Why Bitcoin is not Gold

This is something that has been requested. It is not related to equities per se but instead is the gist of my thesis of why Bitcoin and cryptocurrencies in general won't be able to replace something like gold.

Cryptocurrencies are taking the market by storm now, we have Bitcoin at all time highs this week and lots of hype and exuberance about how they will be a replacement for gold. In this short essay I want to argue that Bitcoin and cryptocurrencies in general can’t never be a replacement for gold as an store the value. 

To crux of this thesis is that gold is very hard to replicate. We have had the ability to synthesize gold from other (cheaper) elements for a long time now however the process itself is prohibitively expensive so while feasible from a technical point of view it makes no sense to replicate gold from an economical point view (perhaps some day if gold prices go up enough there might be an incentive for that).

For cryptocurrencies this is a very important issue. The reason is that they don’t exist in the real world like gold, in theory you could go to a suitable mine and extract gold from the ground and then sell it ( a long, expensive and arduous process) however for cryptocurrencies it only takes computing power to generate them out of thin air. Of course the designers of Bitcoin envisioned this problem and came up with a very ingenious solution to make the process of creating new bitcoins progressively harder (until no more bitcoins can be created at all after certain limit). So Bitcoin and any other cryptocurrency introduced the concept of “proof of work”, the idea is that before being able to generate new bitcoins you have to offer proof that you spend some time solving a problem. The nature of the problem is actually irrelevant, the idea is that it has to be something that is time consuming even with the most powerful computers and specialized hardware available, and also it needs to be something that scales so it can be made harder and harder as technological advances make the machines more powerful.

The way that Bitcoin went about this is to use a proof of work problem based on the concept of a cryptographic hash function. A hash function is a mathematical function that takes an arbitrary length input and generates a fixed length output, the function is designed in such a way that it can be computed in a short time however the idea is that performing the reverse process is extremely hard or impossible. This can be expressed as:

h(x) = y

If you provide x to the function “h” computing y is very simple and fast, however if you have y and want to find x is very hard or impossible to do. Because of this, that is how the proof of work concept works in Bitcoin, you are given a y value and you have to find x (well the exact protocol is slightly different but that is the concept).

Note that because reversing the hash is almost impossible you basically have to explore all possible values of “x” until you find a match. This process is very time consuming, not to mention it wastes a lot of computing power and electricity and is the reason why bitcoins have some kind of intrinsic value on them (it costs time and energy to generate them).

By now, the most astute of you can figure out what is the weakness of this arrangement. The problem with a hash based proof of work is that is assuming that the hash function is irreversible (or nearly impossible to reverse). However the current state of the art in mathematics hasn’t proven at all that hash functions are indeed irreversible. In other words we think they are but we are not 100% sure. Now, we think that even if they turn to be reversible actually doing the computation is a very hard problem to solve (in other words we think that it is an NP complete type of problem) but then again, no one has offered proof that reversing the hash is an NP problem. If if turns out that it is a false assumption then it could be possible to design a clever algorithm that would reverse the hash in no time.

Here is where my thesis resides: For gold we know we can create gold from other elements, however doing so is and will be prohibitively expensive for a long long time, however for Bitcoin we don’t really know for how long the hash problem will remain unsolvable. It would only  take a new mathematical genius to appear and come up with a simple and elegant solution and poof we can generated ungodly amounts of BitCoin with a single click. So even though BitCoins looks safe right now the future is indeed uncertain. A massive breakthrough like that could arrive within 1 or 2 generations, rendering cryptocurrencies worthless (contrast that with gold that has been going strong for milenia).

Leo Valencia hosts the Gamma Optimizer options service at ElliottWaveTrader.net.