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Bitcoin Meets Gresham’s Law

May 24, 2012 6 comments

If you’re a bitcoin user, you’re probably aware of the frailties the system has shown since the big bitcoin bubble of last year. There have been several huge bitcoin heists, a couple of exchanges have gone down, malware has stolen unencrypted wallets, and so on. Most of these issues have been fixed, or are being fixed. While the bitcoin bubble did, in fact burst—as all bubbles must—bitcoin’s trumpeted demise by so called economic experts not only seems to have been wrong, but in the after math of its publicity, the digital currency is actually gaining real traction.

Unfortunately, that real traction has exposed a very real problem with the digital currency that could end up killing it. Not quickly, mind you, but slowly, by a thousand cuts. Or maybe I should have said, a thousand fees.

Let us suppose I receive lots of small, ฿1 payments, and then wish to make a larger purchase. For example, let’s say I receive one hundred payments of ฿1 each, and then want to purchase something that costs seventy bitcoins. I could end up being forced to pay nearly ฿6 in processing fees—that’s an 8% surcharge!—for the transaction to go through. Failure to pay the fee cancels the transaction. This is exactly what happened to one bitcoin user last year. Just yesterday I wanted to test a new savings wallet on my system and was told I would have to pay a ฿0.0005 transaction fee, that’s 2.5%, to move ฿0.02 from my online wallet to my savings wallet. Why? Fragmentation. The bitcoin fragments in my wallet that make up the 2 bitcents are (apparently) very, very small indeed, which means that lots of transactions have to be processed by the miners—the volunteer computers who clear all bitcoin transactions. Apparently, the new bitcoin clients force users to pay fees when a transaction is comprised of a large number of small coins: a 70 bitcoin transaction comprised entirely of single coins, or a very small transaction, like my ฿0.02 transaction made up of even smaller bits of bitcoin.

Why is this problem appearing now? Well, I’m no bitcoin expert, but I suspect it’s because bitcoin has now been around for awhile and, given the very serious economic problems around the world, it’s growing in popularity. With greater use comes increased fragmentation, and there doesn’t seem to be a way to reassemble the fragments back into easily processable transactions. Let’s remember: bitcoin started as an experiment. I seriously doubt anyone believed it truly could become a global currency. Hence the relatively small cap on the number of bitcoins that will ever be created. Hence the complete lack of any mechanism to deal with attrition as wallets are lost (and so the bitcoins within them). Hence the complete lack of security in the original releases of the bitcoin client and the wallet.

The security issues are being fixed. Today, if you lose your bitcoins due to theft, it’s due to a lack of care on your part. Popularity has forced exchanges to ramp up their security to that of a bank. All of these measures are to the good.

But the fragmentation issue is another problem entirely. In the first place, bitcoin is supposed to be “cash.” Hard money that, like dollars or euros, can be handed to anybody else free of charge. While tipping the miners has always been considered the polite thing to do, it was never supposed to be compulsory. Nor was the amount to be “tipped” supposed to be a set fee. Yet slowly, the “tips” are becoming transaction fees that there’s no easy way for the average user to escape. John Doe may be paid his ฿5 in a single block, or his ฿5 may be made up of hundreds of coin fragments. He has no way to know until he tries to buy something with them and is hit with an 8% surcharge for using his money. Worse, unlike being handed 500 pennies, he can’t simply run down to the bank or local grocery and exchange his pennies for a $5 bill, free of charge. He’s literally stuck with five hundred pennies and the best he can hope for is that he might be able to make his purchase free if he breaks his ฿5 down into several smaller transactions.

Which leads us to the second issue, and the one that could end up killing bitcoin. If inflation heats up, sending the world economies into a second recession as many experts believe is likely, bitcoin will once again rise in value. That is only going to increase the rate of fragmentation which, in turn, could end up subjecting a greater percentage of bitcoin transactions to mandatory processing fees. This will set off a twenty first century version of Gresham’s Law. “Clean” bitcoins—those that are freshly minted and so not yet fragmented—will be horded because they’re not debased: There will be no transaction fees attached to using them. Whereas the “old” bitcoins that have been fragmented will be shunned because they’re no longer worth their “face value.” They’re worth their face value less the price of the mandatory transaction fee associated with their use.

And that could kill bitcoin!

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