Where Bitcoin boosters are getting it wrong

In a recent New York Times Dealbook post, venture capitalist Marc Andreessen argued that Bitcoin is here to stay because it provides a payment system better than the one we have now, particularly for online merchants and international transfers. He likened Bitcoin to other disruptive technologies such as the personal computer and the Internet.

These are great analogies. The personal computer has revolutionized the world, but Altair was not one of the winners. (Remember Altair? It was one of the many pioneers.) The Internet was not the first or even the only network for connecting computers. There were several other early networks including Bitnet (the "Because Its Time" network), which was started in 1981. It thrived for a while connecting university computers, but was eventually supplanted by the Internet as we know it today. I believe that Bitcoin will suffer the same fate as Bitnet: a technical advance that will soon be surpassed by even better advances.

Our payment system is undergoing an amazing technical revolution. In a few short years, we have evolved from a world in which most payments were made via paper to one in which most are made with electrons. This evolution has not finished and will continue. There is broad dissatisfaction with the fees involved in the Visa MasterCard duopoly, and definitely room for improvement. We will continue to see innovations that provide even better and more cost-effective payment solutions. Recent innovations include PayPal, Popmoney, and Square. Plenty more are still under development, as many innovators compete to come up with a "digital wallet" that people will actually use.

Somebody will win, and win big. As Andreessen points out, payment systems have strong network effects: The more people who use a network, the more valuable it becomes. The more people who use a payment system, the more will want to use it because everyone else is using it. Products with strong network appeal can create amazing amounts of wealth for the winners of the race to build the biggest and most successful network. Just ask Bill Gates. Part of the brilliance of the Bitcoin invention is that it creates strong incentives for users to proselytize and build the network. By paying miners with Bitcoins, the miners have strong incentive to convince other people to use Bitcoins. The network-building incentives of the Bitcoin system are one of the reasons Silicon Valley VCs like Andreessen are salivating at the potential fortunes to be made.

However, not all the payment innovations will succeed, just as not all the personal computer companies did. Launching a new payment system requires buy-in from a large number of people. There have been many failures along the way. The current Bitcoin payment network (along with the current wave of Bitcoin copycoins) has several flaws that will inhibit its growth and make it vulnerable to competition from leapfrogging technologies:

Consumer protection
Bitcoins lack the consumer protection inherent in existing payment systems. Just as with old fashioned paper money, Bitcoins are subject to theft. A Bitcoin is a number with the special property that it can be transferred from one person to another via a digital signature process that is verified by the network of Bitcoin miners. However, anyone with that number can spend it. Thus, if a hacker gets access to the number, the hacker can immediately steal the Bitcoin. In a recently publicized incident, a Bloomberg TV show briefly flashed the QR code to a Bitcoin and it was almost immediately stolen. Even though Bitcoin transactions are visible in the blockchain and theoretically traceable, "tumbler" sites exist that make it possible to obscure the electronic trail. Thus, Bitcoins are as risky as physical cash, if not more so, and this will inhibit consumer acceptance. Given the incidence of malware that picks digital wallets, the average non-tech savvy person who occasionally screws up and gets some malware infection will eventually end up as a victim of bitcrime.

Fraud
Andreessen errs in his assertion that Bitcoin is fraud-proof for merchants. It is quite easy to imagine several possible situations resulting in fraud losses to merchants. For example, suppose a customer attempts a purchase from an online merchant, and enters the Bitcoin number. Alas, a hacker has broken into the system, Target style, and grabs and spends the Bitcoin number before the merchant even sees it. Even if the compromised system was on the customer's end, it may be hard to prove and the merchant still ends up eating the loss or facing a lawsuit. And, of course, the merchant's wallet could be hacked and the Bitcoins stolen, with no recourse.

The last-mile problem
International transfers through outfits like Western Union are incredibly expensive, and lower-cost alternatives are badly needed. However, one of the reasons that services like Western Union are so expensive is the labor intensity at both ends of the transaction. Humans are often involved at the origination and the receiving end of a payment, and this creates significant costs. Western Union also has to deal with fraud and comply with anti-money laundering laws.

This is similar to the last-mile problem faced in the Internet, in which the consumer's local connection to the Net is the bottleneck. An ex-pat worker wishing to send dollars back to the home country would have to first convert the dollars to Bitcoin, transfer the Bitcoin, and the recipient would then have to convert the Bitcoin to the home country currency. Thus, there will be at least two sets of currency conversions along the way.

Fragility
Part of the essential essence of Bitcoin is that the miners vote with their computing power to verify transactions. As long as the majority of the computing power harnessed by the miners is honest, the system will work. However, mining has gotten so difficult that miners have begun joining in mining pools to increase their chances of earning Bitcoins. If 51 percent of the available computing power is compromised, the system would be vulnerable to whoever controls the 51 percent. The controller could counterfeit Bitcoins and create havoc within the system. While it would be foolish for a profit maximizing pool that controlled 51 percent of the computing horsepower to destroy its profit engine, it is quite credible that a terrorist group with other motives might endeavor to do just that. An al-Qaeda-like outfit could plot to gain control of 51 percent of the computing capacity in order to drive a stake in the heart of the free world economy, even if such an act would be very costly to it.

Technology risk
Although proponents claim that the open and transparent nature of Bitcoin makes it a stable technology, there is the legitimate fear that some as-yet-unexpected flaw will bring the whole system down. History is filled with examples of "invulnerable" technologies that were later found to be very vulnerable. Remember the "unsinkable" Titanic? Whether there exists such a fatal vulnerability or not, the fear of such a vulnerability will slow mainstream acceptance, especially with the lack of any government backstop or regulation.

Lack of regulation
We strictly regulate the current payment system, and for very good reason. We need to make sure that the payment system doesn't collapse, because if it does, the entire economy collapses with it. This is what Ben Bernanke is paid to have nightmares about. We want to make sure that nobody steals the money from our bank accounts, and that the banks are solvent. We fingerprint and background check the people in financial services to make sure that known criminals and fraudsters are not working in those businesses. We want to make sure that the financial system is not used by terrorists, thieves, and drug dealers, so there are strict anti-money laundering rules. Without a sound legal and regulatory framework, mainstream acceptance will not occur.

Bad monetary policy
Many of the proponents of Bitcoin view it as a digital gold standard. Its allegedly fixed supply is seen as a panacea for the problems inherent in fiat money systems. However, the historical experience with the gold standard shows that it regularly blew up in severe recessions. It is essential that there be some flexibility in a monetary system in order to deal with crises. It is highly unlikely that the general public would accept being crucified on a cross of digital gold when the inevitable crisis hits a Bitcoin-based monetary system. (This is a reference to William Jennings Bryan's famous "Cross of Gold" criticism of the gold standard.) Thus policy makers will resist widespread use of the existing Bitcoin as a payment system.

But the Bitcoin technology is useful!
The beauty of the Bitcoin technology is that it can be extended to deal with all of the above problems. At its core, Bitcoin is an open-access payment network compared with closed proprietary networks like Visa and MasterCard. This technology can be used to create an even better payment network to provide competition to existing networks.

What would a better bit-like payment network look like?

• It would use an existing currency. As the total number of Bitcoins issued reaches its alleged limit, the Bitcoin miners will depend on transaction fees that are expected to be small. The ease of entry and exit into mining will push the level of transaction fees to a competitive level, thus leading to a low-cost payment network. There is no reason why a similar network cannot be built right away that uses an existing currency like the US dollar. The Fed would create (mint) bitdollars that would be exchangeable for regular US dollars. The miners would be paid via transaction costs. This would eliminate all of the problems with the instability of Bitcoins and the monetary policy trap of having a fixed money supply with no possibility of alterations. The digital gold bugs won't like this, but it would work a lot better than a digital gold standard. It would provide seignorage revenue for the US government, and help strengthen the role of the US dollar in the global economy.
• It would be regulated. Miners would have to be registered to make sure that they are not criminals. They would be regulated to make sure that they have sufficient cyber-safeguards in place and not colluding to control the payment network. They would be required to comply with the anti-money laundering laws. The network would be required to block transactions with accounts associated with criminals. In this way, funds that have been stolen can be recovered when they have been traced to a specific account.
• Most of us take our payment system for granted. We cash our paychecks, swipe our credit cards, and even spend old-fashioned paper money without thinking much about the infrastructure that supports our payment system. However, our payment system is costly to operate, and there are better ways of processing payments. The Bitcoin breakthrough has demonstrated that a competitive open-access payment system is possible, but it currently has too many weaknesses in its present form to make it overtake current payment systems, except in the niche of the underground economy. The technology can and should be adapted to creating an even better dollar-based payment system.