Saturday, October 15, 2011

How to Fix Bitcoin

In recent months, the Bitcoin price has been drifting steadily downwards, as this log-scale chart shows:

Bitcoin price on Mt. Gox, in USD/BTC, over the year-long period ending Oct. 15th, 2011.
Indeed, as numerous critics of Bitcoin have pointed out, a major flaw in the system is that there is literally nothing that prevents the Bitcoin value from just drifting down and down until it is essentially zero - say as people get bored with it and lose interest.

How can this flaw be repaired?  Well, there is a simple way - if everyone who used the currency agreed, in a contractually-binding legal agreement, that they would, in perpetuity, accept 1 Bitcoin in place of a certain amount of traditional (legal tender) currency that is owed them by anyone.  This would effectively set a floor on the exchange rate.

What should the floor be?  Well, if Bitcoin is to ever become a significant part of the world economy, then it needs to be large enough so that the total value of all Bitcoins in circulation is comparable to the base money supply of traditional currencies.  The limiting number of BTC is 21,000,000, so if the floor were set at say, 1 BTC = $100,000 (i.e., 1 USD = 0.000 01 BTC), then the value of the limiting BTC supply would be $2.1 trillion, comparable to the base supply of physical US money (coins & Federal Reserve Notes).  Or, if the floor were set at 1 BTC = $1,000,000 (i.e., 1 USD = 0.000 001 BTC), then the limiting supply of BTC would be $21 trillion, an amount which is probably larger than the base supply of all existing currencies.

How can we get users to agree to such an exchange rate?  This might not be possible with the existing BTC block chain, because it might give disproportionate wealth to early adopters and others who hold a majority of the BTC today.  But if a new block chain were started from scratch, and using a new version of the software that was distributed with a licensing agreement that required users to contractually accept the new exchange rate, then it might be able to catch on - since miners of the new currency (call it BC2) would stand to gain enormous wealth, due to its much higher value.  (Although eventually, difficulty would rise to the point where mining was only just profitable again.)

For convenience and for psychological favorability, the new unit BC2 should be chosen to have a floor on its value equal to 1 US dollar, thus, 1 BC2 would be 1 hundred-thousandth or 1 millionth of 1 BTC (depending on the money supply target).

With this new price floor, mining would (at least initially) be extremely lucrative, and would attract millions of new users to join the system, and accept its user agreement.  As a result, suddenly, Bitcoin (the new version) would become very widely accepted, and at a very favorable exchange rate, and so its growth would snowball.

One way to enforce the change (which could be done with either the existing block chain, or a new one) would be to distribute a new version of the reference client that only accepts transactions to or from any given address if the owner of that address has digitally signed a contract agreeing to the new minimum exchange rate.  (If the major mining pools accepted this protocol change, it would become the de facto standard.)  However, in order for the contract to be effective, it would have to include the real-world identity of the owner, which would kill Bitcoin's anonymity.  Also, there would have to be a process for verifying that the supplied owner identities are valid.  So the idea is not free of difficulties.  But these sacrifices might be worth it to help Bitcoin grow from the small niche status it has today into a true global phenomenon.

I offer up this idea to the Bitcoin community for comment.

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