What You Should Know About Bitcoin and Cryptocurrencies

5/18/21

The more I learn about Bitcoin and cryptocurrencies in general, the more amazed I am that the population of participants and supporters has been growing.

In recent posts (“The Digital Currency Charade” and “The Future of Cryptocurrencies”), I’ve already expressed my distain for the fact that the most understandable use of cryptocurrencies is for criminal activity — a conclusion that was recently underscored with the allegation that the Colonial Pipeline paid a $5 million ransom using Bitcoin. Clearly, that usage hasn’t dissuaded speculators from sticking in their oars.

Concerns about criminal activity seem to be over-ridden by cryptocurrency supporters who see speculation in these instruments as a key to riches, but the less self-serving rationale for these products is the role they allegedly play in democratizing transactions by empowering the millions of people who lack access to a banking infrastructure. The perplexing issue here is that acquiring cryptocurrency requires reliance of the banking infrastructure that cryptocurrency promoters are decrying. It’s pretty tough to buy cryptocurrencies without some traditional means of moving money.

From what I gather, the most frequent justification that serves as the rationale that some would have you believe trumps the fact that cryptocurrencies abet criminal activity is the idea of creating a “peer-to-peer” (P2P) ability to engage in commerce. P2P means that willing counterparties can transact business without the involvement (cost) of an intermediary. For these people, besides the willingness to ignore the inherent transaction charges when cryptocurrencies are exchanged, somehow, the idea of no governmental oversight, no consumer protection, and limited (or no?) capacity to appeal to judicial intervention are seen as pluses. From whom do these people expect to seek redress if something goes wrong?

The premise underlying all cryptocurrencies is that the community of users themselves provide the safeguards assuring that nothing will go wrong. And people accept this premise! To be candid, my research on this topic is limited, and I don’t hold myself out as an authority; but from what I understand, blockchain technology underlies all the various cryptocurrencies that are trading today; and if the Bitcoin model applies universally to all of the 5,000-plus cryptocurrency brands out there, “miners” play a critical function of validating “legitimate” transactions and adding them to the blockchain.

I worry about how we can be sure that miners won’t collude to “legitimize” their own illegitimate transactions. I don’t pretend to understand the mechanics of the safeguards that are supposed to be in place to protect against this possibility; but it’s an existential threat that shouldn’t be dismissed out of hand. The fact that we haven’t seen a material breach so far may be encouraging, but it’s not definitive. Incentives for hacking are enormous; and efforts to subvert these systems should be expected to be a staple in these marketplaces.

Of more immediate concern… As I understand it, the mining process is one that is expensive and highly energy intensive. Besides coming up with the correct key to the blockchain, the miner has to be fast. Miners not only have to get the right answer to an algorithmic problem; but in order to be paid, they have to get there first. In that instance, they’re compensated in the cryptocurrency of the transaction. Bitcoin has a protocol that reduces the payout to miners every four years; and ultimately, payments to Bitcoin miners will be phased out completely by 2140. (I don’t have a clue as to the rules relating to miners of other cryptocurrencies, nor do I care to waste my time learning about them.)

For the life of me, I can’t figure out how the seemingly vital function of miners will be carried out if they’re no longer incentivized to perform their function. But let’s not worry about details. By 2140, many of the current promoters of cryptocurrencies will be dead or retired. I also wonder what will happen to miners before then, if (when) the price of Bitcoin craters. Right now, successful miners may be making a living, but will they continue to do so irrespective of the value of Bitcoin? Should we have no concern if the population of cryptocurrency miners dwindles?

If I understand one economic principle, it’s that willing mining operations will exit the market as the incentives for this activity decline. But again, who cares about the long-term prospects of these markets. The time to get in is now! You’ll have plenty of time to get out before the mining activity grinds to a halt. Nothing to worry about at this point. You’ll be fine up until we get closer to 2140.

Cryptocurrencies are built on foundations of sand. It’s astonishing how many people are ignoring that simple fact. And it’s even more disheartening that seemingly respectable people and institutions are furthering the development of this sham.

Kawaller holds a Ph.D. in economics from Purdue University.