Bullet points about fundraising for Bitcoin startups

I was looking through my email archive today and came across an email related to Bitcoin startups that I sent to a friend back in July.  Most of the points are still relevant today.

Bitcoin Startups! These Are The Trends We See by Adam Draper

  • Through the first half of 2014, an estimated $240 million in funding has gone into the cryptocurrency space, up from $74 million last year — most of which has gone into exchanges and wallet companies.
  • Number of Mining applications has stayed flat
  • Gambling started strong but has wavered

A Few Reasons Your Bitcoin Startup Might Fail by Sean Percival

  • Bad Branding, do not use “bit,” “block” or “coin” in your name — often that it’s causing consumer (and investor) confusion
  • Solving Problems Too Far Downfield — it’s certainly possible to be too early on many business ideas, especially if your idea is going to take immediate scale to be sustainable
  • Your Office Is An Airport — conference overload, travelling too much and not building the product and business; all that money you spend on travel is money you’re not spending on your company
  • IPO Schemes and Fundraising Fails — we’ve seen a few new approaches to fundraising, including IPO schemes that leverage crypto technology in some way. I would say this is the biggest red flag that the business or idea is doomed to fail
  • Your best plan of action is to launch an MVP (minimum viable product), raise an advisory round of $100K–$500K, and be able to sustain yourself for the next 12–18 months.

False Positives, False Negatives, and Reading Decks in Advance by Charles Hudson

  • at SoftTech we invest primarily in seed stage companies – we are investing in the team and the opportunity, not just what’s in the presentation.
  • reading decks in advance creates more false negatives than it saves false positives
  • Poorly conceived idea – I find that a simple paragraph gives me enough context to figure out whether the basic market opportunity and company idea sounds interesting. If the paragraph is well-written and compelling, I find the deck tends to be so as well. When I struggle to get the big idea from the intro paragraph, I’ll usually just sent a follow-up email to ask more. Still beats looking at slides.
  • Decks do not communicate personal connection and energy – I find that even the most well-crafted deck or presentation does not tell me anything about how I’ll feel when the entrepreneur or team comes in to present. I value the opportunity to get a sense for the energy and personality of the team when they present live.

Why did Investor X not look through the entire deck, the info is right there in font 8 on slide 27?!?!

Put simply due to time constraints this may not be possible.  I don’t have the link, but I recall Jeremy Liew at Lightspeed Venture Partners says he looks through 150 presentations/decks (not including executive summaries) for each investment.  In my own anecdotal experience, based on pitches I have seen over the past year I would probably say to keep it simple to get the point across in less than 15 slides because many investors do not have the time to look through every detail on the first round of a pitch (some, as Charles suggested above, may not even look at it at all).

Startups going through accelerators and incubators such as Plug and Play and 500 Startups may only have as little as 3 minutes to pitch during Demo Day.  So unfortunately for geeks, you would likely need to remove all the techno mumbo jumbo even if your company is say, an analytics startup.  Talk to your mentors to find out more on catering your marketing message.

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Fintech in the news #2

A few links of interest this past week:

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Blockstream’s sidechain’s is announced

I just finished reading through the new sidechains paper (pdf).  The team has clearly been thinking of clever solutions to a multitude of challenges.

Below are my first thoughts which could change as more information is released and/or code is implemented.

The biggest issue they did not address (so far) is how to incentivize mining after block reward halvings, though that probably was not their intent.  Also, and again this is just day one, but it is also unclear if the IP will be released as open source and if someone could use that code to create Blockstream 2, 3, etc.?

My comments below each block quote:

Because the miners do not form an identifiable set, they cannot have discretion over the rules determining transaction validity. Therefore, Bitcoin’s rules must be determined at the start of its history, and new valid transaction forms cannot be added except with the agreement of every network participant.

Even with such an agreement, changes are difficult to deploy because they
require all participants to implement and execute the new rules in exactly the same way, including edge cases and unexpected interactions with other features.

How can this be done in a trustless manner? Mining was supposed to be anonymous.  If they are identifiable by good actors, then they’re also identifiable by bad actors and not-so-good actors.

One problem is infrastructure fragmentation: because each altchain uses its own technology stack, effort is frequently duplicated and lost. Because of this, and because implementers of altchains may fail to clear the very high barrier of security-specific domain knowledge in Bitcoin[Poe14c], security problems are often duplicated across altchains while their fixes are not. Substantial resources must be spent finding or building the expertise to review novel distributed cryptosystems, but when they are not, security weaknesses are often invisible until they are exploited. As a result, we have seen a volatile, unnavigable environment develop, where the most visible projects may be the least technically sound. As an analogy, imagine an Internet where every website used its own TCP implementation, advertising its customised checksum and packet splicing algorithms to end users. This would not be a viable environment, and neither is the current environment of altchains.

Non sequitur.  The same complaint could be leveled at German carmakers versus American carmakers with the fragmentation in something like unit of measurement (meters vs Imperial).  The auto industry did not collapse because of fragmentation.

In addition, there is fragmentation within Bitcoin itself, with different pools relaying different types of transactions (or censoring others).  A couple days ago Dominic Williams pointed this out (in a different email), that there are different payment processors and different wallets that are incompatible (you can send money between them, but you can’t open one wallet with another).

A second problem is that such altchains, like Bitcoin, typically have their own native cryptocurrency, or altcoin, with a floating price. To access the altchain, users must use a market to obtain this currency, exposing them to the high risk and volatility associated with new currencies. Further, the requirement to independently solve the problems of initial distribution and valuation, while at the same time contending with adverse network effects and a crowded market, discourages technical innovation while at the same time encouraging market games. This is dangerous not only
to those directly participating in these systems, but also to the cryptocurrency industry as a whole. If the field is seen as too risky by the public, adoption may be hampered, or cryptocurrencies might be deserted entirely (voluntarily or legislatively).

Why are floating prices considered a bad thing?  Besides, the issues in this paragraph are exactly the same problem bitcoin faces each day and a solution to risks/volatility is not addressed in this white paper.  See Ferdinando Ametrano’s paper as well as Robert Sams’ upcoming draft on Seigniorage Shares.

Our proposed solution is to transfer assets by providing proofs of possession in the transferring transactions themselves, avoiding the need for nodes to track the sending chain. On a high level, when moving assets from one blockchain to another, we create a transaction on the first blockchain locking the assets, then create a transaction on the second blockchain whose inputs contain a cryptographic proof that the lock was done correctly. These inputs are tagged with an asset type, e.g. the genesis hash of its originating blockchain.

This has me thinking about token history and fungibility.  Perhaps it could be argued that moving these coins to a sidechain is an act of “mixing.”  Are atomic swaps a form of mixing?

Also, if the proof-of-burn effectively means “deposits” (from one chain to another) and value transfer is taking place, is this impacted by regulations such as 12 U.S. Code § 1831t – Depository institutions lacking Federal deposit insurance

This is true for almost all aspects of Bitcoin: a user running a full node will never accept a transaction that is directly or indirectly the result of counterfeiting or spending without proving possession. However, trustless operation is not possible for preventing double spending, as there is no way to distinguish between two conflicting but otherwise valid transactions. Instead of relying on a centralised trusted party or parties to take on this arbitration function like Bitcoin’s predecessors, Bitcoin reduces the trust required — but does not remove it — by using a DMMS and economic incentives.

It is still unclear what the additional economic incentives will be in the Blockstream/sidechains model.  Is it just the fees in section 6.1, such as the clever time-shifting mentioned later on?

This gives a boost in security, since now even a 51% attacker cannot falsely move coins from the parent chain to the sidechain. However, it comes at the expense of forcing sidechain validators to track the parent chain, and also implies that reorganisations on the parent chain may cause reorganisations on the sidechain. We do not explore this possibility in detail here, as issues surrounding reorganisations result in a significant expansion in complexity.

What are the costs of running and maintaining this validator?

No reaction. The result is that the sidechain is a “fractional reserve” of the assets it is storing from other chains. This may be acceptable for tiny amounts which are believed to be less than the number of lost sidechain coins, or if an insurer promises to make good on missing assets. However, beyond some threshold, a “bank run” of withdrawals from the sidechain is likely, which would leave somebody holding the bag in the end. Indirect damage could include widespread loss of faith in sidechains, and the expense to the parent chain to process a sudden rush of transactions.

Who determines insurance of a blockchain?  Will FDIC or similar bodies have jurisdictional grounds as described in the above USC citation (not a joke, Blockstream founders are not anonymous nor most large farm & pool operators)?

As miners provide work for more blockchains, more resources are needed to track and validate them all. Miners that provide work for a subset of blockchains are compensated less than those which provide work for every possible blockchain. Smaller-scale miners may be unable to afford the full costs to mine every blockchain, and could thus be put at a disadvantage compared to larger, established miners who are able to claim greater compensation from a larger set of blockchains.

We note however that it is possible for miners to delegate validation and transaction selection of any subset of the blockchains that they provide work for. Choosing to delegate authority enables miners to avoid almost all of the additional resource requirements, or provide work for blockchains that they are still in the process of validating. However such delegation comes at the cost of centralising validation and transaction selection for the blockchain, even if the work generation itself remains distributed. Miners might also choose instead to not provide work for blockchains that they are still in the process of validating, thus voluntarily giving up some compensation in 360 exchange for increased validation decentralisation.

How can that be done trustlessly?  How does that deal with the issues Dave Hudson talked about with respect to IHPP in general?  Until IHPP is changed or modified, Hudson’s models will remain valid.

By using a sidechain which carries bitcoins rather than a completely new currency, one can avoid the thorny problems of initial distribution and market vulnerability, as well as barriers to adoption for new users, who no longer need to locate a trustworthy marketplace or invest in mining hardware to obtain altcoin assets.

This doesn’t seem to be addressing several other reasons for why alts exist: who will pay independent developers wanting to build on sidechains? What about non-SHA-based hardware (like scrypt or X11)?  What is to prevent someone from forking “sidechains” code and creating a similar business?

An alternate mechanism for achieving block rewards on the sidechain is demurrage, an idea pioneered for digital currency by Freicoin (http://freico.in). In a demurring cryptocurrency, all unspent outputs lose value over time, with the lost value being recollected by miners. This keeps the currency supply stable while still rewarding miners. It may be better aligned with user interests than inflation because loss to demurrage is enacted uniformly everywhere and instantaneously, unlike inflation; it also mitigates the possibility of long-unspent “lost” coins being reanimated at their current valuation and shocking the economy, which is a perceived risk in Bitcoin. Demurrage creates incentives to increase monetary velocity and lower interest rates, which are considered (e.g. by Freicoin advocates and other supporters of Silvio Gesell’s theory of interest[Ges16]) to be socially beneficial. In pegged sidechains, demurrage allows miners to be paid in existing already valued currency.

I am not sure Freicoin is a particularly good example here because in practice few participants want an asset to always lose value (what investors actively demand demurrage?).  Maybe this is reflected in its lack of adoption (thus far).  Perhaps that will change, perhaps Freicoin will grow over the course of the next few years. But this also touches on the issue of whether or not these “coins” are commodities or a currency in the first place (I have argued they are informational commodities).

The point about reanimation is an interesting one (and good) because of the uncertainties of “zombie” coins (as John Ratcliff calls them) that jump back onto the market.

Also, while the experimentation use-cases in section 5.1.1 seem to have some active demand (as measured by crowdsales and hype this past year) they could also (IANAL) lead to legal issues that these 2.0 projects are having with respect to unregistered securities (see the SEC with its Howey test).  This is a legally risky area as discussed by these lawyers.  Also, if users can create digital tokens pegged to real world assets — if these are non-deliverable, does this turn that chain into a large “bucket shop“?

Co-signed SPV proofs. Introducing signers who must sign off on valid SPV proofs, watching for false proofs. This results in a direct tradeoff between centralisation and security against a high-hashpower attack. There is a wide spectrum of trade-offs available in this area: signers may be required only for high-value transfers; they may be required only when sidechain hashpower is too small a percentage of Bitcoin’s; etc. Further discussion about the usefulness of this kind of trade-off is covered in Appendix A.

Who will maintain these?  No Free Lunch.

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Measuring Interest and Not User Adoption

[Note: This was originally published on October 20, 2014 at Melotic.com]

Earlier this month CoinDesk published their quarterly State of Bitcoin report.

One stat (on slide 6) that was used to purportedly illustrate growth in user adoption was the increase in the amount of wallets created. According to their figures, there was a 21% increase from June to September this year (5.4 million to 6.5 million respectively).

The problem is however, opening up a wallet or creating a wallet does not constitute growth or adoption, it may simply show interest. Remember: in order to use the Bitcoin network users have to use bitcoins – or more technically speaking, unspent transaction outputs (UTXOs). Wallet creation is a zero-cost economic activity, it is negligible to do so and is not an accurate metric for actually measuring adoption (the use of UTXOs). For a lengthier answer, be sure to read Chapter 4.

On this point, two weeks ago Brian Armstrong, co-founder of Coinbase expressed similar skepticism towards wallet creation numbers, stating: “signups is a poor metric for market share” and had one specific alternative “KYC’ed accounts linked to bank+identity.”

Yet there is a problem with this as well. Both my wife and I have KYC’ed accounts on Coinbase, though neither of us have ever used it (yet). Similarly, I have probably created a handful of wallets over the past year over at Blockchain.info to test out sending several satoshi and never re-used the address. In fact, it is considered ‘best practices’ for end users to not re-use the same address, this is one of the reasons why Electrum and other clients provide multiple addresses to send UTXOs to and from. Another explanation is that some pools switch to dynamic payout addresses which also increases number of new addresses. Thus it should be expected that the amount of “addresses used” or in this case, “wallets created” has increased (recall, there is no such thing as an actual “wallet,” this is just nomenclature to help users better grasp the abstraction that are UTXOs).

Thus, actual bitcoin users (and holders) are probably not a significant fraction of the 6.5 million “wallets” opened through September. That is to say, if a bitcoin user is defined as someone who controls the privkey to a UTXO, it may be the case that bitcoin holders number somewhere between 250,000 to 500,000 globally and has remained in this range for the past six months (see also Android wallet plateau in Chapter 8).

How to measure actual users?

This is an ongoing question, one that has spurred numerous answers. I have written about it at least twice in both books. Some valid metrics include the change in Total Output Volume, Bitcoin Day’s Destroyed and fees to miners. In addition, the Top 500 Richlist is another way to measure on-chain users.

According to their continuously updated Distribution by Address, as of block 320,000 approximately 99.08% of all UTXOs reside on 329,451 addresses. The remaining 0.92% of all satoshis reside on more than 46 million addresses largely in the form of spam, mining rewards, unclaimed tips, etc.

What does this mean?

In April I published a draft of a working paper which used data from block 295,000. At that time, I looked at this slightly differently, noting that 99.08% of used addresses contained less than 1 bitcoin. Andrew Poelstra (andytoshi) corrected this statement, noting that:

“[T]he claim that 99.08% of all addresses contain less than one Bitcoin is an extreme understatement. In fact it is impossible for more than 21 million distinct addresses to correspond to UTXOs containing 1 bitcoin, but there are 1048 addresses. So it will always be the case that at least (100 ‐ 10^ ‐ 38)% of addresses contain less than one bitcoin.”

So what did the actual distribution look like? And what has changed since April? At that time 99.14% of all UTXOs resided on 301,901 addresses. So in the past 5 months there has been a diffusion of less than 1% of those UTXOs to other addresses.

This does not mean there is no activity, or no velocity. Without a full traffic analysis we cannot determine where these UTXOs end up flowing to. Yet it is clear that there has not been a 21% growth in user base during this time frame, otherwise the distribution would have likely changed dramatically (recall that on-chain users cannot participate on the network without at least 5460 satoshi, or the ‘dust limit’ so those marginal holders should not technically be viewed as users).

Again, it is known that certain entities like Bitstamp and Coinbase are large bitcoin holders and they may have on-boarded a number of new users internally. And that some of the addresses containing large amounts of UTXOs likely belong to these types of companies. Yet if there was a 21% growth in the user base over the past 3 months (let alone the 5 month window above), there would likely be other ways to measure and observe this activity as described below.

How to measure adoption?

Due to its pseudonymous nature, one way of measuring adoption is not wallets or price (this largely reflects changes in speculative demand) but in transactional demand. To gauge this metric there are several datum from the blockchain that could be correlated:

In contrast, not a single metric on slide 6 of the CoinDesk report actually measures user adoption. Rather, they all are indicators of interest.

  • According to Google Trends, Bitcoin as a term has remained almost flat since this past spring. Perhaps this will change, but interest is not the same as adoption.
  • Hashrate is not an accurate measure of user growth or adoption as it measures hashrate not usage (and in fact, the amount of actual miners has likely decreased since the advent of ASICs).
  • Github repos may potentially be an accurate if these updates/requests were substantial changes, yet as I have explained elsewhere – most of the innovation has been outsourced to altchains which can afford experimentation (e.g., smaller community, less impact if it fails). Instead, changes to the core protocol are relatively slow and conservative (understandably). To quote Chapter 4:

Similarly, if a serious flaw and vulnerability was found in the core Bitcoin code base (bitcoind) which caused a cascade of hard forks that destroyed Bitcoin entirely, the github commit component would precisely measure the wrong thing, inputs, rather than an accurate attribute: healthy production code. In fact, that measure would spike, leading observers to believe that this collapse is good news for Bitcoin.

  • In terms of merchant adoption, while this has indeed increased, merchants are still dependent on a fixed slice of liquidity (roughly 10% of all mined coins are liquid in any given month). Furthermore, because there is no “circular flow of income,” the vast majority of coins are usually immediately converted back into fiat. Thus, again, merchant adoption should not be conflated with user adoption.
  • VC funding is an indicator of interest and changes in sentiment, but not necessarily growth or adoption (unless these VC deals are done in bitcoin, which some of them are, perhaps this will increase in time).
  • While ATMs will likely continue to be purchased, built and installed, it is unclear at this time if there will be non-marginal growth from these on/off ramps. ATM owners have overhead costs (amortizing machine costs, maintaining a physical presence and compliance), costs that may be added onto the end user and perhaps lowering the demand (due to price elasticities) in certain regions and corridors. These changes in demand could be viewable on-chain through the metrics above.
  • Lastly, “Merchant’s annual revenue” is misleading because that is unrelated to how much revenue they generate from digital currencies. Perhaps digital currencies will eventually impact the bottom line, but total revenue is not a reflection in user adoption of digital currencies.

While future posts may look into these slides more it is necessary to point out that these interest metrics above could turn into user adoption (depends on what the “bitcoin sales cycle” turns out to be).

Readers are also encouraged to look through Sarah Meiklejohn’s research on this topic entitled, A Fistful of Bitcoins: Characterizing Payments Among. Men with No Names. Combing through and correlating this type of data may also be a good research project for students this fall and winter.

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Fintech in the news #1

I am retiring the previous list name “Cryptocurrency in the news” because I think that fintech (financial technology) is a more accurate, all encompassing term for this space.  There are other possible names like “dapps” (decentralized applications) however I prefer fintech because decentralization may not be what the market chooses as an end game.

Some links of interest:

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Traffic analysis from Sarah Meiklejohn

Sarah Meiklejohn is a researcher now at UCL.  She is probably best known for her authorship of one of the best research papers in the digital currency space: A Fistful of Bitcoins: Characterizing Payments Among. Men with No Names.

She recently gave a presentation covering this paper (which admittedly has older data) and talks about some of the new privacy projects like CoinJoin which she says had a noticeable impact on a heuristic used in the study.  The Q/A session at the end also has some good comments.

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Why Market Prices Do Not Double With a Block Reward Halving

[Note: This was originally published on October 15, 2014 at Melotic.com]

For a little background to this post, see my previous post on block reward halving and the scrypt alliance.

One of the common misconceptions within the virtual currency space stated by many advocates is that when a proof-of-work blockchain has a block halving, for some reason the market price is supposed to immediately double. Yet in practice, it rarely, if ever does on that date.

There are a couple reasons for why this is the case.

To be clear, when a block reward halving takes place, it is the future money supply – monetary stock creation rate – that divides in half. The current existing monetary supply does not divide by 50% (see Jonathan Levin’s explanation for defining bitcoin as narrow money stock).

Again, it is not as if the entire monetary stock divides in half overnight, it is just the block reward that does. If half of the money supply was destroyed or permanently lost, then ceteris paribus, it could have a non-negligible impact. For example, in late February and early March of this year, news related to Mt. Gox’s collapse suggested that up to 850,000 bitcoins may not exist.

That is to say that one potential outcome of Mt. Gox’s bankruptcy is that they were fraudulent operating, perhaps by running in an undeclared fractional reserve-like manner and some, many or all those coins simply did not exist. Consequently, market prices actually jumped for several days on this news, with speculators considering the possibility that the total money supply in circulation was smaller than what the market had previously factored in.

This is important, because if the demand of an asset remains the same while the supply is reduced, then ceteris paribus, the price of the asset could rise. The price may only change dramatically if previously unknown information becomes available but the halving does not fall into that category as it is known well in advance.

And as I briefly explored in my last post, perhaps altcoins and altchains are a type of substitute good. If this is the case, if the elasticity of demand for a good (a coin) changes due to the availability of a substitute good, then during this timeframe consumers (or speculators) may switch to other chains (technically this is called price elasticity of demand, or PED). There are several other determinants which readers may also be interested in.

If true, then perhaps during a block halving, what we may be observing is shifts of the demand curve as speculators move towards more profitable chains (since supply is fixed). And in the case of mining, the activity of mining itself is essentially taking out a “long” position on the coin itself. Or in other words, one distinct class of speculators in bitcoin, litecoin and dogecoin are the “long” positions of miners (e.g., to recoup the sunk costs and operating expenses, mining is essentially a market signal for “bullish” sentiment). Miners are a type of speculator and consequently this in turn intersects with the hash rate protection challenge discussed in an earlier post.

Theory and practice

In practice, no virtual asset – including bitcoin – has continually seen price doublings immediately after a block reward halving. In point of fact, in November 2012, bitcoin’s price did not double immediately after the halving (see Chapter 15 for more details).

This again is a challenge and an existential problem for all coins, including bitcoin. As Ray Dillinger aptly noted earlier in May regarding the survivability of altcoins:

It doesn’t halve its remaining coin supply more often than it can double its value. That’s kind of hard to predict, but at this point I think the double-value time for cryptourrency is up to about a year, maybe two. It’ll get longer until it catches up to double-value period for the rest of the economy, which is 7 to 15 years depending on the industry. This is important because whenever the block reward goes down, the hash rate goes down in the same proportion; and when the hash rate gets too low, the blockchain becomes vulnerable to an attack which can destroy its value completely. Expect any coin that mines out its coin supply too fast, to collapse. I think even Bitcoin is going to be too fast in the long run; there’ll come a point when its double-value time is slower than its block-reward halving time and alts will start sucking up the hashing power making bitcoin vulnerable to attacks.

Will bitcoin’s price double again two years from now during its next block reward halving? It is unknowable what the price will be in the interim but historically it seems unlikely this would happen on that specific date.

What is another consequence of having a fixed, inelastic supply?

Again, when supply is fixed and its creation rate known, the only way to reflect changes in demand is through price. In bitcoin’s case, Robert Sams explained several months ago on a panel that this is a problem:

I think the issue [of] should you have more elastic supply or not…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.

This topic is continuously debated and is an issue highlighted by Yanis Varoufakis, a political economist at the University of Texas and the University of Athens. According to Jeffrey Robinson’s new book, Varoufakis says that speculative demand for bitcoin far outstrips transactional demand:

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 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.

While Varoufakis is discussing the circular flow of income, the last sentence in particular is germane to this conversation.

As described above, block rewards are fixed and known in advance. What is unknown in advance however is both the demand (from speculators) and in particular miners (the labor force).  If these assets have a fixed supply rate, the only way to reflect changes in demand is through price signals.

Correspondingly, speculative demand is at odds with transactional demand. Expectations of future demand (or lack thereof) in turn creates shocks and volatility which in turn disincentivizes transactional demand on all chains. There are proposed solutions to this, but those are for later posts and will likely require a new ledger altogether.

For additional perspective I contacted Jonathan Levin, co-founder of Coinometrics, and according to him:

In economics we have a concept called rational expectations where agents use all the available information to decide their actions in equilibrium. In this framework the halving in the block rewards would have been anticipated and factored into the price. You are right to emphasize that when doing a demand and supply analysis, it is not the coins produced on a daily basis that matter but rather the entire stock of bitcoins in circulation. In that way the price of bitcoin should not double for a halve in the hashrate, in fact the effect should be negligible. This is considering just transactional demand and total supply. With goods/commodities this is likely to hold true but in currencies or cryptocurrencies this may be different. There are issues of security and speculation.

Now if we consider that the market price is actually the price that the users wish to sustain in order to have sufficient network security (tenuous). Then we may make an argument that the price of bitcoin should double. People who are speculating that this will have real effect may be buying up coins which moves the price closer to that equilibrium.

In my mind, economics would predict the hashrate to halve as the reward halves. Essentially the argument would go if the price has not doubled the hashrate must fall.

While variables such as compliance/regulatory changes and the transition along the hashrate S-curve (CPU -> GPU -> FPGA -> ASIC) create wrinkles in this dynamic, thus far the empirical data matches the theory. And collectively this is why prices do not double on halving day.

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Cryptocurrency in the news #30

When digital archeologists peruse Reddit in 20 years, to look at what happened to the Bitcoin community, it is posts like this pumper that will serve as a case study — an exhibit of how false information was used to promote adoption.  As shown in the comments, the Klarna Group is not in fact adopting Bitcoin.  It is unclear who is behind these type of posts, but it is unfortunately very common.

Below are some other interesting stories related to digital currencies and China.  Link is not an endorsement to services:

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Thoughts on the 2.0 space

Last week CoinDesk reached out and asked several questions related to Koinify and published a few of the comments in a story, “Crypto 2.0 Roundup: The Overstock Effect, Counterparty Debates and a Crypto iTunes.

Readers may be interested in a few more of my thoughts below.  [Disclosure: I am an advisor for Hyperledger and head of business development at Melotic.]

  • As of today, Koinify is probably the only serious venture-backed startup that solely focuses on building decentralized applications and decentralized autonomous corporations (DACs).   It is also setting some ‘best-practices’ in transparency that has been largely missing in this community.  You will see that soon with Koinify’s following announcements.
  • The biggest problem in the altcoin/decentralize app space is that virtually all of them lack any original utility, are blatant scams or simply cannot fulfill the paper-based promises of their vocal promoters.  In short, virtually all digital asset projects have thus far been overpromised and underdelivered, including, arguably Bitcoin itself and we see that with a dearth of mainstream end user adoption for any of them.  What I’d like to help provide Koinify is the knowledge of the past, to avoid the pitfalls of other projects.  To accomplish this, Melotic is looking to provide liquidity to unique curated assets, potentially those incubated at Koinify.  Thus, this is a mutually beneficial partnership.
  • I have been following the growing list of distributed computing and computational consensus proposals.  Beyond the annual academic Dijkstra Prize, the nascent digital currency space has been fast in proposals but slow in actual production-level roll-outs.  To be frank, I have been fairly disappointed with both the quality of product and traction of 2.0 projects in general, especially given the community euphoria in the first quarter when I did research for Great Chain of Numbers.  However, with that said, if something like Bitcoin is allowed to be given a 5-6 year “grace period” I think it is only fair for a similar runway to be given to other proposals as well.  Furthermore, there are economic trade offs depending on the level of trust and consensus required, but shoving everything onto one ledger, some kind of jack-of-all-trades Houdini ledger, is a bit like the clown car at a circus.  It can be filled with a cornucopia of clowns and coins (and clowncoins) but the economic incentives might not align with the duct tape holding it together. Consequently, the community has evolved and created several new potential methods for untrusted nodes on a public network to arrive at consensus, to the point where consensus-as-a-service is becoming its own commoditized subindustry.  In the future, this will likely be abstracted away and developers will be able to fine tune and granularize the level of centralization and trust they want to expose their users to.  Another big development that I am increasingly paying attention to is the regulatory and compliance arena, which many people seem to want to ignore and handwave away.  It is not going to disappear and structuring your project, company and even ledger in a way that reduces your personal liabilities will be an ongoing concern from now on.  There is no point in being a martyr when there are many other areas to push the envelope on in this expanding space.
  • A few weeks ago I gave a presentation covering a number of factors as to why Bitcoin protocol development has plateaued in the past year and as a result how most of the innovation has effectively been outsourced to the altledger ecosystem.  Here a steady stream of both old and new entrepreneurs and developers are toying with variables that cannot be touched with Bitcoin itself due to its current development cycle.  A friend compared the speed at which this industry moved with dog years and this is particularly true in the altledger space.  As a result, a new ledger can be forked, tweaked and spun up that incorporates the latest ideas in this space.  Most do fail and will likely fail in the future, but that’s the nature of iteration in technology.  The biggest challenges for Koinify is on boarding high quality decentralized apps that bring the utility and value that is now expected by the community.   On the one hand creating a platform that allows access to something like cryptosecurities such as Overstock.com sounds neat, yet it is a hundred year old idea (equity) married to a different type of database (a blockchain). On the other hand, the decentralized app economy that Koinify is attempting to create is in fact has a different form, yet still pragmatic enough given existing technology.  Market participants want to experiment, poke, prod and have choices — this effervescent vitality is attractive and I am excited to try and help out.
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The Collective Action Problem of Mining Fees

[Note: This was originally published on October 7, 2014 at Melotic.com]

Contrary to conventional wisdom, usage fees for many cryptocurrencies including Bitcoin, Litecoin and Dogecoin is voluntary. In fact, when Bitcoin was first released, there were no direct usage fees. The fee that users visibly see included within wallet software (such as BitcoinQT, Electrum, and Hive) is in fact, arbitrarily set by the wallet code and can – in most cases – manually be reduced to zero. That is to say, users can broadcast transactions (UTXOs) to the network for “free” and eventually a mining pool (assuming it the transaction amount is higher than the dust limit) will pick them up and include them into a block. In the meantime these transactions will float around in the mempool, sometimes for several hours waiting to be picked up and confirmed. In theory, the higher the fee a user includes, the faster it will likely be included into a block because mining pools have an incentive to package it.

Why can’t all users permanently “free ride” off of what effectively is a tragedy of the commons (Sybil protection via hashrate and access to the mempool)? There is another variable: blocks have limited space (currently set at 1 MB), are a scarce resource and thus by definition are not a public good. Fees enable users to effectively bid on this private good rationed by the labor force of miners (I describe this at length in Chapter 2). In the future, miners may actually begin to set fees themselves, as the core protocol development team is planning to “float” the fees at some point.

In practice today, “voluntary” fees (donations) represent about 0.3% of the wages a miner earns each day. How do network operators (miners) get paid then? Through block reward subsidies (inflation) which are awarded throughout the day. Nearly all hash-based proof-of-work coins use a similar method of payment in which a coinbase transaction is paid out at intervals – for Bitcoin it is roughly every 10 minutes, Litecoin every 2.5 minutes and Dogecoin every minute. As a reward for services rendered, a fixed amount of payment is sent to the miner who broadcasts the “correct” block first which is then added on top of the previous block of the longest chain (those who broadcast a different block after the fact are said to have worked on “orphaned” blocks).

In theory, based on section 6 of the original 2008 whitepaper, transaction fees are supposed to eventually replace this subsidy:

The incentive can also be funded with transaction fees. If the output value of a transaction is less than its input value, the difference is a transaction fee that is added to the incentive value of the block containing the transaction. Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.

A June 2014 paper published by Kerem Kaskaloglu attempts to illustrate the “ideal scenario” (shown below) of the seamless switch from block rewards (seigniorage subsidy) to transaction fees (donations).

bitcoin-blockreward-timelineAccording to the current narrative, a combination of increased transactional volume and higher mandatory (or perhaps marketed-based) fees will purportedly pay for the labor force to stick around in the coming years. Why is this important? Because the network currently operates almost entirely on subsidies and thus with each block reward halving, the labor force is essentially given notice that their wages have decreased 50% and many could leave for more profitable ventures. While this is not an immediate concern in October 2014 for a network like Bitcoin – which does not have a closely competing SHA-based chain to worry about attack from (yet) – other altchain designers need to be cognizant of the economic incentive model they are building before they launch a new coin.

Again this is an empirical matter, so it cannot be known a priori whether or not the transition from a subsidy to a fee will happen for Bitcoin or other coins. However what we do know is that based on the history of altcoins up to the date of this writing, an increase in fees is the exception rather than the rule. Very few altcoins have seen a markedly significant increase in usage fees over the life of their chain.

The two charts below illustrate this:

bitcoin-litecoin-transaction-feedogecoin-transaction-feesThe first chart shows the “voluntary” transaction fees from the previous 6 months for both Litecoin and Bitcoin. It is almost entirely flat which suggests a number of things including the fact that there probably has not been an increase in usage of either blockchain itself (other indices such as Bitcoin Days Destroyed and Total Volume Output would help narrow the amount of UTXOs on the move and to what extent). One exception is Counterparty, which on some days represents 3% of the Bitcoin network and whose assets may represent increasingly larger commercial transactions that are not fully measured yet.

The second chart shows the same time period but for Dogecoin. In this case, over the past 2 months there has been a steady increase in fees paid to the network, effectively doubling the spring and summer rates. At this time it is unclear why this is the case; almost all tipping is done off-chain in trusted third parties (so fees are usually not assessed) and the default fee for most Dogecoin clients are set at 1 dogecoin. We may learn later that it was due to the AuxPOW merge mine with Litecoin, asset issuance via Dogeparty, or perhaps this is a statistical outlier altogether.

Nevertheless, while it cannot be said for certain, it is unlikely that the voluntary fee mechanism will fully provide the type of income to incentivize the Bitcoin labor force to continue providing its services (hashing) because it is a collective action problem (Note: Robert Sams recently touched on this issue in a new article). After all, why would most or all users one day in the future collectively start to pay (potentially) several orders of magnitude more to have the same exact service (recall that the total network reward to miners for their services today ranges from $20 to $40 per transaction)? In practice the fees alone may not be enough.

While the jury is still out on the longevity of all altcoins, one argument is that some are substitute goods. If this is the case, when conditions change (such as an increase in fees) users may move over to what they perceive as a similar, cheaper service. Or in this case, a similar chain. What does a substitute good mean? One definition explains that:

This means a good’s demand is increased when the price of another good is increased. Conversely, the demand for a good is decreased when the price of another good is decreased.

Or in other words, if the fee for using the Bitcoin network increases and a user perceives that Litecoin, Dogecoin or another network is a substitute good, then they may switch over and use the other, cheaper network for their transactional needs. The increased demand of that network token then may in turn lead to higher market prices of that token. In theory this could lead to some kind of market equilibrium among chains, though in practice there are and likely will be other factors at play.

In summation, there are no real “fees” in Bitcoin as they are entirely voluntary and should probably be called “donations” (until miners require that a fee be included). These donations are entirely arbitrary and are probably not comparable to fees on other payment networks (such as Visa) which are mandatory and holistic (the interchange fee pays for all of Visa’s expenditures, no donations required). This is further described in Chapter 3 and the full costs of today’s subsidies are visibly illustrated in the Cost Per Transaction chart. For more information on interchange fees, Richard Brown recently wrote a highly recommended piece for readers.

The next post will discuss why token prices do not double for a token after a block reward halving.

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Cryptocurrency in the news #29

Turns out about 15 months ago, someone had already figured out how the mining costs of hash-based proof of work moved relative to the market prices of tokens, see “Why Bitcoin will never be a good store of value” by Stefan Loesch.  One common retort to Loesch’s argument is that at some point in the future, for some reason, users will one day start paying higher tx fees.  This is unlikely because it is a collective action problem.  Why would people pay several orders of magnitude more to have the same exact service?

A new feature/dashboard that I came across is CoinGecko — has some interesting metrics to look at.

Other links related to digital currencies and China (linking is not an endorsement of service, coin, chain, etc.):

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