by Karl Denninger, Market Ticker:

A quick primer for those who don’t understand how these work.

Digital “currencies” are all basically the same. There is a finite number of a given “coin” type at inception; each has a cryptographic “key” that must be discovered in order to “acquire” it, which the proponents argue is similar to digging it out of the ground, and thus it is called “mining” them.

However, each successive coin in a given currency is harder to “mine” than the previous one; the cryptographic series is designed intentionally this way. The first few coins are easy and they get more difficult as the number of them mined is a greater percentage of the whole. The designer attempts to slightly outpace the growth rate of processor capability to solve said problem so that (1) it’s reasonably practical to “mine” them at the outset but (2) as time goes on it becomes more difficult at a fast enough rate that the stock of said coins is not completely exhausted at any given time, NOR does it become so prohibitively difficult that there is no point in trying.

The “coins” are designed to be “self-proving” through a technology known as “blockchain” in the generic sense. In order to confirm your coin is valid (and owned by you) others must reproduce your published “signing” result on the coin you claim to have mined. In addition to prevent your “coin” (which is just a series of bits — that is, a number) from being duplicated (counterfeited) whenever you exchange it with someone else they have to sign the “coin” and that transaction has to be published and the signature verified by some number of others before the “spend” is considered to be good. Once it is considered good then ownership of said coin has passed to the new person. Though this mechanism the transfer of a given coin from its mining onward can be irrevocably traced and it is thus impossible (in theory anyway) for someone to duplicate (counterfeit) said coin.

Digital “coins” are divisible and such divisions are just as valid as an original, but again a division must be confirmed and signed as well. Thus you can spend 1/10th of a coin, the person who has 1/10th can spend half of that (or 1/20th of the original) and so on.

The design of these systems, however, is intentionally deflationary. That is, not only is it harder and harder to “mine” more coins but any coin in which the signature cannot be confirmed because the person who last signed it loses their signing key is irrevocably lost.

There are nuances between all the different “coins” but they all share a common set of problems:

While the number of a given coin is distinct, discrete and finite there is no limit to the number of competing digital “coins.” If you don’t like the ones that are present today you can set up another one and nothing prevents you (or someone else) from doing so. This means that the common chestnut of there being a “finite supply” is false.

A deflationary “currency” over time ultimately becomes extinct and valueless. In order for something to have a price it must in some form or fashion, for some period of time store value. The creators of digital currencies try to insure this through their deflationary design. The problem is that in order to get the value out of a non-physical thing that thing must be a medium of exchange. That in turn requires wide acceptance by various individuals and firms transacting in that coin in some fashion. As the number of coins in circulation inevitably decreases due to its deflationary design it ultimately must lose individuals and firms willing to transact in same. At some critical mass point it becomes crippled sufficiently in terms of exchange that the alleged “value” collapses.

Alleged “exchanges” have no clean business model. A valid exchange must exist solely on fees charged for transactions. The problem is that a distributed authentication model, which is what makes “blockchain” work, inherently has no means for the validating nodes to charge back the work of validation to the transacting parties. This results in those nodes having to exist via some other means (e.g. mining), and that means is usually speculating on the coins themselves! If you want to know why these exchanges seem to have a record of absconding with your coins (or “losing” them), this is the reason — they have no legitimate business model to otherwise pay for the continuing daily costs of validating and transacting between parties.

ALL such “digital currencies” are by design and intent a means to separate you from wealth and give it to whoever founded said “currency.” They are for this reason all effectively a pyramid scheme. This will inevitably lead to the seizure and closing of all such systems — if and when governments figure it out. The reason is simple: With a finite and ever-more-difficult means of mining each successive coin the effect on value for participants is exactly the same as it is in any pyramid scheme. Since nothing of physical existence is created or dug out of the ground there is no utility value and thus no floor price, unlike gold or silver (both of which have industrial value due to the metallurgical properties.) The person who “invents” such a system gets to “mine” many coins at very low cost (in electricity or whatever.) He then watches the “value” of said coins escalate as each one becomes harder to “mine” and as hype takes over, and can convert that “wealth” into some other form, whether it be a fiat currency, real property or otherwise. The founder always makes a grossly outsized “profit” in this fashion with the available profit dropping exponentially and ratably in every single case simply based on the number of participants. At the beginning recruiting others who also make money is easy because mining the coins is easy. However, over time recruiting others becomes harder and harder. This is exactly identical to what happens in a traditional pyramid scheme — the founder gets a cut off all the sales from everyone under him. The next layer who all find the field “unmowed” with lots of customers make a lot of money too, but always less than the first group and so on. But since the number of customers is finite, just as is the number of coins, with each successive layer of participants it gets harder and harder to find others to transact in sufficient volume to turn a profit because the acquisition of each new (coin or customer) becomes exponentially more-difficult. It is thus impossible on a mathematical basis for any such design to be self-sustaining since it relies on an exponentially more difficult act in a finite world. ALL such systems are inherently ponzi schemes whether we are talking about digital currencies or the alleged sale of products.

This doesn’t mean you can’t try to speculate in such “currencies”, because you certainly can. However, you must recognize a few things before doing so.

First, it is my contention that you are probably participating in an illegal scheme, albeit one that is not currently recognized as such by the authorities. No matter the instance, design, product or service any exponentially more-difficult (with time or number of “wins” or “participants”) system is inherently a pyramid scheme. That is it will always result in less return for the second participant than the first, for the third than the second, and so on. Eventually the return will always become negative at which point the scheme collapses. This is mathematically provable and is why such schemes are supposed to be illegal everywhere. Part of your risk profile assessment thus must include whether such digital currency schemes will be ruled an illegal pyramid scheme by governing authorities somewhere (or everywhere) and if it is whether you will simply lose all the money you put into it or worse, potentially be criminally prosecuted.

Read More @ Market-Ticker.org