Distributed ledgers, blockchains and Bitcoin in the news

Below are several stories and articles from the past few weeks that either cited one of my papers or where I was quoted:

In a Forbes article today entitled “Five Top VCs Predict The Future” the following claim was made: Traditional banks will keep losing share to startups while bitcoin fades.  Two comments from Bill Gurley of Benchmark Partners and Rebecca Lynn of Canvas Venture Fund were mentioned.  However, given that many of the 5 year predictions cited in the rest of the article sound implausible, it is a bit curious that Bitcoin only made the list in a negative way.

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Book review: Digital Gold

digital goldTwo days ago I had a chance to read through a new book called Digital Gold written by Nathaniel Popper, a journalist at The New York Times.

Popper’s approach to the topic matter is different than other books which cover cryptocurrencies (such as The Age of Cryptocurrency).

This is a character driven story, guided by about a dozen unintentional thespians — key individuals who helped develop and shape the Bitcoin world from its genesis up through at least last summer (when the book effectively tapers off).  Or in other words, it flowed more like a novel than an academic textbook exegesis on the tech.

Below are some of the highlights and comments that came to mind while reading it.

Terminology

I mentioned that in The Age of Cryptocurrency the authors preferred to use the term “digital currency” over “virtual currency.”  I lost count of the dozens of times they used the former, but the latter was only used ~12 times (plus or minus one or two).  I think from a legalese perspective it is more accurate to use the phrase “virtual currency” (see my review as to why).

While I tried to keep track of things more closely in Popper’s book, I may have missed one or two.  Interestingly the index in the back uses the term “virtual money” (not currency) and the “digital currency” section is related to specific types.  Below is my manual tabulation:

  • digital cash, p. 110
  • digital commodity (as categorized by the Chinese government), p. 274
  • digital code, p. 158
  • digital wallet, p. 159, 160, 179, 262 (likely many more during discussions of Lemon)
  • digital currency, p.67, 146 (Facebook credits), 260 (Q coin), 261 (Q coin),
  • digital money, p. 139, 339
  • blockchain, p. 164, 181, 186, 193, 194 (2x), 203, 235, 238 (2x), 250, 289, 295, 326 (2x), 327 (2x), 328 (14x), 336, 345
  • virtual currency (sometimes with a hyphen), p. 126, 139, 142, 144, 145, 146, 156, 174, 179, 180, 181, 186 (2x), 187 (2x), 196 (4x), 197, 198, 204 (2x), 209, 210, 216, 217, 219 (3x), 225, 234, 236,  250, 252 (2x), 256, 257, 259, 267, 268 (2x), 269 (2x), 273, 274, 280 (2x), 289, 295 (2x), 300 (3x), 302 (2x), 303 (2x). 325 (2x), 343, 349
  • tokens, p. 139
  • digital money p. 4, p. 252, 257
  • cryptocurrency, p. 36 (2x), 186, 251, 261, 286 (2x), 325, 334, 341

In the beginning

[Note: I manually typed the quotes from the book, all transcription errors are my own and should not reflect on the book itself.]

On page 38 he writes about pricing a bitcoin, “Given that no one had ever bought or sold one, NewLibertyStandard came up with his own method for determining its value — the rough cost of electricity needed to generate a coin, calculated using NewLibertyStandard’s own electricity bill.”

I have heard this story several times, NLS’s way of pricing a good/service is the 21st century continuation of the Labor Theory of Value.  And this is not a particularly effective pricing mechanism: art is not worth the sum of its inputs (oils, canvas, frame, brushes).  Rather the value of art, like bitcoins, is based on consumer (and speculative) demand.1

Thus when people at conferences or on reddit say that “bitcoin is valuable because the network is valuable” — this is backwards.  The Bitcoin network (and bitcoins) is not valuable because the energy used to create proofs, rather it is the aggregate demand from buyers that increases (or decreases) relative to the supply of bitcoin, which is reflected in prices and therefore miners adjust consumption of energy to chase the corresponding rents (seigniorage).

On page 42 he writes, “Laszlo’s CPU had been winning, at most, one block of 50 bitcoins each day, of the approximately 140 blocks that were released daily. Once Laszlo got his GPU card hooked in he began winning one or two blocks an hour, and occasionally more. On May 17 he won twenty-eight blocks; these wins gave him fourteen hundred new coins that day.”

That translates to roughly 20% of the network hashrate.

Having noted this, the author writes:

I don’t mean to sound like a socialist,” Satoshi wrote back. “I don’t care if wealth is concentrated, but for now, we get more growth by giving that money to 100% of the people than giving it to 20%.

As a result, Satoshi asked Laszlo to go easy with the “high-powered hashing,” the term coined to refer to the process of plugging an input into a hash function and seeing what it spit out.

It’s unclear how many bitcoins Laszlo generated altogether (he was also mentioned in The Age of Cryptocurrency), but he apparently did “stock pile” at least 70,000 bitcoins whereupon he offered 10,000 bitcoins at a time buy pizzas. (Update: this address allegedly belongs to Laszlo and received 81,432 bitcoins; see Popper’s new letter on reddit)

Thus, there was at least one GPU on the network in May 2010 (though it appears he turned it off at some point).  For comparison, on page 189, Popper states that “By the end of 2012 there was the equivalent of about 11,000 GPUs working away on the network.”

Later in the book, on page 191, Popper described the growth in hashrate in early 2013:

Over the next month and a half, as the rest of Avalon’s first batch of three hundred mining computers reached customers, the effect was evident on the charts that tracked the power of the entire Bitcoin network. It had taken all of 2012 for the power on the network to double, but that power doubled again in just one month after Yifu’s machines were shipped.

It’s worth re-reading the Motherboard feature on Yifu Guo, the young Chinese man who led the Avalon team’s effort on building the first commercially available ASIC.

What does this increase look like?

hash-predict

Source: Dave Hudson

Above is a chart published just over a year ago (April 28, 2014) from Dave Hudson.  It’s the only bonafide S-curve in all of Bitcoinland (so far).

In Hudson’s words, “The vertical axis is logarithmic and clearly shows how the hashing rate will slow down over the next two years. What’s somewhat interesting is that whether the BTC price remains the same, doubles or quadruples over that time the effect is still pronounced. The hashing rate continues to grow, but slows dramatically. What’s also important to reiterate is that these represent the highest hashing rates that can be achieved; when other overheads and profits are taken then the growth rate will be lower and flatter.”

Popper noted that this type of scaling also resulted in centralization:

Most of the new coins being released each day were collected by a few large mining syndicates. If this was the new world, it didn’t seem all that different from the old one — at least not yet. (page 336)

Moving on, on page 192, Popper writes:

The pools, though, generated concern about the creeping centralization of control in the network. It took the agreement of 5 percent of the computer power on the network to make changes to the blockchain and the Bitcoin protocol, making it hard for the one person to dictate what happened. But with the mining pools, the person running the pool generally had voting power for the entire pool — all the other computers were just worker bees. (page 192)

I think there is a typo here.  He probably meant 51% of the hashrate, not 5%.  Also, it may be more precise to say “actor” because in practice it is individuals at organizations that operate the farms and pools, not usually just one person.

On page 52 the author discussed the earliest days of Mt. Gox in 2010:

Mt. Gox was a significant departure from the exchange that already existed, primarily because Jed offered to take money from customers into his PayPal account and thereby risk violating the PayPal prohibition on buying and selling currencies.  This meant that Jed could receive funds from almost anywhere in the world.  What’s more, customers didn’t have to send Jed money each time they wanted to do a trade. Instead, they could hold money — both dollars and Bitcoin — in Jed’s account and then trade in either direction at any time as long as they had sufficient funds, much as in a traditional brokerage account.

Needless to say, Jed’s PayPal account eventually got shut down.

On page 65 the author briefly discusses the life of Mark Karpeles (the 2nd owner of Mt. Gox):

Since then, he’d had a peripatetic lifestyle, looking for a place where he could feel at home. He first tried Israel, thinking it might help him get closer to his Catholicism, but he soon felt as lonely as ever, and the servers he was running kept getting disrupted by rocket fire from Gaza.

Initially I thought Popper meant to write Judaism instead of Catholicism (Karpeles is a Jewish surname), but a DailyTech article states he is Catholic based on one of his blog posts.

On page 67 he writes:

But as the headaches continued to pile up, Jed got more antsy. In January, a Mt. Gox user named Baron managed to hack into Mt. Gox accounts and steal around $45,000 worth of Bitcoins and another type of digital currency that Jed had been using to transfer money around.

It’s not clear what the the other digital currency actually was — based on the timeline (January 2011) this is before Jed created XRP for OpenCoin (which later became Ripple Labs).

Also, I believe this is the first time in the book where the term “digital currency” is used.

On page 77 he writes about Roger Ver:

In the midst of his campaign for the assembly, federal agents arrested Roger for peddling Pest Control Report 2000 — a mix between a firecracker and a pest repellent — on eBay.  Roger had bought the product himself through the mail and he and his lawyer became convinced that the government was targeting Roger because of remarks he had made at a political rally, where had had called federal agents murderers.

This version of the story may or may not be true.

Either way, part of Ver’s 2002 case was unsealed last fall and someone sent me a copy of it (you can find the full version at PACER).  Below are a few quotes from the document (pdf) hosted at Lesperance & Associates between the prosecution (Mr. Frewing) and the judge presiding over the case.

“Mr. Ver’s conduct was serious.  I think one factor that the Court can take into consideration or at least should consider is there were some pipe bombs involved in this case as well that were not charged and are not incorporated in the conduct that’s before the Court except arguably as relevant conduct. The split sentence is — would result only in five months incarceration for what I think is a fairly serious offense.  It’s my recommendation to do the ten-month sentence in prison in total.”

[…]

Judge: “Well, I’ve given this case a lot of thought. I’m very troubled by it.  And when I say that I’m troubled by it I’m troubled by it in several ways.  Not only am I troubled by the underlying conduct, which is quite serious, but I don’t want to overreact either and I think that’s what makes it hard.I think if you have a case which strikes you as being particularly severe, in a way that’s kind of an easy thing to just say all right, we’ll throw the book at the defendant and that will satisfy that impulse.”

“But I don’t think judges ought to sentence anybody impulsively.  You have to look at the offense and you have to look at the person who committed it. There are elements in the probation report and in Dr. Missett’s report which concern me a great deal.  One has to be very careful.  Mr. Ver, you’re a young man and you’ve led a law-abiding life for the last two years and you’ve by all accounts performed well on pretrial release.  I did note in your letter that you accepted that your conduct was illegal, and I appreciate that. I also don’t in any way want to confuse your political beliefs, which you are absolutely entitled to have, with your criminal conduct.  There’s a long and honorable tradition of libertarian politics in our country and I don’t mean to in any way hold that against you.  It’s something that you’re entitled to have. The problem, though, is that the law is a representation of authority in a certain way.  People can disagree and they can disagree very vigorously and very reasonably about what ought to be legal and what ought not to be legal and how much the Government ought  to do or ought not to do.   But there is a point at which we start talking about public safety and I think even the most die hard libertarian would agree that one function of government, if there is to be a government, is to protect public safety.  So then it’s just a question of how you do it, how you do it in a way that’s least invasive of individual liberties.   Selling explosives over the Internet doesn’t cut it in any society that I can imagine and I think it’s — the conduct here is simply not tolerable conduct and it’s not — I don’t think one has to be a big government person or believe in government regulation of every aspect of human life to suggest that people should not be selling explosives over the Internet. The other thing that concerns me is that in looking at your social history it seems to me you’ve got some reasons for not trusting authority, and that’s.  I mean, those are feelings that are a product of your life experience.  Nonetheless, those feelings don’t give you the right to be above the same social constraints that bind all of us.”

“And I’m not saying this as well as I’d like to, but I think there’s a difference between saying I believe that the government which governs best governs least and saying that I’m above the law totally, that I’m so smart, I’m so able, I’m so perceptive that I don’t have to follow the rules that apply to other human beings.  There’s a difference between those two positions.  And while one of them is a very respectable position that I think any judge ought to uphold and support rather than punish, the other I think is why we have courts.  It’s when a person believes that he or she is so important and so intelligent and so much better than everybody else that they don’t have to follow even the most basic rules that keep us together in this society.”

“I think that these offenses are very serious.  They could have been a lot more serious.  The bombs could have gone off or people could have used them in destructive ways.  Selling bombs to juveniles is never okay.  I’d like to say that the five and five sentence that your attorney proposed is something that I’m comfortable with, but I just can’t.  And it’s not a desire to be overly punitive or to send you a message.  It’s simply saying that this conduct — when the law punishes behavior, criminal law is directed at conduct.  This conduct to me would have warranted a much stiffer sentence than ten months.  There’s a plea  agreement.  I’m bound by it.  I’m not going to upset it.  It was arrived at in good faith by the Government and by the defense and I will respect it, but I’m not going to dilute it.”

This will probably not be the last time the background and origin story of the characters in this journey are looked at.

Whales

bearwhale

Source: Billy Mabrey

On social media there is frequent talk of large “whales” and “bear whales” that are blamed for large up and down swings in prices.

Popper identified a few of them in the book.

For instance, on page 79 he writes about Roger Ver’s initial purchases:

In April 2011, after hearing about Bitcoin on Free Talk Live, he used his fortune to dive into Bitcoin with a savage ferocity. He sent a $25,000 wire to the Mt. Gox bank account in New York — one Jed had set up — to begin buying Bitcoins. Over the next three days, Roger’s purchases dominated the markets and helped push the price of a single coin up nearly 75 percent, from $1.89 to $3.30.

Another instance, on page 113:

But the people ignoring Jed’s advice ended up giving Bitcoin momentum at a time when it was otherwise lacking. Roger alone bought tens of thousands of coins in 2011, when the price was falling, single-handedly helping to keep the price above zero (and establishing the foundation for a future fortune).

Over the past year I have frequently been asked: why did the price begin increasing after the block reward halving at the end of November 2012?  Where did the price increase come from?

A number of people, particularly on reddit, conflate causation with correlation: that somehow the block halving caused a price increase.   As previously explored, this is incorrect.

So if it wasn’t the halvening, what then led to the price increase?

In January 2013, Popper looked at the Winklevoss twins:

The twins considered selling to Roger. But they also believed BitInstant was a good idea that could work under the right management. In January BitInstant had its best month ever, processing almost $5million in transactions. The price of a Bitcoin, meanwhile, had risen from $13 at the beginning of the month to around $18 at its end. Some of this was due to the twins themselves. They had asked Charlie to continue buying them coins with the goal of owning 1 percent of all Bitcoins in the world, or some $2 million worth at the time. This ambition underscored their commitment to sticking it out with Bitcoin. (page 175)

Simultaneously, another group of wealthy individuals, from Fortress Investment Group were purchasing bitcoins:

Pete assigned Tanona to the almost full-time job of exploring potential Bitcoin investments, and also drew in another top Fortress official, Mike Novogratz. All of them began buying coins in quantities that were small for them, but that represented significant upward pressure within the still immature Bitcoin ecosystem.

The purchases being made by Fortress — and by Mickey’s team at Ribbit — were supplemented by those being made by the Winklevoss twins, who were still trying to buy up 1 percent of all the outstanding Bitcoins. Together, these purchases helped maintain the sharp upward trajectory of Bitcoin’s price, which rose 70 percent in February after the 50 percent jump in January. On the evening of February 27 the price finally edged above the long-standing record of $32 that had been set in the hysterical days before the June 2011 crash at Mt. Gox. (p. 180)

Initially discussed introduction, Popper explains when Wences first met Pete Briger (p. 163, from Fortress Investment Group) during a January 2013 lodge in the Canadian Rockies.

A few pages later, in early March 2013, Wences is invited to a private retreat held at the Ritz Carlton in Tucson, Arizona hosted by Allen & Co.  There he met with and explained Bitcoin to: Dick Costolo, Reid Hoffman, James Murdoch, Marc Andreessen, Chris Dixon, David Marcus, John Donahoe, Henry Blodget, Michael Ovitz and Charlie Songhurst.

During this conference it appears several of these affluent individuals began buying bitcoins:

On Monday, the first full day of the conference, the price of Bitcoin jumped by more than two dollars, to $36, and on Tuesday it rose by more than four dollars — its sharpest rise in months — to over $40. On Wednesday, when everyone flew home, Blodget put up a glowing item on his heavily read website, Business Insider, mentioning what he’d witnessed (though not specifying where exactly he’d been, or whom he’d talked to)” (page 184)

The Henry Blodget article in question appeared on March 6: Suddenly, Everyone’s Talking About Bitcoin…

Why were they talking about it?

To prove how easy this all was, Wences asked Blodget to take out his phone and helped him create an empty Bitcoin wallet. Once it was up, and Wences had Blodget’s new Bitcoin address, Wences used the wallet on his own phone to send Blodget $250,000, or some 6,400 Bitcoins. The money was then passed to the phones of other people around the table once they had set up wallets. Anyone could have run off with Wence’s $250,000, but that wasn’t a risk with this particular crowd. Instead, as the money went around, Wences saw the guests’ laughter and wide-eyed amazement at what they were watching. (page 183)

It would be interesting to do some blockchain forensics (such as Total Output Volume and Bitcoin Days Destroyed) to see if we can identify a blob of 6,400 bitcoins moving around on March 3-5 maybe five to ten different times (it is unclear from the story how many people it was sent to).

And finally a little more whale action to round out the month:

The prices certainly suggested certainly suggested that someone with lots of money was buying. In California, Wences Casares knew that no small part of the new demand was coming from the millionaires whom he had gotten excited about Bitcoin earlier in the month and who were now getting their accounts opened and buying significant quantities of the virtual currency. They helped push the price to over $90 in the last week of March. At that price, the value of all existing coins, what was referred to as the market capitalization, was nearing $1 billion. (page 198)

The following month, in April,  during the run-up on Mt. Gox which later stalled and crashed under the strain of traffic:

The day after the crash, the Winklevoss twins finally went public in the New York Times with their now significant stake in Bitcoin — worth some $10 million. (page 211)

[…]

The twins didn’t want to buy coins while the price was still dropping, but when they saw it begin to stabilize, Cameron, who had done most fo the trading, began placing $100,000 orders on Bitstamp, the Slovenian Bitcoin exchange. Cameron compared the moment to a brief time warp that allowed them to go back and buy at a a lower price. They had almost $1 million in cash sitting with Bitstamp for exactly this sort of situation, and Cameron now intended to use it all.” (page 251)

Prices were around $110 – $130 each so they may have picked up an additional ~9,000 bitcoins or so.

Interestingly enough, Popper wrote the same New York Times article (cited above) that discussed the Winklevoss holdings.  In the same article he also noted another active large buyer during the same month:

A Maltese company, Exante, started a hedge fund that the company says has bought up about 82,000 bitcoins — or about $10 million as of Thursday — with money from wealthy investors. A founder of the fund, Anatoli Knyazev, said his main concern was hackers and government regulators, who have so far mostly left the currency alone.

The tl;dr of this information is that between January through March 2013, at least a dozen or so high-net-worth individuals collectively bought tens of millions of dollars worth of bitcoin.  The demand of which resulted in a rapid increase in market prices.  This had nothing to do with the block reward halving, just a coincidence.

Bigwigs

Interwoven amount the story line are examples illustrating the trials and tribulations of securing bearer assets with new financial institutions that lack clear (if any) financial controls including Bitomat (which lost 17,000 bitcoins) and MyBitcoin (at least 25,000 bitcoins were stolen from).

It also discussed some internal dialogue at both Google and Microsoft.

According to Popper, Google, WellsFargo, PayPal, Microsoft all had high level individuals and teams looking at Bitcoin in early 2013.  On page 101, Osama Abedier from Google, spoke with Mike Hearn and said, “I would never admit it outside this room, but this is how payments probably should work.”

Popper cites a paper that Charlie Songhurst, head of corporate strategy at Microsoft, wrote after the Ritz Carlton event, channeling Casares’s arguments:

“We foresee a real possibility that all currencies go digital, and competition eliminates all currencies from noneffective governments. The power of friction-free transactions over the Internet will unleash the typical forces of consolidation and globalization, and we will end up with six digital currencies: US Dollar, euro, Yen, Pound, Renminbi and Bitcoin.”

Some politics:

I didn’t keep track of the phrase “digital gold” but I believe it only appeared twice.  Unsurprisingly, this phrase came about via some of the ideological characters he looked at.

In Wences’ view:

 “Unlike gold, it could be easily and quickly transferred anywhere in the world, while still having the qualities of divisibility and verifiability that had made gold a successful currency for so many years.” (Page 109)

[…]

Unlike gold, which was universal but difficult to acquire and hold, Bitcoins could be bought, held, and transferred by anyone with an internet connection, with the click of a mouse.

“Bitcoin is the first time in five thousands years that we have something better than gold, ” he said. “And its not a little bit better, it’s significantly better. It’s much more scarce. More divisible, more durable. It’s much more transportable. It’s just simply better.”  (p. 165)

The specific trade-offs between precious metals and cryptocurrencies is not fully fleshed out, but that probably would have detracted from the overall narrative.  Of maybe not.

Meet and greet:

“The Bitcoin forum was full of people talking about their experiences visiting Zuccotti Park and other Occupy encampments around the country to advertise the role that a decentralized currency could play in bringing down the banks.” (p. 111)

Who isn’t meddling?

“Few things occupied the common ground of this new political territory better than Bitcoin, which put power in the hands of the people using the technology, potentially obviating overpaid executives and meddling bureaucrats.” (p. 112)

I thought that was a tad distracting, it’s never really discussed what “overpaid” or “meddling” are.  Perhaps if there is a second edition, in addition to clarifying those we can have a chance to look at some of the sock puppets that a variety of these characters may have been operating too.

Public goods problem:

Many libertarians and anarchists argued that the good in humans, or in the market, could do the job of regulators, ensuring that bad companies did not survive. But the Bitcoin experience suggested that the penalties meted out by the market are often imposed only after the bad deeds were done and do not serve as a deterrent. (p. 114)

That last quote reminded me of an interview with Bitcoin Magazine last year with Vinay Gupta: ‘Bitcoin is Teaching Realism to Libertarians’

About Argentina:

“You don’t have to battling all of the government’s problems, you aren’t going to buy bread with it, but it’ll save you if you have a stash of stable currency that tends to appreciate in value,” twenty-two-year-old Emmanuel Ortiz told the newspaper (page 241)

There is no real discussion between the trade-offs of rebasing a currency to maintain purchasing power and its unclear why Ortiz thinks that an asset that fluctuates 10% or more each month is considered stable.

Practicality

It’s unclear how many of the salacious stories were left on the cutting board, but there is always Brian Eha’s upcoming book.

In the meantime, avoiding the Product Trap:

It turned out that Charlie’s willingness to throw things at the wall, to see if they would stick, was not a bad thing at this point. The idealists who had been driving the Bitcoin world often got caught up in what they wanted the world to look like, rather than figuring out how to provide the world with something it would want. (page 129)

Hacking for fun and profit.  How secure is the code?  On page 154:

After quietly watching and playing with it for some time, Wences gave $100,000 of his own money to two high-level hackers he knew in eastern Europe and asked them to do their best to hack the Bitcoin protocol.  He was especially curious about whether they could counterfeit Bitcoins or spend the coins held in other people’s wallets — the most damaging possible flaw. At the end of the summer, the hackers asked Wences for more time and money. Wences ended up giving them $150,000 more, sent in Bitcoins. In October they concluded that the basic Bitcoin protocol was unbreakable, even if some of the big companies holding Bitcoins were not.

I’m sure we would all like to see more of the study, especially Tony Arcieri who wrote a lengthy essay a couple days ago on some potential issues with cryptographic curves/methods used in Bitcoin.

A little irony on page 162:

For Wences, Bitcoin seemed to address many of the problems that he’d long wanted to solve, providing a financial account that could be opened anywhere, by anyone, without requiring permission from any authority. He also saw an infant technology that he believed he could help grow to dimensions greater than anything he had previously achieved.

Permissionless systems seems to be everyone’s goal, yet everyone keeps making trusted third parties which inevitably need to VC funding to scale and with it, regulatory compliance which then creates a gated, permission-based process.

Altruism on the part of BTC Guild during the fork/non-fork issue in March 2013:

The developers on the chat channel thanks him, recognizing that he was sacrificing for the greater good. When he finally had everything moved about an hour later, Eleuthria took stock on his own costs  (page 195)

Trusted trustlessness?

 “The network had not had to rely on some central authority to wake up to the problem and come up with a solution. Everyone online had been able to respond in real time, as was supposed to happen with open source software, and the user had settled on a response after a debate that tapped the knowledge of all of them — even when it meant going against the recommendation of the lead developer, Gavin.” (page 195)

Origins of Xapo:

They started by putting all their private keys on a laptop, with no connection to the Internet, thus cutting off access for potential hackers. After David Marcus, Pete Briger, and Micky Malka put their private keys on the same offline laptop, the men paid for a safe-deposit box in a bank to store the computer more securely. In case the computer gave out, they also put a USB drive with all the private keys in the safe-deposit box. (page 201)

[…]

First, they encrypted all the information on the laptop so that if someone got hold of the laptop that person still wouldn’t be able to get the secret keys. They put the keys for decrypting the laptop in a bank near Feede in Buenos Aires. Then they moved the laptop from a safe-deposit box to a secure data center in Kansas City. By this time, the laptop was holding the coins of Wences, Fede, David Marcus, Pete Briger, and several other friends. The private keys on the laptop were worth tens of millions of dollars. (page 281)

I heard a similar story regarding the origins of BitGo, that Mike Belshe used to walk around with a USB drive on his key chain that had privkey’s to certain individual accounts.  This is before the large upsurge in market value.  When the prices began to rise he realized he needed a better solution.  Perhaps this story is more apocryphal than real, but I suspect there have been others whose operational security was not the equivalent of Fort Knox prior to 2013.

Alex Waters

An unnamed Alex Waters appears twice:

“The new lead developer called for the entire site to be taken down and rebuilt. But there wasn’t time as a new customers were pouring money into the site. The new staff members were jammed into every corner of the small offices Charlie and Erik had moved into the previous summer.” (page 202)

And again:

“But as problems became more evident, they talked with Charlie’s chief programmer about replacing Charlie as CEO. When Charlie learned about the potential palace coup he was furious and began showing up for work less and less.” (page 221)

For those unfamiliar with Alex, he was the CTO of BitInstant who went on to co-found CoinValidation and then currently, Coin.co & Coinapex.

Last week I had a chance to meet with him in NYC.

alex waters

Alex Waters (CEO Coin.co), Sarah Tyre (COO Coin.co), Isaac Bergman, myself

Yesterday I reached out to Alex about the two quotes above related to BitInstant and this is what he sent (quoted with permission):

“It was sad to see Bitinstant take such a drastic turn after the San Jose conference. It was as if we built a gold mine and couldn’t stop someone from taking dynamite into it. A lot of good people worked at Bitinstant (like 25 people) and the 2.0 product we wanted to launch was outstanding. It’s frustrating that some poor decisions early in the company’s history put pressure on such an important moment. A lot of us who worked there worked really hard with sleepless nights for months on a relaunch that never made it to the public. Those people didn’t list Bitinstant on their resume after the collapse as it was so clearly tainted. The quality of those people’s work was outstanding, and they had no part or knowledge of anything illegal. Our compliance standards were beyond reproach for the industry.”

Coinbase compliance

Just two months ago Coinbase was in the news due to some issues with their pitch deck (pdf) as it related to marketing Bitcoin as a method for bypassing country specific sanctions.

However two years ago they ran into a slightly different issue:

In order to stay on top of anti-money laundering laws, the bank had to review every single transaction, and these reviews cost the bank more money than Coinbase was brining in. The bank imposed more restrictions on Coinbase than on other customers because Bitcoin inherently made it easier to launder money. (page 203)

[…]

Coinbase had to repeatedly convince Silicon Valley Bank that it knew where the Bitcoins leaving Coinbase were going.  Even with all these steps, on several days in March Coinbase hit up against transaction limits set by Silicon Valley Bank and had to shut down until the next day. (page 204)

Not quite accurate

In looking at my notes in the margin I didn’t find many inaccuracies.  Two small ones that stood out:

In early December Roger used some of his Bitcoin holdings, which had gone up in value thousands of times, to make a $1 million donation to the Electronic Frontier Foundation, an organization that had been started by a former Cypherpunk to defend online privacy, among other things. (page 270)

Actually, Ver donated $1 million worth of bitcoins to FEE, the Foundation for Economic Education not EFF.

But over time the two Vals kept more and more of the computers for themselves and put them in data centers spread around the world, in places that offered cheap energy, including the Republic of Georgia and Iceland. These operations were literally minting money. Val Nebesny was so valuable that Bitfury did not disclose where he lived, though he was rumored to have moved from Ukraine to Spain. And Bitfury was so good that it soon threatened to represent more than 50 percent of the total mining power in the world; this would give it commanding power over the functioning of the network. The company managed to assuage concerns, somewhat, only when it promised never to go above 40 percent of the mining power online at any time. Bitfury, of course, had an interest in doing this because if people lost faith in the network, the Bitcoins being mind by the company would become worthless. (page 330)

While the two Val’s did create Bitfury, I am fairly certain the scenario that is described above is that of the GHash.io mining pool (managed by CEX.io) during the early summer of 2014.  At one point in mid-June 2014, the GHash pool was regularly winning 40% or more of the blocks on several days.  Subsequently the CIO attempted to assuage concerns by stating they will make sure their own pool doesn’t go above a self-imposed threshold of 40%.

Probably overhyped:

I spent some time discussing this use-case in the previous review:

On Patrcik Murck: “But he was able to cogently explain his vision of how the blockchain technology could make it easier for poor immigrants to transfer money back home and allow people with no access to a bank account or credit card to take part in the Internet economy.” (page 235)

I think Yakov Kofner’s piece last month outlines the difficult challenges facing “rebittance” companies many of whom are ignoring the long term customer acquisition and compliance costs (not to mention the cash-in/cash-out hurdles).2 That’s not to say they will not be overcome, but it is probably not the slam dunk that Bitprophets claim it is.

The notion that Bitcoin could provide a new payment network was not terribly new. This is what Charlie Shrem had been talking about back in 2012, and BitPay was already using the network to charge lower transaction fees than the credit card networks.” (page 272)

Temporarily.  The problem is, after all the glitzy free PR splash in 2014, there was almost no real uptake.  So the sales and business development teams at payment processors now have a difficult time showing actual traction to future clients so that they too will begin using the payment processors.  See for instance, BitPay’s numbers.

For example, on page 352 the author notes that:

It might have just been the exhaustion, but Wences was sourly dismissive of all the talk about Bitcoin’s potential as a new payment system. He was an investor in Bitpay but he said that fewer than one hundred thousand individuals had actually purchased anything using Bitpay.

“There is no payment volume, ” he scoffed. “It’s a sideshow.”

Payments again:

“But in interviews he emphasized the more practical reasons for any company to make the move: no more paying the credit card companies 2.5 percent for each transaction (the company helping Overstock take Bitcoin, Coinbase, charged Overstock 1 percent)…”

“This was attractive to merchants because BitPay charged around 1 percent for its service while credit card networks generally charged between 2 and 3 percent per transaction.” p. 134

While I have no inside knowledge of their specific arrangement, I believe the promotional pitch is 0% for the first $1 million processed and 1% thereafter.  Overstock processed about $3 million last year.  And the BitPay fee appears to be unsustainable (see my previous book review on The Age of Cryptocurrency as well as the BitPay number’s breakdown).

Probably not true:

The potential advantages of Bitcoin over the existing system were underscored in late December, when it was revealed that hackers had breached the payment systems of the retail giant Target and made off with the credit card information of some 70 million Americans, from every bank and credit card issuer in the country. This brought attention to an issue that Bitcoiners had long been talking about: the relative lack of privacy afforded by traditional payment systems. When Target customers swiped their credit cards at a register, they handed over their account number and expiration date. For online purchases Target also had to gather the addresses and ZIP codes of customers, to verify transactions. If the customers had been using Bitcoin, they could have sent along their payments without giving Target any personal information at all. (page 289)

In theory, yes, if users control their own privkey on their own devices.  In practice, since most users use trusted third parties like Coinbase, Xapo and Circe, a hacker could potentially retrieve the same personal information from them; furthermore, because some merchants collect and require KYC then they are also vulnerable to identity theft.

For instance,

What’s more, Coinbase customers didn’t have to download the somewhat complicated Bitcoin software and thew hole blockchain, with its history of all bitcoin transactions. This helped turn Coinbase into the go-to-company for Americans looking to acquire Bitcoins and helped expand the audience for the technology. (page 237)

That’s a silo-coin.  Useful and helpful to on-ramping people.  But effectively a bank in practice.  Why not just use a real bank instead?

The more you know:

  • I thought the short explanation of hashcash on page 18 was good.
  • Was a little surprised that Eric Hughes was mentioned, but not Tim May.
  • On page 296, Xapo raised $40 million at a $100 million valuation in less than a couple months and on page 306, was banked by Silicon Valley Bank (which Coinbase also uses).
  • The Dread Pirate Roberts / Silk Road storyline that Popper discusses is upstaged by recent events that did not have a chance to make it into the book.  This includes the arrest of a DEA agent and Secret Service agent who previously worked on the Silk Road case for their respective agencies.
  • In addition, ArsTechnica recently published an interesting op-ed on the whole trial: Silk Road film unintentionally shows what’s wrong with the “Free Ross” crowd.

On Roger Ver potentially selling his stake in Blockchain.info:

“Roger was constantly getting entreaties from venture capitalists who wanted to pay millions for some of his 80 percent stake in the company. “(p. 330)

In October 2014, after the book was completed, Blockchain.info announced that it had closed a $30.5 million round, half of which was raised in bitcoins.

Germane citation:

An academic study in 2013 had found that 45 percent of the Bitcoin exchanges that had taken money had gone under, several taking the money of their customers with them (page 317)

The citation comes from an interesting paper, Beware the Middleman: Empirical Analysis of Bitcoin-Exchange Risk by Tyler Moore and Nicolas Christin

Federated blockchain:

This JPMorgan group began secretly working with the other major banks in the country, all of which are part of an organization known as The Clearing House, on a bold experimental effort to create a new blockchain that would be jointly run by the computers of the largest banks and serve as the backbone for a new, instant payment system that might replace Visa, MasterCard, and wire transfers. Such a blockchain would not need to rely on the anonymous miners powering the Bitcoin blockchain. But it could ensure there would no longer be a single point of failure in the payment network. If Visa’s system came under attack, all the stores using Visa were screwed. But if one bank maintaining a blockchain came under attack, all the other banks could keep the blockchain going.

While the The Clearing House is not secretive, the project to create an experimental blockchain was; this is the first I had heard of it.

Concluding remarks:

I had a chance to meet Nathaniel Popper about 14 months ago during the final day of Coinsummit.  We chatted a bit about what was happening in China and potential angles for how and why the mainland mattered to the overall Bitcoin narrative.

There is only so much you can include in a book and if I had my druthers I would have liked to add perhaps some more on the immediate history pre-Bitcoin: projects such as the now-defunct Liberty Reserve (which BitInstant was allegedly laundering money for) and the various dark net markets and online poker sites that were shut down prior to the creation of Bitcoin yet whose customer base would go on to eventually adopt the cryptocurrency for payments and bets (making up some of the clientele for SatoshiDice and other Bitcoin casinos).

Similarly, I would have liked to have looked at a few of the early civil lawsuits in which some of the early adopters were part of.  For instance, the Bitcoinica lawsuit is believed to be the first Bitcoin-related lawsuit (filed in August 2012) and includes several names that appeared throughout the book: plaintiffs: Brian Cartmell, Jed McCaleb, Jesse Powell and Roger Ver; defendants: Donald Norman, Patrick Strateman and Amir Taaki.  The near collapse of the Bitcoin Foundation and many of its founders would make an interesting tale in a second edition, particularly Peter Vessenes (former chairman of the board) whose ill-fated Coinlab and now-bankrupt Alydian mining project are worth closer inspection.

Overall I think this was an easy, enjoyable read.  I learned a number of new things (especially related to the amount of large purchases in early 2013) and think its worth looking at irrespective of your interest in internet fun bux.

End notes:

  1. See What is the “real” price of bitcoin? []
  2. See also: The Rise and Rise of Lipservice: Viral Western Union Ad Debunked []
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Book review: The Age of Cryptocurrency

age of cryptocurrencyOn my trip to Singapore two weeks ago I read through a new book The Age of Cryptocurrency, written by Michael Casey and Paul Vigna — two journalists with The Wall Street Journal.

Let’s start with the good.  I think Chapter 2 is probably the best chapter in the book and the information mid-chapter is some of the best historical look on the topic of previous electronic currency initiatives.  I also think their writing style is quite good.  Sentences and ideas flow without any sharp disconnects.  They also have a number of endnotes in the back for in-depth reading on certain sub-topics.

In this review I look at each chapter and provide some counterpoints to a number of the claims made.

Introduction:

[Note: I manually typed the quotes from the book, all transcription errors are my own and should not reflect on the book itself.]

The book starts by discussing a company now called bitLanders which pays content creators in bitcoin.  The authors introduce us to Francesco Rulli who pays his bloggers in bitcoin and tries to forbid them from cashing out in fiat, so that they create a circular flow of income.1 One blogger they focus on is Parisa Ahmadi, a young Afghani woman who lacks access to the payment channels and platforms that we take for granted.  It is a nice feel good story that hits all the high notes.

Unfortunately the experience that individuals like Ahmadi, are not fully reflective of what takes place in practice (and this is not the fault of bitLanders).  For instance, the authors state on p. 2 that: “Bitcoins are stored in digital bank accounts or “wallets” that can be set up at home by anyone with Internet access.  There is no trip to the bank to set up an account, no need for documentation or proof that you’re a man.”

This is untrue in practice.  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.

Starting on page 3, the authors use the term “digital currency” to refer to bitcoins, a practice done throughout the remainder of the book.  This contrasts with the term “virtual currency” which they only use 12 times — 11 of which are quotes from regulators.  The sole time “virtual currency” is not used by a regulator to describe bitcoins is from David Larimer from Invictus (Bitshares).  It is unclear if this was an oversight.

Is there a difference between a “digital currency” and “virtual currency”?  Yes.  And I have made the same mistake before.

Cryptocurrencies such as bitcoin are not digital currencies.  Digital currencies are legal tender, as of this writing, bitcoins are not.  This may seem like splitting hairs but the reason regulators use the term “virtual currency” still in 2015 is because no jurisdiction recognizes bitcoins as legal tender.  In contrast, there are already dozens of digital currencies — nearly every dollar that is spent on any given day in the US is electronic and digital and has been for over a decade.  This issue also runs into the discussion on nemo dat described a couple weeks ago.

On page 4 the authors very briefly describe the origination of currency exchange which dates back to the Medici family during the Florentine Renaissance.  Yet not once in the book is the term “bearer asset” mentioned.  Cryptocurrencies such as bitcoin are virtual bearer instruments and as shown in practice, a mega pain to safely secure.  500 years ago bearer assets were also just as difficult to secure and consequently individuals outsourced the security of it to what we now call banks.  And this same behavior has once again occurred as large quantities — perhaps the majority — of bitcoins now are stored in trusted third party depositories such as Coinbase and Xapo.

Why is this important?

Again recall that the term “trusted third party” was used 11 times (in the body, 13 times altogether) in the original Nakamoto whitepaper; whoever created Bitcoin was laser focused on building a mechanism to route around trusted third parties due to the additional “mediation and transaction costs” (section 1) these create.  Note: that later on page 29 they briefly mentioned legal tender laws and coins (as it related to the Roman Empire).

On page 8 the authors describe the current world as “tyranny of centralized trust” and on page 10 that “Bitcoin promises to take at least some of that power away from governments and hand it to the people.”

While that may be a popular narrative on social media, not everyone involved with Bitcoin (or the umbrella “blockchain” world) holds the same view.  Nor do the authors describe some kind of blue print for how this is done.  Recall that in order to obtain bitcoins in the first place a user can do one of three things:

  1. mine bitcoins
  2. purchase bitcoins from some kind of exchange
  3. receive them for payments (e.g., merchant activity)

In practice mining is out of the hands of “the people” due to economies of scale which have trended towards warehouse mining – it is unlikely that embedded ASICs such as from 21 inc, will change that dynamic much, if any.  Why?  Because for every device added to the network a corresponding amount of difficulty is also added, diluting the revenue to below dust levels.  Remember how Tom Sawyer convinced kids to whitewash a fence and they did so eagerly without question?  What if he asked you to mine bitcoins for him for free?  A trojan botnet?  While none of the products have been announced and changes could occur, from the press release that seems to be the underlying assumption of the 21 inc business model.

In terms of the second point, nearly all VC funded exchanges require KYC and bank accounts.  The ironic aspect is that “unbanked” and “underbanked” individuals often lack the necessary “valid” credentials that can be used by cheaper automated KYC technology (from Jumio) and thus expensive manual processing is done, costs that must be borne by someone.  These same credential-less individuals typically lack a bank account (hence the name “unbanked”).

Lastly with the third point, while there are any number of merchants that now accept bitcoin, in practice very few actually do receive bitcoins on any given day.  Several weeks ago I broke down the numbers that BitPay reported and the verdict is payment processing is stagnant for now.

Why is this last point important to what the authors refer to as “the people”?

Ten days after Ripple Labs was fined by FinCEN for not appropriately enforcing AML/KYC regulations, Xapo  — a VC funded hosted wallet startup — moved off-shore, uprooting itself from Palo Alto to Switzerland.  While the stated reason is “privacy” concerns, it is likely due to regulatory concerns of a different nature.

In his interview with CoinDesk last week, Wences Casares, the CEO and founder of Xapo noted that:

Still, Casares indicated that Xapo’s customers are most often using its accounts primarily for storage and security. He noted that many of its clientele have “never made a bitcoin payment”, meaning its holdings are primarily long-term bets of high net-worth customers and family offices.

“Ninety-six percent of the coins that we hold in custody are in the hands of people who are keeping those coins as an investment,” Casares continued.

96% of the coins held in custody by Xapo are inert.  According to a dated presentation, the same phenomenon takes place with Coinbase users too.

Perhaps this behavior will change in the future, though, if not it seems unclear how this particular “to the people” narrative can take place when few large holders of a static money supply are willing to part with their virtual collectibles.  But this dovetails into differences of opinion on rebasing money supplies and that is a topic for a different post.

On page 11 the authors describe five stages of psychologically accepting Bitcoin.  In stage one they note that:

Stage One: Disdain.  Not even denial, but disdain.  Here’s this thing, it’s supposed to be money, but it doesn’t have any of the characteristics of money with which we’re familiar.

I think this is unnecessarily biased.  While I cannot speak for other “skeptics,” I actually started out very enthusiastic — I even mined for over a year — and never went through this strange five step process.  Replace the word “Bitcoin” with any particular exciting technology or philosophy from the past 200 years and the five stage process seems half-baked at best.

On page 13 they state, “Public anxiety over such risks could prompt an excessive response from regulators, strangling the project in its infancy.”  Similarly on page 118 regarding the proposed New York BitLicense, “It seemed farm more draconian than expected and prompted an immediate backlash from a suddenly well-organized bitcoin community.”

This is a fairly alarmist statement.  It could be argued that due to its anarchic code-as-law coupled with its intended decentralized topology, that it could not be strangled.  If a certain amount of block creating processors (miners) was co-opted by organizations like a government, then a fork would likely occur and participants with differing politics would likely diverge.  A KYC chain versus an anarchic chain (which is what we see in practice with altchains such as Monero and Dash).  Similarly, since there are no real self-regulating organizations (SRO) or efforts to expunge the numerous bad actors in the ecosystem, what did the enthusiasts and authors expect would occur when regulators are faced with complaints?

With that said — and I am likely in a small minority here — I do not think the responses thus far from US regulators (among many others) has been anywhere near “excessive,” but that’s my subjective view.  Excessive to me would be explicitly outlawing usage, ownership and mining of cryptocurrencies.  Instead what has occurred is numerous fact finding missions, hearings and even appearances by regulators at events.

On page 13 the authors state that “Cryptocurrency’s rapid development is in some ways a quirk of history: launched in the throes of the 2008 financial crisis, bitcoin offered an alternative to a system — the existing financial system — that was blowing itself up and threatening to take a few billion people down with it.”

This is retcon.  Satoshi Nakamoto, if he is to be believed, stated that he began coding the project in mid-2007.  It is more of a coincidence than anything else that this project was completed around the same time that global stock indices were at their lowest in decades.

Chapter 1:

On page 21 the authors state that, “Bitcoin seeks to address this challenge by offering users a system of trust based not on human being but on the inviolable laws of mathematics.”

While the first part is true, it is a bit cliche to throw in the “maths” reason.  There are numerous projects in the financial world alone that are run by programs that use math.  In fact, all computer programs and networks use some type of math at their foundation, yet no one claims that the NYSE, pace-makers, traffic intersections or airplanes are run by “math-based logic” (or on page 66, “”inviolable-algorithm-based system”).  A more accurate description is that Bitcoin’s monetary system is rule-based, using a static perfectly inelastic supply in contrast to either the dynamic or discretionary world humans live in.  Whether this is desirable or not is a different topic.

On page 26 they describe the Chartalist school of thought, the view that money is political, that “looks past the thing of currency and focuses instead on the credit and trust relationships between the individual and society at large that currency embodies” […] “currency is merely the token or symbol around which this complex system is arranged.”

This is in contrast to the ‘metallist’ mindset of some others in the Bitcoin community, such as Wences Casares and Jon Matonis (perhaps there is a distinct third group for “barterists”?).

I thought this section was well-written and balanced (e.g., appropriate citation of David Graeber on page 28; and description of what “seigniorage” is on page 30 and again on page 133).

On page 27 the authors write, “Yet many other cryptocurrency believers, including a cross section of techies and businessmen who see a chance to disrupt the bank centric payments system are de facto charatalists.  They describe bitcoin not as a currency but as a payments protocol.”

Perhaps this is true.  Yet from the original Nakamoto whitepaper, perhaps he too was a chartalist?  Stating in section 1:

Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non-reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. 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.

A payments rail, a currency, perhaps both?

Fun fact: the word “payment” appears 12 times in the whole white paper, just one time less than the word “trust” appears.

On page 29 they cite the Code of Hammurabi.  I too think this is a good reference, having made a similar reference to the Code in Chapter 2 of my book last year.

On page 31 they write, “Today, China grapples with competition to its sovereign currency, the yuan, due both to its citizens’ demand for foreign national currencies such as the dollar and to a fledgling but potentially important threat from private, digital currencies such as bitcoin.”

That is a bit of a stretch.  While Chinese policy makers do likely sweat over the creative ways residents breach and maneuver around capital controls, it is highly unlikely that bitcoin is even on the radar as a high level “threat.”  There is no bitcoin merchant economy in China.  The vast majority of activity continues to be related to mining and trading on exchanges, most of which is inflated by internal market making bots (e.g., the top three exchanges each run bots that dramatically inflate the volume via tape painting).  And due to how WeChat and other social media apps in China frictionlessly connect residents with their mainland bank accounts, it is unlikely that bitcoin will make inroads in the near future.

On page 36 they write, “By 1973, once every country had taken its currency off the dollar peg, the pact was dead, a radical change.”

In point of fact, there are 23 countries that still peg their currency to the US dollar.  Post-1973 saw a number of flexible and managed exchange rate regimes as well as notable events such as the Plaza Accord and Asian Financial Crisis (that impacted the local pegs).

On page 39 they write, “By that score, bitcoin has something to offer: a remarkable capacity to facilitate low-cost, near-instant transfer of value anywhere in the world.”

The point of contention here is the “low-cost” — something that the authors never really discuss the logistics of.  They are aware of “seigniorage” and inflationary “block rewards” yet they do not describe the actual costs of maintaining the network which in the long run, the marginal costs equal the marginal value (MC=MV).

This is an issue that I tried to bring up with them at the Google Author Talk last month (I asked them both questions during the Q&A):

The problem for Vigna’s view, (starting around 59m) is that if the value of a bitcoin fell to $30, not only would the network collectively “be cheaper” to maintain, but also to attack.

On paper, the cost to successfully attack the network today by obtaining more than 50% of the hashrate at this $30 price point would be $2,250 per hour (roughly 0.5 x MC) or roughly an order of magnitude less than it does at today’s market price (although in practice it is a lot less due to centralization).  Recall that the security of bitcoin was purposefully designed around proportionalism, that in the long run it costs a bitcoin to secure a bitcoin.  We will talk about fees later at the end of next chapter.

Chapter 2:

On page 43, in the note at the bottom related to Ray Dillinger’s characterization that bitcoin is “highly inflationary” — Dillinger is correct in the short run.  The money supply will increase by 11% alone this year.  And while in the long run the network is deflationary (via block reward halving), the fact that the credentials to the bearer assets (bitcoins) are lost and destroyed each year results in a non-negligible amount of deflation.

For instance, in chapter 12 I noted some research: in terms of losing bitcoins, the chart below illustrates what the money supply looks like with an annual loss of 5% (blue), 1% (red) and 0.1% (green) of all mined bitcoins.

lost coins

Source: Kay Hamacher and Stefan Katzenbeisser

In December 2011, German researchers Kay Hamacher and Stefan Katzenbeisser presented research about the impact of losing the private key to a bitcoin. The chart above shows the asymptote of the money supply (Y-axis) over time (X-axis).

According to Hamacher:

So to get rid of inflation, they designed the protocol that over time, there is this creation of new bitcoins – that this goes up and saturates at some level which is 21 million bitcoins in the end.

But that is rather a naïve picture. Probably you have as bad luck I have, I have had several hard drive crashes in my lifetime, and what happens when your wallet where your bitcoins are stored and your private key vanish? Then your bitcoins are probably still in the system so to speak, so they are somewhat identifiable in all the transactions but they are not accessible so they are of no economic value anymore. You cannot exchange them because you cannot access them. Or think more in the future, someone dies but his family doesn’t know the password – no economic value in those bitcoins anymore. They cannot be used for any exchange anymore. And that is the amount of bitcoins when just a fraction per year vanish for different fractions. So the blue curve is 5% of all the bitcoins per year vanish by whatever means there could be other mechanisms.

It is unclear exactly how many bitcoins can be categorized in such a manner today or what the decay rate is.

On page 45 the authors write, “Some immediately homed in on a criticism of bitcoin that would become common: the energy it would take to harvest “bitbux” would cost more than they were worth, not to mention be environmentally disastrous.”

While I am unaware of anyone who states that it would cost more than what they’re worth, as stated in Appendix B and in Chapter 3 (among many other places), the network was intentionally designed to be expensive, otherwise it would be “cheap to attack.”  And those costs scale in proportion to the token value.

As noted a few weeks ago:

For instance, last year O’Dwyer and Malone found that Bitcoin mining consumes roughly the same amount of energy as Ireland does annually.  It is likely that their estimate was too high and based on Dave Hudson’s calculations closer to 10% of Ireland’s energy consumption.23 Furthermore, it has likely declined since their study because, as previously explored in Appendix B, this scales in proportion with the value of the token which has declined over the past year.

The previous post looked at bitcoin payments processed by BitPay and found that as an aggregate the above-board activity on the Bitcoin network was likely around $350 million a year.  Ireland’s nominal GDP is expected to reach around $252 billion this year.  Thus, once Hudson’s estimates are integrated into it, above-board commercial bitcoin activity appears to be about two orders of magnitude less than what Ireland produces for the same amount of energy.

Or in other words, the original responses to Nakamoto six and a half years ago empirically was correct.  It is expensive and resource intensive to maintain and it was designed to be so, otherwise it would be easy to attack, censor and modify the history of votes.

Starting on page 56 they describe Mondex, Secure Electronic Transaction (SET), Electronic Monetary System, Citi’s e-cash model and a variety of other digital dollar systems that were developed during the 1990s.  Very interesting from a historical perspective and it would be curious to know what more of these developers now think of cryptocurrency systems.  My own view, is that the middle half of Chapter 2 is the best part of the book: very well researched and well distilled.

On page 64 they write:

[T]hat Nakamoto launched his project with a reminder that his new currency would require no government, no banks and no financial intermediaries, “no trusted third party.”

In theory this may be true, but in practice, the Bitcoin network does not natively provide any of the services banks do beyond a lock box.  There is a difference between money and the cornucopia of financial instruments that now exist and are natively unavailable to Bitcoin users without the use of intermediaries (such as lending).

On page 66 they write, “He knew that the ever-thinning supply of bitcoins would eventually require an alternative carrot to keep miners engaged, so he incorporated a system of modest transaction fees to compensate them for the resources they contributed.  These fees would kick in as time went on and as the payoff for miners decreased.”

That’s the theory and the popular narrative.

However, what does it look like in practice?

Above is a chart visualizing fees to miners denominated in USD from January 2009 to May 17, 2015.  Perhaps the fees will indeed increase to replace block rewards, or conversely, maybe as VC funding declines in the coming years, the companies that are willing and able to pay fees for each transaction declines.

On page 67, the authors introduce us to Laszlo Hanyecz, a computer programmer in Florida who according to the brief history of Bitcoin lore, purchased two Papa John’s pizzas for 10,000 bitcoins on May 22, 2010 (almost five years ago to the day).  He is said to have sold 40,000 bitcoins in this manner and generated all of the bitcoins through mining.  He claims to be the first person to do GPU mining, ramping up to “over 800 times” of a CPU; and during this time “he was getting about half of all the bitcoins mined.”  According to him, he originally used a Nvidia 9800 GTX+ and later switched to 2 AMD Radeon 5970s.  It is unclear how long he mined or when he stopped.

In looking at the index of his server, there are indeed relevant OpenCL software files.  If this is true, then he beat ArtForz to GPU mining by at least two months.

solar pizza

Source: Laszlo Hanyecz personal server

On page 77 they write, “Anybody can go on the Web, download the code for no cost, and start running it as a miner.”

While technically this is true, that you can indeed download the Satoshi Bitcoin core client for free, restated in 2015 it is not viable for hoi polloi.  In practice you will not generate any bitcoins solo-mining on a desktop machine unless you do pooled mining circa 2011.  Today, even pooled mining with the best Xeon processors will be unprofitable.  Instead, the only way to generate enough funds to cover both the capital expenditures and operating expenditures is through the purchase of single-use hardware known as an ASIC miner, which is a depreciating capital good.  Mining has been beyond the breakeven reach of most non-savvy home users for two years now, not to mention those who live in developing countries with poor electrical infrastructure or uncompetitive energy rates.  It is unlikely that embedded mining devices will change that equation due to the fact that every additional device increases the difficultly level whilst the device hashrate remains static.

This ties in with what the authors also wrote on page 77, “You don’t buy bitcoin’s software as you would other products, which means you’re not just a customer.  What’s more, there’s no owner of the software — unlike, say, PayPal, which is part of eBay.”

This is a bit misleading.  In order to use the Bitcoin network, users must obtain bitcoins somehow.  And in practice that usually occurs through trusted third parties such as Coinbase or Xapo which need to identify you via KYC/AML processes.  So while in 2009 their quote could have been true, in practice today that is largely untrue for most new participants — someone probably owns the software and your personal data.  In fact, a germane quote on reddit last week stated, “Why don’t you try using Bitcoin instead of Coinbase.”

Furthermore, the lack of “ownership” of Bitcoin is dual-edged as there are a number of public goods problems with maintaining development that will be discussed later.

On page 87 they describe Blockchain.info as a “high-profile wallet and analytics firm.”  I will come back to “wallets” later.  Note: most of these “wallets” are likely throwaway, temp wallets used to move funds to obfuscate provenance through the use of Shared Coin (one of the ways Blockchain.info generates revenue is by operating a mixer).

Overall Chapter 3 was also fairly informative.  The one additional quibble I have is that Austin and Beccy Craig (the story at the end) were really only able to travel the globe and live off bitcoins for 101 days because they had a big cushion: they had held a fundraiser that raised $72,995 of additional capital.  That is enough money to feed and house a family in a big city for a whole year, let alone go globe trotting for a few months.

Chapter 4:

On page 99 they describe seven different entities that have access to credit card information when you pay for a coffee at Starbucks manually.  Yet they do not describe the various entities that end up with the personal information when signing up for services such as Coinbase, ChangeTip, Circle and Xapo or what these depository institutions ultimately do with the data (see also Richard Brown’s description of the payment card system).

When describing cash back rewards that card issuers provide to customers, on page 100 they write, “Still it’s an illusion to think you are not paying for any of this.  The costs are folded into various bank charges: card issuance fees, ATM fees, checking fees, and, of course, the interest charged on the millions of customers who don’t pay their balances in full each month.”

Again, to be even handed they should also point out all the fees that Coinbase charges, Bitcoin ATMs charge and so forth.  Do any of these companies provide interest-bearing accounts or cash-back rewards?

On page 100 they also stated that, “Add in the cost of fraud, and you can see how this “sand in the cogs” of the global payment system represents a hindrance to growth, efficiency, and progress.”

That seems a bit biased here.  And my statement is not defending incumbents: global payment systems are decentralized yet many provide fraud protection and insurance — the very same services that Bitcoin companies are now trying to provide (such as FDIC insurance on fiat deposits) which are also not free.

On page 100 they also write, “We need these middlemen because the world economy still depends on a system in which it is impossible to digitally send money from one person to another without turning to an independent third party to verify the identity of the customer and confirm his or her right to call on the funds in the account.”

Again, in practice, this is now true for Bitcoin too because of how most adoption continues to take place on the edges in trusted third parties such as Coinbase and Circle.

On page 101 they write:

In letting the existing system develop, we’ve allowed Visa and MasterCard to form a de facto duopoly, which gives them and their banking partners power to manipulate the market, says Gil Luria, an analyst covering payment systems at Wedbush Securities.  Those card-network firms “not only get to extract very significant fees for themselves but have also created a marketplace in which banks can charge their own excessive fees,” he says.

Why is it wrong to charge fees for a service?  What is excessive?  I am certainly not defending incumbents or regulatory favoritism but it is unclear how Bitcoin institutions in practice — not theory — actually are any different.

And, the cost per transaction for Bitcoin is actually quite high (see chart below) relative to these other systems due to the fact that Bitcoin also tries to be a seigniorage system, something that neither Visa or MasterCard do.

cost per transaction

Source: Markos05

On page 102 when talking about MasterCard they state, “But as we’ve seen, that cumbersome system, as it is currently designed, is tightly interwoven into the traditional banking system, which always demands a cut.”

The whole page actually is a series of apples-and-oranges comparisons.  Aside from settlement, the Bitcoin network does not provide any of the services that they are comparing it to.  There is nothing in the current network that provides credit/lending services whereas the existing “cumbersome” system was not intentionally designed to be cumbersome, but rather is intertwined and evolved over decades so that customers can have access to a variety of otherwise siloed services.  Again, this is not to say the situation cannot be improved but as it currently exists, Bitcoin does not provide a solution to this “cumbersome” system because it doesn’t provide similar services.

On page 102 and 103 they write about payment processors such as BitPay and Coinbase, “These firms touted a new model to break the paradigm of merchants’ dependence on the bank-centric payment system described above.  These services charged monthly fees that amounted to significantly lower transaction costs for merchants than those charged in credit-card transactions and delivered swift, efficient payments online or on-site.”

Except this is not really true.  The only reason that both BitPay and Coinbase are charging less than other payment processors is that VC funding is subsidizing it.  These companies still have to pay for customer service support and fraud protection because customer behavior in aggregate is the same.  And as we have seen with BitPay numbers, it is likely that BitPay’s business model is a losing proposition and unsustainable.

On page 103 they mention some adoption metrics, “The good news is found in the steady expansion in the adoption of digital wallets, the software needed to send and receive bitcoins, with Blockchain and Coinbase, the two biggest providers of those, on track to top 2 million unique users each at the time of the writing.”

This is at least the third time they talk about wallets this way and is important because it is misleading, I will discuss in-depth later.

Continuing they write that:

Blockchain cofounder Peter Smith says that a surprisingly large majority of its accounts — “many more than you would think,” he says cryptically — are characterized as “active.”

This is just untrue and should have been pressed by the authors.  Spokesman from Blockchain.info continue to publish highly inflated numbers.  For instance in late February 2015, Blockchain.info claimed that “over $270 million in bitcoin transactions occurred via its wallets over the past seven days.”

This is factually untrue.  As I mentioned three months ago:

Organ of Corti pointed out that the 7 day average was indeed ~720,000 bitcoins in total output volume (thus making) the weekly volume would be about “5e06 btc for the network.”

Is it valid to multiply the total output volume by USD (or euros or yen)?  No.

Why not?  Because most of this activity is probably a combination of wallet shuffling, laundering and mixing of coins (e.g., use of SharedSend and burner wallets) or any number of superfluous activity.  It was not $270 million of economic trade.

Blockchain.info’s press release seems to be implying that economic trade is taking place, in which all transactions are (probably) transactions to new individuals when in reality it could simply be a lot of “change” address movement.  And more to the point, the actual internal volume looks roughly the same as has been the past few months (why issue a press release now?).

Continuing on page 103 they write, “For the first eight months months of 2014, around $50 million per day was passing thought the bitcoin network (some of which was just “change” that bitcoin transactions create as an accounting measure)…”

There is a small typo above (in bold) but the important part is the estimate of volume.  There is no public research showing a detailed break down of average volume of economic activity.  Based on a working paper I published four months ago, it is fairly clear that this figure is probably in the low millions USD at most.  Perhaps this will change in the future.

On page 106 they write about Circle and Xapo:

For now, these firms make no charge to cover costs of insurance and security, betting that enough customers will be drawn to them and pay fees elsewhere — for buying and selling bitcoins, for example — or that their growing popularity will allow them to develop profitable merchant-payment services as well.  But over all, these undertaking must add costs back into the bitcoin economy, not to mention a certain dependence on “trusted third parties.”  It’s one of many areas of bitcoin development — another is regulation — where some businessmen are advocating a pragmatic approach to bolstering public confidence, one that would necessitate compromises on some of the philosophical principles behind a model of decentralization.  Naturally, this doesn’t sit well with bitcoin purists.

While Paul Vigna may not have written this, he did say something very similar at the Google Author Talk event (above in the video).

The problem with this view is that it is a red herring: this has nothing to do with purism or non-purism.

The problem is that Bitcoin’s designer attempted to create a ‘permissionless’ system to accommodate pseudonymous actors.  The entire cost structure and threat model are tied to this.  If actors are no longer pseudonymous, then there is no need to have this cost structure, or to use proof-of-work at all.  In fact, I would argue that if KYC/KYM (Know Your Miner) are required then a user might just as well use a database or permissioned system.  And that is okay, there are businesses that will be built around that.

This again has nothing to do with purism and everything to do with the costs of creating a reliable record of truth on a public network involving unknown, untrusted actors.  If any of those variables changes — such as adding real-world identity, then from a cost perspective it makes little sense to continue using the modified network due to the intentionally expensive proof-of-work.

On page 107 they talk about bitcoin price volatility discussing the movements of gasoline.  The problem with this analogy is that no one is trying to use gasoline as money.  In practice consumers prefer purchasing power stability and there is no mechanism within the Bitcoin network that can provide this.

For instance:

volatility 1volatility 2volatility 3The three slides above are from a recent presentation from Robert Sams.  Sams previously wrote a short paper on “Seigniorage Shares” — an endogenous way to rebase for purchasing power stability within a cryptocurrency.

Bitcoin’s money supply is perfectly inelastic therefore the only way to reflect changes in demand is through changes in price.  And anytime there are future expectations of increased or decreased utility, this is reflected in prices via volatility.

Oddly however, on page 110, they write, “A case can be made that bitcoin’s volatility is unavoidable for the time being.”

Yet they do not provide any evidence — aside from feel good “Honey Badger” statements — for how bitcoin will somehow stabilize.  This is something the journalists should have drilled down on, talking to commodity traders or some experts on fuel hedging strategies (which is something airline companies spend a great deal of time and resources with).

Instead they cite Bobby Lee, CEO of BTC China and Gil Luria once again.  Lee states that “Once its prices has risen far enough and bitcoin has proven itself as a store of value, then people will start to use it as a currency.”

This is a collective action problem.  Because all participants each have different time preferences and horizons — and are decentralized — this type of activity is actually impossible to coordinate, just ask Josh Garza and the $20 Paycoin floor.  This also reminds me of one of my favorite comments on reddit: “Bitcoin will stabilize in price then go to the moon.”

The writers then note that, “Gil Luria, the Wedbush analyst, even argues that volatility is a good thing, on the grounds that it draws profit-seeking traders into the marketplace.”

But just because you have profit-seeking traders in the market place does not mean volatility disappears.

trading view

Credit: George Samman

For instance, in the chart above we can see how bitcoin trades relative to commodities over the past year:

  • Yellow is DBC
  • Red is OIL
  • Bars are DXY which is a dollar index
  • And candlesticks are BTCUSD
DBC is a commodities index and the top 10 Holdings (85.39% of Total Assets):
  • Brent Crude Futr May12 N/A 13.83
  • Gasoline Rbob Fut Dec12 N/A 13.71
  • Wti Crude Future Jul12 N/A 13.56
  • Heating Oil Futr Jun12 N/A 13.20
  • Gold 100 Oz Futr Dec 12 N/A 7.49
  • Sugar #11(World) Jul12 N/A 5.50
  • Corn Future Dec12 N/A 5.01
  • Lme Copper Future Mar13 N/A 4.55
  • Soybean Future Nov12 N/A 4.38
  • Lme Zinc Future Jul12

It bears mentioning that Ferdinando Ametrano has also described this issue in depth most recently in a presentation starting on slide 15.

Continuing on page 111, the writers note that:

Over time, the expansion of these desks, and the development of more and more sophisticated trading tools, delivered so much liquidity that exchange rates became relatively stable.  Luria is imagining a similar trajectory for bitcoin.  He says bitcoiners should be “embracing volatility,” since it will help “create the payment network infrastructure and monetary base” that bitcoin will need in the future.

There are two problems with Luria’s argument:

1) As noted above, this does not happen with any other commodity and historically nothing with a perfectly inelastic supply

2) Empirically, as described by Wences Casares above, nearly all the bitcoins held at Xapo (and likely other “hosted wallets”) are being held as investments.  This reduces liquidity which translates into volatility due to once again the inability to slowly adjust the supply relative to the shifts in demand.  This ties into a number of issues discussed in, What is the “real price” of bitcoin? that are worth revisiting.

Also on page 111, they write that “the exchange rate itself doesn’t matter.”

Actually it does.  It directly impacts two things:

1) outside perception on the health of Bitcoin and therefore investor interest (just talk to Buttercoin);

2) on a ten-minute basis it impacts the bottom line of miners.  If prices decline, so to is the incentive to generate proof-of-work.  Bankruptcy, as CoinTerra faces, is a real phenomenon and if prices decline very quickly then the security of the network can also be reduced due to less proof-of-work being generated

Continuing on page 111, “It’s expected that the mirror version of this will in time be set up for consumers to convert their dollars into bitcoins, which will then immediately be sent to the merchant.  Eventually, we could all be blind to these bitcoin conversions happening in the middle of all our transactions.”

It’s unfortunate that they do not explain how this will be done without a trusted third party, or why this process is needed.  What is the advantage of going from USD-> paying a conversion fee -> BTC -> conversion fee -> back into USD?  Why not just spend USD and cut out the Bitcoin middleman?

Lastly on page 111, “Still, someone will have to absorb the exchange-rate risk, if not the payment processors, then the investors with which they trade.”

The problem with this is that its generally not in the mandate or scope of most VC firms to purchase commodities or currencies directly.  In fact, they may even need some kind of license to do so depending on the jurisdiction (because it is a foreign exchange play).  Yet expecting the payment processors to shoulder the volatility is probably a losing proposition: in the event of a protracted bear market how many bitcoins at BitPay — underwater or not — will need to be liquidated to pay for operating costs?4

On page 112 they write, ‘Bitcoin has features from all of them, but none in entirety.  So, while it might seem unsatisfying, our best answer to the question of whether cryptocurrency can challenge the Visa and MasterCard duopoly is, “maybe, maybe not.”

On the face of it, it is a safe answer.  But upon deeper inspection we can probably say, maybe not.  Why?  Because for Bitcoin, once again, there is no native method for issuing credit (which is what Visa/MasterCard do with what are essentially micro-loans).

For example, in order to natively add some kind of lending facility within the Bitcoin network a new “identity” system would need to be built and integrated (to enable credit checks) — yet by including real-world “identity” it would remove the pseudonymity of Bitcoin while simultaneously maintaining the same costly proof-of-work Sybil protection.  This is again, an unnecessary cost structure entirely and positions Bitcoin as a jack-of-all-trades-but-master-of-none.  Why?  Again recall that the cost structure is built around Dynamic Membership Multi-Party Signature (DMMS); if the signing validators are static and known you might as well use a database or permissioned ledgers.

Or as Robert Sams recently explained, if censorship resistance is co-opted then the reason for proof-of-work falls to the wayside:

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.

On page 113, they write, “the government might be able to take money out of your local bank account, but it couldn’t touch your bitcoin.  The Cyprus crisis sparked a stampede of money into bitcoin, which was now seen as a safe haven from the generalized threat of government confiscation everywhere.”

In theory this may be true, but in practice, it is likely that a significant minority — if not majority — of bitcoins are now held in custody at depository institutions such as Xapo, Coinbase and Circle.  And these are not off-limits to social engineering.  For instance, last week an international joint-task force confiscated $80,000 in bitcoins from dark web operators.  The largest known seizure in history were 144,000 bitcoins from Ross Ulbricht (Dread Pirate Roberts) laptop.

Similarly, while it probably is beyond the scope of their book, it would have been interesting to see a survey from Casey and Vigna covering the speculators during this early 2013 time frame.  Were the majority of people buying bitcoins during the “Cyprus event” actually worried about confiscation or is this just something that is assumed?  Fun fact: the largest transaction to BitPay of all time was on March 25, 2013 during the Cyprus event, amounting to 28,790 bitcoins.

On page 114, the writers for the first time (unless I missed it elsewhere), use the term “virtual currency.”  Actually, they quote FinCEN director Jennifer Calvery who says that FincCEN, “recognizes the innovation virtual currencies provide , and the benefits they might offer society.”

Again recall that most fiat currencies today are already digitized in some format — and they are legal tender.  In contrast, cryptocurrencies such as bitcoin are not legal tender and are thus more accurately classified as virtual currencies.  Perhaps that will change in the future.

On page 118 they note that, “More and more people opened wallets (more than 5 million as of this writing).”

I will get to this later.  Note that on p. 123 they say Coupa Cafe has a “digital wallet” a term used throughout the entire book.

Chapter 5:

On page 124, “Bitcoins exist only insofar as they assign value to a bitcoin address, a mini, one-off account with which people and firms send and receive the currency to and from other people’s firms’ addresses.”

This is actually a pretty concise description of best-practices.  In reality however, many individuals and organizations (such as exchanges and payment processors) reuse addresses.

Continuing on page 124, “This is an important distinction because it means there’s no actual currency file or document that can be copied or lost.”

This is untrue.  In terms of security, the hardest and most expensive part in practice is securing the credentials — the private key that controls the UTXOs.  As Stefan Thomas, Jason Whelan (p. 139) and countless other people on /r/sorryforyourloss have discovered, this can be permanently lost.  Bearer assets are a pain to secure, hence the re-sprouting of trusted third parties in Bitcoinland.

One small nitpick in the note at the bottom of page 125, “Sometimes the structure of the bitcoin address network is such that the wallet often can’t send the right amount in one go…” — note that this ‘change‘ is intentional (and very inconvenient to the average user).

Another nitpick on page 128, “Each mining node or computer gathers this information and reduces it into an encrypted alphanumeric string of characters known as a hash.”

There is actually no encryption used in Bitcoin, rather there are some cryptographic primitives that are used such as key signing but this is not technically called encryption (the two are different).

On page 130, I thought it was good that they explained where the term nonce was first used — from Lewis Carroll who created the word “frabjous” and described it as a nonce word.

On page 132, in describing proof-of-work, “While that seems like a mammoth task, these are high-powered computers; it’s not nearly as taxing as the nonce-creating game and can be done relatively quickly and easily.”

They are correct in that something as simple as a Pi computer can and is used as the actual transaction validating machine.  Yet, at one point in 2009, this bifurcation did not exist: a full-node was both a miner and a hasher.  Today that is not the case and we technically have about a dozen or so actual miners on the network, the rest of the machines in “farms” just hash midstates.

On page 132, regarding payment processors accepting zero-confirmation transactions, “They do this because non-confirmations — or the double-spending actions that lead to them — are very rare.”

True they are very rare today in part because there are very few incentives to actually try and double-spend.  Perhaps that will change in the future with new incentives to say, double-spend watermarked coins from NASDAQ.

And if payment processors are accepting zero confirmations, why bother using proof-of-work and confirmations at all?  Just because a UTXO is broadcast does not mean it will not be double-spent let alone confirmed and packaged into a block.  See also replace-by-fee proposal.

Small note on page 132, “the bitcoin protocol won’t let it use those bitcoins in a payment until a total of ninety-nine additional blocks have been built on top its block.”

Sometimes it depends on the client and may be up to 120 blocks altogether, not just 100.

On page 133 they write, “Anyone can become a miner and is free to use whatever computing equipment he or she can come up with to participate.”

This may have been the case in 2009 but not true today.  In order to reduce payout variance, the means of production as it were, have gravitated towards large pools of capital in the form of hashing farms.  See also: The Gambler’s Guide to Bitcoin Mining.

On page 135 they write, “Some cryptocurrency designers have created nonprofit foundations and charged them with distributing the coins based on certain criteria — to eligible charities, for example. But that requires the involvement of an identifiable and trusted founder to create the foundation.”

The FinCEN enforcement action and fine on Ripple Labs may put a kibosh on this in the future.  Why?  If organizations that hand out or sell coins are deemed under the purview of the Bank Secrecy Act (BSA) it is clear that most, if not all, crowdfunding or initial coin offerings (ICO) are violating this by not implementing KYC/AML requirements on participants or filing SARs.

On page 136 they write, “Both seigniorage and transaction fees represent a transfer of value to those running the network. Still, in the grand scheme of things, these costs are far lower than anything found in the old system.”

This is untrue and an inaccurate comparison.  We know that at the current bitcoin price of $240 it costs roughly $315 million to operate the network for the entire year.  If bitcoin-based consumer spending patterns hold up and reflect last years trends seen by BitPay, then roughly $350 million will be spent through payment processors, nearly half of which includes mining payouts.

Or in other words, for roughly every dollar spent on commerce another dollar is spent securing it.  This is massive oversecurity relative to the commerce involve.  Neither Saudi Arabia or even North Korea spend half of, let alone 100% of their GDP on military expenditures (yet).

Chapter 6:

Small nitpick on page 140, Butterfly Labs is based in Leawood, Kansas not Missouri (Leawood is on the west side of the dividing line).

I think the story of Jason Whelan is illuminating and could help serve as a warning guide to anyone wanting to splurge on mining hardware.

For instance on page 141, “And right from the start Whelan face the mathematical reality that his static hashrate was shrinking as a proportion of the ever-expanding network, whose computing power was by then almost doubling every month.”

Not only was this well-written but it does summarize the problem most new miners have when they plan out their capital expenditures.  It is impossible to know what the network difficulty will be in 3 months yet what is known is that even if you are willing to tweak the hardware and risk burning out some part of your board, your hashrate could be diluted by faster more efficient machines.  And Whelan found out the hard way that he might as well bought and held onto bitcoins than mine.  In fact, Whelan did just about everything the wrong way, including buying hashing contracts with cloud miners from “PBCMining.com” (a non-functioning url).

On page 144 the authors discussed the mining farms managed by now-defunct CoinTerra:

With three in-built high-powered fans running at top speed to cool the rig while its internal chi races through calculations, each unit consumes two kilowatts per hour, enough power to run an ordinary laptop for a month. That makes for 20 kWh per tower, about ten times the electricity used for the same space by the neighboring server of more orthodox e-commerce firms.

As noted in Chapter 2 above, this electricity has to be “wasted.”  Bitcoin was designed to be “inefficient” otherwise it would be easy to attack and censor.  And in the future, it cannot become more “efficient” — there is no free lunch when it comes to protecting it.  It also bears mentioning that CoinTerra was sued by its utility company in part for the $12,000 a day in electrical costs that were not being paid for.

On page 145 they wrote that as of June 2014, “By that time, the network, which was then producing 88,000 trillion hashes every second, had a computing power six thousand times the combined power of the world’s top five hundred supercomputers.”

This is not a fair comparison.  ASIC miners can do one sole function, they are unable to do anything aside from reorganize a few fields (such as date and nonce) with the aim of generating a new number below a target number.  They cannot run MS Office, Mozilla Firefox and more sobering: they cannot even run a Bitcoin client (the Pi computer run by the pool runs the client).

In contrast, in order to be recognized as a Top 500 computer, only general purpose machines capable of running LINXPACK are considered eligible.  The entire comparison is apples-to-oranges.

On page 147 the authors described a study from Guy Lane who used inaccurate energy consumption data from Blockchain.info.  And then they noted that, “So although the total consumption is significantly higher than the seven-thousand-home estimate, we’re a long way from bitcoin’s adding an entire country’s worth of power consumption to the world.”

This is not quite true.  As noted above in the notes of Chapter 2 above, based on Dave Hudson’s calculations the current Bitcoin network consumes the equivalent of about 10% of Ireland’s annual energy usage yet produces two orders of magnitude less economic activity.  If the price of bitcoin increases so to does the amount of energy miners are willing to expend to chase after the seigniorage.  See also Appendix B.

On page 148 they write that:

For one, power consumption must be measured against the value of validating transactions in a payment system, a social service that gold mining has never provided.  Second, the costs must be weighed against the high energy costs of the alternative, traditional payment system, with its bank branches, armored cars, and security systems. And finally, there’s the overriding incentive for efficiency that the profit motive delivers to innovators, which is why we’ve seen such giant reductions in power consumption for the new mining machines. If power costs make mining unprofitable, it will stop.

First of all, validation is cheap and easy, as noted above it is typically done with something like a Pi computer.  Second, they could have looked into how much real commerce is taking place on the chain relative to the costs of securing it so the “social service” argument probably falls flat at this time.

Thirdly, the above “armored cars and security systems” is not an apples-to-apples comparison.  Bitcoin does not provide any banking service beyond a lock box, it does not provide for home mortgages, small business loans or mezzanine financing.  The costs for maintaining those services in the traditional world do not equate to MC=MV as described at the end of Chapter 1 notes.

Fourthly, they ignore the Red Queen effect.  If a new hashing machine is invented and consumes half as much energy as before then the farm owner will just double the amount of machines and the net effect is the same as before.  This happens in practice, not just in theory, hence the reason why electrical consumption has gone up in aggregate and not down.

On page 149 they write, “But the genius of the consensus-building in the bitcoin system means such forks shouldn’t be allowed to go on for long. That’s because the mining community works on the assumption that the longest chain is the one that constitutes consensus.”

That’s not quite accurate.  Each miner has different incentives.  And, as shown empirically with other altcoins, forks can reoccur frequently without incentives that align.  For now, some incentives apparently do.  But that does not mean that in the future, if say watermarked coins become more common place, that there will not be more frequent forks as certain miners attempt to double-spend or censor such metacoins.

Ironically on page 151 the authors describe the fork situation of March 2013 and describe the fix in which a few core developers convince Mark Karpeles (who ran Mt. Gox) to unilaterally adopt one specific fork.  This is not trustless.

On page 151 they write, “That’s come to be known as a 51 percent attack.  Nakamoto’s original paper stated that the bitcoin mining network could be guaranteed to treat everyone’s transactions fairly and honestly so long as no single miner or mining group owned more than 50 percent of the hashing power.”

And continuing on page 153, “So, the open-source development community is now looking for added protections against selfish mining and 51 percent attacks.”

While they do a good job explaining the issue, they don’t really discuss how it is resolved.  And it cannot be without gatekeepers or trusted hardware.  For instance, three weeks ago there was a good reddit thread discussing one of the problems of Andreas Antonopolous’  slippery slope view that you could just kick the attackers off the network.  First, there is no quick method for doing so; second, by blacklisting them you introduce a new problem of having the ability to censor miners which would be self-defeating for such a network as it introduces a form of trust into an expensive cost structure of trust minimization.

On page 152 they cite a Coinometrics number, “in the summer of 2014 the cost of the mining equipment and electricity required for a 51 percent attack stood at $913 million.”

This is a measurement of maximum costs based on hashrate brute force — a Maginot Line attack.  In practice it is cheaper to do via out of band attacks (e.g., rubber hose cryptanalysis).  There are many other, cheaper ways, to attack the P2P network itself (such as Eclipse attacks).

On page 154 when discussing wealth disparity in Bitcoin they write, “First, some perspective.  As a wealth-gap measure, this is a lousy one.  For one, addresses are not wallets.  The total number of wallets cannot be known, but they are by definition considerably fewer than the address tally, even though many people hold more than one.”

Finally.  So the past several chapters I have mentioned I will discuss wallets at some length.  Again, the authors for some reason uncritically cite the “wallet numbers” from Blockchain.info, Coinbase and others as actual digital wallets.  Yet here they explain that these metrics are bupkis.  And they are.  It costs nothing to generate a wallet and there are scripts you can run to auto generate them.  In fact, Zipzap and many others used to give every new user a Blockchain.info wallet por gratis.

And this is problematic because press releases from Xapo and Blockchain.info continually cite a number that is wholly inaccurate and distorting.  For instance Wences Casares said in a presentation a couple months ago that there were 7 million users.  Where did that number come from?  Are these on-chain privkey holders?  Why are journalists not questioning these claims?  See also: A brief history of Bitcoin “wallet” growth.

On page 154 they write, “These elites have an outsize impact on the bitcoin economy. They have a great interest in seeing the currency succeed and are both willing and able to make payments that others might not, simply to encourage adoption.”

Perhaps this is true, but until there is a systematic study of the conspicuous consumption that takes place, it could also be the case that some of these same individuals just have an interest in seeing the price of bitcoin rise and not necessarily be widely adopted.  The two are not mutually exclusive.

On page 155 and 156 they describe the bitsat project, to launch a full node into space which is aimed “at making the mining network less concentrated.”

Unfortunately these types of full nodes are not block makers.  Thus they do not actually make the network less concentrated, but only add more propagating nodes.  The two are not the same.

On page 156 they describe some of the altcoin projects, “They claim to take the good aspects of bitcoin’s decentralized structure but to get ride of its negative elements, such as the hashing-power arms race, the excessive use of electricity, and the concentration of industrialized mining power.”

I am well aware of the dozens various coin projects out there due to work with a digital asset exchange over the past year.  Yet fundamentally all of the proof-of-work based coins end up along the same trend line, if they become popular and reach a certain level of “market cap” (an inaccurate term) specialized chips are designed to hash it.  And the term “excessive” energy related to proof-of-work is a bit of a non-starter.  Ignoring proof-of-stake systems, if it becomes less energy intensive to hash via POW, then it also becomes cheaper to attack.  Either miners will add more equipment or the price has dropped for the asset and it is therefore cheaper to attack.

On page 157 regarding Litecoin they write that, “Miners still have an incentive to chase coin rewards, but the arms race and the electricity usage aren’t as intense.”

That’s untrue.  Scrypt (which is used instead of Hashcash) is just as energy intensive.  Miners will deploy and utilize energy in the same patterns, directly in proportion to the token price.  The difference is memory usage (Litecoin was designed to be more memory intensive) but that is unrelated to electrical consumption.

Continuing, “Litecoin’s main weakness is the corollary of its strength: because it’s cheaper to mine litecoins and because scrypt-based rigs can be used to mine other scrypt-based altcoins such as dogecoin, miners are less heavily invested in permanently working its blockchain.”

This is untrue.  Again, Litecoin miners will in general only mine up to the point where it costs a litecoin to make a litecoin.  Obviously there are exceptions to it, but in percentage terms the energy usage is the same.

Continuing, “Some also worry that scrypt-based mining is more insecure, with a less rigorous proof of work, in theory allowing false transactions to get through with incorrect confirmations.”

This is not true.  The two difference in security are the difficulty rating and block intervals.  The higher the difficulty rating, the more energy is being used to bury blocks and in theory, the more secure the blocks are from reversal.  The question is then, is 2.5 minutes of proof-of-work as secure as burying blocks every 10 minutes?  Jonathan Levin, among others, has written about this before.

cthuluSmall nitpick on page 157, fairly certain that nextcoin should be referred to as NXT.

On page 158 they write:

If bitcoin is to scale up, it must be upgraded sot hat nodes, currently limited to one megabyte of data per ten-minute block, are free to process a much larger set of information.  That’s not technically difficult; but it would require miners to hash much larger blocks of transactions without big improvements in their compensation.  Developers are currently exploring a transaction-fee model that would provide fairer compensation for miners if the amount of data becomes excessive.

This is not quite right.  There is a difference between block makers (pools) and hashers (mining farms).  The costs for larger blocks would impact block makers not hashers, as they would need to upgrade their network facilities and local hard drive.  This may seem trivial and unimportant, but Jonathan Levin’s research, as well as others suggest that block sizes does in fact impact orphan rates.5 It also impacts the amount of decentralization within the network as larger blocks become more expensive to propagate you will likely have fewer nodes.  This has been the topic of immense debate over the past several weeks on social media.

Also on page 158 they write:

The laboratory used by cryptocurrency developers, by contrast, is potentially as big as the world itself, the breadth of humanity that their projects seek to encompass. No company rulebook or top-down set of managerial instructions keeps people’s choice in line with a common corporate objective. Guiding people to optimal behavior in cryptocurrencies is entirely up to how the software is designed to affect human thinking, how effectively its incentive systems encourage that desired behavior

This is wishful thinking and probably unrealistic considering that Bitcoin development permanently suffers from the tragedy of the commons.  There is no CEO which is both good and bad.

For example, directions for where development goes is largely based on two things:

  1. how many upvotes your comment has on reddit (or how many retweets it gets on Twitter)
  2. your status is largely a function of how many times Satoshi Nakamoto responded to you in email or on the Bitcointalk forum creating a permanent clique of “early adopters” whose opinions are the only valid ones (see False narratives)

This is no way to build a financial product.  Yet this type of lobbying is effectively how the community believes it will usurp well-capitalized private entities in the payments space.

Several months ago a user, BitttBurger, made a similar observation:

I’ve said it before and I will say it again. There is a reason why Developers should not be in control of product development priorities, naming, feature lists, or planning for a product. That is the job of the sales, marketing, and product development teams who actually interface with the customer. They are the ones who do the research and know what’s needed for a product. They are the ones who are supposed to decide what things are called, what features come next, and how quickly shit gets out the door.

Bitcoin has none of that. You’ve got a Financial product, being created for a financial market, by a bunch of developers with no experience in finance, and (more importantly) absolutely no way for the market to have any input or control over what gets done, or what it’s called. That is crazy to me.

Luke is a perfect example of why you don’t give developers control over anything other than the structure of the code.

They are not supposed to be making product development decisions. They are not supposed to be naming anything. And they definitely are not supposed to be deciding “what comes next” or how quickly things get done. In any other company, this process would be considered suicide.

Yet for some reason this is considered to be a feature rather than a bug (e.g., “what is your Web of Trust (WoT) number?”).

On page 159 they write, “The vital thing to remember is that the collective brainpower applied to all the challenges facing bitcoin and other cryptocurrencies is enormous.  Under the open-source, decentralized model, these technologies are not hindered by the same constraints that bureaucracies and stodgy corporations face.”

So, what is the Terms of Service for Bitcoin?  What is the customer support line?  There isn’t one.  Caveat emptor is pretty much the marketing slogan and that is perfectly fine for some participants yet expecting global adoption without a “stodgy” “bureaucracy” that helps coordinate customer service seems a bit of a stretch.

And just because there is some avid interest from a number of skilled programmers around the world does not mean public goods problems surrounding development will be resolved.  For reference: there were over 5000 co-authors on a recent physics paper but that doesn’t mean their collective brain power will quickly resolve all the open questions and unsolved problems in physics.

Chapter 7:

Small nitpick on page 160, “Bitcoin was born out of a crypto-anarchist vision of a decentralized government-free society, a sort of encrypted, networked utopia.”

As noted above, there is actually no encryption used in Bitcoin.

On page 162 they write, “Before we get too carried away, understand this is still early days.”

That may be the case.  Perhaps decentralized cryptocurrencies like Bitcoin are not actually the internet in the early 1990s like many investors claim but rather the internet in the 1980s when there were almost no real use-cases and it is difficult to use.  Or 1970s.  The problem is no one can actually know the answer ahead of time.

And when you try to get put some milestone down on the ground, the most ardent of enthusiasts move the goal posts — no comparisons with existing tech companies are allowed unless it is to the benefit of Bitcoin somehow.  I saw this a lot last summer when I discussed the traction that M-Pesa and Venmo had.

A more recent example is “rebittance” (a portmanteau of “bitcoin” and “remittance”).  A couple weeks ago Yakov Kofner, founder of Save On Send, published a really good piece comparing money transmitter operators with bitcoin-related companies noting that there currently is not much meat to the hype.  The reaction on reddit was unsurprisingly fist-shaking Bitcoin rules, everyone else drools.

yakov breakfast

With Yakov Kofner (CEO Save On Send)

When I was in NYC last week I had a chance to meet with him twice.  It turns out that he is actually quite interested in Bitcoin and even scoped out a project with a VC-funded Bitcoin company last year for a consumer remittances product.

But they decided not to build and release it for a few reasons: 1) in practice, many consumers are not sensitive enough to a few percentage savings because of brand trust/loyalty/habit; 2) lacking smartphones and reliable internet infrastructure, the cash-in, cash-out aspect is still the main friction facing most remittance corridors in developing countries, bitcoin does not solve that; 3) it boils down to an execution race and it will be hard to compete against incumbents let alone well-funded MTO startups (like TransferWise).

That’s not to say these rebittance products are not good and will not find success in niches.

For instance, I also spoke with Marwan Forzley (below), CEO of Align Commerce last week.  Based on our conversation, in terms of volume his B2B product appears to have more traction than BitPay and it’s less than a year old.  What is one of the reasons why?  Because the cryptocurrency aspect is fully abstracted away from customers.

marwan p2p

Raja Ramachandran (R3CEV), Dan O’Prey (Hyperledger), Daniel Feichtinger (Hyperledger), Marwan Forzley (Align Commerce)

In addition, both BitX and Coins.ph — based on my conversations in Singapore two weeks ago with their teams — seem to be gaining traction in a couple corridors in part because they are focusing on solving actual problems (automating the cash-in/cash-out process) and abstracting away the tech so that the average user is oblivious of what is going on behind the scenes.

singapore ron

Markus Gnirck (StartupBootCamp), Antony Lewis (itBit) and Ron Hose (Coins.ph) at the DBS Hackathon event

On page 162 and 163 the authors write about the Bay Area including 20Mission and Digital Tangible.  There is a joke in this space that every year in cryptoland is accelerated like dog years.  While 20Mission, the communal housing venue, still exists, the co-working space shut down late last year.  Similarly, Digital Tangible has rebranded as Serica and broadened from just precious metals and into securities.  In addition, Dan Held (page 164) left Blockchain.info and is now at ChangeTip.

On page 164 they write, “But people attending would go on to become big names in the bitcoin world: Among them were Brian Armstrong and Fred Ehrsam, the founders of Coinbase, which is second only to Blockchain as a leader in digital-wallet services and one of the biggest processors of bitcoin payments for businesses.”

10 pages before this they said how useless digital wallet metrics are.  It would have been nice to press both Armstrong and Ehrsam to find out what their actual KYC’ed active users to see if the numbers are any different than the dated presentation.

On page 165 they write:

“It’s a very specific type of brain that’s obsessed with bitcoin,” says Adam Draper, the fourth-generation venture capitalist…”

I hear this often but what does that mean?  Is investing genetic?  If so, surely there are more studies on it?

For instance, later on page 176 they write, “The youngest Draper, who tells visitors to his personal web site that his life’s ambition is to assist int he creation of an iron-man suit, has clearly inherited his family’s entrepreneurial drive.”

Perhaps Adam Draper is indeed both a bonafide investor and entrepreneur, but it does not seem to be the case that either can be or is necessarily inheritable.

On page 167, “The only option was to “turn into a fractional-reserve bank,” he said jokingly, referring tot he bank model that allows banks to lend out deposits while holding a fraction of those funds in reserve.  “They call it a Ponzi scheme unless you have a banking license.”

Why is this statement not challenged?  I am not defending rehypothecation or the current banking model, but fractional reserve banking as it is employed in the US is not a Ponzi scheme.

Also on page 167 they write, “First, he had trouble with his payments processor, Dwolla which he later sued for $2 million over what Tradehill claimed were undue chargebacks.”

A snarky thing would be to say he should have used bitcoin, no chargebacks.  But the issue here, one that the authors should have pressed is that Tradehill, like Coinbase and Xapo, are effectively behaving like banks.  It’s unclear why this irony is not discussed once in the book.

For instance, several pages later on page 170 they once again talk about wallets:

The word wallet is thrown around a lot in bitcoin circles, and it’s an evocative description, but it’s just a user application that allows you to send and receive bitcoins over the bitcoin network. You can download software to create your own wallet — if you really want to be your own bank — but most people go through a wallet provider such as Coinbase or Blockchain, which melded them into user-friendly Web sites and smart phone apps.

I am not sure if it is intentional but the authors clearly understand that holding a private key is the equivalent of being a bank.  But rather than say Coinbase is a bank (because they too control private keys), they call them a wallet provider.  I have no inside track into how regulators view this but the euphemism of “wallet provider” is thin gruel.  On the other hand Blockchain.info does not hold custody of keys but instead provide a user interface — at no point do they touch a privkey (though that does not mean they could not via a man-in-the-middle-attack or scripting errors like the one last December).

On page 171 they talk about Nathan Lands:

The thirty-year-old high school dropout is the cofounder of QuickCoin, the maker of a wallet that’s aimed directly at finding the fastest easiest route to mass adoption.  The idea, which he dreamed up with fellow bitcoiner Marshall Hayner one night over a dinner at Ramen Underground, is to give nontechnical bitcoin newcomers access to an easy-to-use mobile wallet viat familiar tools of social media.

Unfortunately this is not how it happened.  More in a moment.

Continuing the authors write, “His successes allowed Lands to raise $10 million for one company, Gamestreamer.”

Actually it was Gamify he raised money for.

Next the authors state: “He started buying coins online, where her ran into his eventual business partner, Hayner (with whom he later had a falling-out, and whose stake he bought).”

One of the biggest problems I had with this book is that the authors take claims at face value.  To be fair, I probably did a bit too much myself with GCON.

On this point, I checked with Marshall Hayner who noted that this narrative was untrue:  “Nathan never bought my stake, nor was I notified of any such exchange.”

While the co-founder dispute deserves its own article or two, the rough timeline is that in late 2013 Hayner created QuickCoin and then several months later on brought Lands on to be the CEO.  After a soft launch in May 2014 (which my wife and I attended, see below) Lands maneuvered and got the other employees to first reduce the equity that Hayner had and then fired him so they could open up the cap table to other investors.

quickcoin

QuickCoin launch party with Marshall Hayner, Jackson Palmer (Dogecoin), and my wife

With Hayner out, QuickCoin quickly faded due to the fact that the team had no ties to the local cryptocurrency community.  Hayner went on to join Stellar and is now the co-founder of Trees.  QuickCoin folded by the end of the year and Lands started Blockai.

On page 174 they discuss VCs involved in funding Bitcoin-related startups:

Jerry Yang, who created the first successful search engine, Yahoo, put money from his AME Ventures into a $30 million funding round for processor BitPay and into one of two $20 million rounds raised by depository and wallet provider Xapo, which offers insurance to depositors and call itself a “bitcoin vault.”

While they likely couldn’t have put it in this section, I think it would have been good for the authors to discuss the debate surrounding what hosted wallets actually are because regulators and courts may not agree with the marketing-speak of these startups.6

On page 177 they write about Boost VC which is run by Adam Draper, “He’d moved first and emerged as the leader in the filed, which meant his start-ups could draw in money from the bigger guys when it came time for larger funding rounds.”

It would be interesting to see the clusters of what VCs do and do not co-invest with others.  Perhaps in a few years we can look back and see that indeed, Boost VC did lead the pack.  However while there are numerous incubated startups that went on to close seed rounds (Blockcypher, Align Commerce, Hedgy, Bitpagos) as of this writing there is only one incubated company in Boost that has closed a Series A round and that is Mirror (Coinbase, which did receive funding from Adam Draper, was not in Boost).  Maybe this is not a good measure for success, perhaps this will change in the future and maybe more have done so privately.

On page 179-180 the discussion as to what Plug and Play Tech Center does and its history was well written.

On page 184 they write:

With every facet of our economy now dependent on the kinds of software developed and funded in the Bay Area, and with the Valley’s well-heeled communities becoming a vital fishing ground for political donations and patronage, we’re witnessing a migration of the political and economic power base away from Wall Street to this region.

I have heard variations of this for the past couple of years.  Most recently I heard a VC claim that Andreessen Horrowitz (a16z) was the White House of the West Coast and that bankers in New York do not understand this tech.  Perhaps it is and perhaps bankers do not understand what a blockchain is.

Either way we should be able to see the consequences to this empirically at some point.  Where is the evidence presented by the authors?

incumbents

Source: finviz

Fast forwarding several chapters, on page 287 they write, “Visa, MasterCard, and Western Union combined – to name just three players whose businesses could be significantly reformed — had twenty-seven thousand employees in 2013.”

Perhaps these figures will dramatically change soon, however, the above image are the market caps over the past 5 years of four incumbents: JP Morgan (the largest bank in the US), MasterCard and Visa (the largest card payment providers) and Western Union, the world’s largest money transfer operator.

Will their labor force dramatically change because of cryptocurrencies?  That is an open question.  Although it is unclear why the labor force at these companies would necessarily shrink because of the existence of Bitcoin rather than expand in the event that these companies integrated parts of the tech (e.g., a distributed ledger) thereby reducing costs and increasing new types of services.

On page 185 they write, “Those unimaginable possibilities exist with bitcoin, Dixon says, because “extensible software platforms that allow anyone to build on top of them are incredibly powerful and have all these unexpected uses. The stuff about fixing the existing payment system is interesting, but what’s superexciting is that you have this new platform on which you can move money and property and potentially build new areas of businesses.”

Maybe this is true.  It is unclear from these statements as to what Chris Dixon views as broken about the current payment system.  Perhaps it is “broken” in that not everyone on the planet has access to secure, near-instant methods of global value transer.  However it is worth noting that cryptocurrencies are not the only competitors in the payments space.

According to AngelList as of this writing:

Chapter 8:

This chapter discussed “The Unbanked” and how Bitcoin supposedly can be a solution to banking these individuals.

On page 188 they discuss a startup called 37coins:

“It uses people in the region lucky enough to afford Android smartphones as “gateways” to transmit the messages.  In return, these gateways receive a small fee, which provides the corollary benefit of giving locals the opportunity to create a little business for themselves moving traffic.”

This is a pretty neat idea, both HelloBit and Abra are doing something a little similar.  The question however is, why bitcoin?  Why do users need to go out of fiat, into bitcoin and back out to fiat?  If the end goal is to provide users in developing countries a method to transmit value, why is this extra friction part of the game plan?

Last month I heard of another supposed cryptocurrency “killer app”: smart metering prepaid via bitcoin and how it is supposed to be amazing for the unbanked.  The unbanked, they are going to pay for smart metering with money they don’t have for cars they don’t own.  There seems to be a disconnect when it comes to financial inclusion as it is sometimes superficially treated in the cryptocurrency world.  Many Bitleaders and enthusiasts seem to want to pat themselves on the back for a job that has not been accomplished.  How can the cryptocurrency community bring the potential back down to real world situations without overinflating, overhyping or over promising?

If Mercedes or Yamaha held a press conference to talk about the “under-cared” or “under-motorcycled” they would likely face a backlash on social media.  Bitcoin the bearer instrument, is treated like a luxury good and expecting under-electrified, under-plumbed, under-interneted people living in subsistence to buy and use it today without the ability to secure the privkey without a trusted third party, seems far fetched (“the under bitcoined!”).  Is there a blue print to help all individuals globally move up Maslow’s Hierarchy of Financial Wants & Needs?

On page 189 they write:

“But in the developing world, where the costs of an ineffectual financial system and the burdens of transferring funds are all too clear, cryptocurrencies have a much more compelling pitch to make.”

The problem is actually at the institutional level, institutions which do not disappear because of the Bitcoin blockchain.  Nor does Bitcoin solve the identity issue: users still need real-world identity for credit ratings so they can take out loans and obtain investment to build companies.

For instance on page 190 the authors mention the costs of transferring funds to and from Argentina, the Philippines, India and Pakistan.  One of the reasons for the high costs is due to institutional problems which is not solved by Bitcoin.

In fact, the authors write, “Banks won’t service these people for various reasons. It’s partly because the poor don’t offer as fat profits as the rich, and it’s partly because they live in places where there isn’t the infrastructure and security needed for banks to build physical branches. But mostly it’s because of weak legal institutions and underdeveloped titling laws.”

This is true, but Bitcoin does not solve this.  If local courts or governments do not recognize the land titles that are hashed on the blockchain it does the local residents no good to use Proof of Existence or BlockSign.

They do not clarify this problem through the rest of the chapter.  In fact the opposite takes place, as they double down on the reddit narrative:

“Bitcoin, as we know, doesn’t care who you are. It doesn’t care how much money you are willing to save, send, or spend. You, your identity and your credit history are irrelevant. […] If you are living on $50 a week, the $5 you will save will matter a great deal.”

This helps nobody. The people labeled as “unbanked” want to have access to capital markets and need a credit history so they can borrow money to create a companies and build homes.  Bitcoin as it currently exists, does not solve those problems.

Furthermore, how do these people get bitcoins in the first place?  That challenge is not discussed in the chapter.  Nor is the volatility issue, one swift movement that can wipe out the savings of someone living in subsistence, broached.  Again, what part of the network does lending on-chain?

On page 192 they write, “They lack access to banks not because they are uneducated, but because of the persistent structural and systemic obstacles confronting people of limited means there: undeveloped systems of documentation and property titling, excessive bureaucracy, cultural snobbery, and corruption. The banking system makes demands that poor people simply can’t meet.”

This is very true.  The Singapore conference I attended two weeks ago is just one of many conferences held throughout this year that talked about financial inclusion.  Yet Bitcoin does not solve any of these problems.  You do not need a proof-of-work blockchain to solve these issues.  Perhaps new database or permissioned ledgers can help, but these are social engineering challenges — wet code — that technology qua technology does not necessarily resolve.

Also on page 192 they write, “People who have suffered waves of financial crises are used to volatility. People who have spent years trusting expensive middlemen and flipping back and forth between dollars and their home currency are probably more likely to understand bitcoin’s advantages and weather its flaws.”

This is probably wishful thinking too.  Residents of Argentina and Ukraine may be used to volatility but it does not mean it is something they want to adopt.  Why would they want to trade one volatile asset for another?  Perhaps they will but the authors do not provide any data for actual usage or adoption in these countries, or explain why the residents prefer bitcoin instead of something more global and stable such as the US dollar.

On page 193 they write that, “In many cases, these countries virtually skip over legacy technology, going straight to high-tech fiber-optic cables.”

While there is indeed a number of legacy systems used on any given day in the US, it is not like Bitcoin itself is shiny new tech.  While the libraries and BIPS may be new, the components within the consensus critical tech almost all dates back to the 20th century.

For instance, according to Gwern Branwen, the key moving parts that Bitcoin uses:

  1. 2001: SHA-256 finalized
  2. 1999-present: Byzantine fault tolerance (PBFT etc.)
  3. 1999-present: P2P networks (excluding early networks like Usenet or FidoNet; MojoNation & BitTorrent, Napster, Gnutella, eDonkey, Freenet, etc.)
  4. 1998: Wei Dai, B-money5
  5. 19986: Nick Szabo, Bit Gold
  6. 1997: HashCash
  7. 1992-1993: Proof-of-work for spam7
  8. 1991: cryptographic timestamps
  9. 1980: public key cryptography8
  10. 1979: Hash tree

That’s not to say that Bitcoin is bad, old or that other systems are not old or bad but rather the term “legacy” is pretty relative and undefined in that passage.

On page 194 they discuss China and bitcoin, “With bitcoin, the theory goes, people could bypass that unjust banking system and get their money out of China at low cost.”

This is bad legal advice, just look at the problems this caused Coinbase with regulators a couple months ago.  And while you could probably do it low-scale, it then competes with laundering via art sales and Macau junkets and thus expecting this to be the killer use-case for adoption in China is fairly naive.

On page 195 they write “Bitcoin in China is purely a speculator’s game, a way to gamble on its price, either through one of a number of mainland exchanges or by mining it. It is popular — Chinese trading volumes outstrip those seen anywhere else in the world.”

Two months ago Goldman Sachs published a widely circulated report which stated that “80% of bitcoin volume is now exchanged into and out of Chinese yuan.”

This is untrue though as it is solely based on self-reporting metrics from all of the exchanges (via Bitcoinity).  As mentioned in chapter 1 notes above, the top 3 exchanges in China run market-making bots which dramatically inflate trading volume by 50-70% each day.  While they likely still process a number of legitimate trades, it cannot be said that 80% of bitcoin volume is traded into and out of RMB.  The authors of both the report and the book should have investigated this in more depth.

On page 196 they write, “This service, as well as e-marketplace Alibaba’s competing Alipay offering, is helping turn China into the world’s most dynamic e-commerce economy. How is bitcoin to compete with that?”

Great question and the answer is it probably won’t.  See Understanding value transfers to and from China.

Next on page 196 they write, “But what about the potential to get around the controls the government puts on cross-border fund transfers?”

By-passing capital controls was discussed two pages before and will likely cause problems for any VC or PE-backed firm in China, the US and other jurisdictions.  I am not defending the current policies just being practical: if you are reading their book and plan to do this type of business, be sure to talk to a legal professional first.

On page 197 they discuss a scenario for bitcoin adoption in China: bank crisis.  The problem with this is that in the history of banking crisis’ thus far, savers typically flock to other assets, such as US dollars or euros.  The authors do not explain why this would change.  Now obviously it could or in the words of the authors, the Chinese “may warm to bitcoin.”  But this is just idle speculation — where are the surveys or research that clarify this position?  Why is it that many killer use-cases for bitcoin typically assumes an economy or two crashes first?

On page 198 they write, “The West Indies even band together to form one international cricket team when they play England, Australia, and other members of the Commonwealth. What they don’t have, however, is a common currency that could improve interisland commerce.”

More idle speculation.  Bitcoin will probably not be used as a common currency because policy makers typically want to have discretion via elastic money supplies.  In addition, one of the problems that a “common currency” could have is what has plagued the eurozone: differing financial conditions in each country motivate policy makers in each country to lobby for specific monetary agendas (e.g., tightening, loosening).  Bitcoin in its current form, cannot be rebased to reflect the changes that policy makers could like to make.  While many Bitcoin enthusiasts like this, unless the authors of the book have evidence to the contrary, it is unlikely that the policy makers in the West Indies find this desirable.

On page 199 they write, “A Caribbean dollar remains a pipe dream.”

It is unclear why having a unified global or regional currency is a goal for the authors?  Furthermore, there is continued regional integration to remove some frictions, for instance, the ECACH (Eastern Caribbean Automated Clearing House) has been launched and is now live in all 8 member countries.

On page 203 they spoke to Patrick Byrne from Overstock.com about ways Bitcoin supposedly saves merchants money.  They note that, “A few weeks later, Byrne announced he would not only be paying bitcoin-accepting vendors one week early, but that he’d also pay his employee bonuses in bitcoin.”

Except so far this whole effort has been a flop for Overstock.com.  According to Overstock, in 2014 approximately 11,100 customers paid with bitcoin at both its US and international websites.  Altogether this represented roughly $3 million in sales which when coupled with low margin products (based on the top 10 list of things sold on Overstock) is an initiative that Stone Street Advisors labeled “distracting” (see slides 21, 32, 33, 37, 58).

This continues onto page 204, “As a group of businesses in one region begins adopting the currency, it will become more appealing to others with whom they do business. Once such a network of intertwined businesses builds up, no one wants to be excluded from it. Or so the theory goes.”  Byrne then goes on to describe network effects and fax machines, suggesting that this is what will happen with bitcoin.

In other words, a circular flow of income.  The challenge however goes back to the fact that the time preferences of individuals is different and has not lended towards the theory of spending.  As a whole, very few people spend and suppliers typically cash out to reduce their exposure to volatility.  Perhaps this will change, but there is no evidence that it has so far.

On page 206 they talk to Rulli from Film Annex (who was introduced in the introduction):

With bitcoin, “you can clearly break down the value of every single stroke on the keyboard, he says.

And you cannot with fiat?

Continuing the authors talk about Rulli:

He wanted the exchange to be solely in bitcoin for other digital currencies, with no option to buy rupees or dollars: “The belief I have is that if you lock these people into this new economy, they will make that new economy as efficient as possible.”

What about volatility?  Why are marginalized people being expected to hold onto an asset that fluctuates in value by more than 10% each month?  Rulli has a desire to turn the Film Annex Web site “into its own self enclosed bitcoin economy.”  There is a term for this: autarky or closed economy.

Continuing Rulli states, ‘If you start giving people opportunities to get out of the economy, they will just cut it down, whereas if the only way for you to enrich yourself is by trading bitcoins for litecoins and dogecoins, you are going to become an expert in that… you will become the best trader in Pakistan.”

This seems to be a questionable strategy: are these users on bitLanders supposed to be artisans or day traders?  Why are marginalized people expected to compete with world-class professional traders?

On page 210 the second time the term “virtual currency” is mentioned, this time by the Argentinian central bank.

On page 213 they write, “With bitcoin, it is possible to sen money via a mobile phone, directly between two parties, to bypass that entire cumbersome, expensive system for international transfers.”

What an updated version to the book should include is an actual study for the roundtrip costs of doing international payments and remittances.  This is not to defend the incumbents, but rebittance companies and enthusiasts on reddit grossly overstate the savings in many corridors.7 And it still does not do away with the required cash-in / cash-out steps that people in these countries still want and need.

On page 216 they write about the research of Hernando de Soto who discusses the impediments of economic development including the need to document ownership of property.  Unfortunately Bitcoin does not currently solve this because ultimately the recognition of a hash of a document on a blockchain comes down to recognition from the same institutions that some of these developing countries lack.

Continuing on page 217 they write that, “Well, the blockchain, if taken to the extent that a new wave of bitcoin innovators believe possible, could replace many of those institutions with a decentralized authority for proving people’s legal obligations and status. In doing so, it could dramatically widen the net of inclusion.”

How?  How is this done?  Without recognized title transfers, hashing documents onto a chain does not help these people.  This is an institutional issue, not one of technology.  Human corruption does not disappear because of the existence of Bitcoin.

Chapter 9:

On page 219 they write, “Like everything else in the cryptocurrency world, the goal is to decentralize, to take power out of the hands of the middleman.”

By recreating the same middleman, depository institutions, yet without robust financial controls.

On page 220 and 221 they mention “basic encryption process” and “standard encryption models” — I believe that it is more accurately stated as cryptographic processes and cryptographic models.

On page 222 they define “Bitcoin 2.0″ / “Blockchain 2.0″ and put SatoshiDice into that bucket.  Ignoring the labels for a moment, I don’t think SatoshiDice or any of the other on-chain casino games are “2.0” — they use the network without coloring any asset.

One quibble with Mike Hearn’s explanation on page 223 is when he says, “But bitcoin has no intermediaries.”  This is only true if you control and secure the privkey by yourself.  In practice, many “users” do not.

On page 225 they write, “Yet they are run by Wall Street banks and are written and litigated by high-powered lawyers pulling down six- or seven-figure retainers.”

Is it a crime to be able to charge what the market bears for a service?  Perhaps some of this technology will eventually reduce the need for certain legal services, but it is unclear what the pay rate of attorneys in NYC has in relation with Bitcoin.

Also on page 225 a small typo: “International Derivatives and Swaps Association (ISDA)” — need to flip Derivatives and Swaps.

On page 226, 227, 229 and 244: nextcoin should be called NXT.

On page 227 they write, “Theses are tradable for bitcoins and other cryptocurrencies on special altcoin exchanges such as Cryptsy, where their value is expected to rise and fall according to the success or failure of the protocol to which they belong.”

There is a disconnect between the utility of a chain and the speculative activity around the token.  For instance, most day traders likely do not care about the actual decentralization of a network, for if they did, it would be reflected in prices of each chain.  There are technically more miners (block makers) on dozens of alternative proof-of-work chains than there in either bitcoin or litecoin yet market prices are (currently) not higher for more decentralized chains.

On page 228 they write that:

“Under their model, the underlying bitcoin transactions are usually of small value — as low as a “Satoshi” (BTC0.00000001).  That’s because the bitcoin value is essentially irrelevant versus the more important purpose of conveying the decentralized application’s critical metadata across the network, even though some value exchange is needed to make the communication of information happen.”

Actually in practice the limit for watermarked coins typically resides around 0.0001 BTC.  If it goes beneath 546 satoshi, then it is considered dust and not included into a block.  Watermarked coins also make the network top heavy and probably insecure.8

On page 209, the third time “virtual currency” is used and comes from Daniel Larimer, but without quotes.

On page 230 they discuss an idea from Daniel Larimer to do blockchain-based voting.  While it sounds neat in theory, in practice it still would require identity which again, Bitcoin doesn’t solve.  Also, it is unclear from the example in the book as to why it is any more effective/superior than an E2E system such as Helios.

On page 238 they write, “It gets back to the seigniorage problem we discussed in chapter 5 and which Nakamoto chose to tackle through the competition for bitcoins.”

I am not sure I would classify it as a problem per se, it is by design one method for rewarding security and distributing tokens.  There may be other ways to do it in a decentralized manner but that is beyond the scope of this review.

On page 239 they discuss MaidSafe and describe the “ecological disaster” that awaits data-center-based storage.  This seems a bit alarmist because just in terms of physics, centralized warehouses of storage space and compute will be more efficient than a decentralized topology (and faster too).  This is discussed in Chapter 3 (under “Another facsimile”).

Continuing they quote the following statement from David Irvine, founder of MaidSafe: “Data centers, he says, are an enormous waste of electricity because they store vast amounts of underutilized computing power in huge warehouse that need air-condition and expensive maintenance.”

Or in other words: #bitcoin

On page 242 they mention Realcoin whose name has since been changed to Tether.  It is worth pointing out that Tether does not reduce counterparty risk, users are still reliant on the exchange (in this case Bitfinex) from not being hacked or shut down via social engineering.

On page 244, again to illustrate how fast this space moves, Swarm has now pivoted from offering cryptocurrency-denominated investment vehicles into voting applications and Open-Transactions has hit a bit of a rough patch, its CTO, Chris Odom stepped down in March and the project has not had any public announcements since then.

Chapter 10:

If you missed it, the last few weeks on social media have involved a large debate around blockchain stability with respect to increasing block sizes.  During one specific exchange, several developers debated as to “who was in charge,” with Mike Hearn insisting that Satoshi left Gavin in charge and Greg Maxwell stating that this is incorrect.

gavin mike hearn

Source: Reddit

This ties in with the beginning of page 247, the authors write about Gavin Andresen, “A week earlier he had cleared out his office at the home he shares with his wife, Michele – a geology professor at the University of Massachusetts — and two kids. He’d decided that a man essentially if not titularly in charge of running an $8 billion economy needed something more than a home office.”

Who is in charge of Bitcoin?  Enthusiasts on reddit and at conferences claim no one is.  The Bitcoin Foundation claims five people are (those with commit access).  Occasionally mainstream media sites claim the Bitcoin CEO or CFO is fired/jailed/dead/bankrupt.

The truth of the matter is that it is the miners who decide what code to update and use and for some reason they are pretty quiet during all of this hub bub.  Beyond that, there is a public goods problem and as shown in the image above, it devolves into various parties lobbying for one particular view over another.

The authors wrote about this on page 247, “The foundation pays him to coordinate the input of the hundreds of far-flung techies who tinker away at the open-licensed software. Right now, the bitcoin community needed answers and in the absence of a CEO, a CTO, or any central authority to turn to, Andresen was their best hope.”

It is unclear how this will evolve but is a ripe topic of study.  Perhaps the second edition will include other thoughts on how this role has changed over time.

On page 251 they write, “Probably ten thousand of the best developers in the world are working on this project,” says Chris Dixon, a partner at venture capital firm Andreessen Horowitz.

How does he know this?  There are not 10,000 users making changes to Bitcoin core libraries on github or 10,000 subscribers to the bitcoin development mailing list or IRC rooms.  I doubt that if you added up all of the employees of every venture-backed company in the overall Bitcoin world, that the amount would equate to 2,000 let alone 10,000 developers.  Perhaps it will by the end of this year but this number seems to be a bit of an exaggeration.

Continuing Dixon states, “You read these criticisms that ‘bitcoin has this flaw and bitcoin has that flaw,’ and we’re like ‘Well, great. Bitcoin has ten thousand people working hard on that.”

This is not true.  There is a public goods problem and coordination problem.  Each developer and clique of developers has their own priorities and potential agenda for what to build and deploy.  It cannot be said that they’re all working towards one specific area.  How many are working on the Lightning Network?  Or on transaction malleability (which is still not “fixed”)?  How many are working on these CVE?

On page 254 they discuss Paul Baran’s paper “On Distributed Communications Networks,” the image of which has been used over the years and I actually used for my paper last month.

On page 255 the fourth usage of “virtual currency” appears regarding once more, FinCEN director Jennifer Shasky.  Followed by page 256 with another use of “virtual currency.”  On page 257 Benjamin Lawsky was quoted using “virtual currency.”  Page 259 the term “virtual currency” appears when the European Banking Authority is quoted.  Page 260 and 261 sees “virtual currency” being used in relation with NYDFS and Lawsky once more.  On page 264 another use of “virtual currency” is used and this time in relation with Canadian regulations from June 2014.

On page 265 they mention “After the People’s Bank of China’s antibitcoin directives…”

I am not sure the directives were necessarily anti-bitcoin per se.  Rather they prohibited financial institutions like banks and payment processors from directly handling cryptocurrencies such as bitcoins.  The regulatory framework is still quite nebulous but again, going back to “excessive” in the introduction above, it is unclear why this is deemed “anti-bitcoin” when mining and trading activity is still allowed to take place.  Inconsistent and unhelpful, yes.  Anti?  Maybe, maybe not.

Also on page 265 they mention Temasek Holdings, a sovereign wealth fund in Singapore that allegedly has bitcoins in its portfolio.  When I was visiting there, I spoke with a managing director from Temasek two weeks ago and he said they are not invested in any Bitcoin companies and the lunchroom experiment with bitcoins has ended.

On page 268 the authors discuss “wallets” once more this time in relation with Mt.Gox: “All the bitcoins were controlled by the exchange in its own wallets” and “Reuters reported that only Karpeles knew the passwords to the Mt. Gox wallets and that he refused a 2012 request from employees to expand access in the event that he became incapacitated.”

Chapter 11:

On page 275 the authors use a good nonce, “übercentralization.”

On page 277 they write, “While no self-respecting bitcoiner would ever describe Google or Facebook as decentralized institutions, not with their corporate-controlled servers and vast databases of customers’ personal information, these giant Internet firms of our day got there by encouraging peer-to-peer and middleman-free activities.”

In the notes on the margin I wrote “huh?”  And I am still confused because each of these companies attempts to build a moat around their property.  Google has tried 47 different ways to create a social network even going so far as to cutting off its nose (Google Reader, RIP) to spite its face all with the goal of keeping traffic, clicks and eyeballs on platforms it owns.  And this is understandable.  Similarly Coinbase and other “universal hosted wallets” are also trying to build a walled garden of apps with the aim of stickiness — finding something that will keep users on their platform.

On page 277 they also wrote that, “Perhaps these trends can continue to coexist if the decentralizing movements remains limited to areas of the economy that don’t bleed into the larger sectors that Big Business dominates.”

What about Big Bitcoin?   The joke is that there are 300,027 advocacy groups in Bitcoinland: 300,000 privkey holders who invested in bitcoin and 27 actual organizations that actively promote Bitcoin.  There is probably only one quasi self-regulating organization (SRO), DATA.  And the advocacy groups are well funded by VC-backed companies and investors, just look at CoinCenter’s rolodex.

On page 280 they write, “Embracing a cryptoccurency-like view of finance, it has started an investment program that allows people invest directly in the company, buying notes backed by specific hard assets, such as individual stores, trucks, even mattress pads. No investment bank is involved, no intermediary. Investors are simply lending U-Haul money, peer-to-peer, and in return getting a promissory note with fixed interested payments, underwritten by the company’s assets.”

This sounds a lot like a security as defined by the Howey test.  Again, before participating in such an activity be sure to talk with a legal professional.9

On page 281 they use the term “virtual currencies” for the 11th time, this time in reference to MasterCard’s lobbying efforts in DC for Congress.

On page 283 a small typo, “But here’s the rub: because they are tapped” — (should be trapped).

On page 283 they write, “By comparison, bitcoin processors such as BitPay, Coinbase, and GoCoin say they’ve been profitable more or less from day one, given their low overheads and the comparatively tiny fees charged by miners on the blockchain.”

This is probably false.  I would challenge this view, and that none of them are currently breaking even on merchant processing fees alone.

In fact, they likely have the same user acquisition costs and compliance costs as all payment processors do.

For instance, in October 2014, Brian Armstrong and Fred Ehrsam, co-founders of Coinbase, did a reddit AMA.  At the 21:12 minute mark (video):

Q: Is Coinbase profitable or not, if not, when?

A: It’s happened to be profitable at times, at the moment it’s not; we’re not burning too much cash.  I think that the basic idea here is to grow and by us growing we help the entire ecosystem grow — without dying.  So not at the moment but not far.

It’s pretty clear from BitPay’s numbers that unless they’ve been operating a high volume exchange, they are likely unprofitable.

Why?  Because, in part of the high burn rate.  What does this mean?

Last week Moe Levin, former Director of European Business Development at BitPay, was interviewed by deBitcoin, below is one detailed exchange starting at 1:57m:

Q: There was a lot of stories in the press about BitPay laying off people, can you comment on that?

A: Yea, what happened was we had a high burn rate and the company necessarily needed to scale back a little bit on how many people we hired, how many people we had on board, how much we sponsored things.  I mean things were getting a little bit out of hand with sponsorships, football games and expansion — more care needed to be put on how and where we spent the money.

Q: Can you elaborate on the burn rate?  Tim Swanson wrote a piece on BitPay in April, published this piece about the economy, the BitPay economy. Posted this piece on the burn rate and actual figures, have you read that piece?  Can you comment on that?

A: Yes, it is especially hard for a company to build traction when they start off.  Any start up is difficult to build traction.  It’s doubly hard, the hardness is amplified when a company enters a market with competitors that have near unlimited resources because the other companies can either blow you out of the water or have better marketing strategies or they can do a ton of different things to make your startup more irrelevant.  Standard in any company but it is doubly difficult when you enter a market like that.  In the payments industry, forget about Bitcoin for a second, in the payments industry and the mobile commerce, ecommerce, company-to-company payments industry there are massive players with investments and venture backed companies in the billions.  Competing at that stage is tricky and it necessarily requires a burn rate that is much higher than the average startup because of how you need to compete in this space.  What is also important is that the regulation costs a lot of money for the startups in the Bitcoin economy.  It’s the perfect storm of how a startup will be hit with a ton of expenses early on and that can hurt the growth of a company.  Even though a lot of the money that went into it was growth capital it takes a while to get the balance right between spending and growing.

On page 284 they write, “That leads us to one important question: What happens to banks as credit providers if that age arrives? Any threat to this role could be a negotiating chip for banks in their marketing battle with the new technology.”

This is a good question and it dovetails with the “Fedcoin” discussion over the past 6 months.10

On page 285 they write, “With paper money they can purchase arms, launch wars, raise debt to finance those conflicts, and then demand tax payments in that same currency to repay those debts.”

This is a common misconception, one involving lots of passionate Youtube videos, that before central banks were established or fiat currencies were issued, that there was no war or “less war.”  On page 309 they quote Roger Ver at a Bitcoin conference saying, “they’ll no longer be able to fund these giant war machines that are killing people around the world. So I see bitcoin as a lever that I can use to move the world in a more peaceful direction.”

Cryptocurrencies such as Bitcoin will not end wars for the same reason that precious metals did not prevent wars: the privkey has no control over the “wet code” on the edges.  Wars have occurred since time immemorial due to conflicts between humans and will likely continue to occur into the future (I am sure this statement will be misconstrued on reddit to say that I am in support of genocide and war).

On page 286 they write, “Gil Luria, an analyst at Wedbush Securities who has done some of the most in-depth analysis of cryptocurrency’s potential, argues that 21 percent of U.S. GDP is based in “trust” industries, those that perform middlemen tasks that blockchain can digitize and automate.”

In looking at the endnote citation (pdf) it is clear that Luria and his team is incorrect in just about all of the analysis that month as they rely on unfounded assumptions to both adoption and the price of bitcoin.  That’s not to say some type of black swan events cannot or will not occur, but probably not for the reasons laid out by the Wedbush team.  The metrics and probabilities are entirely arbitrary.

For instance, the Wedbush analysts state, “Our conversation with bitcoin traders (and  Wall Street traders trading bitcoin lead us to believe they see opportunity in a market that has frequent disruptive news flow  and large movements that reflect that news flow.”

Who are these traders?  Are they disinterested and objective parties?

For instance, a year ago (in February 2014), Founders Grid asked 50 Bitcoin “experts” what their bitcoin price predictions were over the next year.  The end result — all but a couple were completely, very wrong (see this spreadsheet for a line-by-line itemization).  Later, in May 2014, CoinTelegraph asked (video) more than 30 Bitcoin “experts” as to what their bitcoin predictions were for the end of 2014.  Once again, all but a couple were completely, very wrong.

Or in short, no one has a very good track record of predicting either prices or adoption.  Thus it is unclear from their statements why a cryptocurrency such as Bitcoin will automatically begin performing the tasks that comprise 21% of US economic output based on “trust.”

On page 288 they write, “So expect a backlash once banks start shutting back-office administrative centers in midtown Manhattan or London’s Canary Wharf when their merchant customers start booking more customer sales via cryptocurrency systems to avoid the 3 percent transaction fees.”

I think there is a lot of conflation here.  For starters, back-offices could be reformed with the integration of distributed ledgers, but probably not cryptocurrency systems (why would a trusted network need proof-of-work?).  Secondly, the empirical data thus far suggests that it doesn’t matter how many merchants adopt cryptocurrencies as payments, what matters is consumer adoption — and thus far the former out paces the latter by several an enormous margin.  Third, that 3% is broken down and paid to a variety of other participants not just Visa or MasterCard.  Fourth, the US economy (like that of Europe and many other regions) is consumer driven — supply does not necessarily create its own demand.

There is one more point, but first the authors quote Chris Dixon from Andreessen Horowitz, “On the one hand you have the bank person who loses their job, and everyone feels bad about that person, and on the other hand, everyone else saves three percent, which economically can have a huge impact because it means small businesses widen their profit margins.”

This myth of “3%” savings is probably just a myth.  At the end of the day Coinbase, BitPay and other payment processors will likely absorb the same cost structures as existing payment processors in terms of user acquisition, customer support, insurance, compliance and so forth.  While the overhead may be lean, non-negligible operating costs still exist.

There are two reasons for why it could be temporarily cheaper to use Coinbase:

1) VC funding and exchange activity subsidizes the “loss-leader” of payment processing;

2) because Coinbase outsources the actual transaction verification to a third party (miners), they are dependent on fees to miners staying low or non-existent.  At some point the fees will have to increase and those fees will then either need to be absorbed by Coinbase or passed on to customers.

On page 290 they quote Larry Summers, “So it seems to me that the people who confidently reject all the innovation here [in blockchain-based payment and monetary systems] are on the wrong side of history.”

Who are these people?  Even Jeffrey Robinson finds parts of the overall tech of interest.  I see this claim often on social media but it seems like a strawman.  Skepticism about extraordinary claims that lack extraordinary proof does not seem unwarranted or unjustified.

On page 292 they write, “But, to borrow an idea from an editor of ours, such utopian projects often end up like Ultimate Frisbee competitions, which by design have no referees — only “observers” who arbitrate calls — and where disputes over rule violations often devolve into shouting matches that are won by whichever player yells the loudest, takes the most uncompromising stance, and persuades the observer.”

This is the exact description of how Bitcoin development works via reddit, Twitter, Bitcoin Talk, the Bitcoin Dev mailing list, IRC and so forth.  This is not a rational way to build a financial product.  Increasing block sizes that impact a multi-billion dollar asset class should not be determined by how many Likes you get on Facebook or how often you get to sit on panels at conferences.

Final chapter (conclusion):

On page 292 they write, “Nobody’s fully studied how much business merchants are doing with bitcoin and cryptocurrencies, but actual and anecdotal reports tend to peg it at a low number, about 1 percent of total sales for the few that accept them.”

My one quibble is that they as journalists were in a position to ask payment processors for these numbers.

Fortunately we have a transparent, public record that serves as Plan B: reused addresses on the Bitcoin blockchain.

Evolution Market v Bitpay BtcAs described in detail a couple weeks ago, the chart above is a log scale measuring the amount of bitcoins that both BitPay (in green) and Evolution (in red) received starting January 16, 2014.  The drop off at the end in March 2015 is related to the exit scam that Evolution underwent (and the drop off for BitPay is related to a limitation in WalletExplorer’s data).

As we can see here, based on the clusters labeled by WalletExplorer, on any given day BitPay processes about 1,200 bitcoins (the actual number is probably about 10% higher).

coinbase transactions

Source: Coinbase

The chart above are self-reported transaction numbers from Coinbase.  While it is unclear what each transaction can or do represent, in aggregate it appears to be relatively flat over the past year.11 Perhaps that will change in the future.

On page 295 they write, “Volatility in bitcoin’s price will also eventually decline as more traders enter the market and exchanges become more sophisticated.”

As Christopher Hitchens once remarked, that which can be asserted without evidence, can be dismissed without evidence.  Those making a positive claim (that volatility will decline) are the party that needs to prove this and they do not in this book.  Perhaps volatility will somehow disappear, but not for the non-technical reasons they describe.

At the bottom of page 295 they write, “Even so, we will go out on a limb here and argue that encryption-based, decentralized digital currencies do have a future.”

Again, there is no encryption in cryptocurrencies, only cryptographic primitives.  Also, as described in the introductory notes above, virtual currencies are not synonymous with digital currencies.

Also on page 295 they write, “Far more important, it solves some big problems that are impossible to address within the underlying payment infrastructure.”

Yes, there are indeed problems with identity and fraud but it is unclear from this book what Bitcoin actually solves.  No one double-spends on the Visa network.  No one has, publicly, hacked the Visa Network (which has 42 firewalls and a moat).  The vulnerabilities and hacks that take place are almost always at the edges, in retailers such as Home Depot and Target (which is unfortunately named).  This is not to say that payment rails and access to them cannot be improved or made more accessible, but that case is not made in this book.

On page 296 they write, “Imagine how much wider the use of cyptocurrency would be if a major retailer such as Walmart switched to a blockchain-based payment network in order to cut tens of billions of dollars in transaction costs off the $350 billion it sends annually to tens of thousands of suppliers worldwide.”

Again this is conflating several things.  Walmart does not need a proof-of-work blockchain when it sends value to trusted third parties.  All the participants are doxxed and KCY’ed.  Nor does it need to convert fiat -> into a cryptocurrency -> into fiat to pay retailers.  Instead, Walmart in theory, could use some type of distributed ledger system like SKUChain to track the provenance of items, but again, proof-of-work used by Bitcoin are unneeded for this utility because parties are known.

Also, while the authors recognize that bitcoins currently represent a small fraction of payments processed by most retailers, one of the reasons for why they may not have seen a dramatic improvement in their bottom line because people — as shown with the Wence Casares citation above (assuming the 96% figure is accurate) — do not typically purchase bitcoins in order to spend them but rather invest and permanently hold them.  Perhaps that may change in the future.

On page 297 they write, “But now bitcoin offers an alternative, one that is significantly more useful than gold.”

That’s an unfounded claim.  The two have different sets of utility and different trade-offs We know precious metals have some use-value beyond ornamentation, what are the industrial usages of bitcoin?  In terms of security vulnerabilities there are trade-offs of owning either one.  While gold can be confiscated and stolen, to some degree the same challenge holds true with cryptocurrencies due to its bearer nature (over a million bitcoins have been lost, stolen, seized and destroyed).12 One advantage that bitcoin seems to have is cheaper transportation costs but that is largely dependent on subsidized transaction fees (through block rewards) and the lack of incentives to attack high-value transactions thus far.

On page 300 they write, “As you’ll know from having read this book, a bitcoin-dominant world would have far more sweeping implications: for one, both banks and governments would have less power.”

That was not proven in this book.  In fact, the typical scenarios involved the success of trusted third parties like Coinbase and Xapo, which are banks by any other name.  And it is unclear why governments would have less power.  Maybe they will but that was not fleshed out.

On page 301 they write, “In that case, cryptocurrency protocols and blockchain-based systems for confirming transactions would replace the cumbersome payment system that’s currently run by banks, credit-card companies, payment processors and foreign-exchange traders.”

The authors use the word cumbersome too liberally.  To a consumer and even a merchant, the average swipeable (nonce!) credit card and debit card transaction is abstracted away and invisible.  In place of these institutions reviled by the authors are, in practice, the very same entities: banks (Coinbase, Xapo), credit-card companies (Snapcard, Freshpay), payment processors (BitPay, GoCoin) and foreign-exchange traders (a hundred different cryptocurrency exchanges).  Perhaps this will change in the future or maybe not.

On page 305 they write about a “Digital dollar.”  Stating, “Central banks could, for example, set negative interest rates on bank deposits, since savers would no longer be able to flee into cash and avoid the penalty.”

This is an interesting thought experiment, one raised by Miles Kimball several months ago and one that intersects with what Richard Brown and Robert Sams have discussed in relation to a Fedcoin.

On page 306 they write about currency reserves, “we doubt officials in Paris or Beijing are conceiving of such things  right now, but if cryptocurrency technology lives up to its potential, they may have to think about it.”

This is wishful thinking at best.  As described in Chapter 13, most proponents of a “Bitcoin reserve currency” are missing some fundamental understanding of what a reserve currency is or how a currency becomes one.

Because there is an enormous amount of confusion in the Bitcoin community as to what reserve currencies are and how they are used, it is recommended that readers peruse what Patrick Chovanec wrote several years ago – perhaps the most concise explanation – as it relates to China (RMB), the United Kingdom (the pound) and the United States (the dollar):

There are four main factors that set the Pound and the Dollar apart as viable and attractive reserve currencies. Each was necessary. They were liquid. They were available. And they were perceived as safe. I’m going to run through each of these conditions in turn. I will consider how they applied to the Pound and the Dollar, and to what extent they are satisfied by China’s Renminbi.

(1) Necessity. The fundamental purpose of a reserve currency is to settle external obligations. The greater quantity and variety of obligations a particular currency can settle, the more useful it is as a reserve currency. The currency of a country that produces little of note and lacks funds to lend or invest is not nearly as useful as one whose home economy produces many goods and services desired around the world, serves as an important source of capital, and has many commercial partners who also find its currency relevant to meeting their own obligations. This idea — that the dominant reserve currency derives its status from its connection with the dominant national economy in an interconnected world – is what underlies Roubini’s reasoning that the Renminbi may be next in line to replace the Dollar.

But this conclusion misses something important. A reserve currency must not only be capable of settling obligations in connection with a heavy-weight economy. It must be required to. Because if you can settle those obligations, as sizeable and important as they may be, using your own currency — or the currency of another leading economy — there is no reason to hold that country’s currency as a reserve. That is precisely the case today with China.

It is unclear how or why some Bitcoin advocates can suggest that bitcoins will ever be used as a reserve currency when there is no demand for the currency to meet external trading obligations let alone in the magnitude that these other currencies do (RMB, USD, GBP).

On page 307 they write:

Under this imagined Bretton Woods II, perhaps the IMF would create its own cryptocurrency, with nodes for managing the blockchain situated in proportionate numbers within all the member countries, where none could ever have veto power, to avoid a state-run 51 percent attack.

Proof-of-work mining on a trusted network is entirely unnecessary yet this type of scenario is propagated by a number of people in the Bitcoin space including Adam Ludwin (CEO of Chain.com) and Antonis Polemitis (investor at Ledra Capital).  Two months ago on a panel at the Stanford Blockchain event, Ludwin predicted that in the future governments would subsidize mining.  Again, the sole purpose of mining on a proof-of-work blockchain is because the actors cannot trust one another.  Yet on a government-run network, there are no unverified actors (Polemitis has proposed a similar proof-of-work solution for Fedcoin).

Again, there is no reason for the Fed, or any bank for that matter, to use a Bitcoin-like system because all parties are known.  Proof-of-work is only useful and necessary when actors are unknown and untrusted.  The incentive and cost structure for maintaining a proof-of-work network is entirely unnecessary for financial services institutions.  Furthermore, maintaining anonymous validators while simultaneously requiring KYC/AML on end users is a bit nonsensical (which is what the Bitcoin community has done actually).  Not only do you have the cost structures of both worlds but you have none of the benefits.  If validators are known, then they can be held legally responsible for say, double spending or censoring transactions.

Robert Sams recently noted the absurdity of this hydra, why permissionless systems are a poor method for managing off-chain assets:

The financial system and its regulators go to great lengths to ensure that something called settlement finality takes place. There is a point in time in which a trade brings about the transfer of ownership–definitively. At some point settlement instructions are irrevocable and transactions are irreversible. This is a core design principle of the financial system because ambiguity about settlement finality is a systemic risk. Imagine if the line items of financial institution’s balance sheet were only probabilistic. You own … of … with 97.5% probability. That is, effectively, what a proof-of-work based distributed ledger gives you. Except that you don’t know what the probabilities are because the attack vectors are based not on provable results from computers science but economic models. Do you want to build a settlement system on that edifice?

Though as shown by the NASDAQ annoucement, this will likely not stop people from trial by fire.

Concluding remarks

Bertha Benz, wife of Karl Benz, is perhaps best known for her August 1886 jaunt through present day Baden-Württemberg in which she became the first person to travel “cross-country” in an automobile — a distance of 106 kilometers.

It is unclear what will become of Bitcoin or cryptocurrencies, but if the enthusiasm of the 19th century German countryside echoed similar excitement as reddit sock puppets do about magic internet money, they must have been very disappointed by the long adoption process for horseless carriages to overtake horses as the primary mode of transportation.  For instance, despite depictions of a widely motorized Wehrmacht, during World War II the Teutonic Heer army depended largely on horses to move its divisions across the battlefields of Europe: 80% of its entire transportation was equestrian.  Or maybe as the popular narrative states: cryptocurrencies are like social networks and one or two will be adopted quickly, by everyone.

So is this book the equivalent to a premature The Age of Automobile?  Or The New Age of Trusted Third Parties?

Its strength is in simplicity and concision.  Yet it sacrifices some technical accuracy to achieve this. While it may appear that I hated the book or that each page was riddled with errors, it bears mentioning that there were many things they did a good job with in a fast-moving fluid industry.  They probably got more right than wrong and if someone is wholly unfamiliar with the topic this book would probably serve as a decent primer.

Furthermore, a number of the incredulous comments that are discussed above relate more towards the people they interviewed than the authors themselves and you cannot really blame them if the interviewees are speaking on topics they are not experts on (such as volatility).  It is also worth pointing out that this book appears to have been completed around sometime last August and the space has evolved a bit since then and of which we have the benefit of hindsight to utilize.

You cannot please everyone 

For me, I would have preferred more data.  VC funding is not necessarily a good metric for productive working capital (see the Cleantech boom and bust).  Furthermore, VCs can and often are wrong on their bets (hence the reason not all of them outperform the market).13 Notable venture-backed flops: Fab, Clinkle, DigiCash, Pets.com and Beenz.  I think we all miss the heady days of Cracked.com.

Only two charts related to Bitcoin were used: 1) historical prices, 2) historical network hashrate.  In terms of balance, they only cited one actual “skeptic” and that was Mark Williams’ testimony — not from him personally.  For comparison, it had a different look and feel than Robinson’s “BitCon” (here’s my mini review).

Both Michael and Paul were gracious to sign my book and answer my questions at Google and I think they genuinely mean well with their investigatory endeavor.  Furthermore, the decentralized/distributed ledger tent is big enough for a wide-array of views and disagreement.  While I am unaware of any future editions, I look forward to reading their articles that tackle some of the challenges I proposed above.  Or as is often unironically stated on reddit: you just strengthened (sic) my argument.

Endnotes:

  1. Note: I contacted Rulli who mentioned that the project has been ongoing for about 10 years — they have been distributing value since 2005 and adopted bitcoin due to what he calls a “better payment solution.”  They have 500,000 registered users and all compete for the same pot of bitcoins each month. []
  2. See also Megawatts Of Mining by Dave Hudson []
  3. Additional calculations from Dave Hudson:
    – Current Bitcoin network capacity: approximately 320 PH/s (320 x 10^15)
    – Best case power efficiency (shipping today): approximately 0.5 J/GH (0.5 x 10^-9 J/H)
    Likely power efficiency: approximately 1.0 J/GH (1 x 10^-9 J/H) = 2 x best case
    – Best case power usage (sustained): 320 x 10^15 x 0.5 x 10^-9 = 160 x 10^6 W = 160 MW
    Likely power efficiency: 160 x 2 = 320 MW
    – Best case power usage per day: 160 x 24 = 3840 MWh = 3.84 GWh
    Likely power usage per day: 320 x 24 = 7680 MWh = 7.68 GWh
    – Best case power usage per year: 3.84 x 365 = 1401.6 GWh = 1.4 TWh
    Likely power usage per year: 7.68 x 365 = 2803.2 GWh = 2.8 TWh
    The best case example would represent the entire Bitcoin network using the best possible hardware and doesn’t account for any cooling or any other computers used in the Bitcoin network. As such it represents an impossible best version of a network of this size. The likely example is probably closer as there is older hardware still in use and most data centers need cooling of some sort.
    The US Energy Information Administration estimated the US power generation capacity for 2012 at 1051 GW so the 320 MW number would represent 0.03% of the total electricity supply for the US. Assuming that we take the 320 MW figure then that would put Bitcoin at about 10% of Ireland’s electricity supply. []
  4. See: How do Bitcoin payment processors work? []
  5. See What is the blockchain hard fork “missile crisis?” []
  6. See Distributed Oversight: Custodians and Intermediaries []
  7. See also: The Rise and Rise of Lipservice: Viral Western Union Ad Debunked []
  8. See 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? []
  9. See Mitigating the Legal Risks of Issuing Securities on a Cryptoledger []
  10. See Fedcoin by JP Koning, Fedcoin: On the Desirability of a Government Cryptocurrency by David Andolfatto, A Central Bank “cryptocurrency”? An interesting idea, but maybe not for the reason we think by Richard Brown and Which Fedcoin? by Robert Sams []
  11. See Slicing Data []
  12. 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 by Tim Swanson. See also: Bitcoin Self-Defense, Part I: Wallet Protection by Vitalik Buterin []
  13. See Venture Capitalists Get Paid Well to Lose Money from Harvard Business Review and Ouch: Ten-year venture returns still lag the broader markets from Pando Daily []
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What’s happening in the Singapore fintech arena?

About a week ago I attended two back-to-back events: the Sim Kee Boon Institute’s conference and the DBS blockchain hackathon.

SKBI, where I am a visiting research fellow, is a seven year old institute which is part of Singapore Management University, one of the youngest universities in Singapore. This was its fifth annual event to cover digital banking and its scope has expanded to impact investing and financial inclusion.

While both events took place over the entire week, the conference was a two and a half day event that included panelists, moderators and audience members from around the globe including parts of Europe, both Americas and all across Asia.

The first full day included several keynotes from industry gurus including Piyush Gupta, the CEO of DBS bank, one of the largest banks in Southeast Asia and others such as Omidyar Network, a investment fund focused on social impact investing primarily in developing countries. The second day was entirely conducted in Chinese and among others included speakers from SF Express and VCredit.

Prior to the event a private roundtable took place over a three hour period and included members from policy making and research bodies.  Both Chris Skinner and myself independently gave presentations covering the future of fintech (incidentally a few of our slides were even similar). Some of the feedback and comments discussed the sustainability, or rather the unsustainability of several P2P lending projects such as those in the UK and in China.  For example, some of the problems in this segment include a lack of credit ratings, financial controls and arbitrary quotas (e.g., incentives to approve loans in order to hit specific arbitrary numbers).

The following day, on the first day of the public conference, Professor Rui Meng from CEIBS explained how there are now 1,700 P2P lending platforms in China and that there were at least 7 reasons for why this number has rapidly increased over the past five years including financial “repression” (the dearth of financial instruments by which investors can diversify into).

rui meng

Professor Rui Meng

For some more stats related to China see: Understanding value transfers to and from China.

What was the overall takeaway of the conference?

My thoughts echo Todd McDonald’s, based on my two trips to Singapore over the past 6 months its policy makers seem to be positioning the country (via Smart Nation) as a testbed for a variety of innovations in the overall “fintech” arena. The Minister of Water Resources & Smart Nation, Vivian Balakrishnan, even gave a roughly 3 minute overview of what blockchains are to the conference dinner after the first day of the event.

Conversations on and off chain throughout the remainder of the week seemed to support the notion that key decision makers at institutions across the country were increasingly interested in potential use-cases that blockchains (or derivations thereof) could solve especially those surrounding trade finance and identity/authentication. And this makes sense.  Singapore became a wealthy developed country in part because of its ports (recall that it sits the cross roads of both regional and international maritime trade prior to even the British colonial era).

Trade finance – smart contracts

One of the conversations I had with a banking administrator was that if you took a port manager or bank manager from the late 19th century and brought them to the present day they would likely not see too many differences in how the trade finance system worked in terms of letters of credit and bill of lading. It still involves a number of frictions (manual, heavily trust-based interactions) that are over a century year old, if not longer, yet are a multi-trillion dollar segment that the revolutions in digitization and automation seem to have forgotten.

It’s a chicken-and-egg problem, a little like fax machines and airports (I am trying not to use the overused cliche phrase “network effect”).  A fax machine which cannot connect to other machines is about as useful as a paper weight and a solitary airport that has no connecting flights is effectively a parking lot.

Can distributed ledgers (or whatever we end up calling non-Nakamoto blockchains) reduce the costs and provide transparency to this seemingly anachronistic trade finance system?  Can smart contracts be used to act as custodians of collateral or property titles in the movement of goods?  Or is this all just wishful thinking? There are two startups that have a “trade piece” related to this, including Mountain View-based PurchaseChain (part of the SKUChain project). Readers: if you are working on a replicated ledger project in this area, Singapore is definitely the place to go to test its utility.

Perhaps the second most widely discussed area that came up in conversations with members of the Singapore financial industry was that of identity and authentication. Like the rest of the world, each local bank has its own KYC/AML procedures that creates frictions when transferring value and adds to the already expensive customer acquisition and on-boarding costs.  For instance, one stat that stood out was that the costs for customer on-boarding at a traditional bank branch can reach upwards of $1,500 or more (once marketing is factored in).

Customer-Acquisition-True-Costs

Credit: Amar Banwait and Optirate

Ideally, so the conversations went, something akin to SingPass or Estonia’s e-identity initiative is an idea that seems to be worth its weight in gold as it could not only lower the costs but also the potential fraud and identity theft that currently takes place (among other benefits).

While it is just my opinion, I found the two most interesting presentations to be from the Fidor bank team (Frank Schwab and Matthias Kröner)  and Daniel Epstein from the Unreasonable Group.

I moderated a panel that included Chris Skinner, Frank Schwab, David Shin (from Paywise) and Todd McDonald (from R3).  The videos are supposed to be uploaded soon.

I also enjoyed hanging out with Albert Chu, who was a moderator and also a SKBI visiting research fellow.  His diverse experience in investing, advising and mentoring.  His views are grounded and did not involve the evangelical hype of the typical Silicon Valley investor.  Anju Patwardhan from Standard Chartered also had many interesting comments and insights throughout the event involving financial inclusion, P2P lending and trade finance.  I would like to also thank professor David Lee for his time, effort and enthusiasm as well as Ernie Teo and Priscilla Cheng from the SKBI team for hosting me.  More photos on Twitter #SKBI.

Some other coverage of the conference:

skbi dinner

SKBI Conference participants

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Panel 1 on Day 1 of SKBI conference

Hackathon

Between Friday and Saturday, 18 teams comprised of 3-4 people each (hailing from a variety of countries) participated in the DBS hackathon, competing for $33,000 SGD in prize money as well as a spot at the DBS / Startupbootcamp (SBC) accelerator.

I took a number of photos with commentary that were posted on Twitter #dbshackathon.

Both CoinGecko and Bitcoin Magazine posted an overview with a few of the teams from the event including the winners and David Moskowitz has a short reddit thread on it as well.

The hackathon itself was fairly straight forward.  Held on the third floor of Block 79 called BASH (where the Startupbootcamp facility is), 18 teams initially worked in one large room and there are several adjoining rooms that were also used as meeting spaces.  Throughout the day a group of mentors (of which I was one of) spoke with and provided assistance and consultation to the teams.  Some of the mentors (and later judges) helped a few of the teams walk through the ideation phase.  The self-organized teams themselves were fairly diverse, comprised of individuals whose skillset typically involved a engineering background but also business development.

In addition to creating a three-minute presentation, there were a number of criteria the projects would be judged on including a technical code review.  While some participants arrived earlier in the week and had a chance to brainstorm, the teams themselves only had two days to bring it all together and pitch the product to six judges.  DBS was the main sponsor of the event and more than 10 individuals from the bank were on-hand throughout the event to provide feedback as to how the ideas could be used in a fintech context.  In addition to the three winners covered in the two articles above, three additional startups that participated in the event were recently accepted into SBC for their new batch.

Aside from the top 3 projects, I thought the 4th place was especially of interest.  DBB is similar to Hyperledger and Stellar but is unique in that users individually run their own ledger and validating node yet there is no global consensus or state.  One of its creators is Pavel Kravchenko who is currently chief cryptographer at Tembusu and previously worked at Stellar.

The atmosphere was friendly, informative and competitive.  Some of the teams were laser focused at winning the competition while others were more relaxed, preferring to focus on team building and becoming more proficient with the tech.  A few had not worked with a decentralized ledger before and Blockstrap was on-site to help provide support for everyone.  Overall it was probably a helpful event for both startups and banks as it led to a cross pollination of ideas and professions.

It was good catching up with the active startup scene there:  Anson Zeall from CoinPip; David Moskowitz from CoinRepublic (who led the tech auditing team for the hackathon); Yusho Liu from CoinHako (which got 3rd place), Antony Lewis (and his baby son) from itBit; TM Lee and Bobby Ong from CoinGecko, Pavel Kravchenko and Andras Kristoff from Tembusu (Pavel independently worked on a new project and got 4th place); Adam Giles and Mark Smalley from Blockstrap; Marcus Swanepoel from BitX; Taulant Ramabaja (founder of Pactum but who flew in and was part of the 1st place team); Ayoub Naciri from Artabit; Virgil Griffith (independent); Lilia Vershinina from Kraken; Markus Gnirck from StartupBootcamp; and Ron Hose from Coins.ph.

They all have, as my British friends say, heaps of passion and it appears as if Singapore is positioning itself to be an important integral role in the future of fintech innovation.

Special thanks to Mikkel Larsen and Cade Tan from DBS for organizing the event and taking the time to discuss their views on trends in this space.

IMG_20150509_191339

Blockstrap and team NuBank (which won 2nd place at the DBS hackathon)

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Antony Lewis (itBit), Taulant Ramabaja (Pactum) and a future stuntman

IMG_20150505_200041

Ernie Teo (SKBI), Todd McDonald (R3CEV) and Albert Chu at the Economic Society of Singapore’s annual dinner

dbs hackathon day 1

DBS Hackathon Day 1

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Cryptocurrency KYSF: Know Your Source of Funds

Last week a reporter from CoinDesk asked me a few questions related to the chart (below) discussed in the flow of funds on the Bitcoin network in 2015.

bitcoinland april 2015Below are my answers, a few of which may be of particular interest in light of the FinCEN enforcement action related to Ripple.  For instance, are cryptocurrency payment processors — which typically claim exemption from money service business (MSB) requirements — required to comply with KYC (know your customer) and also submit SARs?  Will VC funded cryptocurrency mining pools and farms be required to do KYM (know your miner) and AML to establish source of funds?  See also: Lowell Ness’s discussion (video) at 20Mission last summer covering MSB/MTL and altcoins.

————–

Q: Are the size of the circles you’ve used in the diagram proportional or arbitrary?

Mostly arbitrary.  They needed to be big enough to where you can see the words, but there is some proportional aspect too.  For instance, in terms of on-chain transactions we know gambling transactions as a whole are likely the largest component of transaction volume.  And based on clusters identified by companies such as Coinalytics, darknet markets as an aggregate likely do more transactions than payment processors do.  While exchanges as a whole also process large amounts of transactions, because it occurs off-chain it is unclear what their real volume is.

Q: Are non-KYC exchanges simply matching darknet sellers (and ‘tainted coins’) with buyers, or are they buying btc from the dark markets themselves?

Mostly the former rather than the latter.  Until we find out more information about who operates the non-KYC exchanges, it is not fully clear what the motives would be for buying BTC from darknet markets.  For instance, there was an “old” joke: the reason BTC-e never gets hacked is that hackers would no longer have a place to launder funds through.  Yet several weeks ago BTC-e allegedly prevented funds from the Evolution hack to be withdrawn from BTC-e for a short period of time before re-enabling withdrawals.  The details of how this was resolved are still unclear.  Similarly, in practice “virgin” coins (newly mined coins) can be sold at a premium on sites like Localbitcoins.com as they lack any history of illicit activity.  Incidentally, according to an ongoing lawsuit from Syscoin, Localbitcoins is allegedly where Alex Green/Ryan Kennedy was selling bitcoins he purportedly stole from the MintPal theft (using the name “LemonadeDev”).

Q: Are ransomware victims only buying btc from non-KYC exchanges?

It may have been a little unclear from the chart but ransomware victims also purchase coins from KYC exchanges too.  Which bucket has more volume is unknown at this time.  Incidentally, according to a recent interview with the BBC, a security expert at IBM thinks that the criminals behind ransomware products like Cryptolocker sell their bitcoins quickly in order to reduce their exposure to price volatility.  To do so, to move into and out of fiat they will use “mules,” individuals that clean the cash and charge a fee of around 20%.  This ties in to your previous question about tainted coins and non-KYC exchanges.

Q: Were there any surprises for you here when compiling the diagram, or did it confirm what you had already found through previous posts?

There weren’t any real big surprises, but what probably stood out most is where the “fiat leakage” occurs — where people take bitcoins out of circulation and purchase them with dollars or euros.  The fact that this is still occurring ties back into the question that Rick Falkvinge raised 18 months ago: since we know that above-board trade is relatively subdued compared with illicit trade — if the non-KYC on and off ramps were shut down, what impact would that have on the overall Bitcoin economy?

Q: You mention the non-KYC and KYC worlds, how separate are the two now? Will they drift further as we see more regulation in the sector?

I think they are both intertwined and perhaps symbiotic for at least three reasons: 1) due to how KYM (know your miner) is not 100% mandatory globally, non-KYC’ed entities create continuous non-negligible demand for a product. 2) The prevalence of “temporary” wallets.  I labeled them “burner” wallets on the chart but in many cases if a user has limited operational security (e.g., does not use Tor and a VPN) therefore they do not have much added privacy and are thus not actually “burner” but rather “temporary.”  Either way, the flow through these wallets, such as Blockchain.info (whose users are not KYC’ed) back into the KYC economy create demand for above-board services.  The third area are non-KYC’ed bitcoins that go to merchants who unknowingly act like “mules,” sometimes exchanging above-board products for bitcoins that had previously circulated through illicit markets.  Last December Carl Mullan published a paper that describes several of the methods this is done (see p. 32).

Whether or not this bifurcation will continue is an open question.  One theory articulated by Jon Matonis and others is that continual adoption and implementation of KYC/AML policies by startups will create “white listed” coins and “black listed” coins and that “black listed” coins will trade at a premium over “white listed” coins.  To understand why this might occur, you have to consider the universal principle of nemo dat quod non habet (one cannot give what they do not have).  Several attorneys, including George Fogg, have indicated that bitcoins are treated as general intangibles under the Uniform Commercial Code.  If bitcoins are general intangibles, not currency (legal tender), negotiable instruments, or security entitlements, they it is not at all clear that bitcoins would have an exemption from nemo dat quod non habet.   In other words, bitcoins would transfer subject to, rather than free and clear of, associated claims and security interests and, as a result, would not be fungible (capable of mutual substitution).  Whether or not that means certain bitcoins will be treated like a hot potato is also an open question.  However, if all on-ramp and off-ramps for all services become KYC/AML compliant, we may be able to answer the question raised by Rick Falkvinge above as to how much of the economy is driven by illicit trade.

Q: With regards to you using word ‘scam’, do you expect a backlash?

Not really.  I don’t think scammers deserve a free pass and I don’t think I am the only one describing their aggregate impact.  On any given week, both Bitcoin media outlets and mainstream news organizations cover this type of activity, there is even a subreddit, sorryforyourloss, that sometimes covers it.  In addition, searching the word “scam” in the CoinDesk search bar found 176 results.  In January you guys reported on academic research that found at least 42 scams involving bitcoin and a number of your reporters have likewise covered the demise of Moolah, Neo & Bee and most recently PayCoin.

Q: How much of the data was available to you publicly?

The blockchain data resides on thousands of nodes.  The labels of clusters started with WalletExplorer (which is public) but the graphs and further analysis comes through Coinalytics which has its own proprietary methods.  There are a few other companies that are also involved in this space including Chainalysis, who also begins by using the public blockchain.  Blockchain.info publishes two charts on its “My Wallet” activity which give some indication of how much activity is occurring by their users.  As far as fiat leakage, mining and activity on exchanges, a lot of this comes from social media, chat groups and anecdotes from reliable sources.

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The Future of Fintech: Crystal balls and tasseography

Yesterday I gave a new presentation at a roundtable talk at the Sim Kee Boon Institute at Singapore Management University.

Additional notes, references and citations are in the comments of each slide.

I would like to thank Arthur Breitman, Andrew Geyl (Organ of Corti), Yakov Kofner, Raja Ramachandran and John Whelan for their feedback and comments on several slides.

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What has been the reaction to permissioned distributed ledgers?

About 3 weeks ago I published the “Consensus as a service” report.  What has the fallout been over it?

The specific, public comments broadly fall into 3 groups:

  • those that think Bitcoin is the only blockchain that can and does matter and everything else is a worthless unholy “Frankenstein” ledger
  • those that think cryptocurrency systems as a whole are superior to non-cryptocurrency distributed ledger networks
  • those, like Nick Williamson, who are open to building technology for specific customers and use-cases

As of this writing, the majority of views on /r/bitcoin and Twitter seem to take the maximalist, one-size-fits-all approach: that Bitcoin is the only way, the truth and the light.

In contrast, the target audience for the report are decision makers and developers within the financial services industry.  These individuals, based on months of conversations, are more interested in permissioned ledgers for their business needs because all of the parties involved in the transactions are known, have real-world reputations to maintain, have responsibilities which are expressed in a terms-of-service that is contractually binding and are ultimately legally accountable for actions (or inaction).

Cryptocurrency networks like Bitcoin, a public good that purposefully lacks a terms of service or accountable validators, were specifically designed not to interface with these organizations and institutions — and intentionally created an expensive method to route around all entities (via proof-of-work).  Thus in practice, it makes some sense that financial institutions may not be interested in Bitcoin as-is.

This may be a problem to maximalists, who have come to create and control a narrative in which Bitcoin can and will disrupt anything and everything that deals with finance and have invested accordingly.  Perhaps it will, but then again, maybe it will not.

While there were a number of interesting comments elsewhere, I think the most objective was — independently — an interview earlier this week in Institutional Investor with Blythe Masters (formerly JPMorgan, now over at DAH):

Q: Everyone talks about the enormous potential of alternative currencies and their underlying technology.  But the whold world of Bitcoin and other currencies was set up to resist centralization and intermediation.  It didn’t want to be part of the organized financial industry; it was openly scornful of it, and there’s still a strong libertarian, antibank strain to much of the sector today. Do you think these worlds want to be bridged?

Blythe Masters: I would say that your general characterization of some in the space is correct. But if you had a really good idea about how to build a better tire for an automobile, you would probably be really interested in talking to the auto companies because they are the people that ultimately are going to make use of your technology. You could think that maybe, because of the power of your tire, there might emerge a whole new brand of auto companies that supplant the General Motors of the world because the incumbents never really got the whole concept of what a good tire should be all about. But I’m not sure that would be a good move.

Why do I think this tire analogy is apt?

Because each month at conferences, Bitprophets claim that financial institutions in New York, London and other global centers where capital resides, will fall to the wayside very soon.

Perhaps this prophecy will come true, but it is unlikely for the reason Masters points out: most of the funded Bitcoin companies thus far seem to act like tire companies.

A few entrepreneurs are hoping that newer, different car companies will not only adopt their tires but simultaneously replace older car companies that already provide the same product lines.  While these startups are likely capable of providing utility and usefulness to someone, this overall narrative is probably wishful thinking.  Why would Toyota or General Motors disappear and be completely replaced by new automobile companies in the coming years because someone created a new tire?  Perhaps these existing car manufacturers will indeed disappear due to changes in consumer preferences or safety concerns but probably not because of a new tire.

Furthermore, characterizing the 8 different projects discussed in the report as Frankenstein ledgers is funny as those writing the comments seem to have forgotten how tech iteration works.

For instance, according to Gwern Branwen, the key moving parts that Bitcoin uses are actually a bit old:

  1. 2001: SHA-256 finalized
  2. 1999-present: Byzantine fault tolerance (PBFT etc.)
  3. 1999-present: P2P networks (excluding early networks like Usenet or FidoNet; MojoNation & BitTorrent, Napster, Gnutella, eDonkey, Freenet, etc.)
  4. 1998: Wei Dai, B-money5
  5. 19986: Nick Szabo, Bit Gold
  6. 1997: HashCash
  7. 1992-1993: Proof-of-work for spam7
  8. 1991: cryptographic timestamps
  9. 1980: public key cryptography8
  10. 1979: Hash tree

Would projects like git, which use a few of these parts, be considered “Frankenchains”?

The reaction that a few have had the past couple of weeks makes one wonder as to how they would initially react if alternative airplanes, automobiles and boats were invented: “But a monoplane cannot work as it is missing essential features from the original biplane!”

Taking a step back, calling one of the 8 projects in the report “Frankenledgers” would be like calling:

  • non-Mercedes vehicles, Frankencars
  • non-Wright Brothers heavier-than-air contraptions, Frankeplanes
  • any non-Unix operating system, FrankenOSes (which is ironic since Unix was itself a FrankenOS relative to Multics)
  • any non-Motorola cell phone, Frankenphones

Maybe none of the projects in the report will ultimately succeed.  Maybe in five or six years they fail to gain traction.  Maybe future ledgers and projects add additional “moving parts” to whatever they ultimately call their chain.

Yet we cannot command customer-driven technology to follow one specific narrative anymore than the previous pioneers of technology.  Just ask Alfred Nobel or other inventors over the past few centuries.  Furthermore, building ever larger quantities of a product without figuring out if there is a product-market fit seems to be how the Bitcoin community has attempted to operate over the past several years.  Perhaps this “marketing myopia” will pay-off, maybe the Kevin Costner syndrome (build it and hope they come) will be avoided.  Or maybe not.

Owning coins without disclosing they do

“It’s about the coin, you cannot downplay the coin!” was another common response.

To me the question of coins or no-coins is a red herring.  Perhaps organizations find them useful or maybe not.  Ultimately however, the target market for the report were organizations who need products that:

1) Create additional financial controls (removing the ability for one administrator to abuse the system because the information and state is distributed and shared)

2) Provide additional transparency for their risk management and capital management teams (such as reducing duplicative effort in Transaction Reporting)

Or in short, this variation of shared, replicated ledgers helps financial institutions to securely reduce costs.  That may sound mundane and unsexy, but reducing IT costs at some banks can mean tens of millions in savings.  As a result, some financial institutions (and likely other industries), are looking to take parts of the toolkit, portions of the 10 moving parts above and develop a new developer stack, just as LAMP did 15 years ago.1

How do validators fit in with this again?

The tl;dr of the report is that permissioned ledgers use known validators whereas permissionless ledgers intentionally use pseudonymous validators.  They each have different cost structures and are targeting two different groups of customers.

Why are known validators important?  Because in the event a chain forks, is censored or transactions are double-spent, there is no legal way to hold pseudonymous validators accountable because there is no terms of service or contractual obligation.  Or more to the point, as a public good, who is responsible for when a block reorg take place?  Apparently no one is.  This is problematic for financial institutions that want to be able to reliably transfer large amounts of value.

If pseudonymous validating nodes and mining pools are required to doxx themselves (or the current euphemism, “trusted transparency”), they lose the advantage of being censorship resistant.  Users might just as well use a permissioned ledger.

Why?

In the event such a fork, censored transaction or double-spending occurs with permissioned ledgers, the validator can be held legally accountable because they are known.  Proof-of-work is no longer needed and entities that are doing the validating are held accountable to specific TOS/EULA.

The main reason that block reorgs do not occur more frequently, like what happened in March 2013, is that it is just not worth the effort right now relative to the amount of value being transacted on the Bitcoin network.  Yet if there were billions or trillions USD in financial instruments like derivatives moving across the network, there would be an more incentives to attack and reverse transactions (this is one of the problems with watermarked coins as they create a disproportional reward delta).  No financial institution is going to put this type of value on a permissionless chain if they cannot claim damages in the event of censorship or reversal.

bitcoin is not useful

Source: Matt Corallo

“But you cannot have a secure ledger without coins,” is a common response.  Isn’t owning bitcoins the most important part of this equation?

Under Meher Roy’s classification chart, this is only true if hyperbitcoinization takes place, which it probably will not (recall: that which can be asserted without evidence, can be dismissed without evidence).

Then why is this continually promoted?  Probably because the company they work for or their personal portfolio includes bitcoins as part of their retirement plan and hope the demand for bitcoins by financial institutions and other organizations launches the price to the moon.  This is not to say that Bitcoin is bad or worthless as a network (or as an asset, it may even have another black swan or two upwards), but neither the UTXO or network (as-is) is a solution to a problem most banks have.

Maybe as Matt Corallo (who shared the picture above) is right: perhaps in the long-run historians will look back at these permissioned, distributed ledgers and declare them non-blockchains.  Maybe they will be called something else?  However, as it stands right now, even with cryptocurrencies, Bitcoin is not the only way to skin a cat.  The wheels (or tires) comprising Bitcoin and its nascent ecosystem can and will be interchanged and removed due to their open source nature and differing business requirements for each organization.

Keeping fees or be altruistic?

Are there any recent examples of doxxing of validators?  Yesterday a bitcoin user (someone who controls a privkey) made a mistake and accidentally sent 85 bitcoins to a miner in the form of a fee.  At ~$228 per BTC (at the time it was sent) this amounted to a $19,380 fee.  After several hours of debugging and troubleshooting, the problem was identified and fixed.

Along the way, the block maker (the pool) was also identified and notified, in this case it was Bitmain (which operates AntPool) based in China who said they would return the fee.

tx fees in USDThe chart above covers the time frame over the past two years, between April 2013 – April 2015.  It visualizes the fees paid to miners denominated in USD.

As we can see, in addition to the large fee yesterday, there are several outliers that have occurred.  One that is publicly known took place on August 28, 2013 when someone sent a 200 bitcoin fee that was collected by ASICMiner.  At the time the market value was $117.59 per BTC, which meant this was a $23,518 fee.  It is unclear who originally sent the fee.

This raises a couple of questions.

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, why not just use a distributed ledger system that already identifies validators from the get go?  What use is proof-of-work at all?

Yet a trend that has actually occurred over the past four years is self-identification.

For instance, I reached out to Andrew Geyl from Organ of Corti and he provided two lists.

Below is a list of the first time a pool publicly claimed a block:

Pool  |  Height
1:  Slush  97838
2:  bitcoinPool 110156
3:  DeepBit 110322
4:  Eligius 120630
5:  BTC Guild 122608
6:  MTRed 123034
7:  EclipseMC 129314
8:  Polmine 131299
9:  Triplemining 134362
10: BitMinter 134500

And a list of the first time a pool signed a coinbase transaction:

Pool  |  Height
1:  Eligius 130635
2:  BitMinter 152246
3:  BTC Guild 152700
4:  Nmcbit.com 153343
5:   YourBTC 154967
6:   simplecoin.us 158291
7:   Ass Penny pool 161432
8:   btcserv.net 163672
9:   Slush 163970
10:  BitLC 166462

A little history: Slush began publicly operating at the end of November 2010.  Eligius was announced on April 27, 2011.  DeepBit publicly launched on February 26, 2011 and at one point was the most popular pool, reaching for a short period in July 2011, more than 50% of the network hashrate.

Why did they begin to identify themselves and sign coinbase transactions?  Geyl thinks they initially did so to help with miner book keeping and that community pressure towards transparency did not happen until later.  And as shown by the roughly ~20% of unknown block creators on any given day, if a block maker wants to remain unknown, it is not hard to do so.

The other question this raises is that of terms of service.  As noted above, since the Bitcoin network is a public good (no one owns it) there is no terms of service or end-user license agreement.  Coupled with a bearer instrument and pseudonomity it is unclear why pools should feel obligated to refund a fee; Bitmain did not steal it and in fact, did nothing wrong.  The user on the other hand made a mistake with a bearer instrument.

This type of altruism 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.  If Bitmain did not send a “refund” it would serve as a powerful warning to future users to try and not make mistakes.

In addition, why do elements in the community think that 85 BTC is considered refundable but are unconcerned with any fee sent above 0.0001 BTC (0.0001 BTC is considered the “default” fee to miners)?  This seems arbitrary.

And this is a problem with public goods, there are few mechanisms besides social pressure and arbitrary decision making to ration resources.  As described by David Evans, since miners are the sole labor force, they create the economic outputs (BTC) and security it is unclear why they are under any expectation to return fees.

This is probably not the last time this will occur.

Conclusion

Public goods are hard to fund as they typically fall victim to tragedy of the commons.  And development, maintenance and security of Bitcoin is no exception.

While it did end up dominating the embedded systems space, despite similar rhetoric 20 years ago by passionate FOSS developers, Microsoft was not killed by Linux.2  Prophetic claims that desktop Linux would bankrupt incumbents and a GNU (and GPL “maximalism”) world order would take over the software industry never materialized: the fact of the matter is desktop Linux became a niche with no more than 1% of marketshare.  Incidentally, some vocal promoters insisted each year, that 200X would be the year of mass adoption for desktop Linux (it even saw a funding boom-bust such as the VA Linux IPO).3

Instead, many of the ideas and libraries were forked and integrated by enterprises such as IBM into other organizations and institutions, such as banks.  The only multi-billion dollar open source company that arose from this time period was Red Hat, yet even the inroads it made with Linux and FOSS is arguably overshadowed by the biggest kernel user: Android, another corporate sponsored “distro.”45

While past performance does not guarantee future results, IBM is once again back and has been looking into blockchain tech (through ADEPT), many of the major tech companies that arose in the ’90s (such as Amazon and Google) have payment solutions and customer usage of Bitcoin — like desktop Linux before it, despite enormous awareness and interest — still remains very niche, perhaps roughly 300,000 that actually control a privkey.

Maybe this will change over time.  Or maybe the buzz with this hot space will cool down in a few years and all the Young Turks will find something new to work on, leaving Bitcoin to fend for itself like Gnu Privacy Guard and many other forgotten public goods.6  Maybe they will move on to permissioned distributed ledgers which have known use-cases and customers, or maybe onto something else entirely.

Update: be sure to see some critical feedback from Peter Todd

End notes:

  1. According to L.M. Goodman, who created Tezos, a better example would be HTTP, not LAMP: “The value of distributed ledgers is in protocols and networks, not software or “stacks”.” []
  2. Linux certainly did change the infrastructure landscape.  Embedded Linux now pretty much dominates inside many devices (e.g. routers, switches), while it also dominates much of the Internet server ecosystem. The key to both of these was that it solved very specific commercial problems; the adoption was frictionless.  In embedded systems Linux was up against quite expensive proprietary RTOS and embedded OS designs.  The smaller ones were not as feature rich, while the larger ones could not compete in markets where gross margins became very tight. In the server space commercial Unix and Windows servers had expensive OS software and Linux could run on smaller, resource constrained, systems very effectively.  Early adopters could often get their hands on hardware but not the software and startups could readily tweak the software for special purposes. Now Linux dominates these spaces because it is actually really efficient for building things like network servers (they can run better on Linux in many cases).  Thanks to Dave Hudson for this insight. []
  3. Mike Hearn made a similar observation a year ago during a presentation: Mike Hearn, Bitcoin Core Developer NBC2014 from Bitcoin Congress.  See also: What Killed the Linux Desktop by Miguel de Icaza, Linus Torvalds on the Linux desktop’s popularity problems from ZDNet, Desktop Linux: The Dream Is Dead from PCWorld and Windows’ Endgame. Desktop Linux’s Failure from ZDNet []
  4. Google has purposefully avoided using almost all other Linux software and particularly GPL’d software. The entire application framework for Android is different than other distributions like Fedora. They only adopted the kernel possibly because of onerous GPL requirements. []
  5. Incidentally parts of Mac OS X are based off of FreeBSD. []
  6. I would like to thank Christopher Allen for this analogy. []
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The flow of funds on the Bitcoin network in 2015

Over the past several months, there has been a number of useful, simplified flow charts that show the general demand and supply for bitcoins.

chain participants

Source: Chain

The diagram above was created this past fall by Adam Ludwin, co-founder of Chain.com.  Subsequently, there have been a variety of similar charts from others describing the flows in an easy-to-understand way.  I think these are helpful and look forward to seeing more.

However, based on blockchain data, what do the specific flows look like?

After consulting with a number of industry experts, I constructed a rough, but more granular flow of funds based on actual user behavior.  This is not to say that these trends or activities will stay the same, but rather this is a visual aid to better understanding where the supply and demand of both “coins” and fiat are within the current ecosystem.

bitcoinland april 2015

Bitcoinland flow chart

The legend

  • The term “BTC” is in reference to unspent transaction outputs (UTXO), because “coins” do not actually exist1
  • The orange buckets and arrows involve mining farms, manufacturers and pools.
  • The brown buckets involve exchanges, ATMs, financial intermediaries, custodians and payment processors which have access to fiat (“early adopters” may also be on the sell side).
  • The green buckets represent fiat, this can be in the form of bank accounts or in the case of Localtrader, Localbitcoins.com, #bitcoin-otc (an IRC room) and “human” ATMs actual physical cash.
  • The champagne arrows involve the sale of BTC and block rewards.
  • The red arrows involve the purchase and buying of BTC.
  • The purple buckets and arrows involve illicit activity including darknet markets, scams, ransomeware, gambling, laundering and mixing of BTC.
  • The black arrows involve the sending of BTC to another hop or address.
  • And the blue buckets and arrows have no real commonality but are important in terms of the flow of funds.
  • Technically wallets do not exist at all, they are just a mental analogy to abstractly describe addresses as UTXO labels (not all wallets are “burner” as that would imply an increase in anonymity and requires knowledge of intent; they all can be effectively “temporary”).
  • In terms of mixing, certain altcoins are now a popular method for mixing.  For instance, litecoin (LTC) is one of the most liquid altcoins.  This typically looks like convert BTC at exchange A to LTC.   Then send LTC to exchange B and convert back to BTC.  Darkcoin (now called Dash) is another popular coin due to its specific “anonymity” features.  See also ring signatures from Monero.

[Note: I used Creately to prototype it and am releasing it as usual under a CC Attribution license]

The good with the bad

If a bitcoin is eventually deemed legally property, does this new flow chart imply that the current Bitcoin blockchain is a public, near-real-time record of contraband?  Maybe not.  Cryptocontraband would only really apply if you indeed were able to show the provenance of the property that you are talking about.2  For many of the use cases it is actually very difficult to show the provenance of individual currency units.   Perhaps this will change in the future, no one knows.

What is observable?  In addition to roughly 1 million bitcoins moving on a daily basis (more on that later), in the last four years we have seen several dozen high profile cases of individuals and companies whose bitcoins were lost, stolen or accidentally destroyed due to improper operational security.  By one account there are more than a million bitcoins that are no longer with their legal owner.345 Consequently, in terms of venture funding, the 2nd largest vertical that has received funds over the past 18 months is hosted wallet companies (“depository institutions”) such as Xapo and Coinbase which provide cold storage (“vaults”) and some type of insurance.

What has been the motivation to do so?  Because in practice, bearer assets are very hard to secure hence the reason for the emergence of banking intermediaries 500 years ago and again today in the era of virtual assets.

And this type of mercurial bearer ownership is not relegated to just the above-board economy.  For instance, about 16 months ago Sheep Marketplace, a darknet market, was “hacked” and 96,000 bitcoins were stolen (this was worth around $40 million at the time).  The purported owner of Sheep Marketplace was arrested last month.  A month ago, another darknet market, Evolution, lost at least 43,000 bitcoins (~$10 million) after two of the administrators stole them.

At a combined valuation of $50 million, this is roughly what BitPay processed in 2014 once mining and precious metals are removed from itemization.6

What about the “ransomware” subheading, what is “ransomware”?  It is a type of software, or malware precisely, that prevents users from using their computer unless the user pays the malware creator some kind of “ransom.”  In this case, bitcoins.

malware secureworks

“SecureWorks’ chart showing the correlation between Bitcoin’s price increases and the creation of new Bitcoin-targeting malware.” Source: Forbes

As noted in Chapter 12, while this type of malware has existed for several years, CryptoLocker itself stole nearly 42,000 bitcoins in the fall of 2013, thus signaling to market participants that this successful method of attack could be copied.  And as shown by the chart above, there were as of February 2014, 146 different families of “Bitcoin-stealing malware.”   According to Dell, during a six month time frame last year, “CryptoWall infected more than 625,000 computers worldwide, including 250,000 in the United States. During that time, the gang that operated CryptoWall raked in about $1 million in ransom payments.”

Currently hackers are targeting smaller and more marginal actors.  For instance, last month the network for Swedesboro-Woolwich School District in New Jersey was held hostage for a 500 bitcoin ransom.  And earlier this month, the Tewksbury Police Department system in Massachusetts became just one of many public organizations that has paid similar ransoms in bitcoin.

The case of the unknown volume

We know from public reports above of some on-chain activity, but not all.

Current total output volume is around 1 million bitcoins per day.  That is to say that on any given day (over the past year), approximately 1 million bitcoins have moved somewhere on the blockchain.  Knowing this and taking the categorization from Slicing Data, let us make a low, conservative assumption that 80% of the remaining volume is “change” being swept into change addresses, faucet outputs (a potential candidate for “long-chains”) and mining payouts.

And as established last week, we know that about $1,000,000 a day is from payment processing and above-board merchant activity, this amounts to less than 5,000 bitcoins per day.

Where is the rest of the volume coming from?

For instance, has the volume of Counterparty transactions increased?

counterparty transaction history

Source: Blockscan

As illustrated in the chart above, transaction volume for Counterparty has stayed roughly the same over the past 9 months or so.  A typical transaction requires about 0.0001 BTC (as a watermark) and about 0.0001 fee to miners.  Thus on any given day the total amount of bitcoins used by Counterparty is a handful, maybe even just 3 or 4 bitcoins.

What about P2SH?

weekly volume p2sh

Source: P2SH.info

As of this writing, about 8.63% of all bitcoins are stored using P2SH.  And while the last several months have each seen more than 1 million bitcoins move into P2SH, this still does not tell the whole story because that is per month and not per day, which we are observing (e.g., roughly 100,000 or so bitcoins per day move into P2SH).

What else comprises this gap?

If actual transactions represent 20% of the total output volume, or 200,000 bitcoins, what else could fit the bill?  Payment processors collectively would account for 2.5%, P2SH would account for 50% (although technically P2SH is not commercial activity), Counterparty less than 1%, gift cards less than 1%.

What about crowdsales?  The largest one right occurring right now is Factom.  Over the past three weeks approximately 2,180 transactions containing 1,955 bitcoins have been sent to the fundraising address; or about 104 transactions per day.

Now lets assume the international payments and remittance market is at least the same size as the merchant economy (it may be lower, based on anecdotally having talked to about 10 different exchanges overseas the past couple of months); so that is about another 5,000 bitcoins per day or 2.5%.

That means that we are still missing around 80,000 bitcoins per day if not more.  And based on address clusters at WalletExplorer, a large portion appears to come from movement in between exchanges and hosted wallets, as well as gambling services and darknet markets.

Recall that at its height in the spring and summer of 2012, nearly half of all transaction volume on the Bitcoin network were related to SatoshiDice.7 Once it blocked US-based IP addresses, its popularity waned.

Over the past two years, since May 13, 2013, there have been 946,261 bitcoins worth of wagers at Primedice, or roughly 1,350 bitcoins per day.

prime dice betting

Source: Dicesites

The chart above visualizes the activity on Primedice since January 1, 2015 – April 18, 2015.  Based on this cluser, there is is roughly as much transactional volume passing through Primedice as BitPay does each day.

A few other notable publicly known dice sites tracked by Dicesites:

  • Pocket Rocket Casino has about 440 bitcoins / day in wagers
  • BitDice has about 240 bitcoins / day in wagers
  • Dicenow has about 70 bitcoins / day in wagers

For perspective, prior to emptying its wallet (the first time), on its then-summer 2012 height, Silk Road’s public address contained 5% of all mined bitcoins at that point.8  In early November 2014, Operation Onymous — an international law enforcement action targeting darknet markets, closed down 414 sites.  Left unaffected were several of the larger DNMs, including Agora, Evolution and Andromeda, each of which actively sell illicit wares denominated in bitcoin.  Evolution, as noted above, suffered a large theft which will be looked at below.

Evolution DNM

Last week we looked at some charts from Coinalytics in relation to BitPay.  Coinalytics specializes in building data intelligence tools to analyze activities on the blockchain.  Using labels from WalletExplorer.com (which identifies reused addresses of a number of different services), the team was able to create visual aides covering Evolution.

Two things to keep in mind:

1) as a Swiss-based bot recently discovered, not everything sold on a DNM like Evolution are necessarily illegal (though a lot probably is)

2) we cannot have 100% confidence on the data since it may be missing some address clusters.  For instance, last week, the 500,000 BitPay transactions identified by WalletExplorer were 10% less than what BitPay officially reported during the same time frame (2014).  Thus, there may be a similar margin of error for the following data.

Evolution was officially launched on January 14, 2014 and its administrators pulled an “exit scam” with a large portion of the funds on March 18, 2015, effectively shutting down its operations.

Evolution Market Number of TransactionsThe chart above visualizes the time period between January 16, 2014 – March 18, 2015.  The average number of transactions per day was 1,004 and average bitcoins per day was 562.  However, as shown in the chart above it was not until the fall of 2014 that Evolution hit its stride.

For the six months between September 18, 2014 – March 18, 2015 saw traction.  During this time frame they processed 2,025 transactions and 1,260 bitcoins per day.

Evolution Market v Bitpay BtcAnother way of looking at that same trend is the comparison above: a log scale measuring the amount of bitcoins that both BitPay (in green) and Evolution (in red) received starting January 16, 2014.  The drop off at the end in March 2015 is related to the exit scam that Evolution underwent (and the drop off for BitPay is related to a limitation in WalletExplorer’s data).

evolution market volume log scaleThe log chart above measures the value of incoming market volume between BTC and USD.

In terms of USD, the average value sent to Evolution between March 18 2014 – March 18 2015 was $190,179 per day.  As it achieved traction, between September 18 2014 – March 18, 2015 the average value sent was $353,669 per day.

For comparison recall that based on the stats released last week by BitPay, on average BitPay processed 1,544 transactions worth $435,068 per day in 2014.

USD Evolution MarketThe final chart above may be of interest to those wondering what the “exit scam” looked like in USD denominated value.  The time frame above is between January 16, 2014 – March 18, 2015.  As shown at the end, in March, the administrators “exited” with a large portion of coins valued at a range between $10-12 million USD (the full amount varies based on media outlet and is not fully captured in the chart above).

A question of ownership

Throughout this post the word “owner” has been used a few times.  Why is this important when looking at economic activity and flows of funds?

In an exchange with Amor Sexton, an Australian attorney that represents cryptocurrency companies, she noted that:

It seems like the preferred legal approach in many jurisdictions is that bitcoin is a form of digital property, and not money. This means that bitcoin would lack the negotiability of money. It is an important distinction in light of the concerns about the volume of fraud and theft.

If the statistics are correct, a significant amount of people may not have good title to the bitcoin that they hold. Of course, this is all theoretical, as it is arguably nearly impossible to prove title to bitcoin and satisfy the nemo dat principle.

However, you can’t merely ignore the issue. The law doesn’t cease to exist because you ignore it. For example, as Pamela Morgan points out, when you build a website, you get a default font without needing to specify any font. If you want to change the font, you need to write code to change it. The law has default positions that are implied into every situation. To change the default position, you have to actively create a new position that takes precedence over the default position.

The default position for property (and bitcoin if it is deemed property) is that the nemo dat rule applies. Ignoring the problem doesn’t fix it. The only thing that can fix it is by creating a new default position – either by law (declaring bitcoin to have the same negotiability as fiat currency) or by private agreement.

Nemo dat (short for nemo dat quod non habet) boils down to clean titles.  If you buy property from someone who does not have ownership right of the property, then the new purchaser does not have a legitimate title to this property (e.g., you cannot sell what is not yours).

Sexton is not the only practicing attorney with this view.

I spoke with Ryan Straus, an attorney at Riddell Williams in Seattle.  According to him:

I think there is a great deal of confusion around the property/currency distinction.  This confusion was magnified by FinCEN’s classification of Bitcoin as “virtual currency” for the purposes of the Bank Secrecy Act.  Shortly after FinCEN’s March 2013 interpretive guidance, people started to use the term “digital currency” rather than “virtual currency.”9

Bitcoin is not currency in digital or virtual form.  Rather, Bitcoin is virtually, or almost, currency.  Why is this important?  Currency can be thought of as property imbued, by the sovereign, with a special power.  Specifically, the legal tender status of currency allows it to be transferred free and clear of, rather than subject to, all claims and defenses.

In other words, currency is the only unconditional exception to nemo dat quod non habet, or the general rule that one can never transfer a better interest than one has.  There are other conditional exceptions to nemo dat that apply to certain types of property (goods, negotiable instruments and security entitlements) if certain conditions are met (property is transferred “for value” and in “good faith”).  If Bitcoin is not currency and does not fit within one of the statutory exceptions to nemo dat, nemo dat applies.  At this point in the conversation, the issue of fungibility inevitably comes up. However, fungibility isn’t a solution; it is merely an evidentiary issue.

The Financial Times, recently covered similar legal analysis by George Fogg, an attorney at Perkins Coie.  According to Fogg, “under the United States’ UCC code (uniform commercial code) as long as bitcoins are treated as general intangibles, no high value investor can be sure that an angry Tony Soprano won’t show up one day to claim that the bitcoins they thought they received in a completely unencumbered manner are actually his.”

Based on this insight the Times noted that:

Indeed, given the high volume of fraud and default in the bitcoin network, chances are most bitcoins have competing claims over them by now. Put another way, there are probably more people with legitimate claims over bitcoins than there are bitcoins. And if they can prove the trail, they can make a legal case for reclamation.

This contrasts considerably with government cash. In the eyes of the UCC code, cash doesn’t take its claim history with it upon transfer. To the contrary, anyone who acquires cash starts off with a clean slate as far as previous claims are concerned. It is assumed, basically, that previous claims on cash are untraceable throughout the system. Though, liens it must be stressed can still be exercised over bank accounts or people.

According to Fogg there is currently only one way to mitigate this sort of outstanding bitcoin claim risk in the eyes of US law. Rather than treating cryptocurrency as a general intangible, Fogg argues, investors could transform bitcoins into financial assets in line with Article 8 of the UCC. By doing this bitcoins would be absolved from their cumbersome claim history.

The catch: the only way to do that is to deposit the bitcoin in a formal (a.k.a licensed) custodial or broker-dealer agent account.

Whether or not a court will agree with this view depends on the jurisdiction that future defendants/plaintiffs are located.  US law seems pretty clear when it comes to property.

And as it is encoded today, there is no technical means for the Bitcoin network to enforce  off-chain asset rights based on terms-of-service (smart contract or otherwise); although there may be technical methods for integrating a terms-of-service into contracts transacted on the network.  However that is a topic for a different post.

Conclusions

As the Bitcoinland flow chart above showed, over the past six-and-nearly-a-half years, a visible division can now been seen between a KYC economy and non-KYC economy.  And while readers will likely find different parts of interest, to me a few of the takeaways are:

  1. In terms of activity, it is still difficult to tell what each category consumes specific amounts of transaction volume (e.g., “change” addresses, above-board merchant volume, gambling and so forth)
  2. Where the fiat leakage is occurring, where people take bitcoins out of circulation and purchase them with dollars or euros; how will this change in the coming months?
  3. The fact that value is actually being transferred: for all its warts some people still use it to transfer value often without intermediaries involved

Bitcoin and most other cryptocurrencies today, were intentionally designed not to interface with the current financial infrastructure.  Satoshi Nakamoto purposefully designed the network so that on-chain activity would route around trusted third parties and this came at a capital intensive cost (e.g., proof-of-work).  The decentralized, pseudonymous nature of these networks are a dual-edged sword: it provides advantages that can and will be used by both good and bad actors alike.  It will be interesting to look again at how this flow chart evolves over the coming years.

energy consumption bitcoin

Bitcoin network power usage from O’Dwyer and Malone

Future researchers may also be interested in breaking down the energy costs for maintaining each segment or bucket in the flows above.

For instance, last year O’Dwyer and Malone found that Bitcoin mining consumes roughly the same amount of energy as Ireland does annually.  It is likely that their estimate was too high and based on Dave Hudson’s calculations closer to 10% of Ireland’s energy consumption.1011
Furthermore, it has likely declined since their study because, as previously explored in Appendix B, this scales in proportion with the value of the token which has declined over the past year.

The previous post looked at bitcoin payments processed by BitPay and found that as an aggregate the above-board activity on the Bitcoin network was likely around $350 million a year.  Ireland’s nominal GDP is expected to reach around $252 billion this year.  Thus, once Hudson’s estimates are integrated into it, above-board commercial bitcoin activity appears to be about two orders of magnitude less than what Ireland produces for the same amount of energy.

If this is the case, is there a way to determine how much energy is being consumed to transfer and secure: the KYC activities as well as the non-KYC’ed activities?  One constraint to consider too for this research is that if it somehow becomes cheaper to secure the network, it is also cheaper to attack the network — and this can impact both currency and non-currency applications of the network.

[Thanks to Fabio Federici, Andrew Geyl (Organ of Corti), Dave Hudson, Jonathan Levin, Amor Sexton and Ryan Straus for their feedback and insights.]

  1. For one explanation why, see Bitcoin: New Plumbing for Financial Services by Jonathan Levin []
  2. The first person I am aware of that used the term “cryptocontraband” is Robert Sams. []
  3. 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 by Tim Swanson. See also: Bitcoin Self-Defense, Part I: Wallet Protection by Vitalik Buterin []
  4. The inability to enforce a contract and retrieve losses in the event of fraud is not just a challenge for Bitcoin, but other cryptocurrency systems such as Dogecoin. For instance, Dogeparty asset “DOGEDIGGERS” was used by someone mid-November 2014 to sell shares in their “mining operation.” The individual(s) behind it managed to extract a few million dogecoin before people caught on and started asking questions, identifying it as a scam and put an end to it — the social media sites that the scammers were using to make the scam look legitimate were taken down. Restitution, if there is any, will take place off-chain where contract enforcement actually exists. See also Meet Moolah, the company that has Dogecoin by the collar from The Daily Dot []
  5. While the verdict is still out on Mt. Gox, new data analysis suggests that hundreds of thousands of bitcoins were systematically stolen from Mt. Gox over a period of two years, many of which were sold on other exchanges including Mt. Gox.  See The missing MtGox bitcoins from Wizsec []
  6. Some other examples include: Neo & Bee, Bitcoin Trader, Moolah from Alex Green/Ryan Kennedy, GAW/PayCoin from Josh Garza, BFL, MyCoin and at least 192 others, more likely hundreds more.  A number of the buckets probably deserve their own flow chart, especially since stolen bitcoins can be observed being split apart, onion style (e.g., the criminal peel off UTXOs little by little). See: Investigating the allinvain heist by GraphLab and An Analysis of Anonymity in the Bitcoin System by Fergal Reid and Martin Harrigan []
  7. On May 4, 2012 Stephen Gornick calculated that of the 42,152 total transaction on the blockchain, 21,076 transactions were wagers related to Satoshi Dice. This volume doubled within four days, as Gornick posted an update that 94,706 total transactions on the blockchain, 47,353 were wagers.  In September 2013, Rick Falkvinge made the following analogy: “Money in gambling – at least instant gambling – is not in a lockdown cycle and does not contribute to the minimum size of the money supply. This becomes important as we look at the different economies making up bitcoin today. There are about 11.7 million bitcoin in circulation today. Out of these, a staggering 2 million bitcoin are gambled every year on the SatoshiDice site alone, and another, PrimeDice, 1.5 million. To put these numbers in perspective, if translated to the global economy, it would mean that people bet the entire production of the USA at one single betting site, and the entire production of Europe on another. But as we have seen, these numbers do not contribute to the money supply pool in any meaningful way in a functioning economy.” See Bitcoin’s Vast Overvaluation Appears Partially Caused By (Usually) Illegal Price-Fixing by Rick Falkvinge []
  8. See A Fistful of Bitcoins: Characterizing Payments Among Men with No Names by Meiklejohn et al. []
  9. FinCEN Issues Guidance on Virtual Currencies and Regulatory Responsibilities from FinCEN []
  10. See also Megawatts Of Mining by Dave Hudson []
  11. Additional calculations from Dave Hudson:
    – Current Bitcoin network capacity: approximately 320 PH/s (320 x 10^15)
    – Best case power efficiency (shipping today): approximately 0.5 J/GH (0.5 x 10^-9 J/H)
    Likely power efficiency: approximately 1.0 J/GH (1 x 10^-9 J/H) = 2 x best case
    – Best case power usage (sustained): 320 x 10^15 x 0.5 x 10^-9 = 160 x 10^6 W = 160 MW
    Likely power efficiency: 160 x 2 = 320 MW
    – Best case power usage per day: 160 x 24 = 3840 MWh = 3.84 GWh
    Likely power usage per day: 320 x 24 = 7680 MWh = 7.68 GWh
    – Best case power usage per year: 3.84 x 365 = 1401.6 GWh = 1.4 TWh
    Likely power usage per year: 7.68 x 365 = 2803.2 GWh = 2.8 TWh
    The best case example would represent the entire Bitcoin network using the best possible hardware and doesn’t account for any cooling or any other computers used in the Bitcoin network. As such it represents an impossible best version of a network of this size. The likely example is probably closer as there is older hardware still in use and most data centers need cooling of some sort.
    The US Energy Information Administration estimated the US power generation capacity for 2012 at 1051 GW so the 320 MW number would represent 0.03% of the total electricity supply for the US. Assuming that we take the 320 MW figure then that would put Bitcoin at about 10% of Ireland’s electricity supply. []
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A gift card economy: breaking down BitPay’s numbers

Two days ago BitPay, the largest payment processor in the cryptocurrency space, published a new infographic filled with a number of new stats.

BitPay claims that in 2014:

  • $158,800,000 total value processed (an increase from $107 million in 2013)
  • 563,568 total number of transactions (an increase from 209,420 in 2013)
  • $281 average order value (a decline from $513 in 2013)

They also state that there is a reason for the decline in average order value:

This number is dropping as adoption increases and Bitcoin moves from an investment commodity to a payment method.

At best that is just a guess.  While it is neat that BitPay is one of a very few companies in this space willing to publicly release some numbers, we cannot determine what the actual cause for this trend with the available information.  Correlation (drop in prices or average order value) does not mean the real cause is payment adoption.

correlation

Source: XKCD

According to Jonathan Levin, head of business development at Chainalysis:

The fall in the average order value seems likely to be attributed to the increase in difficulty and the fall in the number of home miners.

Unless they publish weekly or monthly bar charts (which they used to), or what merchants are their largest by volume each week, it is unclear what could be skewing that number (e.g., large block sales from miners in 2013 and 2014?).

For instance, in December 2013, the chart below was published on the official BitPay blog (it has since been removed):

bitpay 2013The spike in transactions during November 2013 is probably related to two things:

  1. the Bitcoin Black Friday marketing event
  2. simultaneous run-up in prices during the contemporary bubble that early adopters / miners were likely able to capitalize off of by exiting positions

Are there any other numbers?

bitpay 2014Above is the last known public chart of BitPay transaction volume.  The dates on the chart corresponds with April 2013 – March 2014 and the image comes from the Cryptolina conference held in August 2014.

Although the quality is a little fuzzy, transaction volume appears to have reached around 70,000 in March 2014.  Token prices during March ranged from approximately $450 – $650 which they likely weighted and multiplied by the total amount of bitcoins received each day to come up with a figure of $1 million processed each day (note: at the end of May 2014, BitPay announced it was processing $1 million in bitcoins a day).

Yet as we shall see, in terms of fiat transaction equivalent, there is less than half as much today as there was last year.

bitpay chartThe chart above is part of the original BitPay infographic released on Wednesday.

In terms of transaction volume, bitcoin mining alone accounts for the next 4 largest segments combined.  For those who believe this will change in the future, recall that if mining somehow becomes cheaper then it is also cheaper to attack the network.  So as long as there are rents to be extracted, miners will continue to fight for and bid up the slivers of seigniorage up to where the marginal cost eventually reaches the marginal value of the token; and that translates into continuous streams of mining revenue (not necessarily economic profit) that are converted into fiat to pay for land, labor, taxes and electricity.

Furthemore, because bitcoin mining is not on the top 5 list of in terms of number of transactions this likely means that the miners that do use BitPay likely sell large blocks and are therefore large manufacturers or farms or both (and of those miners, most probably come from large entities such as BFL and KnC paying their utility bills).

The second chart to the right states that gift cards as a class represent the lion share for number of transactions processed.  This is actually kind of humorous and unhumorous.  What this means is that the majority of BitPay users (and probably bitcoin users in general) are not doing economic calculation in BTC (the unit of account) but instead some kind of fiat.  And to do so, they are going through a Rube Goldberg-like process to convert bitcoins into fiat-based utility.

This is mostly borne out through a roundabout process such as bitcoins sent to Gyft -> Gamestop -> ShellCard (the gas company).  Or Gyft->Amazon->Purse.io.

What are other motivations?  Some users, based on social media posts, claim to do this in order to reduce identification (KYC) paper trails so taxes will not have to be declared and sometimes to take part in illicit trade (e.g., sell these gift cards at a discount for actual cash for illicit wares).

Based on their chart, roughly $345,000 of merchant activity is processed on a daily basis.  Of that, $277,000 comes from precious metals and bitcoin mining.  The remaining  $68,000 is for unidentified e-commerce, IT services and travel.  Or in other words, nearly 80% of bitcoins processed by BitPay in 2014 went to paying for security (mining) and buying (or selling) gold and silver.

As I have written about previously, that for roughly every $1 spent on security (via mining), there was roughly $1 spent on actual retail commerce which translates into a quantitatively (not qualitatively) oversecured network.1 But based on this new data: more capital is probably being spent securing the network than retail commerce by a factor of at least 2x.2

Recall that bitcoin mining represents just under half of all transaction volume processed by BitPay, and BitPay itself has about 1/3 to 1/2 of the global market share for payment processing, so it is probably a good sample size of world wide non-darkmarket “activity.”

What about others?

The second largest payment processor is Coinbase.  And based on their self-reported transaction volume (below), the “off-chain” trend over the past year is similar to what BitPay processed:

coinbase chartAs described in Wallet Growth, approximately six months ago, in October 2014, Brian Armstrong and Fred Ehrsam, co-founders of Coinbase, did a reddit AMA.  At the 31:56 minute mark (video), Ehrsam discussed merchant flows:

One other thing I’ve had some people ask me IRL and I’ve seen on reddit occasionally too, is this concept of more merchants coming on board in bitcoin and that causing selling pressure, or the price to go down. [Coinbase is] one of the largest merchant processors, I really don’t think that is true.  Well one, the volumes that merchants are processing aren’t negligible but they’re not super high especially when compared to people who are kind of buying and selling bitcoin.  Like the trend is going in the right direction there but in absolute terms that’s still true.  So I think that is largely a myth.

Perhaps those volumes will change, but according to the chart above, that does not appear to be the case.

And as discussed in Slicing Data, the noticeable pattern of higher activity on weekdays versus the weekend is apparent irrespective of holidays with Coinbase too. Consequently, on most days these self-reported numbers comprise between 3-5% of the total transactions on the Bitcoin blockchain.  However, as Jonathan Levin, has pointed out, it is not clear from these numbers alone are or what they refer to: Coinbase user to user, user to merchant, and possible user wallet to user vault?

What does this mean for BitPay?

BitPay has three tiers of customer pricing.  The first plan is free, the second charges $300 for the first month and the third is for enterprise clients.  They claim that there are no transaction fees at all.

While they probably do sign up customers on their 2nd and 3rd tier, it is unclear how much.  Speculatively it may not be very much due to the low transaction volumes overall (e.g., why would Microsoft pay more in customer service than they generate in actual revenue?).  Thus their margins may be razor thin at ~1% which translates to roughly $1.5 million in annual revenue (it has to be below 2-3% otherwise merchants would not perceive an advantage for using their service).  BitPay also charges (collects) a spread through a process called the BitPay Best Bid (BBB) rate.

Based on the current head count of between 70-100 people (9 were probably laid off after the “Bitbowl“), it may be the case that the revenue generated annually covers the labor costs for just one or two months.  Perhaps this will change if prices rebound and/or if volume increases (recall that payment processors sometimes have to put coins on their books if they cannot find a counterparty to sell to in the time frame so in the likely event that BitPay holds coins on their books, they can gain or lose through forex movements).

bitpay twitterOn this point, four months ago I was involved in a mini-twitter debate with Jeff Garzik (a developer with BitPay) and Antonis Polemitis (an investor with Ledra Capital).  It partially centered around some of the findings that Jorge Stolfi (a computer science professor in Brazil) posted the previous month regarding BitPay’s transaction volume.

As discussed on Twitter, their burn rate on labor — as in almost all startups — is most certainly higher than the revenue they generate.  This should not be seen as “picking on BitPay” (because virtually every US-based VC-backed Bitcoin-related startup is in the same boat, see Buttercoin and probably ChangeTip) but they probably are not generating much additional revenue from “monthly SaaS subscriptions and payroll API customers.”

How do we know this?  Again, why would Demandware pay more for a SaaS subscription than they generate via revenue?  Altruism?  Perhaps a few do (like NewEgg or TigerDirect) but even if 1,000 customers paid $300 a month, that is still just $300,000 a month far less than the $1 million (speculatively) needed to cover labor alone.

Clustering

I contacted Fabio Federici, co-founder of Coinalytics which specializes in building data intelligence tools to analyze activities on the blockchain.  Using data from WalletExplorer.com (which identifies reused addresses of payment processors, pools, gambling services and such), his team was able to create visual aides covering BitPay.

It bears mentioning that there is a ~10% discrepancy between the WalletExplorer numbers and BitPay and this is likely a result of the clustering heuristic (by WalletExplorer) which will not give 100% coverage and is not dishonesty from BitPay (e.g., WalletExplorer data set identifies just over 600,000 transactions last year whereas BitPay cites roughly 650,000 transactions).

bitpay daily number of transactionsThe time frame for the chart above takes place between July 2, 2011 and April 13, 2015.  The chart visualizes the Daily Number of Transactions.  The green line is the important line as it represents the incoming transaction amount that BitPay receives each day.  It shows that aside from a brief outlier in the winter of 2014, volume has remained relatively flat at around 1,200 – 1,500 transactions per day for the past 15 months.Daily Volume Btc (2013-2015) [Log] xThe time frame for the log chart above is slightly shorter, between January 1, 2013 and February 28, 2015 (there is a strange drop starting in March that is likely a problem with the clustering heuristic, so it was removed).  The chart visualizes the Daily Volume of bitcoin that BitPay receives.  The green line is the important line as it represents the aggregate of how many bitcoins BitPay received each day.  While there are some days where the total reaches to 8,000 or even 9,000 bitcoins, these are outliers.  Conversely some slower days reach around 500 bitcoins per day.  On average, between January 1, 2013 and February 28, 2015, the daily amount is 1,138 bitcoins.

Other specific ranges:

  • Average February 2013 – February 2015 = 1,209 bitcoins daily
  • Average February 2014 – February 2015 = 850 bitcoins daily

One explanation for the discrepancy is that there is a large incoming transaction of 28,790 bitcoins on March 25, 2013 which skews the average in the first date range.  It the same day that the Cyprus international bailout was announced.  While this coincides with the ‘bull run’ in the spring of 2013, it is unclear from public data what this one sale may have been.  Looking at some other charts, at around that date roughly 52,694,515 bitcoin days were destroyed (BDD) and total output volume (TOV) was around 4 million (which is about 4x higher than today).  During this time frame fees to miners were also about 3x-4x higher than they are today.  And on this specific day, 159 bitcoins in fees were sent to miners, the fifth highest total ever.  While speculative it could have been an “early adopter” or even a company overseas cashing out (market price was around $73.60 per bitcoin on March 25, 2013).

Daily Number of Transactions (2013-2015) [Log] xThe log chart above visualizes the daily number of transactions for BitPay between January 1, 2013 and February 28, 2015.  The interesting phenomenon is the flip that occurred in the fall of 2014.  Whereas previously the number of outgoing transactions exceeded the internally held coins, in late September this appears to have changed.  It is unclear what the reason(s) for this is.  Perhaps more merchants decided to keep coins instead of exchanging for fiat.  Or perhaps due to the continued price decline, BitPay had to hold more coins on their balance sheet due to the inability to liquidate merchant requests fast enough (e.g., between August 1 – November 1, market prices declined from around $558 to $336 per bitcoin).

Other noticeable phenomenon on the green line above include a rapid run-up during the collapse of Mt. Gox in February 2014 and then later Bitcoin Black Friday followed by Cyber Monday in November 2014.

Why are there recognizable patterns for the green line in all of the charts?  Again, since the bulk of payments are related to mining, it is likely that miners sell blocks on a regular basis.  Denominated in USD, when paired up with bitcoin volume between February 2013 and February 2015, the plot would likely look like a left-modal bell curve.

Perspectives and conclusions

On average BitPay processed 1,544 transactions worth $435,068 per day in 2014.  Once mining and precious metals are removed, the BitPay “economy” involves $57.5 million per year.  Even if the full amount, $158 million, were classified as actual economic activity, it is less money than what Harvard Business School generates from selling case studies each year (~$200 million) or roughly the same amount that the University of Texas athletic department generates each year.

If Coinbase and the rest of the bitcoin-to-fiat merchant economy sees similar patterns of activity, that would mean that above-board economic “activity” may currently hover around $350 million a year.  This is just slightly more than venture capital was invested in the Bitcoin space last year (~$315 million) and roughly equivalent to the fund that Lux Capital raised last month for funding science-related startups.  For comparison, Guatemalan’s working abroad remitted more than $500 million back to their families in one month alone last year.

In terms of payments the competitive landscape for Bitcoinland is not just other cryptocurrencies but also incumbent payment providers and tech companies such as Google, Apple, Facebook and Microsoft (the latter has been collecting money transmitter licenses), each of which has launched or is planning to launch an integrated payments system.  Startups such as Venmo and Square, both of which were launched the same year as Bitcoin, have seen some actual traction.  For instance, in the forth quarter of 2014 Venmo payment volume came in just over $900 million, up from $700 million processed in the third quarter (Square Cash claims to have an annualized volume run rate of $1 billion).

And although it is not a completely fair comparison, Second Life from Linden Lab is still around “with 900,000 active users a month, who get payouts of $60 million in real-world money every year” (note: there is some debate over specific user numbers).

When mining payments are removed, Bitcoin, as an above-board economy, appears to generate less in return than the venture capital funds have gone into it (so far).  Perhaps this will change as more of the capital is deployed but it may be the case that Bitcoinland cannot securely grow exponentially (as the bullish narrative envisions) while maintaining a fixed amount of outputs.

In his recent conversation with International Business Times, Wouter Vonk, BitPay’s European marketing manager, described the trends from the infographic, stating:

As bitcoin becomes a more established technology, we expect to see more consumers using it. The investors are usually the first ones to hop on new technology, but as bitcoin circulates more, and as the amount of transactions increases, we should see bitcoin being used by more and more average consumers. We see bitcoin being used in emerging markets as a supplement to the current banking and monetary systems.  Bitcoin breaks down the barriers to financial tools that many people in emerging countries are facing.

Empirically, regarding “more consumer using it,” this does not seem to be true.  Nor is there evidence that bitcoin is circulating “more” — in fact, based on age of last use, more than 70% of coins have not moved in more than 6 months (slightly older figure).  And while cryptocurrencies may play a role in developing countries, so far there is little evidence this is actually occurring beyond talk at conferences.  Again, perhaps this will change as new data could reinforce Vonk’s narrative, but so far that is not the case.

For perspective I contacted Dave Hudson, proprietor of HashingIt, a leading network analysis site.  According to him:

One thing that I did notice is that their earlier “incoming” graphs all look highly correlated to the transaction volume in the Bitcoin network after long chains are removed.  This gets back to the usual Bitcoin transaction volume question of what’s really in a transaction and what’s change?  It seems their transaction volumes have really only crept up in the last 12 months, much slower than the rate of growth in transactions (or non-long-chain transactions) on the main network (increased competition?).

What does this look like?  The chart below measures Number of Transactions Excluding Chains Longer Than 10 between April 2013 – April 2015.

blockchain long chainsWhat are long chains again?  Rather than rehashing the entire paper, recall that in Slicing Data, it was observed that a significant fraction of total transaction volume on any given day was likely inflated through a variety of sources such as faucets, coin mixing and gambling.

As we can see above, while there is indeed an upward trend line over the past two years, it is clearly not growing exponentially but rather linearly, and particularly in spurts around “macro” events (e.g., bubble in late 2013 and collapse of Mt. Gox).

Based on the public data from address clustering, consumer adoption is empirically not growing near the same level as merchant adoption.  In fact, consumer adoption in terms of actual non-mining, retail-usage, has basically plateaued over the past year.  We know this is the case since merchants accepting bitcoin for payments has roughly quintupled over the same time frame (20,000 to 100,000) and includes several large marquis (such as Microsoft) yet without any surge in usage by bitcoin owners in aggregate.

Other companies that have actively promoted bitcoin for payments have likely also been impacted by sluggish sales.

For instance, in February 2015, Overstock.com (which has been using Coinbase as a payment processor for over a year) tried to obfuscate weak traction by using a strange method: measuring orders per 1 million residents.

overstock bitcoinThe top 3 were:

  • New Hampshire has a population of 1,326,813 and according to the chart above Overstock received 131 bitcoin orders per million residents.  This comes out to roughly 175 orders in 2014.
  • Utah has a population of 2,949,902 and according to the chart, Overstock received 89 bitcoin orders per million residents.  This comes out to roughly 270 orders in 2014.
  • Washington D.C. has a population of 658,893 and according tot he chart above Overstock received 85 bitcoin orders per million residents.  This comes out to roughly 56 orders in 2014 (although if the greater D.C. metro population was used, the order number would be about 9x larger).
  • Fighting for last place: Puerto Rico trounced Mississippi, which came in dead last.  Puerto Rico has a population of 3,667,084 and according to the report, Overstock received 12 bitcoin orders per million residents.  This comes out to about 44 orders in 2014.   In comparison, Mississippi, with a population of 2,994,079 had 8 order per million residents.  This comes to about 24 orders.

According to Overstock, in 2014 approximately 11,100 customers paid with bitcoin at both its US and international websites.  Altogether this represented roughly $3 million in sales which when coupled with low margin products (based on the top 10 list of things sold on Overstock) is an initiative that Stone Street Advisors labeled “distracting” (see slides 21, 32, 33, 37, 58).

In addition, since gift cards represent about 16% of all transactions processed by BitPay, they can be added to the list of non-negligible reasons for fluctuation in blockchain transaction volume.  That is to say, on any given day there are roughly 242 gift card related transactions through BitPay which should appears on the blockchain.  This is about the same amount of Counterparty transactions that may take place on a slow day.

Thus, as discussed in Slicing Data, the daily components of blockchain transactions are likely: faucet outputs (which may be “long chains”), mining rewards, some retail activity, coin mixing, gambling, watermarked assets (e.g., Counterparty, Mastercoin), P2SH, movement to ‘change’ addresses, wallet shuffling and now gift cards.

While their new infographic does not come to any direct conclusions as to macro growth of Bitcoinland it is likely that there are still only a few profitable businesses and projects in the ecosystem and most are unrelated to Bitcoin itself:

  • Fabrication plants such as TSMC and designers like Alchip
  • Utility companies (hydroelectric dams in Washington, coal power plants in Inner Mongolia)
  • Large mining farms with access to the newest ASIC batches reducing overall operating costs relative to marginal players (Bitfury in the Republic of Georgia)
  • Some mining pools (Organ sometimes has a break down of block makers)
  • Law firms (such as Perkins Coie)
  • Conference organizers such as Inside Bitcoins (but not The Bitcoin Foundation)
  • A handful of bitcoin-to-fiat exchanges (BTC-e, Bitfinex and a few others)
  • Scams (Moolah from Alex Green/Ryan Kennedy, GAW/PayCoin from Josh Garza, BFL, MyCoin and at least 42 others, more likely hundreds)
  • Botnet operators (botnet mining still exists, externalizing operating costs with “other people’s electricity”)
  • Ransomeware (CryptoLocker, KEYHolder, CryptoWall and a few dozen others)
  • Darknet Markets (Evolution “exit,” Sheep Marketplace “hack“; some low-hanging fruit exists for academics studying operators and providers that transitioned from Liberty Reserve to other DNMs, after it was shut down 2 years ago)

Perhaps all of this will change and this snapshot is “too early” as the bullish narrative claims.  Trends may change, no one has a crystal ball.

[Special thanks to CukeKing, Fabio Federici, Dave Hudson, Jonathan Levin and Pete Rizzo for their feedback and info]

  1. See Are there changes in the volume of retail transactions through Bitpay this past year?, Will colored coin extensibility throw a wrench into the automated information security costs of Bitcoin? and A brief history of Bitcoin “wallet” growth []
  2. In Chapter 14 in The Anatomy: “If the labor force of bitcoin is spending $10 million on protecting the network yet real commerce is only $30 million, this would be equivalent to a mall issuing 1 out of 3 customers a personal security detail to go shopping.  Or in other words it is, arguably, quantitatively oversecure (it is not qualitatively trustless as shown by the trifecta of DeepBit, BTC Guild and GHash.io).” []
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Consensus-as-a-service: a brief report on the emergence of permissioned, distributed ledger systems

I have spent the past month compiling research that took place between August and the present day.  This was much more of a collaborative process than my previous publications as I had to talk with not just 8 geographically dispersed teams to find out what their approach was in this nascent field but also find out who is working on ideas that are closely related to these projects (as seen in Appendix A).

The culmination of this process can be found in this report: Permissioned distributed ledgers

Fortunately I had the help of not just astute practitioners in the industry who did the intellectual heavy lifting, but the resources and experience of the R3 CEV team where I am an advisor.

I think the three strongest areas are:

  • Richard Brown’s and Jo Lang’s description and visualization of smart contracts.  I loathe the term smart contracts (I prefer “banana” and Preston Byrne prefers “marmot”) and fortunately they distilled it to a level where many professionals can probably begin to understand it
  • Meher Roy’s excellent OSI-model for an “internet of money”
  • Robert Sams mental model of the core attributes of a permissioned distributed ledger

I think the weakest part is in the beginning of Section 8 regarding TCP/IP.  That is reflective of the fact that there is no perfect analogy because Bitcoin was designed to do many things that no other system does right now so there probably is no single apple’s to apple’s comparison.

While you do not need special internetcoins or fun buxx to use the internet (as it were), there is still a cost to someone to connect to the net.  So perhaps, the frictional differences between obtaining and securing an internet connection versus obtaining and securing a bitcoin at this time is probably something that should be highlighted more if the report is updated.

Wither Bitcoin?

For cryptocurrencies such as Bitcoin to do what it does best on its own terms, its competitive advantage lays with the native token and not representing real-world assets: its community needs to come to terms about what it is and is not good for.  Because of its inability to control off-chain assets its developers should stop promising that bitcoins — or metacoins and watermarked-coins that use Bitcoin as a transportation layer — as a panacea for managing off-chain assets, assets the network cannot control.  At most Bitcoin’s code base and node network operates as its own legal system for non-watermarked bitcoins.

Consequently, the advantage a cryptocurrency system has is endogenous enforcement of contractual terms — or as Taulant Ramabaja calls it: “fully blockchain endogenous state transition without any external dependencies.”  Or on-chain, dry code to dry code.

I wonder if someone in the future will call themselves a full “dry code” stack developer?

Consensus-as-a-service: a brief report on the emergence of permissioned, distributed ledger systems

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Interview with deBitcoin

Earlier today I was interviewed by Paul Buitink and Jop Hartog, co-hosts of a weekly show at deBitcoin, based in the Netherlands.  The other two guests were Roeland Creve and Andreas Wauters, co-founders of Gent Bitcoincity, based in Belgium.

All views are my own and they do not necessarily represent the views of the companies and organizations I am affiliated with.

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Panel from Blockchain University Demo Day

A couple weeks ago I moderated a panel at Blockchain University, wrapping up the inaugural cohort.

Panelists included Atif Nazir (co-founder of Block.io), Matthieu Riou (co-founder of BlockCypher) and Greg Slepak (co-founder of okTurtles Foundation).  All three were instructors for the course this past winter.

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Distributed Oversight: Custodians and Intermediaries

[Note: This past weekend I took part of a working group at Stanford University as part of the “Blockchain Global Impact”  conference — and we discussed some of the legal issues surrounding digital bearer assets.  Below is my written submission provided beforehand; I am not a lawyer but I did consult with several attorneys familiar with the Bitcoin ecosystem who provided feedback, some of which was incorporated.]

The prevailing view in the bitcoin community is that control, by virtue of knowledge of a private key, is synonymous with ownership of the contents of the associated address. In other words, bitcoin is often touted as a form bearer instrument. With the advent of “exchanges” and “hosted wallets,” the ecosystem birthed facilitators (custodians) and intermediaries (depositories) where an individual no longer controls the applicable access credentials.

As Professor Shawn Bayern noted, the nature of the rights one has with respect to directly-held bitcoin differs significantly from the indirect interest in bitcoin in an account held by a third party: “[As] a matter of law, the [user of an exchange or wallet] probably does not ‘own’ any bitcoins, at least not in the sense of having title to personal property corresponding directly to bitcoins. What the [party] has is simply a contract right against the operator of the website—what was classically, at common law, called a chose (i.e., thing) in action.”

What is the nature of this right? Does the user still own the bitcoins held at an exchange or wallet? Or, instead, has title passed to the wallet/exchange? If title remains with the user, the user might be termed a bailor and the exchange/wallet a bailee. On the other hand, if title has passed to the exchange/wallet, the user would likely be a creditor and the exchange/wallet a debtor. Of course, the user agreements are far from clear on this point. As it turns out, the first question you ask to determine whether a transfer of title has occurred is: does the transferor receive the same exact thing or merely equivalent things that was put in? If the former is true, a bailment may be possible (this is often referred to as safekeeping or custody). If the latter is true, the transaction would not be a bailment except in three specific cases discussed later below.

In terms of both funding and development, the two largest VC-backed verticals in the Bitcoin ecosystem are “exchanges” and hosted wallets – both of which often offer “vaults” called “cold storage” and sometimes some type of insurance for customers. The precise legalities of providing other services such as “tipping” is beyond the scope of this brief article. Suffice to say that at this time, there is probably no US-based VC-backed startup that is fully compliant with all deposit taking laws, money transmission laws, insurance laws and so forth.

Yet irrespective of personal views as to whether or not additional regulatory compliance should be expected of these nuvo financial intermediaries and custodians, one aspect that all startups can and would agree on is the need for “best practices” in financial controls. But this then circles back to legal compliance.

For instance, every funded exchange as of this writing pools their clients deposits into a shared hot wallet which is then dispersed into a cold wallet (which sometimes is further broken into “ice cold” or “glacier” wallets). Yet despite this element of security – or at least security theater – deposits can and have been expropriated by knowledgeable insiders including exchange operators themselves.   Commingling customer bitcoin effectively forecloses the possibility of bailment/custody because, once commingled, the user is unlikely to get the “same thing” bank that they put in.

How can the technology being developed in the larger Bitcoin ecosystem be used to mitigate or prevent his from happening? And more importantly, how can entrepreneurs structure their startups to be in compliance with the law?

In its BitLicense proposal to the New York State Department of Financial Service, the Crypto-Economy Working Group outlined several technology solutions including multisig, escrow, proof of reserves, proof of solvency, keyless wallets and continuous real-time auditing. Empirically we have seen the rapid growth in the use of multisig via a technique called pay-to-script-hash (P2SH) – a method which at the start of 2014 represented roughly 0% of all bitcoins yet now at the time of this writing encompasses about 8% of all bitcoins. That is to say, possessors of those direct and indirect interests have moved 8% of the bitcoin money supply into a multisig schema.

BitReserve is a VC-funded startup that has spearheaded the proof-of-reserve initiative, providing near real-time data of the assets in their “reserve” (cold wallet) and the liabilities or obligations to its depositors. Several other companies have attempted to position themselves as “keyless wallet” providers, most notably Blockchain.info. They claim to be a software company that has no access to user funds, keys or information – solely providing a website that generates a “wallet” based on a multi-word mnemonic that users must memorize or store as it is the sole access credential to “direct interests.” This type of segregation not only prevents maleficence from internal administrators but may also prevent Blockchain.info from being legally defined as a depository or custodian in some, if not all, jurisdictions.

But what happens if Bob loses this mnemonic? Then Bob loses control of the property, the bitcoin becomes inaccessible, ownerless (in our eyes) yet still exists as an entry on the blockchain.

Who does it belong to then? Did the network “steal” it? Its last legal owner was Bob, but to the Bitcoin network there is no distinction between ownership and possession. For instance, stealing is a legal term – not a physical phenomenon – thus whether it is rightfully transferred or not is the subject for legal scholars to debate.

Recall that the job of property systems is to associate the who(s) with the what(s). There is no infallible magic bullet. It is merely a question of best evidence. While possession and control is a pretty crude form of evidence but often nobody has better evidence of ownership. Registration is pretty good evidence but it can still be overcome. Think about a piece of artwork that Bob consigns to a gallery or that he registers. Or a title to his house. No matter what the title search says, Bob can never really know somebody won’t come out of the woodwork with better evidence of ownership. The question is really: how much protection does the law provide to an innocent purchaser for a particular type of property in a particular situation? This is still an open question with bitcoin.

What of bailments then? Does this distributed technology change the legal relationship between a bailor and bailee?

The term custody is reserved for bailments. After some consultation it appears you can only have a bailment when you get the same thing back that you put in and with “pooled” bitcoins, a depositor does not receive the same unspent transaction output (UTXO) as they originally deposited. Exceptions include: (1) fungible goods in warehouse; (2) currency in a particular type of bank account (special deposit); and (3) security entitlements (immobilized securities or pieces of a securitized pie). Bitcoin is not a good. Furthermore, hosted wallets are not warehouses. Bitcoin is not currently a legally defined currency and hosted wallets are not banks. A third idea is the trust company/broker dealer. While an entrepreneur may be able to secure a trust company charter, it has yet to be seen in the wild. And it is probably only scalable for a limited subset of uses and actors.

So, if we don’t have a bailment. We have something else. Again, after consulting with experts, we likely have a transfer of title and a corresponding debt owed to the depositor. If that is “checkable” or repayable upon request of depositor, then certain startups may have a problem under 12 USC 378(a)(2).

This seems to be the model that most startups has assumed is legally allowed. In fact, as of this writing, several VC-backed hosted wallets grant a “security interest” only on bitcoins they own. Alice’s hosted wallet startup may claim that “our bitcoins are insured.” Thus, if we were talking bailment, they would not be Alice’s startup’s bitcoin as the title would remain with the bailor (not Alice’s hosted wallet – who would be known as the bailee).

Now that organizations such as the Consumer Financial Protection Bureau (CFPB) have taken an interest in the Bitcoin ecosystem, how then, can Alice explain this to a consumer in a way that is not unfair, deceptive, or abusive? Is there anything in the technology that can help provide transparency and mitigate abuse?

In practice Alice will need to at least explain the effect on title in a manner that is consistent with reality. And she will likely have to be licensed, regulated and supervised to the same degree as others who operate in the same manner. While laws may change, it does not appear that a hosted wallet company falls within a loophole (currently).

In essence, there is a distinction between a facilitator and an intermediary.

And again, an intermediary is an institution that invests primarily in financial assets and that issues liabilities on itself (e.g., deposits). And a facilitator facilitate the financial transactions between intermediaries and their counterparties. They may hold some financial assets but their holdings are incidental to their facilitating roles. Custodians and money transmitters are the latter. Depositories are the former.

The questions for this working group should take these definitions into consideration and brainstorm how the technology being developed can not only help reduce the compliance requirements (if there is any leeway for that) but also fulfill financial controls “best practices” with respect to existing consumer protection laws.

A special focus should also highlight how exchanges operate in practice, that is to say, since they know the trading history, margin positions, when futures contracts will expire and other customer information – there is potential vectors of abuse such as front running and naked short selling by insiders. How can this be prevented, reduced and stopped?

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Understanding value transfers to and from China

A couple days ago, on Monday, I was on a panel hosted at Stanford University as part of the “Blockchain Global Impact” conference.  The panel covered remittances, unbanked residents and financial inclusion.

Below is a presentation I put together based on research for Melotic, for SKBI in Singapore and in preparation for the panel.

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Air pollution and the environment in China

About two weeks ago an in-depth investigative report covering the impact of pollution on the environment in China was uploaded and published on a number of Chinese video streaming sites.  It is called “Under the Dome” (based on the TV show).  It was an instant hit and reached over 200 million views within its first week — thereupon it was removed, scrubbed from the Chinese internet by censors.

I lived in three different cities during my five-year stay in China and the pollution varied from location to location.  Fortunately I spent the vast majority of the time in the south — which has its own issues — but the air was almost always better than the type found in the north and specifically in the Beijing metro.

This is not to say there were not very bad air pollution days too.  I recall my last week in Shanghai, in December 2013 (prior to moving to California), that in the twilight hours the smog was so thick that I couldn’t see the flashing red lights atop of the apartment I lived in.

It was bad enough that it earned its own Wikipedia entry and a number of news outlets wrote a few stories on it:

Below is the full version with English subtitles:

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Questions for knowledge markets

I am often asked to provide content to community-driven question-and-answer sites like Quora, Stack Exchange and now Zapchain.  Here are a few I recently proposed:

  • “Why does the community tolerate and patronize altcoin exchanges that are fully anonymous, and allow illicit funds to go through?”
  • “What do the large venture funded companies do to promote transparency, financial controls and account segregation?”
  • “Is it possible for insiders at VC funded exchanges to trade against customer flows and futures contracts?”
  • “What can be done to bring assurance to those who have lost coins due to thefts/scams/hacks?”‘
  • “When will the industry begin to self-regulate?”
  • “How to proactively remove or prevent bad apples from tarnishing the community?”
  • “Bitcoin companies talk a lot about transparency of the blockchain, but very few have actual public data, is there ways to incentivize more openness?”

It will be interesting to see what, if any are answered.

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What is the “real” price of bitcoin?

Even before Bitcoin was part of the zeitgeist for the digerati, people have been guessing what the price of a bitcoin should and should not be.

For instance, a couple days after version 0.1 was announced on the Metzdowd mailing list (back in January 2009), Hal Finney posted a possible scenario:

As an amusing thought experiment, imagine that Bitcoin is successful and becomes the dominant payment system in use throughout the world. Then the total value of the currency should be equal to the total value of all the wealth in the world. Current estimates of total worldwide household wealth that I have found range from $100 trillion to $300 trillion. With 20 million coins, that gives each coin a value of about $10 million.

So the possibility of generating coins today with a few cents of compute time may be quite a good bet, with a payoff of something like 100 million to 1! Even if the odds of Bitcoin succeeding to this degree are slim, are they really 100 million to one against? Something to think about…

Hal Finney, brilliant engineer and the world’s first Bitcoin price divinator.

Over the subsequent weeks, months and years there has been no shortage of guesstimates and “technical modeling” that gauge what the price will be.

For instance, a year ago (in February 2014), Founders Grid asked 50 Bitcoin “experts” what their bitcoin price predictions were over the next year.  The end result — all but a couple were completely, very wrong (see this spreadsheet for a line-by-line itemization).

Later, in May 2014, CoinTelegraph asked (video above) more than 30 Bitcoin “experts” as to what their bitcoin predictions were for the end of 2014.  Once again, all but a couple were completely, very wrong.

How could passionate enthusiasts who pay attention to Bitcoin-related news be so wildly off on what some consider a “sure-bet” moon shot?

The short answer: just because you are domain expert in one area does not mean you are a price modeling expert.  (Disclosure: I try not to give price predictions because I know I am not a price modeling expert)

Let’s look at a few examples.

Is there a “fair” price?

A couple days ago CoinDesk interviewed Denis Hertz, a project manager at ALFAquotes who has created the “Fair Bitcoin Price indicator.”  And that according to its calculations, the current fair price is $518.

How has he calculated it?

First, it calculates the changes in the cost of mining equipment and its performance. Next, it attempts to assess the change in difficulty of production, factoring in the electricity costs faced by miners on the network.

In particular, Hertz indicated that the fair value tool should be embraced by miners, as the price today is lower than the fair price – a factor he attributes to the recent string of bankruptcies and closures in the sector.

There are a few mid-to-late 19th century German economists that would be happy to see — what is effectively — the Labor Theory of Value as back en vogue.  But it is disingenuous to attribute value based on inputs because it wholly ignores the subjective valuation of the demand side of the equation.

It is not a valid way to measure value of a widget (or virtual commodity in this instance) for the same reason that the value of a Renoir or Matisse painting is not based on the value of the inputs (oil paint, canvas, brush, frame, etc.).

Speaking of art: David Andolfatto, a marbleized personification of Marcus Aurelius, also disagreed:david andolfatto bitcoin price

Reservation Demand

It is unclear where this theory first started in relation to bitcoin, perhaps it was from Curtis Yarvin, who writes at Unqualified Offerings as Mencius Moldbug (he briefly discussed this idea four years ago).

The main thrust of this idea is that because some market participants buy and perma-hold an asset, it removes supply from the market, thereby ceteris paribus — assuming the same quantity demanded — it should eventually push market prices higher because less supply is available.  Or in short, if people hoard bitcoins, their price will somehow rise.

Their are multiple problems with this theory:

1) Financial history is littered with corpses of people, organizations and countries that try to corner supply to artificially boost an asset price.  And in bitcoin, the hoarders are collectively trying to do what the Hunt brothers tried to do with silver, what Malaysia tried to do with tin and what China tries to do with rare earth elements.  It doesn’t work because cornering supply has never guaranteed long-term price rises and if everyone hoarded, it would make bitcoin have zero economic value because there would be no circular flow of income (see also the coordination problem below in #4).

I spoke with George Samman, co-founder of BTC.sx and frequent writer on Bitcoin-related topics.  In his view:

Hoarding does not help the bitcoin economy at all, in fact it stifles its growth as its clamoring for traction and mass acceptance. It locks up bitcoin in a place where its not being cycled back and forth making it scarce and therefore making it economically unviable as a currency and as a means of transaction. Hoarding in no way makes bitcoin a viable solution in the medium to long term. Not to mention if hoarding is done to manipulate price, it may work short-term, but cornering supply has never been a great wealth strategy especially as people and/or governments sniff out manipulation and “change the rules of the game.” Its more of a going bust strategy.

2) It does not account for and seems to ignore both transactional demand and speculative demand.  Because price discovery currently takes place in relation to national currencies on exchanges, it is the liquidity at exchanges and the changing demand of this liquidity which directly impacts prices.  Perma-holding (“hodling”) likely makes it more difficult to get into and out of positions (due to slippage).1

And what impacts the demand on exchanges?

The volatility in demand (changes in demand) likely comes from the fact that the “fair value” of bitcoin is constantly fluctuating.  For instance, every time a new “big adopter” rumor is posted on reddit, a professional exchange opens, an exchange gets robbed, a new central bank paper is released, or a regulator gives a speech — the expected future value of bitcoin changes.

For instance, last February, when the market learned up to 850,000 bitcoins may have been permanently removed from circulation (simply did not exist), knowledge that became public due to the bankruptcy of Mt. Gox, prices rose but then fell a couple weeks later when it was announced that perhaps 200,000 coins may have been located in a disused wallet.  The market was incorporating changes in supply relative to existing speculative demand.

Robert Sams, co-founder of Clearmatics and a former interest rate trader, has a good explanation (pdf) of this phenomenon:

If a cryptocurrency system aims to be a general medium-of-exchange, deterministic coin supply is a bug rather than a feature. This is because changes in coin demand get translated into changes in coin price, making price volatility proportional to demand volatility. But that is only a first order e ffect, for expectations of future levels of coin demand give rise to speculation. If the expectations of the long-term rate of coin adoption are signi cantly greater than the rate of coin supply growth, people will buy and hold coin in anticipation of future adoption, driving up the current price of coin.

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).

Or in another example: if Satoshi’s alleged 1 million coins started moving around, it would also likely drive down the price as this supply has largely been considered removed from circulation, specifically at exchanges.2

3) While bitcoin’s creation rate is fixed, perma-holding is equivalent to buying a fleet of airplanes and then locking them in warehouses with the belief that merely removing them from the supply chain, that it will increase the overall value of the airplane and/or airline industry. Sure those planes may one day appreciate in value to become highly assessed museum pieces, but this ignores the utility of flying entirely.

nyc tokenThis is a similar problem with most tokens in the “Bitcoin 2.0″ world which purportedly give you access to networks (e.g., pre-paid gift cards).  In this case it would be akin to going to the New York subway in the 1980s, removing a handful of subway tokens and storing them in a lock box with the belief that their value will rapidly appreciate.

They may eventually become a valuable collectible or antique, but all that happens in the latter situation is that the subway token minter will just create more to replace those removed from circulation; the intended utility is riding the subway, not perma-storing value in the token itself (in December 2014, residents of St. Petersburg “hoarded” subway tokens for a different reason).

4) It likely runs into a coordination problem.  Each individual has different time preferences and horizons for how and when they will sell their assets at (in this case, bitcoins).  Empirically we have seen this story before with OPEC, in which participants “cheat” and do not follow their internal “Honors Program” — producing more oil than their quotas.  And as a consequence, it increases downside pressure on the price.

Organizing individuals and jawboning them into selling or holding as frequently occurs on social media with relation to bitcoin and other altcoins.  This is what Josh Garza has tried to do with Paycoin, who has promised a variety of price floors (notably $20).  Yet because the market is decentralized, he has ended up resorting to tactics such as an ad hoc “Honors Program” in which he (and his employees) try to convince other holders/traders not to all sell at once because this drives down the price below the promised price floor (due to a lack of additional demand).  In fact, despite these hopes and dreams, as of this writing Paycoin is roughly at an all-time low hovering around $0.60 per coin.  Maybe that will change, but then again, that could be wishful thinking (note: Garza’s GAW mining is likely some type of fraud).

In order for bitcoin to reach and maintain a stratospheric price level (greater than $2,000 a coin) in the face of similar coordinated and uncoordinated sell-side pressure, at least an equal amount of speculative (and/or transactional) demand would need to be brought on board to absorb a similar sell off of bitcoins.3

What happens if such demand does not materialize to absorb it?  Prices drop.

For example, last September I provided some comments to CoinDesk about why prices fluctuate which touch on the demand side on exchanges and OTC facilitators:

And in other cases, an OTC buyer can affect exchange via “buy pressure.”  If he begins buying directly from an OTC provider, avoiding an exchange, the exchange loses its buy wall thus affecting price.  The sell pressure forces the price down and once a large buyer goes “off-market,” he is weakening the buy pressure.  If all the buyers and sellers are “off-market,” we can say that exchange price and price discovery is distorted.  As my friend Raffael Danielli recently said, “Information is never off-chain and ultimately information makes the price.”  Consequently today information spreads very quickly and if a broker can make money because he facilitates “off-chain” transaction and knows “better” what the real price is then game theory dictates he should take advantage off this (investment banks do the same with OTC).

So in addition to partnership agreements, they probably also sell somewhere else to mitigate exposure to this volatility.  In addition, many miners have to finance their operations and at current prices of $410, roughly $1.6 million is created every day via block rewards and it has to go somewhere.  Fewer people buying?  Down we go.

Merchant acceptance

On almost a daily basis there is a discussion on reddit or Twitter about merchant acceptance and how the increase in adoption of bitcoins for payments by merchants should eventually be reflected in higher market prices of bitcoin itself.  This reasoning is problematic for a variety of reasons but most importantly: empirically it has not happened because it doesn’t account for any changes in consumer demand for the token.

Why haven’t consumers increased their demand of cryptocurrencies for retail transactions?

In August last year, Wedbush, an equity research firm, made the claim that:

Volatility in the price of bitcoin should not impede retailer acceptance of bitcoin, in our opinion, as merchants and payment processors are entirely shielded, and we expect consumers will be shielded in the future.

This is a bit of wishful thinking.  While there are an increasing amount of products and services that can hedge against volatility (such as Hedgy or Tera Exchange), in each instance, this costs a customer both time and money — which the average consumer probably is not interested in becoming experts at (e.g., airline fuel hedging strategies).  Consumers want stable currencies, not friction-full hobbies they have to fiddle around and hedge against every day.4

Why does this matter?

In its February 2015 analysis (pdf), the European Banking Commission looked at a variety of opportunities and challenges of “virtual currency schemes.”  One area that it looked at was:

Is Bitcoin establishing itself as a successful payment method?

In general, a buyer and a seller can agree on anything to be used as money (both regulated and unregulated payment methods) in a specific transaction. Consequently, virtual currencies may also be used as a payment method if both sides agree. The basic problem for every two-sided market is, however, that it needs “critical mass” on both sides for it to function. For payment cards and other payment instruments, reaching critical mass requires having enough merchants who accept the payment instrument and enough users who want to use the payment instrument so that it becomes attractive for other merchants and other users to join, thereby accelerating the network effects.

There are now over 100,000 merchants that now accept bitcoin for payments, up from ~20k last January.  At this rate, by the end of next year, there will probably be more merchants that accept bitcoins than actual on-chain users of bitcoin.

While any number of reasons are stated for why merchants could and should continue supporting bitcoin, unless consumers use it on a regular basis, continuing to train employees on how to accept it at point-of-sale consumes is an opportunity cost for merchants as those resources could be used for other purposes (there have been several recent threads on reddit from Wholly Hemp on this issue).

Why is that?  Recall that there has likely been no change in aggregate retail usage by consumers this past year.  That is to say, while nominal on-chain transaction volume may have increased, the aggregate, the total amount of bitcoins used altogether for retail commerce has stayed roughly the same (the rest is apparently superfluous activity).  If you are a merchant, why should you continue to support a foreign currency that costs more to support than you save by accepting it?  Again, maybe this will change in the future and more merchant adoption does, for some reason, spur consumer usage.

Percent of precious metals and transaction volumes

The basic idea of this argument, from among many organizations such as Pantera Capital (a fund dedicated to Bitcoin-related investments), is that if bitcoin is the digital equivalent to gold or silver — or is even in fact superior to gold and silver — then should it not follow that its market cap should absorb some percentage of these metals?

For instance, last October, Pantera provided an assessment (pdf) related to the price per bitcoin relative to the market capitalization of a variety of assets (including gold, remittances, payments and global money supply (as measured by M2) itself:

pantera bitcoin prices

From Pantera Capital

While some of their 2014 predictions haven’t panned out (recall “interest” versus “adoption”), perhaps future events will swing their way and change with the advent of new investment vehicles like GBTC or ETFs.

Again, that chart above states that if bitcoin absorbed the market cap of gold, each bitcoin would be worth as much as $550,954.  And what would happen if bitcoin somehow absorbed the market cap of the world money supply (and payments, remittances, gold, etc.)?  It would purportedly reach as high as $4,291,060 a piece.

However, under such a scenario, not only does this run into the logistical exergetic issues of the “Million Dollar Bitcoin” (pdf) but variations of this argument also involve supplanting some percentage of a payment rail.  For instance, if the Bitcoin network captured X% of the daily transaction volume of Visa or ACH then it should create additional demand for bitcoin, bidding up the market value to new highs.  But this could be a non sequitur.  Just because supporters find value in this “virtual currency scheme” does not mean the rest of the market will.  Perhaps they will, but in this circumstance, this tech is not being built in a vacuum so maybe not.

For example, currently listed on AngelList:

While many of these startups will burn out of capital and fail to gain traction, there may be a handful that do find significant consumer adoption — and it may or may not involve a cryptocurrency.5

One additional challenge with the X%-of-incumbents market share argument (and this occurs in every industry) is that it assumes that market participants (Alice and Cathy) are willing to go through the frictions to use Bitcoin, the network instead of existing rails or products like Apple Pay.  Or that Alice and Cathy perceive bitcoin, the asset, the same way as some backers do.  It could happen but is conceivable that it may not as well (to be even handed, there are any number of investors and entrepreneurs that have bullish views, Pantera was just used as an example).

For balance I spoke with Raffael Danielli, a quantitative analyst at ING Investment Management and proprietor of Matlab Trading, and in his view:

In terms of pricing bitcoin, equity models do not work (no dividends, no predictable cash flows) and forex models also don’t work.  At this moment I would value Bitcoin somehow like gold, meaning lots of speculative value and little intrinsic value. When people make those comparisons with precious metals they usually assume that “what if Bitcoin became as big as the market cap of xyz”. More realistically would be to assume “what if Bitcoin became x% as big as the market cap of xyz” with x being (a lot) smaller than 100 because both are competing for the same market share (not entirely true but to some degree).

This also touches on the binary outcome argument: that bitcoin will either go to the moon or fall to zero.  This is a false dichotomy.  Just as it would be fallacious to assume that a new car marquis will absorb all of the market share from the rest of the industry (or none at all), or that a new computer company will similarly displace all incumbents (or none at all), so to is it incorrect to assume that a cryptocurrency only has two directions to go: vaulting into geosynchronous orbit or crashing on the launch pad.

What happened to something in the middle; remain-a-viable niche?

Technical analysis

dilbert technical analysis

To cut to the chase, all bitcoin technical analysis has about as much scientific predictive power as phrenology does.  Not only is the market illiquid and manipulable (see Willy Bot) but there is (probably) still no real fundamental value beyond the transactional demand floor set most likely by the demand generated through the trade of illicit goods and services.  Perhaps that will change in the future, but maybe not.

For instance, Ryan Selkis (“Two Bit Idiot”) recently performed a back-of-the-envelope calculation to create an estimate for “transactional demand” — dialing down to a figure of $0.25 per bitcoin.

A year and a half ago, when the market price of a bitcoin was $143, Rick Falkvinge put together perhaps the only analysis of transactional demand generated by illicit trade (e.g., online gambling, dark markets, Silk Road, etc.).  Based on his own break down of the velocity of coins it amounted to roughly $1.12.  Everything on top of that is based on speculative demand.

In his words, “[…] the current value of one bitcoin, as backed by exchange of products and services in its role as a transactional currency, is roughly one US dollar and twelve US cents. And that’s still a generous estimate.”

Interestingly enough, Falkvinge reached out to Automattic, parent company of WordPress (a CMS developer and web host) to find out what kind of payment volume they had observed (they originally announced support for bitcoin payments in November 2012).  According to Falkvinge:

What about normal products and services? To get a ballpark understanding, I contacted Automattic (the parent company of WordPress) and asked politely if they could share how much revenue they have received in bitcoin, being one of the highest-visibility brands ever to accept bitcoin. The answer came quickly – “a couple of hundred dollars worth, so far”. If the highest-visibility brand accepting bitcoin has had less than two bitcoin in revenue in total, then for all intents and purposes, there is currently no measurable bitcoin economy outside of drugs and gambling.

Last July I also reached out to Automattic to find out if the volume had changed.  In an exchange with Chris L., from customer service (ticket #1886104), he stated:

We will not disclose that type of information since we keep our financial information private, as well as any information as it relates to our users.  If you have any follow up questions, or concerns, please do not hesitate to reply back.

Fast forward to last week, Matt Mullenweg, co-founder of WordPress explained that bitcoin was recently dropped as a payments option (it may be added again later).  Why?

The volume has been dropping since launch, in 2014 it was only used about twice a week, which is vanishingly small compared to other methods of payment we offer.

Conclusions

The takeaway should not be seen as “bitcoin does not have value” or that “bitcoin will not increase in value” or that even “bitcoin will not displace gold as a store of value.”  It clearly does have some kind of value to thousands, perhaps enormous value and utility to hundreds of thousands of traders, merchants and consumers of all stripes.

But in almost every case above, as well as many more often stated on forums, the argument is typically from a supply-sided viewpoint and not the demand (see Steve Waldman’s comments from the Cryptoecon event).  Historically most of the speculative demand seems to originate from a variety of investors with high risk tolerance and low time preference, with the expectation that prices will eventually go up (for a variety of reasons).

While it could change, empirically, we see that in general most participants are still holding coins and not using it for trade or commerce.6  And without any additional actual use-cases that generate transactional demand or additional aggregate demand from outside investors, it is likely that the bitcoin price will largely stay within the range it has seen this past year.  After all, why would it increase just because a large whale has moved a significant quantity to a cold wallet?

How then, can the market value of bitcoin — with a marketcap (or money supply) similar to that of the M1 of the Bolivian boliviano (according to the same ECB report above) — change in the future?7

Every bitcoin holder benefits from any kind of “good” news.  So there is an incentive to pump and manufacture as much good news as possible (e.g., astroturfing).  This seems to have culminated in an effort announced last week by the Bitcoin Foundation:

The Bitcoin Foundation announced today a partnership with Bitcoin companies BitFury, BitGo, Tally Capital, ChangeTip, and Bitcoin Foundation lifetime member Bruce Fenton to engage theAudience – one of the world’s largest multi-channel publishers of social and digital content. theAudience’s team of digital storytellers will work closely with these groups to launch a multi-faceted social and traditional media campaign to educate businesses, consumers, and society at large about Bitcoin.

Is this the same type of payola that “Tom Butterfield” investigated last summer?  The downside of this “educational” push is now any time there is “good” news, we may have to consider the source to find out if it is organic or just a sponsored puff piece.

Though in the end, it probably doesn’t really matter what we think or publish, what matters is — like all markets — is what the actual traders on markets think.  And as an aggregate of their demand relative to the available supply on exchanges, the value is around $270 today.  Perhaps future expectations of utility and value will dramatically change once the BitLicense is fully resolved and professional exchanges such as Gemini and LedgerX come online.

future-crystal-ball1Future research

Is there a way to model prices?

Future research could look at breaking down a cryptocurrency into consumption segments/tranches just as gold is typically done: (e.g., jewelry, investments, industry, etc.).

One reviewer suggested another way to model the future price of bitcoin:

Let v(t) denote the purchasing power of bitcoin (or USD) at date t.

Let R(t+1) = v(t+1)/v(t) denote the (gross) rate of return on (zero interest) money.

Since money (BTC included) is an asset, it must earn an expected rate of return E[R(t+1)] that competes with other forms of wealth. We might make adjustments based on liquidity premia etc, but to a first approximation, let’s just say that the expected rate of return from holding BTC must be about the same as holding any other asset. This is basically the EMH. And it is a compelling argument (just do the counterfactual).

So, for those people expecting huge capital gains from holding BTC… they may turn out to be correct ex post but, if they are, they would just be lucky. The same holds true for any other asset.

Moreover, the EMH tells us that the value of BTC v(t) must follow a random walk with drift — the best forecast for tomorrow’s BTC price is today’s BTC price (plus a modest drift term).

The EMH above only pins down the expected rate of return on an asset — it does not have anything to say about the *level* v(t), only its rate of change.

It is unclear what, if anything, pins down v(t) for BTC, or any fiat object. There are some theories, but in general, I think that v(t) may be indeterminate (i.e., the equilibrium v(t) could be a self-fulfilling prophecy).

If this conjecture is correct, then one could imagine discrete jumps in v(t) that happen for no good reason at all (pure psychology), without altering the expected return properties of the asset.

So, for example, the BTC price could suddenly drop from $300 to $100 and at the same time be a very good investment because if you buy it at $100, it is still expected to generate a competitive return. But this does not mean that the price might not jump down again to $50, or, indeed, up to $150.

One limitation to this approach is that EMH probably more appropriately applies in a normal, more highly liquid market with professional traders that are better informed and have equal access to information (there are currently a number of information asymmetries) and in which financial controls are the norm and not the exception — recall that there is no “neutral” exchange in the cryptocurrency world, all “exchanges” are effectively broker-dealers.

So the approach above assumes that insiders and operators of large exchanges are segregated from financial information of their customers, which they are not (e.g., because of a lack of financial controls, some exchange operators can currently front-run and ‘naked short sell’ their own customers which then distorts price discovery and the overall market).

Researchers may also be able to build a short-term sentiment index of large traders and market makers.  For instance, “accelerating merchant adoption” is typically mentioned as a bullish catalyst.  Maybe that’s true in the long-run but in the short-run it probably isn’t (as described above).  In a first step someone could create a simple regression model to measure the coefficient of “one unit of market adoption” on the market price. Then in a second step make some assumptions about market adoption for all of 2015 and use the estimated coefficient to derive (one small part) of the future price.

If someone does it like this for the most important market actors and factors, you could be able to derive a future price that is more than just a gut feeling.

See also: Eric Tymoigne: “The fair price of bitcoins as measured by the discounted value of future cash flows is zero.”

  1. As we have also seen with altcoins it could also reduce liquidity on exchanges amplifying volatility.  One reviewer suggested that with traditional equities, in such a scenario the impact is likely on liquidity and not on value since traditional calculations always take all outstanding shares into account when calculating value, not just the ones traded on an exchange. []
  2. See also: Too Many Bitcoins: Making Sense of Exaggerated Inventory Claims []
  3. See How do Bitcoin payment processors work? []
  4. In one respect, a similar problem faced Linux F/OSS adoption 20 years ago: end-users wanted a desktop OS, not a full-time hobby. []
  5. See Is the adoption of blockchains and consensus ledgers a foregone conclusion? []
  6. It is arguably rational to hold with the expectation of price appreciation; spending may actually be irrational []
  7. See also Why Bitcoin does not have a market cap []
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Eric Tymoigne: “The fair price of bitcoins as measured by the discounted value of future cash flows is zero.”

Earlier today The Wall Street Journal posted two responses to the question: “Do Cryptocurrencies Such as Bitcoin Have a Future?”

The ‘Yes’ answer was penned by Campbell R. Harvey, a professor at Duke University.

The ‘No’ answer was penned by Eric Tymoigne an assistant professor at Lewis & Clark College.

I don’t fully agree with all of Tymoigne’s points, but I think the areas regarding speculative demand are empirically valid — he also has a couple other good, concise points that tie in with what Robert Sams has previously discussed (see Seigniorage Shares).

Below is Tymoigne’s full response:

“NO: As a Currency, Bitcoin Violates All the Rules of Finance”

By Eric Tymoigne

Bitcoins are an odd sort of commodity. They are not financial instruments. The value fluctuates widely, in line with changing views regarding the overall usefulness of the bitcoin payment system and the speculative manias surrounding such views. There is no financial logic behind bitcoins’ face value.

In other words, if you like to gamble, this is a perfect asset. If you are looking for an alternative monetary instrument, look elsewhere.

The bitcoin system has two components: the means of payment themselves, and an online ledger, called the block chain, which is a record of all bitcoins that have been created and who holds them. The ledger is the main innovation. It provides an open, decentralized, fast, cheap and supposedly secure means of completing transactions.

Volatile and Illiquid

But as an alleged alternative currency, bitcoin is unacceptable. Its volatility and lack of liquidity pose risks far beyond most traditional currencies.

To understand why, take a quick look at how real money works. Monetary instruments are securities. As such, they have a term to maturity (instantaneous) and an issuer—often a central bank or private banks—that promises to pay the bearer the full face value. Gold coins are a collateralized form of such security. Paper, cheap metal, and electronic entries are the forms such securities take today. The characteristics of these securities allow them to circulate at a stable nominal value (par) in the right financial infrastructure and as long as the creditworthiness of the issuer is strong. This provides a reliable means to complete transactions and, more important, service debts.

Bitcoins, meanwhile, violate all of the rules of finance. There is no central issuer guaranteeing payment at face value to the bearer; in fact, there is no underlying face value, and subsequently no imputed value at maturity, which means they are completely impractical for use in servicing of debt. The fair price of bitcoins as measured by the discounted value of future cash flows is zero.

Bitcoins pose a huge liquidity risk. Ultimately, anyone with bitcoins has to convert them into a national unit of account—dollars, say, or euros—to pay taxes or personal debts and to make other transactions. Their extreme volatility makes them a bad bet if one plans to buy a house in a few years, is saving for college, or has regular payments on, say, a mortgage or car. If bitcoins were a large asset in a portfolio, the investor’s solvency would be at risk. This certainly would be the case if bitcoins were promoted for poorer individuals who don’t have access to banking today.

Logic and Illogic

For an economy to work well, money needs to be created (for example, through bank credits or government spending) and withdrawn (through debt servicing and tax payments) following economic logic. We have all seen recently, in the global financial collapse of 2008-09, how irresponsible behavior on the part of big banks with regard to their lending and debt-servicing practices can set off widespread financial panic followed by years of economic stagnation.

The mechanics of creating and withdrawing money need to operate not only with sound economic logic. They also should be simple, to accommodate quickly the needs of a flexible economy. Today, money is created and destroyed in seconds through digital entries.

Bitcoins, by contrast, are created using a purely mathematical logic that lacks financial or economic underpinnings (currently 25 new bitcoins every 10 minutes); and they can’t be retired as needed to maintain their scarcity. Given the lack of economic logic behind the net injection of bitcoins, there is increased risk of financial and price instability.

The block chain is useful as an authentication tool and is the main innovation. But it’s too soon to tell whether it can have other applications. For now, unfortunately, it’s a potential step forward accompanied by an actual step backward.

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A brief history of Bitcoin “wallet” growth

There has been a lot of investment and press coverage of the overall Bitcoin ecosystem.  So what kind of growth have some of the larger companies historically had?

Even though it is not an accurate measure of growth or adoption (see Measuring Interest and Not User Adoption), a lot of discussion on social media typically uses self-reported “wallet” numbers as a valid metric for traction.  Ignoring the fact that there is nothing in the protocol that can be described as a “wallet” (there are no real “payment buckets,” since addresses are essentially just UTXO labels), for simplification purposes, we will talk about what are typically referred to as wallets.1

A brief history

As mentioned in a working paper last spring, Coinbase began 2013 with ~13,000 wallets and on February 27, 2014 announced it had reached 1 million.

Similarly, Blockchain.info had roughly ~13,000 wallets in August 2012 and reached 1 million in January 2014.  On April 14, 2014, Blockchain.info reached 1.5 million wallets.

Yet it is unclear how many are active or actually have any bitcoins in them (similar uncertainties surround Coinbase wallets).  More on that later.

Fast forward to the present day, Blockchain.info recently announced that it had 3 million wallets and Coinbase now has 2.5 million (note: the about section on Coinbase also states there are 2 million “users” though that is unclear if they are active, KYC’ed users with an actual balance or just a registered empty account).

Altogether, Coinbase purportedly added 1.5 million new wallets over the past year and Blockchain.info supposedly doubled its own wallets.

Sounds like real consumer traction?

Or, maybe not.

Why?  Because there is no cost to open or create a wallet.  In fact, for “best practices” users are supposed to use only one address per transaction due to privacy and security concerns.  Thus, consequently the growth in wallet creation could be a skewed metric.

Internal usage

According to media reports, merchants accepting bitcoin for payments globally increased from ~21,000 in January 2014 to now over 100,000 as of February 2015.  Of that total, Coinbase states it has 38,000 merchants and BitPay claims 53,738 merchants accept bitcoin payments through them.

What does this “growth” actually look like?

coinbase offchain transactions

Above is a chart covering the past year from Coinbase which illustrates the daily off-chain transaction volume, the transactions that take place within the Coinbase database.

While it is unclear if all of this activity represents merchant processing, vault movements, etc., the trend over the year is actually relatively flat.  Perhaps that will change in the future.

Can we be sure that this flatness is missing actual merchant activity?

Four-and-a-half months ago, in October 2014, Brian Armstrong and Fred Ehrsam, co-founders of Coinbase, did a reddit AMA.  At the 31:56 minute mark (video), Fred discussed merchant flows:

One other thing I’ve had some people ask me IRL and I’ve seen on reddit occasionally too, is this concept of more merchants coming on board in bitcoin and that causing selling pressure, or the price to go down. [Coinbase is] one of the largest merchant processors, I really don’t think that is true.  Well one, the volumes that merchants are processing aren’t negligible but they’re not super high especially when compared to people who are kind of buying and selling bitcoin.  Like the trend is going in the right direction there but in absolute terms that’s still true.  So I think that is largely a myth.

What about Blockchain.info?

blockchain my wallet transaction volume

Above is a chart measuring the internal transaction volume over the past year of the “My Wallet” feature (the product name of the user wallet) from Blockchain.info.

Earlier this week, Blockchain.info claimed that “over $270 million in bitcoin transactions occurred via its wallets over the past seven days.”

But this is probably not accurate.  Organ of Corti pointed out that the 7 day average was indeed ~720,000 bitcoins in total output volume (thus making) the weekly volume would be about “5e06 btc for the network.”

Is it valid to multiply the total output volume by USD (or euros or yen)?  No.

Why not?  Because most of this activity is probably a combination of wallet shuffling, laundering and mixing of coins (e.g., use of SharedSend and burner wallets) or any number of superfluous activity.  It was not $270 million of economic trade.

Blockchain.info’s press release seems to be implying that economic trade is taking place, in which all transactions are (probably) transactions to new individuals when in reality it could simply be a lot of “change” address movement.  And more to the point, the actual internal volume looks roughly the same as has been the past few months (why issue a press release now?).

Is there another way to look at this?

blockchain my wallet number of transaction per day

Above is a chart from Blockchain.info that visualizes “My Wallet” transaction volume over the past year.

While Blockchain.info has seen transactions per day roughly double over the past year (from 25,000 to 50,000), without doxxing where those bitcoins go, it cannot be said that a doubling of economic activity, or that bonafide consumer traction has taken place.

Has there been any “exponential” growth, adoption or traction?  Probably not.  Again, perhaps that will change, but consumer usage could simply continue to grow at a linear fashion or maybe even less as well.

There may be a number of reasons, perhaps the average consumer is still someone who buys and holds bitcoin as a speculative investment and has no need to actually spend it with the available merchants.  But this is a topic for another post (see also Zombie activity).

ChangeTip

ChangeTip was founded on December 17, 2013.  It is not generally seen as a wallet, like the services above, in fact it currently bills itself as a micropayment service (e.g., “tipping”).  However, users need a ChangeTip wallet — which is provided for free through its platform — in order to perform their tipping services.

While their “Offsite storage wallet” (cold storage) is publicly accessible, below are three charts culled from Changetip real-time usage stats which has been broken the last couple of weeks (or the API they were collecting data from is broken; or both).  The time period is from between December 6, 2014 and February 17, 2015, covering ~73 days including Christmas and BitPay’s “Bitcoin St. Petersburg Bowl.”

changetip total number of tips sent

The chart above visualizes the total number of tips sent on the ChangeTip platform .  In just over 2 months it increased from: 119,740 tips to 187,071 tips.  During this 73 day period, approximately 67,331 tips were sent which is roughly 922 per day.

changetip total usd tipped to date

The chart above visualizes the total USD tipped to date (at current exchange rate).  During this time frame it increased from: $54,767 to $111,963.  Thus $57,196 was sent in tips during 73 days, roughly $783 per day.

changetip total numbers of users

The chart above visualizes the total number of ChangeTip users during the same time frame.  It increased from 45,851 users to 67,469 users.  According to this data, 21,618 users joined ChangeTip during 73 days, which is approximately 296 new users per day.

Altogether this comes to a grand total as of February 17, 2015 — 67,469 users have sent 187,071 tips totaling $111,963.  The average user has sent 2.7 tips altogether, with each tip worth about $0.60 (just under 60 cents to be precise).

Perhaps this trend will change — in addition to its usage on Twitter and Reddit they have added support to Slack and Youtube.

But then again, maybe tipping is not a really accurate, useful or desirable signaling mechanism (recall that micropayments is not a new idea).  And while speculative, a lack of traction could be one of the reasons why — after 3 months since Coinbase first launched their own — it recently dropped their own tipping feature (e.g., the engineering resources consumed more than the service generated).

Future research and conclusions

What about Android Bitcoin wallets?  Last October a github user put together a short comparison of the top 10 Bitcoin wallets by number of downloads.  What we saw then was a power law distribution: growth in downloads among the top 3 but a relative plateau for others.  More striking was that there was linear growth, not exponential.  Future research should also take into account the corresponding amount of deleted wallets and inactive wallets.  Note: last May at the Dutch Nationaal Bitcoin Congres, Mike Hearn described this comparison of downloaded vs deleted wallets at length, see his presentation (video) starting at 11:30m.

Bitreserve, which incidentally also launched in October 2014, provides a public transparency stats page which could serve as the beginning of a “best practices” for the industry.

Why is this important?

We have previously looked at BitPay data (which was flat).  Circle and Xapo have not publicly released much data at this time (incidentally, breadwallet is actually ranked higher at #4 in the Apple Store than both Coinbase and Xapo).  Yet from the data above it is increasingly clear that actual user numbers should not be conflated with wallet creation numbers.

Aside from movement into P2SH addresses, it is hard to really say where large, sustained organic growth is occurring.  Perhaps it is only a matter of time, maybe it is “early days” as some say.  Or maybe it is a reflection of other economic development constraints.

Update:

I received an email from Andreas Schildbach, creator of the Android Bitcoin wallet, and a portion of it is posted below (with his permission):

Install count is at 700k. Perhaps an interesting metric is that on GitHub, it’s forked 384 times (and starred 371 times). A lot of these forks made it to the Play Store.

Update 2:

I received an email from Wendell Davis, creator of the Hive Wallet.  According to him, all the Hive Wallet stats are open and accessible.  He also pointed to a similar, smaller discussion on reddit last fall.

Update 3:

BitcoinPulse has been tracking the total amount of downloads for the Satoshi bitcoind client (the reference client); over the past year there has been a linear increase in downloads.  Arianna Simpson pointed out that MultiBit, as of March 2014, had at least 1.5 million downloads.

  1. I would like to, again, thank Andrew Poelstra for crystalizing this point for me. []
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While we wait for another Bitcoin black swan event

I was interviewed and quoted a few times in the past couple weeks:

Is Bitcoin Stalling? at Technology Review:

The design of Bitcoin and the blockchain, its public transaction ledger, make it challenging to distinguish specific types of transactions. Nonetheless, researchers from the U.S. Federal Reserve determined in a recent analysis that the currency is “still barely used for payments for goods and services.” Last week, nearly 200,000 bitcoins changed hands each day, on average. But fewer than 5,000 bitcoins per day (worth roughly $1.2 million) are being used for retail transactions, according to estimates by Tim Swanson, head of business development at Melotic, a Hong Kong-based cryptocurrency technology company. After some growth in 2013, retail volume in 2014 was mostly flat, says Swanson.

After the Bitcoin Gold Rush at The New Republic:

“Some of the New York Bitcoin Center guys are pretty religious,” says Tim Swanson, who has written two e-books on cryptocurrencies in the past year, most recently The Anatomy of a Money-like Informational Commodity: A Study of Bitcoin. Before that, while living in China, he built his own graphics-chip miners. (Some of his miners have since been re-purposed as gaming systems.) Swanson has grown increasingly skeptical that Bitcoin will unsettle the existing finance megaliths. “You have centralization without the benefits of centralization,” he says. Bitcoin’s promise of frictionless finance is drowning in the ever more immense cost of mining, user-friendly infrastructure, and appeasing regulators.

“Being your own bank sounds cool in theory,” Swanson says, “but it’s a pain in reality.”

Beyond Bitcoin, episode #27: An Architecture For The Internet Of Money at Let’s Talk Bitcoin.

In this episode, Meher Roy does a fantastic job explaining what a neutral, agnostic protocol actually is and why the current allotment of cryptocurrency “protocols” are not real protocols.  Many thanks to Arthur Falls for his time, patience and great questions.  We will all miss the show.

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Can Bitcoin’s internal economy securely grow relative to its outputs?

killer app mouse trapHow do economies grow?

At the end of the day, that is ultimately the question that the Bitcoin community is asking when it asks, “what is the non-currency ‘killer app’ for Bitcoin?”  And this could be akin to asking, “what is the ‘killer app’ for the Chinese economy?”

Why?

Because as described in a number of other posts, “Bitcoinland” — a “virtual-state” — probably has more in common with the economic dynamics of a “nation-state” than say, agnostic, inflationary computer protocols like TCP/IP/HTTP.

So what is the “killer app” for a meat space economy like China?  How, as measured in GDP, did China grow from 364 billion RMB ($58 billion USD) in 1978 to 58 trillion RMB ($9.4 trillion USD) in 2013?  Was it solely the result of Deng Xiaopeng efforts of “reform and opening up?”  The full answer to that involves surveying numerous books; the shorter answer involved a combination of liberalizing a nearly fully autarkic economy and improving the productivity levels of existing inputs.

In the physical world, one way to measure how an economy develops is by looking at something called total factor productivity (TFP).  An increase in TFP is largely a result of technological improvements, inventions and innovations.  That is to say, for the same quantity of inputs, more outputs are created.

We see this frequently occur in developing economies as subsistence farmers adopt mechanization to improve agricultural yields, sometimes by several orders of magnitude.   For instance, the 2011 harvest yields in Heilongjiang province China, broke nation-wide records, rising 11% over the previous year due to ‘bigger and better machinery for threshing and plowing’ (for more specifics see also: Wage Growth, Landholding, and Mechanization in Chinese Agriculture).

Historically, as an economy develops, the inputs (such as land and labor) become more productive and therefore produce more outputs.  Can the internal Bitcoin economy also see such productivity gains?

Maybe, but probably not securely.

Let’s rewind for a moment.  Because there is no land per se, let us instead look at the labor component of Bitcoinland.

Unlike the labor market in the real world, this virtual-state has a marginal productivity of labor of zero.  It is very unique in that manner.  That means irrespective of the amount of hashing power (or laborers) added or removed from the network, the virtual country will always (and only) produce a fixed amount of output (block rewards).  Both David Evans and Tadge Dryja independently discussed this observation last year.

keep-calm-and-ceteris-paribusProportionalism

Simultaneously, this virtual country’s economic output is secured through proportionalism: ceteris paribus, in the long-run it should take a bitcoin to make a bitcoin.  Rational laborers (miners) will not spend more than a bitcoin to make one.  Thus if a coin is worth $250, miners as an aggregate will not spend more than $37,500 per hour to secure the ledger.

Recall that maintaining a distributed consensus network is different from consensus on a centralized ledger.  Bitcoin was purposefully designed so that it is artificially expensive for people to cast “votes” for a consensus.  The necessity was to make casting “votes” in the consensus artificially high since we cannot know who is participating in the “vote” (because it operates on an untrusted network).

What is another way to look at this?

I spoke with Jonathan Levin, formerly of Coinometrics.  In his view:

The security model of Bitcoin is how much it would cost a malicious attacker to gain a significant portion of the network. The security model of Bitcoin is therefore an anti-Sybil attack mechanism and not necessarily focused on securing financial transactions. This begs the question: Is any financial transaction secure if the cost of reversing it is less than the value of the transaction. Or would we need a system in which it would cost $1 million to undo $1 million of value?

This question is difficult to answer in the abstract. For different use cases, there might need less proof-of-work needed in order to secure the transaction. There could be a few reasons for this.  In many cases the issuer of the goods may be able to monitor the network for an attack waiting for sufficient work to be done before issuing the goods, e.g. Warehousing and physical delivery. For account balances, the victim could alter the balance of the attacker. There are very few $1 million transactions that are consumed instantly. However it does throw high value escrow services based in Bitcoin into question.

In the original white paper, Satoshi, albeit incorrectly calculated the probability of successful block reversals by an adversary. From this a magic number of 6 confirmations was often deemed as secure. I think this security model should be framed as burying a transaction under some dollar equivalent value of proof-of-work. This might give businesses more accurate view of the security of bitcoin transactions.

One unfortunate reality for assessing the security of bitcoin transactions is that we still need to factor in market concentration due to the possibility of bribes and corruption. Where some of these pools would actually find it profitable to attempt block reversals, a la selfish mining, it is difficult to think of an economic model for bribery and corruption in the Bitcoin network. Furthermore, we have seen the discussion take place on gated entry where you can make the entry into the validating nodes set super secure but someone may be able to bribe that entity to reverse / block transactions.

What does Levin mean by the cost of reversing a transaction?

To successfully disrupt the country (the network), the maximum cost to do so is roughly 0.5 x MC, where MC is the marginal cost of production.

In today’s terms to brute force the network — to attack it head on through its hypothetical ‘Maginot Line‘ it would in theory cost half of $37,500 per hour (or rather, half of the aggregate of 6 blocks as Levin suggested above) to obtain the magical “51%” of the hashrate needed to continuously double-spend.

In reality, the actual cost is significantly less due to out-of-band / side-channel / rubber hose attacks.  But that is a topic for another article.

A parasitic unit of account?

In May 2014, at the Bitcoin Foundation Amsterdam conference, Robert Sams brought up two interesting points that involve Bitcoin as a developing country, the first involved deflation:

There is a different reason for why we maybe should be concerned about the appreciation of the exchange rate because whenever you have an economy where the expected return on the medium of exchange is greater than the expected return of the underlying economy you get this scenario, kind of like what you have in Bitcoin.  Where there is underinvestment in the actual trade in goods and services.  For example, I don’t know exactly how much of bitcoin is being held as “savings” in cold storage wallets but the number is probably around $5 billion or more, many multiples greater than the amount of venture capital investment that has gone into the Bitcoin space.  Wouldn’t it be a lot better if we had an economy, where instead of people hoarding the bitcoin, were buying bitshares and bitbonds.  The savings were actually in investments that went into the economy to fund startups, to pay programmers, to build really cool stuff, instead of just sitting on coin.

I think one of the reasons why that organic endogenous growth and investment in the community isn’t there is because of this deflationary nature of bitcoin.  And instead what we get is our investment coming from the traditional analogue economy, of venture capitalists.  It’s like an economy where the investment is coming from some external country where Silicon Valley becomes like the Bitcoin equivalent of People’s Bank of China.  And I would much prefer to see more organic investment within the cryptocurrency space.  And I think the deflationary nature of bitcoin does discourage that.

As I noted in a previous article, the $500 million that VC’s have deployed to build Bitcoinland are effectively a foreign exchange currency play (because it is a virtual-only foreign country that can only be accessed with a pre-paid card, bitcoin).  This money is being paid to effectively leverage one economy, or rather one unit-of-account (namely USD, EUR, RMB) to build a virtual unit-of-account called BTC.

But because of a number of factors, including volatility and lack of native on-protocol financial services (such as credit facilities), bitcoins are not typically used to fund internal improvements (such as building the actual country of Bitcoinland).  Or as Sam aptly noted:

I think the issue if should you have more elastic supply or not it just really comes down to the fact that if you have a fixed supply of something, the only way that changes in demand can be expressed is through the change in price.  And people have expectations of increased demand so that means those expectations, expectations of future demand get translated into present day prices.

And the inelastic supply creates volatility in the exchange rate which kind of undermines the long term objective of something like cryptocurrency ever becoming a unit of account.  And forever it will be a medium of exchange that’s parasitic on the unit of account function of national currencies.  So I do think the issue does need to be addressed.

What does this have to do with “growing” the GDP of Bitcoinland?  And more to the point, how can Bitcoinland increase the amount of outputs?

If the labor force in Bitcoinland, miners, are continuously expanding and contracting the amount of capital they destroy to secure the network (in concert with the market price of the token), then the size of the Bitcoin economy is continuously shifting in size each hour, day, week and month.

Or in other words, as measured in terms of several foreign unit-of-accounts (because the physical land, electricity and hardware are paid for in foreign currency): the size of Bitcoinland is directly proportional to the amount of fixed outputs.  Denominated in BTC, the economy grows at an incrementally fixed rate.  It cannot, due to deterministic rules, be more productive in terms of outputs.  It can only grow larger and/or faster than this fixed amount through what amounts to ‘secondary issuance’ of watermarked metacoins such as Counterparty, Mastercoin and colored coins.

As described below, while this is not an issue today, these hacked-in under-secured metacoins are a double-edged sword.  Why?  Because these metacoins create a disproportional rewards vulnerability discussed last year.

top heavyHacked-in value

Recall that metaprotocols (or sometimes referred to as ’embedded consensus mechanisms’) that utilize and sit on top of Bitcoin blockchain provide disproportional rewards.  For instance, while both Counterparty and Mastercoin require participants to pay some nominal transaction fee, the social value of the actual asset itself if effectively piggy backing and free-riding off seigniorage rewards (this also happens with colored coins and Dogeparty).  Aside from mining pools that use Luke-Jr.’s software, miners in general currently have no way to distinguish between a watermarked transaction from any other transaction.

Consequently, they have no incentive to destroy more capital to protect these metacoins in part because they receive no additional revenue to do so… because the network and coinbase itself has no knowledge of the social value placed on these metacoins and therefore cannot distribute rewards in proportion to the actual value being protected.  And the network then is effectively top-heavy.

For example, if for some reason Apple Inc. decided to issue all of its shares onto the Bitcoin network via a metacoin, this could create a top-heavy security vulnerability.  Recall that the total market cap of Apple’s shares is ~$750 billion USD but the labor force of Bitcoinland is only destroying enough capital to secure ~$3.46 billion in bitcoins (at the time of this writing $250 x 13.85 million mined coins).

Thus in the long run, miners are probably not destroying enough capital to ultimately secure metacoin assets, making the network less secure.

Or in other words, Bitcoinland — as it is encoded today — probably cannot securely increase its productivity levels (as would be measured by TFP) without opening itself up to some kind of vulnerability.

What about merged mining?

Last year I wrote a short working paper discussing the potential of merged mining as a way of productively reusing the existing capital base.  In theory it sounds like an easy home run but in practice, if it costs miners nothing to merge mine, then it also costs them nothing to attack the merged chain/coin.  Relying on and trusting in goodwill or altruism of a labor force is the direct antithesis of the game theory baked into Bitcoin itself: where it is assumed that all parties can and will be adversaries.

Empirically we have seen Bitcoin pools attack chains that have attempted to merge mine (see Coiled Coin).

bitcoin namecoin hashrate 2015

We have also seen (above) how Namecoin’s hashrate has diverged over this past year and how it now consistently represents less than half of Bitcoin’s (note: Namecoin began merged mining with Bitcoin in October 2011).

This is due to at least 2 reasons:

1) not all Bitcoin pools support AuxPOW (merged mining) with Namecoin

2) also due to a block reward halving that took place in mid-December 2014 (notice that in contrast to the popular narrative, there was in fact no doubling in namecoin value because the market had already priced the future block halving into present day prices)

Or in other words, if it depends on the growth of an underlying unit-of-account hoping for an unseen Bitcoin GDP multiplier (or in this case a non-currency ‘killer app’) probably is similar to wanting something for nothing.

That doesn’t mean it shouldn’t be tried or that all the startups in this space are for naught. In fact, it looks like there are any number of useful innovations with practical applications (such as hierarchical deterministic, multisig, keyless wallets, etc.), including the experiments coming out of the altchain/ledger community.  Several investors and entrepreneurs willing to navigate the space could see a good return if some of these innovations become integrated within other industries (such as financial services).

Yet in practice, operating a distributed consensus network based on proof-of-work seems to require an always changing capital allocation structure that is fused to the market value of its internal unit-of-account relative to national currencies.  And based on the current version of the program, Bitcoinland itself (and not the ecosystem on the edges) may likely remain a laboratory model of a marginally subsistence nation that (often) violently moves between contractionary and expansionary cycles.

Other open questions

  • Aside from currency conversion, can there be a stable, secure domestic economy within Bitcoin.  If so, what is or could be another identifiable, exportable good or service?
  • As its labor force (miners) must continuously exchange the domestic currency (BTC) into a foreign currency (USD, EUR, RMB) to pay for bills — what is the recent historical precedence of economies that start off subsisting off of a foreign unit-of-account that later manage to move on to become an independent unit-of-account for economic calculation purposes?
  • Can other Bitcoin-like cryptocurrency economies actually grow, or are they all faced with similar constraints with respect to proportionalism?
  • Existing metacoins require their own consensus systems and as such, they don’t fully rely on Bitcoin.  Can this be further enhanced?

See also:

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Is the adoption of blockchains and consensus ledgers a foregone conclusion?

Earlier this evening I gave a new presentation to the Sim Kee Boon Institute (SKBI) for Financial Economics at Singapore Management University (where I am a new research fellow).

Covered a lot of ground over 2 hours, I am not sure if there is a recording but will post it if one surfaces.  Below is the deck that I used.  Many thanks to David Lee, Ernie Teo, William Mougayar, Mikkel Larsen, Taulant Ramabaja, Taariq Lewis, Dan O’Prey, Bobby Ong, Meher Roy, Richard Brown, Sidney Zhang, Dave Hudson, Jonathan Levin and Robert Sams for their feedback.

Abstract: 
For the past two years, many entrepreneurs, developers, investors and enthusiasts have promoted the view that blockchains and in particular, Bitcoin will eventually be adopted as a universal value transfer mechanism — a type of global payment rail fit for a cornucopia of use-cases. Empirically this does not seem to be the case as over the past year and specifically the past 6 months, multiple startups have been created that specialize in areas that Bitcoin is not particularly well suited for. Whether any of these succeed is another matter entirely, but it is not a foregone conclusion that any one blockchain will be the “one to rule them all” based on their competitive (dis)advantages. This presentation outlines a number of vendors that have either announced or are working on solutions for the broader “Fintech” space as well as incumbent institutions in the existing ecosystem.
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The myth of a cheaper Bitcoin network: a note about transaction processing, currency conversion and Bitcoinland

Recently the Museum of American Finance hosted an event covering Bitcoin.  One of the panelists allegedly said: “we don’t think about infrastructure cost of VOIP because it’s approaching zero.”  I haven’t seen a video, so it’s unclear if this is a summation of their thoughts.  But in terms of the infrastructure costs of Bitcoin, this is probably not comparing apples to apples because the incentives and costs to successfully attack the Skype network are very different than a network such as Bitcoin.

If the cost to maintain Bitcoin’s infrastructure is zero, so too is the cost to successfully attack it.  In fact, just about anyone motivated to do so could have successfully “attacked” (e.g., double spent) the Bitcoin network in its first 18 months because the hashrate was relatively low because the value of the token was negligible (e.g., miners weren’t destroying additional units of capital because there was no financial incentive to do so).

For example, by the end of June 2010, the network strength (detailed here) was around 139 megahashes/second.  To obtain half that hashrate, or 70 megahashes/second, an attacker would need to only spin up about 10 Xeon processors which could be obtained through AWS relatively cheaply (note: Satoshi probably used just one computer).

It was not until market participants increasingly valued the coin (vis-à-vis higher demand) which then in turn incentivized miners to destroy a corresponding amount of capital to protect the ledger.  Or as Peter Todd recently explained: the maximum cost to successfully attack Bitcoin’s network is directly proportional to the market value of the token.  It is intentionally designed to be expensive to attack otherwise anyone could change the history.  Or as Richard Brown has explained, proof of work as used in Bitcoin is “inefficient” on purpose.

The logistics of currency positions

In practice miners are taking one currency (USD, EUR, RMB), usually one denominated based on where the equipment is located, and through the process of destroying exergy (see Chapter 3), converting it into a foreign currency called bitcoin.  Or in other words, miners are currency convertors.  And irrespective of scale, “to mine” is effectively taking a long position on bitcoin versus a fiat currency (recall that the mining equipment and operating costs are paid for in foreign currency).  For many actors, it is not just a forex bet but also a gamble on appreciation.  As discussed in Chapter 3, there are at least two classes of actors willing and able to mine at losses, including some who hope that the token will appreciate in value.

I, along with several others, have written about this numerous times.  In the long run, most miners, if not all, do not actually generate economic profit because of how the difficulty rating adjusts proportional to the amount of hashrate that is added to the network (e.g., the “Red Queen effect”).  If it becomes cheaper to “mine” then the situation will simply incentivize more hashrate to be added resulting in a higher difficulty rating, negating the temporary advantage.  In the short run, there are actual differences in margins due to differences in climate, electricity prices, administrative overhead, taxes, etc.  Some, such as BitFury and a few in China, have better economies of scale and/or handsome land and energy deals due to guanxi (a few consequently have “cost of production” down to $80 per bitcoin and even lower as of this writing).

How the sausage is made

Unless you have mined some kind of coin before (see 12 Step Guide), in order to understand how mining actually works we must begin by noting that most miners are not actual miners, but rather hashers who effectively ‘rent’ their equipment to pools (pools charge a fee in exchange for this service).  Miners, technically speaking, are the machines that actually select, process and validate a transaction.  Hashing equipment does not do this.

For instance, CoinTelegraph recently ran a story on the new Raspberry Pi 2 Model B which costs $35.

raspberry node

This Pi computer (above) is effectively the only miner, the only “transaction processing” machine in an entire mining warehouse.

Since the entire Bitcoin blockchain can and is processed with something this cheap, why is mining so expensive then?

That is where Sybil protection and decentralization come into play.  Recall that for the supply side of the equation, miners compete with one another to win the block reward (since it accounts for roughly 99.5% of their revenue, a figure which hasn’t changed much in a couple years, see below for more).  Thus, rationally economic actors will strip a mining facility of anything that lacks utility (in some cases, even computer “cases” themselves).  If it is not hashing, it is not helping to generate income.  Thus in all warehouses today, they have row after row of specialized machines called ASICs to provide this spartan hashing function (recall this was all initially spurred on by ArtForz creativity).  In practice, this hashing equipment actually just asks for a block header from the host node of a pool (such as the Pi Raspberry) and only “hashes” the “midstate” but that is another discussion entirely (see this excellent explanation from Vitalik Buterin).  Thus, the only bona fide “mining” equipment in a facility is usually something akin to the Pi computer above.

[Sidebar: whenever someone claims that Bitcoin mining manufacturing pushed fabrication geometries to new limits, the reality is that designing a mining chip (or really, hashing chip) is actually, relatively simple: you only need a small handful of engineers to do it compared with say, a Xeon chip (which requires several hundred).  In fact, most of the IP for SHA256 modules (or tiles) for “mining” equipment can be purchased from existing backend design companies.]

So what utility do those rows of ASICs provide then?

As shown in the video (above), the sole job of those single-use ASIC machines are to provide “proof of work” hashing power which thereupon provides Sybil protection for the blockchain.  The video above was filmed in Liaoning province in China last fall by Vice magazine.  Be sure to also read more details from Jake Smith’s article covering the same facility (he was also the laowai translating in the video).

The bigger picture

Recall that the estimated total deployed capital from VC firms over the past 18 months in the Bitcoin space is roughly $500 million into over 100 startups.  And the direct financial rewards to miners over the same time frame has been roughly $780 million (3,600 bitcoins x 540 days x $400 weighted token price).  This wealth transfer represents a large opportunity cost to the emerging economy that is Bitcoinland (one notable exception is BitFury, which invested in BitGo).  Because instead of being able to hire software developers with that $780 million, it was used to fund exergy dissipation through:

  • Semiconductor firms such as TSMC
  • Utility companies (coal power plants in China, facilities in Washington, Finland and Ukraine)
  • Property and real estate agencies

Or in short, in an alternate universe in which Satoshi had created a different distributed yet secure consensus protocol (one that may or may not exist) in which the infrastructure costs did not directly scale in proportion to the value of the token, $780 million could have been instead used to hire 7,800 full-time developers (based on SF Bay wages).

But the Bitcoin network doesn’t need those developers, the current network can do everything the incumbents provide right?

Based on at least one post, Satoshi may have hoped to compete with Visa but he/she could turn out to be empirically wrong, there are real costs to maintaining a decentralized network.  As it stands today, the Bitcoin protocol does not offer any of the actual banking and credit services of existing financial institutions.  Consequently, recall that the expenditure and threat models on ‘trusted’ centralized networks are different than ‘untrusted’ decentralized networks.  As I and others have described elsewhere, Sybil protection and decentralization add costs to operating a network — they do not in fact, make it cheaper.  There is no free lunch or “free energy” in the mining process, anyone claiming that proof-of-work-based “mining” will somehow become ‘cheaper’ in the future is in the same class as the perpetual motion salesman.

Why is this important?

Another way to think about it: the $500 million that VC’s have deployed to build Bitcoinland are effectively a foreign exchange currency play (because it is a virtual-only foreign country that can only be accessed with a pre-paid card, bitcoin).  This money is being paid to effectively leverage one economy, or rather one unit-of-account (namely USD, EUR, RMB) to build a virtual unit-of-account called BTC (see more from Robert Sams).  But, and this is important for international adoption: there are no real corresponding exports from that economy (yet).  Furthermore, there are several reasons why the narrative of social media enthusiasts will likely not go according to plan.

Bitcoinland – a large, virtual retirement facility

bitcoin mining rewardsFrom a network sustainability perspective, Bitcoinland is a senior citizen and its trust fund (revenue base) is no longer in the “early days.”

Investor and entrepreneur interest may still be in the “early days,” but the asymptotical reward structure rapidly aged this economy into its twilight years much like early stars.

As of this writing, approximately 13.8 million bitcoins have been divvied out to miners over the past 6 years.  This represents roughly 2/3 of the internal income the Bitcoin trust fund had at the beginning.  More than half of the remaining will be apportioned in the next five and half years.

One common refrain is that at some unknown date and time, transaction fees will somehow increase and/or more users will collectively pay more fees.  This is a possibility but is unlikely for the reasons discussed on numerous occasions for reasons described in this working paper (it is a type of collective action problem).

In fact, the biggest counterpoint to this is that we have direct evidence to the contrary.

transaction fees in USD

The chart (above) illustrates the total transaction fees to miners (denominated in USD) over the past 2 years.  Denominated in BTC, the 2 year chart shows the same trend line.

Fees to miners is actually at a 2 year low (in BTC) and not increasing despite the fact that there are now more than 100,000 merchants that accept bitcoin for payments (up from 20,000 last year).

Why is merchant adoption far outpacing consumer adoption?  Well there are multiple reasons which I and others have discussed before.  More on that later.

Perhaps there is another way to visualize this historically, from the beginning?historical transaction fee

The chart (above) is from Organ of Corti and illustrates what I mentioned at the start of this post: that roughly 0.5% of a miner’s revenue comes from transactions (effectively, user donations), the vast majority still comes from the block reward.

But isn’t the retail economy booming and will balance this out?  No.

As shown from Jorge Stolfi (and Coinbase’s own chart), on-chain retail growth is stagnant (in fact, it is one of the glaring omissions in Bitpay’s new infographic).

Why?  Because most consumers are, in practice, not incentivized or otherwise interested in converting their local currency into a foreign currency for goods or services they can already buy with their existing currency.  Endless threads on social media have proposed solutions to this inertia, but the fact of the matter is in practice, consumers are only willing to change if and when the alternative is not just as useful, but significantly so (there is an entire segment of economics that studies consumer choice and indifference curves).  And they are only going to use something if it provides them more utility.  Thus to them, entering Bitcoinland (and current cryptocurrencies in general) is a friction they have preferred to avoid.  Perhaps that will change, but then again, maybe not.

Again, recall that the primary utility provided by the Bitcoin blockchain was to circumvent trusted third parties (TTP), which in practice, the average consumer are okay with having to deal with (the tradeoff between less privacy for more insurance, etc.).  For instance, in terms of demographics, the vast majority of gamblers that use bitcoin are based in the US because online gambling is illegal here.  European gamblers typically use bank transfers.  When SatoshiDice blocked US-based IPs, gambling volume dropped significantly for them (and flowed to other similar sites).  Maybe there will be another “killer app” but then again, maybe blockchains in general attract illicit activities because their decentralized nature enables routing around TTP, which some bitcoin holders find useful and attractive.

Circular flow of income

One last issue that intersects with miners and the Bitcoinland consumer economy is that of volatility.  This is a topic that generates enormous reaction and I am aware of companies such as Bitwage, Hedgy, Teraexchange that are attempting to create either hedging mechanisms against volatility and/or bridges between two different unit-of-accounts.

Ignoring the impact of the Poisson process, there is never a dull moment for being a cryptocurrency miner (professional or otherwise) as you never have a really good idea of how much capital to deploy in the future due largely to the continuous uncertainty over what the future market price of a coin is and what the difficulty rating may adjust to.  Or as Robert Sams aptly noted:

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).

Yanis Varoufakis, the new finance minister for Greece, has written about the monetary supply schedule challenges within Bitcoin several times.  One notable quote he had last year involved how speculative demand for bitcoin outstrips transactional demand:

“By a long mile. Bitcoin transactions don’t go beyond the first transaction. The people who have accepted bitcoins don’t use them to buy something else. It gets back to the circular flow of income. When Starbucks not only accepts bitcoins but pays their workers in bitcoins and pays their suppliers in bitcoins, when you go back four of five stages of productions using bitcoin, then bitcoin will have made it. But that isn’t happening now and I don’t think that will happen.” Because it isn’t happening now, he continues, and because so many more people are speculating on bitcoin rather than transacting with it, “Volatility will remain huge and will deter those who might have wanted to enter the bitcoin economy as users, as opposed to speculators. Thus, just as bad money drives out good money, Gresham’s famous law, speculative demand for bitcoins drives out transactional demand for it.”

What this has looked like in practice is that miners themselves are creating a currency with which they are not necessarily able to pay their electricity bills or leases with.  They have to convert it.  Perhaps this will change, but since the bulk of this virtual currency has to be converted into a foreign currency (USD, EUR, RMB), it creates continuous sell-side pressure on the market (see How do Bitcoin payment processors work?).  And without a corresponding increase in demand from those holding foreign currency, the market price declines.

Hedging may help mitigate some losses for a few of the merchants that choose to keep and not convert bitcoin payments they receive, but again, hedging isn’t free.   It also costs someone something to do — hedging can be expensive, this is why corporates do not typically hedge against ongoing foreign revenue but they only hedge against large one-off items (such as acquisitions, or large shipments / purchases).  Just ask the airline industry about its fuel hedging strategies.  Recall again that consumers in general prefer stable purchasing power for medium’s-of-exchange (no one is trying to directly use petroleum as a currency).

Without a circular flow of income, this is unlikely to change and this is something that requires years, perhaps even decades to build even with dynamically adjusted, elastic money supplies.  For instance, recall even with its $9.5 trillion economy and its $2 trillion in exports, the RMB only represents 2.17% of all international trade settlements (for comparison, the Greeks exported 27 billion in goods and services in 2013).  Perhaps indeed, Bitcoinland is still in the “early days” — or maybe its fixed monetary supply has inflicted it with incurable progeria (i.e., few want to spend it, so not enough fees to replace the block reward).  And thus its main exports will continue to be ways to distribute exergy via currency conversion processes and illicit trade.

Is all lost?

bitcoin moonEarlier this week William Mougayar encouraged advocates in this nascent space to basically chill out with the moon rhetoric.  Again, it is impossible to know what consumers will eventually adopt.  Anyone claiming that there will just be “one winner” that encompasses all use-cases is probably wrong in the short run (note that Richard Brown and Meher Roy have suggested that there may be some kind of “Grand Unified Theory” of cryptofinance but that is a topic for another post).

Every business, institution and customer has different wants and needs that will dictate actual adoption of technology and not the other way around.  Entrepreneurs, developers and investors cannot assume a market will adopt their own narrative any more than shipwreck survivors can “assume a boat” — thus as Mougayar has touched on: blockchains and consensus ledgers may find traction outside of niches only if they satiate mass consumer appeal, not just hobbyist interest.

To the chagrin of the heavily invested, Bitcoin may prove to be the vehicle that will spawn a variety of useful mainstream tech but that will never actually go mainstream itself.  In that respect, perhaps Bitcoinland is essentially a huge R&D program.  Perhaps this is a modern facsimile of The Rise of ‘Worse Is Better.’  Bitcoin enthusiasts believe that they are the “New Jersey” crowd in this particular story but in truth they may be taking the “MIT” approach, where they are seeking to build a perfect new financial platform. The lesson of the story is that the MIT approach almost always fails because it is incredibly hard to do and relies on perfect up-front understanding, while the New Jersey approach favors incremental discovery and evolving things towards something that works well enough.

Or maybe, conversely, some black swan event such as a large hedge fund publicly announces major buys or an ETF is approved or large-scale regulatory clarity occurs (see also: the Bitcoin Bingo card); we can only know in retrospect.

In the meantime, other mental models are being discussed including a separation of specialized distributed ledger systems (via consensus-as-a-service) from the current crop of cryptocurrency systems as well as proposed a dual-currency solution (such as Seigniorage Shares) that could end up implemented in other projects such as Augur’s prediction market: it could also be used for CFDs, it does no one any good if the underlying currency is too volatile to price contracts in — even if you “win” you could still lose due to currency depreciation (this is not an endorsement).

Other ideas such as the new replace-by-fee patch targeted at providing a mechanism for miners to prioritize transactions or metacoin censoring tools to allow mining pools to filter out watermarked coins (colored coins, Counterparty, etc.), will undoubtedly provide empirical feedback to future ledger designers on what to do and not to do.

Welcome to Bitcoinland, a virtual world whose artificial age is more akin to Sumter County than Madison County and whose primary export is currency conversion via exergetic displacement.  On-chain population: roughly 380,000.

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What about the new BitLicense revision?

A new revision (pdf) of the New York BitLicense was released this week.  Yesterday CoinDesk reached out to several people in the industry to see what their view was on the new copy.  I have a small quote in the subsequent article: “BitLicense Revision Leaves Room for Continued Debate

Below are my unabbreviated thoughts (I would like to thank Ryan Straus for being able to discuss in-depth some of these issues the past week as well):

It is still unclear to me whether the BitLicense is establishing a facilitator regime (like money transmission or custody) or an intermediary regime (like deposit taking).   Does the BitLicense permit the acceptance of deposits by licensees?  If not, then the question remains whether organizations like NYDFS and DOJ considers hosted wallet services to constitute deposit taking. If so, BitLicensees would presumably not be able to avail themselves to the securities exemption that is available to banks and other deposit takers. A deposit is a debt owed by the depository to the customer (depositor).  Does holding oneself out as a depository qualify as a securities offering?  If so, would licensees qualify for the bank exemption to the securities laws?

Obviously I’ll let the lawyers hash this out, but so far the interpretations of what “software” is or is not still seems vague especially since it is still not clear if these firms will be classified as a “custodial regime” as custody denotes possession and bitcoins arguably cannot be possessed in any sense (e.g., is Blockstream acting as a custodian for building and providing a service that enables federated pegs; are the servers that participate as the federated nodes liable?).

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What is the blockchain hard fork “missile crisis?”

Over the past couple of months there has been a number of discussions revolving around increasing the Bitcoin block size from its current 1 MB limit to 20 MB. One such plan is Gavin Andresen’s proposal (this is not to single him out as there are others with similar proposals). The code change itself is trivial, as it can simply be changed to any arbitrary number in a couple of keystrokes (for instance, see Vitalik Buterin discuss this at 14:15).

However, getting the majority of validating nodes, miners and the rest of the ecosystem on-board in a timely fashion is a very non-trivial matter.

Recall that, as illustrated by Organ of Corti and Dave Hudson, the average block size has increased over the past year to the point where we will likely max out at around 3 transactions per second with the current 1 MB limit. Since many of the investors, developers and entrepreneurs in this space would like to make Bitcoin ‘competitive’ to other payment platforms such as Visa, according to their view, this number eventually needs to increase by several orders of magnitude.

Fundamentally there are two trade-offs in block size economics:

  • Keeping a 1 MB block size requires higher fees to end-users but results in a more decentralized network
  • With a larger, 20 MB block size, fees are (temporarily) subsidized to end-users but with fewer validating nodes on the network

A quick explanation of both:

  • Retaining a 1 MB block size ultimately results in higher transaction fees because block space is scarce and miners will only process and include transactions based on market-based prioritization rates (e.g., pay higher to be included faster). While this would likely mean the end of certain types of transactions (such as “long chain” transactions) as well as fee-less transactions which have disproportionally increased the size of the blockchain over the past six months relative to actual commerce, simultaneously this design decision would have the effect of retaining some nominal decentralization as the increase in blockchain size would remain relatively linear and thus the blockchain could be validated by several thousand nodes as it is done today without (much) additional cost.

In early March 2014, there were approximately 10,000 nodes however over the past year there has been a decline by roughly 1/3. What does this distribution of roughly 6,400 current nodes look like?

user agents getaddr

Recall that the original value proposition of the Bitcoin blockchain was its decentralized characteristic, thus the more miners and validation nodes that are geographically distributed, the less prone the network is to single-points of failure. Furthermore, while many people call the various artifacts that have increased the blockchain size “bloat,” because this is a public good and no one owns it, it is imprecise to do so (e.g., one man’s 80 byte “trash” OP_RETURN is another man’s data storing “treasure“).

Whether consumers are sensitive to this change in fees is another matter due to elastic demand, they may simply switch over substitute goods (e.g., competing chains and ledgers).  What does this mean exactly?

  • An increase to a 20 MB block size would likely continue the same “low” fee (donation) structure practiced and promoted today as there is purportedly more room for non-priority transactions. The known challenge however is that if 20 MB blocks became “filled,” this would require a corresponding increase in bandwidth and disk space which would require more costs to be borne by the validating nodes which are already operating as public goods. That is to say, a blockchain that increased in size by 20 MB every 10 minutes would fill over 1 terabyte a year which would create additional costs for participants and likely reduce the amount of verification nodes and therefore reduce the decentralization of the network.

The other challenge to Andresen’s plan is, that because the prioritization of transactions would still not be adjusting towards via fees to miners, this would in turn continue the status quo in which miners continue to largely rely on seigniorage to operate. This is an unhealthy trend as it stalls the transition from block rewards to fees which was the narrative stated since day one on October 31, 2008 (see section 6).

What will happen?common user agents

It is difficult to predict what exactly will happen as the key actors in this space are still deciding what to use social capital on.

Gavin Andresen, as recently as two weeks ago, stated that most of the large payment processors, exchanges and other service companies are on-board with his plan (see also David Davout’s recent dialogue with Andresen). Furthermore, others in the community have (likely erroneously) found correlation between market cap and transaction volume yet as we know, correlation does not actually imply causation. Similarly, ‘Death and Taxes’ recently presented a narrative reinforcing Andresen’s view yet for some reason glossed over the all-important miners perspective.  Others, such as in the ideological wing personified by Mircea Popescu claim that they will fight this effort with an actual attack.

Irrespective as to what size a block is increased to, it will likely create at least a temporary fork as validating nodes need to upgrade and they are not being compensated for storage and traffic (Andresen’s plan is to “future proof” the protocol such that the 20 MB change is included in a patch this year but isn’t “turned on” until needed later on). There is at least one open question: what is the minimal amount of full nodes that are required for network to operate within current trust/security model?  Unlike miners, their value to the system is hard to measure.

What the experts say

While the field is young, one expert in this space is Jonathan Levin who modeled network propagation in his masters thesis. I reached out to him and in his view:

I think that the 20mb proposal is untenable given the current way that blocks are propagated around the Bitcoin network. The Bitcoin network and specifically the Bitcoin miners use a gossip network to relay blocks to each other. That means that as the size of the block increases, the time that it takes to spread around the network also increases linearly. We have seen this first in the work of Decker and Wattenhofer as well as my own work.

The problem is that the increased time that blocks take to propagate around the network increase the probability of orphan races between different mining pools. If you create blocks that are 20mb and a competing pool is creating blocks under 1mb or even empty ones, they have a higher expected return per hash. This is because you would expect your blocks to lose out to smaller blocks in an orphan race if both are found in quick succession. Now we can argue that miners will continue to create large blocks out of altruism but if we continue to increase the size of the blocks without greater utilisation of better block relaying protocols we risk breaking this equilibrium and miners resorting to nasty strategies like creating empty blocks which suit no one.

I also spoke with several other professionals in this space.

For instance, I spoke with Atif Nazir, co-founder of Block.io and an instructor at Blockchain University. According to him:

On the one hand, increasing block sizes, as you say, may result in lower transaction fee requirements. However, if the transaction fees actually are lowered by, say, 1000x what they are now (0.00001 is the minimum accepted by the reference client), this will lower the cost of “institutional attacks” on the Bitcoin infrastructure, where an attacker can push 1000 transactions for an erstwhile cost of 1. The attack will basically be “make infrastructure expensive to run for the average joe, drive them towards centralized infrastructure services that run APIs, Blockchain Explorers, etc.” It is good for business, bad for the decentralization of the network in the near term.

We’ve seen something like this occur on the Dogecoin Network in the past few months, where one user or a group of individuals were pushing transactions with 0 transaction fees. These transactions were accepted as valid by the Dogecoin reference clients, and as a result, caused bandwidth consumption hikes for the dorm-room nodes, which populate most of the current network(s). The resulting change by the Dogecoin Core team was to add a fee of 1.0 DOGE for every transaction, which isn’t yet mandatory, but is on its way there. The dorm-room nodes, however, are already on the decline in both Bitcoin and Dogecoin due to the increasing size of the Blockchain, and the bandwidth consumed by them.

Increasing the Block sizes sounds like a good idea for the number of transactions flowing on the network, but in the near term it will drive a lot of the nodes out of the system because of CPU/bandwidth/disk IO hikes. Increasing the Block sizes will definitely increase infrastructure costs, driving more users towards centralized places that can afford to host API services for the Blockchain. However, given this crunch on the average joe Bitcoin nodes, this will lead to a more concentrated effort towards “pick what you need” style nodes (say, SPV). Again, in the near term, the number of “full nodes” on the network will dwindle, but as more companies come into the ecosystem, this number will inevitably rise.

Bitcoin as a whole is headed towards a network where most nodes don’t actually host the entire Blockchain — increasing the block size will only accelerate this change. This will lead to more innovative solutions, and who knows, we might find a way for nodes to communicate cost-effectively rather than the current “gossip”-style protocol we use, where you inform all your peers when you hear about a new transaction. The community can very dynamic, and I think the longer term outlook for the network looks good regardless. Bitcoin is powered by nerds like you and I, and we tend to find solutions where others walk away.

Nazir raises an interesting point in terms of a hypothetical time horizon for when a transition (between short term and long term) could take place.

Another individual who has done a lot of modeling of incentives, mining and block sizes is Dave Hudson, a software developer who also writes at HashingIt. According to him:

Changes to the distributed consensus software within Bitcoin raise really interesting questions about the evolution of cryptocurrencies and how truly decentralised they really are. With each change we’re actually seeing something interesting happen where the ongoing participants in the system all effectively agree to move to a new system: BTC becomes BTC’ becomes BTC”, etc. We might be calling BTC” Bitcoin but any legacy nodes running BTC’ or BTC also think they’re Bitcoin too. At some point in time something happens and the various systems start to disagree about what is or isn’t valid and those could be very subtle. Imagine for example that BTC” introduced a subtle change that inadvertently made some of Satoshi’s coins unspendable; nobody might ever know until someone with Satoshi’s keys tries to spend their Bitcoins. Arguably it might already have happened as the result of some random compiler bug (not a fault in the Bitcoin-core code, but a bug in the way that’s transformed into something that runs on the node CPUs).

Clearly the Bitcoin-core developers try very hard to ensure that this sort of thing doesn’t happen by accident, but in order to sustain all participants holdings within the system they really do have to try to ensure that every node moves from BTC to BTC’ to BTC”, etc. In order to do this they essentially have to persuade everyone to migrate to each new version within some specific time window.

Now let’s imagine for a moment that instead of miners all tending to mine through centralised infrastructure (mining pools), that we really did have true decentralisation and had hundreds of thousands, or millions, of nodes that all did their own transaction selection and mining. Perhaps they’re even embedded into things that their users didn’t even realise were contributing to mining. At this scale it would probably be almost impossible to get them all to move to adopt a planned fork. We would either see the protocol totally stagnate or else we would see potentially very significant forks occurring.

In practice the system holds together in a cohesive way because, in the absence of a precise protocol spec, the core devs try to ensure that everyone uses the same consensus-critical software, runs it on the same sorts of hardware that all do things the same way and with some reasonably consistent set of capabilities.

It’s seems a slight irony that one of the key factors in the successful maintaining and sustaining of the Bitcoin network is continual centralised actions, and that things aren’t actually massively decentralised.

This last point is intriguing in that a lot of the software in this space is still relatively homogeneous and that if a network were to scale to become as distributed (or decentralized) as is hoped while simultaneously incorporating many nodes and clients, then it is likely that a diverse set (or lackthereof) of developer tools could prevent or perhaps even incentivize attacks (e.g., if every actor in the ecosystem uses the same client then that could create a vulnerability to the network).

In an exchange with Peter Todd, a contributor and developer on Bitcoin core and other related protocols (such as ClearingHouse), he framed the issue:

At the recent O’Reilly Media conference basically I pointed out that because this is an externality / tragedy-of-the-commons problem we may have to see Bitcoin fail due to a blocksize increase first before the community actually groks the issue. Personally I’m inclined to not oppose a blocksize increase on this grounds – Bitcoin failing cleanly is probably good for my interests.

In terms of “getting people on board” – to a degree you inherently can’t do this, because a blocksize increase will inherently exclude people from the system. See for example the discussion between Greg Maxwell and Gavin Andresen several weeks ago on the #bitcoin-dev IRC channel.

I spoke with Robert Sams, co-founder of a fintech startup who has previously written analysis covering the marginal costs of Bitcoin-like systems. In his view:

Levin’s point about network propagation is key: mining a larger block has a lower expected return because of the increased probability of losing out to a smaller block in an orphan race.

Now all of what you argue is a totally sound economic conjecture based on the assumption of distributed mining economics. Miners include tx until the marginal cost of tx inclusion (opportunity cost of including a different tx when up against the block limit + block propagation effect) equals marginal revenue (the fee).

However, for me the crucial economic force here is what happens to fees under concentrated mining. The logic changes from the marginal costs equals the marginal revenue logic in the above distributed case to a more strategic, oligopolistic pricing dynamic. What I mean is this. In the distributed case, whether or not a given miner includes a given tx has no material effect on the expected confirmation time for the tx sender. But in the concentrated mining scenario it does. If some pool is 35% of the network, the decision by that pool to not include the tx will materially increase the confirmation time of that transaction. So miners can extract more of the value that a tx senders place on fast confirmation times by setting their own minimum fee threshold, knowing that this threshold will over time effect the fees that tx senders include. What that optimal threshold is depends upon how much senders are willing to pay for faster tx confirmation times. Who knows what that is, but the implication is clear: under concentrated mining, fees levels will start to reflect more what tx senders are willing to pay rather than the cost to miners of including them.

So when you cast the blocksize issue in this concentrated mining context, it’s really not clear what will happen. My bets are that fees will go up and we won’t have to worry about blocksizes because higher fees will act as a break on adoption.

If block sizes are increased we will learn a lot about the dynamics of the community, the interplay between incentives such as fees and seigniorage have for on-boarding (and off-boarding) miners as well as how price sensitive users are in this space.

Ultimately it is the miners who decide as they are the entities creating Sybil protection and preventing double-spend attacks (or in some cases, providing that service). Or as Raffael Danielli, a quantitative research analyst at ING explained:

In theory, fee rewards should incentivize miners to include as many transactions as possible. In reality though fee rewards are a tiny percentage of block rewards and the risk-rewards ratio simply doesn’t add up at the moment (risking a (almost) sure 25 BTC payoff to get a potential say 25.1 BTC). What are the rational incentives for miners to upgrade and actually fill 20mb blocks? At the moment there are none that I am aware of. If there are no incentives for miners then this is not going to happen. Period. There is no altruism when it comes mining and anyone who bets on it is in for a rude awakening.

But this crosses over into the new field of cryptoeconomics which is a topic for another day.

[Thanks to Anton Bolotinksy for his thoughts on measuring the value of nodes within the system.]

Update from Organ of Corti:

I would add that there is a downward pressure on block size for block makers. I’ve done some research with Nadi Sarrer that proves the larger the block, the longer propagation takes. Even if a pool uses the relay network, increased latency also increases the chance of a pool losing an orphan race.

So block makers have to decide how to maximise fees while at the same time minimising block size. Some, like Discus Fish (f2pool) have tested both minimum block size (only including coinbase tx) and maximum block size, and lately seem comfortable producing maximum sized block each time. (They also seem to have a ‘pay for tx inclusion’ scheme here, but I don’t know much about it)

I think eventually pools will aim to use a decision making algorithm to:

a) Pick a block size they think will make losing an orphan race less likely.
b) Include all available high fee density (fee/kb) transactions in the block
c) then include high fee transactions
d) any left over space can be given to low and zero fee txs

With more data, this sort of process could be optimised to calculate the expected value of a block including the probability of losing orphan races. This would only lead to larger blocks when the value of the included txs outweighed the losses due to orphan races in the long term.

Of course, if all block makers had the same sized blocks, this would not be an issue. But if a block maker can win an orphan race by the expedient of having a smaller block, then they will.

Some open questions for the community: How will fewer network nodes affect orphan races? If the blocks are solved many seconds apart, I would think that fewer network nodes will mean fewer orphan races since the time for a block to propagate to most of the network will reduce significantly. However, if the blocks are solved at the same time, an orphan race might be more likely since the paths taken by the blocks propagating will have less affect on the overall propagation time. Which do you think is more likely?

In summary: If block makers are rational actors and the risk of losing orphan races is a significant downward pressure on block size, I don’t think increasing the available block space will have a significant effect on actual block size. There’s a lot of room for improvement in the tx inclusion algorithms used by most pools, and if I was a block maker I would increase the fee density of blocks and include far fewer low-fee and fee-free txs.

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