“The bitcoin industry is not stable and therefore must collapse,” says Kevin Dowd, professor of finance and economics at Durham University and partner at Cobden Partners.
Writing in CityAM, Dowd highlighted the “rollercoaster” ups and downs already experienced by the nascent crypto-currency, suggesting that the latest dip is not another fluctuation, but a sign that the bubble will burst. Many other alternative currencies, including Auroracoin, Terracoin, Freicoin, Mooncoin, Scotcoin and BBQCoin, have already collapsed, he said.
In 2009, the bitcoin was worth just a fraction of a penny, but by the end of 2013 had soared to a peak of $1,200. Now, it has slumped back to around $328. The price volatilities, says Dowd, are partly down to the way that bitcoins are “mined”.
New bitcoins are created through a complex system called mining, whereby individuals that opt to process transactions and take actions to secure the network are rewarded in the currency. Bitcoins themselves are issued at a gradually shrinking rate and will stop altogether when they hit 21 million. While anyone with the right skills can try their hand at mining, this makes the process highly competitive.
In particular, miners search for transactions made between bitcoin addresses, which all leave a public record. They then add these to a ledger, allowing the movement of bitcoins to be tracked. When a new “block” of transactions is created, it is added to the block chain. Miners then use mathematical algorithms to transform the reference numbers to the block into a hash reference, which is technically difficult to produce and totally reliant on the information stored inside. If anyone attempts to fake a transaction or tamper with the digitally stored information, the hash would change and everyone would know. In return for their trouble, miners receive 25 Bitcoins for each completed block.
This system was designed to decentralise mining activities and democratise the currency. However, Dowd claims that the intensity of the competition and the tight margins mean that larger outfits have rapidly come to dominate the space.
“The mining industry is characterised by large economies of scale,” he explains. “These are so large, in fact, that the industry is a natural monopoly, in which it is economically more efficient to have one producer than many. The problem is that these economies of scale are inconsistent with long-run competition.”
“Mining pools are now so big that the original atomistic competition has given way to oligopoly, and there is concern that these mining pools are big enough to threaten the system by subverting the transactions validation process for their own ends: for example, by mounting some kind of double-spend attack,” he adds.
Dowd predicts that there will soon be a “stampede” to sell the currency and that wise investors should make sure they are ahead of the pack. Before long, he predicts, Bitcoin will fall back to its intrinsic value: zero.
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