Bitcoin - Libertarians, Techies and the Coming Bubble

Bitcoin is a p2p (peer to peer) / decentralized currency that is relatively anonymous and is currently having a massive financial bubble involving $100 million.

If you want to know the truth about what is going on I recommend reading the Bitcoin website (notably the forum) and the YouTube videos about it with a skeptical eye. There is a massive amount of Bitcoin boosterism.

Bitcoin works by creating currency based on work done by computers. You can download a client and join the network. The software harnesses the power of your CPU (or better yet GPU - a good graphics cards is roughly 100 times better for the type of work they've chosen) to do some mathematical calculations. Unfortunately instead of these mathematical calculations being used for a good or meaningful cause, they are used to insure the security of the transaction network. So when you give or receive Bitcoins - your transaction is secure, in fact a little too secure.

The more work your computer does, the more bitcoins you get for your account. This is how the money is created.

Another way of viewing it is that people are trading electricity plus fancy hardware for bitcoins.

You can also get bitcoins by selling products for them, or by buying them on the open market. The leading bitcoin market is Mt Gox.

The economy is still relatively small. In the past 30 days, there was 7.5 million of US dollars worth of bitcoin traded on MT Gox. There are about 7 million bitcoins in circulation with a current market value of around 100 million dollars.

One of the major problems of this virtual currency is that the developer designed it to have a maximum money supply of 21 million bitcoins. The supply of the currency increases at a declining rate (eg it increases 50% the second year, then 30% the third year, and ultimately 0% in the final year). This means that people are getting interested in it at a rate faster than the money supply is increasing. This is causing massive deflation and the currency has gone up 100x in the past year. This is especially true in the past month as bitcoin has received major media coverage.

I think a virtual currency is a fine idea. However they need a better way of determining the increase in monetary supply. You'd want a currency that is relatively stable versus other currencies - where the money supply would expand about at the same rate as the economy.

Right now people are just buying it and holding it. Probably very few people are actually using it as a currency as it doesn't seem to make sense to trade a currency that has gone up 100x for any product (unless you want illegal goods like drugs - there is a medium sized drug and other illegal products market that uses bitcoin).

It is completely hilarious that people are doing bitcoin "mining" by investing in hardware. A typical bitcoin miner is a computer techie who thinks it is fun to buy a computer than has 2-4 high end video cards, eats up to 1000 watts of power (vs 200-300w for a regular computer), is overclocked and cooled with noisy fans. These people are making huge amounts of money (ex. 5 times the cost of their hardware and electricity in a year) -- if you assume that bitcoins are actually worth the current market price for them.

The Collapse
I'm trying to figure out what the bubble collapse will look like.

What will cause the collapse? The (US) government could intervene and try to make the currency illegal. (Sidenote: a bitcoin developer spoke at a CIA conference - how crazy is that?). Another p2p currency could come along that solves the money supply issue or has other features that make it more popular than bitcoin. Or some of the major bitcoin owners could try to cash-in and spark a sell-off.

So long as bitcoin continues to quickly appreciate it is hard to trade goods for them. You have to price your goods in a regular currency and then convert them to bitcoin exactly at the moment of the sale (and then ideally back into your currency).

The result of the collapse is that the late joiners to bitcoin lose the most. The original joiners have had many chances to sell at least some of their bitcoins and they also bought them at 1/10 to 1/500th of the price that the late joiners used. The late joiners currently think that they are making tons of money as their bitcoin is going through the roof - but they won't cash in and will lose 90-99% of their original investment. It is possible that the earliest joiners will break even as the market price may only crash (or crash and then recover slightly) to the level at which they bought in (or mined-in).

It looks like there is a strong correlation between Google searches for "bitcoin" and the price.

Bitcoin prices for the past year (MtGox, US dollars)

Google searches for bitcoin past year.