Bitcoin falls victim to its own success

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By:
Peter Lee
Published on:

As investors seek to allocate to cryptocurrency in bigger size, delays in processing blocks, limits on file sizes and increasing electricity consumption expose disagreements among those behind it and lead to high volatility.

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Bitcoin: there are concerns about its environmental impact

Things are moving fast in the cryptocurrency world.

One week ago, the price of bitcoin hit an all-time high of $7,459. It has been a volatile ride, with plenty of dips along the way, but the 12-month performance has been extraordinary. In mid-November 2016, you could have bought a single bitcoin for $742.

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Plenty of financial commentators have cried speculative bubble, none louder than Jamie Dimon, chief executive of JPMorgan, who told the Delivering Alpha conference in September: “If you’re in Venezuela or Ecuador or North Korea, you’re probably better off using bitcoin than their currency. But that can’t possibly happen in the United States, unless you’re speculating. That’s not a reason to say something has value: that other people are going to speculate.”

Dimon confirms: “That’s tulips.”

In mid-November, it looked like investors might finally be taking notice of him. The world’s leading cryptocurrency fell sharply, hitting $5,618 on Sunday, 25% off its high just days earlier, before then lurching back up again to $6,495 on Tuesday.

Various explanations have been offered as to the reasons behind the latest falls. Dimon had suggested that world governments will close cryptocurrency down.

With Chinese authorities cracking down on cryptocurrency exchanges that they might have blamed for enabling capital flight, it did fall back in September, from $4,950 at the start of the month to $3,227 two weeks later – so a 35% fall – before resuming its upward march.

Seeds of destruction

This time analysts see something more at work than the disproval of big-name bankers or efforts of national governments to curb bitcoin’s use. The argument is that the very success of bitcoin carries the seeds of its own destruction, that the need to process high volumes of speculative turnover is exposing flaws in the underlying open blockchain technology and disagreements among the visionaries and drivers of bitcoin.

In August, bitcoin was subject to a hard fork, leading to the creation of Bitcoin Cash amid efforts to increase to 8MB the block sizes being processed on the bitcoin blockchain to meet the needs of large players investing in bitcoin as an asset, rather than small users treating it as a currency of exchange in small units.

The market capitalization of the new Bitcoin Cash grew quickly, surpassing some of the nearest competitors to bitcoin such as Ripple and Litecoin, and approaching that of ether, the currency of the Ethereum network, the second largest cryptocurrency.

However, a further upgrade to bitcoin, scheduled for mid-November, was cancelled.

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Daniele Bianchi,
Warwick Business
School

Daniele Bianchi, an assistant professor of finance at Warwick Business School researching cryptocurrencies, says that the large drop in bitcoin prices is probably due to the competition of Bitcoin Cash.

“Perhaps frustrated by the cancelled technology update of the original bitcoin blockchain, which was announced recently, an increasing number of users are switching to Bitcoin Cash, which allows for bigger block sizing, giving ample capacity for everybody's transactions, as opposed to bitcoin's cap at 1MB blocks.

“Indeed, one of the main problems with bitcoin is that it does not scale up properly as more and more users adopt it. This makes transactions slower and slower as the block size is fixed. In addition, the segregated witness – ie SegWit2x – technology recently introduced by bitcoin scientists raised questions about the progressive centralization of bitcoins mining towards big servers, something which is fundamentally against the original proposition by Satoshi Nakamoto."

Bianchi points out that Bitcoin Cash addressed this issue by increasing the block size to 8MB to accelerate the verification process, with an adjustable level of difficulty to ensure the chain’s survival and transaction verification speed, regardless of the number of miners supporting it.

However, Bianchi says that the security of the Bitcoin Cash blockchain is still unclear.

“The internal fighting between bitcoin to Bitcoin Cash is probably here to stay for few weeks and months,” he adds. “The situation is very fluid, and market valuations are both constantly calibrating and volatile, especially given supply is limited and everything is mostly driven by aggregate demand.”

Environmental impact

These concerns rise even as worries grow about the environmental impact of processing bitcoin blocks or mining them, an activity that requires miners to demonstrate proof of work in computer power consumed to verify algorithms and for which miners, often operating large stocks of computers in remote locations – many in China – are rewarded in bitcoins, which have soared in value.

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Teunis Brosens, ING

Teunis Brosens, senior eurozone economist at ING and a former central banker, analysed this in a recent paper, suggesting that the hidden cost of bitcoin is the vast amount of electricity being consumed by these computers. 

Brosens points out that mining a single bitcoin transaction consumes 260kWh. That’s enough to run a single US household for nine days. Digiconomist suggests that bitcoin processing is now responsible for about 0.13% of world electricity consumption. If the currency were a country, it is now using power at roughly the rate of the Slovak Republic or Ireland.

As mining can provide a solid stream of revenue, people are willing to run power-hungry machines to get a piece of it.

Brosens says: “At current bitcoin prices, the block reward clearly and vastly outweighs electricity costs. Mining is a no-brainer for individual miners, but the benefit to society at large is much less obvious.”

Investors will probably remain more concerned about whether recent volatility of bitcoin’s value raises questions about its sustainability.

Going back to first principles, one of the key attractions of cryptocurrency was supposed to be the ability to transfer value, including as payment for goods and services, at low cost in close to real time.

Dollar backed

This week, Coinfix launched on the blockchain of Chinese developer Achain yet another digital asset, known as USC. This will tokenize currency that users have deposited in reserve accounts at Coinfix. Users will be able to transmit payment in USC anywhere round the world within about 30 seconds at very low cost. 

Kevin Yu, founder of Coinfix, has declared an ambition to use blockchain technology to ease the flow of investment in valuable assets such as commodities, including oil and precious metals, but the USC token is not intended as a speculative investment. One USC will represent $1 and users must have deposited US dollars at Coinfix before their USC tokens go on the blockchain. USC will remain pegged one-to-one to the value of the dollar.

It’s a simple idea to put fiat currency on the blockchain.