Is Bitcoin Like High-Speed Trading?

(Originally published here.)

Bitcoins have something in common with high-frequency trading: both are seen as either a huge waste of resources or a useful new technology that will lower costs in the financial industry for the benefit of consumers.

The knock against HFT is that it’s pointless for programmers to write software that executes profitable trades infinitesimally faster than software written by other programmers, instead of working on projects that may have broader applications. One of the arguments in favor of HFT, though, is that it discourages people from engaging ineven more wasteful attempts to discover private information.

As for bitcoins, each one has a unique signature and every transaction is recorded in a single ledger that is verified multiple times by every computer in the bitcoin network as they solve cryptology puzzles. Since all of those calculations require time and energy, those who help confirm transactions are rewarded with the chance to earn new bitcoins via lottery.

Initially, it was easy to create bitcoins with nothing more than a home computer and some spare time. This encouraged early adoption. But the bitcoin network keeps making it harder to enter the lottery for newly issued bitcoins in an attempt to protect the value of the holdings amassed by the first generation of bitcoin “miners.” One result: an enormous increase in the amount of processing powerdevoted to solving elaborate but pointless puzzles.

According to blockchain.info, which tracks data on bitcoin mining, there is about a half-million times as much computational energy used for bitcoin now as two years ago, with almost all of that increase occurring during the past six months. So-called application-specific integrated circuits that aren’t sufficiently powerful to compete are now being sold on eBay Inc. Those ASICs are “utterly and totally useless for anything other than bitcoin computation,” according to technologist Fred Trotter.

The biggest cost for miners nowadays isn’t computers, however, but electricity. Electricity is so crucial that has become the most important variable for understanding the price of bitcoin. Many miners are relocating their operations to places with cheap electricity, or, in the case of one young man, using energy donated from his father’s power plant to subsidize his cost of operations. Bitcoin enthusiasts claim that efficient miners could recoup most of their energy costs by conserving the heat generated by their processors but it isn’t clear who does this. 

Yet, the tremendous costs associated with running the bitcoin network might be worth it if the stateless currency ends up displacing the existing payments networks run by the big banks. After all, banks collected more than $1.3 trillion in revenue from transaction services in 2011, according to consulting firm McKinsey & Co. The sums spent on electricity and specialized computers are tiny by comparison. If competition from bitcoin ends up lowering the costs of transactions, the extra burdens imposed on the power grid could end up being a small price to pay.

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.

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About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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