Counter-Party Risk for Bitcoin

One of the original selling points for Bitcoin was that it had no counter-party risk. Bitcoins were held in private wallets, and exchange would happen directly between wallets. No third party would be involved. However, most people currently holding Bitcoin have at least some portion of this residing on an exchange. Instead of trading directly with other Bitcoin holders, exchange is made via a broker.

This introduces counter-party risk. There has to be trust in the exchange, that it is both honest and safe against hackers. Unfortunately, this is not always justified. Loss of Bitcoin due to dishonest or unsafe exchanges runs in the millions of dollars.

The way to mitigate this problem is to keep a majority of ones Bitcoin savings on a private wallet, or in cold storage.

However, this does not remove all counter-party risk. There is one counter-party that will for ever be of vital importance for the value of all Bitcoin, namely the network. Without the Bitcoin network, Bitcoin is worthless. The reason for this is that Bitcoin has no use outside the network. It can neither be turned into jewelry nor consumed. It is merely a token, and its value is derived entirely from the fact that it gives access to the network.

As long as the Bitcoin network expands, with new users coming online, there is potential for price appreciation. However, once the network ceases to grow, the game is up, because the network is a constant drain on resources. It must be perpetually maintained and fed in order to exist. With no revenues coming in from outside the network, Bitcoin owners must pay to keep the network alive.

The problem here is that if third party owners of Bitcoin refuse to pay, or leave the network, things unravel. Yet, this will eventually happen, because very few will be prepared to pay for the cost of keeping the network alive through any prolonged period of price stagnation. People will leave the network, and once this starts to happen, there is nothing to stop the process from accelerating.

The network binds everybody together, making everybody dependent on everybody else, and herein lies the true counter-party risk associated with Bitcoin. It does not matter that Bitcoin can be safely stored away in a private wallet or cold storage. If the network deteriorates, the value of Bitcoin will deteriorate. Without the option of turning Bitcoin into jewelry or consumables, its value will go to zero the moment the network deteriorates to a point where Bitcoin no longer functions properly.

Network

By The Opte Project - Originally from the English Wikipedia; description page is/was here., CC BY 2.5, Link