One question that keeps popping up, and was addressed to some extent by NAB's recent report, is whether all the elements of the current Bitcoin are necessary for a viable alternative currency.  And, as Citi's Steve Englander asks (from a libertarian and pragmatic perspective), if they are not, or can be improved on, where does that leave Bitcoin’s first mover advantage?

Via Citi's Steven Englander,

The libertarian streak in me likes the anonymity of Bitcoin transactions, but there  is a rational part of me that asks whether that aspect is essential if I am paying for a latte in Soho.  Similarly if the Bitcoin wallet can be made more secure by dropping  anonymity, how many transactors will give up transactional security for libertarian principle? Giving up anonymity may make Bitcoin transactions more secure, and I suspect almost all transactors will value security much more than anonymity.

Going further, Bitcoin’s decentralized nodes are not needed, if there was less concern about keeping Bitcoin outside the current payments/fiat currency system. The nodes allow transactions to be validated by the Bitcoin community, but you can have efficient transactions without the particular validation system used by Bitcoin.   The secure ledger of transactions can be centralized rather than decentralized. Bitcoin’s particular approach may be attractive for those who really want to operate outside the current financial system. There may be both legitimate and illegitimate reasons for this, but the vast majority of  transactions do not have this need. 

Going even further, if Bitcoin or an alternative currency embraced the financial regulatory system to make it more secure, how much payments efficiency is lost? You can still have secure, instantaneous transactions but inside the financial system there may be more security against fraud and more recourse if your Bitcoins are contained in your PC which gets hit by a meteor.

So there is this story about a special recipe for potato fritters (a very good recipe that I have tried). When a chef is handed the recipe, she decides to  ‘improve’ it by replacing each ingredient one-by-one with something more familiar. Having done so, she and her husband decide that the final result isn’t nearly as good as advertised and is pretty close to what they prepare all the time.  In eliminating anonymity, decentralization and non-regulation, much of the original intent of the Bitcoin developer(s) is being thwarted. The question is whether the core innovation of Bitcoin has been compromised or whether unneeded baggage is being  dropped.

For the record, mining Bitcoin is waste of resources from a social perspective. The amount of CPU and electricity needed to mine Bitcoin is high, and from a social viewpoint about as valuable as building defenses against attacks from Mars. What the mining  does is decide the allocation of the limited amount of Bitcoin produced each period and encourage the ledger to be kept. There is a  real social cost to the decentralization designed into Bitcoin.

If Bitcoin is a payments technology, much of what makes it efficient and attractive can be retained, while dropping some features that most users find unnecessary. Bitcoin may become less attractive to illicit users as a result, but that is a sacrifice many will be willing to make. Culturally, the developers of Bitcoin may find this evolution extremely unattractive, because the distrust of the financial system and of financial authorities was one of the motivations for its development. However attractive philosophically, many users will vote for pragmatism over principle and a Bitcoin clone that satisfied this pragmatic streak could be able to overcome the first mover advantage.

So far I have ignored Bitcoin as a store of value, but the proponents of Bitcoin as a store of value/speculation crucially need Bitcoin to be unique and have strong barriers to entry, despite the replicability of the technology. If it turns out that investors/miners will arbitrage between Bitcoin and other mined alternative currencies, the outcome will be that there are many perfect or near perfect substitutes for Bitcoin, and the effective supply will be much larger than would be suggested by the gradually increasing and ultimately capped supply of the original Bitcoin.  This will mean that valuations will be very fragile because in the long-term there will be no ability to limit the supply of Bitcoin lookalikes ... unless some subset of Bitcoin-like currencies gain government/central bank endorsement which gives them an advantage over non-endorsed Bitcoin-like currencies.

Further, the Fed is now started on tapering and the BoE is talking about tightening, however slowly. Whatever sins major central banks commit, they are forgiven rapidly when they show any sign of moving back to orthodoxy,  provided they have not hugely compromised price stability, and sometimes even when they have. Improved confidence in some G4 fiat currencies is giving gold bad days, and the willingness to take the risk on alternative currencies may be inverse to how unrestrained major central banks are in their reserves creation.  Investors and central banks are looking for improved stores of value beyond fiat currencies, and Bitcoin possibly may be one of them. There are scenarios in which it could work as a store of value  but there are clearly many, many outcomes in which Bitcoin is one of a bunch of alternatives with a very indeterminate value.

Bottom line, there is the possibility that Bitcoin represents a big step forward in payments technology, but there are also seem to be straightforward ways to improve on its security, make it less attractive to criminals and more attractive to governments. It is far from guaranteed that that it will emerge as a stable store of value. Either function would be enhanced if it were within the financial system and embraced by the authorities, but it is unclear whether the Bitcoin philosophy will change fast enough or whether an alternative alternative will pip Bitcoin’s original first mover advantage