Watermarked tokens and pseudonymity on public blockchains

As mentioned a couple weeks ago I have published a new research paper entitled: “Watermarked tokens and pseudonymity on public blockchains

In a nutshell: despite recent efforts to modify public blockchains such as Bitcoin to secure off-chain registered assets via colored coins and metacoins, due how they are designed, public blockchains are unable to provide secure legal settlement finality of off-chain assets for regulated institutions trading in global financial markets.

The initial idea behind this topic started about 18 months ago with conversations from Robert Sams, Jonathan Levin and several others that culminated into an article.

The issue surrounding top-heaviness (as described in the original article) is of particular importance today as watermarked token platforms — if widely adopted — may create new systemic risks due to a distortion of block reorg / double-spending incentives.  And because of how increasingly popular watermarked projects have recently become it seemed useful to revisit the topic in depth.

What is the takeaway for organizations looking to use watermarked tokens?

The security specifications and transaction validation process on networks such as the Bitcoin blockchain, via proof-of-work, were devised to protect unknown and untrusted participants that trade and interact in a specific environment.

Banks and other institutions trading financial products do so with known and trusted entities and operate within the existing settlement framework of global financial markets, with highly complex and rigorous regulations and obligations.  This environment has different security assumptions, goals and tradeoffs that are in some cases opposite to the designs assumptions of public blockchains.

Due to their probabilistic nature, platforms built on top of public blockchains cannot provide definitive settlement finality of off-chain assets. By design they are not able to control products other than the endogenous cryptocurrencies they were designed to support.  There may be other types of solutions, such as newer shared ledger technology that could provide legal settlement finality, but that is a topic for another paper.

This is a very important issue that has been seemingly glossed over despite millions of VC funding into companies attempting to (re)leverage public blockchains.  Hopefully this paper will help spur additional research into the security of watermarking-related initiatives.

I would like to thank Christian Decker, at ETH Zurich, for providing helpful feedback — I believe he is the only academic to actually mention that there may be challenges related to colored coins in a peer-reviewed paper.  I would like to thank Ernie Teo, at SKBI, for creating the game theory model related to the hold-up problem.  I would like to thank Arthur Breitman and his wife Kathleen for providing clarity to this topic.  Many thanks to Ayoub Naciri, Antony Lewis, Vitalik Buterin, Mike Hearn, Ian Grigg and Dave Hudson for also taking the time to discuss some of the top-heavy challenges that watermarking creates.  Thanks to the attorneys that looked over portions of the paper including (but not limited to) Jacob Farber, Ryan Straus, Amor Sexton and Peter Jensen-Haxel; as well as additional legal advice from Juan Llanos and Jared Marx.  Lastly, many thanks for the team at R3 including Jo Lang, Todd McDonald, Raja Ramachandran and Richard Brown for providing constructive feedback.

Watermarked Tokens and Pseudonymity on Public Blockchains

Send to Kindle

What challenges arise when trying to scale watermarked tokens on Bitcoin?

[Note: the following overview on scaling Bitcoin was originally included in a new paper but needed to be removed for space and flow considerations]

Looking in the past, the older Viceroy overlay network scaled at O(logN) where N is the number of peers which is different than the contentious scaling in Bitcoin, where even Core developers do not agree on how per node bandwidth actually scales.1

For instance, one group of developers thinks that per node bandwidth on the Bitcoin network scales linearly, O(n).2

The use of O(n) is a way of capturing simply whether something scales linearly or not.   O(n) means: if it takes 5 seconds to do something when there are 10 nodes, it will take 50 seconds if there are 100. An example would be washing the dishes. It takes 30 seconds per plate and you just keep going one plate after another.

In contrast, another group of developers believes bandwidth requirements squares per node, which reads as O(n2).3

O(n2) means: if it takes 5 seconds to do something when there are 10 nodes, it will take 5 hundred seconds if there are 100. O(x) notation is an approximate. That is to say, while you have increased the number of items by a factor of 10, the time taken increased by a factor of about 100.

An example here might be if Bob needs to broker bilateral contracts between all the members of a new limited partnership fund.   Four partners would require six bilateral NDAs in total. Eight partners would require 24. Thus if Bob doubled the number of partners he would need more than four times as many contracts executing.4

One calculation (BitFury 2015a) implies that in terms of block verification time, Bitcoin scales at: N(1 + 0:091 log2 N).5 For comparison, Ripple’s consensus ledger also has O(n2) scaling.67

What does this have to do with watermarked tokens?

As described in (Breitman 2015c):8

[C]olored coins are potentially nefarious to the Bitcoin ecosystem. The security of Bitcoin rests on the assumption that miners stand to lose more by departing from consensus than they stand to gain. This assumption requires a balance between the reward received by miners, and the amounts they might stand to gain by reversing transactions. If colored coins represent valuable assets, this balance might be upset, endangering the status of all transactions.

A consequence of the hold-up problem is that it could lead to vertical integration. That is to say, to prevent this type of event (holding up the whole network) from happening in the future, colored coin platforms could acquire (or build) hashing facilities and pools.

Yet if they did this, not only would they need to increase expenditures by several orders of magnitude – which is the very reason they wanted to piggy back off the existing infrastructure to begin with – but they would effectively be building a permissioned network, with very high marginal costs.

In (Breitman 2015c) the author uses a car analogy to describe the cantankerous situation colored coins have created.9

In the analogy, the author explores an alternative universe in which the car was recently created and new owners foresaw the ability to use the car in many different ways, including a new “application” called shipping.

In this scenario, the car owners unilaterally dismissed unproven alternative “truck technology” and instead designed a solution for shipping: bolt a new wooden layer on top of four cars, much like watermarked platforms bolt themselves on top of Bitcoin.

But what about all the various mechanical challenges that came with this new ad hoc design?

Breitman makes the point that, though the same functionality of a truck can be achieved by putting a slab of wood on top of four cars, choosing it as a solution when other options exist is not effective. Similarly, in the context of a closed system, it makes little sense to rely on bitcoind, though inexperienced developers may have a bias towards it:

To be sure, they were several problems with the design. The aerodynamics were atrocious, but that could be somewhat alleviated by placing a tent over the contraption. Turning was initially difficult, but some clever engineers introduced swivels on top of the car, making the process easier. The cars would not always stay at the same speed, but using radio communication between the drivers more or less remedied the issue.

But, truck technology? Well that was unproven, and also trucks looked a lot like train wagons, and the real innovation was the car, so cars had to be used!

Where am I going with this? A large number of projects in the space of distributed ledgers have been peddling solutions involving the use of colored coins within permissioned ledgers. As we’ve explained earlier, colored coins were born out of the near impossibility of amending the code base of Bitcoin. They are first and foremost a child of necessity in the Bitcoin world… a necessary evil, a fiendish yet heroic hack unlocking new functionality at a dire cost.

One could argue that reusing the core bitcoind code offers the benefit of receiving downstream bug fixes from the community. This argument falls flat as the gist of such fixes can be incorporated into any implementation. Issues encountered by Bitcoin have ranged from a lack of proper integer overflow checking to vulnerabilities with signature malleability. Such issues can potentially affect any blockchain implementation; the difficulty lies in identifying them, not in producing a patch to fix them, a comparatively straightforward process. Of course, other bugs might be introduced when developing new functionalities, but the same is true regardless of the approach undertaken.

Basing a fresh ledger, independent from the Bitcoin blockchain, on a colored coin implementation is nothing short of perversion. It is akin to designing a truck using a wooden board bolted on the top of four cars. If, for some reason, the only type of vehicle that could use a highway were sedans, that solution might make sense. But if you have the chance to build a truck and instead chose to rig a container on top of a few cars then perhaps you should first learn how to engineer trucks.

As explored in the game theory model in Appendix B and car example above, there are real security issues with using this specific layered approach in both permissionless and permissioned systems.

The typical excuse for going such route is that building a new blockchain from scratch (e.g., Ethereum, Zerocash, Tendermint, Tezos) delays market entry and could make your startup fall behind the competition.

While it may be true that spending a year or more to purposefully design a new distributed ledger network from scratch will take significant time and resources, the reasons for doing (better security and scalabity) outweigh the downsides (systemic risks and vulnerabilities). Future research should also build models with additional agents.

It also bears repeating that based on the model presented in Appendix B, if the cost of attack is very high, the more plausible outcome is to not attack. However, if it is very attractive to attack there could have a different outcome that is worth further research.

  1. See A Survey and Comparison of Peer-to-Peer Overlay Network Schemes by Lua et al. p. 10 and Big-O scaling by Gavin Andresen []
  2. Over the past five months there have been volumes of emails, forum posts and panel discussions on the topic of how Bitcoin can and does scale. One thread that is recommended to readers is a recent reddit debate between Mike Hearn (mike_hearn) and Greg Maxwell (nullc). []
  3. Why do people say that bitcoin scales according to O(n^2)? from StackExchange []
  4. I would like to thank Richard Brown for this example and illustration. []
  5. Block Size Increase from BitFury Group, p. 5 []
  6. See p. 9 from Ripple Protocol Consensus Algorithm Review by Peter Todd []
  7. Surveying literature we can see that historically there have been dozens of attempts to create decentralized peer-to-peer reputation systems that needed to be self-organizing, Sybil-resistant, fault tolerant as well as the ability to scale. A Survey and Comparison of Peer-to-Peer Overlay Network Schemes by Lua et al.; A Survey of Attack and Defense Techniques for Reputation Systems by Kevin Hoffman, David Zage and Cristina Nita-Rotaru; and Survey of trust models in different network domains by Mohammad Momani and Subhash Challa []
  8. Making sense of colored coins by Arthur Breitman []
  9. Ibid []
Send to Kindle

A brief literature review

[Note: the following literature review was originally included in a new paper but needed to be removed for space and flow considerations]

How has previous research looked at information security?

Academic literature covering distributed computing and economics of information security and specifically peer-to-peer networks “Before Bitcoin” spans several decades.

Surveying literature (Lua et al. 2004; Hoffman et al. 2007; Momani and Challa 2009) we can see that there have been dozens of attempts to create decentralized peer-to-peer reputation systems that needed to be self-organizing, Sybil-resistant and fault tolerant.1

For instance, the Content Addressable Network (CAN), Chord, Kademlia and the Cooperative File System (CFS) each had a variety of characteristics that attempted to stave off abuse from attackers due to the environments they operated in (e.g., a distributed decentralized P2P infrastructure). Some used public-private key pairs, content hashes and others used NodeID.

These surveys also looked at Distributed Hash Trees (DHT) which have been known to be vulnerable to a number of attacks including Eclipse attacks, where the peering network itself comes under attack (which Bitcoin’s network is also prone to).2

What about other game theory issues? For example in (Lua et al., 2004) the authors wrote that:3

The ability to overcome free-rider problems in P2P overlay networks will definitely improve the system’s reliability and its value.

Sybil attacked termed by Douceur4 described the situation whereby there are a large number of potentially malicious peers in the system and without a central authority to certify peers’ identities. It becomes very difficult to trust the claimed identity. Dingledine et al.,5 proposes puzzles schemes, including the use of micro-cash, which allows peers to build up reputations. Although this proposal provides a degree of accountability, this still allows a resourceful attacker to launch attacks.

This is the same problem discussed above, that (Rosenfeld 2012) runs into regarding how to pay nodes on an open network.

How do these researchers believe it could be solved or fixed? According to (Lua et al., 2004):6

Having some sort of incentive model using economic and game theories, for P2P peers to collaborate is crucial to create an economy of equilibrium. When non-cooperative users benefit from free-riding on others’ resources, the tragedy of the commons7 is inevitable. Such incentives implementation in P2P overlay services would also provide a certain level of self-regulatory auditing and accounting behavior for resource sharing.

As shown above, despite rhetoric at Bitcoin-related conferences, many of the challenges facing Bitcoin today are in fact known problems facing decentralized peer-to-peer networks in general. The problem space for preventing Sybil attacks was and is relatively well-defined, Bitcoin again side-steps the actual solution by making it economically expensive, but not technically impossible to conduct history-reversing attacks, or even Sybil attacks on the gossip network.

P2Prep is a reputation system designed to “mitigate the effects of selfish and malicious peers in an anonymous, completely decentralized system.”8

How did it do this?

The system guards the anonymity of users and the integrity of packets through the use of public key cryptography. All replies are signed using the requester’s public key, protecting the identity of the responder and the integrity of the data. Only the requester is able to decrypt the packet and check the validity of the information.9

Credence (Walsh and Sirer 2006) is another peer-to-peer reputation system that uses gossip-based techniques to disseminate information.10 It defends itself:11

A key security consideration in the Credence system is the use of mechanisms to prevent spoofed votes or votes generated by fake identities. The system guards against such attacks by issuing digital certificates in an anonymous but semi-controlled fashion. The authors propose to mitigate Sybil attacks by requiring expensive computation on the part of the client before the server grants a new digital certificate. Every voting statement is digitally signed by the originator and anyone can cryptographically verify the authenticity of any given voting statement.

In (Momani and Challa 2010) the authors looked at security and trust concepts surrounding wireless sensor networks (WSN). At first glance this may seem unrelated to peer-to-peer networks but there are many similarities:12

The security issue has been raised by many researchers [14 – 24], and, due to the deployment of WSN nodes in hazardous and/or hostile areas in large numbers, such deployment forces the nodes to be of low cost and therefore less reliable or more prone to overtaking by an adversary force. Some methods used, such as cryptographic authentication and other mechanisms [25 – 32], do not entirely solve the problem. For example, adversarial nodes can have access to valid cryptographic keys to access other nodes in the network. The reliability issue is certainly not addressed when sensor nodes are subject to system faults. These two sources of problems, system faults and erroneous data or bad routing by malicious nodes, can result in the total breakdown of a network and cryptography by itself is insufficient to solve these problems. So new tools from different domains social sciences, statistics, e-commerce and others should be integrated with cryptography to completely solve the unique security attacks in WSNs, such as node capturing, Sybil attacks, denial of service attacks, etc.

In their survey they identified previous research that had looked at some of these same issues including In (Xiong and Liu 2003) where the authors attempted to build a reputation-based trust model for peer-to-peer distributed commerce platforms and use game theory to ameliorate the trust parameters by threats from malicious attacks.13

Going back more than fifteen years we can see that other researchers (Lamport 1998) and (Castro and Liskov 1999), that successful attempts were made to “use cryptographic techniques to prevent spoofing and replays and to detect corrupted messages” on a network that replicates services in the face of Byzantine faults.14

Volumes more can and will likely be written covering the research on these specific topics due in large part to the integral role that different types of information and financial networks play in the lives of consumers and businesses alike.

  1. A Survey and Comparison of Peer-to-Peer Overlay Network Schemes by Lua et al.; A Survey of Attack and Defense Techniques for Reputation Systems by Kevin Hoffman, David Zage and Cristina Nita-Rotaru; and Survey of trust models in different network domains by Mohammad Momani and Subhash Challa []
  2. Eclipse Attacks on Bitcoin’s Peer-to-Peer Network by Heilman et al. []
  3. A Survey and Comparison of Peer-to-Peer Overlay Network Schemes by Lua et al., p. 11 []
  4. J. R. Douceur, “The sybil attack,” in Proceedings of the First International Workshop on Peer-to-Peer Systems , March 7-8 2002, pp. 251– 260. []
  5. R.   Dingledine,   M.   J.   Freedman,   and   D.   Molnar,   “Accountability measures for peer-to-peer systems,” in Peer-to-Peer: Harnessing the Power of Disruptive Technologies , D. Derickson, Ed.     O’Reilly and Associates, November. []
  6. A Survey and Comparison of Peer-to-Peer Overlay Network Schemes by Lua et al., p. 20 []
  7. G. Hardin, “The tragedy of the commons,” Science , vol. 162, pp. 1243– 1248, 1968. []
  8. A Survey and Comparison of Peer-to-Peer Overlay Network Schemes by Lua et al., p. 28. Among other startups, Mnet was a peer-to-peer distributed data store, whose (former) employees would go on to help create BitTorrent and Tahoe-LAFS. This was during the same survey period. []
  9. Ibid, p. 29 []
  10. Experience with an Object Reputation System for Peer-to-Peer Filesharing by Kevin Walsh and Emin Gün Sirer []
  11. A Survey of Attack and Defense Techniques for Reputation Systems by Kevin Hoffman, David Zage and Cristina Nita-Rotaru, p. 30 []
  12. Survey of trust models in different network domains by Mohammad Momani and Subhash Challa []
  13. A Reputation-Based Trust Model for Peer-to-Peer eCommerce Communities by Li Xiong and Ling Liu []
  14. Practical Byzantine Fault Tolerance by Miguel Castro and Barbara Liskov. According to Leslie Lamport, in The Part-Time Parliament, p. 23: “The Paxon Parliament protocol provides a distributed, fault-tolerant imiplmentation of the database system.” []
Send to Kindle

Creative angles of attacking proof-of-work blockchains

[Note: the following views were originally included in a new paper but needed to be removed for space and flow considerations]

While most academic literature has thus far narrowly focused under the assumption that proof-of-work miners such as those used in Bitcoin will behave according to a “goodwill” expectation, as explored in this paper, there may be incentives that creative attackers could look to exploit.

Is there another way of framing this issue as it relates to watermarked tokens such as colored coins and metacoins?

Below are comments from several thought-leaders working within the industry.

According to John Light, co-founder of Bitseed:1

When it comes to cryptocurrency, as with any other situation, an attacker has to balance the cost of attacking the network with the benefit of doing so. If an attacker spends the minimum amount required to 51% attack bitcoin, say $500 million, then the attacker needs to either be able to short $500 million or more worth of BTC for the attack to be worth it, or needs to double spend $500 million or more worth of BTC and receive some irreversible benefit and not get caught (or not have consequences for getting caught), all while taking into consideration the loss of future revenues from mining honestly. When you bring meta-coins into the equation, things get even murkier; the cost is less dependent on the price of bitcoin or future mining revenues, and depends more on the asset being attacked, whether it’s a stock sale or company merger that’s being prevented, or USD tokens being double-spent.

There’s no easy answer, but based on the economics of the situation, and depending on the asset in question, it doesn’t seem wise to put more value on chain than the market cap of BTC itself (as a rough benchmark – probably not that exact number, but something close to it).

Not a single study has been publicly published looking at this disproportionalism yet it is regularly touted at conferences and social media as a realistic, secure, legal possibility.

According to Vitalik Buterin, creator of Ethereum:2

There are actually two important points here from an economics perspective. The first is that when you are securing $1 billion on value on a system with a cryptoeconomic security margin that is very small, that opens the door to a number of financial attacks:

  1. Short the underlying asset on another exchange, then break the system
  2. Short or long some asset at ultrahigh leverage, essentially making a coin-flip bet with a huge amount of money that it will go 0.1% in one direction before the other. If the bet pays off, great. If it does not pay off, double spend.
  3. Join in and take up 60%+ of the hashrate without anyone noticing. Then, front-run everyone. Suppose that person A sends an order “I am willing to buy one unit of X for at most $31”, and person B sends an order “I am willing to sell one unit of X for at least $30”. As a front-runner, you would create an order “I am willing to sell one unit of X for at least $30.999” and “I am willing to buy one unit of X for at most $30.001”, get each order matched with the corresponding order, and earn $0.998 risk-free profit. There are also of course more exotic attacks.

In fact, I could see miners even without any attacks taking place front-running as many markets as they can; the ability to do this may well change the equilibrium market price of mining to the point where the system will, quite ironically, be “secure” without needing to pay high transaction fees or have an expensive underlying currency.

The second is that assets on a chain are in “competition” with each other: network security is a public good, and if that public good is paid for by inflation of one currency (which in my opinion, in a single-currency-chain environment, is economically optimal) then the other currencies will gain market share; if the protocol tries to tax all currencies, then someone will create a funky meta-protocol that “evades taxes by definition”: think colored coins where all demurrage is ignored by definition of the colored coin protocol. Hence, we’ll see chains secured by the combination of transaction fee revenue and miner front running.

Unsolved economics question: would it be a good thing or a bad thing if markets could secure themselves against miner frontruns? May be good because it makes exchanges more efficient, or bad because it removes a source of revenue and reduces chain security.

Cryptoeconomics is a nascent academic field studying the confluence of economics, cryptography, game theory and finance.3

Piotr Piasecki, a software developer and independent analyst explained:4

If a malicious miner sees a big buy order coming into the market that would move the price significantly, they can engage in front running – the buy order could be pushed to the back of the queue or even left out until the next block, while the miner buys up all of the current stock and re-lists it at a higher price to turn a profit. Alternatively, when they see there is a high market pressure coming in, especially in systems that are inefficient by design, they can buy the orders up one by one by using their power to include any number of their own transactions into a block for free, and similarly re-list them for people to buy up.

Or in other words, because miners have the ability to order transactions in a block this creates an opportunity to front run. If publicly traded equities are tracked as a type of colored coin on a public blockchain, miners could order transaction in such a way as to put certain on-chain transactions, or trades in this case, to execute before others.

Robert Sams, co-founder of Clearmatics, previously looked at the bearer versus registered asset challenge:5

One of the arguments against the double-spend and 51% attacks is that it needs to incorporate the effect a successful attack would have on the exchange rate. As coloured coins represent claims to assets whose value will often have no connection to the exchange rate, it potentially strengthens the attack vector of focusing a double spend on some large-value colour. But then, I’ve always thought the whole double-spend thing could be reduced significantly if both legs of the exchange were represented on a single tx (buyer’s bitcoin and seller’s coloured coin).

The other issue concerns what colour really represents. The idea is that colour acts like a bearer asset, whoever possesses it owns it, just like bitcoin. But this raises the whole blacklisted coin question that you refer to in the paper. Is the issuer of colour (say, a company floating its equity on the blockchain) going to pay dividends to the holder of a coloured coin widely believed to have been acquired through a double-spend? With services like Coin Validation, you ruin fungibility of coins that way, so all coins need to be treated the same (easy to accomplish if, say, the zerocoin protocol were incorporated). But colour? The expectations are different here, I believe.

On a practical level, I just don’t see how pseudo-anonymous colour would ever represent anything more than fringe assets. A registry of real identities mapping to the public keys would need to be kept by someone. This is certainly the case if you ever wanted these assets to be recognised by current law.

But in a purely binary world where this is not the case, I would expect that colour issuers would “de-colour” coins it believed were acquired through double-spend, or maybe a single bitcoin-vs-colour tx would make that whole attack vector irrelevant anyway. In which case, we’re back to the question of what happens when the colour value of the blockchain greatly exceeds that of the bitcoin monetary base? Who knows, really depends on the details of the colour infrastructure. Could someone sell short the crypto equity market and launch a 51% attack? I guess, but then the attacker is left with a bunch of bitcoin whose value is…

The more interesting question for me is this: what happens to colour “ownership” when the network comes under 51% control? Without a registry mapping real identities to public keys, a pseudo-anonymous network of coloured assets on a network controlled by one guy is just junk, no longer represents anything (unless the 51% hasher is benevolent of course). Nobody can make a claim on the colour issuer’s assets. So perhaps this is the real attack vector: a bunch of issuers get together (say, they’re issuers of coloured coin bonds) to launch a 51% attack to extinguish their debts. If the value of that colour is much greater than cost of hashing 51% of the network, that attack vector seems to work.

On this point, Jonathan Levin, co-founder of Chainalysis previously explained that:6

We don’t know how much proof of work is enough for the existing system and building financially valuable layers on top does not contribute any economic incentives to secure the network further. These incentives are fixed in terms of Bitcoin – which may lead to an interesting result where people who are dependent on coloured coin implementations hoard bitcoins to attempt to and increase the price of Bitcoin and thus provide incentives to miners.

It should also be noted that the engineers and those promoting extensibility such as colored coins do not see the technology as being limited in this way. If all colored coins can represent is ‘fringe assets’ then the level of interest in them would be minimal.

Time will tell whether this is the case. Yet if Bob could decolor assets, in this scenario, an issuer of a colored coin has (inadvertently) granted itself the ability to delegitimize the bearer assets as easily as it created them. And arguably, decoloring does not offer Bob any added insurance that the coin has been fully redeemed, it is just an extra transaction at the end of the round trip to the issuer.

  1. Personal correspondence, August 10, 2015. Bitseed is a startup that builds plug-and-play full nodes for the Bitcoin network. []
  2. Personal correspondence, August 13, 2015. []
  3. See What is cryptoeconomics? and Formalizing Cryptoeconomics by Vlad Zamfir []
  4. Mining versus Consensus algorithms in Crypto 2.0 systems by Piotr Piasecki []
  5. As quoted in: Will colored coin extensibility throw a wrench into the automated information security costs of Bitcoin? by Tim Swanson; reused with permission. []
  6. This example originally comes from Will colored coin extensibility throw a wrench into the automated information security costs of Bitcoin? by Tim Swanson; reused with permission. []
Send to Kindle

A few known Bitcoin mining farms

[Note: the following overview on known Bitcoin mining farms was originally included in a new paper but needed to be removed for space and flow considerations]

Several validators on the Bitcoin network, as well as many watermarked token issuers, are identifiable and known.1 What does this mean?  Many Bitcoin validators are drifting usage outside the pseudonymous context of the original network due to their use of specialty equipment that creates a paper trail.  In other words, pseudonymity has given way to real world identity.  Soon issuers of color will likely follow because they too have strong ties to the physical, off-chain world.

For instance, on August 4, 2015, block 368396 was mined by P2Pool. This is notable for two reasons.

The first is that the block included a transaction sent from Symbiont.io, a NYC-based startup building “middleware” that enables organizations and financial institutions to create and use ‘smart securities’ off-chain between multiple parties and have the resulting transaction hashed onto a blockchain, in this case, the Bitcoin blockchain.2

Several weeks later, Symbiont announced that it would begin using their “stack” to provide similar functionality on a permissioned ledger.3 This follows a similar move by T0.com – a wholly owned subsidiary of Overstock.com – which initially used Open Assets to issue a $5 million “cryptobond” onto the Bitcoin blockchain, but have subsequently switched to using a “blockchain-inspired” system designed by Peernova.456

The second reason this was notable is that the block above, 368396, included at least one transaction from Symbiont which was mined by a small pool called P2Pool.7 Unlike other pools discussed in this paper, P2Pool is not continually operated in a specific region or city.

It is decentralized in that all participants (hashers) must run their own full Bitcoin nodes which stand in contrast with pools such as F2Pool, KnC mining pool and BTCC (formerly called BTC China), where the pool operator alone runs the validating node and the labor force (hashers) simply search for a mid-state that fulfills the target difficulty.8

Due to this resource intensive requirement (running a full node requires more bandwidth and disk space than merely hashing itself), P2Pool is infrequently used and consequently comprises less than 1% of the current network hashrate.

P2Pool’s users are effectively pseudonymous. Due to the intended pseudonymity it is also unclear where the transaction fees and proceeds of hashing go. For instance, do the hashers comprising this pool benefit from the proceeds of illicit trade or reside in sanctioned countries or who to contact in the event there is a problem? And unlike in other pools, there is no customer service to call and find out.

Bitcoin’s – and P2Pool’s – lack of terms of service was intentionally done by design (i.e., caveat emptor). And in the event of a block reversal, censored transaction or a mere mistake by end-users, as noted above there is no contract, standard operating procedure or EULA that mining pools (validators) must adhere to. This is discussed in section 3.

This pseudonymous arrangement was the default method of mining in 2009 but has evolved over the years. For example, there are at least two known incidents in which a miner was contacted and returned fees upon request.

Launched in late summer of 2012 and during the era of transition from GPUs and FPGA mining, ASICMiner was one of the first publicly known companies to create its own independent ASIC mining hardware. Its team was led by “FriedCat,” a Chinese businessman, who custom designed and integrated ASIC chips called Block Eruptors, ASICMiner operated their own liquid immersion facility in Hong Kong.9

At its height, ASICMiner (which solo-mined similar to KnC and BitFury do today) reached over 10% of the network hashrate and its “shareholders” listed its stock on GLBSE (Global Bitcoin Stock Exchange), GLBSE is a now defunct virtual “stock market” that enabled bitcoin users to purchase, trade and acquire “shares” in a variety of listed companies.10 GLBSE is notable for having listed, among other projects, SatoshiDice which was later charged by the Securities and Exchange Commission (SEC) for offering unregistered securities to the public.1112

While unregistered stock exchanges catering to cryptocurrency users and China-based mining pools may be common sights today, on August 28, 2013, a bitcoin user sent a 200 bitcoin fee that was processed by ASICMiner.13 Based on then-market rates, this was approximately worth $23,518.14 The next day, for reasons that are unknown, ASICMiner allegedly sent the errant fee back to the original user.15 At the time, one theory proposed by Greg Maxwell (a Bitcoin Core developer) was that this fee was accidentally sent due to a bug with CoinJoin, a coin-mixing service.16

Liquid Bitcoin

Liquid cooled hashing equipment at ASICMiner in 2013. Source: Xiaogang Cao

The second notable incident involved BitGo, a multisig-as-a-service startup based in Palo Alto and AntPool, a large China-based pool (which currently represents about 15% of the network hashrate) operated by Bitmain which also manufacturers Antminer hardware that can be acquired directly from the company (in contrast to many manufacturers which no longer sell to the public-at-large). On April 25, 2015 a BitGo user, due to a software glitch, accidentally sent 85 bitcoins as a mining fee to AntPool. Based on then-market rates, this was worth approximately $19,197.17

The glitch occurred in BitGo’s legacy recovery tool which used an older version of a library that causes a 32-bit truncation of values and results in a truncation of outputs on the recovery transaction.18 To resolve this problem, the user “rtsn” spent several days publicly conversing with tech support (and the community) on Reddit.19

Eventually the glitch was fixed and Bitmain – to be viewed as a “good member of the community” yet defeating the purpose of a one-way-only, pseudonymous blockchain – sent the user back 85 bitcoins.

May Bitcoin Fee

Fee to Bitmain (Antpool) highlighted in red on Total Transaction Fee chart.  Source: Blockchain.info

On September 11, 2015 another user accidentally sent 4.6 bitcoins (worth $1,113) as a fee to a mining pool, which in this instance was AntPool.20 Bitmain, the parent company, once again returned the fee to the user.

Do we know about other farms?21

HaoBTC is a newly constructed medium-sized hashing farm located in Kangding, western Sichuan, near the Eastern border with Tibet.22 It currently costs around 1.5 million RMB per petahash (PH) – or $242,000 – to operate per year. This includes the infrastructure and miner equipment costs. It does not include the operating costs which consists of: electricity, labor, rent and taxes (the latter two are relatively negligible).

The facility itself cost between $600,000 – $700,000 to build (slightly less than the $1 million facility BitFury built in 2014 in the Republic of Georgia) and its electrical rate of 0.2 RMB per kWh comes from a nearby hydroelectric dam which has a 25,000 kW output (and cost around $10 million to construct).23

In dollar terms this is equivalent to around $0.03 / kWh (during the “wet” or “summer” season). For perspective, their electric bill in August 2015 came in at 1.4 million RMB (roughly $219,000); thus electricity is by far the largest operating cost component.

When all the other costs are accounted for, the average rises to approximately $0.045 per kWh. The electricity rate is slightly more expensive (0.4 RMB or $0.06) during winter due to less water from the mountains. The summer rate is roughly the same price as the Washington State-based hashing facilities which is the cheapest in the US (note: it bears mentioning that Washington State partly subsidizes hydroelectricity).


HaoBTC staff installing hashing equipment. Source: Eric Mu

At this price per joule it would cost around $105 million to reproduce “work” generated by the 450 petahash Bitcoin blockchain. Due to a recent purchase of second-hand ASICMiner Tubes, HaoBTC currently generates just over 10 PH and they are looking to expand to 12 PH by the end of the year.24 The key figure that most miners are interested in is that at the current difficulty level it costs around $161 for HaoBTC’s farm to create a bitcoin, giving them a nearly 100% margin relative to the current market price.

The ASIC machines they – and the rest of the industry uses – are single use; this hashing equipment cannot run Excel or Google services, or even bitcoind. Thus common comparisons with university supercomputers is not an apples-to-apples comparison as ASIC hashing cannot do general purpose computing; ASIC hashing equipment can perform just one function.25

There is also a second-hand market for it. For instance, hashing facilities such as HaoBTC actively look to capitalize off their unique geographical advantages by using older, used hardware. And there is a niche group of individuals, wanting to remain anonymous, that will also purchase older equipment.26

Although individual buyers of new hashing equipment such as Bob, do typically have to identify themselves to some level, both Bob can also resell the hardware on the second-hand market without any documentation. Thus, some buyers wanting to buy hashing equipment anonymously can do so for a relative premium and typically through middlemen.2728

While Bitbank’s BW mining farm and pool have been in the news recently29, perhaps the most well-known live visual of mining facilities is the Motherboard story on a large Bitcoin mining farm in Dalian, Liaoning:30

Incidentally, while Motherboard actually looked at just one farm, the foreigner helping to translate for the film crew independently visited another farm in Inner Mongolia which during the past year Bitbank apparently acquired.31

Are there any other known facilities outside of China?32

Genesis Mining

Source: Business Insider / Genesis Mining

Genesis Mining is a cloudhashing service provider that purportedly has several facilities in Iceland.33 According to a recent news story the company is one of the largest users of energy on the island and ignoring all the other costs of production (aside from electricity), it costs about $60 to produce a bitcoin.34 However, when other costs are included (such as hardware and staffing) the margin declines to — according to the company — about 20% relative to the current bitcoin price. At the time of the story, the market price of a bitcoin was around $231.

The four illustrations above are among a couple dozen farms that generate the majority of the remaining hashrate.

What does this have to do with colored coins?

The network was originally designed in such a way that validators (block makers) were pseudonymous and identification by outside participants was unintended and difficult to do.  If users can now contact validators, known actors in scenic Sichuan, frigid Iceland or rustic Georgia, why not just use a distributed ledger system that already identifies validators from the get go?  What use is proof-of-work at all? Why bother with the rhetoric and marginal costs of pseudonymity?

The social pressure type of altruism noted above (e.g,. Bitmain and BitGo returning fees) actually could set a nebulous precedent: once block rewards are reduced and fees begin to represent a larger percentage of miner revenue, it will no longer be an “easy” decision to refund the user in the event there is a mistake.35 If Bitmain did not send a refund, this backup wallet error would serve as a powerful warning to future users to try and not make mistakes.

While there have been proposals to re-decentralize the hashing process, such as a consumer-device effort led by 21inc which amounts to creating a large corporate operated botnet, one trend that has remained constant is the continued centralization of mining (block making) itself.3637 The motivation for centralizing block making has and continues to be about one factor: variance in payouts.38 Investors in hashing prefer stable payouts over less stable payouts and the best way to do that with the current Poisson process is to pool capital (much like pooling capital in capital markets to reduce risk).

Whether or not these trends stay the same in the future are unknown, however it is likely that the ability to contact (or not contact) certain pools and farms will be an area of continued research.

Similarly one other potential drawback of piggy backing on top of a public blockchain that could be modeled in the future is the introduction of a fat tail risk due to the boundlessness of the price of the native token.39 In the case of price spikes even if for short time can create price distortions or liquidity problem on the off-chain asset introducing a correlation between the token and the asset that theoretically was not supposed to be there.

  1. For instance, the staff of Let’s Talk Bitcoin issues LTBCoin on a regular basis to listeners, content creators and commenters. []
  2. Wall Street, Meet Block 368396, the Future of Finance from Bloomberg []
  3. On August 20, 2015, Symbiont announced it is also building a permissioned ledger product. See also the second half of Bitcoin’s Noisy Size Debate Reaches a Hard Fork from The Wall Street Journal, Why Symbiont Believes Blockchain Securities Are Wall Street’s Future from CoinDesk and Why Symbiont Believes Blockchain securities are Wall Street’s Future []
  4. The CoinPrism page for the specific token that Overstock.com initially used for the “cryptobond” can be viewed here; similarly the file on the T0 domain that verifies its authenticity can be seen here. See also: World’s First Corporate “Cryptobond” was issued using Open Assets []
  5. Overstock CEO Uses Bitcoin Tech to Spill Wall Street Secret from Wired and Overstock.com and FNY Capital Conclude $5 Million Cryptobond Deal from Nasdaq []
  6. One reviewer likened the Overstock “cryptobond” proof of concept as a large wash trade: ”Basically it’s a cashless swap of paper and thus no currency settlement. And the paper has no covenants and thus very easy to digitally code. Basically Overstock is paying FNY a spread of 4% for doing this deal. And if the bond and loan are called simultaneously, say in the next month, that means that Overstock paid FNY about $16,667.00 to do this trade. And since there was no cash exchanged, I am presuming, then this is smoke and mirrors. But they actually did it. However, I don’t see much of a business model where the issuer of a bond has to simultaneously fund the investor with a loan to buy the bond and pay him 33 basis points to boot!” []
  7. P2Pool wiki and P2Pool github []
  8. See Target, How Bitcoin Hashing Works and On Mining by Vitalik Buterin []
  9. ASICMINER: Entering the Future of ASIC Mining by Inventing It from Bitcoin Talk, Mystery in Bitcoinland…. the disappearance of FriedCat from Bitcoin Reporter; Chinese Mining mogul FriedCat has stolen more than a million in AM hash SCAM from Bitcoin Talk and Visit of ASICMINER’s Immersion Cooling Mining Facility from Bitcoin Talk []
  10. See 12.2 Pool and network miner hashrate distributions from Organ of Corti and Bitcoin “Stock Markets” – It’s Time To Have A Chat from Bitcoin Money []
  11. See SEC Charges Bitcoin Entrepreneur With Offering Unregistered Securities from SEC and the Administrative Proceeding order []
  12. In (Rosenfeld 2012) the author noted that one of the risks for running an “alternative to traditional markets” – such as GLBSE – were the regulatory compliance hurdles. Overview of Colored Coins by Meni Rosenfeld, p. 4. []
  13. Block 254642 and Some poor person just paid a 200BTC transaction fee to ASICminer. []
  14. According to the Coindesk Bitcoin Price Index, the market price of a bitcoin on August 28, 2013 was approximately $117.59. []
  15. Included in block 254769 []
  16. A thread discussed this theory: Re: CoinJoin: Bitcoin privacy for the real world (someday!) []
  17. According to the Coindesk Bitcoin Price Index, the market price of a bitcoin on April 25, 2015 was approximately $225.85. []
  18. The user “vytah” debugged this issue in a reddit thread: Holy Satoshi! Butter pays 85Btc transaction fees for a 16Btc transaction. Is this the largest fee ever paid? []
  19. Help! Losing Over 85 BTC Because of BitGo’s Flawed Recovery Process! on Reddit []
  20. To AntMiner, miner of block #374082. I did an accidental 4.6 BTC fee. on Reddit []
  21. Readers may be interested in a little more history regarding self-identification by miners: Slush, the first known pool, began publicly operating at the end of November 2010 and was the first to publicly claim a block (97838).   Eligius was announced on April 27, 2011 and two months later signed the first coinbase transaction (130635).   DeepBit publicly launched on February 26, 2011 and at one point was the most popular pool, reaching for a short period in May 2011, more than 50% of the network hashrate. See Deepbit pool owner pulls in $112* an hour, controls 50% of network and DeepBit pool temporarily reaches critical 50% threshold from Bitcoin Miner and What has been the reaction to permissioned distributed ledgers? []
  22. This information comes from personal correspondence with Eric Mu, July 7, 2015 as well as two other public sources: Inside a Tibetan Bitcoin Mine: The Race for Cheap Energy from CoinTelegraph and Three months living in a multi-petahash BTC mine in Kangding, Sichuan, China from Bitcoin Talk []
  23. Last summer BitFury quickly built a relatively cheap data center in Georgia partly due to assistance from the national government. See BitFury Reveals New Details About $100 Million Bitcoin Mine from CoinDesk []
  24. Personal correspondence with Eric Mu, August 10, 2015 []
  25. One common talking point by some Bitcoin enthusiasts including venture capitalists is that Google’s computers, if repurposed for mining Bitcoin, would generate only 1-2% of the network hashrate – that the Bitcoin network is “faster” than all of Google’s data centers combined. This is misleading because these Bitcoin hashing machines cannot provide the same general purpose utility that Google’s systems can. In point of fact, the sole task that ASIC hashing equipment itself does is compute two SHA256 multiplications repeatedly. []
  26. Some academic literature refers to miners on the Bitcoin network as “anonymous participants.” In theory, Bitcoin mining can be anonymous however by default mining was originally a pseudonymous activity. Participants can attempt to remain relatively anonymous by using a variety of operational security methods or they can choose to identify (“doxx”) themselves as well. See The Bitcoin Backbone Protocol: Analysis and Applications by Garay et al. []
  27. Thanks to Anton Bolotinsky for this insight. []
  28. This is similar to the “second-hand” market for bitcoins too: bitcoins originally acquired via KYC’ed gateways sometimes end up on sites like LocalBitcoins.com (akin to “Uber for bitcoins”) – where the virtual currency is sold at a premium to those wanting to buy anonymously. []
  29. The Unknown Giant: A First Look Inside BW, One of China’s Oldest and Largest Miners from Bitcoin Magazine []
  30. Inside the Chinese Bitcoin Mine That’s Grossing $1.5M a Month from Motherboard []
  31. Jake Smith, the translator, also wrote a short story on it: Inside one of the World’s Largest Bitcoin Mines at The Coinsman []
  32. While it is beyond the scope of this paper, there are a couple of general reasons why medium-sized farms such as HaoBTC have been erected in China. Based upon conversations with professional miners in China one primary reason is that both the labor and land near energy generating facilities is relatively cheap compared with other parts of the world. Furthermore, energy itself is not necessarily cheaper, unless farms managers and operators have guanxi with local officials and power plant owners.   And even though it is common to assume that due to the capital controls imposed at a national level – citizens are limited to the equivalent of $50,000 in foreign exchange per year – there have been no public studies as to how much capital is converted for these specific purposes. There are other ways to avoid capital controls in China including art auctions and pawn shops on the border with Macau and Hong Kong. See also How China’s official bank card is used to smuggle money from Reuters and What Drives the Chinese Art Market? The Case of Elegant Bribery by Jia Guo See On Getting Paid From China. Is There Really A $50,000 Yearly Limit? from China Law Blog and Bitcoins: Made in China []
  33. Look inside the surreal world of an Icelandic bitcoin mine, where they literally make digital money from Business Insider []
  34. It is unclear how much hashrate they actually operate or control, a challenge that plagues the entire cloudhashing industry leading to accusations of fraud. []
  35. And this is also a fundamental problem with public goods, there are few mechanisms besides social pressure and arbitrary decision making to ration resources. As described in (Evans 2014), since miners are the sole labor force, they create the economic outputs (bitcoins) and security, it is unclear why they are under any expectation to return fees in a network purposefully designed to reduce direct interactions between participants. See Economic Aspects of Bitcoin and Other Decentralized Public-Ledger Currency Platforms by David Evans []
  36. See 21 Inc Confirms Plans for Mass Bitcoin Miner Distribution from CoinDesk and What impact have various investment pools had on Bitcoinland? []
  37. In 2014 the state of New Jersey sued a MIT student, Jeremy Rubin, for creating a web-based project that effectively does the same thing as the silicon-based version proposed by 21inc. See Case Against Controversial Student Bitcoin Project Comes to Close from CoinDesk. In addition, the FTC, in its case against Butterfly Labs also looked at BFL not informing customers properly regarding difficulty rating changes. According to the FTC’s new release on this case: “A company representative [BFL] said that the passage of time rendered some of their machines as effective as a “room heater.” The FTC charged that this cost the consumers potentially large sums of money, on top of the amount they had paid to purchase the computers, due to the nature of how Bitcoins are made available to the public.” []
  38. This issue was cited in the CryptoNote whitepaper as one motivation for creating a new network. On p. 2: “This permits us to conjecture the properties that must be satisfied by the proof-of-work pricing function. Such function must not enable a network participant to have a significant advantage over another participant; it requires a parity between common hardware and high cost of custom devices. From recent examples [8], we can see that the SHA-256 function used in the Bitcoin architecture does not possess this property as mining becomes more efficient on GPUs and ASIC devices when compared to high-end CPUs. Therefore, Bitcoin creates favourable conditions for a large gap between the voting power of participants as it violates the “one-CPU-one-vote” principle since GPU and ASIC owners possess a much larger voting power when compared with CPU owners. It is a classical example of the Pareto principle where 20% of a system’s participants control more than 80% of the votes.” []
  39. I would like to thank Ayoub Naciri for providing this example. []
Send to Kindle

A dissection of two Bitfury papers

BitFuryBitfury, the Bitcoin mining company, recently published two papers:

The underlying motivations for writing them was that Bitfury is trying to assure the world that public blockchains can still be used in “proprietary contexts.” While they provide a good frame for the issue, there are several leaps in logic, or direct contradictions to established theory that necessarily weaken their argument.

Below is my discussion of them. Note: as usual, this only represents my opinion and does not necessarily represent the views of the organizations that I advise or work for.

Overall I thought the two papers did not seem to have been reviewed by a wider audience including lawyers: specifically they should have sent them to commercial and securities lawyers to see if any legal issues should be considered. Much of their pitch basically amounts to mining for the sake of mining.

One final note: for additional commentary I also reached out to Dave Hudson who is proprietor of HashingIt and an expert as it relates to Bitcoin mining analysis.  He is unaffiliated with Bitfury.

Notes for Part 1:

On p. 2, Bitfury wrote the following statement:

The key design element of blockchains – embedded security – makes them different from ordinary horizontally scalable distributed databases such as MySQL Cluster, MongoDB and Apache HBase. Blockchain security makes it practically impossible to modify or delete entries from the database; furthermore, this kind of security is enforced not through the central authority (as it is possible with the aforementioned distributed databases), but rather through the blockchain protocol itself.

Is this a problematic summary?

According to Dave Hudson:

As a network protocol engineer of many years I tend to find the concept of a “blockchain protocol” somewhat odd. Here’s a link to definitions of “protocol.”

What do we mean by protocol here? It’s not actually a network protocol because there is no “blockchain protocol”, there are many different ones (each altcoin has its own and there are many more besides). At best the idea of a “blockchain protocol” is more a meta-protocol, in that we say there are some things that must be done in order for our data to have blockchain-like characteristics. It’s those characteristics that provide for non-repudiation.

Also on p. 2, Bitfury uses the term “blockchain-based ledger.”  I like that because, as Vlad Zamfir and Peter Todd (among others) have pointed out in the past, the two concepts are not the same — distributed ledgers are not necessarily blockchains and vice versa.

On p. 4 and 5 they list several objections for why financial institutions are hesitant to use a public blockchain yet leave a couple noticeable ones off including the lack of a service level agreement / terms of service between end users and miners.  That is to say, in the event of a block reorg or 51% attack, who calls who?

On p. 7, I don’t think that censorship resistance can be generalized as a characteristic for “all blockchains.”

In Dave Hudson’s view:

Moreover, censorship resistance makes absolutely no sense in many instances. Who would be censoring what?

I’m actually not convinced that censorship resistance is actually a “thing” in Bitcoin either. Plenty of well-formed transactions can be censored by virtue of them being dust or having non-standard scripts. If anything the only thing that Bitcoin does is provide a set of conditions in which a transaction is probabilistically going to be mined into blocks in the network.

For those interested, there are a handful of “standard’ transaction types that are usually accepted by most mining pools.

On p. 11, I disagree with this statement:

If a blockchain database is completely opaque for clients (i.e., they have no access to blockchain data), the security aspect of blockchain technology is diminished. While such system is still protected from attacks on the database itself, interaction with clients becomes vulnerable, e.g. to man-in-the middle attacks. As a built-in protocol for transaction authorization is one of core aspects of blockchain technology, its potential subversion in favor of centralized solutions could negatively influence the security aspect of the system. Additionally, as transactions are accessible to a limited set of computers, there exists a risk of human factor intervening into the operation of the blockchain with no way for clients to detect such interference. Thus, the opaque blockchain design essentially undermines the core aspects of blockchain technology:
• decentralization (absence of a single point of failure in the system)
• trustlessness (reliance on algorithmically enforced rules to process transactions with no human interaction required).

I think trustlessness is a red herring that cypherpunks and Bitcoiners have been perpetually distracted by. It may be an end-goal that many would like to strive for but trust-minimization is a more realistic intermediate characteristic for those operating within the physical, real world.

Why? Because existing institutions and legal infrastructure are not going to disappear tomorrow just because a vocal group of cryptocurrency enthusiasts dislikes them.

According to Dave Hudson:

As with so many things-Bitcoin, I think this is an implementation necessity being seen as a innately desirable characteristic. Bitcoin requires “trustlessness” because it’s non-permissioned, yet in truth it totally relies on trust to work. We trust that Sybil attacks aren’t happening and that network service providers are not colluding to support such attacks. We trust that a large body of miners are not colluding to distort the system. We trust that changes to the software (or updates to compilers and operating systems) have not rendered old, non-recently-used keys are still able to support signing of transactions. We trust that Satoshi (and other large holders) will not drop 1M, or worse 10M coins onto exchanges crashing the price to a few cents per coin! There’s no “too big to fail” here!

In truth real-world people actually like to trust things. They want to trust that their national governments will ensure services work and that invaders are kept out. They want to trust that law enforcement, fire and medical services will keep them safe. I’m not sure that I like the idea of a trustless Police force?

What people do like is the ability to verify that the entities that they actually do trust are in fact doing what they should. Blockchain designs allow us to do just this.

That last statement in particular succinctly summarizes some of the motivations for financial institutions looking to use a shared ledger that is not the Bitcoin blockchain.

On p. 12, I disagree with this statement:

While the permissioned nature of blockchains for proprietary applications may be a necessary compromise in the medium term because of compliance and other factors, read access to blockchain data together with the publicly available blockchain protocol would remove most of vulnerabilities associated with opaque blockchain designs and would be more appealing to the clients of the institution(s) operating the blockchain. As evidenced by Bitcoin, simplified payment verification softwarecan be used to provide a direct interface to blockchain data that would be both secure and not resource intensive.

The reason I disagree with this statement is because the term “opaque” is loaded and ill-defined.

For instance, several groups within the Bitcoin ecosystem have spent the last several years trying to delink or obfuscate transaction history via zk-SNARKs, stealth addresses, mixing via Coinjoin and Coinshuffle and other methods. This type of activity is not addressed by Bitfury — will they process Bitcoin transactions that are obfuscated?

Granular permissions — who is allowed to see, read or write to a ledger — is a characteristic some of these same Bitcoin groups are not fans of but is a needed feature for financial institutions. Why? Because financial institutions cannot leak or expose personal identifiable information (PII) or trading patterns to the public.

Securely creating granular permissions is doable and would not necessarily reduce safety or transparency for compliance and regulatory bodies. Operating a non-public ledger is not the same thing as being “opaque.” While hobbyists on social media may not be able to look at nodes run by financial institutions, regulators and compliance teams can still have access to the data.

It also bears mentioning that another potential reason some public blockchains have and/or use a token is as an anti-spam mechanism (e.g., in Ripple and Stellar a minute amount is burnt).1

On p. 13, I disagree with this statement:

The problem is somewhat mitigated if the access to block headers of the chain is public and unrestricted; however, convincing tech-savvy clients and regulators that the network would be impervious to attacks could still be a difficult task, as colluding operators have the ability to effortlessly reorganize the arbitrary parts of the blockchain at any given moment. Thus, the above consensus protocol is secure only if there is no chance of collusion among blockchain operators (e.g., operators represent ideal parties with conflicting interests). Proof of work provides a means to ensure absence of collusion algorithmically, aligning with the overall spirit of blockchain technology.

This is untrue. People run pools, people run farms. Earlier this year Steve Waldman gave a whole presentation aptly named “Soylent Blockchains” because people are involved in them.

As we have seen empirically, pool and farm operators may have conflicting incentives and this could potentially lead to collusion. Bitcoin’s “algorithms” cannot prevent exogenous interactions.

On p. 14 I disagree with this statement:

There is still a fixed number of miners with known identities proved by digital signatures in block headers. Note that miners and transaction processors are not necessarily the same entities; in the case that mining is outsourced to trusted companies, block headers should include digital signatures both from a miner and one or more processing institutions.

Having a “trusted company” run a proof-of-work mining farm is self-defeating with respect to maintaining pseudonymity on an untrusted network (which were the assumptions of Bitcoin circa 2009). If all miners are “trusted” then you are now operating a very expensive trusted network. This also directly conflicts with the D in DMMS (dynamic-membership multi-party signature).

According to Dave Hudson:

If the signing is actually the important thing then we may as well say there’s a KYC requirement to play in the network and we can scale it all the way back to one modest x86 server at each (with the 1M x reduction in power consumption). Of course this would kill mining as a business.

On p. 14 I think the Bitfury proposal is also self-defeating:

The proposed protocol solves the problem with the potentially unlimited number of alternative chains. Maintaining multiple versions of a blockchain with proof of work costs resources: electricity and hashing equipment. The hashing power spent to create a blockchain and the hashing power of every miner can be reliably estimated based on difficulty target and period between created blocks; an auditor could compare these numbers with the amount of hashing equipment available to operators and make corresponding conclusions.

The authors go into detail later on but basically they explain what we can already do today: an outside observer can look at the block headers to see the difficulty and guess how much hashrate and therefore capital is being expended on the hash.

On p. 15 they present their proposal:

Consequently, $10 million yearly expenses on proof of work security (which is quite low compared to potential gains from utilizing blockchain technology, estimated at several billion dollars per year [54]) correspond to the hash rate of approximately 38 PHash / s, or a little less than 10% of the total hash rate of the Bitcoin network.

This is entirely unneeded. Banks do not need to spend $10 million to operate hardware or outsource operation of that hardware to some of its $100 million Georgia-based hydro-powered facilities.

According to Dave Hudson:

Precisely; banks can use a permissioned system that doesn’t need PoW. I think this also misses something else that’s really important: PoW is necessary in the single Bitcoin blockchain because the immutability characteristics are derived from the system itself, but if we change those starting assumptions then there are other approaches that can be taken.

In section 3.1 the authors spend some time discussing merged mining and colored coins but do not discuss the security challenges of operating in a public environment. In fact, they assume that issuing colored coins on a public blockchain is not only secure (it is not) but that it is legal (probably not either).2

On p. 16 they mention “transaction processors” which is a euphemism that Bitfury has been using for over a year now. They dislike being called a mining company preferring the phrase “transaction processors” yet their closed pool does not process any kind of transactions beyond the Bitcoin variety.

On page 17 they wrote:

[M]aintenance of the metachain could be outsourced to a trusted security provider without compromising confidential transaction details.

If taken to the logical extreme and all of the maintenance was “outsourced” to trusted security providers they would have created a very expensive trusted network. Yet in their scenario, financial institutions would have to trust a Republic of Georgia-based company that is not fully transparent.

Also on page 17 they start talking about “blockchain anchors.” This is not a new or novel idea. Peter Todd has talked about it in the past and Guardtime puts anchors into newspapers like The New York Times (e.g., publishes the actual hashes in a newspaper).  And, again, this could easily be done in other ways too. Why restrict anchoring to one location? This is Bitcoin maximalism at work again.

On p. 20 they wrote:

Bitcoin in particular could be appropriate for use in blockchain innovations as a supporting blockchain in merged mining or anchoring due to the following factors: • relatively small number of mining pools with established identities, which allows them to act as known transaction validators by cooperating with institutions

This is self-defeating for pseudonymous interactions (e.g., Bitcoin circa 2008). Proof-of-work was integrated to fight Sybil attacks. If there are only a few mining pools with established identities then there are no Sybil’s and you effectively have an extremely expensive trusted network.

Notes on Part 2:

On p. 3 they wrote:

If an institution wants to ensure that related Bitcoin transactions are mined by accredited miners, it may send transactions over a secure channel directly to these miners rather than broadcasting them over the network; accepting non-broadcast transactions into blocks is a valid behavior according to the Bitcoin protocol.

An “accredited miner” is a contradiction.

On p. 4 the first paragraph under section 1.3 was well written and seems accurate. But then it falls apart as they did not consult lawyers and financial service experts to find out how the current plumbing in the back-office works — and more importantly, why it works that way.

On p.4 they wrote:

First, the transfer of digital assets is not stored by the means of the Bitcoin protocol; the protocol is unaware of digital assets and can only recognize and verify the move of value measured in bitcoins. Systems integrating digital assets with the Bitcoin blockchain utilize various colored coin protocols to encode asset issuance and transfer (see Section 2.2 for more details). There is nothing preventing such a protocol to be more adapted to registered assets.

Yes there is in fact things preventing Bitcoin from being used to move registered assets, see “Watermarked tokens and pseudonymity on public blockchains.”  And their methods in Section 1.6 are non-starters.

Also on page 4 they wrote:

Second, multisignature schemes allow for the creation of limited trust in the Bitcoin environment, which can be beneficial when dealing with registered assets and in other related use cases. Whereas raw bitcoins are similar to cash, multisignature schemes act not unlike debit cards or debit bank accounts; the user still has a complete control of funds, and a multisignature service provides reputation and risk assessment services for transactions.

This is the same half-baked non-sense that Robert Sams rightly criticized in May. This is a centralized setup. Users are not gaining any advantage for using the Bitcoin network in this manner as one entity still controls access via identity/key.

On p. 5 they wrote:

One of the use cases of the 2-of-3 multisignature scheme is escrow involving a mediator trusted by both parties. A buyer purchasing certain goods locks his cryptocurrency funds with a multisignature lock, which requests two of the three signatures: the buyer’s, the seller’s, and the mediator’s.

This is only useful if it is an on-chain, native asset. Registered assets represent something off-chain, therefore Bitcoin as it exists today cannot control them.

On p. 6 they talk about transactions being final for an entire page without discussing why this is important from a legal perspective (e.g., why courts and institutions need to have finality). This paper ignores how settlement finality takes place in Europe or North America nor are regulatory systems just going to disappear in the coming months.

On page 7 they mention that:

To prevent this, a protocol could be modified to reject reorganizations lasting more than a specified number of blocks (as it is done in Nxt). However, this would make the Bitcoin protocol weakly subjective [21], introducing a social-driven security component into the Bitcoin ecosystem.

There is already a very publicly known, social-driven security component: the Bitcoin dev mailing list. We see this almost daily with the block-size debate. The statement above seems to ignore what actually happens in practice versus theory.

On p. 7 and 8 they write:

The security of the Bitcoin network in the case of economic equilibrium is determined by the rewards received by block miners and is therefore tied to the exchange rate of Bitcoin. Thus, creating high transaction throughput of expensive digital assets on the Bitcoin blockchain with the help of colored coin protocols has certain risks: it increases the potential gain from an attack on the network, while security of the network could remain roughly the same (as there are no specific fees for digital asset transactions; transaction fees for these transactions are still paid in bitcoins). The risk can be mitigated if Bitcoin fees for asset transactions would be consciously set high, either by senders or by a colored coins protocol itself, allowing Bitcoin miners to improve security of the network according to the value transferred both in bitcoins and in digital assets.

There is no way to enforce this increase in fee. How are “Bitcoin fees for asset transactions … consciously set high”? This is a question they never answer, (Rosenfeld 2012) did not answers it, no one does. It is just assumed that people will start paying higher fees to protect off-chain securities via Bitcoin miners.

There is no incentive to pay more and this leads to a hold-up problem described in the colored coin “game” from Ernie Teo.

On p. 8 they wrote:

As there is a relatively small number of Bitcoin mining pools, miners can act as known processors of Bitcoin transactions originating from institutions (e.g., due to compliance reasons). The cooperation with institutions could take the form of encrypted channels for Bitcoin transactions established between institutions and miners.

This is silly. If they are known and trusted, you have a trusted network that lacks a Sybil attacker. There is no need for proof-of-work mining equipment in such a scenario.

On p. 8 they wrote:

In the ideal case though, these transactions would be prioritized solely based on their transaction fees (i.e., in a same way all Bitcoin transactions are prioritized), which at the same time would constitute payments for the validation by a known entity. Thus, this form of transaction processing would align with the core assumption for Bitcoin miningthat miners are rational economic actors and try to maximize their profit.

It cannot be assumed that miners will all behave as “rational economic actors.” They will behave according to their own specific incentives and goals.

On p. 9 they wrote:

Additionally, partnerships between institutions and miners minimize risk in case transactions should not be made public before they are confirmed.

Registered and identifiable miners is the direct anti-thesis of pseudonymous interactions circa Bitcoin 2008. That type of partnership is a win-lose interaction.

On p. 10 they wrote:

One of the interesting financial applications of colored coins is Tether (tether.to), a service using colored coins to represent US dollars for fast money transfer. Several cryptocurrencies such as Nxt and BitShares support custom digital assets natively.

As it exists today, Tether.to is similar in nature to a Ripple gateway such as SnapSwap: both are centralized entities that are subject to multiple regulatory and compliance requirements (note: SnapSwap recently exited its USD gateway business and locked out US-based users from its BTC2Ripple business).

tether msb

According to FinCEN’s MSB Registrant Search Web page, Tether has a registration number (31000058542968) and one MSB.  While they have an AML/CTF program in place, it is unclear in its papers how Bitfury believes the Bitcoin network (which Tether utilizes) can enforce exogenous claims (e.g., claims on USD, euros, etc.).

Furthermore, there has been some recent research looking at how the Federal Reserve and the Bank of England could use distributed ledgers to issue digital currency.3

If a central bank does utilize some kind of distributed ledger for a digital currency they do not need proof-of-work mining or the Bitcoin network to securely operate and issue digital currency.

Ignoring this possible evolution, colored coins are still not a secure method for exogenous value transfers.

On page 10 they wrote:

Colored coins are more transparent for participants and auditors compared to permissioned blockchains

This is untrue and unproven. As Christopher Hitchens would say, what can be asserted without evidence can be dismissed without evidence.

On page 10 they wrote:

As colored coins operate on top of permissionless blockchains, systems using colored coins are inherently resistant to censorship – restrictions on transactions are fully specified by a colored coins protocol instead of being enforced by a certain entity

This is also untrue. This is a bit like trying to have their cake and eat it too.

On page 11 they have a diagram which states:

Figure 2: Using colored coins on top of the Bitcoin blockchain to implement asset transactions. For compliance, financial institutions may use secure communication channels with miners described in Section 2.1 to place asset transactions on the blockchain

Again this is self-defeating. As the saying goes: be careful what you wish for. If Bitfury’s proposal came true, their pool(s) could become payment service providers (PSP) and regulated by FinCEN.

On page 12 and 13 they wrote:

Bitcoin and other public permissionless blockchains could be a part of the interconnected financial environment similarly to how cash is a ubiquitous part of the banking system. More concretely, cryptocurrencies could be used as: • one of the means to buy and sell assets on permissioned blockchains • an instrument that enables relatively fast value transfer among permissioned blockchains • an agreed upon medium for clearing operations among blockchains maintained by various institutions (Fig. 4).

Bitcoins as a permanent store-of-value are effectively a non-starter as they lack any endogenous self-stabilizing mechanism.4

According to Dave Hudson:

The systemic risks here just make this idea farcical. The Internet is somewhat immune to this because there are technology providers all over the world who can independently choose to ignore things in regulatory domains that want to do “bad things”. There is no such safety net in a system that relies on International distributed consensus (the Internet has no such problem, although DNS is a little too centralized right now). Even if it could somehow be guaranteed that things can’t be changed, fixed coin supply means artificial scarcity problems are huge (think Goldfinger trying to irradiate the gold in Fort Knox) – you wouldn’t need a nuclear weapon, just a good piece of malware that could burn coins (if they’re not stolen then there’s no way to trace who stole them). There’s also the 1M coins dropped onto exchanges problem.

The discussion over elastic and inelastic money supplies is a topic for another post.

On page 15 they wrote:

If a blockchain is completely opaque for its end users (e.g., a blockchain-based banking system that still uses legacy communication interfaces such as credit cards), the trustless aspect of blockchains is substantially reduced. End users cannot even be sure that a blockchain system is indeed in use, much less to independently verify the correctness of blockchain data (as there is no access to data and no protocol rules to check against). Human factor remains a vulnerability in private blockchain designs as long as the state of the blockchain is not solely based on its protocol, which is enforced automatically with as little human intervention as possible. Interaction based on legacy user authentication interfaces would be a major source of vulnerabilities in the case of the opaque blockchain design; new interfaces based on public key cryptography could reduce the associated risk of attacks.

While mostly true, there are existing solutions to provide secure verification. It is not as if electronic commerce did not or could not occur before Bitcoin came into existence. Some private entities take operational security seriously too. For instance, Visa’s main processing facility has 42 firewalls and a moat.

On page 15 they wrote:

Proprietary nature of private blockchains makes them less accessible; open sourced and standardized blockchain implementations would form a more attractive environment for developers and innovations. In this sense, blockchains with a public protocol are similar to open Internet standards such as IP, TCP and HTTP, while proprietary blockchain designs could be similar to proprietary Internet protocols that did not gain much traction. A proprietary blockchain protocol could contain security vulnerabilities that remain undiscovered and exploited for a long time, while a standardized open blockchain protocol could be independently studied and audited. This is especially true for protocols of permissionless blockchains, as users have a direct economic incentive to discover vulnerabilities in the system in order to exploit them.

This is just scaremongering. While some of the “blockchain” startups out there do in fact plan to keep the lower layers proprietary, the general view in October 2015 is that whatever bottom layer(s) are created, will probably be open-sourced and an open-standard. Bitcoin doesn’t have a monopoly on being “open” in its developmental process.

On page 15 they wrote:

As the Bitcoin protocol has been extensively studied by cryptographers and scientists in the field, it could arguably form the basis for the standardized blockchain design.

This is untrue, it cannot be the backbone of a protocol as it is not neutral. In order to use the Bitcoin network, users are required to obtain what are effectively illiquid pre-paid gift cards (e.g., bitcoins). Furthermore, an attacker cannot collect “51%” of all TCP/IP packets and take over the “internet” whereas with Bitcoin there is a real “majoritarianism” problem due to how network security works.

A truly neutral protocol is needed and there have been at least two proposals.5

On page 15 they wrote:

The key design element of blockchains is “embedded economy” – a superset of embedded security and transaction validation. Each blockchain forms its own economic ecosystem; a centrally controlled blockchain is therefore a centrally controlled economy, with all that entails.

This is untrue. If we are going to use real-world analogies: Bitcoin’s network is not dynamic but rather disperses static rewards to its labor force (miners). It is, internally, a rigid economy and if it were to be accurately labeled, it is a command economy that relies on altruism and VC subsidies to stay afloat.6

On page 16 they wrote:

It is not clear how the blockchain would function in the case validators would become disinterested in its maintenance, or how it would recover in the case of a successful attack (cf. with permissionless blockchains, which offer the opportunity of self-organization).

The statement above is unusual in that it ignores how payment service providers (PSPs) currently operate.  Online commerce for the most part has and likely will continue to exist despite the needed maintenance and profit-motive of individual PSPs.  There are multiple motivations for continued maintenance of maintenance transfer agreements — this is not a new challenge.

While it is true that there will likely be dead networks in the futures (just like dead ISPs in the past), Bitcoin also suffers from a sustainability problem: it continually relies on altruism to be fixed and maintained and carries with it an enormous collective action burden which we see with the block-size debate.

There are over a hundred dead proof-of-work blockchains already, a number that will likely increase because they are all public goods that rely on external subsidies to exist. See Ray Dillinger’s “necronomicon” for a list of dead alt coins.

If Bitfury’s proposal for having a set of “fixed” miners arises, then it is questionable about how much self-organization could take place in a static environment surrounding a public good.


Despite the broad scope of the two papers from Bitfury neither was able to redress some of the most important defects that public blockchains have for securing off-chain assets:

  • how is legal settlement finality resolved
  • how to incentivize the security of layers (such as colored coins) which distort the mining process
  • how to enforce the security of merged mining which empirically becomes weaker over time

If Bitfury is truly attempting to move beyond merely processing Bitcoin transactions in its Georgian facilities, it needs to address what constraints and concerns financial institutions actually face and not just what the hobbyist community on social media thinks.

  1. See also: Needing a token to operate a distributed ledger is a red herring and A blockchain with emphasis on the “a” []
  2. See also: Can Bitcoin’s internal economy securely grow relative to its outputs? and Will colored coin extensibility throw a wrench into the automated information security costs of Bitcoin? []
  3. This includes: Fedcoin—how banks can survive blockchains by Robin Winkler and Centrally Banked Cryptocurrencies by George Danezis and Sarah Meiklejohn []
  4. See Seigniorage Shares from Robert Sams []
  5. See: A Protocol for Interledger Payments by Stefan Thomas and Evan Schwartz and An architecture for the Internet of Money by Meher Roy []
  6. See also: Chapter 10 in The Anatomy of a Money-like Informational Commodity and Economic Aspects of Bitcoin and Other Decentralized Public-Ledger Currency Platforms by David Evans []
Send to Kindle

Integrating, Mining and Attacking: Analyzing the Colored Coin “Game”

[Note: Below is a guest post from Ernie Teo, a post-doctorate researcher at SKBI (where I am currently a visiting research fellow).  It is referenced in a new paper covering the distorted incentives for securing public blockchains.]

Integrating, Mining and Attacking: Analyzing the Colored Coin “Game”

By Ernie G. S. Teo, Sim Kee Boon Institute for Financial Economics,
Singapore Management University

The research in this post came about when Tim Swanson invited me to look at colored coin providers and their incentives from a game theory perspective. The results are based on a number of phone conversations with Tim; I would like to take the opportunity to thank Tim for his insights on the matter. For an introduction to what colored coins are, refer to Chapter 3 in Great Chain of Numbers.

The initial question Tim wanted to know was if colored coins can be identified will miners charge excessively high fees to include these transactions. The led to a discussion of the possibilities of the colored coin issuer becoming a miner; and of an attack on the network to take control of the colored assets.

The problem proved to be very interesting as there could be many implications on the success of the system given the potential costs and benefits. Entities or players within the “game” could strategically choose to sabotage themselves if the incentives were right. In this post, I will attempt to explain this using a “sequential game” format. I will explain the various stages where choices can be made and the players involved in each stage. This will be followed by an analysis of the various outcomes and the strategic choices of each party given the incentives involved.

Before we start, I would like to disclaim that the model that follows is a simplified version of the problem and helps us to think about the potential issues that could arise. They are based on various assumptions and in no way should the results be taken at face value.

Stage 1: Before the colored coin issuer (CCI) starts operations, we assume that they will consider if they will choose to become a miner (Assuming that they can include their own transactions into blocks if no one else would). The decision maker (or player) here is the CCI, the choices available are to integrate or to not integrate.

Stage 2a: When the CCI starts issuing colored coins, it would have to decide on the fees it would pay for the transaction. We assume that the CCI is a rational entity and will choose the optimal fees. However as there are two possibilities in stage 1, there will be 2 possible fees quoted; one for a CCI whom is also a miner (integrated) and another for a CCI whom is not a miner (non-integrated). The decision maker here is the CCI and the choice is the fee quoted.

Stage 2b: This is immediately followed by the miners deciding to include the transaction in the block or not. For simplicity’s sake, we assume that there is only one miner in this game (this can be the CCI). The decision maker here is the miner and the choice is to mine the transaction or not.

If the decision in Stage 2b is not to mine, the game ends (End 1).

Stage 3: We next assume that the miner can choose to fraudulently attack the system and transfers the colored coin to itself. The decision maker here is still the miner and the choice is to attack or not.

This gives us 2 alternative endings (End 2 and End 3). The game can be described by Figure 1.

Colored Coin Teo

Figure 1: The stages of the “game”

If we consider the game, there are only 2 decision makers or players: The CCI and the miner. Next, we consider what are the possible outcomes or payoffs for each possible ending described above. This is described in Figure 2 below, there are actually 6 possibilities as there are 2 types of CCIs, integrated and non-integrated. When there is integration, there is really only one player.

Colored Coin Teo 2

Figure 2: Payoffs of the game

Having setup the game and determined the payoffs, we analyze the possibilities of each outcome. This is subject to the comparative magnitude of each payoff. Let’s start with the non-integrated outcomes, there are 3 possibilities:

  1. Not Integrated. Mined. Attacked.
  2. Not Integrated. Mined. Not Attacked.
  3. Not Integrated. Not Mined.

An attack happens if M3>M2 (this will happen if the net benefit of the attack is positive).

If M3>M2, the transaction will be mined if M3>M1. This is because the miner expects the attack to take place, the miner will thus only mine the transaction if it the payoff from mining and attacking is better than not mining. Since we assumed that M1=0, M3 will be always larger than M1. Thus When M3>M2, mining always takes place and an attack happens.

If M2>M3, the attack will not happen (this would indicate that the net benefits of the attack is negative). The transaction will be mined if M2>M1 or if the transaction fees are positive.

The transaction will not be mined if M1≥M2. Since M2 (the transaction fee) has to be at least zero, if M2=0, the transaction will not be mined.

To summarize, there are 3 scenarios:

  1. M3>M2≥M1: The transaction is mined and an attack takes place. The CCI gets CC3NI.
  2. M2>M3 and M2>M1: The transaction is mined and an attack will not take place. Note that the inequality between M1 and M3 does not matter for this outcome. The CCI gets CC2NI.
  3. M1≥M2>M3: The transaction is not mined. The CCI gets CC1NI.

In stage 1, the CCI is making the decision to integrate. To analyze this, we need to compare the non-integrated outcomes with the integrated ones. We thus have to look at the integrated outcomes first before we discuss stage 1. The outcomes are:

  1. Mined. Attacked.
  2. Mined. Not Attacked.
  3. Not Mined.

An attack happens if CC3I>CC2I. (This again will happen if the net benefit of the attack is positive).

If CC3I>CC2I, mining will occur if CC3I>CC1I. Similar to the non-integrated case, CC3I is always larger than CC1I . In fact this case is stronger as CC1I is at most zero and is likely to be negative as it is a cost. Thus if the CCI is willing to launch an attack against itself, it will definitely mine the transaction.

If CC2I>CC3I, no attack happens. For mining to occur, CC2I≥CC1I (the CCI will prefer to mine if they are indifferent). CC2I will always be larger than CC1I unless mining fees are zero (in which case it is equal), mining will always occur if CC2I>CC3I.

For mining to not occur, CC1I>CC2I or CC1I>CC3I needs to hold. To summarize, there are 3 scenarios:

  1. CC3I>CC2I and CC3I>CC1I: The transaction will be mined and an attack occurs. CC3I is the final payoff.
  2. CC2I>CC3I and CC2I>CC1I: The transaction is mined and no attack happens. CC2I is the final payoff.
  3. CC1I>CC3I (we had determined that CC1I>CC2I could not be possible): No mining occurs. CC1I is the final payoff.

Note that we have determined that mining will always occur if the CCI chooses to integrate. Thus there are only 2 relevant scenarios instead of the 3 found in the non-integrated case. The main assumption is that the CCI miner will be able to get its transaction included on the blockchain; this could be either because it is the only miner or it has invested in sufficient computing resources to ensure it.

There are a total of 9 combinations of events detailed in Figure 3. Figure 3 also shows the conditions required for integration to occur under each scenario.

Colored Coin Teo 3

Figure 3: Analyzing the Integration Choice.

Colored Coin Teo 2

Figure 2: Payoffs of the game

Referring back to figure 2, we can make the following assumptions:

CC1NI is always larger than CC1I

CC2NI is always larger than CC2I

CC2NI is always larger than CC1I

Thus the 3 inequalities highlighted in red in Figure 4 are never possible, no integration will occur in scenario B+E, B+F and C+F.

In the other 6 scenarios, integration could occur given the right conditions. We can make some predictions on what is likely to occur.

  1. In all scenarios with event A (A+D, A+E and A+F) where the non-integrated miner attacks, it is likely that the CCI prefers to integrate.
  2. In scenario B+D, there are two possibilities. If the cost of attack is large, the CCI will not integrate. Otherwise, it will integrate and reap the benefits of launching an attack on itself.
  3. When event C occurs and no integration takes place, the transaction will not be mined and the CCI gets nothing. Integration will thus occur as long as the cost of integration is small enough. This will be relevant for scenario C+D and C+E as we has ruled out C+F earlier.

One may ask if the CCI would want to attack itself. Well, if the benefit of attacking is large, a colored coin issuer may want to attack the network to derive a onetime benefit even though the company will never be trusted afterwards. However, this is unlikely as the cost of integration has to be extremely large for the CCI to be able to successfully attack the network.

Finally to answer our initial question, let us consider the issue of whether a non-integrated miner (in the event that a colored coin transaction can be identified) will force the CCI to quote high fees in order to get the transaction included. This is only relevant in the scenarios where the CCI initially chooses not to integrate. However, if colored transactions can be identified, miners can choose not to include these transactions unless the transaction fees are high enough. The fee can only be so high that it does not force the CCI to choose integration instead. In general, we can say that this fee cannot be higher than the cost of integration (this would refer to the per transaction cost of integration on average).

Based on this “game”, will colored coins be able to exist on a network such as Bitcoin? If colored transactions can be identified, there could be 2 issues. 1. The colored assets are so valuable that the non-integrated miner would want to attack the system, 2. The fees do not incentivized non-integrated miners to include the transactions. To overcome these issues the CCI could chose to integrate (or become a miner with sufficient computing power to be able to ensure that its transactions gets recorded). However, if the cost of doing so is too high to be justifiable, the CCI is better off not operating at all.

Send to Kindle

What are a few direct and indirect costs of the “block size debate”?

About six weeks ago I mentioned a dollar figure during a panel at the Consensus event in NYC: $6 million. Six million USD is a loose estimate — for illustrative purposes — of the amount of engineering time representing thousands of man hours over the past 7-9 months that has gone into a productivity black hole surrounding the Bitcoin block size debate.

A little recent history

While there had been some low intensity discussions surrounding block size(s) over the past several years, most of that simmered in the background until the beginning of 2015.

On January 20th Gavin Andresen posted a 20 MB proposal which was followed over the subsequent weeks by a number of one-and-done counterpoints by various developers.

About four months later, beginning on May 4, Gavin posted a series of blog articles that kicked things up a notch and spurred enormous amounts of activity on social media, IRC, web forums, listservs, podcasts and conferences.

The crescendo of public opinion built up over the summer and reached a new peak on August 15th with a post from Mike Hearn, that Bitcoin would fork into two by the beginning of next year.

The passionate enthusiasts on all sides of the spectrum took to social media once again to voice their concerns.  During the final two weeks of August, the debate became particularly boisterous as several moderators on reddit began to ban discussions surrounding Bitcoin XT (among other forks and proposals).  There was even an academic paper published that looked at the sock puppets involved in this period: Author Attribution in the Bitcoin Blocksize Debate on Reddit by Andre Haynes.

Ignoring the future evolution of block size(s), with respect to the opportunity costs of the debate itself: investors and consumers have unintentionally funded what has turned out to be a battle between at least two special interest groups. 1

So where does the $6 million figure come from?

Of the roughly $900 million of VC funding related to Bitcoin itself that has been announced over the past 3 years, about half has been fully spent and went towards legal fees, domain names, office rent, conference sponsorship’s, buying cryptocurrencies for internal inventory and about a dozen other areas.2

At the current burn rate, Bitcoin companies collectively spend about $8-$10 million a month, perhaps more.  And since the debate is not isolated to development teams, because upper management at these companies are involved in letter writing campaigns (and likely part of the sock puppet campaigns), then it could be the case that 5-10% of on-the-clock time at certain companies was spent on this issue.

Consequently, this translates into about $400,000 to $1 million each month which has been redirected and spent funding tweets, reddit posts, blog posts, conferences, research papers and industry conferences.3

What about specific numbers?

For instance, with around 150-200 attendees the Montreal scalability conference likely absorbed $250,000 from everyone involved (via travel, lodging, food, etc.).  Similarly, one independent estimate that Greg Maxwell mentioned at the same Consensus event was his back-of-the-envelope projection of the opportunity costs: a few hundred thousand USD in the first couple weeks of May alone as engineers were distracted with block sizes instead of shipping code.

While a more precise number (+/-) could probably be arrived at if someone were to link individual developer activity on the dev mailing list/reddit/twitter with their estimated salaries on Glassdoor — since this past spring roughly $6 million or so has probably gone towards what has amounted to basically two diametrically opposed political campaigns.

And the issue is still far from resolved as there are more planned scalability conferences, including one in Hong Kong in early December.

Why is it a black hole though?  Surely there is utility from the papers and projects like Lightning, right?

It’s a money pit because it doesn’t and cannot resolve the coordination problem that decentralized governance creates.  I have an upcoming paper that briefly touches on this issue (in Appendix A): the key point is that any time decision making is decentralized then specific trade-offs occur.

In this case, due to an intentional power vacuum in which there is no “leader,” special interest groups lobby one another for the de facto right to make decisions.  Some decisions, like raising the minimum transaction relay fees involve less tweets and downvotes and are for various reasons considered less important as others.  Yet ultimately, de jure decision making remains out of reach.

Not the first time to a rodeo

Because decentralized governance (and external social consensus) was/is a key feature for many cryptocurrencies, this type of political activity could happen again with say, increasing the money supply from 21 million or if KYC becomes mandatory for all on-chain interactions.

Again, this was bound to happen because of the tragedy of the commons: because the Bitcoin network is a public good that lacks an explicit governance structure.  Anytime you have a lack of formal governance you often end up with an informal power structure that makes it difficult to filter marketing fluff from sock puppets like Cypherdoc (aka Marc Lowe) from actual fact-filled research.

And this subsequently impacts any project that relies on the Bitcoin network as its security mechanism.  Why?  According to anecdotes, projects from new organizations and enterprises have reconsidered using public blockchains due to the aforementioned inherent governance hurdles alone.

After all, who do they call when the next Mexican standoff, block reorg or mutually assured destruction situation arises?  There is no TOS, EULA or service-level agreement and as a result they look at other options and platforms.4

  1. It is probably too simplistic to say that, with $6 million in funding, these same developers could have simply created a new system, like Ethereum, from scratch that factors in scalability challenges from day one.  It is unlikely that these same developers would have come to agreement on what to spend those funds on as well. []
  2. See What impact have various investment pools had on Bitcoinland? and Flow of investments funds in Bitcoinland []
  3. The academic term for this is single-issue politics. []
  4. For instance, Tezos was designed specifically with a self-amending chain in mind due to this issue. []
Send to Kindle

Some housekeeping of events and interviews

It has been a little while since I posted the events, panels and presentations I have been involved with.  Below is some of the public activity over the past 5-6 months.

Interviews with direct quotes:

Indirect quotes:

Academic citations:

Presentations, panels and events:

Send to Kindle

The great pivot? Or just this years froth?

smjmeAbout a year ago I briefly explored the PR and branding challenges of Bitcoin, a topic that has been independently discussed by others.

Over the past 6 months there has been a visible trend in the overall “Bitcoin” space to rebrand or not use the term “Bitcoin” on corporate material.  This has been done for a variety of reasons.

Some startups simply are no longer touching or interfacing with bitcoins or the Bitcoin network.  Others do not want to be affiliated with the term preferring the alternative “Blockchain” as a catch-all euphemism.

For instance, below are 10 companies which raised their Series A (and sometimes more) and were originally affiliated with “Bitcoin” in some manner but are no longer publicly positioning themselves as such:

  • Abra ($14 million): originally launched as a “rebittance” company, still claims to use the Bitcoin network but the word Bitcoin does not appear on its homepage
  • BitGold ($5.3 million): pivoted from Bitcoin last December
  • Bitreserve ($14.6 million): rebranded as Uphold and now vocally moving away from Bitcoin
  • ChangeTip ($4.25 million): removed the word Bitcoin from its frontpage, now focused on USD-denominated tips
  • Chain ($43.7 million): after closing its recent B round, remarketed from Bitcoin-only and removed the word Bitcoin from its frontpage except in the headlines of past news articles
  • Circle ($76 million): rebranded after receiving a Bitlicense; neither its frontpage nor its new 60 second ad use the word Bitcoin
  • Cryex ($10 million): the word Bitcoin does not appear on its frontpage
  • Mirror, formerly Vaurum ($12.8 million): the word Bitcoin does not appear on its frontpage (but does on some older blog posts)
  • Peernova ($19 million): originally a Bitcoin mining company that is no longer affiliated with Bitcoin at all
  • Vogogo ($21 million): the word Bitcoin does not appear on its frontpage

A few others who have done marketing changes (some more substantive than others):

  • BTC China ($5 million): still focused on its virtual currency exchange renamed itself as BTCC to move further abroad into the international marketplace
  • itBit ($28.25 million): in addition to running its virtual currency exchange, they also launched the Bankchain initiative this past summer
  • DAH: originally planned on using the Bitcoin blockchain but broadened its scope during the summer after acquiring Hyperledger; the word Bitcoin does not appear on its homepage although it still uses the network for product launches (like Pivit)
  • Symbiont: originally used the Counterparty platform and the Bitcoin network as part of its financial service, but has now built a permission-based system
  • Align Commerce, Serica and many others do not use the word Bitcoin on their homepages yet still use the Bitcoin network for some lines of business
  • Coindesk renamed their quarterly report: “State of Bitcoin and Blockchain”
  • Inside Bitcoins (the conference circuit) added “with Blockchain Agenda” prominently at the top of their homepage

What about venture capital itself?


Source: CB Insights

As visualized in the chart above, Bitcoin-related investments have declined the past two quarters.

However, the chart is not fully accurate as CBI includes 21inc funding as “one” round in Q1 2015.  According to Nathaniel Popper, 21inc did not raise its war chest in one round but rather over the course of 3 rounds.  So it is likely that Q1 2015 probably was altogether around $175 million as the other ~$60 million were raised in 2013 and 2014.  Similarly Q3 2015 should be less as Chain.com is no longer a Bitcoin-specific company.

What about other changes in the VC world?

Crypto Currency Partners: renamed itself Blockchain Capital

Boost VC: while the word Bitcoin does appear on its homepage, in his most recent writeup of its portfolio, Adam Draper does not use the word Bitcoin but instead uses “block chain” to describe his investments

Pantera: while it remains publicly committed to Bitcoin, based on its most recent newsletter the team likely views the word “blockchain” as more palatable to investors and LPs.

For instance, the year-over-year comparison of word frequency between two Pantera Capital newsletters:

DCG: launched its website during the summer, prominently display the word “blockchain technology” instead of Bitcoin, despite the fact that nearly all of its portfolio is Bitcoin-reliant or Bitcoin-specific.

In fact it appears that the trend by some VC-backed Bitcoin-heavy portfolio’s adopting the term “blockchain” is a marketing gimmick as neither DCG, Pantera nor Boost have purposefully invested in non-Bitcoin blockchain companies.  In fact, individuals such as Barry Silbert (founder of DCG) are outspoken in their dismissal of non-Bitcoin blockchains.

What are some reasons for the decline shown in the CBI numbers?

Part of it has to do with the fact that consumer-facing Bitcoin companies have found muted traction, if any at all.  For instance, BitPay (which raised $32.5 million) recently laid off most of its staff, liquidated a large portion of its bitcoin holdings, raised its fees in order to stay afloat and did a (non-pivot) pivot towards catering to other enterprises.  This looks bad for other Bitcoin-branded companies looking to try and raise funds for consumer-facing products.

Another reason is that some of the buzz and froth simmered down with the price of bitcoin itself.  It seems common parlance to hear people at conferences say “the price of bitcoin doesn’t matter” but that is very untrue for fundraising.  If prices were on a tear into orbit or were managing some stability higher than it was 2 years ago, it’d be easier for entrepreneurs to convince new investors (not just the same 4-5 funds) to deploy new capital in Bitcoin-specific products.  Maybe Gemini will change that?

So where has some capital been deployed instead?

Into that amorphous catch-all term: “blockchain.”

There are just over a dozen “blockchain” / distributed ledger startups collectively trying to raise $200 million at over a $1 billion valuation.

And incidentally, there are a couple companies in each of the VC portfolio’s above that have now built non-Bitcoin blockchains or ledgers.

Some of them are currently raising while others recently closed funding rounds.

This includes: Symbiont, Chain, Peernova, Ripple, Eris, Setl, Credits, Tradeblock, itBit, Tembusu, Clearmatics, MultiChain, BlockStack, DAH, Blockstream (via Liquid) and a few others in stealth that well, are in stealth.

What does being a “blockchain” company mean?

blockchain search google

January 2009 – October 2015. Source: Google Trends

The term “blockchain technology” is basically a catch-all term at this point.

In many cases, when someone at a fintech conference now says they’re interested in “blockchain technology” it typically means they are interested in common elements like public/private key signing, resolutions to double-spending and permission-based multitenancy environments.  Bitcoin, as described by Gwern Branwen, was not the creator of those elements.

What will next year look like?  Will there be a new term that is co-opted?  Or are we stuck using a word that never appeared in the original Satoshi white paper (it had a demarcated space between “block chain”) and has now become an umbrella term for many different neat ideas?

See also: Needing a token to operate a distributed ledger is a red herring and also A blockchain with emphasis on the “a”

Send to Kindle

Designing a Global Fabric for Finance (G3F)

Over the past two weeks there have been a number of news stories related to R3 — a fintech startup that I now work at.  The first of which was from the Financial Times, entitled Blockchain initiative backed by nine large investment banks.  Today we announced an additional 13 banks have joined our effort.

Although I cannot speak for the whole team, I can give you the vision I have with the aim of bringing clarity to the various bits of information that have been circulating.


Over the past year, the R3 team has spent copious amounts of time conducting due diligence on the greater “distributed ledger” or “shared ledger” space.  I joined as an advisor in January when they were already knee deep in the task; I am now Director of Market Research.

What I and several others on the team found is that while there were a number of orthogonally useful pieces floating around (such as multisig and ideas like Engima), none of the publicly available technology platforms that has been funded by venture capital provided a flexible, holistic base layer with the specific functional requirements for secure, scalable enterprise use.

This includes incorporating non-functionals that globally regulated financial institutions must adhere to such as: compliance, privacy, reporting and reconciliation.  Similarly, many of the venture funded projects also failed to address the business requirements of these same institutions.

In sportsball terms, the nascent industry is 0-for-2 in their current approach.

Some of that is understandable; for example, Bitcoin solves a set of problems for a niche group of individuals operating under certain security assumptions (e.g., cypherpunks not wanting to interface with banks or governments).  Regulated financial institutions do not operate under those assumptions, thus axiomatically Bitcoin in its current form is highly unlikely to be a solution to their problems at this time.  As a consequence, the technology solutions pitched by many of these startups are hammers looking for nails that do not exist in the off-chain world.

R3 is not a Bitcoin company nor a cryptocurrency company.  We are not seeking to build a “better” or even a different type of virtual currency.  Why not?  Instead of starting with a known solution, such as a spreadsheet, we are starting with the problem set which continually influences the customized solution.  This is one of the biggest reasons I was attracted to this specific effort: R3 is not a re-enactment of Field of Dreams.  Build it with the hopes that someone will come is the siren song, the motto even, for throngs of failed startups.

But weren’t the original shared ledgers — often called blockchains — robust enough to protect all types of assets and a legion of use-cases?

Many public ledgers were originally designed to secure endogenous, on-chain information (e.g., the native token) but in their current incarnations are not fit for purpose to handle off-chain titles.  For instance, Bitcoin was not initially designed to secure exogenous data — such as transmitting high-value off-chain securities — vis-a-vis pseudonymous miners.  And it appears all attempts to mutate Bitcoin itself into a system that does, ends up creating a less secure and very expensive P-o-P network.

What are we doing then?

Rather than try to graft and gerrymander our business requirements onto solutions designed for other problems, we are systematically looking at a cornucopia of challenges and cost-drivers that currently exist at financial institutions.  We will seek to address some of these drivers with a generalized agnostic fabric, with layers that fulfill the critical infrastructure specifications of large enterprises and with services that can be run on top in a compliant fashion.

What is a Global Fabric for Finance (G3F) then?  If you had the chance to build a new financial information network from scratch that incorporated some of the elements and learnings of the shared ledger world, what would it look like?

For starters, a fabric specifically built for and by trusted parties does not need something akin to mining or block rewards.  In fact, not only is there is no Sybil spoofing problem on a trusted network but there are already many known, existing methods for securely maintaining a transaction processing system.  Consequently, needing a block reward may (or may not) be a red herring and has likely been a costly, distracting sideshow to other types of utility that this technology represents.

If trust is not an issue, what use (as Arvind Narayanan and certain high profile enthusiasts have asked) is any part of the shared ledger toolkit?  There are a number of uses, many of which I touched on in a paper back in April.

What about specific use-cases?

While a number of ideas that have surfaced at conferences and media events over the past summer, R3 remains focused on an approach of exploration and ideation.

And while there will likely be some isolated tests on some use-case(s) in sand boxes in the coming year, it is important to reflect on the G3F vision which will be further elaborated on by Richard Brown (our head of technology) in the coming weeks.  If the fabric is only capable of handling one or two specific asset classes, it will fall short of the mandate of being a generalized fabric used to secure financial information for enterprises.

Why directly work with banks during this formative stage?  Why not just raise money and start building and shipping code?

To be frank, if financial institutions and regulatory bodies are not involved and engaged  from the beginning, then whatever fabric created will likely: 1) fail to be viewed as an authoritative and legal record of truth and 2) fall short of adequately address their exacting needs.  It would be a non-starter for a financial institution to use technology that is neither secure, or whose on-chain record is considered non-canonical by off-chain authorities.

What does that mean?

While some in the shared ledger community would like to believe that dry, on-chain code supersedes off-chain wet-code, the facts on the ground continue to contradict that thesis.  Therefore, if you are going to create a non-stealth fintech startup, it must be assumed that whatever products and services you create will need to operate under existing laws.  Otherwise you will spend most of your time hiding out in remote Caribbean islands or Thailand.


The R3 team is comprised of pragmatic thinkers and doers, experienced professionals who understand that a financial system cannot be built with up and down votes on reddit or whose transaction processors may reside in sanctioned countries.


Source: XKCD

While nothing is finalized at the time of this writing, it is our aim at R3 to make the underlying base layer of this fabric both open sourced and an open standard.

After all, a foundation layer this critical would benefit from the collective eyeballs of the entire programming community.  It also bears mentioning that the root layer may or may not even be a chain of hashed blocks.

Furthermore, we are very cognizant of the fact that the graveyard for building industry standards is deep and wide.  Yet, as I mentioned to IBT, failing to create a universal standard will likely result in additional Balkanization, recreating the same silos that exist today and nullifying the core utility of a shared ledger.

It is a pretty exciting time in modern history, where being a nerd — even a cryptonerd — means you are asked to appear on stage in front of decision makers, policy makers, captains of industry and social media influencers.  Some even get to appear in person and not just as a telepresence robot.  Yet as neat as some of the moon math and cryptographic wizardry may be, failing to commercialize it in a sustainable manner could leave many of the innovative forks, libraries and github repos no more than starry-eyed science fair projects.

To that end, we are currently hiring talented developers keen on building a scalable, secure network.  In addition, rather than reinventing the wheel, we are also open to partnerships with existing technology providers who may hold key pieces to building a unified standard.  I am excited to be part of this mathematical industrial revolution, it’s time to strike while the iron is hot and turn good academic ideas into commercial reality.  Feel free to contact us.

Send to Kindle

Cryptocurrency KYSF: Know Your Source of Funds part 2

ecommerceA few days ago I was asked a number of questions from a reporter at CoinDesk regarding on-chain trade volume; this was a follow-up from some questions back in early May.

A few of my responses were published in a new article today: Dark Web Markets ‘Processed more Bitcoin than BitPay in 2014’

Below are my unabbreviated comments:

Q: How have the recent posts from Coinbase and BitPay impacted the diagram you outlined in that previous post? Has it had any impact at all?

A: The most striking data point from the Coinbase and BitPay posts was what was missing: actual real user numbers.  Neither one of them is willing to publicly say how many monthly active users (MAU) they have which stands in contrast to other fintech companies, financial institutions and “social media” startups they like to compare themselves to.

For instance, even though Coinbase claims to have 2.4 million users/3.1 million wallets, what does that mean?  Are these all fully KYC’ed accounts?  What percent have logged on in the past month?  What percent have actually used Coinbase’s services?  How many simply create an account, deposit $10 and never log on again?

Similarly, BitPay numbers are actually pretty sobering.  We know demographically from both the CoinDesk report and the leaked Coinbase pitch deck that the over 80% of all bitcoin holders/owners are males between the ages of 18-45.  And that the majority of the overall users reside in North America.  Yet according to the BitPay charts, North American volume has been relatively flat the last 6 quarters.

So if the largest group of bitcoin owners are not using their holdings despite a marked increase in available merchants, that is probably not an indication that they are interested in spending their funds and probably see bitcoins as an investable asset than actual money.  BitPay also does not disclose aggregate USD or euro volume.  Startups like to make noise when they are doing good or can show growth; if the value of their volume was actually growing, they probably would say.

And while transaction count in Europe and Latin America appear to be growing, perhaps the collective value has stayed the same (the Latin America numbers are also a bit misleading; it’s easy to show large growth percentages when you start from 0).

Another point about BitPay’s post is that they don’t really say what “IT services” is.  Notably absent from this post, compared with their post in April, is what “mining” related activity is.  Recall that some miners, such as KnC and now defunct BFL were (are) using BitPay as their payment processor.  In fact, in BitPay’s post earlier this year, “Bitcoin Mining” — by volume — represented the largest share of volume processed.  Does “IT services” now include this previously large segment?

Lastly, one number they do not include is the total aggregate transactions by each quarter.  Eye-balling it, it appears for Q2 2015 they processed about 180,000 transactions.  Divided by 60,000 merchants comes to around 3 transactions per quarter or 1 transaction per month per merchant.

In all likelihood usage follows a power law or a 80-20 rule, that 20% of the merchants account for the majority of transaction volume.  My understanding is that Gyft uses (or used BitPay) as their payment processor and since 9% of all bitcoin-related transactions last quarter were related to gift cards, it is likely that the lionshare of this “gift card” activity in the power law distribution is represented by just one or two companies (e.g., FoldApp and Purse.io are a couple potential ones to look at as well).

Startups like Blockseer, Sabr, Coinalytics and Chainalysis have APIs and address labeling that may be able to tell us more about specific merchant/payment processor activity,

Q: Also, are clearnet tx outweighed by darknet tx with bitcoin? Silk Road and other marketplaces were the first use case for bitcoin, but are they still the biggest?

A: According to a new paper (Soska and Christin 2015), if you look at Figure 5 and the discussion involved, prior to Operation Olympus, six large dark net marketplaces collectively accounted for more than $600,000 in sales per day.  It is unclear how much of that activity was expressly illegal, although the paper does attempt to break down the amount of illicit drugs being sold on the same sites.

dark net market volume

Source: Soska and Christin

During the same time frame (most of 2014), volume at payment processors such as BitPay and Coinbase were relatively flat with a few outliers during days with speculative and media frenzies as well as ‘Bitcoin Black Friday.’

As of today it is unclear what activity is the “biggest” — we would need to aggregate all of the dark net marketplaces and compare that with the reused addresses BitPay uses plus the self-disclosed numbers from Coinbase.

In the chart above, illustrating off-chain activity between August 14, 2014 – August 13, 2015, it is also unclear from Coinbase’s number what a “off-chain” transaction is.  Is it only related to merchant activity?  Does it also include movement between users or with cold storage as well?

Therefore based on past historical trends (above) I do not think that “clearnet” or on-chain “licit” activity outweighs illicit transactions.  One darknet market alone — Evolution — processed roughly the same amount of bitcoins last year as BitPay did.

Q: Do you think consumer volumes will change significantly in the next year – what would it take for this to happen?

A: It depends on what we mean by “consumer volume.”  If this includes both illicit and licit activity, sure, maybe.  If it also includes “off-chain” transactions, then yes, probably as well.  But it is important to note you are not using Bitcoin (or bitcoin) when you go off-chain.  The transparency and auditability trail disappears and a user is now reliant on a trusted third party — many of whom in the “Bitcoin space” have a checkered past on financial controls — to protect and secure your privkeys.

I think we have already largely witnessed what the “killer apps” that incentivize increased usage of on-chain bitcoin activity are: censorship-resistant activities.

If the goal of Bitcoin was to provide a censorship-resistant payment processing platform (the word “payment” appears 12 times in the white paper) then it is safe to say that: dark net markets, casino sites, ransomware and other activities that require censorship-resistance and cannot be globally accessed on permissioned networks will continue to attract users towards it.1

It is my view that the following two laws explain the on-chain phenomenon we observe on a regular basis.  Folk law: “Anything that needs censorship-resistance will gravitate towards censorship-resistant systems.”  In contrast is Sams’ law: “Anything that doesn’t need censorship-resistance will gravitate towards non censorship-resistant systems.”

As far as other “apps” such as sites like Zapchain, while boasting growth numbers, appears to recreate a trusted third party system (e.g., facilitate deposit-taking and MSB activities like other hosted wallets) all while simultaneously scraping content from other sites.2

So Buzzfeed, but with bitcoins.

Does it have legs?  Porter Bibb would probably say no.

In closing, one last comment related to real on-chain trade (as opposed to spam-like “long-chain transactions“) is the recent announcement / non-announcement from TigerDirect.  Jorge Stolfi, a computer science professor in Brazil, probably best summarized the nebulous responses from the electronic retailer:

  • How much have you been making in bitcoin payments? “While Expedia has seen a decrease in bitcoin payments, TigerDirect shared a different story.”
  • How many customers are paying with bitcoin? “46 percent of customers purchasing with bitcoin are new users”
  • Sorry, how much did you say you made with bitcoin payments? “the average order placed with bitcoin is 30 percent larger than the average order.”
  • Yes, but, how much are you selling with bitcoin? “TigerDirect sees the highest volume of bitcoin orders during periods of volatility for bitcoin price.”
  • We would really like to know how much, roughly, you are getting from bitcoin payments. “TigerDirect has still seen consistent bitcoin transaction volume.”
  1. According to Kotov and Rajpal, bitcoins are now the most common method of payment for ransomware.  See Understanding Crypto-Ransomware. []
  2. Zapchain uses Coinbase as a wallet provider for deposits — the tipping of transactions is done via via BlockCypher. []
Send to Kindle

What is permissioned-on-permissionless?

As of this writing, more than half of all VC funding to date has gone into building permissioned systems on top of a permissionless network (Bitcoin). Permissioned-on-Permissionless (PoP) systems are an odd hydra, they have all of the costs of Sybil-protected permissionless systems (e.g., high marginal costs) without the benefits of actual permissioned systems (e.g., fast confirmations, low marginal costs, direct customer service).

Thus it is curious to hear some enthusiasts and VCs on social media and at conferences claim that the infrastructure for Bitcoin is being rolled out to enable permissionless activity when the actual facts on the ground show the opposite is occurring.  To extract value, maintain regulatory compliance and obtain an return-on-investment, much of the investment activity effectively recreates many of the same permission-based intermediaries and custodians that currently exist, but instead of being owned by NYC and London entities, they are owned by funds based near Palo Alto.

For example, below are a few quotes over the past 18 months.

In a February 2014 interview with Stanford Insights magazine, Balaji Srinivasan, board partner at Andreessen Horowitz and CEO of 21inc, stated:

Thus, if the Internet enabled permissionless innovation, Bitcoin allows permissionless monetization.

In July 2015, Coinbase announced the winners of its hackathon called BitHack, noting:

The BitHack is important to us because it taps into a core benefit of Bitcoin: permissionless innovation.

Also in July 2015, Alex Fowler, head of business development at Blockstream, which raised $21 million last fall, explained:

At Blockstream, our focus is building and supporting core bitcoin infrastructure that remains permissionless and trustless with all of the security and privacy benefits that flow from that architecture.

Yet despite the ‘permissionless’ exposition, to be a customer of these companies, you need to ask their permission first and get through their KYC gates.

For instance, in Circle’s user agreement they note that:

Without limiting the foregoing, you may not use the Services if (i) you are a resident, national or agent of Cuba, North Korea, Sudan, Syria or any other country to which the United States embargoes goods (“Restricted Territories”), (ii) you are on the Table of Denial Orders, the Entity List, or the List of Specially Designated Nationals (“Restricted Persons”), or (iii) you intend to supply bitcoin or otherwise transact with any Restricted Territories or Restricted Persons.

Is there another way of looking at this phenomenon?

There have been a number of interesting posts in the past week that have helped to refine the terms and definitions of permissioned and permissionless:

Rather than rehashing these conversations, let’s look at a way to define permissionless in the first place.

Permissionless blockchains

permissionless blockchainA couple weeks ago I gave a presentation at the BNY Mellon innovation center and created the mental model above to describe some attributes of a permissionless blockchain.  It is largely based on the characteristics described in Consensus-as-a-service.

DMMS validators are described in the Blockstream white paper.  In their words:

We  observe  that  Bitcoin’s  blockheaders  can  be  regarded  as  an  example  of  a dynamic-membership multi-party signature (or DMMS ), which we consider to be of independent interest as a new type of group signature. Bitcoin provides the first embodiment of such a signature, although this has not appeared in the literature until now. A DMMS is a digital signature formed by a set of signers which has no fixed size.  Bitcoin’s blockheaders are DMMSes because their proof-of-work has the property that anyone can contribute with no enrolment process.   Further,  contribution is weighted by computational power rather than one threshold signature contribution per party, which allows anonymous membership without risk of a Sybil attack (when one party joins many times and has disproportionate input into the signature).  For this reason, the DMMS has also been described as a solution to the Byzantine Generals Problem [AJK05]

In short, there is no gating or authorizing process to enroll for creating and submitting proofs-of-work: theoretically, validating Bitcoin transactions is permissionless.  “Dynamic-membership” means there is no fixed list of signatories that can sign (i.e. anyone in theory can).  “Multi-party” effectively means “many entities can take part” similar to secure multi-party computation.1

Or in other permission-based terms: producing the correct proof of work, that meets the target guidelines, permits the miner (block maker) to have full authority to decide which transactions get confirmed.  In other words, other than producing the proof-of-work, miners do not need any additional buy-in or vetting from any other parties to confirm transactions onto the blockchain. It also bears mentioning that the “signature” on a block is ultimately signed by one entity and does not, by itself, prove anything about how many people or organizations contributed to it.2

Another potential term for DMMS is what Ian Grigg called a Nakamoto signature.

Censorship-resistance, while not explicitly stated as such in the original 2008 white paper, was one of the original design goals of Bitcoin and is further discussed in Brown’s post above as well as at length by Robert Sams.

The last bucket, suitable for on-chain assets, is important to recognize because those virtual bearer assets (tokens) are endogenous to the network.  DMMS validators have the native ability to control them without some knob flipping by any sort of outside entity.  In contrast, off-chain assets are not controllable by DMMS validators because they reside exogenous to the network.  Whether or not existing legal systems (will) recognize DMMS validators as lawful entities is beyond the scope of this post.

Permissionless investments

What are some current examples of permissionless-related investments?

zooko permissionless

Source: Twitter

This past week I was in India working with a few instructors at Blockchain University including Ryan Charles.  Ryan is currently working on a new project, a decentralized version of reddit that will utilize bitcoin.

In point of fact, despite the interesting feedback on the tweet, OB1 itself, the new entity that was formed after raising $1 million to build out the Open Bazaar platform, is permission-based.

How is it permission-based when the DMMS validators are still permissionless?  Because OB1 has noted it will remove illicit content on-demand from regulators.

In an interview with CoinDesk, Union Square Venture managing partner, Brad Burnham stated that:

Burnham acknowledged that the protocol could be used by dark market operators, but stressed the OpenBazaar developers have no interest in supporting such use cases.  “They certainly won’t be in the business of providing enhanced services to marketplaces that are selling illegal goods,” he noted.

Based on a follow-up interview with Fortune, Brian Hoffman, founder of OB1 was less specific and a bit hand-wavy on this point, perhaps we will not know until November when they officially launch (note: Tor support seems to have disappeared from Open Bazaar).

One segment of permissionless applications which have some traction but have not had much (if any) direct VC funding include some on-chain/off-chain casinos (dice and gambling games) and dark net markets (e.g., Silk Road, Agora).  Analysis of this, more illicit segment will be the topic of a future post.

What are some other VC-funded startups that raised at least a Series A in funding, that could potentially be called permissionless?  Based on the list maintained by Coindesk, it appears just one is — Blockchain.info ($30.5 million).

Why isn’t Coinbase, Xapo or Circle?  These will be discussed below at length.

What about mining/hashing, aren’t these permissionless activities at their core?

Certain VC funded mining/hashing companies no longer offer direct retail sales to hobbyists, this includes BitFury and KnC Miner.  These two, known entities, through a variety of methods, have filed information about their operations with a variety of regulators.3  To-date BitFury has raised $60 million and it runs its own pool which accounts for about 16% of the network hashrate.  Similarly, KnC has raised $29 million from VCs and also runs its own pool, currently accounting for about 6% of the network hashrate.

What about other pools/block makers?  It appears that in practice, some require know-your-customer (KYC), know-your-business (KYB), know-your-miner (KYM) and others do not (e.g., selling custom-made hardware anonymously can be tricky).

  • MegaBigPower gathers KYC information.
  • Spondoolies Tech is currently sold out of their hardware but require some kind of customer information to fill out shipping address and customs details.  They have raised $10.5 million in VC funding.
  • GHash allows you to set up a pseudonymous account with throwaway email addresses (or via Facebook and Google+), but they have not published if they raised any outside funding
  • Most Chinese hashing and mining pools are privately financed.  For instance, Bitmain has not needed to raise funding from VCs (yet).  The also, currently, do not perform KYC on their users.  I spoke with several mining professionals in China and they explained that none of the big pools (Antpool, F2pool, BTC China pool, BW.com) require KYM at this time.  Over the past four days, these pools accounted for: 21%, 17%, 10% and 8% of the network hashrate respectively — or 56% altogether.  Update 7/29/2015: a representative at BTC China explained that: “Yes, we do KYC the members of our mining pool. We verify them the same way we KYC all registered users on BTCC.”
  • 21inc, not much more is known publicly at this time but if the idea of a “BitSplit” chip is correct, then what could happen is the following: as more chips are flipped on in devices, the higher the difficulty level rises (in direct proportion to the hashrate added).  As a result, the amount of satoshi per hash declines over time in these devices.  What this likely will lead to is a scenario in which the amount of satoshi mined by a consumer device will be less than “dust limit” which means a user will likely be unable to move the bitcoins off of the pool without obtaining larger amounts of bitcoin first (in order to pay the transaction fee).  Consequently this could mean the users will need to rely on the services provided by the pool, which could mean that the pool will need to become compliant with KYC/AML regulations.  All of this speculation at this time and is subject to changes.  They have received $121 million in VC funding.
  • As explained above, while individual buyers of hashing equipment, Bob and Alice, do typically have to “doxx” themselves up to some level, both Bob and Alice can resell the hardware on the second-hand market without any documentation.  Thus, some buyers wanting to pay a premium for hashing hardware can do so relatively anonymously through middlemen.4  This is similar to the “second-hand” market for bitcoins too: bitcoins acquired via KYC’ed gateways end up on LocalBitcoins.com and sold at a premium to those wanting to buy anonymously.

Notice a pattern?  There is a direct correlation between permissionless platforms and KYC/AML compliance (i.e., regulated financial service businesses using cryptocurrencies are permissioned-on-permissionless by definition).

Blockchain.info attempts to skirt the issue by marketing themselves as a software platform and for the fact that they do not directly control or hold private keys.5

This harkens back to what Robert Sams pointed out several months ago, that Bitcoin is a curious design indeed where in practice many participants on the network are now known, gated and authenticated except the transaction validators.

What about permissioned-on-permissionless efforts from Symbiont, Chain and NASDAQ?  Sams also discussed this, noting that:

Now, I am sure that the advocates of putting property titles on the bitcoin blockchain will object at this point. They will say that through meta protocols and multi-key signatures, third party authentication of transaction parties can be built-in, and we can create a registered asset system on top of bitcoin. This is true. But what’s the point of doing it that way? In one fell swoop a setup like that completely nullifies the censorship resistance offered by the bitcoin protocol, which is the whole raison d’etre of proof-of-work in the first place! These designs create a centralised transaction censoring system that imports the enormous costs of a decentralised one built for censorship-resistance, the worst of both worlds.

If you are prepared to use trusted third parties for authentication of the counterparts to a transaction, I can see no compelling reason for not also requiring identity authentication of the transaction validators as well. By doing that, you can ditch the gross inefficiencies of proof-of-work and use a consensus algorithm of the one-node-one-vote variety instead that is not only thousands of times more efficient, but also places a governance structure over the validators that is far more resistant to attackers than proof-of-work can ever be.

This phenomenon is something I originally dubbed “permissioned permissionlessness” for lack of a better term, but currently think permissioned-on-permissionless is more straightforward and less confusing.

What does this mean?


PoP blockchainThe Venn diagram above is another mental model I used at the BNY Mellon event.

As mentioned 3 months ago, in practice most block makers (DMMS validators) are actually known in the real world.

While the gating process to become a validator is still relatively permissionless (in the sense that no single entity authorizes whether or not someone can or cannot create proofs-of-work), the fact that they are self-identifying is a bit ironic considering the motivations for building this network in the first place: creating an ecosystem in which pseudonymous and anonymous interactions can take place:

The first rule of cypherpunk club is, don’t tell anyone you’re a cypherpunk.  The first rule of DMMS club is, don’t tell anyone you’re a DMMS.

The second bucket, neither censorship resistant nor trade finality, refers to the fact that large VC funded companies like Coinbase or Circle not only require identification of its user base but also be censor their customers for participating in trading activity that runs afoul of their terms of service.  Technically speaking, on-chain trade finality hurdles refers to bitcoin transactions not being final (due to a block reorg, a longer chain can always be found, undoing what you thought was a confirmed transaction).  This has happened several times, including notably in March 2013.

For instance, in Appendix 1: Prohibited Businesses and Prohibited Use, Coinbase lays out specific services that it prohibits interaction with, including gambling.  For example, about a year ago, users from Seals with Clubs and other dice/gambling sites noticed that they were unable to process funds from these sites through Coinbase and vice versa.

brian armstrong coinbase

Source: Twitter

The tweet above is from Brian Armstrong is the CEO of Coinbase, which is the most well-funded permissioned-on-permissionless startup in the Bitcoin ecosystem.  For its users, there is nothing permissionless about Bitcoin as they actively gate who can and cannot be part of their system and black list/white list certain activities, including mining (hashing) itself.6  It is not “open” based on common usage of the word.

In other words, contrary to what some Coinbase executives and investors claim, in an effort to extract value in a legally palatable manner, they must fulfill KYC/AML requirements and in doing so, effectively nullify the primary utility of a permissionless network: permissionlessness.  Furthermore, Coinbase users do not actually use Bitcoin for most transactions as they do not control the privkey, Coinbase does.  Coinbase users are not using Bitcoin on Coinbase, they are using an internal database.7 Or to use the marketing phrase: you are not your own bank, Coinbase is — which leads to a bevy of regulatory compliance questions beyond the scope of this post.8 However, once your bitcoins are out of Coinbase and into your own independent wallet where you control the private key, then you get the utility of the permissionless platform once more.

What are other permissioned-on-permissionless platforms?  Below are twenty-seven different companies that have raised at least a Series A (figures via CoinDesk) in alphabetical order:

  • Bitex.la: ($4 million)
  • BitGo: ($14 million)
  • BitGold: ($5.3 million)
  • Bitnet: ($14.5 million)
  • BitPay: ($32.5 million)
  • Bitreserve: ($14.6 million)
  • Bitstamp: ($10 million)
  • BitX: ($4.82 million)
  • BTC China ($5 million)
  • ChangeTip: ($4.25 million)
  • Chain: ($13.7 million)9
  • Circle: ($76 million)
  • Coinbase: ($106 million)
  • Coinplug: ($3.3 million)
  • Coinsetter: ($1.9 million)
  • Cryex: ($10 million)
  • GoCoin: ($2.05 million)
  • Huobi ($10 million)
  • itBit: ($28.25 million)
  • Korbit: ($3.4 million)
  • Kraken: ($6.5 million)
  • Mirror, formerly Vaurum: ($12.8 million)
  • OKCoin: ($11 million)
  • Ripple Labs ($37 million)
  • Vogogo ($21 million)
  • Xapo: ($40 million)

Altogether this amounts to around $492 million, which is more than half of the $855 million raised in the overall “Bitcoin space.”

What do these all have in common again?  Most are hosted wallets and exchanges that require KYC/AML fulfillment for compliance with regulatory bodies.  They require users to gain permission first before providing a service.

pie chart bitcoin fundingThe chart above visualizes funding based on the schema’s explored in this post.  Based on a total venture capital amount of $855 million, in just looking at startups that have received at least a Series A, 57.5% or $492 million has gone towards permissioned-on-permissionless systems.  An additional $224 million, or 26.1% has gone towards mining and hashing.10

Permissionless-on-permissionless includes Blockchain.info, ShapeShift, Hive, Armory and a sundry of other seed-stage startups that collectively account for around $50 million or 5.8% altogether.  The remaining 10.6% include API services such as Gem and BlockCypher; hardware wallets such as Case and Ledger; and analytic services such as Tradeblock.  In all likelihood, a significant portion of the 10.6% probably is related to permissioned-on-permissionless (e.g., Elliptic, Align Commerce, Bonafide, Blockscore, Hedgy, BitPagos, BitPesa) but they have not announced a Series A (yet) so they were not included in the “blue” portion.

Ripple Labs

Why is Ripple Labs on that funding list above?  While Ripple is not directly related to Bitcoin, it is aggregated on the funding list by CoinDesk.

Is it permissioned or permissionless?  A few weeks ago I met with one of its developers, who said in practice, the validator network is effectively permissionless in that anyone can run a validator and that Ripple Labs validators will process transactions that include XRP.11

This past week, Thomas Kelleher tried to outline how Ripple Labs is some kind of “third way” system, that uses ‘soft permissions’ in practice.  There may be a case for granular permissions on a permissionless network, but it did not coherently arise in that piece.

For example, in early May, Ripple Labs announced that it had been fined by FinCEN for not complying with the BSA requirements by failing to file suspicious activity reports (SARs), including notably, on Roger Ver (who did not want to comply with its KYC requests).

In addition to the fine, Ripple Labs also implemented a new identification gathering process for KYC compliance, stating:

The Ripple network is an open network. No one, including Ripple Labs, can prevent others from using or building on the Ripple protocol as they desire. However, when Ripple Labs provides software, such as the Ripple Trade client, Ripples Labs may impose additional requirements for the use of the software. As such, Ripple Labs will require identification of Ripple Trade account holders.

We will ask you to submit personally identifiable information (PII) similar to what you would submit to open a bank account, such as full name, address, national ID number, and date of birth. Users may also be asked to upload their driver’s license or other identifying documents. We will use this information to verify your identity for compliance purposes. We take privacy seriously, so the information you provide during the customer identification process is encrypted and managed by Ripple Trade’s Privacy Policy.

In other words, Ripple Labs was just fined by FinCEN for doing the very thing that Kelleher wants you to believe he is not required to do.   All new Ripple Labs-based “wallets” (Ripple Trade wallets) require user info — this likely means they can control, suspend and block accounts.12  All eight of the main Ripple gateways are also obliged to gather customer information.  The current lawsuit between Jed McCaleb and Ripple Labs, over the proceeds of $1 million of XRP on Bitstamp, will probably not be the last case surrounding the identification and control of such “wallet” activity (e.g., specific XRP flagged).

Thus, while the Ripple network started out as permissionless, it could likely become permissioned at some point due to compliance requirements.  Why?  If you download and install rippled, in practice you are going to use the default settings which rely on Ripple Labs core nodes. In practice, “choose your own” means “choose the default” for 99% percent of its users, ergo Ripple Labs sets the defaults.13 In a paper recently published by Peter Todd, he explained there is no game theoretic advantage to selecting non-default configurations which were not discussed in Kelleher’s essay.

Bob cannot choose his own rules if he has to follow compliance from another party, Ripple Labs. The UNL set may converge on an explicit policy as nodes benefit from not letting other nodes validate (they can prioritize traffic).14

I reached out to Justin Dombrowski, an academic who has spent the past year independently studying different ledger systems for a variety of organizations.  In his view:

I have a hard time thinking of Ripple as anything but plain permissioned because I have a hard time thinking of a realistic circumstance under which an active user wouldn’t also have an account subject to KYC, or be indirectly connected to one. Sure, I can run a node for the purpose of experimenting with some Ripple app I’m developing, but at the end of the day I expect to be payed for that app. And I could mine for free—and yeah, in that case the network is permissionless for me—but that’s a atypical, trivial example I’d think. Ripple is theoretically permissionless, but practically not because incentives align only with permissioned uses.

As Dombrowski noted, things get taxonomically challenging when a company (Ripple Labs) also owns the network (Ripple) and has to begin complying with financial service regulations.  This trend will likely not change overnight and until it explicitly occurs, I will probably continue to put an asterisk next to its name.

Challenges for DMMS validators in a permissioned-on-permissionless world

Over the past month, I have been asked a number of questions by managers at financial institutions about using public / communal chains as a method for transferring value of registered assets.

For instance, what happens if Bank A pays a fee to a Bitcoin or Litecoin miner/mining pool in a sanctioned country (e.g., EBA concerns in July 2014)?

In February 2015, according to a story published by Free Beacon, Coinbase was on “the hot seat” for explicitly highlighting this use-case in an older pitch deck because they stated: “Immune to country-specific sanctions (e.g. Russia-Visa)” on a slide and then went on to claim that they were compliant with US Treasury and NY DFS requirements.

Another question I have been asked is, what if the Bitcoin or Litecoin miner that processes transactions for financial institutions (e.g., watermarked tokens) also processes transactions for illicit goods and services from dark net markets?  Is there any liability for a financial institution that continues to use this service provider / block maker?

Lastly, how can financial institutions identify and contact the miner/mining pool in the event something happens (e.g., slow confirmation time, accidentally sent the wrong instruction, double-spend attempt, etc.)?  In their view, they would like to be able to influence upgrades, governance, maintenance, uptime (i.e., typical vendor relationship).


In the Consensus-as-a-service report I used the following chart showing trade-offs:permissioned tradeoffsI also used the following diagram to illustrate the buckets of a permissioned blockchain:

permissioned chainsRecall that the term “mintette” was first used by Ben Laurie in his 2011 paper describing known, trusted validators and was most recently used in Meiklejohn (2015).

The general idea when I published the report several months ago was that permissionless-on-permissioned (what effectively what Ripple sits) is untenable in the long-run: due to regulatory pressure it is impossible to build a censorship-resistant system on top of a permissioned network.

Ryan Shea pointed this out in his recent piece, noting that:

Permission-ed blockchains are useful for certain things but they are limited in what they can do. Fully decentralized, permission-less, censorship-resistant applications CANNOT be built on them, which for many is a deal-breaker.

What does this mean for your business or organization?  Before deciding what system(s) to use, it is important to look at what the organizations needs are and what the customer information requirements are.


As explored above, several startups and VC funds have unintentionally turned an expensive permissionless system into a hydra gated permissioned network without the full benefits of either.  If you are running a ledger between known parties who abide by government regulations, there is no reason to pay the censorship-resistance cost.  Full stop.15

fixing bitcoin

[The optics of permissioned-on-permissionless]

Most efforts for “legitimizing” or “fixing” Bitcoin involves counteracting features of Bitcoin that were purposefully designed such that it enables users to bypass third parties including governmental policies and regulations.  Businesses and startups have to fight to turn Bitcoin into something it isn’t, which means they are both paying to keep the “naughty” features and paying to hide them.  For example, if Satoshi’s goal was to create a permissioned system that interfaces with other permissioned systems, he would likely have used different pieces — and not used proof-of-work at all.

The commercial logic of this (largely) VC-backed endgame seems to be: “privatize” Bitcoin through a dozen hard forks (the block size fork is the start of this trend that could also change the 21 million bitcoin hard-cap).16

It seems increasingly plausible that some day we may see a fork between the “permissionless-on-permissionless” chain (a non-KYC’ed chain) and the “permissioned-on-permissionless” chain (a fully KYC’ed chain) — the latter comprising VC-backed miners, hosted wallets, exchanges and maybe even financial institutions (like NASDAQ).  The motivations of both are progressively disparate as the latter appears uninterested in developer consensus (as shown by the special interest groups wanting to create larger blocks today by ignoring the feedback from the majority of active core developers and miners).  At that point, there is arguably minimal-to-no need for censorship resistance because users and miners will be entirely permissioned (i.e. known by/to participating institutions and regulators).

When drilling down, some of the permissioned-on-permissionless investment appears to be a sunk cost issue: according to numerous anecdotes several of these VCs apparently are heavily invested in bitcoins themselves so they double down on projects that use the Bitcoin network with the belief that this will create additional demand on the underlying token rather than look for systems that are a better overall fit for business use-cases.17

This raises a question: is it still Bitcoin if it is forked and privatized?   It seems that this new registered asset is best called Bitcoin-in-name-only, BINO, not to be confused with bitcoin, the bearer asset.18

If the end game for permissionless systems is one in which every wallet has to be signed by something KYC/KYB approved, it appears then that this means there would be a near total permissioning of the ledger.  If so, why not use a permissioned ledger instead for all of the permissioned activity?

The discussion over centralized versus institutionalized will also be discussed in a future post.

[Acknowledgements: thanks to Richard Apodaca, Anton Bolotinsky, Arthur Breitman, Richard Brown, Dustin Byington, Justin Dombrowski, Thomas Kelleher, Yakov Kofner, Antony Lewis and John Whelan for their feedback.]


  1. See Does Smart Contracts == Trustless Multiparty Monetary Computation? []
  2. Thanks to Richard Brown for this insight. []
  3. In raising funds, they have “doxxed” themselves, providing information about founders and management including names and addresses.  They are no longer pseudonymous. []
  4. Thanks to Anton Bolotinsky for this insight. []
  5. Are there any other non-mining projects that are VC funded projects that do not require KYC?  A few notable examples include ShapeShift (which de-links provenance and does not require KYC from its users) and wallets such as Hive and Armory.  All three of these are seed-stage. []
  6. For more about know-your-miner and source of funds, see The flow of funds on the Bitcoin network in 2015 []
  7. Perhaps this will change in the future.  Coinbase users can now send funds both on-and-off-chain in a one-click manner. []
  8. Learning from the past to build an improved future of fintech and Distributed Oversight: Custodians and Intermediaries []
  9. Chain is working with NASDAQ on its new issuance program which requires KYC compliance.  In contrast, I created a new account for their API product today and it did not require any KYC/KYB. []
  10. See What impact have various investment pools had on Bitcoinland?  It bears mentioning that BitFury raised an additional $20 million since that post, bringing the publicly known amount to around $224 million. []
  11. Visited on July 2, 2015 []
  12. Using similar forensics and heuristics from companies like Chainalysis and Coinalytics, Ripple Labs and other organizations can likely gather information and data on Ripple users prior to the April 2015 announcement due to the fact that the ledger is public. []
  13. Two years ago, David Schwartz, chief cryptographer at Ripple Labs, posted an interesting comment related to openness and decentralization on The Bitcoin Foundation forum. []
  14. Thanks to Jeremy Rubin and Roberto Capodieci for their feedback. []
  15. Thanks to Arthur Breitman for this insight. []
  16. Thanks to Robert Sams for this insight. []
  17. Richard Apodaca, author of the forthcoming Decoding Bitcoin book, has another way of looking at VCs purchasing bitcoins, that he delves into on reddit twice. []
  18. One reviewer suggested that, “this would cease being bitcoin if the measuring stick is what Satoshi wanted.” []
Send to Kindle

Buckets of Permissioned, Permissionless, and Permissioned Permissionlessness Ledgers

A few hours ago I gave the following presentation to Infosys / Finacle in Mysore, India with the Blockchain University team.  All views and opinions are my own and do not represent those of either organization.

Send to Kindle

Learning from the past to build an improved future of fintech

[Note: below is a slightly edited speech I gave yesterday at a banking event in Palo Alto.  This includes all of the intended legalese, some of which I removed in the original version due to flow and time.  Special thanks to Ryan Straus for his feedback.  The views below are mine alone and do not represent those of any organization or individual named.]

Before we look to the future of fintech, and specifically cryptocurrencies and distributed ledgers, let’s look at the most recent past.  It bears mentioning that as BNY Mellon is the largest custodial bank in the world, we will see the importance of reliable stewardship in a moment below.

In January 2009 an unknown developer, or collective of developers, posted the source code of Bitcoin online and began generating blocks – batches of transactions – that store and update the collective history of Bitcoin: a loose network of computer systems distributed around the globe.

To self-fund its network security, networks like Bitcoin create virtual “bearer assets.” These assets are automatically redeemable with the use of a credential.  In this case, a cryptographic private key.  From the networks point of view, possession of this private key is the sole requirement of ownership.  While the network rules equivocate possession and control, real currency – not virtual currency – is the only true bearer instrument.  In other words, legal tender is the only unconditional exception to nemo dat quod non habet – also known as the derivative principal – which dictates that one cannot transfer better title than one has.

Several outspoken venture investors and entrepreneurs in this space have romanticized the nostalgia of such a relationship, of bearer assets and times of yore when a “rugged individual” can once again be their own custodian and bank.1 The sentimentality of a previous era when economies were denominated by precious metals held – initially not by trusted third parties – but by individuals, inspired them to invest what has now reached more than $800 million in collective venture funding for what is aptly called Bitcoinland.

Yet, the facts on the ground clearly suggests that this vision of “everyone being their own bank” has not turned into a renaissance of success stories for the average private key holder.  The opposite seems to have occurred as the dual-edged sword of bearer instruments have been borne out.  At this point, it is important to clearly define our terms.  The concepts of “custody” and “deposit” are often conflated.  While the concepts are superficially similar, they are very different from a legal perspective.  Custody involves the transfer of possession/control.  A deposit, on the other hand, occurs when both control and title is transferred.

Between 2009 and early 2014, based on public reports, more than 1 million bitcoins were lost, stolen, seized and accidentally destroyed.2 Since that time, several of the best funded “exchanges” have been hacked or accidentally sent bitcoins to the wrong customer.  While Mt. Gox, which may have lost 850,000 bitcoins itself, has attracted the most attention and media coverage – rightfully so – there is a never ending flow of unintended consequences from this bearer duality.3

For instance, in early January 2015, Bitstamp – one of the largest and oldest exchanges – lost 19,000 bitcoins due to social engineering and phishing via Gmail and Skype on its employees including a system administrator.4 Four months later, in May, Bitfinex, a large Asian-based exchange was hacked and lost around 1,500 bitcoins.5 In another notable incident, last September, Huobi, a large Bitcoin exchange in Beijing accidentally sent 920 bitcoins and 8,100 litecoins to the wrong customers.6  And ironically, because transactions are generally irreversible and the sole method of control is through a private key they no longer controlled them: they had to ask for the bitcoins back and hope they were returned.

A study of 40 Bitcoin exchanges published in mid-2013 found that at that time 18 out of 40 – 45% — had closed doors and absconded with some portion of customer funds.7 Relooking at that list today we see that about another five have closed in a similar manner.  All told, at least 15% if not higher, of Bitcoin’s monetary base is no longer with the legitimate owner.  Can you imagine if a similar percentage of real world wealth or deposits was dislocated in the same manner in a span of 6 years?8

In many cases, the title to this property is encumbered, leading to speculation that since many of these bitcoins are intermixed and pooled with others, a large percentage of the collective monetary base does not have clean title, the implications of which can be far reaching for an asset that is not exempted from nemo dat, it is not fungible like legal tender.9

As a consequence, because people in general don’t trust themselves with securing their own funds, users have given – deposited – their private keys with a new batch of intermediaries that euphemistically market themselves as “hosted wallets” or “vaults.” What does that look like in the overall scheme?  These hosted wallets, such as Coinbase and Xapo, have collectively raised more than $200 million in venture funding, more than a quarter of the aggregate funding that the whole Bitcoin space has received. Simultaneously, the new – often unlicensed – parties collectively hold several million bitcoins as deposits; probably 25-30% of the existing monetary base.10 Amazingly, nobody is actually certain whether a “hosted wallet” is a custodian of a customers bitcoin or acquired title to the bitcoin and is thus a depository.

Yet, in recreating the same financial intermediaries that they hoped to replace – in turning a bearer asset into a registered asset – some Bitcoin enthusiasts have done so in fashion that – as described earlier – has left the system ripe for abuse.  Whereas in the real world of finance, various duties are segregated via financial controls and independent oversight.11 In the Bitcoin space, there have been few financial controls.  For example, what we call a Bitcoin exchange is really a broker-dealer, clearinghouse, custodian, depository and an exchange rolled into one house which has led to theft, tape painting, wash trading, and front-running.12 All the same issues that led to regulatory oversight in the financial markets in the first place.

And while a number of the better funded and well-heeled hosted wallets and exchanges have attempted to integrate “best practices” and even third-party insurance into their operation, to date, there is only one Bitcoin “vault” – called Elliptic — that has been accredited with meeting the ISAE 3402 custodial standard from KPMG. Perhaps this will change in the future.

But if the point of the Bitcoin experiment, concept, lifestyle or movement was to do away or get away from trusted third parties, as described above, the very opposite has occurred.

What can be learned from this?  What were the reasons for institutions and intermediation in the first place?  What can be taken away from the recent multi-million dollar educational lesson?

We have collectively learned that a distributed ledger, what in Bitcoin is called a blockchain, is capable of clearing and settling on-chain assets in a cryptographically verifiable manner, in near-real time all with 100% uptime because its servers – what are called validators – are located around the world.  As we speak just under sixty four hundred of these servers exist, storing and replicating the data so that availability to any one of them is, in theory, irrelevant.13

Resiliency, accountability and transparency, what’s not to like?  Why wouldn’t financial institutions want to jump on Bitcoin then, why focus on other distributed ledger systems?

One of the design assumptions in Bitcoin is that its validators are unknown and untrusted – that there is no gating or vetting process to become a validator on its open network.  Because it is purposefully expensive and slow to produce a block that the rest of the network will regard as valid, in theory, the rest of the network will reject your work and you will have lost your money.  Thus, validators, better technically referred to as a block maker, attempt to solve a benign math problem that takes on average about 10 minutes to complete with the hope of striking it rich and paying their bills. There are exceptions to this behavior but that is a topic for another time.14

The term trust or variation thereof appears 13 times in the final whitepaper.  Bitcoin was designed to be a solution for cypherpunks aiming to minimize trust-based relationships and mitigate the ability for any one party to censor or block transactions. Because validators are unknown and untrusted, to protect against history-reversing attacks, Bitcoin was purposefully designed to be inefficient.15 That is to say attackers must expend real world resources, energy, to disrupt or rewrite history.  The theory is that this type of economic attack would stave off all but the most affluent nation-state actors; in practice this has not been the case, but that again is a topic for another speech.

Thus Bitcoin is perhaps the world’s first, commodity-based censorship resistance-as-a-service.  To prevent attackers on this communal network from reversing or changing transactions on a whim, an artificially expensive anti-Sybil mechanism was built in dubbed “proof of work” – the 10 minute math problem.  Based on current token value, the cost to run this network is roughly $300 million a year and it scales in direct proportion to the bitcoin market price.16

Thus there are trade-offs that most financial institutions specifically would not be interested in.

Why you may ask?

Because banks already know their customers, staff and partners. Their counterparties and payment processors are all publicly known entities with contractual obligations and legal accountability.  Perhaps more importantly, the relationship created between an intermediary and a customer is clear with traditional financial instruments.  For example, when you deposit money in your bank account, you know (or should know) that you are trading your money for an IOU from the bank.17 On the other hand, when you place money in a safe deposit box you know (or should know) that you retain title to the subject property.  This has important considerations for both the customer and intermediary.  When you trade your money for an IOU, you are primarily concerned with the financial condition of the intermediary.  However, when you retain title to an object held by somebody else, you care far more about physical and logical security.

As my friend Robert Sams has pointed out on numerous occasions, permissionless consensus as it is called in Bitcoin, cannot guarantee irreversibility, cannot even quantify the probability of a history-reversing attack as it rests on economics, not technology.18 Bitcoin is a curious design indeed where in practice many participants on the network are now known, gated and authenticated except the transaction validators.  Why use expensive proof-of-work at all at this point if that is the case?  What is the utility of turning a permissionless system into a permissioned system, with the costs of both worlds and the benefits of neither?

But lemonade can still be squeezed from it.

Over the past year more than a dozen startups have been created with the sole intent to take parts of a blockchain and integrate their utility within financial institutions.19 They are doing so with different design assumptions: known validators with contractual terms of service. Thus, just as PGP, SSL, Linux and other open source technology, libraries and ideas were brought into the enterprise, so too are distributed ledgers.

Last year according to Accenture, nearly $10 billion was invested in fintech related startups, less than half of one percent of which went to distributed ledger-related companies as they are now just sprouting.20

What is one practical use?  According to a 2012 report by Deutsche Bank, banks’ IT costs equal 7.3% of their revenues, compared to an average of 3.7% across all other industries surveyed.21)  Several of the largest banks spend $5 billion or more in IT-related operating costs each year.  While it may sound mundane and unsexy, one of the primary use cases of a distributed ledger for financial institutions could be in reducing the cost centers throughout the back office.

For example, the settlement and clearing of FX and OTC derivatives is an oft cited and increasingly studied use case as a distributed ledger has the potential to reduce counterparty and systemic risks due to auditability and settlement built within the data layer itself.22

How much would be saved if margining and reporting costs were reduced as each transaction was cryptographically verifiable and virtually impossible to reverse? At the present time, one publicly available study from Santander estimates that “distributed ledger technology could reduce banks’ infrastructure costs attributable to cross-border payments, securities trading and regulatory compliance by between $15-20 billion per annum by 2022.”23

With that said, in its current form Bitcoin itself is probably not a threat to retail banking, especially in terms of customer acquisition and credit facilities.  For instance, if we look at on-chain entities there are roughly 370,000 actors.  If the goal of Bitcoin was to enable end-users to be their own bank without any trusted parties, based on the aggregate VC funding thus far, around $2,200 has been spent to acquire each on-chain user all while slowly converting a permissionless system into a permissioned system, but with the costs of both.24

That’s about twice as much as the average bank spends on customer acquisition in the US.  While there are likely more than 370,000 users at deposit-taking institutions like Coinbase and Xapo, they neither disclose the monthly active users nor are those actual Bitcoin users because they do not fully control the private key.

If we were to create a valuation model for the bitcoin network (not the price of bitcoins themselves), the network would be priced extremely rich due to the wealth transfer that occurs every 10 minutes in the form of asset creation.  The network in this case are miners, the block makers, who are first awarded these bearer instruments.

How can financial institutions remove the duplicative cost centers of this technology, remove this $300 million mining cost, integrate permissioned distributed ledgers into their enterprise, reduce back office costs and better serve their customers?

That is a question that several hundred business-oriented innovators and financial professionals are trying to answer and we will likely know in less time it took Bitcoin to get this far.

Thanks for your time.


  1. Why Bitcoin Matters by Marc Andreessen []
  2. Tabulating publicly reported bitcoins that were lost, stolen, seized, scammed and accidentally destroyed between August 2010 and March 2014 amounts to 966,531 bitcoins. See p. 196 in The Anatomy of a Money-like Informational Commodity []
  3. Mt. Gox files for bankruptcy, hit with lawsuit from Reuters []
  4. Bitstamp Incident Report []
  5. Bitfinex Warns Customers to Halt Deposits After Suspected Hack from CoinDesk []
  6. Why One Should Think Twice Before Trading On The Bitcoin Exchanges from Forbes []
  7. See Beware the Middleman: Empirical Analysis of Bitcoin-Exchange Risk by Tyler Moore and Nicolas Christin []
  8. This has occurred during times of war.  See The Monuments Men []
  9. Bitcoin’s lien problem from Financial Times and Uniform Commercial Code and Bitcoin with Miles Cowan []
  10. Based on anecdotal conversations both Coinbase and Xapo allegedly, at one point stored over 1 million bitcoins combined. See also: Too Many Bitcoins: Making Sense of Exaggerated Inventory Claims []
  11. See Distributed Oversight: Custodians and Intermediaries []
  12. See Segregation of Duties in the CEWG BitLicense comment []
  13. See Bitnodes []
  14. See Majority is not Enough: Bitcoin Mining is Vulnerable from Ittay Eyal and Emin Gün Sirer []
  15. See Removing the Waste from Cryptocurrencies: Challenges and More Challenges by Bram Cohen and Cost? Trust? Something else? What’s the killer-app for Block Chain Technology? by Richard Brown []
  16. See Appendix B []
  17. See A Simple Explanation of Balance Sheets (Don’t run away… it’s interesting, really!) by Richard Brown []
  18. Needing a token to operate a distributed ledger is a red herring []
  19. See The Distributed Ledger Landscape and Consensus-as-a-service []
  20. Fintech Investment in U.S. Nearly Tripled in 2014 from Accenture []
  21. IT in banks: What does it cost? from Santander []
  22. See No, Bitcoin is not the future of securities settlement by Robert Sams []
  23. The Fintech 2.0 Paper: rebooting financial services from Santander []
  24. One notable exception are branchless banks such as Fidor which is expanding globally and on average spends about $20 per customer.  See also How much do you spend on Customer Acquisition? Are you sure? []
Send to Kindle

A blockchain with emphasis on the “a”

Over the past month a number of VCs including Chris Dixon and Fred Wilson use the term “the blockchain” in reference to Bitcoin, as if it is the one and only blockchain.1

There are empirically, many blockchains around.  Some of them do not involve proof-of-work, some of them are not even cryptocurrencies.  Yet despite this, Dixon blocked Greg Slepak on Twitter (creator of okTurtles and DNSChain) for pointing that out just a couple weeks ago.

But before getting into the weeds, it is worth reflecting on the history of both virtual currencies and cryptocurrencies prior to Bitcoin.

The past

Below are several notable projects that pre-date the most well-known magic internet commodity.

  • DigiCash (1990)
  • e-gold (1996)
  • WebMoney (1998)
  • PayPal (1998) “Bitcoin is the opposite of PayPal, in the sense that it actually succeeded in creating a currency.”  — Peter Thiel
  • Beenz (1998)
  • Flooz (1999)
  • Liberty Reserve (2006)
  • Frequent flyer points / loyalty programs
  • WoW gold, Linden Dollars, Nintendo Points, Microsoft Points

According to an excellent article written a couple years ago by Gwern Branwen:

Bitcoin involves no major intellectual breakthroughs, so Satoshi need have no credentials in cryptography or be anything but a self-taught programmer! Satoshi published his whitepaper May 2009, but if you look at the cryptography that makes up Bitcoin, they can basically be divided into:

  • Public key cryptography
  • Cryptographic signatures
  • Cryptographic hash functions
  • Hash chain used for proof-of-work
    • Hash tree
    • Bit gold
  • cryptographic time-stamps
  • resilient peer-to-peer networks

And what were the technological developments, tools and libraries that spearheaded those pieces?  According to Branwen:

  • 2001: SHA-256 finalized
  • 1999-present: Byzantine fault tolerance (PBFT etc.)
  • 1999-present: P2P networks (excluding early networks like Usenet or FidoNet; MojoNation & BitTorrent, Napster, Gnutella, eDonkey, Freenet, i2p etc.)
  • 1998: Wei Dai, B-money
  • 1997: HashCash; 1998: Nick Szabo, Bit Gold; ~2000: MojoNation/BitTorrent; ~2001-2003, Karma, etc
  • 1992-1993: Proof-of-work for spam
  • 1991: cryptographic timestamps
  • 1980: public key cryptography
  • 1979: Hash tree

Other prior art can be found in The Ecology of Computation from Huberman.2 One open question for permissionless systems is whether or not a blockchain is a blockchain if it is neither proof-of-work-based or proof-of-stake-based (“Cow system” in Bram Cohen’s terminology).  But that’s a topic for another post.

The present

About two weeks ago, /r/bitcoin learned that Bitcoin was not the creator of all this fundamental technology.  That indeed, there were over 30 years of academic corpus that cumulatively created the system we now call “a blockchain,” in this case, Nakamoto consensus.  And this has spawned a sundry of other experiments and projects that have since been kickstarted.

For example:

  • CoinMarketCap currently tracks 592 cryptocurrencies / 59 assets
  • CoinGecko tracks 225 cryptocurrencies/assets
  • Ray Dillinger’s “Necronomicon” includes over 100 dead altcoins
  • Map of Coins is currently tracking 686 derivatives of various cryptocurrencies; this includes all hashing functions (e.g., scrypt, X11, X13) and includes existing and defunct chains
  • These are just publicly known blockchains and there are likely dozens if not hundreds of private trials, proof of concepts in academia, institutions and from hobbyists (e.g., Citibank announced in July 2015 that it was testing out three blockchains with a “Citicoin” to better understand use-cases)

So it appears that there are more than one in the wild.

Yet, a couple weeks ago Fred Wilson wrote that:

If you think of the blockchain as an open source, peer to peer, massively distributed database, then it makes sense for the transaction processing infrastructure for it to evolve from individuals to large global corporations. Some of these miners will be dedicated for profit miners and some of them will be corporations who are mining to insure the integrity of the network and the systems they rely on that are running on it. Banks and brokerage firms are the obvious first movers in the second category.

He later clarified in the comments and means the Bitcoin blockchain, not others.

One quibble is that transaction processing is not clearly defined relative to hashing.  Today, bitcoin transactions are actually processed by very small, non-powerful computers (even a Raspberry Pi).

What about the pictures with entire rooms filled with computers?  Why does it cost so much to run a hashing farm then?

Because of the actual workhorse of the network: ASICs designed to generate proofs-of-work.  These hashing systems do not do any transaction processing, in fact, they cannot even run a Bitcoin client on them.3

Tangentially William Mougayar, investor and author, stated the following in the AVC thread:

Only trick is that mining is not cheap initially, and the majority is done in China. It presents an interesting energy challenge: you need lots of electricity to run the computers, but also to keep them cool. So, if you’re using solar you still need to cool them. And if you put them in cool climates like near the north pole, there is no solar. Someone needs to solve that equation.

Mining cannot be made “cheaper” otherwise the network becomes cheaper to attack.

In fact, as Bram Cohen mentioned last week, “energy efficient” proofs-of-works is a contradiction in terms.

Thus, there is no “equation to solve.”  In the long run, miners will bid up the marginal costs to which they equal the marginal value (MC=MV) of a bitcoin in the long run.  We see this empirically, there is no free lunch.  If hashing chips somehow became 50% more efficient, hashing farms just add 50% more of them — this ratcheting effect is called the Red Queen effect and this historically happens in a private seigniorage system just as it does in proof-of-work cryptocurrencies.4

organ proportionalismAs shown in the chart above, hashrate follows price; the amount of resources expended (for proof-of-work) is directly proportional to market value of a POW token.

Furthermore, in terms of Wilson’s prediction that banks will begin mining: what benefit do banks have for participating in the mining process?  If they own bitcoins, perhaps it “gives them a seat at the table.”  But if they do not own any, it provides no utility for them.

Why?  What problem does mining solve for organizations such as banks?  Or to put another way: what utility does proof-of-work provide a bank that knows its customers, staff and transaction processors?5

Permissioned Permissionlessness, BINO-style

One goal and innovation for Bitcoin was anonymous/pseudonymous consensus which comes with a large requirement through trade-offs: mining costs and block reorganization risk.

To quote Section 1 of the Nakamoto whitepaper regarding the transaction costs of the current method of moving value and conducting commerce:

These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party


  • Bitcoin was designed with anonymous consensus to resist censorship by governments and other trusted third parties.
  • If you are running a ledger between known parties who abide by government regulations, there is no reason to pay that censorship-resistance cost.  Full stop.

Today several startups and VC funds have (un)intentionally turned an expensive permissionless system into a hydra, a gated permissioned network without the full benefits of either.  Consequently, through this mutation, some of these entities have also turned a bearer asset into a registered asset with the full costs of both.

For instance, it is currently not possible to build a censorship-resistant cash system on top of a permissioned ledger (due to the KYC requirements) yet this is basically what has attempted with many venture funded wallets such as Coinbase.

The end result: Bitcoin in name only (BINO).  In which a permissionless network is (attempted to be) turned into a permissioned network.  It bears mentioning that companies such as Peernova and Blockstack are not trying to compete with Bitcoin — they are not trying to build censorship-resistant cash.

While financial institutions can indeed download a client and send tokens around, Bitcoin was purposefully designed not to interface with financial intermediaries as it was modeled on the assumption that no one can be trusted and that parties within the network are unknown.  Therefore if parties transacting on the network are both known and trusted, then there probably is no reason to use Bitcoin-based proof-of-work.  Instead, there are other ways to secure transactions on a shared, replicated ledger.

Ask the experts

I reached out to several experts unaffiliated with Bitcoin itself to find out what the characteristics of a blockchain were in their view.

Ian Grigg has spent twenty years working in the cryptocurrency field and is the author of the Financial Cryptography blog as well as the Ricardian Contract and most recently the “Nakamoto signature.”  Below are his thoughts:

As far as *history* is concerned, it looks like just about every individual component of Bitcoin was theorised before 2009.  The last thing that I’d thought was new was the notion of a shared open repository of transactions, but it seems Eric Hughes actually proposed it in the 1990s.  And of course Todd Boyle was banging the triple entry drum in the late 1990s.

Bitcoin has no monopoly on any term except bitcoin and BTC as far as I can see. The big question is really between permissioned and permissionless ledger designs.

If you go for a permissioned ledger, then you can do some more analysis and also reduce the need for the consensus signing to be complicated. At the base level, just one signatory might be enough, or some M of N scheme. But we don’t need the full nuclear PoW-enfused Nakamoto Signature.

But also, the same analysis says we don’t need a block. What’s a block? It’s a batch of transactions that the ‘center’ works on to make them so. But if we’ve got permissioned access, and we’ve reduced the signing to some well-defined set, why not go for RTGS and then we haven’t got a block.

The block in the blockchain exists because of the demands of the networking problem – with a network of N people all arguing over multiple documents, we know it can’t be done in less than a second for a small group and less than 10 seconds for a large group. So to get the scaling up, we *have to make a block* or batch of *many* transactions so we can fit the consensus algorithm over enough tx to make it worthwhile.

Therefore the block, the Nakamoto Signature, PoW and the incentive structure all go together. That’s the blockchain.

Zaki Manian, co-founder of SKUChain and all around Bay-area crypto guru:

Cryptography is interesting right now because the primitives have matured and pre-cryptographic systems are becoming less and less robust.

Commitment schemes are widely used in cryptography. Nakamoto signatures (if Adam Back wants to concede the naming rights) are the thermodynamic commitment to a set of values. A conventional signature in attributable commitment.

A cryptocurrency is an application of a ledger. A distributed ledger needs to syndicate the order of stored transaction. There is a lot of value to syndicating and independently validating the commitments to interested parties. Generalized Byzantine Agreement, n-of-m signatures and transaction syndication decrease the discretion in the operating of systems. Ultimately, discretion is a source of fragility. I think Ian’s reference to RTGS is somewhat disingenuous. Systems with a closed set of interacting parties aren’t particularly helpful. Open participation systems are fundamentally different.

There don’t seem to be any settle lines between the properties of permissioned and permission-less systems. We have both and time will tell.

Pavel Kravchenko, formerly chief cryptographer at Stellar, now chief cryptographer at Tembusu Systems:

I’ve seen the discussion, it seems rather political and emotional. Since the term blockchain is not clearly defined people tend to argue. To make everything clear I would start from security model – who is the adversary, what security assumptions we are making, what is the cost of a particular attack etc. For now (still very early days of crypto-finane) using blockchain as a common word for such variety of conditions is acceptable for me.

Vlad Zamfir, who has helped spearhead the cryptoeconomics field alongside others at Ethereum (such as Vitalik).  In his view:

“Blockchains” are a class of consensus protocols (hence why I like to pedantically refer to them as blockchain-based consensus protocols).  They are not necessarily ledgers, although blocks always do contain ordered logs.

These logs need not be transactions – although we can call them transactions if we want, and so you can call it a ledger if you want – it’s just misleading.

Blockchains are characterized by the fact that they have a fork-choice rule – that they choose between competing histories of events.

Traditional consensus protocols don’t do this, so they don’t need to chain their blocks – for them numbering is sufficient.

Economic consensus protocols contain a ledger in their consensus state, in which digital assets are defined – assets who are used to make byzantine faults expensive.

It is much less misleading to refer to this class of protocols as ledgers, than to blockchains generally speaking – although it is still misleading.

You can make an economic consensus protocol that lets people play chess. It would have a ledger, but it wouldn’t be fair to call it a distributed ledger – it’s a distributed chess server.

Economic consensus allows for public consensus, which acts as a (crappy) public computer.

Public consensus protocols have no “permissioned” management of the computers that make up this crappy public computer.

Non-public consensus protocols have “permissioned” management of these computers.

I think the main thing that is consistently lacking from these discussions is the fact that you can have permissioned control of the state of a public consensus protocol without “permissioning” the validator set.

Robert Sams, co-founder of Clearmatics who has done a lot of the intellectual heavy lifting on the “permissioned ledger” world (I believe he first coined the term in public), thinks that:

If I were to guess, I’d say that the block chain design will eventually yield to a different structure (eg tree chains). It’s the chaining that’s key, not the particular object of consensus (although how the former works is parasitic on the latter).

I think Szabo’s use of “block chain” rather than “blockchain” is more than a question of style. Out of habit I still merge adjective and noun like most people, but it’s misleading and discourages people from thinking about it analytically.

I tell you though, the one expression that really gets on my nerves is “the blockchain” used in contexts like “the blockchain can solve problem X”. Compound the confusion with the definite article. As if there’s only one (like “the internet”). And even when the context assumes a specific protocol, “the” subconsciously draws attention away from the attacker’s fork, disagreements over protocol changes and hard forks.

Anyway this debate with people talking up their Bitcoin book and treating innovation outside its “ecosystem” as apostasy is tiresome and idle.

Christopher Allen, who has had a storied career in this space including co-authoring the TLS standard:

I certainly was an early banner waiver — I did some consulting work with Xanadu, and later for very early Digicash. At various points in the growth of SSL both First Virtual and PGP tried to acquire my company. When I saw Nick’s “First Monday” article the day it came out, as it immediately clicked a number of different puzzle pieces that I’d not quite put together into one place. I immediately started using the term smart contracts and was telling my investors, and later Certicom, that this is what we really should be doing (maybe because I was getting tired of battles in SSL/TLS standards when that wasn’t what Consensus Development had been really founded to solve).

However, in the end, I don’t think any thing I did actually went anywhere, either technically or as a business, other than maybe getting some other technologists interested. So in the end I’m more of a witness to the birth of these technologies than a creator.

History in this area is distorted by software patents — there are a number of innovative approaches that would be scrapped because of awareness of litigious patent holders. I distinctly remember when I first heard about some innovative hash chain ideas that a number of us wanted to use hash trees with it, but we couldn’t figure out how to avoid the 1979 Merkle Hash Tree patent whose base patent wouldn’t expire until ’96, as well as some other subsidiary hash tree and time stamp patents that wouldn’t expire until early 2000s.

As I recall, at the time were we all trying to inspired solve the micropayment problem. Digicash had used cryptography for larger-sized cash transactions, whereas First Virtual, Cybercash and others were focused on securing the ledger side and needed larger transaction fees and thus larger amounts of money to function. To scale down we were all looking at hash chain ideas from Lamport’s S/KEY from the late 80’s and distributed transactional ledgers from X/Open’s DTP from the early 90s as inspirations. DEC introduced Millicent during this period, and I distinctly remember people saying “this will not work, it requires consumers to hold keys in a electronic wallet”. On the cryptographic hash side of this problem Adam Back did Hashcash, Rivest and his crew introduced PayWord and Micromint. On the transaction side CMU introduced NetBill.

Nick Szabo wrote using hashes for post-unforgeable transaction logs in his original smart contract paper in ’97, in which he referred to Surety’s work (and they held the Merkle hash tree and other time signature patents), but in that original paper he did not look at Proof of Work at all. It was another year before he, Wei Dai, and Hal Finney started talking about using proof-of-work as a possible foundational element for smart contracts. I remember some discussions over beer in Palo Alto circa ’99 with Nick after I became CTO of Certicom about creating dedicated proof-of-work secure hardware that would create tokens that could be used as an underlying basis for his smart contract ideas. This was interesting to Certicom as we had very good connections into cryptographic hardware industry, and I recommended that we should hire him. Nick eventually joined Certicom, but by that point they had cancelled my advanced cryptography group to raise profits in order to go public in the US (causing me to resign), and then later ceased all work in that area when the markets fell in 2001.

I truly believe that would could have had cryptographic smart contracts by ’04 if Certicom had not focused on short-profits (see Solution #3 at bottom of this post for my thoughts back in 2004 after a 3-year non-compete and NDA)…

What is required, I believe, is a major paradigm shift. We need to leave the whole business of fear behind and instead embrace a new model: using cryptography to enable business rather than to prevent harm. We need to add value by making it possible to do profitable business in ways that are impossible today. There are, fortunately, many cryptographic opportunities, if we only consider them.

Cryptography can be used to make business processes faster and more efficient. With tools derived from cryptography, executives can delegate more efficiently and introduce better checks and balances. They can implement improved decision systems. Entrepreneurs can create improved auction systems. Nick Szabo is one of the few developers who has really investigated this area, through his work on Smart Contracts. He has suggested ways to create digital bearer certificates, and has contemplated some interesting secure auctioning techniques and even digital liens. Expanding upon his possibilities we can view the ultimate Smart Contract as a sort of Smart Property. Why not form a corporation on the fly with digital stock certificates, allow it to engage in its creative work, then pay out its investors and workers and dissolve? With new security paradigms, this is all possible.

When I first heard about Bitcoin, I saw it as having clearly two different parts. First was a mix of old ideas about unforgeable transaction logs using hash trees combined into blocks connected by hash chains. This clearly is the “blockchain”. But in order for this blockchain to function, it needed timestamping, for which fortunately all the patents had expired. The second essential part of Bitcoin was through a proof-of-work system to timestamp the blocks, which clearly was based on Back’s HashCash rather than the way transactions were timestamped in Szabo’s BitGold implementation. I have to admit, when I first saw it I didn’t really see much in Bitcoin that was innovative — but did appreciate how it combined a number of older ideas into one place. I did not predict its success, but thought it was an interesting experiment and that might lead to a more elegant solution. (BTW, IMHO Bitcoin became successful more because of how it leveraged cypherpunk memes and their incentives to participate in order to bootstrap the ecosystem rather than because of any particularly elegant or orginal cryptographic ideas).

In my head, Bitcoin consists of blocks of cryptographic transactional ledgers chained together, plus one particular approach to time-stamping this block chain that uses proof-of-work method of consensus. I’ve always thought of blockchain and mining as separate innovations.

To support this separation for your article, I have one more quote to offer you from Nick Szabo:

Instead of my automated market to account for the fact that the difficulty of puzzles can often radically change based on hardware improvements and cryptographic breakthroughs (i.e. discovering algorithms that can solve proofs-of-work faster), and the unpredictability of demand, Nakamoto designed a Byzantine-agreed algorithm adjusting the difficulty of puzzles. I can’t decide whether this aspect of Bitcoin is more feature or more bug, but it does make it simpler.

As to your question of when the community first started using the word consensus, I am not sure. The cryptographic company I founded in 1988 that eventually created the reference implementation of SSL 3.0 and offered the first TLS 1.0 toolkits was named “Consensus Development” so my memory is distorted. To me, the essential problem has always been how to solve consensus. I may have first read it about it in “The Ecology of Computation” published in 1988 which predicted many distributed computational approaches that are only becoming possible today, which mentions among other things such concepts as Distributed Scheduling Protocols, Byzantine Fault-Tolerance, Computational Auctions, etc. But I also heard it from various science fiction books of the period, so that is why I named my company after it.

The future

What about tokens?

Virtual tokens may only be required for permissionless ledgers – where validators are unknown and untrusted – in order to prevent spam and incentivize the creation of proofs-of-work.  In contrast, if parties are known and trusted – such as a permissioned ledger – there are other historically different mechanisms (e.g., contracts, legal accountability) to secure a network without the use of a virtual token. 6

Is everything still too early or lack an actual sustainable use-case?

Maybe not.  It may be the case, as Richard Brown recently pointed out, that for financial institutions looking to use shared, replicated ledgers, utility could be derived from mundane areas, such as balance sheets.  And you don’t necessarily need a Tom Sawyer botnet to protect that.

What attracts or repels use-cases then?

  • Folk law: “Anything that needs censorship-resistance will gravitate towards censorship-resistant systems.”
  • Sams’ law: “Anything that doesn’t need censorship-resistance will gravitate towards non censorship-resistant systems.”

Many financial institutions (which is just one group looking at shared, replicated ledgers) are currently focused on: fulfilling compliance requirements, reducing cost centers, downscaling branching and implementing digital channels.  None of this requires censorship-resistance.  Obviously there are many other types of organizations looking at this technology from other angles and perhaps they do indeed find censorship-resistance of use.

In conclusion, as copiously noted above, blockchains are a wider technology than just the type employed by Bitcoin and includes permissioned ledgers.  It bears mentioning that “permissioned” validators are not really a new idea either: four years ago Ben Laurie independently called them “mintettes” and Sarah Meiklejohn discussed them in her new paper as well.


  1. See The financial cloud from Adam Ludwin []
  2. Thanks to Christopher Allen for pointing this out. []
  3. See The myth of a cheaper Bitcoin network: a note about transaction processing, currency conversion and Bitcoinland []
  4. See Bitcoins: Made in China []
  5. Why would banks want to use a communal ledger, validated by pseudonomyous pools whom are not privy to a terms of service or contractual obligation with? See Needing a token to operate a distributed ledger is a red herring and No, Bitcoin is not the future of securities settlement []
  6. See also Needing a token to operate a distributed ledger is a red herring and Consensus-as-a-service []
Send to Kindle

Panel with financial service professionals involved with baking shared, replicated ledgers into organizations

The last part of the PwC discussion 10 days ago involved a panel with myself moderating, Peter Shiau (COO of Blockstack) and Raja Ramachandran (co-founder of eFXPath and an advisor at R3CEV).  Robert Schwentker (from Blockchain University) also helped provide a number of questions for us.

We cover a number of topics including use-cases of distributed ledgers for financial institutions.

Send to Kindle

Q&A regarding the Distributed Ledger Landscape

About 10 days ago I had the pleasure of speaking at Blockchain University (hosted over at PwC) regarding distributed ledgers (permissioned and permissionless).  One of the slides was intentionally taken out of context by a user on reddit and unsurprisingly the subsequent /r/bitcoin thread covering it involved a range of ad hominem attacks that really missed what was being discussed at the actual talk: what are the characteristics of a blockchain.

I will likely write a post on this topic at length in the next couple of days.  In the meantime, below is the video which incidentally pre-emptively answered a few of the questions from that thread.

Also, for those curious to know who were asking the good questions in the audience, this included: Jeremy Drane (PwC), Christopher Allen (co-creator of the TLS standard) and Nick Tomaino (Coinbase) among others.

Send to Kindle

Bram Cohen: “Removing the Waste from Cryptocurrencies: Challenges and More Challenges”

Bram Cohen, the creator of BitTorrent, has opined on Bitcoin over the years on social media (such as Twitter).  Over the last couple of weeks he has been increasingly vocal on some hurdles such as the increase in block sizes (via a hard fork) and the dangers of accepting and institutionalizing zero-confirmation transactions.

Last week he gave a presentation at the SF Bitcoin Dev meetup in which he covered a variety of alternatives to proof-of-work such as proof-of-steak (which he dubs “Cow systems”).

Send to Kindle

The Distributed Ledger Landscape: Who is developing shared, replicated ledgers and why

Earlier today I gave a presentation for Blockchain University hosted at PricewaterhouseCoopers in San Francisco.  It covers the different startups developing permissioned ledgers, the use-cases they are looking at and the reasons for why permissionless systems are currently inadequate to fulfill similar business requirements.

Send to Kindle

Unable to dynamically match supply with demand

This post will look at an amalgam of ideas touched on by Eli Dourado in a post several days ago regarding Bitcoin.  This includes volatility, cross-border payments, nemo dat, settlement finality and machine-to-machine transactions.

I also answered a few frequently-asked-questions that have been emailed to me that intersect with some of the same ideas.


On Sunday Eli Dourado posted a response to Noah Smith and JP Koning both of whom previously discussed why bitcoin has not become a medium-of-exchange.

I don’t want to turn this into a post solely on volatility so if you’re interested in other ideas, skip to the next section titled cross-border payments.

The problem with Dourado’s analysis on volatility is that it does not look at what the actual causes of volatility are, the core of which is a perfectly inelastic money supply.

What does it mean to have a “perfectly inelastic money supply”?  In short, irrespective of the quantity demanded, the money supply itself does not change or shift.  For a Bitcoin-like network, its supply is programmed to remain static irrespective of external conditions.  While some advocates and enthusiasts consider this a feature, it is a bug if bitcoin wants to be used as a modern medium-of-exchange.  Why?  Because the only way to reflect changes in demand is through a change in price, which as described below, is done so via volatility, often violently.

And consequently, determining what the elasticity of demand could be is effectively impossible due to the opaqueness in both the exchange and OTC markets, which partly explains the unpredictability around cryptocurrency prices in general.1

In contrast to Dourado’s view, Robert Sams recently provided a more cohesive look at the fundamental reasons for why, despite the creation of new “liquidity” venues, uncertainty cannot be removed in a similar manner:

volatility 1

volatility 2

volatility 3

The three slides above appear in an April 2015 presentation by Sams.

Yet it is Sams’ short white paper on stable coins that probably, succinctly, describes the issue of future uncertainty with present day prices:

It is the nature of markets to push expectations about the future into current prices. Deterministic money supply combined with uncertain future money demand conspire to make the market price of a coin a sort of prediction market on its own future adoption.  Since rates of future adoption are highly uncertain, high volatility is inevitable, as expectations wax and wane with coin-related news, and the coin market rationalises high expected returns with high volatility (no free lunch).

In other words, at present bitcoin’s price inelasticity of demand means bitcoin’s price isn’t a function of the availability of bitcoin or, for that matter, demand for it.  This makes bitcoin vulnerable largely to the machinations of prognosticators (e.g., pumpers), not tangible market forces.2

Below are a few other questions that have hit my inbox related to volatility which tie into the ideas addressed by Dourado and others above.

Some short Q&A on volatility and prices

Visible volatility appears to have declined in the past 5 months, why?

One possible explanation relates to the inelasticity argument: if traders “feel” that this is a good price and there is no motivation or incentive to trade, thereby moving it up or down, it will tend to stay there (i.e., trading based on sentiment).

Another potential explanation for why there has been less volatility in the last couple months could be that as participants have left the market, there has been less demand from speculators due to a lack of interest and thereby a corresponding lack of volume.3  We may not know for sure what the actual trading volume is at exchanges in aggregate for years to come.

For instance, contrary to the Goldman report, the Chinese RMB does not compromise 80% of the trading volume; this “volume” as discussed by Changpeng Zhao (former CTO of OKCoin) were a combination of internal market making bots, wash trades and tape painting.4  If there was a legitimate increase in demand from speculator then there would have been corresponding increases.  Maybe “whales” will return again after Fed tightening or concerns over Greece.  Or maybe not.

In addition, VC funded companies like BitPay are stating on record that they absorbing some (all?) bitcoins onto their balance sheet, this likely in the short run reduces some of the volatility but is not sustainable.

Why not?

Because with roughly $400,000 – $800,000 in trade volume per day that BitPay processes, it simply does not have the cash on hand to absorb all of the incoming bitcoins for more than a few weeks at most.  Thus, despite the claims (video) from Jason Dreyzehner — that BitPay tries to keep all of the bitcoins that they process — after talking with several contacts at large exchanges, it turns out BitPay does in fact sell bitcoins in bulk to exchange and OTC partners.  See also, A pre-post-mortem on BitPay.

Another common question I have received: with a string of “positive” developments lately such as GBTC, new exchange infrastructure, and more VC funding, why hasn’t bitcoin’s price risen?

It hasn’t risen in part because of elasticity.  Bitcoin’s value can be susceptible to external factors, but it does not need to be if there is inelasticity of demand.  In that case, steady prices amounts to Newton’s First Law.5

In addition, thus far there is no compelling reason for:

1) Consumer-based transactional demand.  To most consumers in developed countries, trying to use bitcoin is an added friction, so they are not interested in doing that.  What are the demographics of a bitcoin owner?  Based on several sources we know what the owner demographics are: a North American / European male in his early 30s, they have access to other payment platforms and own bitcoins primarily as an investment, not virtual cash.6

2) Speculative demand has not increased (yet) because it is now an old story for some active traders — they know what a “bitcoin” as an asset is and how to get it.  As Nathaniel Popper (from NYT) discussed a couple weeks ago at Plug and Play, editors and writers at large media companies are tired of the same stories, these Bitcoin companies need to now go execute which few have actually done.

What about the new exchange companies and liquidity providers being added to the market?

As noted above, as of this writing the price of bitcoin is largely a function of speculative demand still.  Companies like Coinalytics have looked at the on-chain data to show that there has not been much of an increase in on-chain usage or demand from above-board commercial entities.7 Perhaps that will change.

Therefore if consumers are not participating, bitcoin is left with movements dictated by changes in the unpredictable demand curve (and appetite) of speculators.  There are startups that provide different types of instruments: SolidX, LedgerX, Mirror, Tera Exchange and Hedgy but none has likely gotten much volume and only have limited capital to absorb the continual bitcoin production rate of miners and other sell-side participants.  Again, maybe this will change over time.

What if bitcoin adoption were to proceed more aggressively in non-currency applications (real-time securities settlement, for e.g.), what is the impact from that on bitcoin’s price?

First off, the Bitcoin network is not a real-time securities settlement, at most it clears one batch in roughly 10 minutes — not real-time.  But if we are truly defining post-trade finality in terms of title transfer, Bitcoin itself cannot do that with off-chain assets.  Why not?  Because Bitcoin’s validators — in this case mining pools — have no control over off-chain assets.  Title still resides and is controlled off-chain, out of the purview of miners.8

Ignoring that for a moment the main reason why watermarked methods have seen a surge in interest is so that a company (or financial institution) does not need to buy gobs of bitcoins in order to represent socially-recognized value on the edges (houses, cars, airplanes, boats) — thus since watermarking takes a small fraction of a bitcoin, even in aggregate it probably does not add much demand to bitcoin itself.  Whether that is a secure method for transferring value is another topic altogether.9

On this point I also spoke with George Samman, co-founder of BTC.sx and weekly contributor to CoinTelegraph.  In his view:

When talking about settlement and clearing the sheer size – in dollar terms – of the FX and equity markets, it makes a 51% attack on watermarked assets much more of an eventuality than a probability simply because it’s now worth the effort to do so.  Why?  Because the increase in aggregate asset value transferred on a blockchain incentivizes attacks.  In fact a new paper suggests that an attacker does not even need 51% to achieve their goals.

How might Bitcoin help FX traders and arbitrageurs more easily and quickly align their books and execute a global strategy?

As of June 2015, probably none. The market simply is not deep or liquid enough compared to the multi-trillion dollar FX space.  Even if we took the volume of Bitcoin exchanges at face value — that operators are not exaggerating their numbers which we know they are10 — you would need volume to increase by several orders of magnitude before FX traders probably are interested in using it either as a vehicle or as part of their “global strategy.”

According to Bitcoinity — which uses self-reported volumes — total global bitcoin trading volume over the past 24 hours amounted to 312,532 BTC (~$78 million), though 70-80% of that is likely market making bots and wash trading.  For comparison, according to the BIS, in April 2013 the daily FX turnover globally was $5.3 trillion.  This number has stayed roughly the same over the past several years.11

What impact can the BitLicense have now that it has been finalized?

Again, I’m one of the few people that thinks the BitLicense is not a bad thing — it may seem expensive but if a Bitcoin company provides the same good and service as a traditional company then it would make sense to have them liable to the same type of compliance — why do they get an exception just because of the word Bitcoin?  With that said I do think that it could bring in more players who believe this now provides regulatory certainty.

For example, I am looking forward to seeing how Gemini impacts the network now that there is a legitimate exchange you can “short” bitcoin on — it may provide a new incentive to destabilize the network in order to gain.

For perspective I reached out to Raffael Danielli, Quantitative Analyst at ING Investment Management.  In his view:

The points made in Robert Sams recent post are worth looking at. It is a reason to be wary of a professional exchange such as Gemini. Also it adds to the volatility problem. It is probably just a question of time until we see some hedge fund disrupt the network somehow while profiting from it with a massive short. The incentives will be in place sooner or later.

Honestly, I believe that the misconception about volatility (“it will go down over time”) might blow up in the face of many people. The argument that Robert Sams makes is strong. As long as supply cannot be dynamically adjusted to match changes in demand expectations (essentially what the Fed is trying to do) volatility is unlikely to decrease.

It is worth pointing out that a trader can currently “short” bitcoin on Tera Exchange and Crypto Facilities via their forwards contracts (and swaps in the case of the former).  So far the only participants interested are miners for obvious reasons (though it is unclear if anyone involved is generating much revenue yet).  It is also unclear what the incentive for doing a swap is too, with the inability to predict or model exchange rate changes months into the future.

I also reached out to George Samman once more.  According to him:

It is more about the implied volatility which for bitcoin, is always higher than other asset classes and the reason I believe this is because bitcoin is still a giant unknown. Bitcoin continues to trade mainly on sentiment and technicals as well, and this in turn makes it by nature a more volatile asset.

I would also say to the disappearing volume on exchanges it has to do with a lack of trust, hoarding by deep pockets, and its been going off-exchange.  For example LocalBitcoins volume hit record highs in May, while volume at the biggest exchange and the one used by the most active traders use, Bitfinex, has declined steady all year long.12

Kraken, the San Francisco-based crypto currency exchange, is launching a new “DarkPool” option for volume traders who want to buy and sell coins in larger orders. Typically, large orders in the exchange swing the price of bitcoin dramatically, but with the new dark pool trading option, it lets people or institutions order in a way that the rest of the market does not see. Think of it as a level of privacy for people buying or selling bitcoin in bulk. The service will cost users an addition point-one-percent on orders.

Kraken is not the first exchange to bring a “dark pool” to market.  In 2013 Tradehill launched a service called “Prime” that purportedly acted as a “dark pool.”  In addition, one of the attractions to LocalBitcoins may be that it does not require traders to provide identification (via KYC); its volume could decline if it tried to comply with similar KYC/AML/BSA requirements that many other exchanges do.

Cross-border payments

Dourado’s explanation for how credit card processing work is not fully fleshed out.  For a more detailed explanation I recommend readers peruse two posts from Richard Brown found below in the notes.13 In short, Dourado’s explanation for the alleged value proposition between Bitcoin versus a credit card ignores the biggest difference: there is no native credit facility or lending ability on the Bitcoin network.

At best the comparison should be with debit cards.  In addition, in his example, not only is there unnecessary foreign exchange fees in moving into and out of bitcoin, but transactions do not occur instantaneously (even zero-confirmations take longer than a card swipe).  Furthermore, the current Bitcoin network is unable to handle everyone wanting to use bitcoin today (there is a continuous backlog of unconfirmed transactions, sometime measuring into the thousands).  One thing he could have mentioned is that that foreign exchange trades may offset merchant fees, but he did not (yet).

For instance, Dourado states:

You may use a payment processor such as BitPay to instantly convert the bitcoins you receive into dollars. I may use a wallet that instantly converts dollars to Bitcoin at the time I want to make a payment. We both have trust relationships with intermediaries, but because the transaction and settlement occurs on the blockchain, we no longer have to trust the same intermediary.

There is no reason to use Bitcoin itself to do this.  Since users on both ends of the transaction are not only identified but they also need to “trust” a trusted third party, they could just as easily use a different payment method.  And empirically they do, hence one of the reasons why JP Koning wrote the first post in the first place.  In practice, Bitcoin as a payment system is just an added friction: why go from USD->BTC->USD when a user can simply bypass this artificial friction and pay in USD?

Dourado does not provide a cost-benefit analysis nor does he explain why credit card companies work the way they do (see again Brown’s posts in the end notes).   Instead, he discusses the example of unbanked and underbanked, stating:

This is relevant when thinking about bringing the next few billion people online and into the global economy. These people will not have credit histories that are accessible to the same intermediaries that I am set up to use. They may have local intermediaries that they can use, or they may be willing to use Bitcoin directly. If that is the case, they will be able to enter into the stream of global commerce.

In my lengthy book review on The Age of Cryptocurrency I explained 3-4 reasons for why Bitcoin probably is not the savior of the unbanked and underbanked.

One of the reasons is volatility, another is compliance and customer acquisition costs.

One more is the fact that nearly all venture capital (VC) funded hosted “wallets” and exchanges now require not only Know-Your-Customer (KYC) but in order for any type of fiat conversion, bank accounts.  Thus there is a paradox: how can unbanked individuals connect a bank account they do not have to a platform that requires it?  This question is never answered in the book yet it represents the single most difficult aspect to the on-boarding experience today.

Thus contra, Dourado and others, Bitcoinland has recreated all of the same types of intermediaries as the traditional financial world, only with less oversight and immature financial controls.

In terms of “rebittance,” in practice, what ends up happening in these emerging markets is that local residents attempt to cash out into their local currency, irrespective of whatever cryptocurrency funds were originally sent with.14 It is highly recommended that readers peruse analysis below in the notes from Yakov Kofner who studies this at SaveOnSend — looking at actual data such as margins and fees15 And again, maybe this will slightly change through the efforts of Align Commerce, Coins.ph and BitX but it has not yet.

Continuing Dourado writes:

We will finally have a unified global financial system to which everyone will have access. Capital controls will become impossible, or nearly so.

Unlikely via Bitcoin, perhaps through other distributed ledger systems being developed (with mintettes).  The above statement may be the hopes and dreams of many Bitcoin investors, but recall the drama surrounding Coinbase this past February when the leaked pitch deck (pdf)  — which highlighted Bitcoin’s ability to bypass sanctions on Russia — ended up in the hands of regulators.  The head of compliance at Coinbase ended up leaving and the startup was on thin ice (maybe still is?).16

Settlement finality

Another quibble with Dourado’s piece is based on his statement:

So in order to do apples-to-apples comparisons, we might want to examine other systems of final settlement. One such system is cash. Cash of course has some limitations, chief among them that it is not possible to send cash online without an intermediary.

The problem with this is that cash in the real world is given exception to nemo dat and bitcoin is not.  I tried pointing this out to him on Twitter, to which he responded with one word: “Absurd.”  Nemo dat is the legal rule that states that Bob cannot purchase ownership of a possession from Alice if she herself does not have title to the possession.

And it is not absurd.

In fact, as described two months ago, when talking to attorneys such as Amor Sexton, Ryan Straus and George Fogg we learned that one of the problems facing bearer instruments like bitcoin is that many of these virtual assets do not have clean title — that they are encumbered.  What this means is that while the Bitcoin network itself may provide settlement with respect to the transfer of private key credentials, on the edges of the network in the social ‘wet code’ world, the title to these credentials could be non-final.

This means that because of how trusted third parties such as Xapo or Coinbase originally pooled and commingled (e.g., did not segregate) customer deposits, some customers may unknowingly end up with encumbered bitcoins.  Whether anyone litigates on this issue may be a matter of time as Mt. Gox may have practiced the same behavior with pooled deposits.

Ignoring this could impact the bitcoins you may have.  Did you mine the coins yourself or did you buy them through an OTC provider like Charlie Shrem?  There is currently no method of “cleansing” these virtual commodities from previous claims.  Thus, as described earlier in this post, while settlement finality is a potential benefit of distributed ledgers, it probably needs to be integrated within the current custodial framework in order to be effective. 17

Machine to machine

My last quibble regarding Dourado’s piece is where he states:

Direct settlement also means that machine-to-machine transactions will be possible without giving your toaster a line of credit or access to your full bank account. What new inventions will people create when stuff can earn and spend money?

The core innovation around Bitcoin are censorship-resistant cash and its decentralized ledger — thus trying to merge costly pseudonomity with the KYC of a traditional financial system and then innovate on top of that seems like a one step forward and then one step back.

Therefore it makes little sense for why Dourado, Antonis Polemitis, 21inc and others continue to bring up machine-to-machine as if it is the “killer app” for Bitcoin.  What is the need for proof-of-work in these cases?  I briefly looked at this in Appendix B: why can’t prepaid cards be used to pay for the same service?  If parties — or washing machines and toasters — are known, what benefit does this asset provide that cannot be done with other systems?  Why do you need to insert censorship-resistant virtual cash in a transaction that ultimately will need national currency on both sides of the transaction?

Furthermore, even if machine-to-machine transactions somehow did take off and the Bitcoin blockchain was used, it would quickly become bogged down due to block size issues.  For more on this point, it’s worth reviewing the two most recent posts from TradeBlock below in the notes.18


It is unlikely that many early adopters or those who believe static money supplies are a feature, will find any of the discussion above of merit.19  Yet, as Noah Smith pointed out again yesterday, bitcoin’s volatility may need to become “boring” (non-existent) if it ever were to become a viable medium-of-exchange.  However as described above, there are multiple external factors for why this may not occur including the fact that there is no current method to automatically, trustlessly rebase the purchasing power in Bitcoin.

Last fall Robert Sams published a short paper (pdf) proposing one solution, via a “stable coin” — an idea that has subsequently been explored by Ferdinando Ametrano20 and may eventually be emulated in projects like Augur and Spritzle.

Whether or not this feature is adopted by the Bitcoin community remains and open question.  What is probably not an open question is whether volatility will ever disappear for a perfectly inelastic money supply, particularly one without a type of rebasement mechanism.

[Acknowledgements: thanks to Raffael Danielli, Justin Dombrowski, Yakov Kofner and George Samman for their feedback.]

End notes:

  1. See What is the “real” price of bitcoin? and Too Many Bitcoins: Making Sense of Exaggerated Inventory Claims []
  2. I would like to thank Justin Dombrowski for bringing this point to my attention. []
  3. Readers may be interested in Low Volatility and The Shanghai Composite Are Killing Bitcoin by Arthur Hayes.  Note that you can have liquidity from underlying demand as a transactional cryptocurrency, but that does not seem possible to coordinate with a limited, decentralized money supply in the Bitcoin model. []
  4. The Goldman Sachs report used self-reported numbers from the exchanges themselves.  See 80% of bitcoin is exchanged for Chinese yuan from Quartz. []
  5. I would like to thank Justin Dombrowski for this insight. []
  6. See New CoinDesk Report Reveals Who Really Uses Bitcoin as well as the the leaked Coinbase pitch deck (pdf). []
  7. See The flow of funds on the Bitcoin network in 2015 and A gift card economy: breaking down BitPay’s numbers []
  8. See: Consensus-as-a-service as well as No, Bitcoin is not the future of securities settlement by Robert Sams and On the robustness of cryptobonds and crypto settlement by Izabella Kaminska []
  9. See also: Will colored coin extensibility throw a wrench into the automated information security costs of Bitcoin? and Can Bitcoin’s internal economy securely grow relative to its outputs? []
  10. See Too Many Bitcoins: Making Sense of Exaggerated Inventory Claims []
  11. See Daily FX volumes hold above $5 trillion in Feb-CLS from Reuters []
  12. George Samman suggested interested readers look at a presentation he made for Coinsetter last week, starting at slide 93. []
  13. A simple explanation of fees in the payment card industry and Why the payment card system works the way it does – and why Bitcoin isn’t going to replace it any time soon both from Richard Brown []
  14. See The Rise and Rise of Lipservice: Viral Western Union Ad Debunked []
  15. Western Union: permanent leader of international money transfer? and Does Bitcoin make sense for international money transfer? both from Yakov Kofner []
  16. In addition, while an organization like a government may not be able to totally eliminate Bitcoin itself, they could likely severely reduce its use by imposing such absurd punishments that most would fear to use it.  But that is a topic for another post. []
  17. See also: No, Bitcoin is not the future of securities settlement by Robert Sams []
  18. Bitcoin Network Capacity Analysis – Part 3: Miner Incentives and Bitcoin Network Capacity Analysis – Part 4: Simulating Practical Capacity from TradeBlock []
  19. This concept, of static money supplies, is not an unknown idea for central banks.  David Andolfatto, VP at the St. Louis Federal Reserve, pointed this out in his presentation last month. []
  20. Slides and video from Ametrano’s March 2015 presentation []
Send to Kindle