5 Myths About Bitcoin You Need to Understand

This month, bitcoin, the digital currency launched by Satoshi Nakamoto in 2009, hit a record price of US$17,428.42 per coin. It got its own futures market at a traditional brokerage firm, and it even earned a joke in a recent "Saturday Night Live" sketch.

Perhaps because of its complicated technical design, zealous community of advocates and famously mysterious founding story (its creator was unknown for years), a variety of widespread myths about bitcoin have persisted. Here are five.

MYTH #1: There is a finite supply of bitcoin

Bitcoin has been described, per the title of one book, as "digital gold," because it is supposedly impossible to create more than the 21 million units already planned for circulation.

This past week Goldman Sachs published a research report stating that "bitcoin has a mathematically certain total supply." Modern-day gold bugs, such as Ron Paul, like the idea that no government can debase bitcoin by increasing the supply.

Yet there is no guarantee that the supply of bitcoin won't change. The currency's original design calls for the 21 million units to be slowly created over the next 100 years or so.

But the protocol can be amended by community consensus - a majority of participants in the bitcoin network - as has already occurred several times, such as an update that helped users specify payment conditions.

So far, the bitcoin community has fiercely defended the planned finite supply and is notoriously change-averse. But politics among users, not math, keeps things that way for now.

Those politics may shift if bitcoin's adherents come to agree with mainstream economists, who say the currency will hit a deflationary spiral as bitcoin are accidentally lost over time and the supply dwindles.

Computer scientists also fear that the protocol will become unstable as inflationary rewards for bitcoin "miners" (who secure the system using tremendous computing power) are phased out in favour of transaction fees.

For these reasons, some newer cryptocurrencies have eschewed bitcoin's finite-supply plans. Instead, they follow a digital version of Milton Friedman's proposal for low but constant inflation.

MYTH #2: Bitcoin users are anonymous

Nakamoto, bitcoin's founder, claimed that the currency offers privacy, since transactions are not listed under real-world identities. Bitcoin's blockchain, the permanent public record of transactions, uses cryptographic pseudonyms.

Users can create as many free pseudonyms as they want, and most bitcoin software generates a unique pseudonym for every transaction. WikiLeaks encourages donors to use bitcoin because it's "anonymous" and "cannot be easily tracked back to you."

Harvard economist Kenneth Rogoff has even suggested that governments will eventually move against cryptocurrencies because of their anonymity features.

But the vast majority of bitcoin users don't get significantly more privacy than they would with traditional bank transfers, and they probably get much less than they would by paying with cash. That's because it's possible to link a user's pseudonyms together by studying patterns in the blockchain.

Several blockchain analysis firms already offer their services to law enforcement. What's more, most users leave a paper trail when they buy or sell bitcoin in exchange for dollars or other fiat currencies, as reputable exchange services record identities to comply with "know your customer" laws.

The most technically savvy users can still hide their identities through coin-mixing protocols, in which users swap coins with each other to jumble ownership patterns, but these remain difficult and sparsely used.

Some bitcoin competitors offer stronger built-in privacy, but these currencies are much less popular.

MYTH #3: Bitcoin is beyond the reach of the law

In bitcoin's early days it was the currency of choice for a multimillion-dollar underground drug market called the Silk Road, prompting critics, from JPMorgan Chase's chief executive to France's financial-market regulator to Nobel laureate Joseph Stiglitz, to claim that bitcoin is a haven for those seeking to evade the law.

(Stiglitz said that it "ought to be outlawed.")

And even bitcoin's advocates sometimes say, as one analysis put it, that the technology is "one step ahead of anti-competitive laws and unfriendly jurisdictions."

Not really. New technology always requires updated interpretations of existing statutes and case law - in this case originally written for other parts of the financial sector - and that gradual process is well underway for bitcoin.

Its exchanges are already regulated through specific laws in some states, such as New York, and by rules on money transmission services elsewhere. All mainstream bitcoin exchanges at least attempt to comply with "know your customer" laws to prevent money laundering.

The IRS regards bitcoin as taxable property. The Securities and Exchange Commission recently began cracking down on initial coin offerings, a new type of blockchain-based fundraising mechanism, under its existing authority to regulate securities.

The original Silk Road market has been closed, and authorities have managed to shutter numerous follow-up efforts. And many other countries, most notably China, have moved aggressively to regulate or ban certain types of cryptocurrency business.

MYTH #4: Bitcoin wastes energy

Bitcoin mining is an energy-intensive process. Anybody can become a miner, but he or she needs special hardware chips working constantly to solve the cryptographic puzzles that create new blocks in the bitcoin ledger (in exchange for the rights to newly created bitcoin).

Because of its decentralised nature, nobody knows the exact amount of electricity this process consumes, but it's likely to be several gigawatts at any given moment, roughly equal to the output of a massive power plant such as the Hoover Dam.

No wonder observers have lamented bitcoin's environmental impact, with reports that individual transactions use as much energy as a home uses in a week or, more hyperbolically, that bitcoin will consume all of the world's electricity within a few years.

But compare the overhead for various currencies. Banks pay for security guards (among many other security expenses), who often merely stand around watching the customers. We don't think of this as wasteful, because without guards, theft could undermine the entire system.

The same is true for the raw power used by bitcoin miners. We don't yet know how to secure a decentralised ledger like bitcoin's blockchain without the energy-intensive mechanism.

There's an open scientific argument about what level of energy expenditure, as dictated by the revenue earned by bitcoin miners, is necessary to secure the system.

If research on lower-energy methods pans out, bitcoin can change - or be replaced by a greener competitor. Until then, this is an essential cost for the currency.

MYTH #5: Bitcoin will replace credit cards and/or cash

Many utopian bitcoin supporters, such as Kim Dotcom, creator of the Megaupload file-sharing site, predict bitcoin will overtake other payment schemes.

"In five years, if you try to use fiat currency, they will laugh at you," says major Silicon Valley investor Tim Draper.

But bitcoin does not yet have several key properties needed for a universal payment mechanism.

First, the design currently limits the system to handling only a few transactions per second, nowhere near the tens of thousands that credit card networks can handle, nor the tens of thousands more done in cash every second.

The community has worked for years on various plans to improve bitcoin's capacity, but there is no agreed-upon path forward.

Second, bitcoin transactions, once free, are increasingly expensive, with fees now averaging US$20 and reaching as high as US$400, based on demand. Developers are working to improve capacity, but for now the trend is going in the wrong direction.

Finally, bitcoin transactions do not take effect immediately because of the limitations of the blockchain. New transactions are added only every 10 minutes, on average, and when users desire extra security, they can take more than an hour.

Even with planned improvements, it's unclear if the technology can ever become a universal payment system. Bitcoin is more like a reserve store of value, akin to gold bullion or Treasury notes, than a day-to-day tender.

This article was originally published by The Washington Post