Gandal & Halaburda paper: Competition in the Crypto-Currency Market

Over the past several months, there have been a near infinite amount of conversations about the continual existence of altcoins — especially as it relates to prices (i.e., rising tide lifts all boats).  Some new preliminary research from Neil Gandal and Hanna Halaburda suggest that cryptocurrencies are not a winner-take-all scenario.  It should be noted that their time scale and usage of a select few exchanges may not be adequate for generalizations yet but some food for thought.

(Paper) (Slides)


We analyze how network effects affect competition in the nascent crypto-currency market. We do so by examining the changes over time in exchange rate data among crypto-currencies. Speci fically, we look at two aspects: (1) competition among different currencies, and (2) competition among exchanges where those currencies are traded. We fou nd that early in the market as Bitcoin becomes more valuable (against the USD), other crypto-currencies become less valuable against Bitcoin. This trend is reversed in the later period. Some of the other crypto-currencies lost most or all of their value. On the other hand, the values of some of the successful currencies increased in price against the USD, and at the faster rate than Bitcoin. The data in the latter period are consistent with the use of crypto-currencies as financial assets (popularized by Bitcoin), and not consistent with \winner-take-all” dynamics. For exchanges, we found little if any evidence of arbitrage opportunities. With no arbitrage opportunities, it is possible for multiple exchanges to coexist in equilibrium despite two-sided network effects.

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Dalio explains what credit is and how it works

After receiving some feedback on a variety of articles this past month it has been pretty sobering to realize that many Bitcoin advocates simply have no idea how the current economic system works, especially what credit is, where it comes from and how it functions.

Ray Dalio, founder of Bridgewater Associates (the largest hedge fund in the world), put together a short guide called Principles (pdf) and later developed the video below to help explain “How The Economic Machine Works”:

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Digital currency usage in the developing world

[Note: a revised version of this interview appeared on CoinDesk.  I hold no equity in the company nor is this an endorsement to use the service.]

This past week I spoke with Ron Hose, co-founder and CEO of, the leading Bitcoin exchange in the Philippines. Hose is a graduate of Cornell, a founding partner at Innovation Endeavors and previously co-founded Tokbox which was acquired by Telefónica Digital in 2012.

While began trading late last year, the actual exchange launched publicly in February. According to Hose, “In terms of volume, we have been doing pretty well in growth so far – high double digit, triple digit growth which is a very encouraging sign.” The main reason he credits this success is that, “we focus on building trust with customers through fast customer service. They care about this when dealing with bitcoin – they care that the money is safe. And because emerging markets are more different than developed countries, we had to provide a positive customer service process to where they can trust turning bitcoins into cash and cash into bitcoins. As a consequence we built out a physical network and actually deliver cash through retail locations and even conduct do door-to-door deliveries too.”

Because the team has an active exchange they can now see what customers use it for and have begun building a second layer of applications on top of it creating banking services to those who do not have traditional banking services. “In contrast to developed countries,” noted Hose, “where bitcoins as a payment method are more of a novelty – here it is serving a real problem. For instance, credit card penetration in the Philippines is 3%. Only 3 out of 100 customers that land on an ecommerce site have an immediate way to pay for it. Others have to travel to a bank for 45 minutes on bus, wait in line and then return back on the bus. Before you know it, it takes 3 hours to pay for something online.”

According to Hose there is even a larger pain point: sending and receiving money abroad. With about $25 billion a year the Philippines is the 3rd largest recipient of remittances – roughly half the size of its gross domestic exports. And these funds are predominantly going to people who do not have bank accounts and thus have to pick money up at retail locations like Western Union and consequently pay an average of 9% in fees. “The reason they pay this 9%,” explained Hose, “is because they don’t have a bank account and likely will never have a bank account because they do not have enough savings. Banks have a cost structure (location, tellers, rent) and if you do not have sufficient savings on the first day when you open an account, the bank is already losing money. This pain point is an area where mobile banking and bitcoin can help out. For instance, if a relative abroad sends money to you and you have to pay a transaction fee to a retail location, then that is equivalent in 3-4 days of income that you paid just to pick up your money.”

And, in his view, what differentiates and sets his team apart from other local competition, “we have a well-seasoned Silicon Valley team. And even though Bitcoin is not yet regulated in the Philippines, as well as neighboring countries is that we treat it as if it was regulated. We work to comply with industry standard KYC/AML regulations; we are self-regulated and assume that we are being regulated.” As far as operating in an uncertain environment, “there are definitely a lot of very particular challenges related to working in an emerging markets (for example, there is no automated way for us to do bank-to-bank money transfers here, we actually have someone going to the bank, withdraw cash, and deposit it at another bank.”

So then, what is the most important issue in operating the exchange? In Hose’s view, “again, customer service is the most important area. For instance, they might see my profile or cofounder profile on the website yet there is a lot of trust involved. And so I tell my team, “we are only as good as our last transaction.” Thus we have to make sure the funds go in the right time window.”

According to Hose, virtually anyone can come to, cash out their bitcoin and in turn receive cash at 12 major banks, thousands of retail locations or even have it sent door-to-door by messenger. For its first market, the team launched in the Philippines. However they see themselves as a regional player, aiming towards providing similar services to other markets in the area – expanding into places like Thailand, Malaysia, Indonesia and Vietnam. In addition to a foot network (sneaker net), the team is still quite lean, roughly 10 people – half in engineering and the other half in operations.

To accomplish its goal domestically, the team has built a large physical network and the next step is opening up this network up with an API (a sneaker net API) providing Bitcoin ATM makers the ability to use this infrastructure to send money anywhere else in the Philippines. In terms of physical throughput, Hose noted, “users can put in who they want to receive the funds and when they want to receive it. Next day delivery. We have providers that can do same-date, however we only guarantee next day as it is important to not overcommit to our customers. Part of providing good service is giving people the proper understanding what will happen and standing up for it 100% of the time.”

Concluding, Hose mentioned he was recently on a panel in Singapore (Echelon 2014), and was asked what is going to drive Bitcoin adoption. In his view, “the thing that will drive digital currency adoption is the use-case. It must solve a real problem; there has to be something that is painful enough to convert, somewhere there is enough friction, the thing about emerging markets is that pain exists – you don’t have a bank account or you have to pay 9% to transfer money to your family – so it is much easier to make that leap. And if we can make it so their friend had a positive experience, then through word-of-mouth they have a reason to try and use it as well.”

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Quote of the day: Unaware of legal environment

Below is a part of an interview between Juan Llanos, executive vice president of Bitreserve and David Landsman, Executive Director of the National Money Transmitters Association (NMTA):

JL: I understand you have been in touch with Bitcoin industry members.  What have those discussions been like?  How do their approaches and strategies compare to yours or the NMTA’s?

DL: Most Bitcoiners I have spoken to are not aware of their legal environment, or in a state of deep denial. It is not only about the federal and state legalities I mentioned above. They lack of awareness of the direct culpability society attaches to the Bitcoin dealer, if it later turns out that his Bitcoin customer dealt in drugs, terror, human smuggling, copyright infringement, hacking, or any type of criminal activity.  How could you have known, you say?  You are not responsible, you say?  Well, it is your responsibility, they say, to develop a credible ‘Know-Your-Customer’ program, one that is ‘reasonably designed’ to prevent, detect and report illegal money that moves through, or is in any way facilitated by, your company.

There are now at least 3 funded startups in the Bitcoin KYC space: Blockscore, Coin Validation and CoinTrust.

This all ties together with a post by Kristo Käärmann back in March: Government backed bitcoin

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Cryptocurrency in the news #17 (and some on China)

Lot of interesting stories the past couple of weeks but I need to close some tabs.  One older post of interest — for you statistics buffs — comes from Distributome Data & Activity: Horse Kicks which describes the use of a Poisson distribution to model how Prussian Calvary officers were kicked and killed by horses between the years 1875 and 1894.

Other notable links related to China as well cryptocurrencies (and sometimes both):

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Many thanks to those who have helped provide feedback

It is pretty easy to find people who are strictly bullish or bearish on a particular asset or idea (or philosophy).  It is another to find people who take the time to look at the details and also give of their time to help educate you.

Over the last few weeks, I’ve had the fortunate chance to speak with a diverse group of experts, entrepreneurs and educated contrarians.  And without their feedback, my thought processes and writings would be much weaker, poorly structured and lacking data.  This is not to say I am correct in my analysis — perhaps just slightly less wrong!

Below is a list of these individuals.  I should point out that their inclusion does not mean they endorse my own views, in fact several strongly disagree.  These are the people who are creating or trying to create the future in the roller coaster world.

  • Taariq Lewis
  • Petri Kajander
  • Jonathan Levin
  • Dave Babbitt
  • Dave Hudson
  • Jack Wang
  • Ron Hose
  • Raffael Danielli
  • Preston Byrne
  • Oliver Bruce
  • Chris Turlica
  • Karl Holmqvist
  • John Ratcliff
  • Adam Stradling
  • Robert Sams
  • Robby Dermody
  • Joseph Chow
  • Andrew De Gabriele
  • Peter Todd
  • Mike Hearn
  • Andrew Poelstra
  • Bryan Vu
  • Steve Kirsch
  • Ryan Orr
  • Matt Wilson
  • Daniel Cawrey
  • Pamela Morgan
  • Pete Rizzo
  • Jon Southurst
  • David Shin
  • Sidney Zhang
  • Stephanie Murphy
  • Adam B. Levine
  • Greg Simon
  • David Mondrus
  • Andrew White
  • Martin Harrigan
  • James Duchenne
  • Mark DeWeaver
  • Byron Gibson
  • DC, Cukeking and David S
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Separating activity from growth on Bitcoin’s network

[Note: the following article was reposted on Business Insider, a PDF version is available]

One of the contentious areas of writing about Bitcoin data and emerging markets, is discussing what conclusions and interpretations (if any) can be drawn from say, transactional volume.

Let us put that aside for a moment and consider ways to estimate real commercial volume. Are there any other ways to do so besides a full traffic analysis?

Sell side pressure

On any given day there are at least three entities that continuously sell bitcoins onto the market: merchants (and merchant processors), miners and mining manufacturers (who are sometimes paid in bitcoin).

As I noted in my previous article, last month BitPay announced that it was processing about $1 million in daily payments. It is unclear what amount of bitcoins that constitutes, depending on the time frame and therefore price levels (early December or the month of May) it could represent 1,000-2,000 tokens per day.

Let us assume that the other merchant processors such as Coinbase and BIPS are also processing a similar amount. And that altogether between 5,000-10,000 bitcoins per day are collectively being spent on commercial activities through these processors.

This puts pressure on the sell side of the price equation. That is to say, to minimize exposure to volatility, nearly all merchants elect to immediately convert bitcoins into fiat and those bitcoins are sold onto the market (both Ben Edelman and David Evans have written on this before).

Similarly, because miners have to pay real costs – capital and operating costs – they too sell their mining rewards on the market: around 3,600 each day (because again, MV=MC).

It is unclear how much mining manufacturers have to sell each day to fund their own developmental and logistical operations, but for the sake of simplicity and roundedness, let us say 1,400 bitcoins (it could also be as little as zero).

Thus altogether, there is a regular 10,000 – 15,000 bitcoins representing commerce that are sold daily on the market today. It also bears mentioning that, although technically the miners receive money, virtually all of it is spent towards utility (electricity) and hardware, not on the bitcoin ecosystem itself. While it is unclear how much other positive-sum value exchange is taking place (such as remittances, houses or cars) we can see that the transactional volume of potential commerce has remained flat during the past six months:

excluding popular addressesIs there a chart that shows this amount of transactions?

In my last article, I mentioned Total Volume Output – the total value of all transaction outputs per day – yet this includes coins which were returned to the sender as “change” and thus the real number trying to be measured is substantially less. And taken to its maximum readings, roughly 1,000,000 bitcoin outputs (UTXOs) are used each day.

If only 10,000 – 15,000 bitcoins are being used in real commercial activities (instead of merely zero-sum activities like gambling, mixing of coins or cybercrime), then the perceived Total Volume Output is potentially two orders in magnitude larger than the real economy.

What is the real economy? While the debate over what percentage of bitcoins are being spent in positive-sum activities, between October 15 and December 18 of last year, 41,928 bitcoins were sent to addresses controlled by Cryptolocker (a type of malware) – this is not real economic growth, in fact it is negative-sum. And because it signaled to the market that it was a successful way of generating (stealing) wealth, there are numerous copycats using similar methods (including CryptoDefense and Cryptolocker 2.0).

The cost of information security

For the moment, let us ignore the buy side of the equation, that in order to keep the same price level, at least 10,000 – 15,000 bitcoin are being acquired by other parties each day (primarily high-net worth individuals and institutions through OTC brokers).

What this actual activity translates into is the following:

Miners are the labor force that secures and processes transactions. And because this labor force has real depreciating capital costs and operating expenses, in theory, the cost for their services amounts to roughly $2 million per day (3,600 bitcoins X $600 per bitcoin).

In practice however, most miners are operating at losses. In fact, the network is vastly oversecured by miners operating at losses probably by a factor of 2-5x (described in Estimated costs). For instance, according to a recent report from the National Science Foundation (NSF), a now-banned researcher used, “about $150,000 worth of NSF-supported computer use at the two universities to generate bitcoins worth about $8,000 to $10,000.” Or in other words, the researcher externalized the real costs of mining (energy and capital deprecation) onto another party (the NSF and therefore taxpayers). This is inefficient, yet there are many cases of such activity taking place each day.

Thus while the Bitcoin ‘trust fund’ (a more accurate description for the network which divvies out a finite amount of block rewards) pays out security of $2 million each day, the labor force is providing significantly more security than they are being paid, probably closer to $6 – $10 million if not more (Hass McCook has additional estimates).

Simultaneously, they are providing these services for commercial activity that ranges from as little as 5,000 bitcoins to perhaps as high as 15,000 bitcoins. Or $30 million to $90 million respectively in today’s prices.

For comparison, MasterCard spent $299 million on their capital expenditures in 2013. As part of these expenses, it builds data centers similar to the “fortresses” (with moats) that Visa has also built. In 2013, MasterCard and Visa processed a combined $7.4 trillion in purchases.  Together with American Express and Discover, these four companies generated $61.3 billion in revenue during the same period.

While this is not an entirely apples-to-apples comparison, what this means is that the Bitcoin network is enormously oversecured compared with other transactional platforms. The reason this is, is because it is decentralized which creates overhead (since all the nodes have to process and verify the transactions). Yet, as shown with over the past month, the network is qualitatively insecure due to economies of scale. That is to say, so as long as the proof-of-work mechanism can be economically scaled, this leads towards centralization. No amount of white papers or tweets will change that.

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 and previously, Deepbit). Perhaps this mix will change over time. However one thing to consider is that some bullish advocates contend that the Bitcoin network will one day supplant and compete head on with Paypal and even Visa. In order to do so, the Bitcoin labor force are still (assumedly) being paid a fixed income to provide the same services. Thus perhaps in the future, the opposite will occur – the network could become undersecure due to disproportional rewards.

I spoke with Greg Simon, co-founder of Cryptowerks who worked as head of International Equity Sales for JP Morgan in Japan. According to him,

Cryptoledger miners are Japanese banks. They are producing an oversupply of crypto trust relative to an under supply of borrowers of that trust. Their only solution, producing an ever increasing supply of crypto trust, is making the problem worse, not better. It is the equivalent of central bank QE [quantitative easing], or pushing on as string. Just as an oversupply of central bank produced money causes the value of each unit of money to decline, so does an oversupply of crypto ledger miner produced crypto trust cause the value of each unit crypto trust, which we can measure in units of ghash, to decline. The problem is not the aggregate supply of crypto trust. The problem is aggregate demand for crypto trust. Until demand for crypto trust improves, either from monetary or non-monetary borrowers, we can expect the same fate for crypto trust in the crypto economy as we are seeing for fiat money in the legacy central bank fiat economy.

Another way to visualize this phenomenon is the chart below:

age of last send transactionJohn Ratcliff recently published an explanation about zombie bitcoins (coins, or rather UTXOs, that have not been active in more than 18 months) which is where the chart above comes from. Each color band represents the last time a private key corresponding to these UTXOs was used.

Thus, one take-away from this chart is that liquidity – as shown by the One Day, One Week and perhaps One Month bands – represents between 100,000 to 2,000,000 bitcoins. What is the actual number? Without a full traffic analysis we probably will never know.

But we can tell from spikes that the largest movements take place during volatile time periods, specifically during price run-ups. So, for instance, in the spring of 2013 there was enormous Western media attention and a subsequent boom that peaked in mid-April (when Mt. Gox had to temporarily shut down). Similarly, in November and early December corresponds with additional global media coverage and Chinese adopters coming online – with prices peaking on December 4th. Or in other words, transactional volume rises and falls with price levels – that the bulk of on-chain activity corresponds primarily to day trading and speculation. This, despite the fact that Ratcliff notes, that prices during this 18 month time span increased 4,000%.

That is to say, even though there are more than 100,000 merchants that accept bitcoin and even though token valuation has risen logarithmically, UTXO holders as a whole prefer speculating over conducting actual commercial activity. What could change this behavior?

Maybe nothing will because Bitcoin is a recreation of a medieval agrarian economy; few people spend, in part because the network codifies what is essentially negative time value of money.

Money and credit

There is an endless stream of papers and books on the topic of what constitutes and attributes of money. Arguably one of the most thorough explanations of what money is and how it arose is, The Ascent of Money by Niall Ferguson which was later turned into a good PBS series.

Despite what some Bitcoin advocates claim, gold itself was not used on a large scale since time immemorial. In practice, there were numerous types of physical assets ranging from metals to stones. England even used a system of money known as tally sticks for several hundred years. And the reality is that prior to the birth of civilizations, many tribes and villages operated with barter and gift systems with themselves and one another (some never even created something akin to “money”).

As noted by Ferguson, up until the Renaissance, there were no real financial instruments or professionalized banking or hedging methods in the West. Bonds, joint-stock corporations and insurance companies evolved throughout time (all post-Fibonacci). And consequently, this is reflected in the dearth of economic output at the time. That without a way to expand credit – to create loans to start businesses – the pie cannot be enlarged. In his words, “Credit and debt, in short are among the essential building blocks of economic development, as vital to creating the wealth of nations as mining, manufacturing or mobile technology.” In contrast, poverty (subsistence) more often, “has more to do with a lack of financial institutions, with the absence of banks, not their presence.”

Thus, I would argue that ultimately Coinbase could turn into a fully-fledged bank, providing interest to bitcoin holders to be able to loan out bitcoins (much like BTCJam does). And they could do this through a fractional reserve process. In fact, Huobi’s new Hong Kong branch (BitVC) is heading in that direction; users can lend funds to Huobi for interest and Huobi will then lend it out to users to trade on margin. Contrary to what many Bitcoin adopters contend, fractional reserve banking itself is not inherently a bad thing but that is a topic for another article.

However, for the time being, Coinbase and others – while on-ramping a lot of new users and providing utility through ease-of-use functionality – have a long way to go before this occurs. For instance, this past week Coinbase announced instant buyback (once you spend bitcoins, you can buy more). However, the reddit comment below sums up actually what happens:

coinbaseAgain, there is a difference between the economy Bob wants to have versus the economy Bob currently has. Today Bitcoin, as I have argued, is at most an emerging market akin to a pre-industrialized agrarian economy with enormous frictions. Internally it is an inflexible command economy that outsources and arbitrarily rations its scarce resources (block rewards) irrespective of economic conditions (e.g., Bob, the miner, is rewarded whether or not he processes transactions).   Front loading rewards the first four years without processing any transactions is an unsustainable activity. In fact, as Jonathan Levin, co-founder of Coinometrics, notes in his upcoming paper, Creating a decentralised payment network, he found that “[i]n total over the network history there have been 84,469 blocks with no transactions.” Yet because there is no one at the helm, no entrepreneur to rationally allocate block rewards or market value for those rewards the first year, ultimately 4.2 million bitcoins were given out for naught.

Many adopters note that this was done to help bootstrap the economy and that the initial distribution of bitcoins through the block reward is purportedly not how bitcoin will operate in the long run. And that at some point Bitcoin’s internal economy will somehow be incentivized by transaction fees only – or at least that is theoretical transition (see Reducing and removing block rewards). But the fact that miners were rewarded irrespective and arbitrarily of their actual work is very similar to how top-down command economies work rationing wages. This is a topic that will likely be debated over the coming years.

For additional perspective I spoke with Martin Harrigan, a software developer and founder of Quantabytes, a cryptocurrency analytics start-up. In his view:

The initial distribution of bitcoins is a one-time process that is distorting our understanding of the Bitcoin economy. I think that the peaks in transaction volume during the price run-ups are a form of secondary distribution: early adopters are distributing their bitcoins, for profit, to new users. This is a vital part of Bitcoin’s distribution process and may continue for as long as there are periods of significant price increase. It may be that institutional investors will take-over a significant portion of this process for several years. Then, at some point, when the technology, infrastructure, regulatory frameworks, and our understanding of cryptocurrencies has matured, the price will stabilise and Bitcoin will return to individual users as a stable transactional currency in the traditional sense.

Of course, I’m speculating wildly here. My point is that we don’t have a good null model. We’re not seeing “hockey stick growth” but maybe that’s okay. Many start-ups need this type of growth to survive — I don’t think Bitcoin does. During the Bitcoin crash of 2011 the price dropped 93% and didn’t recover until 2013. The difficulty also dropped and remained stagnant for a year and half. Although I can’t quantify it, the “mood” on the Bitcointalk forums was grim. The equivalent event would have been fatal to most start-ups.

Perhaps at Harrigan noted, this will change in the future. And perhaps those frictions are still lower than the cost of doing business in certain regions (like the Philippines). And this is not to single-out Coinbase. I still think they are one of the best companies in this space, I even consider them one of the most promising in part because they are trying to create value (and have). But that does not mean this particular service is frictionless. For instance, David Evans recently delved into the specific transaction costs of various platforms and explained how the actual roundtrip cost of Coinbase is 2% + $.15, not the 1 percent that is frequently cited (Evans also had another good explanation of how Coinbase and merchants like Overstock work).

Building a continuous series of bubbles or building utility

One of the common refrains about altcoins and appcoins in general is that none of the underlying systems are able to give out real equity and thus cannot have P/E expectations – neither does bitcoin, nor will it. This is a bug and it is why I argue that using the “TCP/IP” analogy is probably incorrect.  The internet is an amalgam of private-public intranets cobbled together and cost real capital to build.  It was not built with magic; real incentives had to be provided to build it.  Imagine if those incentives decreased 50% every 4 years?  That’s Bitcoin’s internal economy. The Bitcoin network cannot operate without bitcoins – the app or currency or commodity (choose your definition). The two are united together. Yet TCP/IP, the protocol, can still work even if substantial portions of the network fail; it is not tied to a specific set of hardware or token (TCPIPCoin).

This is not the first time a set of unrealistic expectations have been created in the past 10 years.

cleantechSo what kind of bubble is bitcoin then? Some claim that it “crashes upwards” which makes no rational sense at all. Bitcoin (the token) is not immune to the laws of economics. Perhaps as illustrated above (source), the current investment cycle in Bitcoin is more akin to Cleantech circa 2005? What this means is that, as noted in my previous article, even though many of the startups are clever, they may lack sustainable business models. Once this froth is removed, the businesses that survive will likely be those that are actually creating real pain killers (utility) to real needs; perhaps reusing the infrastructure of the network (like merged mining proposed by Blockstream or that of Cryptowerks) to process contracts and titles. Again, all of this is speculative, yet it warrants attention because Cleantech also had a similar dedicated ideological group of early adopters that created economic activity (though, not much growth yet) and wanted to change the world. And despite their best efforts it popped.

In conclusion, expanding credit alone is not the answer to Bitcoin’s stagnant economy. For instance, China’s money supply grew leaps and bounds since November 2008 (when it implemented a series of stimulus packages). It also signed bilateral currency agreements with new countries every year which led many outside commentators to erroneously conclude that this somehow leads to mass adoption of the RMB. Yet the stark reality is that the RMB only accounts for 1.4% of global payments compared with the dollar at 42.5%. This is unlikely to change either. However, even in its current doldrums, the Chinese economy still produces real goods and services to the tune of trillions of dollars per annum. Obviously it is unfair to compare Bitcoin, a five-and-a-half-year old “startup” to China. Yet the emerging market aspect, the reuse of capital stock, the implementation of new financial instruments, the training of unskilled laborers and ultimately the creation of needed utility to outside parties can be viewed as facsimiles to learn and grow from.

As noted by John Kenneth Galbraith in the last article, there is only so much capital that can be extracted from the “fleece-me” crowds of reddit. Significantly more capital is needed to scale operations to enterprise-level reliability. While some advocates believe eschewing the ancien regime of venture funds and private equity is the way to move forward, this is short-sighted.

Below is a list of companies I think have potential to create value in this digital ecosystem – embryonic solutions to this quagmire (I hold no equity in them):

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Beyond exchanges and wallets

Below are some start-ups or at least young companies in this cryptocurrency space that are trying to move beyond primary exchange functionality (simple order books) and/or hosted wallet services.  Note: this is not an endorsement of them as an investment or service.

API: Chain, Blockr, HelloBlock, BlockCypher, HiBitcoin
Analytics: Coinalytics, Coinometrics
KYC: CoinTrust, Block Score, Coin Validation
Decentralized cloud: MaidSafe, StackMonkey, decloud, Bitcloud, StorJ
Hedging/lending: BTCJam, Bitreserve, Bitfinex
Platforms: SecondMarket (BIT), CampBX, TruCoin, Coinfloor, Atlas ATS, Kraken, Coinsetter, Vaurum, itBit, ICBIT, LedgerX


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Modeling economic growth and zero-sum games in Bitcoin

lotteryI have a new article that went up over at Let’s Talk Bitcoin yesterday called, Can Bitcoin change from a bubble economy into a growth economy? (pdf).  It is essentially part 2 to the previous piece and put together based on feedback I received this past week.

I should mention that while I did use an equation in the middle of the article to describe prices, I do not think the regression itself is valid.  As my friend RD mentioned, the error term does not seem random. There is a deterministic trend that would have to be filtered out first.  It is the same problem with modeling long term GDP growth.  After all, why would we need all these economic models if we can simply draw a straight line and predict GDP using high school math?  Many things follow an exponential growth curve, that is nothing new. The exciting thing is to forecast it in the short term, which this method is extremely bad at (the same criticism can be lobbed at models like Elliot wave theory).

Over the last 12 hours I have received some criticism about one particular point: zero-sum games and gambling.

In one email exchange, Bob disagreed that gambling was zero-sum, stating:

Gambling in and of itself does not create productivity, but the businesses that surround gambling certainly can. See: casinos, bitcoin mixing services.

Also, if the house makes a bunch of money, and the owning entrepreneur uses those funds to start another, productive business, then in some sense the gambling has facilitated economic development by liberating wealth from unproductive suckers who participate in online gambling to a highly productive entrepreneur. This was, of course, exactly the case with the most popular bitcoin gambling website.

The issue here is a measurable one.  A zero-sum game is one in which wealth is merely redistributed and not grown.  What Bob described above is economic activity but not economic growth.  Gambling is zero-sum game as is speculating on stocks or cryptocoins, no new utility itself is created.  Tokens are simply being moved from person to person. Eventually many people are left with assets that they cannot sell because all the demand has been fulfilled, and at that point the price may actually crash.  In other words, to make money in a zero-sum game, it is only because others have lost an equal amount.  In fact, in many cases, value diminishes because of interchange fees or in the case of mixing services, transaction fees.

This touches on an economic principle of opportunity costs (the “seen” and “unseen”) — the traditional example used is Alice throwing a brick through a shop keepers window.  While the seen result is a repairman being hired to fix the window, thus spurring economic activity, this does not actually create economic growth because the shop keeper must now forgo certain opportunities to spend repairing existing physical stock.

Note: Gambling has the name “math tax” because it is a tax on people who are not good with statistics (49.5% odds means in the long-run, you will always lose to the house).  This is derived from Ambrose Bierce’s quote, “Lottery: A tax on people who are bad at math.”

After a quick Google scholar search, I think there is more concise explanation of this phenomenon in Gambling and speculation, by Borna & Lowry:

Unproductive nature of gambling

For players, gambling, at best, is a zero-sum game, i.e., the aggregate wealth of the players will not be altered due to a gambling activity. The losses of one party are precisely equal to the gains of the other participants. Of course, if the gambling activity were taxed by the government, or there were other ‘leakages,’ then the expected value of winning would be negative, i.e., the aggregate wealth of the players after the play would not be equal to their original wealth.

Although gambling is a sterile transfer of money or goods among individuals creating no new money or goods, it nevertheless consumes the players’ time and resources and may subtract from the national income. From a macro-economic point of view, the aggregate wealth of the players will change, in the long run, due to the fact that the transfer of wealth is usually among unequal productive sources. It may be argued that the productivity lost due to a transfer of money from one player will be offset by an increase in the productivity of the other player. This assumption is true only if both the winners’ and losers’ production schedules were assumed to be identical and linear.

One last note: there are a number of people I would like to thank for their comments included in this article; this does not mean they agree with or endorse my view.  This includes: Dave Babbitt, RD, Mark DeWeaver, Dave Hudson, JL, Taariq Lewis, CK, Petri Kajander and Chris Turlica.

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Cryptocurrency in the news #16

Some relevant news of interest as I close some tabs:

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Interview with core developer, Peter Todd

A new interview is up with IamSatoshi Network and Bitcoin core developer, Peter Todd.  While the first part explains the politics of getting code into (or out of the protocol) — which many enthusiasts gloss over — I especially found Peter’s discussions in Part 2 of germane interest due to the sky-is-falling on reddit surrounding the last few days.  Here is one such comment thread.  And I think this comment sums it up the best:

If a 51% can occur, all trust in bitcoin should be lost forever. An investment that relies on people begging random strangers on reddit not to ruin it every couple of weeks is not really something that seems like a great thing to pour actual money into, tbqh.

Tbqh means “to be quite honest” (that same user made other good points about this issue too).  And here is also another interesting subthread (mulligan for that decentralization + neutrality notion…). is the largest mining pool on the Bitcoin network (it actually supports merged mining for Devcoin, Namecoin and Ixcoin as well) and it hit 48% of the network hashrate this past weekend (it is now 43%, see this chart).  Its parent operating company is and the system is run in a cloudhashing manner — customers rent hashrate by purchasing contracts with bitcoin.  Interestingly enough, the cost of these contracts is now more than what you receive as a reward for hashing, leading to the joke that Ghash (and other such services) are pay-for faucets.  That is to say, faucets are way to distribute tokens, for free (usually by filling out some Captcha once a day).  Yet in this case, because of bitcoin volatility the past 5 months, users are actually paying to receive a minute amount of bitcoins — they might as well terminate their contracts and buy bitcoins on the open market.

One common refrain that some Bitcoin advocates say about mitigating 51% attacks is that hashers in mining pools can simply move and/or point their hashing equipment at another pool.  This may be possible in the “early” days of today, yet there are two problems as time goes on:

1) As we approach the top of the S-curve in ASIC tech improvements, mining farms (and pools) will gravitate to locations with the best and cheapest network and energy infrastructure.  This itself creates centralization risks that I and many others have written about.  If you are renting out equipment (hashing systems) from a cloud provider at one of these locations, you can no longer physically move the equipment to another farm and perhaps in some cases, you may not be able to direct your miner to other farms (there is one proposal by Greg Maxwell that hasn’t been reported on involving tamper resistant private keys physically built into the gear, but that’s a story for another post).

2) Block size increases.  In order to make the Bitcoin network more competitive as a payments and transportation network, there have been many proposals to increase the hard cap of 1 MB block sizes by several orders of magnitude.  To date however, the average block size is around 350 KB, with an average of 0.7 transactions per second — thus the need to increase it is low (primarily because few people actually use the chain for much activity such as commerce).  If block sizes are increased, without the use of something like tree chains, then centralization will occur because miners (and fully validating nodes) will need to pay for larger bandwidth options, larger hard drives, etc. which squeezes out marginal players.  This is a known issue but Peter Todd highlights this as a hurdle for hashers wanting to move to another pool for the same reasons mentioned in point #1.

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Confirmation bias and Bitcoin

A week ago I did an interview with Adam and Stephanie over at Let’s Talk Bitcoin.  The interview was actually done ad hoc as we were supposed to interview someone else entirely but due to a scheduling issue at the last moment, he did not arrive.  Instead, Adam asked me what I was working on, I started talking, he started recording, Stephanie asked some follow-up questions and one thing led to another:

This interview was not planned and as a consequence I wrote a lengthier follow-up that explains more of these issues in detail including data from the blockchain:  A Marginal Economy versus a Growth Economy

And again, I’m not anti-Bitcoin, but a lot of the “facts” that some advocates say about how many bitcoin users there are — most of which are widely exaggerated —  and this will not help data-driven companies who are on the fence of adopting the protocol.  At some point these same companies will figure out that adoption rates are actually relatively low, so might as well be upfront about it.  In addition, I think many of these challenges are surmountable, especially the technical ones.  Lastly, I like the tech, I still go to meet-ups and start-up presentations on a weekly basis to meet more in this space too.  And, I could also be incorrect.

I have also begun receiving some messages and mail.  The one below is one I received from Bob moments ago:

I was going to tweet but I chose to go private.

I had to stop listening to the show because I just couldnt believe the nonesense that was coming out of your mouth. I was cringing because I know you are actually very intelligent. You sounded like a daft fundamentalist politician from the deep south. You make sweeping value judgements, logical fallacies and aspersions. If you continue on like this, no-one will take you seriously. I’m frankly stunned – you know what it sounded like? Like someone arguing the earth is flat and that the sun revolves the earth.

I don’t care if you dont drink the koolaid, dont invest or hodl (sic) bitcoins, but you have to stop talking nonesense or you will end up branded the next Professor Bitcorn

I’m going to promptly forget I ever listened to that because I usually find your writings intelligent and well thought out.

It is fine to disagree with me, in fact, my skeptical views are held by a mere a small minority.  However, the blockchain is public and the data reinforces all of the claims in the interview which I later in A Marginal Economy versus a Growth Economy.  And in terms of what Bob is looking for — someone to confirm his Bitcoin-to-the-moon views —  this just creates an echo chamber, a confirmation bias that happens a lot in ideologically driven organizations.  This technology is open-sourced and institutions will likely just cobble together the parts that provide utility to them and not drink the kool-aid, just as they did with the F/OSS community in the mid to late 90s.

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Thread of the day: List of all the known dead altcoins

The past year has seen what some the “Cambrian explosion” in altcoins.  Most are complete pump-and-dump scams.  Others experimentally toy with a couple variables and a remote few actually bring something genuinely new to the scene (like proof-of-transaction in Fluttercoin).

Wouldn’t it be neat to see a list of all the known altcoins and a little bit about what they were before they became ledger rot?

For the last couple of months Ray Dillinger on Bitcoin Talk has been attempting to chronicle this digital death in: Necronomicon thread: Altcoins which are dead.  I wonder who holds the record for creating the most alts?  Is that something you brag about at a bar?

Furthermore, here are some patterns that Ray sees are emerging based on alts that are not (completely obvious) scams:

  • Alts have a plethora of different hashing algorithms, but there are really only three divisions that matter between their proof of work.  Either they are CPU dominated, GPU dominated, or they are mined with a particular kind of algorithm-specific ASIC.  ASICs exist for SHA256D coins like bitcoin and for Scrypt coins like Litecoin.  No other algorithm-specific hardware exists, so no other difference in hashing algorithm matters.
  • Within each division, coins rapidly reach an equilibrium where whichever hardware generates their proof of work is allocated in direct proportion to the financial reward per minute of the block reward.   Usually this means that halving the block reward of an alt, other things being equal, halves the hashing power securing its block chain.
  • Most alts become unstable when 3/4 or more of their coin supply has been mined (second reward halving), even if no other factors have made the cryptocurrency unstable prior to that time.  If the value being secured exceeds the block reward by too great a fraction, 51% attacks and forks are to be expected.
  • “Burst mining” or “automatically switching multipools” act like positive feedback amplifiers with a delay loop in mining – they make it VERY difficult for an alt to maintain a ‘stable’ block rate when its hash rate gets too small relative to the pool (GPU, CPU, or specific ASIC type) of hashing power it belongs to.  This is a heavy contributing factor in the 51% attacks and forks mentioned above.
  • Several alts switched to proof-of-stake after to this instability led to bad forks or “stuck” block chains where miners essentially had given up due to a burst miner leaving the chain at a ridiculously high difficulty level.
  • A shift from proof-of-work to to proof-of-stake, whatever its effect on market value, has usually led to stagnation or decline in the community surrounding the alt.  In turn this usually leads to a collapse in value of the alt, unless heroic measures (such as direct giveaways by stakeholders to non-stakeholders) are used to bring people into the community.

See also: Different proof-of-work mechanisms and several altcoins that have been hit with a 51% attack

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The increasing importance of energy sources and location for bitcoin mining

I mentioned BitFury in passing in my lengthy piece on energy arbitrage.  Last week they announced that they had received $20 million in venture financing.

But one story that has not been translated into English yet (here is the Finnish version) is that their facility in Finland is nearing completion.  They are reusing an old steel mill on Kimito Island and are coming up with a way to increase the efficiency of the heat recovery process to surpass that of Google (which also has a data center in the area).  And according to my friend who helped translate it for me, BitFury has a 20 MW power plant at that location and it’s almost entirely in use.

And that is with a token below $1,000.

For more on the $1 million token, see Bitcoins: Made in China (pdf) (BM)

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Fun fact: Litecoin’s hashrate nearly doubled after Bitcoin’s halvingday

What Dogecoin (of all cryptocurrencies) is highlighting is the huge importance of incentivizing the labor force to stay and continue providing security and utility.  With each halvingday Doge has gone through, this has led an exodus of labor elsewhere, sometimes to competing chains like Litecoin.

Again, a halving day is when the network informs the labor force that they are now receiving a 50% wage cut.

One common refrain that some Bitcoin advocates have stated in the past is that Bitcoin does not have a similar incentives issue.  As I have described in numerous articles and papers, this is false.

For instance, below is data from the Litecoin Hashrate statistics database at Bitinfo Charts.  The numbers expressed represent the collective hashing power of the Litecoin network:

  • 576.8 megahash/s on November 25, 2012
  • 572.62 megahash/s on November 26, 2012
  • 578.92 megahash/s on November 27, 2012
  • 687.47 megahash/s on November 28, 2012
  • ——— Bitcoin Halving Day ————
  • 1.11 gigahash/s on November 29, 2012
  • 1.28 gigahash/s on November 30, 2012
  • 1.14 gigahash/s on December 1, 2012
  • 834.75 megahash/s on December 2, 2012

What we see here is that some marginal miners that were previously hashing on the Bitcoin network left and began providing their labor on a competing network (Litecoin) that was temporarily more profitable to them (or at least, what they may have seen as future profitability relative to their costs).

These were likely GPU-based miners as FPGAs were increasingly being acquired and used by larger Bitcoin mining farms.  Remember, while there were some proprietary ASICs that were developed and used in this time frame, they were not available to the public at-large — the first ASICs that were sold to the public (from Avalon) did not come online till the end of January / beginning of February the following year.

Below are the corresponding dates on the Bitcoin network using the same database:

  • 24.65 terrahash/s on November 25, 2012
  • 26.52 terrahash/s on November 26, 2012
  • 25.29 terrahash/s on November 27, 2012
  • 29.47 terrahash/s on November 28, 2012
  • ——– Bitcoin Halving Day ———
  • 28.2 terrahash/s on November 29, 2012
  • 21.71 terrahash/s on November 30, 2012
  • 28.31 terrahash/s on December 1, 2012
  • 24.19 terrahash/s on December 2, 2012

The chart below is a visual representation of this phenomenon.


I have described the reasons for why this has occurred in the following articles:

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Comment of the day: Mining Rewards

Yesterday Ray Dillinger from this thread messaged me on Bitcoin Talk and said:

I think the economics of “mining” reveal a design flaw in proof-of-work cryptocurrencies.

The idea that people can ‘farm’ the money supply by buying and powering hashing hardware guarantees that the difference between the amount of value produced and the amount of resources expended will approach zero.

It’s something like a tautology, where people are spending money in an auction for the right to print money.  Such an auction is more or less guaranteed to bring the costs of printing money right up to its value, which is an unnecessary (and unwanted) feature.

Aside from externalities and subsidies in the markets for electrical power and waste heat making the auction unfair from the beginning, that simply is not a necessary feature of a currency.  Certainly no government-issued fiat currency is so resource-intensive to supply.  But that comes about mostly because the government can impose additional costs (such as jail time) on unauthorized printing which are not borne by those doing authorized printing.

And that distinction between “authorized” and “unauthorized” is something that peer-to-peer and distributed systems don’t have access to.

For more information on this issue I recommend interested readers visit a great post by Robert Sams, “The Marginal Cost of Cryptocurrency.”  Earlier this month I wrote a detailed follow-up post that Sams also helped contribute to (especially the concluding remarks) which discusses some of the the issues that Bob mentioned in the above comment.

I think in the long-run both Ray and Robert will likely be proven correct though there may be some interim solutions such as sidechains that delay or mitigate some of these problems.

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