By Ulrich Bindseil and Jürgen Schaaf *
The “prosperity” of bitcoin continues despite repeated adversity. The success story of the most popular cryptocurrency (cryptocurrency) to date, with a market capitalization of over a year and over one trillion US dollars, is based on three promises: first, to create an effective global currency, second, to be resistant to inflation and allow even large capital gains, and, thirdly, to liberate the “individual” from the state and strengthen it. But the promises of this digital trinity are not being fulfilled. And because collective delusion has now taken on dimensions that will cause significant damage to society, interventions by legislators are becoming more and more likely. And then the paper tower will be threatened with collapse.
But let's put things in perspective: bitcoin was originally just a ploy whose economic justification seemed sham. In 2007, a then-clouded team of software developers came up with a completely decentralized accounting concept that allows electronic payments to be largely anonymous through encryption and irreversible, ie without subsequent settlement. Under the pseudonym Satoshi Nakamoto, a white paper and the source code for this “digital money” were published, and in January 2009 the first fifty bitcoins were created. Without a central authority, a global network of equivalent computers controls, monitors and stores the system and sets financial incentives for all participants to keep it running. Every few minutes, new data packets are collected in the “blockchain”, in a digital payment book. Technically, a blockchain is a chain of data blocks that continues to be updated over time and is maintained as a distributed register. To prove this, computers must solve a mathematical “cryptographic puzzle” for each “block”, for which a reward awaits them in the form of transaction fees and newly created bitcoin. New bitcoins are being cut by decentralized “mining” by countless users and their computers. The maximum total number of bitcoins is technically limited to about 21 million, of which just under 19 million are already in circulation.
Bitcoin is not a currency
There is now widespread consensus that bitcoin has not achieved its original goal of being a currency. Bitcoin is very volatile and very expensive to maintain so that it can fulfill the classic functions of money, namely currency, means of payment, and means of maintaining value. Providing incentives to maintain the system without central authority is inherently wasteful and costly. It can not compete with traditional market infrastructure governance. Therefore, the bitcoin business model as legitimate money can not work in the long run. Lack of acceptance by traders due to long settlement times and high fees already show that bitcoin can not be taken seriously as a means of payment except for a few small and scattered pockets. The latest major failure was El Salvador's attempt to introduce bitcoin as the second legal currency next to the US dollar on September 7th. The attempt failed at the moment, mainly because there was no acceptance from the population, and sent the bitcoin exchange rate down (loss of 15% overnight).
The technically stable “money supply” of bitcoin is also proving to be a weakness if we look at it more closely: what is being launched as a protection against inflation would inevitably lead to the trap of deflation in a growing economy. When we have deflation, falling prices tempt people to postpone less urgent markets for the future. This may make sense when it comes to one person, but when it comes to society as a whole, demand is declining and the economy is slowing down. Consolation, however, is the fact that the supposed protection against inflation through a steady supply of cryptocurrencies is false as the number of possible cryptocurrencies that can compete with bitcoin is, in the end, unlimited.
The commonly used comparison with gold is also misleading, as gold was used in industry and had value as jewelry for centuries before anyone considered using it as a means of storing value, an investment form, or a foreign exchange stock. In addition, gold does not degenerate over time and retains its value even in chaotic conditions or in the temporary failure of digital infrastructure.
Finally, the argument that the fiat money of modern central banks has no intrinsic value is unfounded as with the deliberate departure from gold hedging, states and central banks have introduced strict mandates, legal guarantees, and institutional and operating arrangements (independence, as well as loans against collateral) to be able to let go of the gold brake without losing stability.
The favorite investment of the “biggest sucker”
Because bitcoin is not effective as a means of payment, it is not competitive for legal payments and has no other intrinsic value. In addition, bitcoin produces neither cash flows nor dividends, and its maintenance is extremely expensive. No deep knowledge of financial mathematics is required – common sense is enough to realize that the price of bitcoin will sooner or later be zero.
Investors who bet on a steady increase in value because supply is limited confuse the rare with the valuable: limited quantities of any good are worth a dime a dozen – it is only the useful subjective demand that makes a good valuable. The subjective enthusiasm for bitcoin alone is not enough in the long run, especially since the following principle also applies to a purely numerical chain such as bitcoin: technologies are being replaced by better technologies and newer ones are soon displacing new ones. In fact, the relative importance of bitcoin dominating the cryptocurrency market continues to decline: while bitcoin accounted for almost 90% of all cryptocurrencies at the end of 2016, it now accounts for only about 40%.
It is therefore not surprising that the market celebrations for other cryptocurrencies are frantic, without the working hypothesis having become more convincing. The cardano doubled in value in August and climbed to third place among the cryptocurrencies behind bitcoin and ethereum. A token called avalanche tripled in value over the same period. At the same time, prices for digital photographs of rocks with laser eyes or encrypted whales skyrocket, sometimes in just a few days. And tabloids in some countries are now giving advice on investing in cryptocurrencies, just like running a local tattoo studio.
Since the value of bitcoin is not associated with any economic benefit (as it is unsuitable as a means of payment) and since the cost of maintaining this economically meaningless system is too high, the valuation of bitcoin in the market is purely based on speculation. This only works as long as the bitcoin community's illusion of its supposed benefits as a means of payment can be maintained.
You can see it from whichever side you want: bitcoin exaggeration has all the hallmarks of a speculative bubble according to the “biggest sucker” theory: value increases as there is an even bigger sucker who assumes he can sell at an even higher price some time later. But like the fact that the number of bitcoins is ultimately limited, at some point there will no longer be enough suckers wanting an ultimately useless speculative item. In the long run, the inherent lack of value of bitcoin will prevail in the market.
The illusion of release
Despite its financial weaknesses, there is still a vision of liberation from state control and abuse of power by central authorities. Bitcoin, with its decentralized organization, promises the emancipation of the individual and the complete democratization of the monetary system. However, bitcoin's pseudo-liberal ambitions tend to come from privileged elites who are comfortable with the security of the rule of law, without understanding how the market works and the regulatory effect of the rule of law and institutions. Freedom needs rules, otherwise there is the threat of anarchy and the law of the strongest.
This lack of understanding was already evident in Nakamoto's (2007) White Paper. In it, Nakamoto criticized the fact that e-commerce, unlike cash, relies almost exclusively on financial institutions as trusted third parties to process payments. Irreversible transactions are not possible, he said, as disputes sometimes have to be settled through arbitration. With the possibility of overthrow, however, the need for trust increases. These costs increase the cost of transactions, reduce the minimum practical size of transactions and prevent small occasional transactions.
However, the finality of payments is an established concept, and the reversibility of payments has less to do with payment systems per se than with the objectives of civil and criminal law, namely the possibility of repaying or seizing illegally acquired funds. The fact that a payment cannot technically be reversed does not preclude the subsequent initiation of a new payment, either voluntarily or by order, in the event of compensation for example. The fact that this reversibility is costly in the case of bulk payments is not due to technology but to legal and contractual requirements.
The almost religious glorification of maximum decentralization as the best organizational form of markets reveals something similar. The fact that the economy and financial markets in developed market economies are not organized in a purely decentralized and spontaneous way, but know central institutions and structures with internal hierarchy (enterprises) within defined frameworks, has long been recognized in the economic literature, at least by in the era of Nobel laureates Ronald Coase and Oliver E. Williamson. Businesses and incomplete contracts help to address uncertainty and complexity and reduce transaction costs – and are by no means the second best solution in the absence of appropriate technologies. The mechanistic rules that bitcoin seems to create are not the right solution for a changing world.
Bitcoin is also by no means as “democratic” as its community once thought, at least in the early days, but it is shaped by financial interests and strong shareholders. The mass, 75% of the addresses, holds only 0.2% of the market share. The 100 largest bitcoin shareholders hold more value than the smaller 38 million combined. In such concentrated markets, the comment of a large investor with numerous followers on Twitter is enough to cause prices to slide or fireworks. This is more elitist than egalitarian. Tesla CEO Elon Musk has repeatedly commented on bitcoin, repeatedly revising his opinion, to which the price reacted violently each time.
Finally, the prospect of a borderless world is part of the pseudo-liberal fantasy that bitcoin, as a global means of payment without national jurisdiction, could cross borders – in stark contrast to conventional cross-border payments. In particular, the benefit of bitcoin would then be that people could send value across borders for free and unhindered to anyone with a bitcoin wallet. This argument does not recognize that the high cost of conventional cross-border payments is not due to the inefficiency of the means of payment, but to a significant extent to the regulatory requirements for combating money laundering and terrorist financing. However, these requirements, compliance costs and legal risk provisions only affect the regulated financial sector. The fact that bitcoin payments have so far managed to completely escape this phenomenon is therefore a regulatory omission and not a technological achievement. But more on that below.
Possible change of attitude of the regulatory authorities
In addition to the design flaws that undermine the long-term interest in bitcoin, the cryptocurrency also poses risks to society and the environment: the system is widely used for criminal activities and large-scale waste of energy. The fact that lawmakers in many countries have been watching this game for a long time does not mean that this situation will remain the same.
The growth of the bitcoin market was characterized from the beginning by the manipulation of the market and the dubious activities of the operators. This is combined with the fact that a not insignificant percentage of bitcoin is used for illegal activities. Drug trafficking, money laundering, terrorist financing and extortion are the most popular areas of use, especially for cross-border payments. The relative sizes are disputed here. Some studies conclude that the use for illegal activities reaches 40-50%. Supporters of bitcoin, on the other hand, speak of a percentage of less than 1%. But this is mainly due to the fact that the denominator confuses the volume of trade with economic activity.
To the extent that the “same function – same risks – same rules” principle is to be applied to money laundering and terrorist financing and to be targeted in practice rather than in the middle, a change in the attitude of regulators is becoming more and more likely. In fact, European legislators are already moving in that direction. Otherwise, a simple feature of a computer network could bypass a central element of the global financial regulatory framework. The G20, a team of twenty major industrial and emerging economies, is currently working hard to improve cross-border payments. These are also expensive because the not always clear and globally still inconsistent application of regulatory requirements leads to high compliance costs and legal risks for legally operating companies. An overall improvement in the regulatory framework would include covering all cross-border payments and at the same time improving the clarity and applicability and, consequently, the effectiveness of the regulatory framework.
Finally, there is the giant energy waste of the bitcoin network. In June, the University of Cambridge estimated bitcoin's annual energy consumption at just under 115 terawatt hours, which is roughly equivalent to Pakistan's electricity consumption. And there is no hope of improvement on the horizon, because the insatiable thirst for energy is inherent in the system. Without an official or reliable issuer, complex decentralized control mechanisms and therefore high computing power are required, ie huge energy consumption is the inevitable symptom of the social inefficiency of the bitcoin system. Electronic means of payment issued centrally by reputable issuers are incomparably more energy efficient and therefore more sustainable, as various studies have now shown.
The threat of environmental damage as well as regulatory arbitrage, especially of illegal activities, make the government response increasingly likely. Leading global bodies, such as the Financial Action Task Force (FATF) and the Financial Stability Board (FSB), have recently unequivocally declared war on cryptocurrency.
The list of arguments against a permanent bitcoin is long. Even though no one can say exactly how much longer the ghost will be wandering, everyone is already well enough informed that they do not rely on bitcoin either as a means of payment or as a capital investment. A viable bitcoin is as impossible as dividing by zero.
Ulrich Bindseil is the Director-General for Purchasing and Payment Infrastructure at the European Central Bank (ECB) – Jürgen Schaaf is a consultant in the same field. The authors express their personal views, which do not necessarily reflect the views of the ECB.
