First, let me say that as a deep value investor, it is impossible for me to call Bitcoin - or any cryptocurrency for that matter - an “investment”. At best, anyone buying Bitcoins before it is in widespread use is merely speculating on a highly uncertain future. Anyone that speculates on them should do so only with money they can afford to lose. Please act accordingly.

I also must warn that this is a rather in-depth article, but if you are planning to invest any substantial money into Bitcoin or related businesses, I would argue that you’d better be willing to get seriously educated on it. This article should get you 90% of the way to understanding the big risks and why they matter.

Why Bitcoin anyway?

For the purposes of this article, I will assume that you are familiar with the basics of Bitcoin. For an excellent overview, visit Bitcoin’s website. But how exactly does it work? Basically, Bitcoin is both a decentralized user-run payments network and the digital currency that transacts across that network.

Bitcoin’s payments network maintains what is essentially a public ledger of all the Bitcoin transactions ever conducted. These transactions are verified by the users that constitute the network. Transactions seemingly occur at no cost to users or merchants that accept them for payment, with no need for an expensive intermediary such as Visa (V) or a bank to validate transactions. However, there’s a caveat to that last statement that I’ll get back to later.

The currency itself has many attractive qualities. Like cash, it is nearly anonymous (especially if you take a few basic precautions). No personally identifiable information about the user is transmitted. The utility of that quality alone is demonstrated by the recent Target (TGT) and Nordstrom (JWN) data breaches. Transactions are also non-reversible (attractive for merchants worried about credit card fraud reversals) and completely digital (attractive for ecommerce). It’s also more portable than cash. In fact, millions of Bitcoins can fit on a USB drive just as easily as one. It’s also impossible - yes, impossible - to counterfeit a coin, and there is a limited number that can ever be created. No wonder Libertarians seem to love Bitcoin.

Bitcoin’s design is cryptographic genius, pure and simple. If you are interested in understanding the cryptographic processes, click here. It will help you appreciate just how elegant and simple the Bitcoin design is. It is fascinating reading and it answers all those nagging questions you might have about the nuts and bolts of Bitcoin in layman’s terms.

Mining, and nodes, and blockchains, oh my!

So, it all sounds pretty good so far, right? Not so fast. Bitcoin’s flaws are many, and unfortunately, they are not easily fixed. Bitcoin’s growth has unearthed these flaws, yet the media - thus far anyway - hasn’t focused on them… probably because the issues are too complex to explain in three paragraphs, or because few people really understand them. At this point, Bitcoin’s network is strained and fragile. If it grows much further without major changes, a lack of trust in the network could result, imploding the currency.

The first issue resides with the public ledger, called the “blockchain”. This blockchain stores the entire history of all the transactions ever made in Bitcoin. As you can imagine, the blockchain has started to grow to be quite large as hundreds of thousands of users join the network and transact with each other. At the time of this writing, the blockchain had grown to nearly 13 GB, enough data for three full length DVDs. As the number of transactions grows, the blockchain will continue to grow with it.

There’s a much larger problem, though. The Bitcoin system relies on volunteers called “miners” to maintain the integrity of the blockchain. Miners compete with each other to solve complex cryptographic puzzles, and the winner of each competition gets to append all the latest transactions to the blockchain and collect a reward - currently about 25 Bitcoins worth something about $20,000 - for his or her efforts. This process is called “proof-of-work” mining. The issue is that the difficulty of the cryptographic puzzles adjusts based on the total mining capacity of the system, and as you’ll see, the capacity being added to maintain the system has become an incomprehensible arms race.

170,000,000,000,000,000,000 operations / second

Say it with me… 170,000 petaflops. That is the amount of computing power dedicated to solving these cryptographic puzzles today. Let’s put that in perspective. The combined computing power of the world’s 500 fastest supercomputers is currently 250 petaflops. That’s right, combine the top 500 supercomputers in the world - you know, the ones that can simulate the entire earth’s weather system - into one giant “megacomputer"… then duplicate it nearly 700 times over and you’d have the amount of computing power currently used to maintain the Bitcoin network… a network that maxes out its capacity at just seven transactions per second. Take a moment to let that sink in. NO… STOP!!!… and LET THAT SINK IN. Think about these numbers, and ask yourself how sustainable a payment network is that consumes this much computing resources.

Personally, I can’t wrap my brain around numbers that large. If you took the number of Powerball combinations, multiplied that number by itself, and then multiplied it by 5,000, then you’d be in the ballpark for the number of operations these computers can do each second. Click here to see what one quintillion pennies would look like next to the Empire St. building (hint: the Empire State is hardly visible). Take 170 of those piles, and you’d have a cube more than 28 miles each side (4 times taller than Mt. Everest)… that number of pennies is the number of operations done every single second on the Bitcoin network. Literally hundreds of thousands of dollars every day is spent on electricity alone to run these machines. That doesn’t count the cost of the required servers, bandwidth or physical infrastructure.

How perverted!

You may be asking yourself, "How could something like this happen?”. The simple answer is that there is a fundamental design flaw in Bitcoin that has caused perverse incentives for miners. Bitcoin’s design assumed that users would simply use their desktop computer CPU to mine Bitcoin. However, some innovative programmers quickly realized that they could use their graphics cards to solve the cryptographic puzzles hundreds of times faster than by using their CPUs. A bit later, even more innovative chip designers realized that they could make application-specific integrated circuits (ASICs) - basically a specialized chip that can mine Bitcoins efficiently, but are incapable of doing anything else - which operated thousands of times faster than any general-purpose computer chip ever could. Ever since then, the Bitcoin mining community has been in an arms race to build the fastest, biggest mining operations possible.

This arms race has several negative effects on the Bitcoin community, though many in the community may not be aware of the extent of the problem because the issues are largely obscured from end users. First, with each new generation of faster and more powerful ASICs, individual miners are being competed out of the market. You can no longer profitably mine Bitcoins using anything but highly specialized hardware. Increasingly large, professional, and sophisticated operators have supplanted the casual Bitcoin miner. Even for sophisticated miners, the days of earning huge multiples on a mining operation are quickly ending. And here’s the scary part for mining operators… the reward size for mining new blocks halves every four years or so, resulting in a jolting drop in rewards (and profits), making capital planning difficult. The first “jolt” should happen sometime around September 2016, and no one can yet predict what the consequences of this sudden change will be.

We’ll just charge fees… of $90/transaction

Proponents of Bitcoin claim to have a solution to the miner’s revenue problem. The Bitcoin development team is supposedly working on a market-based system to set transaction fees that will ensure that there will still be sufficient rewards to incentivize miners just enough to keep mining. Unfortunately, the computing arms race will still continue and proof-of-work mining will remain an environmentally wasteful activity. In addition, transaction fees will no doubt be very unpopular with Bitcoin users, many of whom joined the network specifically because there are no transaction fees.

The Bitcoin network is anything but “free”, however. Total miner revenues totaled about $4.8m over a 24 hour period this past weekend, and this is not unusual. Out of that total, only about 0.2-0.3% of the revenue came from voluntary transaction fees. The rest came from mining new Bitcoins. These new Bitcoins are essentially a tax on the system… when new money is created, all else remaining equal, the existing coins in user wallets become less scarce and proportionally drop in value. If you count this “tax” on owners of Bitcoin, total network “fees” are currently over $90 per transaction. Anyone with any common sense can see that this arrangement is hardly the most efficient method for any network to validate transactions.

The tax isn’t noticed by Bitcoin users, though, as it is a secondary effect… they don’t pay the transaction fees directly from their accounts to the miners, so it goes unnoticed that their holdings are being diluted (especially as long as rising demand for Bitcoin allows Bitcoin exchange rates to keep rising). This arrangement is obviously unsustainable in the long-term, and miner revenue cannot remain so high forever for providing relatively low-value encoding of a handful of transactions in the blockchain. And it won’t once reward sizes decrease, since transaction fees could never soar to $90 per transaction to make up the difference.

In the long-run, the computing arms race means that only a couple of large mining operations are likely to eventually survive (probably physically concentrated in the least expensive energy cost locations of the world), and that would be catastrophic for the integrity of the Bitcoin network. Here’s why. If one individual, or coordinated group (called a “pool”) of miners ever controls 51% of the network’s computing power, they have the ability to rewrite the blockchain in any manner they wish and force that blockchain on the network. They could reverse transactions, transfer Bitcoin to themselves, double spend their Bitcoins, anything. And it’s not pure fantasy that this could happen. Today, one mining “pool” called Ghash.IO controls about a third of the total. On January 9th, they briefly controlled a record 45% of the network. Bitcoin miner discussion boards were filled with alarm this weekend over the possibility of a “51% attack”, which many proponents of Bitcoin said could never happen. Ghash.IO has proven that it can. Even if someone honest (as Ghash.IO claims to be) controls 51% of the network, the level of trust in the Bitcoin network is nonetheless diminished if users must now trust a small number of entities. In November, Cornell researchers even suggested that it might be possible to take over Bitcoin with as little as 1/3rd of the network power if you have enough luck in being first to solve some of the puzzles. If that’s the case, then the Bitcoin network is already vulnerable to attack.

The problems don’t stop there. Volunteer “nodes” are needed to actually conduct the transactions and operate the network (separate from miners). Most of these nodes are simply end users, but the Bitcoin protocols don’t provide compensation for maintaining a node (which coincidentally involves storing a copy of that enormous blockchain discussed earlier). As transaction volumes and blockchain storage drive up the cost of hosting a node’s required bandwidth and storage, it is unclear if end users will begin disabling their nodes, thus destabilizing the network.

The network doesn’t scale well either. There is a limit of only about 7 transactions per second in the Bitcoin protocol driven by limits on the size and frequency with which new blocks may be added to the blockchain. During a recent spike in transaction volumes in November, average transaction confirmation times increased to as high as 19 minutes (vs. 7 minutes typically) as a backlog of transactions waited to be added to the blockchain. Those transaction limits will need to be changed or network performance will suffer. While I understand that is entirely possible, this will cause the blockchain to grow even faster and put additional stress on nodes.

So far, all the necessary players - the users, node hosts, and miners - have managed to keep the system working. As Bitcoin grows and strains, it will certainly be interesting to see what unfolds. The network of miners could decline resulting in an easily attacked network (perhaps by a state entity with massive computing resources). End users might stop volunteering their bandwidth to host the nodes needed to run the network. Users could balk at the proposed transaction fees and move to a lower-cost currency. Or the demand for Bitcoin transactions could rise faster than the programmers can adapt the code, causing transaction delays. Perhaps the press will become fond of criticizing Bitcoin for its waste of electricity and other resources. Or maybe the next steep drop in reward size will cause the whole system to collapse rapidly sometime in 2016.

A religion crushed

So, if Bitcoin fails, or becomes less popular, what happens? The initial implications will obviously be painful to all cryptographic currencies, not just Bitcoin. I imagine the previously “religious” Bitcoin community will need to do some soul searching about the flaws of the system. But the idea of a cryptocurrency is a good one, in my humble opinion. Digital currencies have many benefits, and designed smartly, can correct a lot of Bitcoin’s flaws. A new cryptocurrency should rise from the dust. In fact, I believe the next Bitcoin is already here. Even if Bitcoin doesn’t fail, I think this newer currency could still come to prominent use alongside Bitcoin. It’s called Peercoin, and I’m a huge fan. Let me explain why.

There are over 200 virtual currencies in existence… probably much more now that there’s a website to create your own. Most of them are either a joke (e.g., Dogecoin is named after an internet meme), a scam (e.g., the developer “pre-mined” the coin), are a near duplicate rip-off of Bitcoin, or offer minor improvements over Bitcoin. Peercoin appears to be the most sustainable, well-thought out technical design I’ve seen. And Sunny King, the lead developer, is a thoughtful leader that listens to the Peercoin community. Peercoin is currently the third largest cryptocurrency with a market cap of about $100+ million, a fraction of Bitcoin’s $10 billion or so. But it has a thriving community backing it.

Nobody likes difficult math anyway…

Peercoin offers substantial improvements over Bitcoin. First, it uses a different model to secure the network called “proof-of-stake”. Proof-of-stake secures the network by rewarding end users for holding Peercoins for a period of time. The reward is something like a raffle… the more coins you hold for more days, the more “raffle tickets” (called “coin days”) you have. When you’ve held your coins for long enough and have enough “raffle tickets”, you are rewarded with the opportunity to test a limited range of answers to a very simple version of a cryptographic puzzle - much like with proof-of-work mining but far easier to solve. As you hold your coins longer, you are rewarded with more chances to solve the puzzle.

There are two major benefits to this model. The first is that the network is more secure. Attackers would no longer be able to attack the network by simply acquiring 51% of the computing power, but instead would need to purchase 51% of the Peercoins. That would be hugely difficult and expensive, as the price of the coins would rise with the sudden and enormous surge in new demand. However, once the attackers controlled 51% of the coins, they would have no incentive to destroy the integrity and trust of the network, because their coins would subsequently lose all their value. The second major benefit is that owning a hugely expensive mining rig becomes useless on Peercoin. Your desktop computer has more than enough computing power to solve the necessary puzzles. And end users are incentivized to maintain a node in the process so that they can collect their proof-of-stake rewards. As a consequence, operating the Peercoin network costs a fraction of what it does for Bitcoin, it is friendlier to the environment in the process, and it ensures end users are incentivized to host full nodes capable of minting their proof-of-stake rewards.

For now, just while Peercoin ramps up, proof-of-work mining is permitted to build out an initial community of Peercoin owners and users, but that will be phased out in favor of proof-of-stake over time. As the network grows, the reward size for proof-of-work will drop, until eventually proof-of-work will become unprofitable.

There are other usability improvements with Peercoin that should allow it to function better for users. First, small transaction fees are mandated by the protocol. These so-called “fees” are actually “destroyed” rather than transferred to others, because they are simply meant to ensure that spammers can never use the network to send basically worthless transactions (fractions of a cent) - along with an unwanted spam message - to thousands of users. Bitcoin spamming has already happened. Google it and you’ll see a litany of complaints. The current Peercoin transaction fee (0.01 Peercoins) works out to about $0.06 per transaction, but Sunny King has stated this amount is not set in stone. If the value of Peercoin rises, the fee can be lowered… it just needs to be high enough to prevent spam.

Scarcity or Scare City?

There’s one other problem with Bitcoin that I’ve ignored, but I think is serious. There is a limit on the number of Bitcoins of 21 million. There can never be more than that. Therefore, even if Bitcoin becomes popular as a form of payment, the lack of new money supply will cause prices of goods to decline (when priced in Bitcoins anyway) since Bitcoin in circulation will surely shrink over time (people will lose them, casual users will forget their passwords, etc.), and the remaining coins will proportionally increase in value. The problems typically caused by price deflation are well documented and I will not expand upon them here, but I see this as a real issue.

In contrast, the change in Peercoin money supply is not fixed, but rather determined by several competing factors that should lead to an equilibrium in supply. First, proof-of-work mining increases the initial supply, just to get the network going. The difficulty of proof-of-work puzzles will increase, while reward sizes decrease, causing a natural decline in mining. Transactions, meanwhile, decrease supply because of the current 0.01 Peercoin “transaction fee” that is destroyed. And finally, the proof-of-stake system increases supply at a rate of up to 1% per year, once the initial proof-of-work mining subsides.

All this means that the more people use Peercoins as a currency and transact with them, the more Peercoins that will be destroyed as transaction fees (reducing the money supply). The fewer Peercoins there are in circulation, the higher their scarcity and value will be. In turn, the higher the value of a Peercoin, the higher the fixed transaction fee will become, thus increasing the share of users that will opt to be “savers” rather than “spenders”. And finally, the more people are saving Peercoin, the more proof-of-stake minting will occur (increasing the money supply). It is a self-correcting supply system.

There’s always a critic!

There are some criticisms of Peercoin, but I believe them to be non-issues. One common complaint is that the supply isn’t explicitly capped the way that Bitcoin is. While this is true, the supply can only grow by at most 1% per year. This low growth rate will ensure Peercoins remain scarce. In fact, that’s not even enough to keep up with population growth, and is a stable and predictable growth rate that wouldn’t threaten the stability of the currency. Even so, supply will never actually grow at this rate for two reasons. First, not everyone will chose to operate a node and will forego their proof-of-stake rewards. Second, destroyed transaction fees along with “lost” coins will offset a portion - if not all - of the supply growth.

Another related criticism is that due to the 1% “interest” rate, Peercoin makes the rich richer and the poor poorer. Not true. Everyone has the same opportunity to earn 1% interest by running a node. Thus, if everyone’s wallets increase by the same proportion, all the users would be just as proportionally rich as before. Besides, at 1% interest, it would take about 70 years for one to double one’s money… hardly the best avenue for the rich to grow their wealth when they have so many other advantageous investment vehicles not available to the general public (e.g., hedge funds, tax shelters).

You may wonder why Bitcoin doesn’t adopt some of these innovations. The biggest innovation, proof-of-stake, would be a tough sell to the Bitcoin mining community. Miners have spent unknown millions of dollars on mining equipment which would become worthless. I’m sure users aren’t clamoring for a mandatory fee, either. Unfortunately, the perverse incentives of the Bitcoin community will make meaningful changes difficult to implement. By the time either of these groups is willing to incorporate the necessary changes, it will probably be in response to an extreme event or total collapse of the currency. By then, it may be too late, and trust in the Bitcoin network may have been destroyed.

Conclusion??? TBD

Bitcoin is a beautifully designed concept. However, the first iteration of any new innovation is usually flawed, and unfortunately Bitcoin isn’t an exception. Bitcoin’s designers had no idea their proof-of-work design would lead to the largest computing arms race in history. Whether Bitcoin survives its challenges or not, I think there’s room for more than one successful digital currency. Perhaps a proof-of-stake currency will appeal to the environmental crowd, for example.

Regardless of Bitcoin’s future, the currency that has solved the problems of Bitcoin most effectively is Peercoin. I believe that at 1% of the market cap of Bitcoin, Peercoin offers a better risk/reward tradeoff and may make a good long-term hedge against the considerable risk that Bitcoin fails.

If you’d like to speculate on Peercoin on the long-shot bet that it becomes a viable currency, I recommend buying Bitcoin at Coinbase and trading it for Peercoin at any major cryptocurrency exchange. You can also buy Peercoins directly with USD on Vault of Satoshi.

Disclosure: I have no positions in any of the stocks mentioned. I have no business relationship with any company whose stock is mentioned in this post. I did recently purchase a small amount of Peercoin and have a small fraction of a Bitcoin. I occasionally - and unprofitably - mine both Peercoin and Bitcoin for an unidentified and undoubtedly irrational reason using highly unsophisticated hardware.