Bitcoin is currently the dominant digital currency. What would it take for another digital currency to displace it, or at least carve out a sizable market for itself?
Some would argue that nothing will displace Bitcoin. The network effect of currencies is too strong, so value will always go to the currency with the most liquidity. And any protocol-level innovations will be integrated into Bitcoin.
These aren’t bad arguments. One year ago, I thought the same. But after many months immersed in the crypto currency world, I can see several ways for value to accrue to other currencies.
Especially if you take a long-term view (say, 10 years), a lot can happen. No one can predict the future; however, you can model various scenarios and position yourself to benefit from them.
Bitcoin is only pseudo-anonymous. Anyone who could map some portion of addresses to identities (such as a prosecutor with subpoena power) could deanonymize a large part of the blockchain. And data in the blockchain stays there forever, so your identity could be unmasked any point in the future.
There is huge demand for an anonymous payment system and store of value. An estimated 22% of the world economy is in the black market.
Several of the recent AltCoins that have done well (drk, bc, xc) tout anonymity features. However, these coins provide imperfect anonymity. They leak information that would still allow successful forensic blockchain analysis (albeit harder than with bitcoin).
There’s a protocol called Zerocash that promises perfect anonymity. However, it’s extremely complicated, and uses bleeding edge cryptography. It’s not out yet, and the first few versions will likely contain security holes.
Although Zerocash doesn’t currently exist, it’s safe to say that sometime in the next few years, a truly anonymous coin will be available. What might be the market value of such a coin? Especially after a few high-profile cases of people convicted of financial crimes based on Bitcoin blockchain analysis?
Maybe people will quickly trade their bitcoins in and out of this currency as a way to launder them, in which case it won’t be worth very much. Or maybe users will migrate en masse over to this new currency, as it has a clearly differentiated superior feature, in which case it will become the dominant digital currency.
Governments may try to ban an anonymous currency, but unless they also ban bitcoin, it will be impossible to stop. That’s because trading between fiat and digital currencies requires connecting to the banking industry, which is centralized enough for government control. But crypto-to-crypto trading is merely a sequence of data broadcasts. There’s no way to stop it.
Solve Centralized Mining
There are a couple problems with how bitcoins are mined. First of all, it’s incredibly wasteful. It takes something like $12 in electricity to confirm each transaction.
The other problem is Bitcoin is vulnerable to a 51% attack. Any entity that controls over 50% of the network’s hashing power can decide what to put in the ledger going forward (enabling such nefarious activities as double spending).
Mining pools routinely get close to this 50% level. In fact, last month, ghash.io briefly exceeded 50% until enough of their users voluntarily left to bring the hashrate down.
Some people have made game theoretic arguments that centralized mining is inevitable. It wouldn’t even have to be nefarious — a benevolent mining monopoly could process all valid transactions, but only add blocks that it forges to the ledger. All other miners would disappear, as they would no longer be able to mine. You’d have a functioning currency, but without the decentralization that makes Bitcoin appealing.
AltCoins are experimenting with different approaches. Some use proof-of-stake, where transactions are processed by those who already own coins (51% attacks are still possible, but much more expensive). Others use web-of-trust, which is able to verify transactions in real time.
All these approaches have their own set of problems. Nonetheless, it’s possible that over the next several years, a consensus will emerge around some algorithm that’s significantly better than Bitcoin’s SHA-256-based proof of work. And value will flow to the currency that best embodies this new approach.
A More Expressive Protocol
Bitcoin introduced to the world a distributed, unforgeable data structure called the blockchain. It didn’t take long for people to come up with lots of uses for this concept beyond payment. You could track ownership of physical assets. You could create financial derivatives, and trade them in a fully distributed fashion. You could even create a distributed organization, with transparent logic for how decisions are made, and a native currency for paying for resources.
But you can’t do most of this in Bitcoin. The protocol is just not expressive enough. Today, there’s not much demand for these features. But over the next several years, who can say? Maybe significant portions of our legal and financial industries will run on a protocol like Ethereum, giving value to its currency.
Brokering a Scarce Resource
Another AltCoin that could prove valuable is one that controls access to a scarce resource.
For instance, Storj plans to release a coin that pays people who rent out space on their hard drives. Such a coin could be worth a lot, considering the size of the storage market and how much unused space exists on everyone’s home computer.
There could exist several AltCoins in this category that all have real value, while not displacing Bitcoin as the biggest digital currency.
Bitcoin Becomes too Conservative to Improve
I often hear the argument that if any AltCoin were to produce a useful feature, Bitcoin would just add it to its protocol.
In theory, Bitcoin can keep changing. But in practice, Bitcoin is already so conservative that it’s difficult to make meaningful protocol changes. And it will only become harder as the Bitcoin ecosystem grows, and the number of stakeholders increases.
Some changes are easier than others. Like adding more expressiveness to the protocol. Others are harder. For instance, Zerocash could theoretically be integrated into Bitcoin, but it’s so complicated, so risky, and would change the image of Bitcoin so drastically that I doubt it will ever happen.
And it would be impossible to get miners to agree to change their SHA-256 proof of work, since that would require that they write off their entire investment in ASIC mining hardware.
What might happen is in a few years, some developers create a hard fork of the Bitcoin blockchain and create a new protocol with lots of desired features. Everyone who owns bitcoins at a certain point in time will also own some of this new coin. Some bitcoin holders will have low faith in this new currency, and sell it for bitcoin. And this new fork becomes an AltCoin.
So in conclusion, the future is uncertain. There are many scenarios under which some AltCoin might displace Bitcoin as the leading digital currency, or at least find a sizable niche in the digital currency economy.