A Tulip By Any Other Name

Mt. Gox has fallen. Approximately $500 m USD worth of bitcoins “disappeared” overnight. What is a bitcoin? It is a cryptocurrency with a floating price and a fixed supply. Bitcoins can be exchanged for free. No government, central bank, or financial institutions govern, regulate, or take fees from bitcoin transactions.  There are many other cryptocurrencies including litecoins, dogecoins, namecoins, peercoins, and the list goes on and on.

Bitcoin Stack
Bitcoin Stack

Trouble in Paradise

Mt. Gox got its start as an online card trading platform for the game Magic: The Gathering Online. The appeal of cryptocurrencies is the freedom from the perceived control and corruption of the Central Banking system. Mt. Gox provided users with the ability to exchange cash in various foreign currencies for bitcoins. At its height, Mt. Gox held as much as $500 m USD worth of the cryptocurrency and then things fell apart. The exchange suddenly stopped honoring transactions. Days later, the CEO apologized at a press conference where he announced that Mt. Gox was filing for bankruptcy. These actions left Mt. Gox customers broke and befuddled.

What is Money?

This post is not just about Mt. Gox or dogging bitcoin. The fall of one of the largest bitocin exchanges begs the question: “Why are cryptocurrencies any better than money?”. It helps to define what money and currency are. Money is a medium of exchange, a store of value, and a unit of account. Currency refers to a specific type of money. There are and have been many different currencies.

Government-backed currencies like the US dollar, Japanese Yen, or the Euro are backed by the full faith and credit of the respective government. Banks that are based or transact in each country have to follow a set up established rules and regulations. Central banks study trends in the economy and adjust the money supply to maximize employment and control inflation. Inflation occurs when the money supply exceeds the demand for money. Deflation occurs when the demand outpaces the money supply. I did mention that bitcoins have a fixed supply of the currency making them deflationary. However, the price does fluctuate.

The freedom derived from cryptocurrencies not being backed by governments is also its greatest flaw. The US Federal Deposit Insurance Corporation (FDIC) insures customers’ money in banks up to $250,000 in the event the bank fails or files for bankruptcy. Mt. Gox customers had no one to turn to. Rogue exchanges also don’t have to follow best practices for security – leaving them more open to attacks from hackers.

Tulips, Stamps, and Bitcoins

We’ve heard this story before with tulips, stamps, and other bubbles. Tulipmania. The value of tulips skyrocketed to astronomical heights before crashing. Furthermore, Charles Ponzi thought he found a legitimate way to make money by trading International Reply Coupons (IRC) for postage stamps. For a moment, it seems like there was a business opportunity there. However, it just didn’t scale. That didn’t stop Ponzi (or Madoff) from engaging in his scheme.

A Tulip

It only requires a few believers in the bulb, stamp, or cause. Convince a few suckers to invest. Pay off the next set of suckers with the last suckers’ money. Wash, rinse, repeat. In this case, cryptocurrencies address the real problem of corruption in politics and banking. It is extremely important to attain freedom from financial corruption. Unfortunately, without adequate standards and regulations, cryptocurrencies are just tulips by another name.