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Altcoins - Nothing To Worry About

The rise of altcoins has sparked discussion whether all those altcoins will negatively affect Bitcoin's future. Does the fact that Bitcoin is open source not lead to the creation of an unlimited number of altcoins? In this article, I will argue that this is not the case.

1. The Rise of Altcoins

In its young live, Bitcoin has already caused quite a stir. All major news media in the Western world have reported on this phenomenon. Although reporting is still mostly based on its meteoric price rise, it is undeniable that knowledge of Bitcoin - and with it: cryptocurrency - is spreading. The world is slowly learning about cryptocurrency and its endless possibilities. The focus is on Bitcoin, but the discussion is moving beyond Bitcoin as a coin to bitcoin as a protocol.

Bitcoin was started in 2009 as open source software. It took some time to spark attention, but when things got heated (everybody remembers the 10,000 BTC pizza in 2010) Bitcoin's big rush forward was underway.

Because Bitcoin is open source software, the program can be copied and altered by anyone who desires to do so. Soon, some people took a good look at the source code and developed their own software, based on Bitcoin. These coins - derived from Bitcoin - are called 'altcoins' (alternative coins). Examples of early altcoins are Namecoin, Devcoin and Litecoin. Meanwhile, the list of altcoins is not limited to a few. In fact, the list of altcoins is massive (probably 200+ as per January 2014). A list of the most active altcoins can be found at Coinwarz.com. Most altcoins are a variation on Bitcoin. Only a handful of altcoins really try something different (e.g., Namecoin, Devcoin).

There's a vibrant exchange of all these coins going on. While the big exchanges (like MtGox and Bitstamp) only deal with Bitcoin, there are lots of other exchanges (like BTC-E, Vircurex and CoinEx) where numerous altcoins are traded 24/7. It is clear that - at this stage - there is life in altcoins, with new altcoins still being launched on a daily basis. The most recent successful altcoin is Dogecoin.

2. A closer look at Bitcoin as money

As stated above, Bitcoin is open source software. Anyone can take the source, alter it and bring out his own cryptocurrency. It is even possible to bring out a new Bitcoin that is a 1:1 copy of the original (Bytecoin). This is an essential property of software. Duplication is easy and near free.

But wait a minute. Was money not meant to be scarce in order to be accepted as money? If everyone can make all the coins he wants, wouldn't the value of cryptocurrency diminish very quickly?

While this seems to make sense, a closer look reveals that there is nothing to worry about. In order to illustrate this point, we dive into a book that can be considered a classic if studying money and the role of government in relation thereto: Rothbard - What has Government Done to Our Money? (PDF).

2.1. The Classic Definition of Money

On page 15, Rothbard describes the essence of what money is.

Money is a commodity used as a medium of exchange.

Like all commodities, it has an existing stock, it faces demands by people to buy and hold it. Like all commodities, its “price” in terms of other goods is determined by the interaction of its total supply, or stock, and the total demand by people to buy and hold it. People “buy” money by selling their goods and services for it, just as they “sell” money when they buy goods and services.

Money is not an abstract unit of account. It is not a useless token only good for exchanging. It is not a “claim on society”. It is not a guarantee of a fixed price level. It is simply a commodity.

The above quote illustrates that in the classic thoughts of economists, money was a commodity having intrinsic value and not a 'useless' token. Over time, the most appropriate commodity is stated to have gradually taken on the role of money. No wonder that economists of today have some trouble seeing the abstract notion of a Bitcoin as money. There is an extensive debate going on whether Bitcoin has intrinsic value and if so, why (for examples, see Krugman and others). I will leave that discussion for what it is and focus on Rothbard's introductory notes on money.

Rothbard mentions on page 17 that important functions of money as described in literature are 1) a medium of exchange, 2) unit of account and 3) a store of value. It is quite obvious that Bitcoin can fulfill the elements 1 and 2. For the sake of argument, let's assume that Bitcoin can also meet element 3. Below, we will dig further into the subject on how Bitcoin can be considered money.

2.2. How Does a Commodity Promote to Money?

Now, getting back to the classic idea of how a commodity assumes the role of and is promoted to money, I refer to pages 14/15 of Rothbard. I think this is illustrative for the manner in which Bitcoin is slowly being adopted as a medium of exchange. Rothbard describes how certain commodities over time are exchanged not only for their properties as commodities, but also because they have greater marketability. The receiving person will accept this commodity with ease, knowing that another person will again accept this commodity. In the end, this can turn a commodity into a medium of exchange: money.

If one good is more marketable than another—if everyone is confident that it will be more readily sold—then it will come into greater demand because it will be used as a medium of exchange. It will be the medium through which one specialist can exchange his product for the goods of other specialists.
[…]
It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media—in almost all exchanges—and these are called money.

The free market is an essential element in the establishment of money. Money is not established by government decree, however hard they try. Rothbard continues in this respect on page 15.

This process: the cumulative development of a medium of exchange on the free market—is the only way money can become established. Money cannot originate in any other way, neither by everyone suddenly deciding to create money out of useless material, nor by government calling bits of paper “money.”
[…]
Thus, government is powerless to create money for the economy; it can only be developed by the processes of the free market.

Again, I note that Rothbard assumes that money is based on a commodity. A commodity that - by free market forces - is promoted to money over time. Bitcoin raises the question whether this construction is correct. As the following article states, it is possible that in case of Bitcoin, it is sufficient that market participants have reached 'mere agreement' that Bitcoin is money. This contradicts Rothbards statement that money cannot be a 'useless token only good for exchanging'.

Perhaps Bitcoin is not a commodity. The fact that it is nonetheless perceived as money by market participants who are anonymous versus each other, operating in a network without a 'leader', is the revolutionary aspect of Bitcoin.

3. How Does This Relate To Altcoins?

3.1. Applying Rothbard To Bitcoin

The reflections on Rothbard's concept of money are important to grasp the rise of Bitcoin and - in its wake - altcoins. It is clear that the free market plays an essential role. Apparently, the free market is increasingly choosing Bitcoin as a medium of exchange, regardless whether it is a commodity or just a useless token. According to Rothbard's line of thinking, this could work ”if everyone is confident that [Red. Bitcoin] will be more readily sold” as having greater marketability than other goods. Apparently, this is the case.

Whether Bitcoin proves fragile because its acceptance may be solely based on the fickle minds of men, remains an open question. That is part of the great experiment.

Necessarily, this logic also applies to Altcoins.

3.2. Applying The Laws of Bitcoin to Altcoins

Most altcoins have similar properties as Bitcoin. For example, a limited supply and the same properties as medium of exchange (near free payments, 24/7, p2p, etc). The number of altcoins has exploded. Furthermore, they are heavily traded on numerous online exchanges. It is save to assume that the elements that have propelled Bitcoin into what it is today, are also present in respect of altcoins.

The trading is not confined to altcoins with a value of only a fraction of a dollar. There are also altcoins with considerable value. For instance, Altcoins like Litecoin and Namecoin trade at values of multiple US dollars per coin.

Altcoins operate in the same arena as Bitcoin. Altcoins also represent free market money and provide for an underlying network. They compete with Bitcoin. The principles as described by Rothbard and quoted above, are equally applicable to altcoins as to Bitcoin. Their specific properties like the number of coins, speed of confirmation and encryption techniques may draw specific interest of investors. A comparison is Myspace versus Facebook. Both social media networks, but not the same. It is not unlikely that Bitcoin will face enduring competing of altcoins or is even surpassed in time just like Facebook took over the throne from Myspace.

This is essentially a good thing.

3.3. Some More Thoughts On Competition

Just as competition between firms competing with better and cheaper products is beneficial for people, competing cryptocurrencies are essential for strong and effective markets. The free market determines which money is superior and most preferred. If Bitcoin falls back and loses an advantage over altcoins, it is quite possible that Bitcoin is surpassed. This is nothing to worry about. This competition puts pressure on developers of cryptocurrency to make sure that users get the best out of it. It encourages innovation and continues efforts to develop new applications, better quality and choice.

To understand why free creation of money in the form of altcoins does not endanger Bitcoin, I draw an analogy to free banking as described by Rothbard. Yes, again Rothbard who has expressed very clear thoughts in this field: Rothbard - What has Government Done to Our Money? (PDF). In Chapter VIII of this book, Rothbard describes the concept of free banking, meaning a (hypothetical) situation that anybody can start a bank.

Below, I will present some quotes from this chapter. Rothbard describes the fear for chaos if banking is left totally free and his arguments against chaos appearing. We can apply those fears and arguments to cryptocurrencies to determine how and to what extent the analogy holds up.

3.3.1. Fear of An Unlimited Money Supply

First, the fear of unlimited supply of money (page 112).

Propagandists for central banking have managed to convince most people that free banking would be banking out of control, subject to wild inflationary bursts in which the supply of money would soar almost to infinity. Let us examine whether there are any strong checks, under free banking, on inflationary credit expansion.

On a first look, it is easy to see the fear for an unlimited supply of money. If everybody can start a bank and creates lots of money, the supply of money would explode rendering money worthless. The same would apply to cryptocurrency. If everyone can create his own coin (you can even buy your own coin nowadays), there would not be much value to all that money.

Luckily, there is an ever present force that will prevent money becoming worthless or, better stated, money being created without limits. In Rothbards example, it's about banks issuing bank notes and issuing bank deposits. The bank cannot create money without limits, due to an important restriction: acceptance by the public.

[…] there are several strict and important limits on inflationary credit expansion under free banking.
[…]
If I set up a new Rothbard Bank and start printing bank notes and issuing bank deposits out of thin air, why should anyone accept these notes or deposits? Why should anyone trust a new and fledgling Rothbard Bank? Any bank would have to build up trust over the years, with a record of prompt redemption of its debts to depositors and noteholders before customers and others on the market will take the new bank seriously.
The buildup of trust is a prerequisite for any bank to be able to function, and it takes a long record of prompt payment and therefore of noninflationary banking, for that trust to develop.

Looking at cryptocurrencies, we can translate this argument into the concept of acceptance of a cryptocurrency. Only if users accept a cryptocurrency, it will be held and valued by the public. Acceptance can for instance be based (and lost) on the basis of the developers behind the coin and the size and/or security of the network behind it.

It could take several years for a specific cryptocurrency to build up acceptance and trust. The fact that we currently experience a vast explosion of altcoins and various seemingly pump and dump schemes, does not mean that this will forever be the norm. Bitcoin is the leader because of first mover advantage and representing the biggest and most secure network, but also because it's not about pump and dump. Over the years, people see that it functions and put more and more trust in that network. Bitcoin acceptance is growing and all on the basis of free choice. I expect pump and dump practices with new altcoins to vanish over time as people grow wiser. The main cryptocurrencies will attain a dominant position in the market, making it harder to start a widely accepted new coin.

A rough analogy with bakeries can be made. The number of bakeries in a given area is determined by the restraints and possibilities within that specific area. Costs of production, supply and demand all play a role in the question how many bakeries will exist. If demand for bread is low, the number of bakeries can be expected to be lower. But if demand for bread is high, the number of bakeries can be expected to be higher. It makes sense to expect a similar effect in case of free market money, but then specifically tied to the acceptance of coins by the free market from time to time.

The free market will regulate acceptance of an altcoin as money, not the issuer. This forms an important limitation in the expansion of money.

The argument of free market as limiting force is also applied further by Rothbard in his free banking example.

There are other severe limits, moreover, upon inflationary monetary expansion under free banking. One is the extent to which people are willing to use bank notes and deposits. If creditors and vendors insist on selling their goods or making loans in gold or government paper and refuse to use banks, the extent of bank credit will be extremely limited. If people in general have the wise and prudent attitudes of many “primitive” tribesmen and refuse to accept anything but hard gold coin in exchange, bank money will not get under way or wreak inflationary havoc on the economy.

This argument works perfectly fine with cryptocurrencies as well. Market participants will determine the acceptance of cryptocurrencies. Since man is not stupid, he will grow accustomed to the power of free money (creating cryptocurrency freely) very quickly and adapt his behaviour accordingly. There will be over-issuance of altcoins, but those coins will fall flat in the free market. Only the most trustworthy and widely used cryptocurrencies will be generally accepted by the public. The general limit to acceptance of just any altcoin as money in a transaction limits the amount of money in circuation.

See? There is nothing to worry about.

3.3.2. A 'Bank Run' on a Cryptocurrency

It is clear that developers of a cryptocurrency will not mess with a coin without giving this much thought and reaching out to their user base first. Just like unsound banking practices may lead to a bank run, onerous changes made by the developers of a cryptocurrency may lead to users dumping this cryptocurrency on the spot.

The trust in and value of a cryptocurrency is constantly visible by means of exchange rates. Trading between different cryptcurrencies is bound to happen since it can be expected that at least several cryptocurrencies will acquire a long lasting dominating position in the market. The ebb and flow between these cryptocurrencies are based on supply and demand operating in a free market. A decreasing exchange rate may provide an early warning signal that acceptance and trust in a certain cryptocurrency - for whatever reason - is waning.

As Rothbard depicts a bank run as a marvelously effective weapon (page 113), I depict the power of users to sell and refuse acceptance of a cryptocurrency as a marvelously effective weapon against developers tampering with a cryptocurrency.

3.3.3. Conclusions

The thoughts of Rothbard applied to cryptocurrency shows that the freedom to create cryptocurrency is nothing to be worried about. In fact, it is an essential element for its success. Freedom is not without ripples; trust and fear will exist like ebb and flow. In times of high confidence, it can be expected that more confidence is placed in altcoins whereas in times of fear, the large established coins or just Bitcoin is where people run to. This is perfectly natural.

I conclude this paragraph with a powerful quote of Von Mises (Ludwig von Mises, Human Action). Let us not fear freedom, because it is our saviour.

It is a mistake to associate with the notion of free banking the image of a state of affairs under which everybody is free to issue bank notes and to cheat the public ad libitum. People often refer to the dictum of an anonymous American quoted by (Thomas) Tooke: “free trade in banking is free trade in swindling.” However, freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which (Henri) Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865: “I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.”

4. Summing It Up

Altcoins are a good thing for Bitcoin. But altcoins are also a good thing for people. The creation of money is not confined to the government, banks or the creators of Bitcoin. Anybody can create money, and anyone - as in: the free market - can determine what will be considered money. There is no reason to assume that a massive creation of altcoins will crash the price of Bitcoin or established altcoins.

Cryptocurrency | E-Currency


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