I’m quite fascinated by Bitcoins and in a previous post I’ve started to tell what I have learned by taking theory into practice. In the second part I continue the story as there is still a bit to tell about Bitcoin exchanges, market volatility, limitations of the system and how bad guys might be using the system to their advantage. Read on for the details.
Bitcoin Exchanges / Market Places
One way to convert Euros, Dollars or any other currency into Bitcoins is to use websites that offer such a service. For the details see the end of the previous post on the topic. While this is fast, such websites take quite a cut from the transaction. When I converted a few Euros into Bitcoin the difference to getting Bitcoins via a trade was around 5 percent.
To trade Bitcoins a market place or exchange is required where sellers can meet buyers and where supply and demand determine the price. Bitcoin.de is such an exchange and trades are made directly between a buyer who wants to exchange Euros into Bitcoins and a seller who has Bitcoins and wants to exchange them for Euros. To make sure the seller really has the Bitcoins he offers, he has to transfer them to a Bitcoin ID of the Bitcoin market place. When a sale is made the exchange will give the buyer the bank account details of the seller so he can make a bank transfer of the amount of Euros required to buy the Bitcoins. Once the seller confirms to the exchange that the money has been received, the Bitcoins are removed from his account at the exchange and put into the account of the buyer. Bitcoin.de charges half a percent to each party for its services, which is much less than what the before mentioned Bitcoin portal charges. The buyer can then move the acquired Bitcoins to one of his own Bitcoin IDs outside the exchange. This way the buyer does not have to trust the seller as the seller’s Bitcoins are held by the Bitcoin exchange. In other words, the seller can’t run away with the money and the Bitcoins. Obviously both seller and buyer have to trust in the security of the Bitcoin exchange platform. More about that later. To prevent money laundering, users have to go through a bank account validation and video authentication procedure. Bitcoin.de charges 10 euros for the pleasure.
Converting Bitcoins to Euros and Dollars
The same two methods described above can also be used to convert Bitcoins into Euros or any other currency. The fastest method is to use a Bitcoin portal that offers to buy Bitcoins at a the current market value plus a premium for their services and transfer the corresponding amount of Euros to a banking or Paypal account. If time is not of essence, using the Bitcoin exchange is a cheaper alternative but it could take some time before a buyer and seller meet and again additional time for the bank transfer to be executed. In other words if you don’t have a special bank account connected to the Bitcoin exchange (which I did not have) a transaction can take one or two days and longer if a weekend is just ahead of a bank transaction.
Volatility
Owning Bitcoins is a volatile business. While I was writing the two blog posts on this topic, the price for a Bitcoin changed from 400 to 440 Euros, i.e. 10 per cent in just two days. Changes in the other direction can happen just as quickly as the graph at Coindesk shows quite vividly. In other words, holding Bitcoins for a longer amount of time is a risky business.
Trust
While sending and receiving Bitcoins is straight forward and requires no trust between the two parties as far as the transaction is concerned, using Bitcoin portals or exchanges to convert Bitcoins into Euros or vice versa is another matter. In the case of a portal, you have to trust the portal to actually send you the Bitcoins for the money you have paid to it. In the other direction, you have to trust the portal to send you the amount of Euros for the Bitcoins you have sent to the portal. As the portal isn’t a bank it is not state regulated so if the portal goes out of business or is attacked by cyber criminals while your transaction is ongoing you could be out of luck.
When using a Bitcoin exchange for trades between buyers and sellers, Bitcoins are kept at the Bitcoin exchange until the transaction is finalized, which, as described above, can take several days. If during that time something goes wrong with the Bitcoin exchange you are again out of luck, they are not a bank so there’s no insurance to cover any loss. This might all sound theoretical but it has happened in practice before, Mt.Gox is a prominent example. Therefore select the Bitcoin exchange you want to trade on carefully.
Bitcoins And Bad Guys
In part 1 I’ve mentioned that Bitcoins are anything but anonymous. All Bitcoin IDs on which Bitcoins are deposited are part of the public ledger as are all transactions ever made. Thus if a Bitcoin ID is ever used for receiving a payment that was previously used to exchange Bitcoins into other currencies for which identification was necessary, anonymity is gone. As all transactions are also public, anonymity is also lost if another Bitcoin ID from which money was sent to this Bitcoin ID was at any point in time used for currency exchange for which an identification was necessary.
Given all that how could bad guys use Bitcoins to receive ransom and engage in money laundering activities if the authorities just have to monitor Bitcoin IDs that were used to receive a ransom? After doing a bit of research I found the answer: Mixers! Mixers are Bitcoin websites that receive Bitcoins on one Bitcoin ID and send the same amount of Bitcoins, minus a commission on another and totally unrelated Bitcoin ID. This way the transaction log is broken and anonymity can be restored. Obviously, the user of a mixer has to trust the mixer because there is nothing that would prevent the operator of a mixer to take the Bitcoins at some point in time and run. In addition the bad guy needs to ensure that the transaction process itself is anonymous which means he has to use TOR to send transactions to the Bitcoin system and to query for the result. So while there are many legitimate uses for TOR and Bitcoin mixers they can obviously be misused.
Problems And Limits
Having said all of this there are a number of problems in the Bitcoin system that one should be aware about to make informed decisions. The main ones are that that 50% of the Bitcoin mining and transaction capabilities are in the hands of two Bitcoin pools, both operated out of China. There are critics that say this is to much power over the system in to few hands. Another thing that I’ve mentioned before is that the Bitcoin system is limited by design to around 7 transactions per seconds. That is way too little and way to slow to make Bitcoins a mainstream method for real time payments. And a third thing, also already mentioned is the price volatility which makes buying, selling and using bitcoins a very speculative thing. For more details here’s a podcast I can recommend.
Summary
My takeaway from using Bitcoin to donate to a number open source projects is mixed. Without significant effort invested by using TOR and mixers it is not an anonymous payment system. But even without that extra effort, converting Euros to Bitcoins and then sending Bitcoins is either more effort than using other online payment services such as Paypal or traditional bank transfers or commissions are higher. So I can’t really see a major advantage of using Bitcoins over other methods of payment for such transactions. That would leave Bitcoins as an investment strategy. Given its volatility, however, that’s not something I’d risk with my money. It was good to have tried it out but for the moment I don’t see how Bitcoins could change the way I conduct business online.
Money has two contradictory aspects: 1) a store of value, and 2) a medium of exchange. Bitcoin, by being limited in total number of Bitcoins ever, emphasizes 1); it wants to be hard money (that doesn’t prevent volatility, of course). Modern economies need to emphasize 2), so that trade happens efficiently and effectively. Eventually, Bitcoins will be the toys of billionaires; they will not revolutionize the economy. But blockchains might.