The (practical) End of Bitcoin

From what I read on the Gawker article, Silk Road permits Americans to buy from a dealer they've never met before from anywhere in the world based solely on reputation. No one in their right mind would pay a dealer via a bank transfer because of the paper trail it leaves, but they probably wouldn't be too concerned with transferring bitcoins. For many, you may have a greater risk of being defrauded, but you've eliminated risk associated with dealing with drug dealers in person. For some people this is an acceptable tradeoff in risk, especially since people have been robbed at gun-point by dealers.

Interestingly, services like Silk road have the potential to eliminate much of the violence associated with the drug trade because physical proximity of the counter-parties is eliminated. You can't get beat up and shot by someone you never have to meet.

In my opinion the number one threat to the mainstream adoption of bitcoin in the US would be the legalization of Marijuana. Marijuana is so widely used that it is the one commodity that prevents the social graph of potential bitcoin users in the US from being full of wholes.

Users can trade amongst themselves if every user in a market has visibility into the reputation of their counterparties.

Even using untraceable pseudonyms, there is economic value in having a high trading reputation. Oftentimes companies on eBay and in other markets are able to command a price premium over their competitors based largely on their reputation. B&H PhotoVideo is a perfect example of this. They don't have the lowest prices, but they have easily the best reputation on the web, especially among professionals and consumers that purchase the types of products they sell. They are extremely successful and many people I know purchase from them based largely on their reputation.

The general equation that would govern whether counterparty A would defraud counterparty B would basically be:

if the value of price premium of Counterparty A's reputation multiplied by trading volume is greater than the transaction amount then they have an economic incentive to remain honest.

Of course this equation isn't that simple. For example, the reputation damage from one fraudulent transaction committed by Counterparty A would not ripple through the system immediately. This means that if Counterparty A wanted to extract the maximum value from his reputation at the cost of torpedoing his reputation, he would be able to commit as many fraudulent transactions as his daily transaction volume multiplied by the number of days it takes for fraud to be reported in the reputation system.

So long as the "speed of fraud reporting" is small, Counterparty A can enjoy very little economic value from torpedoing his reputation, expect in the case that the transaction amounts are very very high.

One way to increase the amount that could be transacted solely on reputation would be to apply relationship data to reputation. i.e. my reputation helps/hurts the reputation of those that I vouch for and vice versa. Such a system would greatly reduce the incentive to defraud others, because you'd have to hurt those that placed their trust in you. This system is of course vulnerable to Bernie Madoff types that take advantage of the trust of their in-group, but then again everyone who put their money in with Bernie Madoff are idiots who are in deniable about their financial stupidity.

Bitcoin is more like a currency than oil or coal, because it mechanically works a lot like one. But just because you say 'this is a currency', doesn't mean it actually is one. You are missing all of the higher level stuff. There is a reason a dollar backed by the US government is far more useful than a random coin 'backed' by a government of an island nobody recognizes.

My uncle is a mechanic, and has traded his time fixing commercial vangs for goods. We've had plenty of parties cartered in exchange for fixing the restaurent's delivery fan, or borrowed plenty of heavy equipment from contractors that need their truck fixed but don't have cash. Does that mean a tray of chicken marsala and a plate of bakery cookies are a currency? Of coruse not. Trade/bartering existed long before currency existed, and it still goes on today. Commodities existed long before currency existed. Being able to trade one commodity (bitcoin) for a good or service doesn't make it a currency.

We've learned this lesson over the last 200 years but a lot of people seem to ignore them. Most of the people pushing bitcoins harp on the fact that dollar keeps getting devalued, but they are ignoring the history showing that is a far better problem than a deflationary currency .

But I guess that's why it's fiction.