Tyler Cowen recently linked to a Wikipedia article for BitCoin; a decentralized, peer-to-peer (crypto-)currency. I originally found the idea quite confusing (but I’m not a master of p2p technology), but Leigh Caldwell recently brought it up and after doing a little research, and joining the network myself, I’ll offer some comments.

BitCoin is a money that uses a p2p protocol similar to HashCash to resolve transactions. Apparently there is planned to be a finite amount of this currency generated (at BC 21,000,000). Currency is “earned” by using your CPU clocks to resolve transactions, which ensures that each BitCoin unit only gets spent for a single transaction once…or, of course, buy selling goods and services.

In effect, what you are doing is hiring your computer to work for you in the former scenario. You also happen to be your own banker, and your own transaction clearing house. I’m not sure exactly how much you “earn” for each transaction you resolve, but I haven’t appreciated a sizable amount of currency as of yet. The downside to this is that at some given exchange rate, it might not be profitable to run your computer 24/7 to generate BC…but of course if you leave your computer on all the time anyway (as I do), then the opportunity cost is zero.

(Note: Second Life has this kind of structure too, where you can earn small amounts from the game itself, and in Entropia: Universe you can earn money by “sweating” things.)

In any case, this is literally a “wild-west” of money, and there are infinite sorts of possibilities.

Currently, BC is in an “inflationary” state, where currency is being issued. Apparently there are around BC 2-5 million units in circulation. However, you cannot earn interest — BUT, there is nothing stopping you from creating an amortization schedule by purchasing BitCoin on an exchange, thereby creating an interest-bearing account.

There is a marketplace at the site in which I’ve found ideas for a lottery, an operational casino, quite a few ads for electronics, and apparently some guy was able to get a Papa John’s pizza.

However, these types of transactions don’t intrigue me as much as the possibility for entirely new financal institutions to arise, due to the open-ended nature of the project. No “banks” have arisen, but it seems possible that they could. There is some sort of bond market that is denominated in BitCoin, but I can’t find the link right now. There are both nominal and real exchange rates, which means it is definitely possible that a more robust “forex” market could arise. Unfortunately without robust, forward-looking markets, it is nearly impossible to tell how the knowledge that the currency will be fixed at some point in the future affects current variables…and I don’t even think that is a good idea, although BitCoin does resolve to the eighth decimal place, so there is ample room for deflation…

BitCoin loans backed by diversified assets is another realm to explore — although the founders seem to be against fractional-reserve banking.

Okay, now for the sobering part. If you are a fan of alternative currency systems, the turn-of-the-century looked like a golden age for your aspirations. The internet seemed to offer unlimited promise…but of course, that was all shattered by reality. Peter Thiel started PayPal as an alternative exchange system, only to become a simple payment clearing house due to the harsh realities of regulation. RevolutionMoney had similar high ambitions. e-Gold became a favorite among money launderers, and was subsequently shut down, and BitCoin runs the same risk. Exchanges are currently a legal gray area, but you can probably assume they are illegal, and any meaningful sort of banking is out the door…and should you find yourself incredibly “BitWealthy”, you can bet that when you make your first large transaction, you’ll get a (not so) friendly knock at the door from the IRS.

Of course, this suspicion is inextricably linked to the fact that a popular “feature” of BitCoin is the perceived privacy…and also the talks of people in China using this currency to exchange for dollars using proxies, circumventing the state.

In his book, Alan Greenspan said he “foresees private currency markets in the 21st century”. This may be a step in the that direction, but the state is a terrible beast to overcome.

And finally, three questions:

It seems the only risk to hoarding is that the currency might not even exist by the time the “deflationary period” sets in. This actively discourages me from selling anything of marginal value (to me)…and discourages me from investing. This limits both my income, and the types of transactions that get made to odd junk and novelties (of course one man’s trash…) Are the benefits in terms of the reduction in transaction costs sufficient to be able to overcome these “features”?

Currently, there is no eBay-style reputation system. This obviously poses an incredible problem…but transactions in BC are non-recourse (as there is no clearing house)…so you have to rely on a mutual agreement on returns. Does this justify the lack of transaction costs in the long run?

There is no postal service that will deliver goods for BC. This necessarily pushes you into the “dollar economy” anyway. I wonder at what point BitCoins become useful enough that something like that could arise? Could it arise in a deflationary environment?

Addendum: Last thought, I swear! BitCoins seem insufficiently immobile. As it stands, I need to get a 34 character alphanumeric address unique to each user to be able to transfer credits. I also need to be at my one computer to be able to access my account. This is no doubt due to the emphasis on privacy…but it seems like a very large drawback to the use of the currency. I wonder how hard it would be to adapt mobile technology to this format.