The Coming Demise of the Altcoins (And What You Can Do to Hasten It)

Introduction

I understand the word altcoin to mean a network which competes with Bitcoin’s function as a currency and which is smaller than Bitcoin’s network. Thus, Litecoin is an altcoin, whereas Bitmessage is not, even though it is inspired by Bitcoin technology. The Ripple system is not an altcoin, although there is an altcoin called ripples (XRP) which is inexorably linked to it. Ripples the currency should still be considered an altcoin even though its underlying technology is quite different from Bitcoin.

This article explains why there is a tendency towards a single dominant currency, why the network effect overwhelmingly favors Bitcoin above any of its competitors, and why people should speak out against altcoins rather than allow more people to get fooled by them.

The Uses of a Currency

There are two things you can do with a currency: save it or spend it. Although in the future I expect that most people will become both savers and spenders of bitcoins, it is possible to separate these two uses conceptually.

It is possible for people to save with a currency even if there is nothing to buy with it, but it is impossible to spend a currency (that is, use it as a medium of exchange) unless there is someone who wants to save it. If everyone who acquired bitcoins did so simply to spend them literally immediately, then it would be impossible for them to have any value because anyone who held them for any period of time at all would be willing to get rid of them at any price, including zero. Once the currency develops a little bit of demand, then it can be used as a medium of exchange by paying to those who demand it in exchange for a good or service, or indirectly by paying it to a merchant who immediately resells it for money.

The market cap of a currency should be seen as roughly proportional, all things being equal, to a currency’s liquidity, which refers to the value that can be bought or sold without significantly altering the price. While it is theoretically possible for a currency of a given market cap to support any volume of trade as a medium of exchange, this requires that people become less and less willing to hold the currency for any length of time as the volume of trade increases. In this situation, severe practical difficulties ultimately develop. For example, if someone wanted to buy something worth more than the entire market cap of the currency he was using, he would have to pay with several transactions.

Any disruption in the balance of buyers and sellers would affect a currency’s market price more drastically if its market cap was small than if it was large, so the currency with the smaller market cap would be less liquid than the other.^[1]

The Highlander

A more liquid currency has an advantage over a less liquid one because it can support more trade. Furthermore, liquidity in a currency is self-reinforcing. The more that people buy a currency, the more liquid it becomes. This naturally tends to promote the success of a single currency over all the rest.

Consider the hypothetical example of an economy that uses exactly two currencies, Acoin and Bcoin, which are equally preferred by holders. For whatever reason, Acoin develops a very slight advantage over Bcoin. Consequently, a few people exchange Bcoin for Acoin, thus very slightly increasing the market cap and liquidity of Acoin and slightly decreasing that of Bcoin.

Now, in addition to its initial slight advantage over Bcoin, Acoin has the advantage of becoming more liquid. As a result, more people will tend to sell Bcoin for Acoin. Thus, Acoin’s initial advantage is self-reinforcing, and as the disparity between Acoin and Bcoin increases, its superiority becomes more and more evident.

This process will continue as long as Bcoin still serves as a currency. It may ultimately remain only to serve some extremely marginal purpose, but not as a general medium of exchange. This process should be expected for any two currencies on the free market, ultimately leaving one that is overwhelmingly dominant.^[2]

Thus, a more liquid currency will tend to be preferable to both savers and spenders: to savers because of its self-reinforcing superiority and to spenders because there is simply more that can be bought with it.

Liquidity Cannot Be Designed

Liquidity, which is required for anything to be used as a currency, cannot be built into a protocol. It does not matter how brilliantly designed an altcoin is and what cool features it has. Its value depends on a factor that is outside its designer’s control, something more characteristic of the “spontaneous order” of the market than an intrinsic property of the currency.

Bitcoin and the dollar have very different properties, so it is possible to explain Bitcoin’s success in competition with the dollar despite the network effect of the dollar in light of those different properties. However, cryptocurrencies do not have very different properties from one another, so there is very little basis to predict that an altcoin can successfully compete with Bitcoin. In the case of, for example, as Bitcoin and Litecoin, I see no evidence in reality or in my understanding of human psychology that investors should see the difference in their mining algorithms or confirmation times as remotely important. The factor of roughly twenty by which Bitcoin’s market cap outweighs Litecoin’s is by far the biggest difference between them. Right now Bitcoin is growing by supplanting the national currencies, but eventually will absorb the altcoins as well. Bitcoin will gobble up Litecoin at some point, but I do not know if it will be the appetizer or the dessert.

A new altcoin cannot survive with only a fraction of the cryptocurrency pie. It must defeat everything else to succeed, including Bitcoin. Since it begins at an extreme disadvantage with respect to Bitcoin, it cannot succeed with technology that is marginally superior to Bitcoin. It must be as significant an advance over Bitcoin as Bitcoin is over the dollar.

Merchants Don’t Matter

The above discussion explains why Vitalik Buterin’s objection to my earlier article completely misses the point. He first downplays the network effect for currencies on the basis of switching costs.

Making the switch from fiat currency to Bitcoin is quite difficult, and creating bridge services that work between the two is a multi-million dollar affair involving placating established banking partners and complying with a large body of regulation. The path from one cryptocurrency to another is much simpler. Anyone can set up an anonymous exchange over Tor, and it may even be possible to make trust-free decentralized exchanges between currencies using Bitcoin’s underlying cryptography directly.

He then argues that merchants can easily accept as many cryptocurrencies as they wish.

For a merchant accepting Bitcoin, if alternative currencies gather any popularity at all then switching to Litecoin or Primecoin will be a simple matter of downloading a patch. It is even possible for a merchant to accept every cryptocurrency at the same time.

These arguments entirely misconstrue the nature of the network effect for currencies. Merchants are totally irrelevant and so is anyone who uses the coins only for the purpose of transferring funds. What matters are the investors, the people who hold the coins long-term. For them, there is an enormous difference between the different coins, and switching costs are largely irrelevant. Investors will prefer to hold the coin that has the best prospects, thereby necessarily improving it relative to its competitors.

Analogy to Social Networks

For currency investors, the network effect is absolute because it is impossible to buy bitcoins and some altcoin with the same money. This is why analogies to other network effects, such as that between social networks like Facebook and G+, are spurious. It is possible to leverage the benefit of Facebook and G+ at the same time. I can, for example, write a single status update and then post it to both social networks at almost no additional cost.

Furthermore, there is very little long-term investment in the use of a social network. New status updates lose all value in hours. Message boards come and go. All it takes is to ignore Facebook for a few weeks before there is little to draw one back to it. The network effect for social networks is therefore tiny compared to that of currencies.

Intellectually Barren

So far, altcoiners have been able to continue creating and mining altcoins without having to justify themselves very clearly. The responses I have heard to my arguments against them have been terribly inadequate: I get either a non sequitur (“Scrypt is ASIC-resistant”) a misunderstanding of the network effect (as with Vitalik’s piece) or a vapid, inappropriate skepticism (“How can you be absolutely certain that Bitcoin will win?”^[3]

I have never even heard any positive argument for any altcoin that explains why a majority of Bitcoin investors should sell and buy the new coin, or why enough new investors should reject Bitcoin and invest in the new one, in spite of the enormous advantage that Bitcoin already has.

Altcoin Investment Psychology

The present popularity of altcoins should be explained in terms of foolishness and hubris because it cannot be explained rationally.

As investors look at a new altcoin that has come out, they might think to themselves, “This cryptocurrency network is innovative, perhaps this means it will do well.” They might buy in at that point, or they might think a little harder and continue, “But wait. Bitcoin has the much larger network and is therefore objectively more useful as a currency than this new altcoin, despite its innovative features. If I decide to buy some, I would have to sell some of my bitcoins for it, so there is a real opportunity cost. Furthermore, the only way it can win is if all the other investors also switch. Will they or won’t they?”

At the same time, many of the other investors will be thinking the same thing. They will think about the fact that the rest are thinking it too. They will think, “No reasonable person would expect this coin to have any but a small chance of success. But since it can only succeed if lots of people really believe in it, this ensures that it cannot be successful because if no one buys more than a small gamble, then its failure is virtually guaranteed.” If they stop thinking there, they will stick with Bitcoin.

However, they might also think something along the lines of, “It’s quite possible that this altcoin will have an extra jolt in price during the next Bitcoin mania because some people may buy it either because they were not intelligent enough to follow the same train of thought as me or because they too, like me, realize that it may attract people who can be preyed upon. However, that is a risky proposition because it will be hard to know if I am the one preying upon suckers or if I am a sucker myself.” They will then either buy it or not depending on their own confidence in their ability to predict the behavior of foolish people.

Thus, altcoin investment ends up as a dynamic interplay between people who have not thought very far ahead, and people who think they are taking advantage of other people.

The Bursting of the Bubble

The more that altcoiners are asked for valid self-justifications, and the more they are asked how their new coin will achieve liquidity, the less effective their arguments will become, the less hype they will be able to generate, and the less that people will buy them. To defeat the altcoin movement, keep warning newbies against them and insist upon relevant arguments every time an altcoiner tries to change the subject.

The irrationality that props up the prices of altcoins cannot continue indefinitely. As soon as enough investors learn to think far enough ahead to wonder who the sucker is, the prices of the altcoins will begin to drop inexorably. We can make this happen sooner than later. I would like to see a more concerted effort within the Bitcoin movement to demand valid answers and to denounce as charlatans those who cannot give them.

I don’t think it is right to let the altcoin bubble continue without trying to stop it. Altcoins will cause a lot of people to lose money and for a lot of people to make money who are not adding value. Many who are already invested will lose, but I would prefer at least that there will be no more.

Although I cannot be certain, and I am, like everyone, prone to wishful thinking, I think that there is some indication that the altcoin movement is playing itself out: it is no longer possible to generate any interest in a straight Bitcoin clone like Litecoin. It is now necessary to add either a lot of extra features, as is the case with Mastercoin and Ethereum, or simply to act outrageous, as with Dogecoin. Furthermore, it is ridiculously easy to create altcoins now: Coingen is a service that automatically creates altcoins to any specification, and which, amusingly, only accepts payments in Bitcoin. It was apparently created especially for the purpose of helping to discredit altcoins.

Dogecoin

Dogecoin is the highest form of satire. It is such a perfect depiction of the real-life insanity that it is being treated seriously. It is unabashedly coasting on image with no substance whatsoever. Dogecoin supporters do not claim to be the silver to Bitcoin’s gold or attempt to make any arguments (other than “such wow”) to justify Dogecoin as an investment; they just make jokes and give tips to one another.

As I write this, Dogecoin is the fourth largest altcoin between Peercoin and Mastercoin. This fact should get altcoin investors thinking, “Does this mean that other altcoin investors are so stupid that they can’t tell the difference between a joke and innovative projects like Mastercoin and Peercoin or does it mean that there actually is no difference?” The more people think this way, the more the concept of an altcoin will be discredited.

Mastercoin and Ethereum

The other trend in altcoin creation is to add a lot of bells and whistles and to pretend to be a very advanced product so as to hide the fact that it is, at bottom, an altcoin. Examples of this trend are Protoshares, Mastercoin, Ethereum.

All of them are basically altcoins that are also platforms for creating more altcoins. This is insane. Each of them has its own individual problems, but the fundamental problem with all of them is that none of their features are useful unless the underlying altcoin is liquid. Thus, their extra features should not be seen as necessarily granting a competitive advantage over Bitcoin. They still have an enormous hurdle to overcome before they could be a viable competitor to Bitcoin. When people say, “But Ethereum can do smart contracts!” this is actually false. It is only the Ethereum protocol plus liquidity that make smart contracts possible. If Ethereum were not liquid, it would be impossible to build any real penalties into a contract because it would be impossible to tie a sufficient value into them. Since there is no logical reason to expect Ethereum ever to be liquid, there is no logical reason to expect that many people will be able to create smart contracts with it.^[4]

Protoshares and Mastercoin are no longer being hyped much and Ethereum is the big new thing. However, none of them addresses the real issue of being a viable competitor to Bitcoin. Ethereum will therefore soon be forgotten like the rest once it inevitably fails to deliver on its promise.

Legitimate Reasons for Altcoins

I don’t object to altcoins in themselves. What I object to are the lies. There are legitimate reasons for altcoins, but none of them allow for real money to be made off of them. Altcoins should have little or no market value, but the distributed system as a whole can have value as an experiment or test of a possible upgrade to Bitcoin.

If you tell me this altcoin implements some cool new idea, then very well. But if you tell me it’s going to be the next big thing and that it’s a great investment, you’re lying. And if you believe it yourself, you’re lying to yourself.

The only reason that an altcoin should have any value at all is as an extreme speculation on the death of Bitcoin. Although it is impossible for an altcoin to beat Bitcoin on its own merits, it is theoretically possible that the Bitcoin community could destroy Bitcoin through its own foolishness. If that possibility should loom, then altcoins can do a valuable service by going up in value, thus alerting the Bitcoin community to reverse whatever it is doing.

Namecoin

Namecoin is unique among altcoins as far as I know in that it provides a valuable service directly to users that does not depend on the value of the underlying coin. It is not simply an experiment that might be viable one day if it were incorporated into the Bitcoin protocol, although it would be more useful if it could at least be made compatible with Bitcoin in some way.

Namecoin is a system that includes both an altcoin and a distributed name registration service. Namecoin is designed so that namecoins must be spent in order to register a name on its block chain. This is a design flaw because the extra currency is extra baggage. It would have been better to design Namecoin to work directly with Bitcoin instead, but since a distributed DNS service is inherently useful, it is possible that Namecoin could succeed anyway.

In a future world in which Namecoin has gone mainstream, namecoins would have to have some value, even if they did not become the dominant currency. In that case, however, namecoins would not be a currency at all, but simply a token used to interact with the Namecoin system. They will survive as a parasite that detracts from the overall value of the namecoin system.

If a means could be designed to make Namecoin work with Bitcoin payments, for example by designing a protocol that provably ties a Namecoin payment to a Bitcoin payment that goes to the Namecoin miner, then Namecoin the currency would become a nearly worthless token more rapidly and the Namecoin system would be greatly improved.

Conclusion

Altcoins are not viable because they cannot reproduce that which gives Bitcoin an overwhelming competitive edge: its market cap. It is unethical to create an altcoin with the purpose of making money off of it for this reason. They should not be taken seriously. The way to defeat them is to keep demanding of the altcoin promoters that they spell out why their altcoin makes sense as an investment. The more that this demand is made, the worse altcoins will look.

This point needs to be made in a variety of ways, again and again. This article and the few others that have been written are not enough. It needs to be restated in as many different ways as possible until the altcoin movement is over.

Disclosure: the author owns bitcoins but has never owned altcoins, due to the fact that they are unsustainable. If he thought altcoins were sustainable, he would buy them rather than explain very carefully why they are unsustainable. He did try to mine dogecoin for a few hours once, but was not wowed.

Update March 17, 2014: Clarified 2nd paragraph of section “Liquidity Cannot be Designed”.