An insightful comment about Bitcoin in 2011

By a user named Construct in spring of 2011:

Four days ago, Bitcoin was under $2 USD. Now it’s over $4 USD (depending on when you refresh the page). There are 6 million bitcoins in existence, and trade volume is only about 54,000 according to the biggest exchange. There aren’t enough bids/asks to soak up more than about $100 USD without throwing the exchange rate one direction or the other. For example, right now (as I write this) exchanging $1000 USD for some Bitcoins is all it takes to push the exchange rate up $0.10 from $3.77 to $3.87.

What a lot of Bitcoin newcomers don’t realize is that Bitcoin depends on ‘mining’ to generate new bitcoins. Computers run cryptographic hashes to find the ‘winning’ has which is less than the current difficulty target number. The computer that finds this hash is awarded 50 BTC. The difficulty target is automatically adjusted upward to keep new bitcoin generation at a constant pace.

Some quick research shows a handful of big players in the mining market who have invested heavily in high-end GPUs for dedicated bitcoin mining, some with over 50 GPUs running 24/7 for months now. These guys are bound to have huge quantities of bitcoin they are eager to unload when the price is right. Meanwhile, news coverage is driving exploding popularity, which appears to be pulling the exchange rate sky high. On paper, many of these guys have become overnight millionaires just by running a bunch of computers 24/7. Of course, as these players cash out the exchange rate will fall. These guys are too smart to sell all at once and flood the market, but with volatility like this I’m willing to bet a lot are eager to pull their bitcoin out of the game before the bubble pops.

Meanwhile, hardware enthusiasts all over the internet are rushing to buy GPUs to dedicate to mining. They don’t seem to realize that the bitcoin system automatically adjusts to keep the bitcoin generation rate constant at 50 BTC per 10 minutes. As the mining market becomes flooded with new ‘miners’ the difficulty will climb rapidly, until it becomes unprofitable to run a GPU if you have to pay for electricity.

Finally, bitcoin is highly illiquid. My research was brief, but I couldn’t find an easy way to exchange small amounts of BTC for USD that didn’t look terribly sketchy or involve a lot of fees. Stores aren’t eager to accept bitcoin because the exchange rate at the moment can easily swing 10% between when the user presses ‘check out’ and the transaction is processed.

The bitcoin system is a very interesting concept, and it was clearly implemented by some very intelligent people. But as it currently stands it’s just a playground for speculators and market manipulators. Expect some carnage in the coming months.