banks have the power to create hundreds of billions of pounds in just a few years.

But there are serious problems with Bitcoin. This was highlighted most recently when one of the largest exchanges MtGox, revealed that it had lost around $500 million of customer’s Bitcoins after hacking incident. “Lost” in this sense doesn’t mean they made bad investments that went bad; the Bitcoins were literally stolen, now exist on somebody else’s computer, and the exchange has no idea where they are.

I want to look at Bitcoin’s design flaws here, so if you want to know more about the details of the currency itself, read How to Explain Bitcoin to your Grandmother by Brett Scott or this Chicago Federal Reserve paper for a central bank perspective.

Bitcoin is a prototype

The key point to note is that Bitcoin is a prototype for what is now known as crypto currency. It was the first of its kind, an experiment designed by someone (or a some group) going by the name Satoshi Nakamoto. The original paper that outlines the proposal for a currency is well written but has the tone of a working paper – an initial proposal, not fully thought out, rather than a fully worked out master plan.

What usually happens with a new idea or product is that you try it out, find that it’s inherently flawed, and then you alter the design to make it work better. Orville and Wilbur Wright’s original plane flew just a few metres. The first bicycle, designed in 1817, involved sitting on a saddle whilst pushing the bike along by running with your feet on the floor:

The fanaticism of some Bitcoin enthusiasts, along with the claims that Bitcoin – specifically – will become the currency of the future, is a bit like someone in 1902 insisting that in the future we’ll all be flying across the Atlantic in individual gliders that look like this:

Of course we won’t. The first prototype of something should be a test case, which reveals the design flaws then gets discarded in favour of something better.

(UPDATE: A few people have commented that the Bitcoin source code has already been changed significantly, and further design changes can be made, which is exactly what should happen with a prototype. It’ll be interesting to see whether Bitcoin can be changed enough to deal with the flaws and make it a functioning currency.)

I believe there are two  design flaws that are fatal for Bitcoin.

Design Flaw 1. The rate of money creation

Bitcoin is designed so that new Bitcoins are created (‘mined’) at a predetermined and gradually decelerating speed. Around half the Bitcoins that were ever designed have been created already. The money supply will increase by another 66% between now and 2025, but by then the rate of creation of new Bitcoins will have slowed to a negligible amount, essentially making it a fixed money supply by 2025.

Source – DGCMagazine.com

This limited supply was supposed to be a clever design feature, but actually it’s turned Bitcoin into a speculative asset. The problem with this is that the amount of the currency doesn’t increase in line with the number of people using it. Economists from the Austrian school would argue that this is fine: just allow prices to fall relative to the currency. Indeed, that’s what has happened with Bitcoin – each Bitcoin now buys you more real “stuff” in the economy than it did in the past.

The problem comes when the limited supply affects the way people use the currency. Bitcoin users who have seen the currency go from 1 Bitcoin = $5 (in 2011) to 1 Bitcoin = $445 (as it currently is) don’t think “Great, the price of a Coke is falling in terms of Bitcoin”. Instead they think, “If I sit on the Bitcoins that I own, in 1 year they might be worth 10 times more. So I won’t spend them.”

This means that Bitcoin users don’t want to pay using Bitcoin. In other words, they want to use Bitcoin as a speculative investment, rather than as a means of payment. 

The only way to avoid this is to ensure that the supply of the currency increases in line with how much it is being used, so that the exchange of Bitcoin to other currencies or of Bitcoin to real goods and services is broadly stable. Without this design feature, a currency that consistently and rapidly appreciates relative to other currencies will be held as an asset rather than being used to make payments.

This is a design flaw specific to Bitcoin. Other cryptocurrencies have different ways of regulating the creation of the coins.

A Note on Volatility

Bitcoin is also highly volatile, having jumped from $13.36 at the beginning of 2013 to $1,124.76 in November 2013 – an 8,313% increase – and then back down to $445 today. I don’t list this as one of the currency’s design flaws as it’s largely to do with the fact that Bitcoin is new, uncertain, and that the authorities aren’t quite sure how to deal with it, so volatility is a result more of the speculation about whether Bitcoin will be banned or accepted, rather than the fundamental issue of the rate of money creation.

Design Flaw 2: Bitcoin rewards the adopters and speculators

As with the current monetary system, Bitcoin rewards the creators of the currency (the ‘miners’ who use their computers to do complex calculations to create the currency). The early adopters have become very wealthy, along with speculators who sit on their coins rather than spending them. Again, this means that those who benefit from the currency are not those who use it to trade in the real economy i.e. people who actually produce real value and make Bitcoin a viable and usable currency. Instead, the benefit goes to those who sit on the currency (which prevents it functioning as a currency and makes it a speculative asset).

I would prefer to see a cryptocurrency that rewards those who use the currency as a means of payment, rather than as a speculative asset. So the more you use the currency to buy goods and services from the real economy, the more you would get rewarded with a portion of any newly created currency, whereas those who sit on their coins and use them as a speculative asset would get no share of the newly created money.

My knowledge of computer science and maths aren’t sufficient to propose a particular algorithm for managing that, but there are people who could. (There would need to be some kind of check to ensure that you don’t end up with people gaming the system, for example two users trading the currency between themselves at high speed in order to ‘earn’ more of the newly created coins.)

Design Flaw 3: Bitcoin is LESS secure that national currencies

Because of the design of Bitcoin, anyone who gets access to your password (‘private key’) has access to all your funds, and the authority to spend them. In the same way that a house burglar could steal gold coins (which I’m sure you have lying around the house), a computer hacker can steal your password and use it to spend your Bitcoins.

One user left his private key on a hard-drive which went to landfill, and then saw the value of the coins appreciate to hundreds of thousands of pounds. The exchange MtGox has alleged ‘lost’ 650,000 Bitcoins as a result of hacking.

Anyone holding a significant amount of Bitcoins is advised to transfer them to “cold storage” –  a hard drive or USB disk that is disconnected from any computer connected to the internet, and hidden somewhere secure (eg. a physical safe).

For all the arguments that Bitcoin is ‘safer’ because it has no central authority, it certainly isn’t yet safer in practical terms.

The Way Forward

Cryptocurrencies are fascinating. We’ve made a very clear argument that the current monetary system, in which most money is created by banks when they make loans, has been a disaster. But at the same time, when states have used their power to create money, such as through QE, they’ve used it to inflate financial markets (enriching the already wealthy), rather than benefitting the real economy and ordinary people.

We’re obviously campaigning for national currencies to be created and used in the public interest, but it’s still possible that national currencies might be bypassed completely if a currency comes along that is stable, works in the interest of ordinary people, and prevents abuse of the power to create money.

Since Bitcoin was established, literally hundreds of other cryptocurrencies have been designed and released. One of them already out there might have the right design features to make a stable currency that can be a real benefit to society and the economy. Cryptocurrencies have only been around for half a decade; there will be a lot of innovation over the next 5 years and it’s possible that we might see something genuinely socially useful come out of it.

But with regards to Bitcoin, it’s time to let it die to make way for something better.

(UPDATE: It’s been pointed out that the code and design of Bitcoin is being continually updated by the Bitcoin community. It might be that Bitcoin can deal with these initial problems and morph into the standard cryptocurrency. Time will tell.)

PS. This reddit thread by people who lost money when the MtGox exchange shut down shows how Bitcoin has become a speculative asset bubble similar to the dot com bubble or any stock market bubble. There are stories of people taking their  kid’s education fund, or partner’s life savings, and investing them entirely in Bitcoin. One guy even claims his friend committed suicide after investing – and losing – over $900,000 in Bitcoin.

But this is not the fault of Bitcoin, or a disadvantage of Bitcoin. It’s more a fault of a lack of general financial literacy, in particular an ignorance of the basic point that you should never invest all of your wealth in one single asset, whether it’s Bitcoin, or RBS shares (or property for that matter). Many of these people had no concept of risk management. I’m not sure we can blame them – an understanding of money and financial literacy is not something that most people acquired at school.

There’s also the desire to “get rich quick” or even just boost your income beyond what you can earn from working. Again, I’m not sure how much we can blame people for that. When the current monetary system is making it harder and harder for people to save anything after paying the mortgage and the costs of living, it’s natural to look for other ways of making money. If the guy mentioned above genuinely believed that investing in Bitcoin would mean that his kids could go to university whilst avoiding being saddled with the debt, then it’s natural for him to take that option. It was the lack of understanding of money, finance or risk management that led to him making such a bad decision.