Bitcoin: Cryptography and the Crowd

Bitcoin is the world’s first decentralized, digital currency. Its extraordinary performance over the last half year has caused quite some stir, not only among ‘cyber geeks’. Users and supporters see Bitcoin as a technological breakthrough and expect its spending possibilities to increase as exponentially as its price. Meanwhile, critics point to many of these same characteristics as flaws. They are waiting for the bubble to burst, calling it a structurally flawed experiment.

How it works: This video – made possible with donations from the Bitcoin community– explains the basic idea behind the new currency:

To acquire Bitcoins, users can buy them on a trading platform or become ‘miners.’ The latter requires hardware and electricity – both usually purchased with conventional money.

What sets Bitcoin apart from other currencies is the way it is administrated: Bitcoin isn’t backed by any government or other legal entity, nor does it have a central clearing house that sets the rules and checks transactions. The entire system is underwritten by a peer-to-peer network and relies on self-policing by its members. While such control-mechanisms have proven successful in the past, most people still prefer to devolve this sort of responsibility to the authorities – be it due to a lack of trust or for ideological considerations.

Bitcoin users remain partially anonymous and their accounts cannot be frozen, hence many fear that the system provides a gateway to illegal activities. While most will agree that facilitating money laundering or drug businesses shouldn’t have a place in any monetary system, opinions regarding the financing of organizations such as Wikileaks are deeply divided*.

Bitcoin’s predictable and decreasing rate of creation is another point of contention. This is supposed to keep a lid on inflation and goes down particularly well with those opposing interventionist monetary policy: no authority can play with the value of the currency by manipulating its supply. Critics, on the other hand, say that the decreasing rate of money creation over time automatically entails growth-inhibiting deflation and is designed to reward early adaptors. (Ironically, this argument is based on the assumption that Bitcoin is successful.)

As with any other currency, Bitcoin’s future value and persistence depend on institutional arrangements and on the level of trust people put in those arrangements. The system is technically sophisticated and — because of its open-source character — may even be safer from cybercrime than traditional financial institutions. But this doesn’t change the fact that ordinary users have trouble trusting an unprecedented system that they cannot personally assess. At the end of the day, many feel uncomfortable putting their hard-earned savings into a system that relies on cryptography and the crowd. Regardless of how the story continues, Bitcoin has sparked a renewed debate about what makes a good monetary system in a globalized world. One could only wish that some of the more established practices within the current financial system would undergo similar scrutiny.

* See Grinberg, Reuben for a preliminary discussion of legal issues surrounding Bitcoin.