What is... | January 20, 2014

What is bitcoin?

In January 2014, Brit singer Lily Allen posted she was an “idiot” for not accepting payment in bitcoin for a gig five years ago. Should the singer have been so upset?

A “bit” of background
Bitcoin is a digital currency that was launched in 2009, by Satoshi Nakamoto (a name that is widely presumed to be made up to protect the creator’s anonymity).
In 2013, the value of bitcoin increased tenfold, wrote the Chicago Federal Reserve in its December 2013 Letter, with this rise helping propel it into mainstream awareness.
Bitcoin is also in the headlines for the unusual manner in which it comes into circulation – being “mined” by powerful computers that solve increasingly difficult equations – and because increasing numbers of businesses are accepting the “peer-to-peer” digital currency as payment.
Bitcoin was added to Oxford Dictionaries Online in August 2013 and by January 2014 the video What is Bitcoin? had almost 5 million views on YouTube.
It is one of several digital currencies that have existed, such as ripple and e-gold (since shut down).

More than a “bit” volatile
Bitcoin’s own website lays out the possibility that bitcoins could become worthless – also citing examples of failed traditional currencies, such as the Zimbabwean dollar.
Research out of Belgium – Virtual Currency, Tangible Return – highlights the volatility of bitcoin and chronicles two major speculative crises in its short history. It said the first started in June 2011 and ended in a crash after the first major bitcoin theft in July 2011, and the second started in March 2013 “just after the US published legislative guidance on virtual currencies, and ended in April 2013 when bitcoin lost nearly half of its value in a couple of hours”.
Bitcoin’s volatility may also be linked to some of the types of transactions for which it has been used – most notably on the online drugs marketplace Silk Road. The Guardian writes, for example, that bitcoin’s price plummeted after Silk Road’s alleged founder was arrested in October 2013.

A “bit” different to “money”?
The extreme volatility in its price is one reason why New York University Stern School of Business’s David Yermack argued in research note Is Bitcoin a Real Currency? that bitcoin does not adhere to the typical definition of money.
Money is typically defined by economists as having three characteristics: it functions as a medium of exchange, a unit of account, and a store of value.
But, Yermack wrote, bitcoin was too volatile to meet the second two characteristics: “For bitcoin to become more than a curiosity and establish itself as a bona fide currency, its daily value will need to become more stable so that it can reliably serve as a store of value and as a unit of account.”
He wrote bitcoin appears to behave more like a speculative investment than like a currency and notes that there is no mechanism to short-sell (to bet on a weakening of the currency).
Financial Times columnist Tim Harford blogs “bitcoin is currently used for speculation not transactions” as there is a tendency to want to own bitcoins “but few spend them”. He suggests that if bitcoin is to be truly successful, it would be down to the mainstream seeing it as useful.
In theory, anyone can create a currency (think of cigarettes in prison or Rai stones on the Pacific Island of Yap) but wide acceptance seems to be a condition of success.

Lily Allen’s a “bit” disappointed
That Tweet from Lily Allen said: “About 5 years ago someone asked me to stream a gig live on second life for hundreds of thousNds of bitcoins, "as if" I said. #idiot #idiot”.
There is perhaps an element of hindsight bias in her reaction – that tendency to feel after the fact that we always knew market shifts were coming or a certain party would win power (when, in fact, the ability to predict it was extremely low or impossible).
eZonomics contributor and economist Chris Dillow writes on his personal blog Stumbling and Mumbling about how the Tweet relates to tail risk (the small chance of extreme outcomes) and opportunity cost (how every choice closes off some opportunities). Dillow suggests the rule the singer may have applied (reject offers from those appearing to be time wasters) was rational, “even though it was wrong in this one instance”.

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