What’s the deal with off-chain transactions?

Based on comments from both reddit and Coindesk, the number one question today seems to be related to off-chain transactions.  Why aren’t these being factored in to the equation? [Note: it bears mentioning that I did discuss this on p. 84, Chapter 4]

There are multiple problems with this perspective, however before delving into that I should point out that in the previous article, I did in fact link to Coinbase’s self-reported off-chain transaction numbers.  They are relatively marginal, on most days comprising less than 5% of the total transactional numbers.  But it is not clear from these numbers alone are or what they refer to: Coinbase user to user, user to merchant, and possible user wallet to user vault?

Below is their chart:

coinbase offchain transactions

What impact does this have on the network?

It actually makes the network insecure in two ways:

1) Users become increasingly dependent on trusted third parties (TTP) on the edges, which defeats the purpose of having a blockchain in the first place (recall that “trusted” appears 11 times in the white paper).  This also opens both consumers and entrepreneurs up to a host of vulnerabilities and abuses that the industry is continually plagued by.

2) As more users leave the actual blockchain and move off onto TTP, less funds (or “fees”) are going to pay miners for actual security, making the entire network more reliant on seigniorage (block rewards) which in the long-run has empirically been a losing battle.

Below is a chart from Blockchain.info that illustrates fees to miners:

total transaction fees two year

Another chart illustrating this data was compiled from data by Jonathan Levin (formerly of Coinometrics) over the same time period:

Notice how fees have actually decreased and are now at a two year low.  This is actually the opposite trend we would want to see and potentially troubling.  In fact, contrary to prudence, instead of floating fees the core developers have “slashed” fees (more accurately called “donations“) by tenfold this past year.  From an economic sustainability point-of-view, this is the diametrically opposite action that should be taking place.  It will make the adjustment period at the next block halving much more painful to consumers as fees have to go up to incentivize miners to stay.

Earlier this summer, L.M. Goodman (creator of the Tezos protocol) noted a similar conundrum:

The race to build more hashing power (by developing ASICs for instance) means that the cost to pull off a 51% attack on the network increases. In this respect, the network is more secure. Note however that the amount of money spent on mining and mining equipment must be approximately equal, in the long run, to the amount of bitcoin paid in transaction fees or created through mining. Given off chain transactions, this could dwindle to very low levels in the future.

As Dave Hudson and others have pointed out (see Chapter 3), this fee has to increase because transactional volume simply is not increasing to the level it needs to in order to replace the block reward.

Meher Roy succinctly summed up this conundrum in a comment earlier today:

The question is how will the low-fee high volume work when off-chain is / will prove to be more convenient?  Any on-chain fee will be out-competed by speed, lower fees and convenience of off-chain transactions. Why exactly are we sure on – chain transactions will rise 10000 fold that it needs to? How exactly does Bitcoin solve this collective action problem?

These are important questions that thus far, everyone seems to punt on.

What about off-chain data from exchanges?  Surely they should be factored into this?

Unless exchanges are willing to publicly share that data, it is difficult to surmise what is taking place in their black boxes (we can have some idea based on public addresses).

But again, this is not a particularly good metric for those who believe lots of commercial trade is taking place.  Off-chain transactions on an exchange are equivalent to forex.  Value transfer, possibly.  Retail commerce, no.

We do in fact know how much Bitpay and other payment processors do in business each day, we know this through the bitcoins they sell each day to liquidity providers.  And altogether this amounts to around 5,000 – 6,000 bitcoins per day.  Although there are some merchants that keep part or all of their bitcoins, the liquidity sales is the most accurate version of retail commerce we can estimate with today.  And that has not changed much over the past six months.

[Special thanks to Dave Babbitt and Jonathan Levin for their constructive feedback]

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Approximately 70% of all bitcoins have not moved in 6 or more months

Back in May I published a blockchain analysis piece on Coindesk that utilized graphs created by John Ratcliff.  Ratcliff published several new charts yesterday that provide a fuller picture of this overall movement.

bitcoin age

The chart above visualizes nearly 6 years of token movements.

Is there a way to isolate the past year and if so, what does the past year look like? That’s what the next chart illustrates:

bitcoin distribution by age

What conclusions can be drawn from these charts?

1) that token movement (velocity) strongly correlates with a rapid increase in market prices (e.g., more velocity during the bull runs, less during price decreases); you can see that in the first chart with large bumps in April 2013 and then again in November 2013

2) because of the large dip in prices over the past year, most tokens are inactive in part because the owners are still “underwater”

3) that monthly liquidity is still only around 10% (more on consumption below)

4) the “tx volume” chart on Blockchain.info is no longer entirely valid due to a combination of the usual mixing and mining rewards but also because of increased advertisement spam (e.g., metadata within OP_RETURN), increase in P2SH and Counterparty tx’s.  Only a full traffic analysis can provide a more accurate breakdown.

What is especially interesting is to see the “overhang” or rather the “underwater” coins that are moving from the 3 months to the 6-12 month band. What this effectively shows is that owners of those UTXOs purchased them during the bubble of November-December 2013 and are still willing to wait and hold onto these coins until the price rebounds.  If there is no upward change in prices then some (or all) of these coins will eventually move into the next band sometime in the spring of 2015.

What other conclusions can be made?

This is a sobering chart for advocates or entrepreneurs within the merchant payment processing vertical.  What this shows is that despite the near quadrupling of merchants that now accept bitcoin as payments (this past year increased from ~20k in January to ~76k through September), on-chain activity has not seen a corresponding increase by consumers.  They are all effectively fighting for the same thin slice of liquid coins, a segment which empirically has not grown. This does not mean that there are no consumers, only that when paired with data from Bitcoin Day’s Destroyed, there probably hasn’t been any real on-chain growth beyond the exceptions in #4 above. Thus on any given day, payment processors (collectively) likely only process 5,000-6,000 bitcoins still. Other additional activity could be taking place off-chain in trusted third parties (like hosted wallets and exchanges such as Coinbase).

Too reuse an analogy from Chapter 14 (p. 224 and 230), that also means that since 3,600 bitcoins are created each day to pay for security, that with this ratio (3,600 : 6,000) every other mall patron is effectively being guarded by a mall cop which in laymens terms means there is massive security overkill still taking place.  This is not a big deal today but when coupled with analysis from Dave Hudson, network transaction fees will have to increase by several orders of magnitude to replace the seigniorage that currently incentivizes miners.  This is best illustrated in the cost per transaction metric on Blockchain.info.

As I mentioned on a panel on Tuesday this collective “hodling” (hoarding) behavior is understandable given the future expectations of price appreciation.  Yet it is probably not a good characteristic for a modern “currency,” for reasons discussed in Chapter 9 and also Why Market Prices Do Not Double With a Block Reward Halving.

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Panel for Follow The Coin with Tina Hui and Jackson Palmer

On Tuesday I was a panelist on a new segment from Follow The Coin, hosted by Tina Hui.  The other panelist was the creator of Dogecoin (among other projects), Jackson Palmer.

Below are transcribed comments I made throughout the recorded portion with the approximate time they were said.

[2:46]

Ditto.  When I first got involved with Bitcoin a few years ago, I was really excited, I did some mining.  I built some machines in China and slowly but surely I kind of became more of a skeptic.  I guess that’s what people know me for.  I wouldn’t say I’m anti-Bitcoin, I think there is a lot of Koolaid that is continually circulated.  I think Jonestown would be very  jealous of the Koolaid in this space.  Right now, the phrase I was talking to Jackson earlier was, you know how people are saying “Be your own bank”?  I’m not saying you can’t be your own bank but what happens in reality is, like “Be your own textile factory” or “be your own data center” — for whatever reason that just doesn’t work out in reality.  I’m not saying it can’t work out in this space but it looks like people prefer to be nannied, prefer to have costumer assurance.  I probably just lost a few friends and followers but that’s how I kind of look at things.  It’s become BINO: Bitcoin in name only.  I have a whole talk on that otherwise.

[4:39]

I’d have to agree for the most part.  For listeners, the use cases I think are interesting with the actual technology are pretty mundane.  I was talking to Everett from Bloomberg, there is this thing called Consolidated Audit Trail.  Back two years ago, the SEC put together something called Rule 613.  The idea was to get all these institutions together in the financial industry to actually track every single transaction.  That seems like a mundane, unsexy thing but at the same time this might be something that a blockchain may be able to do in some capacity because you have people who do not necessarily trust each another, you have a lot of them.  Maybe you don’t need Bitcoin’s blockchain, maybe you can use some kind of other ledger, a proof-of-stake based ledger.  I do think the technology does have some interesting potential but probably not for a lot of the things that are being funded.

[7:13]

Sure, so I’ll be mean, I’ll say something not nice.  Tipping is a neat idea but in practice what ends up happening a lot and we see this on reddit and LTBCoin and stuff like that, is it incentivizes begging.  So we end up having this magnet to rewarding behavior that you really don’t want to have.  Obviously there are people who do take tipping seriously and put together some good comments and stuff like that.  For example, with LTBCoin.  If you are not familiar with it, Adam Levine had this really cool idea: “hey, how about we reward people who make comments.”  That sounds great, you are part of the message, part of the community.  What ended up happening is that attracted just tons of bots basically, people just spamming.  We see this with reddit too with the different tippers.  Some guy the other day, 2 or 3 days ago said, “hey, I literally made sock puppets to collect as many tips as I could.”  And he collected something like 50,000 satoshi worth, which is not a whole lot but that’s a lot just spending time spamming around to try and get.  It has some interesting ideas, the question is, how do you filter out the froth from legitimate players in this.  And I’m not sure there is a real silver bullet to that.  Maybe it just has to be part of the ecosystem, we’ve lived with it this far maybe it is something we have to soldier on with.

[9:24]

So I’ll be mean again.  There really is no correlation between tipping and then encouraging that behavior in a restaurant.  Most of the literature doesn’t point to the reason why China is stagnating for example isn’t because a lack of tipping in the country.  It’s a cultural thing here in the US, I’m not anti-tipping.  My wife and I tip, maybe on the lower side of scale of things.  I think it is a funny activity that people do and I’m not against it, but I’m not sure it’s providing a good marketing signal to the participants or the people who receive it.

[10:11]

I don’t put tipping addresses for two reasons.  The first one is, actually I talked with Victoria van Eyk at Changetip yesterday, and she said, “Tim, you shouldn’t use this reason.”  But I’ll tell you the first reason why, I don’t want to accept candy from strangers.  I’m not sure where that coin came from, maybe it is a Silk Road coin.  Obviously that is something way down the line, I don’t think anyone is going to bust me for accepting some tip that way.  But I do think we should be judicious against who we receive money from, especially in this era of Alex Green and just the amount of scammers and bad apples in this space you don’t know where that money comes from.  The other, and this is nothing against Changetip, it’s just how it is efficient: it’s all off-blockchain.  The whole purpose of this blockchain space is to provide decentralization, if we’re accepting tips from centralized silos it just reinforces that.  So again, I’m not anti their service, but it kind of defeats the purpose if you have to rely on a centralized service to do all that.

[14:17]

Just like you said, it’s unsexy to build these vigilante services because they become centralized and who are you to decide who is the bad guy and stuff like that.  So you end up recreating the system that we’re in right now, for better and for worse.  There are some tools, if you guys are interested, there is a company called Bitreserve.  They just released their transparency initiative called Reservechain and Reserveledger.  The idea is you use the Merkle root to trace back to make sure all the tx’s are accounted for.  Obviously multisig is one of the few areas I’m not bearish on, it’s legit.  Whether or not you can build an entire company around just multisig, I don’t know, we’ll find out.  Taking that internally for financial controls, segregating.   Even hardware wallets, actually I just tweeted about that the other day.  Hardware wallets seem like they have, I hate to say it, maybe they do have some potential — that’s not sexy again, who wants to carry around a wallet, a smartphone and then a hardware wallet with your private keys.  Maybe that’s something that user behavior will end up changing or maybe it’s not.

[18:04]

So there is this thing called “affinity fraud.”  And just like the name affinity, when you were in school you had affiliations, it’s kind of the same idea.  It happens a lot in Bitcoin because there are so many self-identified libertarians essentially.  So if you pretend to be a libertarian you can — no offense to anyone here — I’m about to lose some more friends here.  They are identifiable targets, it happens in religions, it happens in just about any ‘affinity’ essentially.  It’s not something that can be stopped immediately, there’s going to be bad actors that know they can take advantage of this.  You have to be judicious.  Again, I’m not sure if there is a way you can build a startup, fund it somehow and then go after these guys.  It becomes this public goods issue.  Again, I’m not saying the only solution is a government, but it seems like there is a perverse incentive to not get rid of these actors.  Because what happens is, is especially with thefts and scams is these people need to launder the money and move their money – exit somehow.  And to do so, they end up having to use — it creates demand for these other services.  So in a way, there is a perverse incentive to not get rid of these actors because creates more demand for the underlying currency.  Again, I’m not saying that it is going to stay the way it is, I’m sure I’m going to get a lot of emails saying, “no Tim you are wrong.”  But so far no body has done much to get rid of these guys and maybe there is a reason why, maybe everyone is sort of benefiting from this underlying demand.

[22:29]

I will argue that Satoshi pre-mined.  And I’m not saying that because I hate Satoshi.  Is Satoshi here?  Does anyone know Satoshi?  You can prove it either way by signing.  The reason I argue that is the biggest complaint with pre-mining is you have this allocation that took place before anyone else could particpate, that’s the bottom line.  Satoshi only advertised Bitcoin on one obscure mailing list and then preceded to mine basically for an entire year without advertising it again and without doing any effort at all to do PR.  He could have run a testnet.  He could have done mulligan, “hey, we have these people, it’s been a year now, we’re going to reset it.”  And if you add up all the coins that were basically coinbase free, that were just the coinbase transaction or plus one tx, that is about 4.8 million bitcoins (see p. 163) that were basically handed out for free.  Without any merit.  Again, I’m not saying that you need to confiscate those guys.  But what we’re having today is capacity issues with blocks right now: about 30% to 40% of capacity on any given day.  Dave Hudson has been doing a lot of good research on this.  And so these miners are essentially doing more work today than they were at the beginning.  And they’re not being rewarded any more than they were then.  That’s an issue with the static rewards.  So I would argue that it is essentially a pre-mine, he could have said testnet for the first year and didn’t.

[25:24]

Mine what, Bitcoin?  So home mining, industrial mining?  The only way most people are making money off of Bitcoin is price appreciation.  You mine, you hope that it will increase in value.  But you might as well just buy coins at this point.  The only people who are really making money are Bitfury, a few places in China (see Chapter 5) and this is because they’re able to scale it and benefit off the energy.  This is not to say you can’t possibly do it in maybe certain locations here in the US, like Washington I believe has 3 cents a kilowatt hour.  And they were in the news for setting up some certain sites.  But in general in this day in era, with ASICs it’s very difficult to actually have any margin.  The argument is, ceteris paribus, it should take one bitcoin to actually make one bitcoin just because of the way the difficulty is auto-adjusted every two weeks.  So on the margins there really is no profit except maybe a few different entities that can scale, like Bitfury.

[27:22]

So many questions.  So to give you an idea, the Gini coefficient in Bitcoin is 0.88 (see p. 129), perfect number 1.0 is unequal.  I’m not some kind of egalitarian marching in the street.  But a 0.00 is just the opposite, basically it’s perfectly even distribution.  Bitcoin basically has a Gini coefficient higher than North Korea.  I’m not saying that’s a good thing or bad thing, it kind of disincentivizes some people to join because they think they can no longer participate in the “get rich quick.”  The whole asymptote itself was just one “get rich quick” idea.  Again, I’m not saying it was a scam, I’m not saying that at all.  As far as the hording versus the savings.  So people get this often confused: the protocol itself does not have any mechanism to actually save.  It is simply a lockbox.  So it is essentially a digital mattress.  There is nothing wrong with that.  If you just want to hold onto it.  But there is no mechanism to take that money within the protocol and lend it out.  And what we’re seeing is we can build out lending platform, through like BTCJam.  So as a result you have, if you actually look at liquidity, on any given month you have about 10% of all mined tokens ever are actually liquid (see Chapter 12).  You have about 90% of tokens that haven’t moved for over a month and about 50% that haven’t moved in more than 6 months.  And this is because there is nothing built into the protocol to actually put these into active, lending purposes or any of these other financial instruments.  So that kind of creates a stagnant economy.  Well you wouldn’t call it a currency.  Like you’d call that some kind of commodity.  There is no velocity of gold even though it’s legal.  You just kind of bury it.  Again, I’m not against if you guys want to hold coin.  That’s the rational thing to do.  The rational thing is, if you believe it is going to appreciate in value you hold onto it.  Everyone thinks it’s going to go to the moon.  Everyone is actually [acting] rational.  So it’s not actually being used as a currency, it’s being used as a commodity and that makes sense because everyone thinks it’s going to raise and appreciate.

[29:52]

It’s hard to know how much money laundering has occurred.  I mean unless you can identify ever single transaction and know what the intent was, you don’t know how much.  Again, I’m not saying that this doesn’t take place with fiat.  Everyone’s always saying fiat is number 1.  We have the ability with a blockchain to actually monitor this stuff.  And actually it defeats the whole purpose if you have to identify everybody along the way because then it adds all this costs and stuff like that.  So it’s this weird paradox.  [Question: So you’re actually pro-bitcoin?]  I’m on the fence with the technology.

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Quotes about cryptocurrency in Singapore

I was asked to provide some comments related to the SKBI conference last week in Singapore.  Below are my full quotes that were lightly edited for two different publications.

Singapore Event Puts Bitcoin on Mainstream Finance Agenda from Coindesk:

“One of the discussions throughout the conference was related to bitcoin as a commodity, currency and potentially emerging asset class.  While this is ultimately an empirical issue, the market so far — based on blockchain behavior — suggests that it could be some form of commodity.  As to whether or not it can go the distance and become an entrenched asset class is another issue altogether largely due to the tendency for all proof-of-work based blockchains to ultimately “selfdestruct” due to block rewards.   Perhaps this will change and bitcoin will somehow be the exception to Ray Dillinger’s rules but it may be the case that its monetary policy cannot incentivize the labor force to stick around long enough to make bitcoin a viable asset class.”

Singapore Crypto Conference Brings Together Academia, Businesses and Regulators from CoinTelegraph:

“The Singapore conference was unique in that it provided a well-balanced cross-section of academics, business professionals, decision makers at governmental organizations and entrepreneurs within the industry.  As a result, the sobering conversations that took place focused more around actual opportunities and challenges in the community today rather than the typical scifi cheerleading that is divorced from the reality that companies in this space face.”

Videos and other media should be up in the next week or so.

Bonus: some of my thoughts as to why transactional volume has increased despite a lack of corresponding increase in BDD and miner fee volume: Markets Weekly: Bitcoin Rises Amid Dark Markets Crackdown from Coindesk.

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Moving Beyond BINO Beta

Last week I participated in a couple panels at the inaugural CAIA-SKBI Cryptocurrency Conference 2014 hosted at Singapore Management University.

Below are the slides of the presentation I did at a closed-door session on November 5th.  Citations and references can be found in the notes of each slide.

Abstract:

With nearly six years of empirical data and use-cases behind the Nakamoto consensus method the community has observed that a cryptocurrency economy behaves differently than originally envisioned and intended.  What has arisen from these half-a-decade of physical interactions is a nearly complete rollback of the primary attributes embodied within the first of these Nakamoto consensus protocols, Bitcoin – to the point where it may best to refer to it as Bitcoin-in-name-only (BINO).  Consequently there are two other challenges within this existing BINO framework: (1) the diametrically opposed forces of speculative demand versus transactional demand; (2) decoupling coins from the ledger altogether.  This presentation discusses several proposed solutions to the challenges currently being devised by a multitude of teams.

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Reading the tea leaves and Magic 8 ball

[Last week CoinTelegraph sent me a couple questions for an article that has not appeared (I will link to it if it does).  Below are the responses I provided.]

Q: “What can be inferred from the decline in Bitcoin price and market cap in the course of 2014? There are two downward trends, separated by a level period and slight uptick.”

A: I probably wouldn’t call it a “market cap” (due in part to Jonathan Levin’s cogent post) and in my view, an analysis of the self-reported bitcoin price is difficult because of the lack of transparency in the underlying trusted third parties.  Perhaps something like a Consolidated Audit Trail or “proof of non-collusion” will become the norm as the industry professionalizes but until then this space will likely be vulnerable to a bevy of manipulations which may be causing these types of trends (e.g., purportedly like Willy Bot did last year).  Furthermore, because bitcoin’s supply is based on a fixed, limited issuance the only way to reflect changes in demand is through it’s price.  Thus, the fluctuations this past year are based on a myriad of factors some of which are difficult to measure like perceived regulatory/solvency risk and future law enforcement activity.  And because it is still very illiquid, sudden shocks are absorbed / reflected through volatility.  Consequently I do not think the market price is a reflection of the value of bitcoin as a transactional medium but almost entirely a function of speculative demand.  This past May, Robert Sams spoke on this duality as did Yanis Varoufakis in a new book.

Q: “Bitcoin’s technical foundations have been stated as insufficient to support wide-scale adoption by Mike Hearn. Do you think price volatility could be directly influenced in future by improvements or failures in this area?”

A: Both Gavin Andresen and the Blockstream team have independently discussed some of the technical limitations this past week, reaffirming the challenges that Mike Hearn described on several occasions this past year.  They have all also proposed potential solutions to these solutions, some involving soft forks, hard forks and even closer partnerships between mining farms, pools and developers.  Fundamentally however I do not think that Bitcoin’s blockchain will be able to serve the vast majority of use cases that it’s proponents claim it will for a couple of intractable reasons.  The first is because of the physics of decentralization; it is a matter of spatial topology (distance, length and redundancies) not materials science.  Thus the more dense, the less lag which favors centralization.  This past summer Murat Demirbas briefly wrote about this: Distributed is not necessarily more scalable than centralized.  The other is costs to maintain (nominal) trustless decentralization though the proof-of-work mechanism.  As I have written about several times, contrary to the traditional narrative, there are in fact no mandatory fees to utilize the blockchain and/or its Sybil-protection scheme.  The direct fees users believe they are paying are better defined as donations, as fees are something that are mandatory.  Consequently, the way to calculate how much proof-of-work costs is through a metric that Blockchain.info has visualized over the past years and which has hovered around $20-$30 per transaction.  That is not a competitive price relative to other payment systems and will likely relegate Bitcoin to certain niches.  I also think we will see other alternative consensus mechanisms come into production-level environments, creating a type of “consensus-as-a-service” (CaaS) of which a proof-of-work-based blockchain, such as Bitcoin, represents one part of that spectrum.

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