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Bitcoin, for anyone who's not up on their techno-trends, is this year's hot trendy digital payment system. Its main claim to fame is that it is peer-to-peer, not depending on a central bank to issue or validate the "coins", actually blobs of cryptographically signed bits. This makes it both fairly anonymous and hard to manipulate (at least in the ways that real money is manipulated), making it a darling of anarcho-libertarians.

A lot of people have opined on its merits, most notably this Quora message.

I took a look at the design of Bitcoin, which is credited to "Satoshi Nakamoto". Nobody seems to know who he is (or who they are), but he definitely knows his crypto. As a piece of cryptographic software design, it's quite clever. As a system you might want to use to pay for stuff, it's hopeless.

To somewhat adapt the arguments in the Quora message, Bitcoins suffer from two problems, one technical and the other economic. The technical problem is that bad guys control vastly more computer power than good guys, but as the bitcoin paper says:

The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.

The way you create a bitcoin (which they call "mining" as in gold mining) is to solve very time-consuming computational problems. So long as the cost of doing the computing is at least as great as the value of the bitcoins created, we'd expect the supply to grow at a modest rate, and the creation rules are designed to ensure that. The cheapest legal source of a lot of computing power is Amazon's EC3 where you can rent a high performance PC with a graphics accelerator for about a dollar an hour, and at this point it looks like it'd take several hundred hours to create a bitcoin which is worth about $10. But the bad guys have botnets, which can easily include hundreds of thousands of PCs. It's not at all clear to me what would happen if a botnet calculated a million new bitcoins and dumped them all at once into the system which currently has about 6 million, total.

The other problem is economic. A year ago, you could buy bitcoins for about 1¢ apiece. In January, they cost about $1. Now they're about $10. We have a name for that -- it's a bubble. (Bitcoin fans tend to assume that bitcoins are money, and describe what's happending as deflation, but you'll have to look pretty hard to find any real-world examples of 1000 to 1 deflation.) Since there's no central bank to manage exchange rates, nor can you pay your taxes with them, which is the practical definition of money, a bitcoin is only worth what the next sucker thinks it's worth. So what we have here is a system that lets you pay for stuff with tulip bulbs, or perhaps shares of stock in theglobe.com.

It's hard to predict exactly when a bubble will pop, and even harder to predict why. Perhaps people will discover that their bitcoins aren't as anonymous as they thought, because they can be tracked via the publicly visible sequence of transactions. (In this regard they are not unlike disposable prepaid phones, where they don't know who bought the phone, but they can see all the calls it makes.) Or maybe there'll be a bot shock like I described above, or maybe people will suddenly realize that you can't actually buy anything other than illegal drugs with them. Whatever it is, the bubble will pop, all the people who paid $20 for their bitcoins will try to unload them and be lucky to get 5¢ for them, and that will be that.

Update: Peter's point about the cost of botnets is a good one. But botnets are usually rented to do obviously antisocial stuff like sending spam or DDoS. Bitcoin crunching would be nearly invisible, and hence lower risk to the bot farmer, so it might be possible to negotiate a lower price.