By Deepak Machado (@dpkmac)
In the previous parts of the series I covered, money, what is bitcoin and how bitcoin works. In this part of the series, I will try to cover few misconceptions about bitcoin and risks of bitcoin.
From its launch in 2008, bitcoin has come a long way and along the way there have been many hurdles. Bitcoin has survived the attacks, regulations and may be poised for new growth; not in terms of price, but in adoption and usage. Given the era of easy money around us, a need for a sound money may be quite justified.
Because bitcoin is disruptive in terms of the technology and because of our traditional understanding of money, it is quite a challenge to understand the merits behind the protocol.
Here are some of the main misconceptions to bitcoin:
* Bitcoin is used by criminals, terrorists: One of the most common argument we hear is that bitcoin is used by criminals. While it is true to some extent that bitcoin is used for illegal purpose, the merits of bitcoin should not be sidelined. Whereas bitcoin may be used by criminals, so is cash. Would this mean, we should ban cash? Majority of the illegal activity still happens with cash. Law enforcement agencies would be happy if someone used bitcoin to commit illegal activities as the transaction can be carefully studied and they can arrive at the doors of the perpetrators.
* Bitcoin is anonymous: No, all transactions of the bitcoin live forever on the bitcoin blockchain. They can not be reversed or erased. Bitcoin can be termed as pseudonymous. While you will not be able to see who the bitcoin address belongs to, with careful analysis of the transaction, the origin of the transaction creator could be tracked.
* Bitcoin is the quick way to become rich: Very few people knew about bitcoin 5 years ago.. Nobody thought it would be as valuable as it is today. Nobody knows what the price is going to be in few hours, days, months…. It is highly speculative. It is surely not the best way to be rich, especially these days. The innovators, early adopters who held onto their bitcoin (rather than spending 10000 bitcoin for pizzas.) since the early days are surely quite rich these days. However, given the current price and the volatility, I am sure it would not be as easy as it was. So do not invest your hard earned money to speculate.
* Bitcoin is a bubble: It actually looks like bitcoin is a bubble. Most monetary goods seem so. Bitcoin value is a product of supply and demand, more so from the speculators. Every news article, every government action is closely tracked by speculators. Whales (those who hold large quantities of assets), can literally influence the price of bitcoin. Anything that seems so volatile intraday like bitcoin, would be referred as a bubble. From this sense, bitcoin has been in a longest bubble in the history.
* Bitcoin is not backed by anything: The first feature anyone looks in a currency is whether it is backed by any authority or government - Bitcoin has none, therefore it must be worthless! Bitcoin mining is the activity that keeps the protocol safe from all kinds of manipulations and attacks. Being a decentralised protocol, the various parties involved need not trust each other personally, but validate the transactions based on the predefined rules and consensus mechanism. This safe network of bitcoin is the only fact that keeps faith in the network and people settle their dues, conduct business with bitcoins. This increased interest makes up demand for bitcoin. How is the strength of rupee or dollar derived could be attributed to the economic conditions and strength of the underlying economy. At the end of, the market governs the price of bitcoin.
* There will be better forms of cryptocurrency (competition): Being open source in nature, bitcoin’s code can be easily taken and a new protocol built upon this. Therefore, we now have more than 1500 coins and tokens floating around, with their own market caps and values. Ethereum, Ripple for example are other multi-billion dollar market cap currencies/tokens. Another factor that may affect others from taking over bitcoin is the ‘network effect.’ If there is something better form of sound money, most of us would embrace this. This is one of the reasons silver lost out to gold as standard and whoever stuck to silver were left far behind the race while gold standard became the norm.
There are umpteen number of other misconceptions, however, these I believe are the top ones.
Risk for bitcoin
Bitcoin is not perfect at all. It is slow, it is cumbersome to comprehend, it is quite abstract to common understanding. There are graver risks though.
* Protocol level risk: Bitcoin is governed by cryptographic hash functions. This is the only thing that keeps bitcoin protocol safe. For its security bitcoin uses SHA 256, which till now has not been compromised. But with the development of quantum computers, super computers, this algorithm may be broken. Anyone who has access to such advanced technology, would be able to reverse the transactions and double spend the bitcoins, literally ripping the value apart. This, when it happens, would be the demise of bitcoin. While this is theoretically possible, quantum computers are not yet common. It is only to be seen whether such a technology would emerge and what would be steps taken to prevent this. Some cryptocurrencies have made their mining protocol quantum resistant. Bitcoin is not there yet.
* 51% attack: Anyone who controls 51% and more hashrate, would be able to reverse the transactions and would be able to double spend.
The above image shows the distribution of hash rate between various mining pools of bitcoin. What keeps them from collaborating together may be the economic factors. These miners have invested heavily into the mining equipment and they would be negatively affected if the protocol was compromised. However, any large entity, government with access to technology, could theoretically launch a 51% attack. At this point in time we are talking about billions of dollars of investment if this was to be carried on.
* Bitcoin Forks: Another great risk is the forks of bitcoin. As on date there are at least 10 or more forks of bitcoin active, prominent among them was Bitcoin Cash. Bitcoin Cash proponents wanted to increase the block size of bitcoin from 1MB. This fork happened on August 1st 2017. A fork is when a digital currency splits into a new blockchain while maintaining the history until the fork. If you do not agree with how a protocol should work, you could suggest these changes, users need to update to the newer version. At this point, majority of the market value would settle on a version that they believe is the true version. Bitcoin forks are a real risk as this may confuse the users as to which chain to follow. Positive aspect for those who hold bitcoin before the day of the split is that they are rewarded with equal amounts of the new coin as they held in the previous version.
* Control of centralised exchanges: While authorities can not control the bitcoin protocol, what they can effectively do is control of bitcoin exchanges. What happened in India recently is an example when Reserve Bank of India, instructed the banks not to transfer funds to crypto exchanges. This may temporarily reduce the propagation of bitcoin, market forces would find other ways of getting around this. In Venezuela, government controls most aspects of bitcoin, including mining, exchanges and so on. So the proliferation has been through a site called, localbitcoins.com, which is a peer to peer exchange.
While there are many risks associated with bitcoin on the road to become a sound money, bitcoin boasts some of the most dedicated developer community. There is an exodus of professionals from Wall Street investment banks to bitcoin related companies. There are thousands of jobs being created within the exchange companies while the profits of these bitcoin related exchanges have soared much above some main street banks. From my point of view, we are just getting started in this industry and there is a long way to cover.
In the next and final part of the series, I will share with you the list of literature and prominent reference to read to understand more about bitcoin and blockchain.
Disclaimer: The contents of the article are gathered / referred from various sources, are for information purposes only and are not to be considered as financial advice. The opinions expressed are that of the author and do not necessarily reflect that of Daijiworld Media Pvt Ltd.