Bitcoin, Alt-coins, and Free Money Theory

Gavin with some BitBills

Gavin Andresen wrote this piece on his blog about alt-coins and several of the issues they create. As much as his concerns are valid, there is a different perspective where digital currencies of all kinds can compete in an open market to capture the most customers bases off of the greatest advantages they offer. This was presented in “The Denationalization of Money,”  the magnum opus of Fredrick Von Hayek, Nobel laureate in economics and close friend of John Maynard Keynes. Hayek’s primary argument in this work was that through allowing the private issuance of currencies, banks would be forced to compete on the open market to have the most competitive currency. Below I am going to explore some of the concerns that alt-coins present and how they can be understood from the perspective that Hayek offers in the Denationalization of Money.

Free money theory

Bitcoin has a significant advantage over other digital currencies with that it is the first digital currency, and no other digital currency is significantly different from bitcoin. With that being said, alt-coins not only help legitimize bitcoin as THE currency of the internet, but also help create a whole new digital currency economy, in which alt-coins can specialize, or succumb to market forces.

Gavin makes an excellent point that alt-coins don’t do too great of a job differentiating themselves:

“So what?  The free market at work, right? If they’re good they’ll survive, if not, then they’ll fail. If they’re better than Bitcoin somehow then maybe someday one or more of them will usurp Bitcoin as the biggest and best!”

He then goes on one to voice his concern that:

“Creating gazillions of alt-coins seems to me to just be a way of getting back to an “inflate on demand” world. Not enough genuine Bitcoin money for you? No problem! Create a new alt-coin to produce more!

As much as this concern is valid, I think we can see that his first point seems to be the direction we are heading. The value storage of the number of alt-coins in circulation vs. their price simply does not compare to bitcoin. There are more than 20 million litecoins today, with the total supply capping out at 84 million. LTC price in recent months has gone from  $2.75 per LTC, to under $2. You can see that despite there being a total cap on the supply of LTC at 84 million, it is still is valued 30 to 40 times less than bitcoin, despite being a pretty good copy of it. This is because bitcoin has the first-mover advantage behind it, and thus has had more time to establish a market for itself.

If bitcoin is doing such a good job, than why are alt-coins valued at all?

Each one has its own reason, so I’ll just use litecoin as an example for now. Litecoin has value most because of speculation, but it is also a good bitcoin catastrophe insurance, it has second-mover advantage, and it is the most liquid way to get out of bitcoin, but not back into another fiat currency.

Insurance

Let’s face it–bitcoin does not have a lot of friends, and it has a bad reputation

Personally I’m bullish enough on digital currencies to believe there will be a $10,000 bitcoin one day, and so are others like Max Keiser. Gavin hypothesized this may be part of the reason why alt-coins are around.

Maybe altcoins will be an important safety valve in some future crypto-currency-dominated world. Maybe if there is lots of economic growth and some technical reason prevents the velocity of money from accelerating to match the increased demand for transactions people will use alt-coins to fill the gap.

And I think what Gavin is saying about the velocity of money is true. I believe this is the behavior that we are seeing with litecoin being used as a shelter during turbulent bitcoin times.

Even if alt-coins were to become a threat to bitcoin, it would most likely be for a good reason. Perhaps mining centralization could lead to some issues down the line, or pump and dumps too frequent–who knows? Other than a faster block-time, and 4x the supply of coins, I don’t see any difference of advantage of using litecoin as a storage of wealth, or a mode of exchange.

I do however see how it is useful as a short-term hold of wealth for shelter during turbulent bitcoin market periods. There are members of the /r/bitcoinmarkets is an example of a community that utilizes this technique. There is also ample evidence that this is also done on the Russian exchange btc-e.com as well in order to do ‘pump n’ dumps–where one inflates the price through rapid buying, and then dumps to collapse the price and buy back at a lower value.

Litecoin may also become valuable as a mode of exchange. We can see that the recently closed online drug market place, Atlantis, accepted litecoin, in addition to bitcoin. Litecoin could very well bootstrap its way to become more valuable, similar to how bitcoin did with The Silk Road.

Other Altcoins

Namecoin, Peercoin, and Primecoin all have there own unique features that one day may make them very valuable, but today that is not the case. As Gavin pointed out, these developers could focus more on their alt-coins unique features (which I’ll discuss in a separate post), but to simply have it be another bitcoin copy is little more than inflationary flack. There are always 51% attacks, and people simply not accepting alt-coins to solve that. I believe from seeing where we are at in this very new economic paradigm we are see exactly what we need to see: A few unique and well-differentiated alt-coins seeing limited success, along with the death of dozens of other more useless coins.

When we look at bitcoin through the eyes of Hayek, none of this is surprising. Digital currencies represent Free Money, or money that has no monetary authority other than itself. This means that the value of digital currencies can only come from their intrinsic value which is established through the market. This is one of the reasons that bitcoin’s first-mover advantage is so important–it was the first digital currency to gain a wider following and create market legitimacy, thus it has the largest market cap of all digital currencies in circulation.

This also helps explain why alt-coins do have some limited success. Because they still have the same money function that bitcoin has, which is more efficient that fiat currency, that can be used to give them value. Yet, because there are fewer people accepting alt-coins today, nor do they differentiate from bitcoin greatly, many of them are still highly-speculative prospects that have gained little traction because of this lack of differentiation.

Conclusion

Hayek’s theory on free money found in the denationalization of money helps explain why digital currencies have value. This theory also helps explain the complex market relationships that allows for some currencies to keep and hold value, while limiting the success of others. It will remain to be seen how successful alt-coins will become, but it is most likely that because of bitcoin’s first-mover advantage that it will always remain the primary digital currency. With that being said, alt-coins will always be needed in the market for bitcoin catastrophic insurance, and to act as an alternative mode of exchange.

5 thoughts on “Bitcoin, Alt-coins, and Free Money Theory

  1. The reason Bitcoin has value is because it is resistant to censorship (e.g., prohibiting transactions related to illicit purchases) and corruption (e.g., an authoritative source changing the rules). It does this thanks to the innovation known as proof-of-work.

    But this proof-of-work means Bitcoin is vulnerable to attack from a party or cartel with more than 50% of the hashing capacity. The cost to perform the attack is enormous, and there is no economic incentive to do so — thus the likelihood that will occur is significantly discounted.

    Litecoin also is a proof-of-work based crypto currency. The primary difference between Bitcoin and Litecoin is the algorithm used for the proof-of-work (Bitcoin uses SHA256, and Litecoin uses Scrypt) and the amount of hashing capacity needed to be successful with a 51% attack.

    With an arsenal of maybe ten thousand GPUs and a distributed denial-of-service (DDoS) attack against the LItecoin pools, a 51% attack against Litecoin is likely to technically be a success. But such an attack isn’t performed to prove a point, it is performed to gain a profit. And whether there is the potential to profit from a Litecoin 51% attack depends on a few factors. Exchanges that don’t require identity would be the targets. This means the attacker won’t be double spending litecoins against the exchanges like Mt. Gox, Kraken, etc., but instead Vircurex, Cryptsy, etc, Today there likely isn’t the possibility to suddenly convert several million dollars worth of litecoins into bitcoins and then withdraw those bitcoins. Those exchanges simply don’t have that level of liquidity. So today there is no economic incentive to perform a 51% attack against Litecoin. But if an attacker were to perform a 51% attack, Litecoin is a lot more vulnerable than Bitcoin – due to the inability to acquire 2,300 Th/s of SHA256 hashing capacity, nonetheless the cost — something that would cost, using equipment prices offered today, over ten million dollars.

    That doesn’t mean Litecoin or some other alt can’t reach a similar level as Bitcoin as far as there being no economic incentive for a 51% attack. And if an alt were to reach that level, Litecoin would probably be it. But Litecoin is vulnerable for a period of time until it gets there. And that’s why, other than the first-mover-advantage that Bitcoin has, that an alt is not simply a lesser-valued coin than Bitcoin. They simply have differences and the market recognizes these differences and that shows up in the price.

    Now if wanting to choose between a Feathercoin and Litecoin, for instance, and the risk of a 51% is even more pronounced. And that’s why a Feathercoin, for example, has had (and likely will continue to have) successful 51% attacks performed against it. So Gavin probably doesn’t need to worry about a thousand alts, each being considered suitable alternatives to Bitcoin.

    The wildcard is the potential that a proof-of-stake based alt coin, which doesn’t have mining based on proof-of-work, would be an acceptable solution. But a proof-of-stake coin essentially changes the risk from an attacker acquiring hashing capacity to an attacker acquiring a sufficient quantity of coins themselves. Again, — such an attack brings no economic benefit, at least not today. But the market seems to agree that proof-of-work architecture is the right approach for a decentralized digital currency.

    And of all proof-of-work based digital currencies, bitcoin trumps all others. And that’s enough to prefer Bitcoin over the alternatives. At least, that’s the case today.

    • Thanks for the thoughtful comment. It’s going to be interesting to see how proof-of-stake plays out in 10 years or so. I think as bitcoin becomes more successful we may see alt-coins gain traction, but they will need to differentiate themselves with something like proof-of-stake. I think bitcoin will have to become much more mainstream before that potential opportunity presents itself, but it could happen.

  2. Alt currencies pose a threat to Bitcoin and crypto-currencies as a whole because they might supersede Bitcoin,but then what is to prevent them from being superseded ? If the idea that that might happen were to gain traction,confidence in Bitcoin and in crypto-currencies as a whole could be lost.

  3. Large transactions, maybe $10,000+ you would wait for 6 or more confirmations to be sure. Say you buying that Tesla for $100,000 using bitcoin, It would probably take longer to fill out all the paperwork than the time it would take the 6 confirmations to go through.

    • Sure you might be right–but there are other solutions to this problem other than waiting for all 6 confirmations. There are several companies like Bitpay that will take 1 confirmation payments, and Greenaddress.it will even do 0-confirmation payments. While I’ll agree that bitcoin’s blocks are a lot slower than some other digital currencies, we’ll have to wait and see if that’s enough to dethrone bitcoin from being the largest digital currency market.

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