Bitcoin fever gripping the world, part 4: Risks

As I explained in my previous post, Bitcoin can be an excellent means of avoiding the risks inherent in the existing monetary system. However, it shouldn’t be forgotten that Bitcoin is also part of an entirely different type of system, surrounded by entirely different (systemic) risks. The system is based on the miner program (which verifies transactions), the peer-to-peer network of miner computers and the totality of the wallets. Until now they’ve performed their job well and proved reliable. Transactions have been performed correctly, Bitcoins have been generated in the prescribed quantity and nobody has managed to hack the system (a few bugs were discovered in the Bitcoin code and other problems have arisen, but these were corrected before they could cause any real trouble). However, Bitcoin has only been around for 4 years. That’s not an insignificant length of time and its flawless operation to date should not be underestimated. On the other hand, it’s far from being a long time, and the spotlight has only really been on Bitcoin in recent weeks. In other words, the real tests of whether it can operate stably in the long term are still to come. There is now considerable motivation for hackers to dedicate their efforts to seeking out the weak points of the new system, because, if they can find them, they can convert their knowledge into money by short selling Bitcoin. We don’t know whether the technology will fail and, if so, when and how. It’s certain that it will have to prove its viability a lot of times and in many ways, and will be thoroughly put to the test. It may turn out to be viable. It may turn out not to be viable, and discovery of the system’s Achilles’ heel will see the exchange rate tumble to zero. It may turn out not to be viable in its present form, but Bitcoin 2.0 will eliminate those faults.

In addition to potential technological problems, governments could impose legal obstacles on Bitcoin. It would be a massive blow if, for example, the USA were to decide that it’s had enough of illegal wares being traded using Bitcoin and ban Bitcoin payments or investments. Such a step, however, would meet with serious resistance, since the majority of Bitcoin buyers are not criminals, and numerous businesses have recently invested millions of dollars in developments related to Bitcoin. They would rightly be up in arms, since a questionable law would reduce the value of their investments to zero overnight. It would be disputable since the majority of people do not use Bitcoin for criminal purposes – the crime should be punished, not the users of a thing that so happens also to be used by criminals. By that reasoning, knives could be banned because there are people who use them to kill.

Moreover, such a ban would probably serve little purpose. Bitcoin in itself cannot be eliminated. In order to do so, the open-source software (the miner program and the wallet-generating programs), which can be downloaded from hundred of thousand of places, would also have to be prohibited, and such a thing has never happened before. Such a ban would be impossible to implement and easy to get around. Just look at the distribution of copyrighted content. Downloading copyrighted films and music using torrents is theoretically prohibited, yet almost anything can be downloaded online. Of course I know that by hearsay, not from personal experience J. In other words, the Bitcoin system would remain. At worst, its value would fall, let’s say to 1 USD. It would still be possible to use Bitcoin to pay for illegal products as earlier: anonymously and untraceably. The ban would make it more tricky to convert it to real money, but not impossible.

Regardless, it is not inconceivable that legislators will try to impose some form of ban, which would have a negative impact on the BTC value. Fortunately, however, that is not the current position: the guidance issued by the American FinCEN (Financial Crimes Enforcement Network) recommends regulation, rather than a ban.

Interestingly, there’s also a different kind of risk in terms of the law: if, for instance, drugs were to be legalized, then demand for Bitcoins could fall precisely because it would no longer be necessary to use Bitcoin to pay for drugs.

Trust in Bitcoin could also be undermined by an attack on the infrastructure surrounding it. As the figure below shows, in 2011 its value looked to be on the rise. Then, however, the price plummeted (and remained at that level for a long time) after the largest Bitcoin exchange was hacked and some money was stolen from there. That was sufficient at that time to erode confidence in Bitcoin to a considerable extent, despite the fact that the monetary system itself was not harmed (the hackers didn’t manage, for example, to generate extra Bitcoins or forge transfers and nor have they managed to since). I suspect that today such an attack would at most cause Bitcoin’s value to dive temporarily, and business would shift to a competing exchange.

Bitcoin’s infrastructure suffered a recent attack. Last week Bitcoin crashed from 266 to 54 USD – the price fell to almost a fifth of its previous value within two days. Perhaps, in that light, the title of this post should be “Bitcoin fever dies down”, though I still think it’s closer to the truth to say that Bitcoin fever is breaking out. As can be seen from the figure below, investors buying at a price of 13.5 USD at the beginning of year still did incredibly well, even if they sold their Bitcoins at the very bottom of last week’s crash.

Events were initially triggered by the recent surge of interest in Bitcoin. Users opened massive numbers of new accounts on the exchanges and trade volume multiplied. That placed such strain on the servers of the largest exchange that the system started to experience problems – which triggered the panic sales – and was then completely down for a few hours. After the reopening, the servers were hit, not for the first time that month, by a distributed denial-of-service (DDoS) attack. Vast numbers of requests were sent continuously by the computers of a zombie network controlled by hackers to the servers of the exchange, which remained overburdened and experienced problems. That naturally did nothing to restore confidence. The aim of such an attack is not to steal money directly, but more likely for the hackers to buy Bitcoins cheaply during the panic. Similar cases can be expected in the future. However, it looks as though the Bitcoin fever is still going strong. The monetary system itself is still operating as it should, and the BTC price has since stabilized at around 80 USD. From time to time the steam from the feverish speculation needs to be let off one way or another.

Another potential risk to Bitcoin is that of being ousted by a competing virtual tender. Today there are several competitors using technology similar to that of Bitcoin (such as Litecoin). However, Bitcoin came first and has a worldwide reputation. Another virtual tender would only be able compete with that degree of recognition if it offers considerable advantages over Bitcoin. At present there is no such competitor.

Individual risks that don’t affect the whole system, but are extremely important for individuals, also arise in connection with Bitcoin. Such risks result from anonymity and the lack of central supervision, which maximize the responsibility of the individual. If you make a mistake, you could easily lose the Bitcoins in your wallet, and nobody will compensate you for them. For instance, if a virus on your computer transfers the Bitcoins from your wallet, there is no one for you to complain to. You cannot reverse the situation and the thief will go untraced. Our money will also be lost if we make a transfer deliberately, but to an incorrectly given wallet. If you forget or lose the private key (password) to your wallet, then your Bitcoins will be stuck there forever and no one will be able to access them any more. There won’t be anyone to tell you your password or restore your access in any other way.

As you can see, alongside the benefits, Bitcoin has numerous risks. In the next post I’ll briefly review the Bitcoin phenomenon.

Original date of Hungarian publication: 18 April 2013