Bitcoin virtual currency may be worst of both worlds

After being celebrated by some as the future of money in a digital age, the virtual “peer-to-peer crypto currency” known as Bitcoin has taken some serious hits in the past week or so. Among other things, it has been criticized as a scam — based on economic assumptions that are described as “laughable” — and has come under fire from the U.S. Senate for the ease with which drug dealers and other subversive elements can make use of it. And if all that wasn’t bad enough, a user now says he has lost the equivalent of almost half a million dollars in a Bitcoin theft. The virtual currency could be the worst of both worlds: easy to steal and impossible to trace.

To recap, Bitcoin is an attempt to create a distributed, open-source form of virtual currency that relies not on gold bars in Fort Knox or the monetary policy of a central bank for its value, but on a computerized ecosystem. The project was started by programmer Satoshi Nakamoto (although that may or may not be his real name) in 2009. The Economist described the process quite well in a recent post, as did Stephen Chapman at ZDNet, and there is more information on a wiki devoted to the concept. There’s also a fascinating discussion of the criticisms about Bitcoin in a thread on Hacker News.

In a nutshell, Bitcoin generates currency at a predictable rate (which reduces the chances of an inflationary spiral like those that have occurred in countries with traditional currencies) through a computer-intensive mathematical process known as “Bitcoin mining.” However, since the currency only exists as ones and zeroes in a computer program — not unlike most of the money we use via credit cards, etc. — it can also be stolen by hackers, as one user has claimed that his Bitcoin bank account was.

Bitcoin can’t track the thief or reverse transactions

Although there is no way of knowing for sure whether this report is accurate or not, all transactions involving Bitcoins are public and can be seen through services such as BlockExplorer, and there appears to be a record of a transfer of those funds to a new user. One of the leaders of the Bitcoin movement told Ars Technica that not only is such a theft possible, but the project currently doesn’t have any way of tracking the lost coins or reversing any related transactions — a rather disturbing admission from someone running what amounts to a central bank for a new currency (Ars Technica also has a great backgrounder on Bitcoin).

Meanwhile, a Quora user named Adam Cohen (a developer with SeatGeek) ripped into the idea of Bitcoin recently on the Q & A service, calling it a “ludicrously bad idea” and an outright scam. Cohen said the economic assumptions underpinning the system were “laughable” and ignore hundreds of years of understanding about how currencies work. He added that “fortunately, it’s such an obviously flawed system that it will probably never grow to a point where it causes any ill-effects [sic], or even impact, to world economies.”

No reliable exchange for real currencies

Because of the way the global supply of Bitcoins is artificially limited (it grows at a predictable rate until there are 21 million and then stops), Cohen argues that the entire process is designed to enrich early adopters — many of whom seem to spend a lot of time obsessively checking the value of their Bitcoins on exchanges such as Mt. Gox. Cohen also argues that while there are private exchanges that allow you to convert your Bitcoins into “real” currencies, there’s no guarantee of exchangeability, because there is no central governing body for the payment system.

[B]ecause Bitcoin is completely decentralized, no one is completely invested in the long-term success of the system. No one is literally making the market, saying “no matter what happens, I’ll buy Bitcoins from you at some price”.

Like Cohen, former Cato Institute writer Tim Lee has also argued that Bitcoins represent a bubble that will soon pop. But that’s not the only issue that some have with a completely distributed, unregulated — and theoretically anonymous — system of currency. Not surprisingly, perhaps, a couple of senators aren’t happy with the way such a system can be used to buy and sell drugs and other illegal items over the Internet, something that has also torpedoed previous attempts to set up virtual currencies.

As its defenders point out, it will be difficult for the U.S. government to completely stamp out Bitcoin use, since there is no central repository for the currency and no central authority that can be targeted (there is a FAQ with some responses to popular misconceptions about Bitcoin, including the central authority question). But the combination of negative press about threats from the Senate and untraceable thefts of virtual millions could make it a lot harder for Bitcoin proponents to sign up new users for the fledgling currency. And without users, a currency isn’t much good at all, no matter how cool it sounds.

Post and thumbnail photos courtesy of Flickr users and Quazie Foto