Bitcoin Is A Remarkable Innovation, Here’s Why It Will Fail

an economist, business advisor and Founder of Market Platform Dynamics
3:15 PM EDT October 16th, 2013

Bitcoin is absolutely brilliant. 
The insight behind this alternative currency is counterintuitive. Most everyone in payments sees cash as an inferior species. Cash is technologically backward and dirty to boot. It’s only bad habits that die hard that perpetuate anyone ever paying with paper. But Satoshi Nakamoto—the pseudonym for the anonymous inventor of bitcoin—recognized that people use cash because it has critical features that other payment methods lack.

Like being untraceable, for starters.

People like cash because it is anonymous. Once cash exchanges hands there is no identifying information concerning the payor. People also like cash because it’s is irrevocable. Once someone pays you with cash, they can’t get it back. Irrevocability also makes cash cheap. No one needs to maintain an infrastructure to deal with fraud and chargebacks. Counterfeiting is a relatively manageable problem. If only cash wasn’t so bulky and a pain to carry and transport.

Nakamoto’s innovation was to deconstruct cash, then rebuild a new currency that had all the great features of cash, but was also digital, so it could be beamed around the world and stored electronically. This inventor stated the problem clearly in the white paper that laid the foundations of bitcoin. “These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communication channel without a trusted party.”

Bitcoin has succeeded where many other virtual currencies have failed because it was designed to be as similar to cash as possible while still being digital. The genius behind bitcoin is the recognition that people use cash because, despite its age, it’s an amazingly good payment method. Other virtual currencies haven’t taken off because frankly no one needed them and only used them mainly in closed systems such as games where they were forced to. These virtual currency innovators committed a common sin in payments—giving people gee-whiz things that don’t solve a problem for them and actually aren’t even as good as what people are currently using (see almost all payments “innovations” but particularly NFC and many current mobile payments methods).

Bitcoin’s birth comes, however, at an unfortunate time for its founders, minters, exchange operators and investors. Governments have wised up to the benefits—for them at least—of easily traced electronic payments such as cards, giros and ACH. Traceable electronic payments make it hard for businesses and consumers to avoid taxes. All the government needs to do is compare reported income and expenditures with reports from the banks or other financial institutions that maintain those records in the ordinary course of their businesses. More importantly, traceable electronic payments also make it hard for people to engage in illegal activities—from selling hard drugs to supporting terrorism. For better or worse, law enforcement can match electronic payment records with the vast amount of other information they collect to find the bad guys.

To put this another way, governments have discovered that the payment method they own and operate as a monopoly—cash—aids and abets tax evasion, terrorism, drug cartels, and all sorts of other illegal and nasty activities. Not surprisingly they have increasingly passed laws and regulations that make it harder to use the cash. A number of countries have passed laws that prohibit merchants from accepting payment in cash over some limit. That is partly in response to the desire to increase tax revenues and to damp down the underground economy. Money transmission laws have become increasingly onerous as governments deal with money laundering and terrorism.

Governments will—and I think sooner rather than later—realize that bitcoin is to cash what crack is to marijuana – a more potent and addictive drug. Exactly because bitcoin has done such an exceptional job of replicating the critical features of cash—anonymity and irrevocability—it has become a much more potent method for engaging in tax evasion, various illegal activities and terrorism than cash ever was. Bitcoins have all those exceptional features of cash but can also be zapped instantaneously across the globe from criminal to criminal.

In fact, the “killer app” for the bitcoin payment platform has been dark web sites such as Silk Road that sell everything from drugs to weapons to murder-for hire. A heroin user in Peoria can order his fix from a drug lord in Bogota through a dark web intermediary—and pay for it with bitcoins—while maintaining (almost) perfect anonymity on both sides of the transaction. That’s an amazing development. Bitcoin was the final piece needed for vast global illegal eCommerce business.

Governments aren’t going to allow this to happen. Nor should they. While the libertarian streak in me makes me sympathetic to bitcoin’s objectives, the fact of the matter is that bitcoin, if it is allowed to continue and grow, will promote a massive global expansion of very bad stuff: from child pornography to hard drugs to terrorism to contract killings. We may be willing to wink and nod about people that shave their taxes by taking their pay in cash. But there’s no reason we should countenance an “innovation” that sharply reduces the transactions costs of engaging in activities that virtually all of us agree are bad if not horrible.

I think there are two realistic directions the bitcoin ecosystem could go in. First, it could just implode and disappear if governments decide that virtual currencies cause too much harm and are too hard to regulate. Long-term investments in bitcoin would then go up in smoke. Second, it could continue as a virtual currency that is only used on the dark web with exchanges that are run by people willing to break the laws. The value of bitcoin would decline to whatever the illegal sector could support; regular investors wouldn’t be able to get their value from bitcoin unless they cashed it in with someone who wanted to do bad things.

In theory, bitcoin could become a lawful virtual currency if the bitcoin community gave up anonymity and therefore incorporated the identities of bitcoin senders and receivers as part of the currency. But that would eliminate the cash-like feature that makes bitcoin attractive and vastly decrease the demand for bitcoin. That does not seem like a viable path forward.

The FBI’s bust of the founder of the Silk Road should be a wake up call to those who have bought into the bitcoin hype. That website is one of many popping up that are trying to become the criminal versions of Amazon. They depend on bitcoin—or other virtual currencies with the same features—to survive. It is very hard to see how governments that make it illegal for people to transport large sums of cash across borders are going to permit a vast global payment system that can easily circumvent anti-terrorism, money laundering and other laws that protect people.

While I praise the sheer ingenuity of bitcoin and its payments innovation, it should be buried.

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