“Look mum. No hands!” It is every parent’s nightmare to be forced to watch helplessly as their 7 year-old, with the new-found independence of two wheels, goes careering fearlessly along the uneven pavement in front of the house. Thanks to a guardian angel, the escapade normally ends with nothing more than a toppling skid or collision with an ancient lamppost that the child’s pride leads him to insist was not there yesterday – painful but, mercifully, not tragic.
Bitcoin, the virtual currency that has taken the world by storm, is like a bike with no handlebars being ridden by a reckless kid with a pair of cheap tyres thrown in for free.
A friend of mine, a financial adviser by trade, told me the other day that one of his clients was considering investing in some Bitcoins. I expressed genuine delight as someone could now finally explain to me in non-binary language how the Mining process works. Not so fast. His face glazed over as he offered me another whisky. Had he heard of the Mt Gox collapse or the thefts from Flexcoin and Poloniex? Yes – but everybody seemed to agree that these were local problems, not a systematic issue. “Everybody” would appear to consist of the Lower Manhattan Chapter of 7 year-old bicycle-mounted Hells Angels.
For the uninitiated, Bitcoins had the internet equivalent of an immaculate conception about 5 years ago, appearing on the scene as an orphaned concept, the creator not known until this very day. The idea was to produce an alternative currency to those currently maddening the world that would not be dogged by regulation of Central Banks and Governments. The ostensible genius was in the way – in the absence of all that regulation – the system would regulate itself.
In the beginning there was the Algorithm and a digital Bible that had fallen from the Heavens telling the first punters how to play. In the maturing market participants are required to open accounts, generally through brokers (they are even given virtual wallets to keep their Bitcoins in) and are given two codes – one private and one public. When they undertake a transaction, they only provide the public code (surprise, surprise). Privately held increasingly powerful computers then race to calculate, by trial and error, the single solution for a block of transactions that is attached to the Block Chain (which includes the entire history of Bitcoin transactions). Every 10 minutes a single computer finds the solution, it is verified by at least 50% of computers (or computer power) extant in the system and the winner is rewarded with 25 newly mined Bitcoins. This process will continue until a predetermined maximum number of bitcoins are mined (I believe around 2030).
This all sounds very clever and infallible but, let’s face it, to err is human, to really screw things up requires a computer. Lo and behold, in the recent Mt Gox, Flexcoin and Poloniex debacles Bitcoins have been disappearing into the ether. But, being the computer dinosaur that I am (I once had to plead with a New York hotel computer help line not to ask me if the computer was plugged-in) my reasoned reservations are entirely analog.
When I studied Monetary History – if my children are to be believed, around the time people were bartering pigs for firewood – I learned what defines money (not as bloody obvious as you think, clever clogs). It must be three things: a “medium of exchange”, which can reliably be swapped for goods and services; a stable store of value, enabling users to hold it for a while more or less maintaining its purchasing power; and it should function as a unit of account against which value in an economy can be measured. Throwing all three conditions into a basket, Bitcoin is not looking too respectable. Leaving aside the recent insane fluctuations in value which might sort themselves out eventually, realistically until such time as citizens of the world are paid in Bitcoins and pay for their daily needs in Bitcoins, their value is always going to be measured against other currencies.
Then, even if all the conditions were somehow met ( which they will not), the Bitcoin economy will need to operate according to a very narrow, and largely discredited, “Monetarist” regime. Monetarism, adopted by Thatcher at the end of the Inflationary Roaring 70s and given lip service by Reagan a few years later, claimed control of the money supply as the critical factor in the macro economy. But the money supply had various definitions that went well beyond notes and coins. Only real whackos believed it was about keeping the supply of notes and coins constant – effectively aping the gold standard. Looking at the recent successful use of Quantitive Easing – resort to the printing presses – by the world’s central banks (most recently the ECB) to stimulate the economy it is easy to realize how futile a fixed narrow money supply would be. But that is precisely what Bitcoin is about. The only way for it to work long-term, even if it were adopted as a regular currency, would be for the system to develop an override which would have to be regulated by dreaded humans – a Bitcoin Central Bank. Back to square one.
Having got all that off my chest this is one of the rare moments when I find myself praising the IRS. They issued guidance last week on how Bitcoins should be treated for tax purposes. Instead of giving them the longed-for special status of money (not defined in the Code) they decided that Bitcoins are property. Hence, increases in value will be liable to capital gains tax (or, in some circumstances, income tax on sale of inventory). This treatment also exposes transactions to possible Sales Tax at the State level. The IRS approach is in line with several other countries that insist on charging VAT on transactions – a noted exception being the UK.
With complex reporting requirements and huge dollops of VAT, it means that there is – thankfully – little hope of Bitcoins being more than speculative assets in the foreseeable future. Of course, if circumstances change as the digital economy expands tax treatment could be altered. But a cautionary tale – we are 20 years into the Information Revolution and only now are tax authorities beginning to try to find solutions to the basic problems, while as I noted last month, they are over a hundred years behind with the central tax concept of management and control. It is a “bit” too soon to throw away your dollars.