Crypto currencies are mirroring pre-crash banking systems - FT (Has Bitcoin betrayed us all?)

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When bitcoin, the crypto currency, first arrived on the scene in 2009 it sold itself on a simple principle.

Unlike central bank money, the supply of which could be expanded on the whim of a non-democratically elected committee, bitcoin’s supply would remain capped at 21 million coins at any cost. This would be effected by way of a decentralised protocol, making it theoretically impossible for any single authority to override or control it.

This, ultimately, was bitcoin’s promise to the world: a currency manufactured and supported by the users for the users, which no single entity could manipulate, and which no third party was required to intermediate. Understandably the pledge appealed most to those who might describe themselves as hard money enthusiasts. Their view was that uncontrolled money creation was the probable cause of most economic instability in the world, and must therefore be constrained. Bitcoin offered them the perfect conduit for this vision.

More than eight years after bitcoin’s arrival, most of these principles have fallen by the wayside. Bitcoin spawned a litany of copycat systems — each with its own profiteering opportunity for early adopters. It no longer matters, for example, that the system is being engulfed by rogue and untethered private money creation. Nor does it seem to matter that it’s been a long time since bitcoin could be honestly described as a decentralised system, free of intermediaries. Economies of scale, as is their habit, have ensured only a handful of professional mining outfits and pools control the bitcoin production scene — they can collude oligopolistically if they so want. What matters is that the crypto scene’s popularity and profitability is soaring, especially for those who have become the new bitcoin power elite.

Even bitcoin is succumbing to the pressure. As of Tuesday, a bitter ideological dispute over how the protocol should scale in the future has led to a breakaway version of the original currency. Because of the way bitcoin is designed, if this breakaway copy gains traction with miners, corporations and users — something we could know within a few hours or days — it could immediately expand bitcoin’s lifetime money supply to 42m from 21m.

Dubbed “bitcoin cash”, this money-creating breakaway ironically owes its existence to the more puritanical part of the community, who insist replica bitcoin systems (known as sidechains) should never be allowed to tie themselves to the core system without limit: that would replicate the conventional and inflationary banking system.

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Unsurprisingly, it is the miners, corporations and intermediaries who support these sidechains: only by forgoing some of their core principles can they remain profitable in this sector. Bitcoin purists tend to be the staunchest critics of the expanded crypto scene, pointing out that almost every day a new token or coin is being issued into the market on the flawed assumption that full convertibility and liquidity can be guaranteed.

Today’s crypto system is beginning to replicate the pre-crisis financial system of the UK, when banks — as long as they had acceptable assets to pledge at the central bank — could receive whatever official liquidity they demanded. For everything else, such as self-created assets, there was the wholesale funding market. We know many of these assets were self-valued at entirely fantastical rates. When the wholesale market froze up, only the central bank had the capacity to support them. The purists understand that the crypto scene will not have that saving grace.

That makes the bitcoin fork a judgment of Solomon moment. Only a decisive win by either side will prevent bitcoin from splitting itself apart. Who, if anyone, gives way in the event of a stand-off will be a telling indicator of what really motivates the community.