What comes after the Bitcoin bubble bursts?
Monday, December 16, 2013/
The cryptocurrency Bitcoin has been in the news lately with a sudden surge in value followed by a spectacular crash – not to mention the unfortunate tale of US$4 million in bitcoin on a hard drive that was accidentally dumped in a rubbish tip.
Bitcoin was the first widely used cryptocurrency, but few people know it is not the only one. So how do the top five cryptocurrencies by capitalisation compare?
What is Bitcoin?
The core of Bitcoin is a loose alliance of people (“miners”) who process and add transactions to the Bitcoin public record and get rewarded with Bitcoins for their efforts. This process (predictably enough) is called mining. Changes to the mining process are negotiated and when 80% of miners agree, the change becomes mandatory.
This process has worked well because the miners have an interest in keeping a stable reliable system that does not drop in price or go into a bubble then crash. The value of a Bitcoin is set by the market, which is the shared delusion of market players as there is no backing to the currency.
In terms of risk it sits some where between the share market, which can drop significantly but seldom to zero, and the derivatives market where you can lose more than you invested.
While Bitcoin transactions are public the true identities can be hidden so it’s an easy way to purchase illegal goods or shift money around the world from one Bitcoin wallet to another and then to a normal currency. The low transaction fees and inability to track and tax money also appeals to some.
So why even look at alternatives to Bitcoin? There are two main reasons:
- the recent burst of the Bitcoin bubble
- there’s a problem with the rewards to keep miners in the system. Mining rewards are dropping and eventually there will be no more new Bitcoins mined, as there is an inbuilt limit of 21 million Bitcoins. Will the very small transaction fees be enough to keep honest miners in the system – or will transaction fees need to rise?
By capitalisation, the next biggest cryptocurrency is Litecoin. It’s built on Bitcoin ideals but aims to have a wider range of miners with algorithms that do not give a great advantage to hi-tech miners. This aim has been only partially met. Tweaks such as faster transactions and a bigger currency limit also help but the same problems that plague Bitcoin will also affect Litecoin.
Bitcoin can be converted into other currencies quite easily but to date this is difficult with Litecoin and the other cryptocurrencies, the best path being to Bitcoin then a normal currency.
Peercoin has a built-in interest rate of 1% per year, which is trivial compared to exchange rate movements. Each transaction costs 0.01 Litecoin which does not suit high volume or low value trading.
At present it has a centralised transaction checking system, controlled by Peercoin’s creator Sunny King. In theory this will be removed down the track, but for now, it remains.
Namecoin is built on Bitcoin technology but adds a parallel internet which is uncensored and outside government control. While lack of government control sounds appealing it also implies that security exploits will not be blocked by the know-how of big corporate carriers or the government.
As a result Namecoin is a much riskier option than Bitcoin, which does diminish Namecoin’s attraction.
In concept, Quarkcoin (or Quark) is close to Litecoin. It has faster transaction times than Bitcoin (typically a few minutes versus an hour). Its security algorithms are much more advanced than Bitcoin and this means that normal PCs can be competitive in mining coins. Miners who buy expensive high speed machines for Quarkcoin will have much less of an advantage than those doing the same for Bitcoin.
Does encryption matter?
The new cryptocurrencies discussed here are based on Bitcoin but all have added tweaks which may make them better technologies in the longer term. For now Bitcoin is by far the biggest with about US$12 billion value which is some 16 times bigger than its nearest rival Litecoin. Bitcoin is also a proven technology that has withstood the acid test of many hacking attacks.
In the long-term, a concern is the weakness of the SHA-2 encryption algorithm which is the basis of all cryptocurrencies above, with the exception of Quarkcoin.
For now it appears impossible to crack but who knows what the amazing computer power of security agencies can do now, and what commodity computers will do in five years time. Quarkcoin may be the better long-term bet with its superior security algorithms and faster transaction times.
Now back to you
When should you use a cryptocurrency? If you are an investor who enjoys playing the market then all cryptocurrencies have a lot of ups and downs and if you get it right there is money to be made.
There is a lot of good theory about boom and bust in speculative markets. Expect to lose if you are not a knowledgeable investor who is familiar with charting and market psychology. Margin trading is already happening, so you can profit (or lose) on rises and falls in cryptocurrencies.
There are many tales of fraud and other problems so be very careful and read a lot before you do anything. Some claim the market is being manipulated by big players who can cause booms and busts and make money from it.
The long term investment value of cryptocurrencies is uncertain. The current crop of reports about sudden fortunes being made is in no way a good predictor for the future.
If cryptocurrencies are like other speculative activities, the early players and the big players benefit to the detriment of the late entrants and the small players. Given the recent spike in cryptocurrency values we are most likely past the early entry stage.
There is an increase in real businesses willing to accept Bitcoin and this may help the long term outlook. You can see Bitcoin maps which show businesses that accept Bitcoins, most of which are in the US.
The majority of cryptocurrency activity still appears to be speculative rather than usage as a currency. If this state of affairs starts to reverse then cryptocurrencies may do well; if not then the whole concept may die like the great South Sea Bubble.
Probably the biggest practical use for cryptocurrencies is in international money transfers where the overheads of credit card fees and currency exchange margins are ridiculously high.
Moving your Bitcoins into normal cash still attracts fees of around 5% including buying and selling, so real savings will only be made if your destination is happy to work with Bitcoin.
Cryptocurrencies are fascinating and the appeal of easy money may grab the imagination. If you still fancy cryptocurrencies then do a lot of homework before spending any serious money because there are serious dangers and you could easily lose money rather than make a profit.
This article first appeared on The Conversation. Pj Radcliffe is a senior lecturer in electrical and computer engineering at RMIT University.