Lessons from the Second Great Bitcoin Crash

What the hell happened and what have we learned?

April 16, 2013, 2:55pm

Only a week ago, it seemed like bitcoin could do no wrong. The digital currency’s value against the U.S. dollar surged past $200, at one point reaching $270. Then, suddenly, as many expected, the bubble finally popped, and it all came crashing down. As I’m writing this, bitcoins are trading around $60 on Mt. Gox, the largest exchange, which, last week, suspended trading for twelve hours, after panicked speculators flooded the market with sell orders.

For the bitcoin ecosystem, this was a much needed shake-up, as the frenzy to get rich quick had reached a fever pitch. Fueled by the events in Cyprus, acknowledgement from the U.S. Treasury, and a wave of mainstream news coverage, everyone seemed to want to join the party. Now the punch has run dry and a few latecomers have surely lost their shirts. What the hell happened and what have we learned?

The anatomy of the bitcoin bubble. Trendline 1 follows the linear growth Bitcoin has displayed before the recent hype, while 2 and 3 show how price growth ramped up higher than normal in the latest bubble. Trendline 3's rapid growth shows the hyper deflation that led to the recent price collapse.

Bitcoin isn't ready for primetime. What precipitated the crash was a failure of infrastructure. At the height of the panic, almost every major bitcoin trading tool was down either due to traffic overload or rumored denial of service attacks including Mt. Gox; Bitcoinity, another exchange; Bitcoin Charts, a popular site for monitoring markets; and even the bitcoin forums.

For a market that was at one point worth over $2 billion, that’s a big joke and completely unacceptable. It’s also unavoidable. Waves of hype will often outpace the development of infrastructure, and there’s something about human nature that fuels these inevitable bubbles. Whatever the reason—whether it be greed or mob mentality or something else entirely—the fact remains that the services and systems that support the burgeoning bitcoin ecosystem aren't yet able to keep up with demand when things get crazy.

Growing pains are a fact of bitcoin growth, and indeed they caused the last great bitcoin market crash in the summer of 2011. Back then it was because of poor security and wallet thefts. This time it was because the exchanges simply couldn’t handle the volume. For what is supposed to be decentralized, it’s ironic and almost embarrassing that the system was taken down by a single centralized point of failure, the Mt. Gox exchange. But these issues can only be addressed slowly and organically over time, and generally, this is already happening.

According to one bitcoin insider who has access to exchange data, the share of total bitcoin trading volume that goes through Mt. Gox has already dropped to 50 percent from a high of 80 percent. That's an improvement, but bitcoin has a long way to go. Development is incremental, but hype comes in waves.

For what is supposed to be decentralized, it’s almost embarrassing that the system was taken down by a single centralized point of failure, the Mt. Gox exchange.

Expect volatility. When the majority of all bitcoin trading volume comes down to speculation, volatility is going to be the norm. The mainstream press still loves to say that the only use for bitcoins is for buying drugs online. It’s an unfair assessment, but it’s not completely untrue.

For most users, there’s little reason to actually use bitcoins outside of curiosity, gray market gambling, and yes, procuring some top shelf molly off the Silk Road. Everyone else is just speculating, hoarding, and selling (oh, and buying socks). This does not make for a healthy market.

For all the talk about bitcoin being a worthy alternative for Europeans with fiscal worries, with this kind of volatility, it’s not much of a safe haven for anyone. Again, these are issues that only time can solve. In the meantime, bitcoins remain an extremely risky endeavor.

Don’t get greedy. Bitcoin was never supposed to be a get-rich-quick scheme and there’s little sympathy for those who lost money. As lead developer Gavin Andresen has said, don’t invest more in bitcoins than you are willing to lose. The value of bitcoins could reach $10,000 or just as easily go back to zero.

This is the essence of uncertainty and it’s not just limited to bitcoin. This week, gold fell the most since the 1980s. Fiat currencies around the world are also experiencing high levels of volatility. Sure, the swings in bitcoin are wilder, but it’s also, by definition, exponentially riskier.

The price doesn’t matter. To the early adopters and core users, it never has. The concept of bitcoin remains the same. The fundamentals haven’t changed. With bitcoins, no matter the price, you can still send money to anyone anywhere in the world nearly instantaneously without a middleman or bank or service with minimal fees. Try doing that with cash or PayPal.

What’s important is what bitcoin represents, a vision of what money might look like in the future. Bitcoin could fail, but the idea will live on. And what matters more than the price, as we’ve seen in the last week, is the infrastructure.

Bitcoin isn’t dead. Even at around $60, the value of bitcoin is still up over 100 percent since it matched its last all-time high in the low $30 range just two months ago. One trend is clear, at $60 or at $250, the bitcoin ecosystem continues to expand. Every day, more companies are accepting bitcoins, more companies are being created to serve bitcoin users, and more people are acquiring bitcoins.

Bitcoin could fail, but the idea will live on. What matters more than the price is the infrastructure.

And despite the latest correction, many, like the Winklevoss twins, are seeing it as an opportunity to buy. It’s also clear that this latest bitcoin run has made a big statement about the credibility of virtual currencies. As Silicon Valley venture capitalist Chris Dixon noted on Tumblr, what we are witnessing is the third era of currency, the three being: “Commodity based, e.g. Gold, Politically based, e.g. Dollar, and Math based, e.g. Bitcoin.”

The VC firm Andreessen Horowitz, where Dixon is a partner, has now committed an investment in the opencoin project, which developed a “math based” currency known as Ripple. The San Francisco-based startup has also accepted funds from the Founders Fund, Lightspeed Venture Partners, Vast Ventures, and Bitcoin Opportunity Fund.

Digital currencies like bitcoin are still a long way from going mainstream, but that's okay since the system wasn’t ready to anyway. What we do know is that, crash or no crash, we are on the cusp of something brand new, a truly disruptive technology that could change the way we see money forever--even if we're still a few years off.

Some people think bitcoin could be revolutionary, by allowing people to remove themselves from the traditional banking structure. In the end, it might just make it easier for us to split the check after dinner. But as Dixon noted in a blog post, “what the smartest people do on the weekend is what everyone else will do during the week in ten years.”