A Bitcoin Apocalypse: Possible Scenarios
A few months ago, Bitcoin was an obscure open source project. Since then, it has been featured on hundreds of blogs and prominent podcasts including Security Now and This Week in Start-Ups. CNN even did a piece on Bitcoin. There are now more than 12,500 members on Bitcoin’s forum and a Bitcoin community called We Use Coins has emerged. On April 12th, a Bitcoin was valued at $0.80. The exchange rate for a Bitcoin is now $8.61. Some believe there is a Bitcoin bubble and others believe that Bitcoin will become a stable currency over the course of time. Although there has been substantial interest in Bitcoin during the last few months, there are a number of scenarios that could result in a Bitcoin apocalypse in which the currency is devalued to near zero.
The U.S. government has a history of cracking down on alternative currencies. The Department of Justice came down on E-Gold for violating money laundering regulations. The Treasury Department accused the Liberty Dollar of illegally trying to compete with U.S. Dollars as a currency. The FBI and the Secret Service raided the offices of the Liberty Dollar, effectively shutting down the currency.
Governments worldwide would have a greater difficulty in cracking down on Bitcoin usage since it does not rely on a central issuing authority, but that does not mean Bitcoin would survive attempts to crackdown on the crypto-currency. Governments could prosecute those involved in the Bitcoin open source project and those involved in community websites that promote the use of Bitcoin. A few targeted prosecutions would likely make many people think twice about participating in the Bitcoin community. There’s also the possibility that a government would simply mandate that Bitcoin traffic be blocked. This is unlikely to happen in the United States, but it’s certainly not outside the realm of possibility in China. If a country blocked Bitcoin traffic, users would be unable to send or receive Bitcoins, essentially taking those Bitcoins out of circulation.
As a peer-to-peer network, it’s unlikely that Bitcoin would ever be totally eliminated, but governments could interfere with the Bitcoin community enough so that the currency is effectively useless.
Bitcoin is arguably the first successful implementation of a crypto-currency, but that does not mean it will be the last. There’s nothing stopping developers from building more technologically advanced versions of Bitcoin. For example, there could be a digital currency that would allow the network as a whole to manage inflation and deflation. A competing currency could also be developed by an organization that would be better respected. It’s unlikely that Bitcoin would succeed in a world where PayPal or a major financial institution developed and promoted its own digital currency.
Bitcoin’s peer-to-peer network provides for a managed level of inflation in which the total number of Bitcoins that exist will increase, but at a rate that slows over time. The total number of Bitcoins will approach, but never surpass 21 million. By 2013, half the total supply of Bitcoins will have been generated. There is no way for the Bitcoin network to increase or slow the rate of the creation of new Bitcoins based on demand.
Bitcoin is a deflationary currency, meaning that the value of Bitcoin will naturally increase over time relative to the goods and services that it can be exchanged for. Deflation occurs when people anticipate that the value of their currency will grow relative to what it can be exchanged for. As a result, prices decline and people have an incentive to hold on Bitcoins if the prevailing wisdom is that Bitcoins will only increase in value over time. People would likely begin to hoard Bitcoins expecting that their “investment” will continue to increase in value, leading to significantly lower the transaction volume.
I won’t pretend to have a strong understanding of the economic forces at play, but economists generally believe that deflation can be disastrous to a currency and economies that make use of deflating currencies.
Declining User Base
Perhaps the most likely scenario is that Bitcoin will fade into internet history. Bitcoin has gotten substantial coverage and interest during the last few months, but the users are very fickle. Bitcoin users could simply lose interest in the currency, leaving their Bitcoins orphaned. However, it’s more likely that disinterested Bitcoin users will exchange their Bitcoins for dollars via one of the exchanges that have propped up.
The real threat to the Bitcoin currency would be if there was a significant drop in demand for Bitcoin. This could happen if there was a major technical malfunction with Bitcoin’s technology. It’s also very likely that the level of interest in Bitcoin will peak at some point and decline as the technology media moves on to other stories. If a large number of users wanted to divest themselves of their Bitcoins at once and there isn’t enough demand to purchase those Bitcoins, the value of Bitcoins will drop sharply, possibly even to zero depending upon the ratio of sellers to buyers.
Bitcoin is a technological marvel and a fascinating experiment. Unfortunately, that doesn’t make it a currency with staying power. Bitcoin will have to continue to attract interest, be used as a digital currency for an extended period of time and avoid the aforementioned scenarios before anyone should trust Bitcoin as a true digital currency.