Bitcoin revisited: beware the bubble

I’ve written about Bitcoin before, warning that I was worried about volatility and botnets.

Bitcoin has been on my mind again, lately, due to a big bubble spurred in part by the Cyprus financial crisis, worries that Linden Dollars might see increased regulation, and a Kaspersky Labs report about botnets being used for Bitcoin mining.

A botnet is what you get when a hacker hijacks a bunch of innocent but badly secured computers and and makes them do his bidding. They’re typically used to send out spam or click on ads but are now also being used to create new Bitcoins. According to reports, a single botnet can make up to $2.7 million a year by cranking out Bitcoins.

The volatility in particular is problematic for grids considering accepting Bitcoin either as payment for land and virtual currency, or as a replacement virtual currency for in-world transactions.

The value of a single Bitcoin has gone from $30 in 2011, down to $3, to over $170 today.

Keep in mind that Bitcoins have no underlying value. Unlike a stock price, or a traditional commodity like gold, or a fiat currency like the dollar or Euro, if prices start to drop there is no minimum landing value. Stock prices, by comparison, are based on the underlying value of the company and its assets. Commodities like gold have value in jewelry making and manufacturing. Fiat currencies have a base value in that they can be used, at the very least, to pay taxes in their countries of origin.

Even traditional, corporate-backed virtual currencies like Linden Dollars or iTunes gift cards have a base value in that they can be used to purchase land from Linden Lab or music from iTunes at fixed prices — at least, as long as those companies exist and honor those currencies.

Volatility risks

Bitcoins do allow users to avoid the risks associated with volatile national currencies.

For example, over the past ten years, a single Euro has gone from US $1.13 to a high of US $1.58 and back down to the current US $1.30.

Top line is Bitcoin prices. Bottom graph is Euro prices, both in US dollars. (Data sources: Google Finance)
Top chart is Bitcoin prices, ranging from $0 to $175. Bottom graph is Euro prices for the same time period, ranging from $1.20 to $1.60 , both in US dollars. (Data sources:, Google Finance)

That’s not particularly volatile when you compare it to Bitcoin, though. In fact, most national currencies, these days, are stable compared to Bitcoin, even considering the recent financial crisis — the whole country would have to go into default in order for its currency to collapse. It happens, and gets a lot of attention when it does, but you usually get a lot of warning that a country is about to go down the tubes.

You’re not likely to get any warning when the Bitcoin bubble bursts, so I don’t recommend that anyone keep more money in this currency than they can afford to lose.

But let’s say, for argument’s sake, that Bitcoin never collapses, and the price just keeps going up.

Every business owner would need to reprice their products constantly to keep up with the exchange rate. Today, a single Bitcoin can get me three months of hosting — tomorrow, that could be five.

And for small, in-world transactions — I can’t even begin to imagine how you would price those in Bitcoin.

So that’s one problem of pricing in Bitcoin, just keeping the price tags up-to-date.

Then you’ve got the problem of rapid inflation or deflation. Say Bitcoin prices are going up. It’s to your customers benefit to wait a few days before buying anything, because then they’d be able to get more for their money.

It’s kind of the way computer prices are dropping every year, except that here, it’s every day.

But say your customers bite the bullet, buy your product and service — and a week later, it costs half of what they paid. Will you be a good guy and offer them a refund?

The flip side is if the currency starts going down, and you wind up having to keep raising your prices. Customers hate seeing prices go up and if they see this happening often, they will pay for more service up front, so that they lock in low prices — which means you’ll be losing money on all subsequent months. Plus, there’s always going to be a delay between the time you send out the bill, the time they pay the bill, and the time you convert the Bitcoin into dollars or Euros. The longer that delay, the more money you’ll be losing, so you’ll need to factor that into pricing as well.

Criminal activity

Botnets aside, there are several ways that criminals are active with Bitcoin, all of which could cause harm to legitimate business users.

First, criminals can collude to sell Bitcoins to one another — or a single criminal with multiple accounts can sell Bitcoins to themselves — driving up the prices.

When this happens in regular stock markets, regulators get involved and people go to jail. Remember Martha Stewart?

With Bitcoin, there is no regulatory authority. There is nobody to watch out for that kind of behavior, nobody to catch the crooks, no laws to prosecute them under. Plus, given Bitcoin’s built-in anonymity, it would be practically impossible to prove that market manipulation actually took place.

Second, criminals can attack Bitcoin exchanges, cause prices to drop, buy up Bitcoin on the cheap, and sell them when prices go up again.

In fact, that’s exactly what’s been happening with Mt. Gox, the largest Bitcoin trading platform.

“Believe it or not, there is pretty much nothing that can be done,” Mt. Gox said in a press release issued late last week.

Third, criminals can break into the exchanges themselves, or into private computers, and steal the Bitcoins directly. It’s like stealing cash — except there are no serial numbers to be traced, and no exploding dye packs, and no jail sentences if you get caught.

In addition, unlike Bitcoin deposits, most bank accounts in most countries are insured by the government or by government-backed organizations of some sort. When a bank in the U.S. fails, or is robbed, the Federal Deposit Insurance Corporation steps in and makes sure that depositors don’t lose their money — typically up to $100,000 per account is covered.

Maria Korolov