The Government(s): Bitcoin’s number one threat

My next post won’t be about Bitcoin, I promise :-)

Lots of articles and interest regarding Bitcoin today, checkout the new highs at Google Trends. In particular a number of people getting on the “it’s a bubblebandwagon. My blog is new so I’ll forgive them for not reading my last post! Can I see some actual evidence of the bubble? At what price is it not a bubble? When Bitcoin went from sub-penny to one dollar was it a bubble then? If there were only 11 Bitcoins instead of 11 million would it still be overpriced at $125? Show me the math people. I think right now people just see the hockey stick chart and say “Oh, that must be a bubble!”. For Bitcoin I see positive expected value, even if you assume there is a 90% chance of losing all your money. But that isn’t what I want to talk about today.

I was impressed by this post from Cullen Roche at pragcap.com. I’m happy to see someone who has done some serious thinking on money has some positive things to say about Bitcoin. His conclusion however isn’t very optimistic. He believes the government will likely choose to shut down Bitcoin when it becomes too successful as people use it’s anonymity to escape government monitoring (e.g. to avoid taxes, launder money, break embargoes, fund terrorism etc). For this reason he is “hopeful, but skeptical” of Bitcoin’s success.

A government instigated shutdown is number one on my list of Bitcoin threats, so I’ve been doing some thinking about it. Here is a simple way for the government to solve the “monitoring” problem. In fact the new system would likely be a huge improvement on the old system, at least from the governments perspective.

Cullen says the government could easily shutdown Bitcoin by forbidding merchants from using Bitcoin. I agree this would probably work and send Bitcoin’s price to essentially zero. But here is an alternative solution for the government. Bitcoin is based on a “shared public transaction log” where everyone can see every transaction that occurs (read here to get up to speed on how Bitcoin works). Checkout the “Latest Transactions” section on the blockchain.info site and you can see transactions as they occur real-time and these end up in the shared public transaction log which anyone, including the government, can see. The problem for the government is they can’t see is associated with each transaction. In our current system the banks would give that information to the government when needed.

Instead of forbidding merchants from accepting BTC, the government could require merchants to only accept/send to Bitcoin addresses that are registered in the governments central database. Bitcoin is based on public key cryptography so implementing this central registry is quite easy. Users can register their Bitcoin address along w/ social security numbers, drivers licenses etc on-line and sign the registration using the private key associated w/ the Bitcoin address to prove they are in fact the owners of address. The private key is the piece of information that allows you to spend your Bitcoins, but can also be used to digitally “sign” things. People who do not have your private key, and nobody should otherwise they could steal your Bitcoins, cannot replicate your signature.

With this central database the government can see what you do just by looking at the shared public transaction log, but they can’t touch your money since they don’t have your private key. For users/merchants who don’t want the hassle of dealing w/ this, they can deposit their BTC at banks and let the banks deal with this.

This system does give the government too much transparency in my opinion so maybe we need an agency (private?) that runs this database and the government can issue subpoena’s to get access to private information. Taking it a step further: this database could be global and could allow users to specify which governments they want to allow to see their transactions. That would enable them to do Bitcoin business in those countries.

However “monitoring” is probably only half of the governments concerns. The Fed uses it’s ability to create/destroy money to buy/sell assets as part of implementing monetary policy. If Bitcoin becomes popular enough that nobody wants to hold dollars, dollars will lose their value and the Fed will have to print more to buy the same assets. The end result could be hyper-inflation for the dollar. If you are holding Bitcoins you won’t care, but the Fed can’t print Bitcoins!

Could the government give up on having the Fed controlling interest rates via printing? Probably not. Are there other effective mechanisms the Fed could use to implement monetary policy? I don’t know of any (any ideas?). Would it be a good thing if the government didn’t control monetary policy? I’m definitely getting out of my league here but I’d say no. Will China launch a cyber attack on the Bitcoin network if the US government doesn’t shutdown it down? Maybe!

So at what Market Cap does the government start getting scared and act? No idea. Maybe $100B? Keep in mind that $100B worth of BTC will travel through the economy slower than $100B of dollars. First Bitcoin doesn’t have fractional reserve banking yet, so a dollar in the bank will hit the economy multiple times whereas a Bitcoin can be in only one place at one time for now. Checkout the graph from FRED in wikipedia illustrating how the monetary base (BOGUMBNS) is multiplied into M2 by over 7x as of 2007 (in 2012 it’s ~3x). Second Bitcoin does encourage hording more than dollars since they don’t suffer the pains of inflation. Now hording is probably rampant since many if not most people buying Bitcoins are speculators. Lets face it, there isn’t much to buy w/ BTC right now. But I’m speculating (literally) that will change.

Valuing Bitcoins or: how I learned to stop worrying and speculate

Lots of posts on Bitcoin recently as the price continues to rise. I don’t want this to be a Bitcoin only blog, but I do have a long position, it’s a hot topic and I have done some thinking on this so I’ve got some value add here (pun intended). This post will be on value. The next one some thoughts on government regulation which I think is really the most important topic surrounding Bitcoin.

So lets put a value on Bitcoins! Should you buy Bitcoins? Well I’m long so you know my opinion. However the main reasons for me starting this blog are:

  • Force myself to articulate my thoughts to help ensure I’m making sense. Sometimes your write things down and it just doesn’t look right.
  • Get feedback! I’m not always right and I can be swayed. I’m searching for intelligent life.

So here is why I’m long. Lets calculate the expected value (EV) of buying a Bitcoin. In “probability theory” expected value is calculated by taking all the possible outcomes multiplied by their probabilities of occurring and adding them together (here is an example with dice). In our case the output of the expected value calculation represents the price below which we should be buying Bitcoins and above which we should be selling.

First lets list the possible outcomes and approximate what the Bitcoin price should be in each of these outcomes:

  1. Disaster! A bug or hack results in utter loss in confidence of Bitcoin system. Or governments uniformly ban Bitcoin. Price goes to $0.
  2. Mediocrity. Merchants don’t universally adopt Bitcoin. Some folks use it as a store of value, but as a medium of exchange the results are well…medium. Price end up around $100.
  3. Success! Bitcoin becomes a commonly accepted medium of exchange competing w/ major currencies although not replacing them. Bitcoin grows to be as used as the US dollar. There are 1.2 trillion dollars in circulation and there will never be more than 21 million BTC so 1.2T/21M = $52,381 per Bitcoin.
  4. Massive Success! Bitcoin becomes the primary currency used world-wide. As of 2008 Wikipedia has global currency circulation at around $4T. USA had 20% of the share so lets assume that share stayed the same making the worlds total circulation is $6T (1.2T/0.2). So $6T/21M = $285,714 per Bitcoin.

Thats right, there is a chance each Bitcoin that is currently trading at a paltry $125, could be trading at $285K each! I’ve seen estimates for 100K-1M per Bitcoin, not sure how So lets chuck these numbers into a spreadsheet and see what they look like when we probability weight them. I’ve provided 2 sets of what probabilities, one optimistic one pessimistic to illustrate my point.

Scenario Bitcoin Price Optimistic Probability Optimistic EV contribution Pessimistic Probability Pessimistic EV contribution
Disaster! $0 69% $0.00 90.00% $0.00
Mediocrity $100 20% $20.00 8.99% $8.99
Success! $52,381 10% $5,238.10 1.00% $523.81
Massive Success! $285,714 1% $2,857.14 0.01% $28.57
Optimistic EV $8,115.24 Pessimistic EV $561.37

So according to these calculations a the price of Bitcoin should be somewhere between $561 and $8,115. I certainly wouldn’t call $125 a bubble. Of course as new information comes in probabilities change and therefore so does the EV. Obviously I’m winging it on the probabilities here, but I think if you are honest with yourself it’s pretty hard to say there isn’t a 1% chance of the “Success!” scenario occurring and munging the numbers to get the EV below $125 is really, really, hard.

So dump all your savings into Bitcoin? Obviously not. This is a speculative bet w/ at least a 69% chance of losing ALL your money, but the upside is tremendous for the other 31% so a small bet could pay big dividends.