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Bitcoin: the New Era of Wildcat Banking

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If you're a history buff, you might remember a period of American history called the "free banking era," or the "era of wildcat banking," that took place in the decades before the Civil War. During that period, state banks were allowed to issue their own currencies without any federal regulation. Many of those banks operated on the frontier of the American West, some of them in remote places inhabited only by "wildcats" (hence the name) and engaged in some loose accounting practices. Quite often these fly-by-night operations went out of business, either as a result of fraud, incompetence or bad market conditions. In any case, the result was the same: The bank's customers found themselves holding wads of worthless bills, since the FDIC wasn't around in those days to bail them out.

Well, folks, the era of wildcat banking has returned with a vengeance, only now it's taken on an electronic form. It's called Bitcoin. The past month has been hectic for Bitcoin investors as they've watched the Bitcoin economy erupt in chaos. It's either tragic or comic, depending on whether you actually own bitcoins.

Things started to go haywire on February 24, when Mt. Gox, the world's largest Bitcoin exchange went offline. Several days later, it filed for bankruptcy as the company claimed that it had lost more than $470 million worth of bitcoins -- including both company money and depositor accounts -- to theft by hackers (oops). Mt. Gox's young CEO, the doughy-faced Frenchman Mark Karpeles, held a press conference in Tokyo, where he meekly apologized for causing "inconvenience." Afterwards, he scurried off into hiding as angry customers protested outside the Mt. Gox office.

The Mt. Gox debacle only got worse on March 20, when the company announced that it had mysteriously found another hundred million or so in bitcoins that were apparently just sitting around in electronic storage. This discovery leads some to wonder whether Mt. Gox's losses resulted from actual hacking, internal fraud or sheer ineptitude. Regardless, the incident doesn't inspire a lot of confidence in Mt. Gox's management team.

And bad news just keeps rolling in from other regions of the Bitcoin world: a "Bitcoin bank" called FlexCoin, shut down on March 3 after hackers drained its reserves. A day later, the Bitcoin exchange Poloniex announced that it, too, had lost customer deposits after a hack attack.

Meanwhile, a new subplot developed in the Bitcoin drama when Newsweek published a story on March 6 claiming that it had found the true identity of Satoshi Nakamoto, the elusive inventor of Bitcoin who dropped out of sight in 2011. The debate about the accuracy of the Newsweek story rages on, but it's really distracting us from the main point: Is Bitcoin feasible as either a currency or an investment?

We've heard a lot about the possible benefits of Bitcoin. First, Bitcoin cuts out financial middlemen. Bitcoin purchases can be made directly between parties without the aid of banks, credit card companies, or wire services. Second, Bitcoin will supposedly free the world economy from the interference of meddling governments that manipulate currency for political ends. This last consideration has earned Bitcoin such a rabid following among Libertarians, Anarchists, Crypto-Anarchists, Cypherpunks, political dissidents, gold bugs and other malcontents distrustful of the world banking system.

Recent events, however, have shown that the entire concept of Bitcoin contains fatal flaws -- flaws that can't be resolved with mere tweaks in Bitcoin's software code. Here are a few to begin with:

1. Bitcoin faces massive security problems.
Since the Bitcoin currency network can function only through "peer-to-peer" software, it's vulnerable to hacking attacks. Hackers stole bitcoins from Mt. Gox by exploiting a Bitcoin loophole known as "transaction malleability." Apparently, the thief (or thieves) made it appear as though a transaction didn't go through, causing Mt. Gox's servers to keep resending Bitcoins automatically until its reserves were emptied. Mt. Gox experienced similar attacks in 2011, yet didn't take any measures to fix the problem. This is only one crack in Bitcoin's structure. Undoubtedly, hackers will search relentlessly for new ones.

2. Bitcoin's value is insanely volatile.
In the past year alone, Bitcoin's price has fluctuated wildly, more so than any modern currency. In March of 2013, it sold for roughly 47 U.S. dollars. By December 4, 2013 it had climbed to about $1,117, and then fell to $539 on December 18, 2013. Even if Bitcoin survives its current tribulations, this volatility makes it unsuitable as a currency. How can you count on Bitcoin as a long term store of value, when its price never seems to stabilize?

3. Bitcoin is backed by nothing but the goodwill of its users.
In the past, the U.S. dollar was backed by gold -- that is, each dollar was redeemable for a certain amount of gold. That system vanished decades ago, but the value of the dollar and other national currencies are still guaranteed by the laws of national governments. Bitcoin, on the other hand, is a fabricated currency, made of nothing but strings of software code floating through the ghostly ether of cyberspace.

4. Bitcoin currently has no insurance or government protections.
Bank deposits in the U.S. are insured by the FDIC, credit union holdings are guaranteed by the NCUSIF, and securities are protected from fraud by the SIPC. Bitcoin owners, on the other hand, have no legal protections. The unlucky customers of Mt. Gox have most likely lost all their money. Some have filed lawsuits, but this could take years of costly litigation to recover any damages, let alone the full amount of the losses. Litigation is not a guarantee of recouping your money.

And here's another problem: Bitcoin transactions, unlike credit card purchases, are irreversible. If you buy merchandise with bitcoins and the merchant fails to deliver, that money is now securely in his hands. There will be no third-party company to go to bat for you the way a credit card company might.

5. Bitcoin ownership is highly concentrated. Business Insider reports that "47 individuals own 28.9 percent of the approximately 12 million Bitcoins in existence so far." With wealth concentrated in such a small number of hands, the Bitcoin market becomes susceptible to manipulation through hoarding or pump-and-dump schemes. Moreover, the process of creating bitcoins -- or "mining" them, as Bitcoin aficionados say -- depends on the use of high-powered software to solve complex cryptographic puzzles too complex for human computation. Each time a puzzle is solved, more bitcoins enter the money supply, and become the property of those who "mined" them.

As time goes on, the puzzles become progressively more complicated, requiring more processing power to solve. That feature was built into the system by Bitcoin's anonymous creator (or creators) in order to limit the supply of bitcoins and guard against the inflation that plagues many currencies.

In the early days of Bitcoin, the cryptographic puzzles could be solved with ordinary personal computers, but the puzzles have become so complex that they require specialized computer "rigs" that gobble up large amounts of electricity. This evolving complexity has unleashed a computational game of one-upmanship as Bitcoin miners strive to outdo each other in mining capacity. Today, the cost of equipment and electricity has made Bitcoin mining too expensive for small-time investors, turning it into the prerogative of a wealthy clique. This aspect in Bitcoin's design only magnifies the problem of wealth concentration.

6. Bitcoin faces the danger of obsolescence.
Even as I write this, computer engineers are designing new and improved types of electronic currency: Ripple, Dogecoin, Namecoin, Litecoin, Peercoin, Quark and others yet to be revealed. Most likely, one of these will win out and supplant Bitcoin, just as VHS supplanted Betamax as the dominant VCR format in the 1980s. Bitcoin is too young to have gained a strong competitive advantage over its rivals. Its popularity depends on a fickle public.

In the face of those difficulties, the Bitcoin faithful still keep buying Bitcoin and praising its virtues. That leads me to believe that the real appeal of Bitcoin is more emotional than rational. A case in point: a group called Arisebitcoin set up billboards in the San Francisco Bay area that read: "The revolution has started... where do you stand?" Cool! Why be a mere currency speculator when you can be a revolutionary?

Everybody wants to get ahead of the curve, to ride the wave of the future, to jump on a trend before the rest of the world catches on. That's probably how early adopters of the Internet felt circa 1991. Yet the search for the Next Big Thing in finance sometimes causes us to let down our guard and make irrational decisions. That's what happened to the unlucky investors who stored their money with Mt. Gox. At least the old-time wildcat banks left their customers with some colorful paper banknotes for souvenirs. When Bitcoin disappears, they won't even get that much.