On the 1st of June, an article appeared on the website Gawker with the intriguing headline ‘The Underground Website Where You Can Buy Any Drug Imaginable’. It is an interesting article, and yes, you still can buy a whole host of illegal products from the site . However, the article’s significance to the world lay not in its exposition of this shady eBay knockoff, but in its explanation of one of the underlying anonymising technologies being employed: Bitcoins.

What are Bitcoins? An explanation is offered in this video by its proponents:

In other words, Bitcoins are a digital currency, virtual tokens. They were dreamt up in December 2009 by a cryptographer under the probable pseudonym ‘Satoshi Nakamoto’ who has now vanished from the scene. Put simply, their value – like the U.S Dollar following its exit from the gold standard – is not ‘backed up’ by any tangible assets, but is instead derived from ‘faith’. By faith, I mean a collective belief that Bitcoins possess any value; a faith that someone, somewhere will trade your Bitcoins for something. Again simplifying, a similar belief gives a ten pound note its value – if all shopkeepers refused to accept your note it would be little more than paper. By holding your savings in pounds, one is placing faith in Britain’s multibillion economy.

Bitcoins crucially differ from a Ten pound note though, in that whilst in theory the British government retains some control over the pound sterling, Bitcoins have no central issuing authority. They are instead controlled by a decentralized peer-to-peer network. The role of gold as a holder of value is drawn from its scarcity; to achieve this, as the video mentions, the total number of Bitcoins is programmed to approach a finite 21 million by 2033. Nearly 7 million have been ‘created’ so far through the process of Bitmining whereby computers solve complex equations in return for Bitcoins. The difficulty of their creation (the complexness of the equation requiring solving) increases over time depending on the total computing power of the network so that their creation follows a the predetermined curve.

By virtue of this decentralization, Bitcoins possess several benefits over traditional forms of currency. Being in theory anonymous and under no governing body’s control, they appeal to libertarian sensibilities in that they cannot be taxed or traced. Without the need for ‘middle-men’ – think Paypal, Banks, Credit Card companies – in their exchange, transaction costs are kept to a minimum. Anyone can posses as many Bitcoin wallets as they like regardless of credit history or criminal convictions. Whereas Paypal has a long history of shutting down undesirable accounts your Bitcoin account cannot be frozen by any authority. A Bitcoin software developer, Amir Taaki, sees Bitcoins as the solution to how ‘people in the third world are at the mercy of corrupt governments and banks’.

In practice, Bitcoins have had far from a simple journey since their inception. From their creation in 2009 to the publication of The Gawker article in June their existence was little known outside Geek circles. As such, there was less ‘faith’ in the currency, meaning it held less value – in fact, as this chart shows:

it was worth next to nothing until February of this year, and very little until the start of media interest in May. The June Gawker article was a tipping point; the article was picked up by the mass media and meant Bitcoins finally entered the mainstream consciousness, and hence their price rocketed as demand surged. One could finally buy something with Bitcoins – class A drugs, guns, pirated software – as opposed to the Alpaca socks previously on offer, and so people wanted them. The sudden interest began a bubble, the exchange value of a bitcoin rising to over $30 – a 48,300% increase on their value the previous October.

The Gawker journalist tweeted his regret at not buying more Bitcoins before he published the article.

This rise became a bubble fed by increasing media coverage, and their rapid hike in value led to unforeseen consequences: hackers began to use Botnets to mine Bitcoins; the US Senator Schumer attacked the currency as a form of money laundering; 25,000 Bitcoins were stolen from a single account, and finally, the main US dollar to Bitcoin exchange - ‘Mt.Gox’ - was hacked. This security breach led to faith in the currency falling quickly, meaning of course value did too – to roughly $10. To many, this did not come as a surprise, the rapid rise in value of Bitcoins being unmatched by adequate security developments. Mt.Gox, which in the last 30 days has processed transactions worth 14 million US dollars, retains its name from its previous use as an amateur site for fantasy card-game trading – it is the Magic the gathering online exchange. The geek’s currency had left the safety of its bedroom, entered the wider world and found it a tough place. In a volatile couple of weeks the currency’s value had risen 30-fold, before halving in just two days.

The speculative bubble revealed drawbacks in the very nature of the currency. Because it is a currency of a fixed circulation set by the strict curve governing its disbursement, as its popularity has grown it has thus far been a deflationary currency and if popular will always be so. This means a Bitcoin, unlike an inflationary currency such as the pound, has on average due to increasing demand held more purchasing power as time has gone on. This undermines its purpose as a medium of trade: if the Bitcoin in your virtual wallet will be worth more tomorrow, why ever actually spend it?

This in-built deflation encourages a lack of fluidity within the currency that is further problematic as it means the value of the whole currency is determined by a relatively small amount of trade. This website illustrates the problem. At the time of writing, there are nearly 7 million Bitcoins, worth around $12 each, valuing the entire currency at nearly $84 million. This value of $84 million however, is set by at most under $500,000 worth of trading on the biggest exchange a day. The exchange value against the pound is determined by a total trade volume of less than £5000 a day (on the main exchange )

Such a small volume of trade increases the volatility of the value of Bitcoins and leaves it open to easy manipulation by large trades. Indeed, the Mt.Gox hacker sold 100,000 stolen Bitcoins at incredibly cheap rates on Mt. Gox, plunging the market from around $17.50 USD per Bitcoin to just $0.01 in a day.

With the exception of the deflationary issue however, these problems are short term rather than long term. Security will improve, as might liquidity (how freely the currency circulates). It is the long term problems Bitcoins face that warn against investing money (or computational power through Bitmining) in the currency. The first is government opposition: the US government understandably opposes the creation of any currency that cannot be taxed or controlled. A previous internet currency, the Liberty Dollar was destroyed by an FBI and Secret Service raid. If Bitcoin grows larger it will face the same threat. Whilst its peer to peer nature makes closure as difficult as the very much alive torrent network, there are other means of attack. A few days ago a Bitcoin user was denied entry to the US as he intended to use Bitcoins to fund his trip.

Unfortunately though, it is the difficult problem of initial distribution that means Bitcoins will never be a viable currency. Early adopters who began mining when the ‘difficulty’ – the computational power needed to generate a new bitcoin – was low made large amounts of Bitcoins extremely quickly. A quarter of the total number of Bitcoins which will ever be produced were shared amongst the relatively small number of people who knew about the project. When I, and the rest of the world, stumbled upon Bitcoin in June, the average user already had thousands of coins. By 2013 half of the total supply will have been generated, and by 2017, 3/4 will have been generated, heavily penalising those who came to the table late. This webpage , which one can assume was created by early adopters and which does a good job at arguing against other criticisms levelled at the currency, makes Bitcoins sound like a Pyramid scheme in its attempt to justify the distribution method:

Early adopters are rewarded for taking the higher risk with their time and money.

In more pragmatic terms, "fairness" is an arbitrary concept that is improbable to be agreed upon by a large population. Establishing "fairness" is no goal of Bitcoin, as this would be impossible.

The vast majority of the 21 million Bitcoins still have not been distributed. By starting to mine or acquire bitcoins today, you too can become an early adopter.

Which seems to be saying: ‘Yes, this is unfair. But not on you if you join now rather than later and so also stand at the top of the pyramid’. This sentiment is not uncommon; the way in which the currency rewards its early adopters has aided its growth as those with vested interests have unsurprisingly been quick to comment on articles and blog posts questioning the currency.

The attractive libertarian aspects of the currency simultaneously threaten its stability; whether the positives will outweigh the negatives depends perhaps to an extent on your view of mankind in relation to the age-old Hobbes vs. Rousseau debate. For the lack of a Paypal-style controlling authority over the transactions means there is a corresponding lack of protection too – man is, in a way, left to his own devices. Someone had 25,000BTC stolen and can do little except watch the money being moved about publicly on the network yet anonymously. Indeed, the anonymity afforded by Bitcoins allows the worst of human nature, and means a surprisingly large number of businesses using Bitcoins are at best amateurish and at worst totally fraudulent yet, unlike with scammers using traditional bank accounts, very little can be done. It is safe to assume the police would not be sympathetic to any complaints.

Currencies have two purposes: holding value and exchange. I like the idea of Bitcoins, and it is sad that I see them having very limited success on both fronts. Their deflationary nature which restricts liquidity combined with the lack of a meaningful economy backing the currency’s valuation means their price is simply too volatile to be used as a medium of exchange – in the week I’ve been writing this article their value fell from $11 to $7 before rising to $10. The value of any currency is tied to its ability as a medium of exchange; as such Bitcoins ability to retain their current value in the long term is questionable.

Returning to the Silk Road website which began the Bitcoin bubble illustrates this. The rapidly changing dollar conversion rate means the site now allows sellers to receive a rate fixed at the time of purchase, the difference if a change occurs being paid (or gained) from the 6% fee charged by the website. In this way, the website is playing the role of an intermediary in order to safeguard transactions due to Bitcoins shortcomings – it is acting not dissimilarly to a central authority guaranteeing the currency, albeit one without moral values or qualms for what is being sold.

So where are Bitcoins headed ultimately? They are a solution to the problem of ‘how can I give you a fiver online?’ or ‘how do I buy goods anonymously?’ Indeed, it is interesting porn companies have not yet picked up on this potential use.

But as for a wider purpose, Bitcoins are unsustainable. The price will fall slowly as early adopters look to cash in whilst being mindful of the need to do so slowly. There will always be demand (if only from those seeking to buy drugs online) so the price will never reach absolute zero. By all means use Bitcoins to have LSD delivered to your front door. But don’t hold onto them; make sure there is always someone next who wants to take them off you...