How the CME (un)intentionally weighed in on chain splits

For background, this post assumes you have read some (or ideally all) of the previous posts:

Last year, when the CME first announced that it was considering backing a Bitcoin-related futures product, it also announced the CME CF Bitcoin Reference Rate (BRR).  At the time, the reference pricing data came from the following cryptocurrency exchanges: Bitfinex, Bitstamp, GDAX, itBit, Kraken and OKCoin.com (HK).

As of today, the CME has formally whittled down those six into a smaller group of four exchanges: Bitstamp, GDAX, itBit and Kraken.

They did not publicly disclose why they removed Bitfinex and OKCoin, although we can speculate:

  • It is likely they removed OKCoin because of the laws and regulations around cryptocurrencies in China over the past year included various types of bans.  OKCoin’s mainland spot price exchange for yuan <-> cryptocurrency have been shut down.  OKEX, an international subsidiary of OKCoin, replaced the China-based exchanges on its own index (including OKCoin itself).
  • Bitfinex’s corporate and organizational structure has been described in previous articles.  Even though it has the largest trading volume and is the key player to price discovery, it has a lot of red flags around compliance and transparency (described in the links at the top) that likely made organizations such as the CME uneasy.

It bears mentioning that the proposed Winklevoss COIN ETF also went through a similar evolution in terms of how to price the instrument.  The principals initially created and used the Winkdex.  The Winkdex included many different cryptocurrency exchanges over time, including Mt. Gox and BTC-e.  Eventually, in future amended filings to the COIN ETF, the Winkdex was completely discarded in favor of a daily auction price conducted at an exchange (Gemini) that the principals and creators of the COIN ETF owned and managed.  This is chronicled in a paper I wrote last year.

So what does this have to do with the CME and how did the CME (un)intentionally weigh in on the Bitcoin block size debate?

During the recent Bitcoin Core versus SegWit2X (S2X) political battle, one of the four exchanges that constitute the CME reference rate announced which ticker symbol would be attributed to a specific chain.

GDAX (Coinbase), made the following public announcement on October 25:

In our prior blog post we indicated that at the time of the fork, the existing chain will be called Bitcoin (BTC) and the Segwit2x fork will be called Bitcoin2x (B2X).

Since then, some customers have asked us to clarify what will happen after the fork. We are going to call the chain with the most accumulated difficulty Bitcoin.

We will make a determination on this change once we believe the forks are in a stable state. We may also consider other factors such as market cap and community support to determine stability.

It’s important for us to maintain a neutral position in any fork. We believe that letting the market decide is the best way to ensure that Bitcoin remains a fair and open network.

Note: original emphasis is theirs.

There have been several articles that attempted to track and chronicle what all of the exchanges announced with respect to the ticker symbol and the fork.  At the time of this writing, itBit, Kraken, and Bitstamp have not publicly commented on this specific fork (although they have publicly signaled specific views on other proposed forks in the past).

And this creates a challenge for any financial institution attempting to create a financial instrument that is compromised of a basket of cryptocurrency-specific prices from different, independent cryptocurrency exchanges.

Ignoring the lack of adequate market surveillance for the moment, if there is a future fork and the constituent exchanges that comprise the reference data choose different forks to be represented by the same ticker symbol, this will likely create problems for the financial product.

For instance, in a hypothetical scenario in which a fork occurs, and two of the exchanges comprising the BRR index choose one side of the fork to list as “BTC” and the other two exchanges choose the other fork to also represent “BTC,” because these forks are linked to separate different ecosystems and even economic systems the combination could impact the volatility of the product.

Or in short: there is no universal agreement or consensus from cryptocurrency exchanges comprising the BRR about what the ticker symbol, let alone the chain should be defined as.

Concluding remarks

Over the past several years the primary debate has been around scaling, specifically around block sizes.  What if future forks are fought over changes to transaction fees, money supply, or KYC requirements?  This isn’t idle speculation as these have been proposed in the past with both Bitcoin and other cryptocurrencies (Ethereum Classic  held an event last year to focus on what the future money supply generation rate should be).

Obviously this is a situation the CME (and similar financial institutions) wants to avoid at all costs.

In order to do this, it’ll have to pick a side and either:

a) force an errant exchange on its index to fall in line or lose the free marketing; or

b) ditch it from the index

Either way, as by far the largest player in the market, in doing so it will be governing what Bitcoin is.  Unlike what most Bitcoin promoters often think: traders follow liquidity not the other way around so the CME is likely to become kingmaker in Bitcoin political disputes.  It is going to become a key arm in its governance.  That said, as we have seen before, rather than directly get involved with the tribes and religions of development they might simply defer to the incumbent Bitcoin Core rules — so that they can remain above the politics and out of any legal liabilities.

For more detailed commentary on this topic, be sure to read the articles linked to at the top.  This will be worth re-visiting once the CME and other regulated institutions fully launch their proposed products.

Acknowledgements: special thanks to Ciaran Murray for several insights articulated above.

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Eight Things Cryptocurrency Enthusiasts Probably Won’t Tell You

[Note: I neither own nor have any trading position on any cryptocurrency.  I was not compensated by any party to write this.  The views expressed below are solely my own and do not necessarily represent the views of my employer or any organization I advise.  See Post Oak Labs for more information.]

Alternative title: who will be the Harry Markopolos of cryptocurrencies?

If you don’t know who Harry Markopolos is, quickly google his name and come back to this article.  If you do, and you aren’t completely familiar with the relevance he has to the cryptocurrency world, let’s start with a little history.

Background

Don’t drink the Koolaid

With its passion and perma-excitement, the cryptocurrency community sometimes deludes itself into thinking that it is a self-regulating market that doesn’t need (or isn’t subject to) government intervention to weed out bad actors.1 “Self-regulation,” usually refers to an abstract notion that bad actors will eventually be removed by the action of market forces, invisible hand, etc.

Yet by most measures, many bad actors have not left because there are no real consequences or repercussions for being a bad dude (or dudette).

Simultaneously, despite the hundreds of millions of dollars raised by VCs and over a couple billion dollars raised through ICOs in the past year or so, not one entity has been created by the community with the power or moral authority to rid the space of bad apples and criminals.  Where is the regulatory equivalent of FINRA for cryptocurrencies?2

Part of this is because some elements in the community tacitly enable bad actors. This is done, in some cases, by providing the getaway cars (coin mixers) but also, in other cases, with a wink and a nod as much of the original Bitcoin infrastructure was set-up and co-opted by Bitcoiners themselves, some of whom were bad actors from day one.3

There are many examples, including The DAO.4 But the SEC already did a good dressing down of The DAO, so let’s look at BTC-e.

BTC-e is a major Europe-based exchange that has allegedly laundered billions of USD over the span of the past 6 years.  Its alleged operator, Alexander Vinnik, stands accused of receiving and laundering some of the ill-gotten gains from one of the Mt. Gox hacks (it was hacked many many times) through BTC-e and even Mt. Gox itself.5 BTC-e would later go on to be a favorite place for ransomware authors to liquidate the ransoms of data kidnapping victims.

Who shut down BTC-e?

It wasn’t the enterprising efforts of the cryptocurrency community or its verbose opinion-makers on social media or the “new 1%.”  It was several government law enforcement agencies that coordinated across multiple jurisdictions on limited budgets.6 Yet, like Silk Road, some people in the cryptocurrency community likely knew the operators of the BTC-e and willingly turned a blind eye to serious misconduct which, for so long as it continues, represents a black mark to the entire industry.

In other cases, some entrepreneurs and investors in this space make extraordinary claims without providing extraordinary evidence.  Such as, using cryptocurrency networks are cheaper to send money overseas than Western Union.  No, it probably is not, for reasons outlined by SaveOnSend.7

But those who make these unfounded, feel-good claims are not held accountable or fact-checked by the market because many market participants are solely interested in the value of coins appreciating.  Anything is fair game so as long as prices go up-and-to-the-right, even if it means hiring a troll army or two to influence market sentiment.

And yet in other cases, the focus of several industry trade associations and lobbying groups is to squarely push back against additional regulations and/or enforcement of existing regulations or PR that contradicts their narrative.8

Below are eight suggested areas for further investigation within this active space (there could be more, but let’s start with this small handful):

(1) Bitfinex

Bitfinex is a Hong Kong-based cryptocurrency exchange that has been hacked multiple times.9  Most recently, about 400 days ago, $65 million dollars’ worth of bitcoins were stolen.

Bitfinex eventually painted over these large losses by stealing from its own users, by socializing the deficits that took place in some accounts across nearly all user accounts.10  Bitfinex has – despite promising public audits and explanations of what happened – provided no details about how it was hacked, who hacked it, or to where those funds were drained to.11 It has also self-issued at least two tokens (BFX and RRT) representing their debt and equity to users, listed these tokens on their own exchange and allowed their users to trade them.12

There have been suggestions of impropriety, with its CFO (or CSO?) Phil Potter publicly explaining how they handle being de-banked and re-banked:

“We’ve had banking hiccups in the past, we’ve just always been able to route around it or deal with it, open up new accounts, or what have you… shift to a new corporate entity, lots of cat and mouse tricks that everyone in Bitcoin industry has to avail themselves of.”

Yet there is little action by the cryptocurrency community to seek answers to the open questions surrounding Bitfinex.  I wrote a detailed post several months ago on it and the only reporters who contacted me for follow-ups were from mainstream press.

There are a lot of reasons why, but one major reason could be that some customers have financially benefited from this lack of market surveillance because relatively little KYC (Know Your Customer) is collected or AML (Anti-Money Laundering) enforced, so some trades and/or taxes are probably unreported.13 This wouldn’t be an isolated incident as the IRS has said less than 1,000 United States persons have been filing taxes related to “virtual currencies” each year between 2013 – 2015.

But that’s not all.

The latest series of drama began earlier this spring: Bitfinex sued Wells Fargo who had been providing correspondent banking access to Bitfinex’s Taiwanese banking partners.  Wells Fargo ended this relationship which consequently tied up tens of millions of USD that was being wired internationally on behalf of Bitfinex’s users.  About a week later Bitfinex dropped the suit and at least one person involved on the compliance side of a large Taiwanese bank was terminated due to the misrepresentation of the Bitfinex account relationship.

This also impacted the price of Tether.

Tether, as its name suggests, is a proprietary cryptocurrency (USDT) that is “always backed by traditional currency held in our reserves.”  It initially used a cryptocurrency platform called Mastercoin (rebranded to Omni) and recently announced an ERC20 token on top of Ethereum.1415

As a corporate entity, Tether’s governance, management, and business are fairly opaque.  No faces or names of employees or personnel can be found on its site.16  Bitfinex was not only one of its first partners but is also a shareholder.  Bitfinex has also created a new ICO trading platform called Ethfinex and just announced that Tether will be partnering with it in some manner.17

Tether as an organization creates coins.  These coins are known as Tethers that trade under the ticker $USDT each of which, as is claimed on their webpage, is directly linked, 1-for-1, with USD and yen equivalents deposited in commercial banks.  But after the Wells Fargo suit was announced, USDT “broke the buck” and traded at $0.92 on the dollar.18   It has fluctuated a great deal during the summer currently trades at $1.00 flat.

Which leads to the question: are the seven banks listed by the recent CPA disclosure aware of what Tether publicly advertises its USDT product as?19

Source: Tether LTD

Who is responsible for issuance, and how if at all can they be redeemed?  Are they truly backed 1:1 or is there some accounting sleight-of-hand taking place behind the scenes?20  Where are those reserves going to be exactly?  Who will have access to them?  Will either Tether (the company) or Bitfinex going to use them to trade?21 These are the types of questions that should be asked and publicly answered.

The only reason anyone is learning anything about the project is because of an anonymous Tweeter, going by the handle @Bitfinexed, who seemingly has nothing better to do than listen to hundreds of hours of audio archives of Bitcoiners openly bragging about their day trading schemes and financial markets acumen (in that order).

Despite myself and others having urged coin media to do so, to my knowledge there have been no serious investigations or transparency as to who owns or runs this organization.  Privately, some reporters have blamed a lack of resources for why they don’t pursue these leads; this is odd given the deluge of articles posted every month on the perpetual block size debate that will likely resolve itself in the passage of time.

The only (superficial) things we know about Tether (formerly Realcoin) is from the few bits of press releases over time.22  Perhaps this is all just a misunderstanding due to miscommunication.23  Who wants to fly to Hong Kong and/or Taiwan to find out more?

(2) Ransomware, Ponzi’s, Zero-fee and AML-less exchanges

Last month a report from Xinhua found that:

China’s two biggest bitcoin exchanges, Huobi and OKCoin, collectively invested around 1 billion yuan ($150 million) of idle client funds into “wealth-management products.”

In other words, the reason these exchanges were able to operate and survive while charging zero-fees is partially offset by these exchanges using customer deposits to invest in other financial products, without disclosing this to customers.24

Based on conversations with investigative reporters and former insiders, it appears that many, if not most, mid-to-large exchanges in China used customer deposits (without disclosing this fact) to purchase other financial products.  It was not just OKCoin and Huobi but also BTCC (formerly BTC China) and others.  This is not a new story (Arthur Hayes first wrote about it in November 2015), but the absence of transparency in how these exchanges and intermediaries are run ties in with what we have seen at BTC-e.  While there were likely a number of legitimate, non-illicit users of BTC-e (like this one Australian guy), the old running joke within the community is that hackers do not attack BTC-e because it was the best place to launder their proceeds.

Many exchanges, especially those in developing countries lacking KYC and AML processes, directly benefited from thefts and scams.  Yet we’ve seen very little condemnation from the main cheerleaders in the community.25

For example, two years ago in South Africa, MMM’s local chapter routed around the regulated exchange, patronizing a new exchange that wouldn’t block their transactions.26  MMM is a Ponzi scheme that has operated off-and-on for more than twenty years in dozens of countries.  In its most current incarnation it has raised and liquidated its earnings via bitcoin.  As a result, the volume on the new exchange in South Africa outpaced the others that remained compliant with AML procedures.  Through coordination with law enforcement it was driven out for some time, but in January of this year, MMM rebooted and it is now reportedly back in South Africa and Nigeria.  The same phenomenon has occurred in multiple other countries including China, wherein, according to inside sources, at least one of the Big 3 exchanges gave MMM representatives the VIP treatment because it boosted their volume.

It was a lack of this market surveillance and customer protections and outright fraud that eventually led to many of the Chinese exchanges being investigated and others raided by local and national regulators in a coordinated effort during early January and February 2017.27

Initially several executives at the non-compliant exchanges told coin media that nothing was happening, that all the rumors of investigation was “FUD” (fear, uncertainty, doubt).  But they were lying.28

Regulators had really sent on-site staff to “spot check” and clean up the domestic KYC issues at exchanges.  They combed through the accounting books, bank accounts, and trading databases, logging the areas of non-compliance and fraud.  This included problems such as allowing wash-trading to occur and unclear margin trading terms and practices.29 Law enforcement showed these problems (in writing) to exchange operators who had to sign and acknowledge guilt: that these issues were their responsibility and that there could be future penalties.

Following the recent government ban on ICO fundraising (described in the next section), all exchanges in China involved in fiat-to-cryptocurrency trades have announced they will close in the coming weeks, including Yunbi, an exchange that was popular with ICO issuers.30  On September 14th, the largest exchange in Shanghai, BTCC (formerly BTC China), announced it would be closing its domestic exchange by the end of the month.31 It is widely believed it was required to do so for a number of compliance violations and for having issued and listed an ICO called ICOCoin.32

Source: Tweet from Linke Yang, co-founder of BTCC

The two other large exchanges, OKCoin and Huobi, both announced on September 15th that they will be winding down their domestic exchange by October 31st.33  Although according to sources, some exchange operators hope this enforcement decision (to close down) made by regulators will quietly be forgotten after the Party Congress ends next month.34

One Plan B is a type of Shanzhai (山寨) hawala which has already sprung up on Alibaba whereby users purchase discrete units of funds as a voucher from foreign exchanges (e.g., $1,000 worth of BTC at a US-based exchange).35  Many exchanges are trying to setup offices and bank accounts nearby in Hong Kong, South Korea, and Japan, however this will not solve their ability to fund RMB-denominated trades.36

It is still unclear at this time what the exact breakdown in areas of non-compliance were largest (or smallest).37  For instance, how common was it to use a Chinese exchange for liquidating ransomware payments?

As mentioned in an earlier post, cryptocurrencies are the preferred payment method for ransomware today because of their inherent characteristics and difficulty to reclaim or extract recourse.  One recent estimate from Cybersecurity Ventures is that “[r]ansomware damage costs will exceed $5 billion in 2017, up more than 15X from 2015.”  The victims span all walks of life, including the most at-risk and those providing essential services to the public (like hospitals).

But if you bring up this direct risk to the community, be prepared to be shunned or given the “whataboutism” excuse: sure bitcoin-denominated payments are popular with ransomware, but whatabout dirty filthy statist fiat and the nuclear wars it funds!

Through the use of data matching and analytics, there are potential solutions to these chain of custody problems outlined later in section 8.

(3) Initial coin offerings (ICOs)

Obligatory South Park reference (Credit: Jake Smith)

Irrespective of where your company is based, the fundraising system in developed – let alone developing countries – is often is a time consuming pain in the rear.  The opportunity costs foregone by the executive team that has to road show is often called a necessary evil.

There has to be a more accessible way, right?  Wouldn’t it just be easier to crowdfund from (retail) investors around the world by selling or exchanging cryptocurrencies directly to them and use this pool of capital to fund future development?

Enter the ICO.

In order to participate in a typical ICO, a user (and/or investor) typically needs to acquire some bitcoin (BTC) or ether (ETH) from a cryptocurrency exchange.  These coins are then sent to a wallet address controlled by the ICO organizer who sometimes converts them into fiat currencies (often without any AML controls in place), and sends the user/investor the ICO coin.38

Often times, ICO organizers will have a private sale prior to the public ICO, this is called a pre-sale or pre-ICO sale.  And investors in these pre-sales often get to acquire tokens at substantial discounts (10 – 60%) than the rate public investors are offered.39.  ICO organizers typically do not disclose what these discounts are and often have no vesting cliffs attached to them either.

The surge in popularity of ICOs as a way to quickly exploit and raise funds (coins) and liquidate them on secondary markets has transitively led to a rise in demand of bitcoin, ether, and several other cryptocurrencies.  Because the supply of most of the cryptocurrencies is perfectly inelastic, any significant increase (or decrease) in demand can only be reflected via volatility in prices.

Hence, ICOs are one of the major contributing factors as to why we have seen record high prices of many different cryptocurrencies that are used as gateway coins into ICOs themselves.

According to one estimate from Coin Schedule, about $2.1 billion has been raised around the world for 140 different ICOs this year.40  My personal view is that based on the research I have done, most ICO projects have intentionally or unintentionally created a security and are trying to sell it to the public without complying with securities laws.41 Depending on the jurisdiction, there may be a small handful of others that possibly-kinda-sorta have created a new coin that complies with existing regs.42  Maybe.

Ignoring the legal implications and where each fits on that spectrum for the moment, many ICOs to-date have pandered to and exploited terms like “financial inclusion” when it best suits them.43  Others pursue the well-worn path of virtue signaling: Bitcoiners condemning the Ethereum community (which itself was crowdfunded as an ICO), because of the popularity in using the Ethereum network for many ICOs… yet not equally condemning illicit fundraising that involves bitcoin or the Bitcoin network or setting up bucket shops such as Sand Hill Exchange (strangely one of its founders who was sued by the SEC now writes at Bloomberg).

The cryptocurrency community as a whole condemned the “Chinese government” for its recent blanket ban on fundraising and secondary market listing of ICOs.44 The People’s Bank of China (PBOC) is one of seven regulators to enforce these regulations yet most of the public antagonism has been channeled at just the PBOC.45

Irrespective of whether you think it was the right or wrong thing to do because you heart blockchains, the PBOC and other regulators had quite valid reasons to do so: some ICO creators and trading platforms were taking funds they received from their ICO and then re-investing those into other ICOs, who in turn invested in other ICOs, and so forth; creating a fund of fund of funds all without disclosing it to the public or original investors.46 ICO Inception (don’t tell Christopher Nolan).

In China and in South Korea, and several other countries including the US, there is a new cottage industry made of up entities called “community managers” (CM) wherein an ICO project hires an external company (a CM) who provides a number of services:

  1. for X amount of BTC the CM will actively solicit and get your coin listed on various exchanges;
  2. the CM takes a sales commission while marketing the coin to the public such that after the ICO occurred, they would take a juicy cut of the proceeds; and several other promotional services.47

The ICO issuers and fundraising/marketing teams usually organize a bunch of ICOs weekly and typically employ a market maker (known as an “MM” in the groups) whose role is to literally pump and dump the coin.  They engage in ‘test pumps’ and ‘shakeouts’ to get rid of the larger ICO investors so they can push the price up on a thin order book by 10x, 20x, or 30x before distributing and pulling support. You can hire the services of one of these traders in many of the cryptocurrency trading chat groups.48

There were even ICO boot camps (训练营) in China (and elsewhere) usually setup with shady figures with prior experience in pyramid schemes.49  Here they coached the average person to launch an ICO on the fly based on the ideas of this leader to people of all demographics including the vulnerable and at-risk.50  Based on investigations which are still ongoing, the fraud and deceit involved was not just one or two isolated incidents, it was rampant.51 Obtaining the training literature that was given to them (e.g., the script with the promises made) would make for a good documentary and/or movie.

Scene from Boiler Room

In other words, the ICO rackets have recreated many aspects of the financial services industry (underwriters, broker/dealers) but without any public disclosures, organizational transparency, investor protections, or financial controls.  Much like boiler rooms of days past.  It is no wonder that with all of this tomfoolery, according to Chainalysis, that at least $225 million worth of ETH has been stolen from ICO-related fundraising activity this past year.52

At its dizzying heights, in China, there were about sixty ICO crowdfunding platforms each launching (or trying to launch) new ICOs on a monthly basis.53  And many of these platforms also ran and operated their own exchanges where insiders were pumping (and dumping) and seeing returns of up to 100x on coins that represented “social experiments to test human stupidity” such as the performance art pictured below.

One recent estimate from Reuters was that in China, “[m]ore than 100,000 investors acquired new cryptocurrencies through 65 ICOs in January-June [2017].”54  It’s still unclear what the final straw was, but the universal rule of don’t-pitch-high-risk-investment-schemes-to-grandmothers-on-fixed-incomes was definitely breached.

As a result, the PBOC and other government entities in China are now disgorging any funds (about $400 million) that ICOs had raised in China.55  This number could be higher or lower depending on how much rehypothecation has taken place (e.g., ICOs investing in ICOs).  All crowdfunding platforms such as ICOAGE and ICO.info have suspended operations and many have shut down their websites.  In addition, several executives from these exchanges have been given a travel ban.56

Cryptocurrency exchanges (the ones that predated the ICO platforms) have to delist ICOs and freeze plans from adding any more at this time.  Multiple ICO promotional events, including those by the Fintech Blockchain Group (a domestic fund that organized, promoted, and invested in ICOs) have been canceled due to the new ban.57  Several well-known promoters have “gone fishing” overseas.  This past week, Li Xiaolai, an early Bitcoin investor and active ICO promoter, has publicly admitted to having taken the ICO mania too far (using a car acceleration example), an admission many link to the timing of this crackdown and ban.58

A real ICO in China: “Performance Art Based on Block Chain Technology” (Source)

For journalists, keep in mind this is (mostly) just one country described above.  It would be a mistake to pin all of the blame on just the ICO operators based in China as similar craziness is happening throughout the rest of the world (observe the self-serving celebrity endorsements).  Be sure to look at not just the executives involved in an ICO but also the advisors, investors, figureheads, and anyone who is considered “serious” lending credibility to dodgy outfits and dragging the average Joe (and Zhou) and his fixed income or meager savings into the game.

There may be a legitimate, legal way of structuring an ICO without running afoul of helpful regulations, but so far those are few and far between.  Similarly, not everyone involved in an ICO is a scammer but it’s more than a few bad apples, more like a bad orchard.  And as shown above with the initial enforcement actions of just one country, short sighted hustling by unsavory get-rich-quick partisans unfortunately might deep-six the opportunities for non-scammy organizations and entrepreneurs to utilize a compliant ICO model in the future.59

(4) VC-backed entities

Theranos, Juicero, and Hampton Creek, meet Coinbase, 21.co, Blockstream, and several others.

Okay, so that may be a little exaggerated.  But still the same, few high-profile Bitcoin companies are publishing daily active or monthly active user numbers for a variety of reasons.

Founded in May 2012, the only known unicorn to-date is Coinbase.  Historically it has kept traction stats close to the chest but we got a small glimpse at what Coinbase’s user base was from an on-going lawsuit with the IRS.  According to one filing, between 2013-2015 (the most recent publicly available data) Coinbase had around 500,000 users, of which approximately 14,355 accounts conducted at least $20,000 in business.60 This is a far cry from the millions of wallets we saw as a vanity statistic prominently displayed on its homepage during that same time period.61

What did most users typically do?  They created an account, bought a little bitcoin, and then hoarded it – very few spent it as if it were actual money which is one of the reasons why they removed a publicly viewable transaction chart over a year ago.62

To be fair, the recent surge in market prices for cryptocurrencies has likely resulted in huge user growth.  In fact, Coinbase’s CEO noted that 40,000 new users signed up on one day this past May.  But some of this is probably attributed to new users using Coinbase as an on-and-off ramp: United States residents acquiring bitcoin and ether on Coinbase and then participating in ICOs elsewhere.63

After more than $120 million in funding, 21.co (formerly 21e6) has not only seen an entire executive team churn, but a huge pivot from building hardware (Bitcoin mining equipment) into software and now into a pay-as-you-go-LinkedIn-but-with-Bitcoin messaging service.  Launched with much fanfare in November 2015, the $400 Amazon-exclusive 21.co Bitcoin Computer was supposed to “return economic power to the individual.”

In reality it was just a USB mining device (a Raspberry Pi cobbled together with an obsolete mining chip) and was about as costly and useful as the Juicero juicing machine.  It was nicknamed the “PiTato” and unit sales were never publicly disclosed.  Its story is not over: in the process of writing this article, 21.co announced it will be launching a “social token” (SOC) by the end of the year.64

Blockstream is the youngest of the trio.  Yet, after three years of existence and having raised at least $76 million, as far as the public can tell, the company has yet to ship a commercial product beyond an off-the-shelf hardware product (Liquid) that generates a little over $1 million in revenue a year.65  It also recently launched a satellite Bitcoin node initiative it borrowed from Jeff Garzik, who conceived it on a budget of almost nothing about three years ago.66

To be fair though, perhaps it does not have KPIs like other tech companies.  For instance, about two and half years ago, one of their largest investors, Reid Hoffman, said Blockstream would “function similarly to the Mozilla Corporation” (the Mozilla Corporation is owned by a nonprofit entity, the Mozilla Foundation).  He likened this investment into “Bitcoin Core” (a term he used six times) as a way of “prioritiz[ing] public good over returns to investors.”  So perhaps expectations of product roadmaps is not applicable.

On the flipside, some entrepreneurs have explained that their preference for total secrecy is not necessary because they are afraid of competition (that is a typical rationale of regular startups), but because they are afraid of regulators via banks.67  For example, a regulator sees a large revenue number, finds out which bank provides a correspondent service and if the startup is fully compliant with AML, CFT, and KYC processes, starts auditing that bank, and banks re-evaluates NPV of working with a startup and potentially drops it.  Until that changes, we will not know volumes for Abra, Rebit, Luno, and others and that is why a year-old claim about 20% market share in the South Korea -> Philippines remittance corridor remains evidence-free.6869

While we would all love to see more data, this is a somewhat believable argument.  A more insightful question might be if/when we get to a point where supporting Bitcoin players becomes enough of real revenue that banks would agree to higher investments and support.  In the meantime, business journalists should drill down into the specifics about how raised money has been spent, is compliance being skirted, customer acquisition costs, customer retention rate, etc.70

(5) The decline of Maximalism

If you were to draw a Venn diagram, where one circle represented neo Luddism and another circle represented Goldbugism, the areas they overlap would be cryptocurrency Maximalism (geocentrism and all).71  This increasingly smaller sect, within the broader cryptocurrency community, believes in a couple of common tenets but most importantly: that only one chain or ledger or coin will rule them all.  This includes the Ethereum Classic (ETC) and Bitcoin Core sects, among others.

They’re a bit like the fundamentalists in that classic Monty Python “splitters” sketch but not nearly as funny.

If you’re looking to dig into defining modern irony, these are definitely the groups to interview.  For instance, on the one hand they want and believe their Chosen One (typically BTC or ETC) should and will consume the purchasing power of all fiat currencies, yet they dislike any competing cryptocurrency: it is us versus them, co-existence is not an option!  The rules of free entry do not apply to their coin as somehow a government-free monopoly will form around their coin and only their coin.  Also, you should buy a lot of their coin, like liquidate your life savings asap and buy it now.

Artist rendering of proto-Bitcoin Maximalism, circa 14th century

This rigidity has diminished over time.

Whereas, three years ago, most active venture capitalists and entrepreneurs involved in this space were antagonistic towards anything but bitcoin, more and more have become less hostile with respect to new and different platforms.

Source: Twitter

For instance, Brian Armstrong (above), the CEO of Coinbase, two and a half years ago, was publicly opposed to supporting development activities towards anything unrelated to Bitcoin.

But as the adoption winds shifted and Ethereum and other platforms began to see growth in their development communities (and coin values), Coinbase and other early bastions of maximalism began to support them as well.

Source: Twitter (1 2)

There will likely be permanent ideological holdouts, but as of this writing I would guesstimate that less than 20% of the bitcoin holders I have interacted with over the past 6-9 months would label themselves maximalists (the remaining would likely self-identify with the “UASF” and “no2x” tags on Twitter).

So interview them and get their oral history before they go extinct!

(6) Market caps

There is very little publicly available analysis of what is happening with Bitcoin transactions (or nearly all cryptocurrencies for that matter): dormant vs. active, customers vs. accounts, transaction types (self-transfers vs. remittances vs. B2B, etc.).

On-chain transaction growth seems to be slowing down on the Bitcoin network and we don’t have good public insights on what is going on: are there are pockets of growth in real adoption or just more wallet shuffling?

In other words, someone should be independently updating “Slicing data” but instead all we pretty much see is memes of Jamie Dimon or animated gifs involving roller coaster prices.72

In the real world, “market cap” is based on a claim on a company’s assets and future cash flows.  Bitcoin (and other cryptocurrencies) has neither — it doesn’t have a “market cap” any more than does the pile of old discarded toys in your garage.

“Market Cap” is a really dumb phrase when applied to the cryptocurrency world; it seems like one of those seemingly straightforward concepts ported to the cryptocurrency world directly from mainstream finance, yet in our context it turns into something misleading and overly simplistic, but many day traders in this space who religiously tweet about price action love to quote.

The cryptocurrency “market cap” metric is naively simplistic: take the total coin supply, and multiply it by the current market price, and voila!  Suddenly Bitcoin is now approaching the market cap of Goldman Sachs!73

Yeah, no.

To begin with, probably around 25% or more of all private keys corresponding to bitcoins (and other cryptocurrencies too) have been permanently lost or destroyed.74  Most of these were from early on, when there was no market price and people deleted their hard drives with batches of 50 coins from early block rewards without backing them up or a second thought.

Extending this analogy, 25% of the shares in Goldman Sachs cannot suddenly become permanently ownerless.  These shares are registered assets, not bearer assets.  Someone identifiable owns them today and even if there is a system crash at the DTCC or some other CSD, shareholders have a system of recourse (i.e., the courts) to have these returned or reissued to them with our without a blockchain.  Thus, anytime you hear about “the market price of Bitcoin has approached $XXX billion!” you should automatically discount it by at least 25%.

Also, while liquidity providers and market makers in Bitcoin have grown and matured (Circle’s OTC desk apparently trades $2 billion per month), this is still a relatively thinly traded market in aggregate.  It is, therefore, unlikely that large trading positions could simultaneously move into and out of billion USD positions each day without significantly moving the market.  A better metric to look at is one that involves real legwork to find: the average daily volume on fee-based, regulated spot exchanges combined with regulated OTC desks.  That number probably exists, but no one quotes it.  Barring this, an interim calculation could be based on “coins that are not lost or destroyed.”

(7) Buy-side analysts and coin media

We finally have some big-name media beginning to dig into the shenanigans in the space.  But organizations like CoinDesk, Coin Telegraph, and others regularly practice a brand of biased reporting which primarily focus on the upside potential of coins and do not provide equal focus on the potential risks.75  In some cases, it could be argued that these organizations act as slightly more respectable conduits for misinformation churned out by interested companies.76

Common misconceptions include continually pushing out stories like the example above, on “market caps” or covering vanity metrics such as growth in wallet numbers (as opposed to daily active users).  It is often the case that writers for these publications are heavily invested in and/or own cryptocurrencies or projects mentioned in their stories without public disclosure.

This is not to say that writers, journalists, and staff at these organizations should not own a cryptocurrency, but they should publicly disclose any trading positions (including ‘hodling’ long) as the sentiment and information within their articles can have a material influence on the market prices of these coins.

For instance, CoinDesk is owned by Digital Currency Group (DCG) who in turn has funded 80-odd companies over the last few years, including about 10 mentioned in this article (such as Coinbase and BTC China).  DCG also is an owner of a broker/dealer called Genesis Trading, an OTC desk which trades multiple cryptocurrencies that DCG and its staff, have publicly acknowledged at having positions in such as ETC, BTC and LTC.77

What are the normal rules around a media company (and its staff) retweeting and promoting cryptocurrencies or ICOs the parent company or its principals has a stake in?

If coin media wants to be taken seriously it will have to take on the best practices and not appear to be a portfolio newsletter: divorce itself of conflicts of interest by removing cross ownership ties and prominently disclose all of the remaining potential conflicts of interest with respect to ownership stakes and coin holdings.  Markets that transmit timely, accurate, and transparent information are better markets and are more likely to grow, see, and support longer-term capital inflows.78

Source: Twitter

Source: Twitter

For example, if Filecoin is a security in the US (which its creators have said it is), and DCG is an equity holder in Filecoin/Protocol Labs (which it is)… and DCG is an owner in CoinDesk, what are the rules for retweeting this ICO above?  There are currently 16 stories in the CoinDesk archive which mention Filecoin, including three that specifically discuss its ICO.  Is this soliciting to the public?79

Similarly, many of the buy-side analysts that were actively publishing analysis this past year didn’t disclose that they had active positions on the cryptocurrencies they covered.  We recently found out that one lost $150,000 in bitcoins because someone hacked his phone.

At cryptocurrency events (and fintech events in general), we frequently hear buzz word bingo including: smart assets, tokens, resilience, pilots, immutability, even in-production developments, but there is often no clear articulation of what are the specific opportunities to save or make money for institutions if they acquire a cryptocurrency or uses its network to handle a large portion of their business.80

This was the core point of a popular SaveOnSend article on remittances from several years ago.  I recommend revisiting that piece as a model for similar in-depth assessments done by people who understand B2B payments, correspondent banking and other part of global transfers.  Obviously this trickles into the other half of this space, the enterprise world which is being designed around specific functional and non-functional requirements, the SLAs, compliance with data privacy laws, etc., but that is a topic for another day.

What about Coin Telegraph?  It is only good for its cartoon images.81

Source: LinkedIn

There are some notable outliers that serve as good role models and exceptions to the existing pattern and who often write good copy.  Examples of which can be found in long end note.82

Obviously the end note below is non-exhaustive nor an endorsement, but someone should try to invite some or all these people above to an event, emceed by Taariq Lewis.  That could be a good one.

(8) Analytics

What about solutions to the problems and opaqueness described throughout this article?

There are just a handful of startups that have been funded to create and use analytics to identify usage and user activity on cryptocurrency networks including: Chainalysis, Blockseer, Elliptic, WizSec, ScoreChain, Skry (acquired by Bloq) – but they are few and far between.83  Part of the reason is because the total addressable market is relatively small; the budgets from compliance departments and law enforcement is now growing but revenue opportunities were initially limited (same struggle that coin media has).  Another is that the analytic entrepreneurs are routinely demonized by the same community that directly benefits from the optics they provide to exchanges in order to maintain their banking partnerships and account access.

Such startups are shunned today, unpopular and viewed as counter to the roots of (pseudo) anonymous cryptocurrencies, however, as regulation seeps into the industry an area that will gain greater attention is identification of usage and user activities.

For instance, four years ago, one article effectively killed a startup called Coin Validation because the community rallied (and still rallies) behind the white flag of anarchy, surrendering to a Luddite ideology instead of supporting commercial businesses that could help Bitcoin and related ideas and technologies comply with legal requirements and earn adoption by mainstream commercial businesses.  For this reason, cryptocurrency fans should be very thankful these analytics companies exist.

Source: Twitter. Explanation: Wanna Cry ransomware money laundering with Bitcoins in action. Graph shows Bitcoin being converted to Monero (XMR) via ShapeShift.io

More of these analytics providers could provide even better optics into the flow of funds giving regulated institutions better handling of the risks such as the money laundering taking place throughout the entire chain of custody.

Without them, several large cryptocurrency exchanges would likely lose their banking partners entirely; this would reduce liquidity of many trading pairs around the world, leading to prices dropping substantially, and the community relying once again on fewer sources of liquidity run out of the brown bags on shady street corners.84

One key slide from Kim Nilsson’s eye-opening presentation: Cracking MtGox

And perhaps there is no better illustration of how these analytic tools can help us understand the fusion of improper (or non-existent) financial controls plus cryptocurrencies: Mt. Gox.  Grab some warm buttery popcorn and be sure to watch Kim Nilsson’s new presentation covering all of the hacks that this infamous Tokyo-based exchange had over its existence.

Journalists, it can be hard to find but the full order book information for many exchanges can be found with enough leg work.   If anyone had the inclination to really want to understand what was going on at the exchange, there are 3rd parties which have a complete record of the order book and trades executed.

Remember, as Kim Nilsson and others have independently discovered, WillyBot turned out to be true.

Final Remarks

The empirical data and stories above do not mean that investors should stop trading all cryptocurrencies or pass on investing in blockchain-related products and services.

To the contrary, the goal of this article is to elevate awareness that this industry lacks even the most basic safeguards and independent voices that would typically act as a counterbalance against bad actors.  In this FOMO atmosphere investors need to be on full alert of the inherent risks of a less than transparent market with less than accurate information from companies and even news specialists.

Cryptocurrencies aren’t inherently good or bad.  In a single block, they can be used as a means to reward an entity for securing transactions and also a payment for holding data hostage.

One former insider at an exchange who reviewed this article summarized it as the following:

The cryptocurrency world is basically rediscovering a vast framework of securities and consumer protection laws that already exist; and now they know why they exist. The cryptocurrency community has created an environment where there are a lot of small users suffering diffuse negative outcomes (e.g., thefts, market losses, the eventual loss on ICO projects). And the enormous gains are extremely concentrated in the hands of a small group of often unaccountable insiders and “founders.” That type of environment, of fraudulent and deceptive outcomes, is exactly what consumer and investor protection laws were created for.

Generally speaking, most participants such as traders with an active heartbeat are making money as the cryptocurrency market goes through its current bull run, so no one has much motive to complain or dig deeper into usage and adoption statistics.  Even those people who were hacked for over $100,000, or even $1 million USD aren’t too upset because they’re making even more than that on quick ICO returns.

We are still at the eff-you-money stage, in which everyone thinks they are Warren Buffett.85  The Madoffs will only be revealed during the next protracted downturn.  So if you’re currently getting your cryptocurrency investment advice from permabull personalities on Youtube, LinkedIn, and Twitter with undisclosed positions and abnormally high like-to-comment ratios, you might eventually be a bag holder.86

Like any industry, there are good and bad people at all of these companies.  I’ve met tons of them at the roughly 100+ events and meetups I have attended over the past 3-4 years and I’d say that many of the people at the organizations above are genuinely good people who tolerate way too much drivel.  I’m not the first person to highlight these issues or potential solutions.  But I’m not a reporter, so I leave you with these leads.

While everyone waits for Harry Markopolos to come in and uncover more details of the messes in the sections above, other ripe areas worth digging into are the dime-a-dozen cryptocurrency-focused funds.

Future posts may look at the uncritical hype in other segments, including the enterprise blockchain world.  What happened after the Great Pivot?

[Note: if you found this research note helpful, be sure to visit Post Oak Labs for more in the future.]

Acknowledgements

To protect the privacy of those who provided feedback, I have only included initials: JL, DH, AL, LL, GW, CP, PD, JR, RB, ES, MW, JK, RS, ZK, DM, SP, YK, RD, CM, BC, DY, JF, CK, VK, CH, HZ, and PB.

End notes

  1. One reviewer commented: “Another meta-topic is the notion of “community,” which is a myth if you ask me.  Why hasn’t the “community” done “X”? Because the word is mostly a marketing fiction.” See also the discussion of the idea that “Code is not law” []
  2. One former regulator mentioned: “The cryptocurrency community needs to police itself better or it risks being policed more severely by unfriendly and unsympathetic regulators.  Self-regulation is what certain hands-off banking supervisors attempted with US banks and other financial institutions 15 years ago and that ended poorly for many parties including those who were not directly responsible for making the poor decisions in the first place.  Even in sports it is understood, with the exception of golf, it doesn’t work. In this Wild West atmosphere where are the sheriffs?” []
  3. Not unique to cryptocurrencies, but by enabling such bad actors, certain platform operators may even increase their short term profit. []
  4. Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO []
  5. For an in-depth look at how the various moving pieces of the ecosystem interact, see: The flow of funds on the Bitcoin network in 2015, Cryptocurrency KYSF: Know Your Source of Funds, and Cryptocurrency KYSF: Know Your Source of Funds part 2 []
  6. Bitcoin Exchange Was a Nexus of Crime, Indictment Says from The New York Times []
  7. For an in-depth look at these different costs, it is highly recommended to read this post from Save on Send.  Some are convinced that this is the case because, on a small scale, the illiquidity of the end points serves to finance the operation, i.e. buying BTC with USD then selling BTC for MXN, may allow an apparent savings when compared with traditional remittance service providers.  Also oft-forgotten is the cost of cash-out and distribution of cash at the end point; also KYC / AML / CFT functions are frequently left-off the calculation. []
  8. One reviewer stated that, “Any working groups advising the government on policy are certainly worthy of investigation. Who are these people and what are their potential conflicts of interest?  For starters, in the US look at The Bitcoin Foundation and the Blockchain Alliance.” []
  9. It has a complex corporate structure and is nominally based in Hong Kong, operations and incorporation of subsidiaries are in other jurisdictions including BVI. []
  10. There were exceptions. Some users reported smaller haircuts as they were customers of SynapsePay.  Another user claims to have retained a lawyer and he did not have any haircut.  I independently verified this with an executive at SynapsePay. []
  11. Phil Potter, an executive at Bitfinex, has spoken about the hack on multiple different podcasts including once in detail, but this has since been deleted. []
  12. Bitfinex also recently announced that they will be doing an ICO (called NEC) to capitalize on the current token mania. []
  13. Bitfinex does do KYC and AML when a user withdraws USD and when they receive subpoenas. []
  14. ERC20 tokens are arguably not the same thing as a cryptocurrency, they are more like colored coins. See “Watermarked tokens and pseudonymity on public blockchains” by Tim Swanson. []
  15. Tether brings tokenised USD to Ethereum network from Finextra []
  16. We only know who is involved through various reddit threads wherein users dox and identify themselves as employees and founders. []
  17. Tether brings tokenised USD to Ethereum network from Finextra []
  18. This wouldn’t be the first time that a peg “broke the buck;” money market funds have been propped up by a parent organization in the past. []
  19. Tether Update []
  20. One reviewer noted that: “Theoretically they could maintain a fractional reserve to service redemptions although this isn’t a problem per se, provided that it is disclosed.  By saying you have “cash” backing, you could have some really bizarre stuff, like USD loans to unsavory entities.  But maybe they do not do this either.”  []
  21. Source for some of these questions. []
  22. One reviewer commented: “Tether offers users a way to move USD from one country to another, much like Western Union. So Tether should be obligated to run KYC/AML checks on not only those who are depositing US$ funds to get new Tethers (as it currently does), but also everyone who uses second-hand Tethers (it doesn’t). Now if Tether was like bitcoin, and had no physical address, it would be complicated for the authorities to enforce this requirement. But Tether is anchored to the brick & mortar banking system, so law enforcement should be easier, will it?” []
  23. One reviewer commented: “Let’s assume the worst for Tether, what does that mean?  If it were to collapse would it harm the small investors or the whales? A few exchanges that allow Tether also allow you to hold your deposits in USD, aside from the ability to send USDT between exchanges, which arguably could actually be a net positive because it allows clients to net positions between exchanges potentially reducing the overall credit in the system. But this goes back to one of their continual issues: lack of communicating and transparency for how the whole money issuance and transmission process works.” []
  24. Note: they did have withdrawal fees which likely generated revenue from arbitrageurs.  Several of the larger exchanges also raised venture capital and setup (and still run) order books outside of China with other business lines which may help offset some costs. []
  25. Described in further detail, “Comments on the COIN ETF (SR-BatsBZX-2016-30)” by Tim Swanson []
  26. See the section “Stopping Predators” within A Kimberley Process for Cryptocurrencies []
  27. China Central Bank Said to Call Bitcoin Exchanges for Talks from Bloomberg []
  28. In addition to lying about being investigated, they were lying about the true volume on their exchanges.  When the zero-fee domestic exchanges were required to add a minimum fee (to discourage wash trading), volume plummeted. []
  29. Central bank warns Bitcoin exchanges over margin trading, money laundering from Xinhua and Chinese bitcoin exchanges resume withdrawals after freeze from Reuters []
  30. Li Xiaolai: Yunbi Is Winding Down In 3 Months from 8BTC []
  31. BTCC to Cease China Trading as Media Warns Closures Could Continue from CoinDesk []
  32. Sources: CNLedger and ICOcoinOfficial []
  33. Huobi, OKCoin to Stop Yuan-to-Bitcoin Trading By October’s End from CoinDesk []
  34. The 19th National Congress of the Communist Party of China starts on October 18th.  All exchanges involving fiat-to-cryptocurrency trades will be closed. Both OKCoin and Huobi have overseas platforms (with independent order books and bank accounts independent of the domestic Chinese exchanges).  These have cryptocurrency-to-cryptocurrency trading and will remain operating.  Currently, users of the domestic fiat-to-currency platform can move their coins to the overseas platforms. []
  35. Something similar was done with voucher codes sold on Taobao in 2014 as well.  See After Crackdown, A New Bitcoin King Emerges in China from Wired []
  36. At one time or another, the spot price for each of the three large Chinese exchanges was a constituent part of several different pricing indices including the Winkdex, TradeBlock XBX index, and others such as OKEX (OKEX is an international subsidiary of OKCoin who replaced these exchanges on its own index).  This is potentially problematic because, as I detailed in my COIN ETF report, these exchanges were prone to mismanagement, crashes, and ultimately quick closure.  Going forward, what other sources of reliable pricing data can ETFs use that also accurately reflect market prices? []
  37. One insider in China noted that: “These exchanges had multiple chances to clean up their act and even self-regulate but because of the competitive pressures in China towards zero-fees, no one wanted to be left behind.  It was a type of collective action failure, so the government finally had to come in and clean up the mess because no one else would.” []
  38. These are mostly ERC20 tokens, not coins. []
  39. One reviewer mentioned: “Depending on the jurisdiction, these pre-arranged discounts might be deemed as structured products.” []
  40. Is There a Cryptocurrency Bubble? Just Ask Doge. from The New York Times []
  41. “How the ICO, OCO, and ECO ecosystem works at a high level” by Tim Swanson and “Comments on the COIN ETF (SR-BatsBZX-2016-30)” by Tim Swanson []
  42. Note: volumes can and will be written on this section alone.  If not on the legalities but on the ‘pump and dumps’ that have taken place. []
  43. One former regulator suggested: “Ignoring for the moment the overarching legal implications of what they did, because these activities took place on blockchains, future researchers should be able to eventually provide very accurate estimates the costs and losses to investors who put their trust and money into deceptive ICO organizers who were unscrupulous.” []
  44. Some argue this ban may just be temporary and cite a CCTV 13 interview with Hu Bing with the Institute of Finance and Banking who says the government will issue licenses in the future. []
  45. As of this writing there are many rumors circulating regarding how these new guidelines could impact cryptocurrency mining operators based in China.  One recent story from the Wall Street Journal articulates a rumor that miners will need to also shut down operations because they are trading cryptocurrencies without a license.  More existentially, if all fiat-to-cryptocurrency exchanges shut down domestically, miners would need a new method to liquidate their coins because they need to pay utilities in RMB (e.g., it doesn’t help to have a JPY or KRW-denominated bank account because Chinese utilities require being paid in RMB). []
  46. This same phenomenon occurred several years ago with “wealth management products” doing the same re-investment into other WMPs; revisiting the P2P Lending scams that came to light in the past two years as well is helpful.  See China’s ICO ban makes more sense in light of its history with fintech by Nik Milanovic []
  47. One insider noted that: “A New Zealand based person (and company) is one of the main men in all of this. I’ve encountered him on a number of occasions. He’s a complete fraudster. For example he told a group I am in that MGO would be listed on Poloniex within weeks of launch. Months later he hasn’t even got it on Bittrex. He’s now buying up lots of it wholesale from disenchanted investors who’ve taken a massive hit recently and will inevitably be sitting on a pile when the intentionally delayed launch and pump happens.” []
  48. Whalepool and The Coin Farm on Telegram are both examples of this type of coordination. []
  49. ICO被定性为涉嫌非法集资,想一夜暴富的“韭菜”们醒醒吧 from Huxiu []
  50. Based on translated stories from after the investigations as well as conversations with observers of these training sessions. []
  51. According to a source close to the investigations, law enforcement are using WeChat correspondence to chronicle the intentional cases of fraud and deceit.  In some cases, ICO organizers would run a public WeChat group, providing investors with false information and then use a private WeChat group with a smaller circle of insiders to “laugh at the stupidity” of these investors and coordinate dumps.  As a result, ICO organizers are leaving WeChat to use platforms like Telegram.  See China’s WeChat crackdown drives bitcoin enthusiasts to Telegram from South China Morning Post []
  52. That is the best case scenario because it assumes that there were not additional losses to fraud and mismanagement, which we know there has been. []
  53. China bans companies from raising money through ICOs, asks local regulators to inspect 60 major platforms from CNBC []
  54. Cryptocurrency chaos as China cracks down on ICOs from Reuters []
  55. Ibid []
  56. China shuts down Bitcoin industry; bans executives from leaving the country from Australian Financial Review []
  57. Another ICO Conference Cancels in Wake of China Ban from CoinDesk []
  58. He had to refund the ICOs he promote (plus with an added premium). []
  59. One reviewer commented: “The inevitability of regulations coming down the pipeline is a certainty (not just “blanket bans”).  Whether it’s 1 month or 1 year, regulations or enforcement of existing regulations will be coming in. A lot of these participants in the market seem to want to get in before regulations come into effect but in many jurisdictions they can still be liable for past actions (depending on the statute of limitations). That’s part of what I think is driving this tremendous amount of ICOs right now.” []
  60. 14,000 Coinbase Customers Could Be Affected by IRS Tax Summons from CoinDesk and Legitimate? IRS Defends Coinbase Customer Investigation in Court Filing from CoinDesk []
  61. At the time of this writing Coinbase has raised more than $225 million.  By January 2015, Coinbase had in aggregate raised just north of $106 million.  The ongoing lawsuit with the IRS states that there were 500,000 users by the end of the 2013 – 2015 period, of which 14,355 had done $20,000 or more of trading.   Future research can look into Coinbase’s customer acquisition costs over time (e.g., switching costs) versus the same costs traditional banks have.  Note: this also does not include the user numbers at GDAX, their platform marketed to professional traders. []
  62. According to an alleged insider (which may be untrue), some Coinbase users allegedly didn’t even know they may have been entitled to things like CLAM coins.  Maybe they weren’t. Tangentially, the continual high percentage of hoarding done by cryptocurrency enthusiasts suggests that this still remains a virtual commodity and continues to fail the medium of exchange test needed to be defined as a transactional currency. []
  63. At this time, it is unclear what the breakdown of these new (or old) users are acquiring cryptocurrencies on Coinbase and then participating in ICOs.  As a company, Coinbase has been publicly supportive of the ICO zeitgeist and hosted multiple meetups where ICO creators presented.  Earlier this year it co-sponsored a publication discussing the securities law framework of tokens.  Based on several interviews for this article, users of both the Coinbase wallet and its subsidiary, GDAX, currently can send bitcoins and ether from their user accounts to participate in ICOs.  It is unclear how often this is screened and/or prevented.  For perspective, a former employee was allegedly fired for sending bitcoins from his Coinbase account to gamble on Chinese web casinos.  Assuming this is true (and it may not be) then Coinbase could have the knowledge and/or ability to prevent users from participating in ICOs or other off-platform activity that violates its terms of service. []
  64. Another tech company that supposedly struggled raising funding and later issued its own coin (through an ICO) is Kik, through its Kin Foundation. []
  65. If this post is true (and it may not be), a dozen or so exchanges paying between $7,000 – $10,000 a month is roughly $1.4 million a year.  The SaaS monthly estimate has been independently validated from conversations with a couple participating exchanges. []
  66. One reviewer recommended: “If I were a journalist, I would more closely scrutinize the social media habits of the executives (and their surrogates) on these teams so the ecosystem can ascertain the relationship between the amount of time senior employees spend opining on Twitter, Reddit, mailing lists, IRC, WhatsApp, Slack, WeChat, Telegram, BitcoinTalk, GitHub, Discord, etc., and the number of hours in a working day, or number of products shipped.  Other social media analytics ideas for journalists: look at the Twitter tribes of Bitcoin (and other cryptocurrencies). Who is aligned with whom and pushing what agendas? Who are the trolls associated with those different tribes?  How many suspect accounts are associated with each group? For example, how many accounts that were just created, or never tweeted before, or only have followers from within their own tribes?” []
  67. One reviewer argued that, “It could also because they want to protect their valuations and because they are privately held companies that may be legally forbidden to divulge this information.” []
  68. This article in Quartz did not provide actual data or evidence that these remittance numbers were real, no one fact-checked it and instead, reproduced similar headlines for several months. []
  69. According to a recent interview with Forbes, after nearly two years of operations Abra only has 73 users per day. They are currently raising another round at this time; it is believed that this will help fund their compliance team and for licenses which they currently lack. []
  70. One reviewer said, “A counterpoint could be: VC returns are even sharper than standard Pareto; 1:9 or even 1:99 as opposed to 2:8. Startups are hard – most fail – why should cryptocurrency world be any different?” []
  71. One reviewer suggested that: “In the future, you should explain why Maximalism is a type of Authoritarianism and is not to be conflated with cypherpunks.” []
  72.  In mid-September, vocal promoters and owners of cryptocurrencies such as Bitcoin collectively spent thousands of hours yelling on social media and conducting letter writing campaigns all to channel their anger towards comments made by Jamie Dimon.  A couple worthwhile followups include: JPMorgan handles bitcoin-related trades for clients despite CEO warning from Reuters and  MUFG CEO on Dimon Remarks: Bank Cryptocurrencies Have ‘Nothing to Do With Bitcoin’ from CoinDesk []
  73. Bitcoin was only used as an example, nearly all cryptocurrencies listed on CoinMarketCap have the same issue in terms of calculating a real “market cap.” []
  74. Learning from Bitcoin’s past to improve its future from Tim Swanson []
  75. The theatrics around “BearWhale”-like events still persists.  For example, one current conspiracy theory is that: “the Chinese government is shutting down Bitcoin miners to mine bitcoins themselves.”  This is most likely false and the proposed solution is to “use satellites.”  But in talking with professional miners in China, many of them have contracts directly with State Grid, so they could lose access to energy in a worst-case scenario and satellites would not be of any use (assuming any of those rumors are true). []
  76. To be fair, this is not unique to the cryptocurrency space. []
  77. Genesis Trading is also the marketing and distribution agent for Bitcoin Investment Trust and Ethereum Classic Investment Trust, two regulated financial products.  DCG also is an owner in Grayscale Investments which is the legal sponsor both of these Trusts []
  78. Research: How Investors’ Reading Habits Influence Stock Prices by Anastassia Fedyk and Effects of Misinformation on the Stock Return: A Case Study by Ahsan et al. []
  79. Some employees in coin media have used social media channels to discuss various cryptocurrencies including ICOs over the past year.  How many of these were sponsored or received a cut of the coins to do so? []
  80. A great paper on this topic is The Path of the Blockchain Lexicon (and the Law) by Angela Walch []
  81. Nearly all of the coin media site allow ICO advertisements as well.  What are the terms and benefits that these media sites receive in exchange for displaying these advertisements and advertorials? []
  82. Note: this is not an exhaustive list and I’ll likely be flamed for not including X but including Y.  Journalists who write good original stories include: Nathaniel Popper, Matt Levine, and Matt Leising.  There have been several good op-eds written by lawyers which have appeared on CoinDesk, including Joshua Stark, Jared Marx, Brian Klein, Benjamin Sauter and David McGill.  Some other original, constructive views that should be highlighted include Stephen Palley, Ryan Straus, George Fogg, Miles Cowan, Patrick Murck, Amor Sexton, Houman Shadab, Angela Walch, Scott Farrell, Claire Warren, Simon Gilchrist, and two perpetual curmudgeons: Izabella Kaminska and Preston Byrne (very prickly at times!).  Non-lawyer thought-leaders, technical, and subject matter experts with bonafides worth interviewing include: Adam Krellenstein, Alex Batlin, Alex Waters, Andrew Miller, Andy Geyl, Antony Lewis, Ari Juels, Arvind Narayanan, Christian Decker, Christopher Allen, Ciaran Murray, Colin Platt, Danny Yang, Dave Hudson, David Andolfatto, David Schwartz, Dominic Williams, Duncan Wong, Elaine Shi, Emily Rutland, Emin Gun Sirer, Ernie Teo, Fabio Federici, Flavien Charlon, Gideon Greenspan, Ian Grigg, Ittay Eyal, Jackson Palmer, Jae Kwon, James Hazard, James Smith, Jana Moser, Jeff Garzik, JP Koning, John Whelan, Jonathan Levin, Jonathan Rouach, Jorge Stolfi, Juan Benet, Juan Llanos, Kieren James-Lubin, Lee Braine, Leemon Baird, Makoto Takemiya, Mark Williams, Matthew Green, Martin Walker, Massimo Morini, Michael Gronager, Mike Hearn, Muneeb Ali, Piotr Piasecki, Richard Brown, Robert Sams, Ron Hose, Sarah Meiklejohn, Stefan Thomas, Stephen Lane-Smith, Vitalik Buterin, Vlad Zamfir, Yakov Kofner, Zaki Manian, Zennon Kapron, and Zooko Wilcox-O’Hearn, as well as dozens of others from several different financial institutions and enterprises too long to list.  I also think that Michael del Castillo, Ian Allison, Simon Taylor, Jon Southurst, and Arthur Falls try to do an honest job reporting too.  Epicenter TV is arguably the best podcast in this space. []
  83. For an example, see Cracking Mt. Gox by WizSec []
  84. Chainalysis has a partnership with Circle which in turn enabled Circle to open up an account with Barclays.  Two years ago, an alleged business plan for Chainalysis was leaked online and unsurprisingly, some in the community were up in arms that this small company provided these forensic services. []
  85. Partially inspired by this tweet. []
  86. Click farms are being used by various ICO and Bitcoin-related online personalities to boost their perceived importance. []
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Citations, interviews, and events for the final third of 2016

Presenting at Bitcoin / Ethereum Meetup in Hong Kong

I ended up traveling a lot more than I expected last year, including 9 times just to East Asia.  The level of interest in that region will probably increase this year — especially as more projects and companies are funded — though I probably won’t do the Trans-Pacific shuffle nine times again this year.

As of right now there are probably just a small handful of startups in APAC that have the capital, connections, and capability to execute and build the commercial products and applications that are discussed at the plethora of fintech events.  And almost none of them have anything to do with a cryptocurrency itself either… because cryptocurrencies weren’t designed to solve most problems financial service organizations have.

Below are the interviews, events, and presentations I participated in the last few months of 2016.

Note: according to their stats, my “Settlement Risks Involving Public Blockchains” was one of TABB Forum’s top stories of 2016.

Quoted:

Cited:

Interview:

Events:

  • Smart Cloud Show 2016 from Chosun Ilbo on September 21, 2016 in Seoul, South Korea.
    • Keynote: “Blockchain and Financial Big Bang”
    • Coverage: Naver
  • Global Blockchain Summit event held by Wanxiang Blockchain Labs on September 23, 2016 in Shanghai, China
    • Presentation: “Opportunities and Challenges for Financial Services in the Cloud: Trade-offs in digitizing and automating finance” (R3 Blurb)
  • Fujitsu Laboratories of America Technology Symposium annual event on October 11, 2016 in Santa Clara, California
    • Panel: “The Blockchain Future – Challenges and Opportunities Ahead”
  • Fórum Blockchain event jointly held by Itaú and Bradesco on October 13, 2016 in São Paulo, Brazil
    • Presentation: “Smart Contracts: cryptographically secured, automated business logic”
  • MIT Fintech Course: Future Commerce on October 18, 2016 (virtual)
    • Discussion: “Distributed Ledger Technology Landscape and Regulations”
  • GAIM OPS West Coast annual event held on October 25, 2016 in Rancho Mirage, California
    • Panel: “Blockchain: What Exactly is it disrupting? Will it Negate Counterparty Risk?” (Photo)
  • CIO Study Trip hosted by the Capgemini Applied Innovation Exchange Lab on behalf of the IT Management Association on October 26, 2016 in San Francisco
    • Presentation: “Distributed Ledger Technology” and “Legal and Regulatory Challenges”
  • Day long discussions on November 9, 2016 at Cornell University in Ithaca, New York
    • Presentation: “Code is not law” (Photos)
  • Guest lecture at the Boston Economic Club on November 16, 2016 in Boston, Massachusetts.
    • Presentation: “DLT as Financial Market Infrastructure” (Photo)
  • Global Trade Review: West Coast Trade & Working Capital Conference on November 17, 2016 in San Jose, California
    • Panel: “Fintech investment and evolution of the trade finance sector” (Photo)
  • The Future of Financial Payment Services Driven by Technology Innovation on November 22, 2016 from Korea Finance Telecommunications & Clearings Institute 30th Anniversary Seminar in Seoul, South Korea
    • Presentation: “DLT as Financial Market Infrastructure” (Photos)
    • Panel: (Photos)
  • Inside Fintech on December 8-9, 2016 in Seoul, South Korea
    • Presentation: “Why Building Financial Infrastructure is Different than Building a Social Media App” (Photos)
    • Panel: “Regulating the Unregulated: How is Regulation and Compliance Impacting the Adoption of New Technology and Innovation” (Photos)
  • Ethereum and Bitcoin joint meetup on December 12, 2016 in Hong Kong
    • Presentation:  “On Consortiums: R3’s Tim Swanson in Conversation”
  • 13th annual China International Finance Forum on December 15, 2016 in Shanghai, China
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Citations, presentations, and panels

Below are a number of events, presentations, panels, and interviews I have participated in over the past three months.

Academic citation:

Quoted:

Presentations:

Interviewed:

Panels:

Cited:

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A Kimberley Process for Cryptocurrencies

[Note: the views expressed below are solely my own and do not necessarily represent the views of my employer or any organization I advise.]

I have spent the past few weeks in East Asia, primarily in China visiting friends and relatives. Because the connection to the outside world was limited, the upside was that the cacophonous noise of perma cryptocurrency pumpers was relatively muted. I have had a chance to reflect on a number of ideas that are currently being discussed at conferences and on social media.

The first idea is not new or even unique to this blog as other companies, organizations and individuals have proposed a type of digital signature analytics + KYC tracking process for cryptocurrencies. A type of Kimberley Process but for cryptocurrencies.1

For instance, the short lived startup CoinValidation comes to mind as having the first-to-market product but was notably skewered in the media.  Yet its modus operandi continues on in about 10 other companies.2

A Formal Kimberley Process

For those unfamiliar with the actual Kimberley Process, it is a scheme enacted in 2003 to certify where diamonds originated from in order to help prevent conflict diamonds from entering into the broader mainstream diamond market.

The general idea behind proving the provenance of diamonds is that by removing “blood diamonds” from the market, it can cut off a source of funding of insurgencies and warlord activity.3

What does this have to do with cryptocurrencies? Isn’t their core competency allowing non-KYC’ed, pseudonymous participants to send bearer assets to one another without having to provide documentation or proof of where those assets came from? Why would anyone be interested in enabling this?

Some may not like it, but a de facto Kimberley Process is already in place.

For instance, in many countries, most of the on-ramps and off-ramps of venture-backed cryptocurrency exchanges are actively monitored by law enforcement, compliance teams and data analytic providers who in turn look at the provenance of these assets as they move across the globe.4

On the fiat side, while many jurisdictions in North America and Western Europe currently require domiciled cryptocurrency exchanges and wallets to enforce KYC and AML compliance requirements, several areas of Asia are less strict because the local governments have not defined or decided what buckets cryptocurrencies fall into.5

There are some other noticeable gaps in this system involving crypto-to-crypto exchanges.  Irrespective of regions: implementing harmonized KYC/AML standards on the non-fiat side of exchanges appears to be missing altogether.  That is to say that very few, if any, exchange does any kind of KYC/AML on crypto-to-crypto.6

What are some examples of why a Kimberley Process would be helpful to both consumers and compliance teams?

Below are three examples:

(1) During my multi-country travel I learned that there are several regional companies that sell debit cards with pre-loaded amounts of cryptocurrency on them. Allegedly two of of the popular use-cases for these cards is: bribery and money laundering. The example I was provided was that it is logistically easier to move $1 million via a thin stack of debit cards than it is to carry and disperse bags of cash with.7

Attaching uniform KYC and legal identities to each asset would aid compliance teams in monitoring where the flow of funds originated and terminated with cryptocurrencies.  And it would help consumers shy away from assets that could be encumbered or were proceeds of crime.

(2) Affinity fraud, specifically housewives (家庭主妇), are common targets of predators. This has been the case for long before the existence of computers let alone cryptocurrencies, but it came up several times in conversations with friends. According to my sources, their acquaintances are repeatedly approached and some actually took part in Ponzi schemes that were presented as wealth management products.

The new twist and fuel to these schemes was that there is some kind of altcoin or even Bitcoin itself were used as payout and/or as rails between parties. We have already seen this with MMM Global — which is still an active user of East Asia’s virtual currency exchanges — but two questionable projects that I was specifically shown were OctaCoin and ShellCoin.8

Note: in January 2016 multiple Chinese governmental bodies issued warnings about MMM Global and other Ponzi schemes.

[Video of MMM Global operations in The Philippines. Is that really Manny Pacqiauo?]

Victims who were not tech savvy and lied to, have no recourse because there is no universal KYC / KYCC / AML process to identify the culprits in these regions.  Similarly, when these illicit virtual assets are re-sold to exchanges, customers of those exchanges such as Alice and Bob, may receive potentially encumbered assets that are then resold to others who are unaware of the assets lineage (much like a stolen motorcycle being resold multiple times).  This creates a massive lien problem.

But property theft is not a new or unknown problem, why is it worth highlighting for cryptocurrencies?

Many of the original victims in East Asia are not affluent, so these scams have a material impact on their well being. The average working adult in many provinces is still less than $500 per month. Thus not only do they lack a cushion from scams but any price volatility — such as the kind we continue to see in cryptocurrencies as a whole, can wipe out their savings.

(3) Due to continual usage of botnets and stolen electricity — which is still a problem in places like China — the lack of identification from coin generation onward results in a environment in which ‘virgin coins’ sell at a premium because many exchanges don’t investigate where machines are located, who owns them, who paid for the opex and capex of those operations (e.g., documentation of electric bills).9

Unfortunately, the solutions proposed by many cryptocurrency enthusiasts isn’t to create more transparency and identification standards enabling better optics on coin provenance but rather to make it even harder to track assets via proposals like Confidential Transactions.10

Heists, thefts and encumbered coins

I am frequently asked how is it possible to know who received potentially encumbered cryptocurrencies?  For amateur sleuths, there is a long forum thread which lists out some of the major heists and thefts that occurred early on in Bitcoinland.

Above is a video recording of a specific coin lineage: transactions that came from the Bitcoinica Theft that ended up in the hands of Michael Marquardt (“theymos”) who is a moderator of /r/bitcoin and owner of Bitcoin Talk.11

Recall that in July 2012, approximately 40,000 bitcoins were stolen from the Bitcoinica exchange.12 Where did those end up?  Perhaps we will never know, but several users sued Bitcoinica in August 2012 for compensation from the thefts and hacks.

How are consumer protections handled on public blockchains?

In short, they do not exist by design. Public blockchains intentionally lack any kind of native consumer protections because an overarching goal was to delink off-chain legal identities from the pseudonymous interactions taking place on the network.

Thus, stolen cryptocurrencies often recirculate, even without being mixed and laundered.13

Consequently a fundamental problem for all current cryptocurrencies is that they aren’t exempt from nemo dat and have no real fungibility because they purposefully were not designed to integrate with the legal system (such as UCC 8 and 9).14 Using mixers like SharedCoin and features like Confidential Transactions does not fundamentally solve that legal problem of who actually has legal title to those assets.1516

Why should this matter to the average cryptocurrency enthusiast?

If market prices are being partially driven by predators and Ponzi schemes, wouldn’t it be in the best interest of the community to identity and remove those?17

Perversely the short answer to that is no. If Bob owns a bunch of the a cryptocurrency that is benefiting from this price appreciation, then he may be less than willing to remove the culprits involved of driving the prices upward.

For example, one purported reason Trendon Shavers (“pirateat40”) was not immediately rooted out and was able to last as long as he did — over a year — is that his Ponzi activity (“Bitcoin Savings & Trust”) coincided with an upswing in market prices of bitcoin.18  Recall over time, BS&T raised more than 700,000 bitcoins.  Why remove someone whose activity created new demand for bitcoins? 19

But this incentive is short-sighted.

If the end goal of market participants and enthusiasts is to enable a market where the average, non-savvy user can use and trust, then giving them tools for provenance could be empowering.  Ironically however, by integrating KYC and provenance into a public blockchain, it removes the core — and very costly — characteristic of pseudonymous, censorship-resistant interaction.

Thus there will likely be push back for implementing a Kimberley Process: doxxing every step of provenance back to genesis (coin generation) with real world identities removes pseudonmity and consequently public blockchains would no longer be censorship-resistant.  And if you end up gating all of the on-ramps and off-ramps to a public chain, you end up just creating an overpriced permissioned-on-permissionless platform.

Despite this, Michael Gronager, CEO of Chainalysis, notes that:

Public ledgers are probably here to stay – difficult KYC/AML processes or not.  I probably see this as a Nash equilibrium – like in the ideal world all trees would be low and of equal height but there is no path to that otherwise optimal equilibrium.   We believe that fighting crime on Blockchains will both build trust and increase their use and value.

One way some market participants are trying to help law enforcement fight crime is through self-regulating organizations (SRO).

For instance, because we have seen time and time again that the market is not removing these bad actors from the market, several companies have created SROs to help stem the tide.  However, as of right now, efforts like the US-based “Blockchain Alliance” — a gimmicky name for a group of venture-backed Bitcoin companies — has limited capabilities.20 They have monthly calls to discuss education with one another in the West (e.g., what is coin mixing and how does it work?) but currently lack the teeth to plug the KYC/AML gaps in Asia.  Perhaps that will change over time.

And as one source explained: consider this, has any Bitcoin thief been caught?  Even when there is decent evidence, we are not aware of a Bitcoin thief that was actually found guilt of stealing bitcoin, yet.21  Thus an open to question to people who argue that cryptocurrencies are great because of transparency: a lot of bitcoin has been stolen, and no one has been found guilty for that crime.  Why not?

Process of elimination

Over the past six weeks, there has been very little deep research on why market prices have risen and fallen. Usually it is the same unfounded narratives: emerging market adoption; hedge against inflation; hedge against collapse of country X, Y or Z; hedge against Brexit; etc.  But no one provides any actual data, least of all the investors financing the startups that make the claims.

Perhaps the research that has been done on the matter was from Fran Strajnar’s team at BNC.  For instance, on June 1st they noted that:

brave new coinI reached out to Fran and according to him, in early June, “Somebody dropped many many millions ($) across 4 different Chinese Exchanges in a 2 hour period, without moving price – 4 days before the price rise started last week. Because it was over multiple exchanges and these trades were filled, we are digging into it further.”

If there was a standardized Kimberley Process used by all of these exchanges, it would be much easier to tell who is involved in this process and if those funds were based on proceeds of illicit activity.

Furthermore, barring such a Process, we can only speculate why journalists haven’t looked into this story:

(1) many of them do not have reliable contacts in East Asia
(2) those that do have contacts with exchange operators may not be getting the full story due to exchanges lacking KYC / KYCC / AML standards themselves
(3) some reporters and exchange operators own a bunch of cryptocurrencies and thus do not want to draw any negative attention that could diminish their net worth

Third parties such as Wedbush Securities and Needham have also published reports on price action, but these are relatively superficial in their analysis as they lack robust stats needed to fully quantify and explain the behavior we have seen.

Strangely enough, for all the pronouncements at conferences about how public blockchains can be useful for data analysis, very few organizations, trade media or analysts are publishing bonafide stats.

After all, who are the customers of these virtual currency exchanges?  Because of reporting requirement we know who uses Nasdaq and ICE, why don’t we know who uses virtual currency exchanges still?

Stopping predators

Two months ago I had a chance to speak with Marcus Swanepoel, CEO of BitX, about his experiences in Africa.  BitX coordinates with a variety of compliance teams to help block transactions tied to scams and Ponzi schemes. In the past, BitX has managed to help kill off two ponzi schemes and has tried to block MMM Global which has spread to Africa.

Earlier this spring, some MMM users that were blocked by BitX just moved to another competing local exchange that didn’t block such transactions. As a result, over the course of 8 weeks this exchange did more than 3x volume than BitX during same time frame.22 BitX has subsequently regained part of this market share partly due to MMM fading in popularity.

Why is MMM so successful?  Users are asked to upload videos onto Youtube of why MMM Global is great and why you should join and are then paid by MMM as a reward.  This becomes self-reinforcing in large part because of the unsavvy victims who are targeted.

But MMM isn’t to blame for everything.

For instance, in China there have been a variety of get-rich-quick Ponzi schemes that rose and blew up, such as an ant farm scheme in 2007.  And earlier this year, Ezubao, the largest P2P lending platform in China fell apart as a $7.6 billion Ponzi scam.23 No cryptocurrency was involved in either case.

Yet as Emin Gün Sirer pointed out, some of the activities such as The DAO, basically act as a naturally arising Ponzi.

In fact, one allegation over the past couple weeks is that The DAO attacker placed a short of 3,000 bitcoin on Bitfinex prior to attacking The DAO (which was denominated in ether).24  If there was a Kimberley Process in which all traders on all exchanges had to comply with a universal KYC / KYCC / AML standard, it would be much easier to identify the attackers as well as compensate the victims.

Similarly, because ransomware remains a “killer app” of cryptocurrencies such that companies, police stations, hospitals, elementary schools and even universities are now setting up Coinbase accounts and stockpiling cryptocurrencies to pay off hackers.  What is the aggregate demand of all of this activity?  If it is large, does it impact the market price?  And how would a Kimberley Process help provide restitution to the victims of this ransom activity?

A strawman Kimberley Process

How can you or your organization get involved in creating a Kimberley Process for cryptocurrencies?

Right now there is no global, industry standard for “best practices” in mutualizing, implementing, or carrying out KYC / AML provisions for cryptocurrencies.25

In writing this post, several sources suggested the following process to kick-start an effort:

(1) organize an industry-level event(s) which brings together:

(a) AML analytics companies
(b) representatives from regulatory bodies and law enforcement (e.g., FATF, FinCEN)
(c) KYC/AML practitioners
(d) existing market structures and utilities such as SIFMA, ROC, Swift (e.g., KYC registry, LEI)
(e) compliance teams from cryptocurrency exchanges and wallets

(2) at the event(s) propose a list of baseline standards that exchanges and wallets can try to implement and harmonize:

(a) what documentation is required for KYC / KYCC / AML
(b) other financial controls and accountability standards that can assist exchange operators (e.g., remove the ability for an operator to naked short against its own customer base)

(3) tying these standards together with a uniform digital identity management system could be the next step in this process.

On that last point, Fabio Federici, CEO of Skry (formerly Coinalytics), explained:

In general I believe the biggest unsolved problem is still identity and information sharing. Obviously you don’t want all your PII and transaction meta data on a public blockchain, as this information could not only be leveraged by profit seeking organizations, but also malicious actors. So the question becomes what’s the right framework for sharing the right amount of information with only the people that need access to it (maybe even only temporarily).

PII stands for personal identifying information.  In theory, Zcash (or something like it) has the potential to solve some of Fabio’s concerns: relevant info can be encoded in the transaction, and only the relevant parties can read it.  But this delves into “regulated data” which is a topic for another post.26

Similarly, Ryan Straus, an attorney at Riddell Williams and adjunct professor at Seattle University School of Law explained that:

Identity is central to the legal concept of property. Property systems are information systems: they associate identified entities with identified rights.  With the sole exception of real currency, possession or control is not conclusive indicia of ownership.

Factual fungibility simply makes it harder to prove that you have a better claim to a specific thing than the person who now possesses or controls it.  The hard part about what you have written about is that it is difficult to avoid conflating KYC (which involves identity of people) and the Kimberley Process (which involves identifying things).

In order to enable participants to share information without being unduly hounded by social media, it was also suggested that the presence of: investors, cryptocurrency press and cryptocurrency lobbying groups should kept to a minimum for the initial phase.

Conclusions

In addition to implementing additional financial controls and external audits, cryptocurrency exchanges and wallets adopting a Kimberley Process would help provide transparency for all market participants.

While it is probably impossible to remove all the bad actors from any system, reducing the amount of shadows they have to hide could provide assurances and reduce risks to market participants of all shapes and sizes.

However, the trade-off of implementing such a Process is that it negates the core utility that public blockchains provide, turning them into expensive permissioned gateways.  And if you are permissioning activity from the get-go, you might as well use a permissioned blockchain which are cheaper to manage and operate and also natively bake-in the KYC, KYCC and AML requirements.  But that is a topic for another post as well.

End notes

  1. One reviewer argued that analytics may be superior to KYC.  In the event of a compromised account — so goes the argument — analytics can help provide linkage between the flow of funds whereas KYC of compromised accounts would be “illusory.” []
  2. This includes but is not limited to: Chainalysis, Blockseer, Skry, Elliptic, Netki and ScoreChain. []
  3. Incidentally there is a UK-based startup called Everledger which works with insurance companies and tracks a catalogue of diamonds vis-à-vis a blockchain. []
  4. See: Flow of Funds; KYSF; KYSF part 2; and bitcoin movements. To actively monitoring transactions at these entry and exit points, based on anecdotes, up to 20% of all nodes on the Bitcoin network may be managed and operated by these same set of participants as well. []
  5. Note: it bears mentioning that as of this writing, no country has recognized cryptocurrencies as actual legal tender and consequently cryptocurrencies are not exempt from nemo dat. This is important as it means the provenance of the cryptocurrencies actually does matter because those assets could be encumbered. []
  6. I asked around and my sources do not know of a single exchange that does KYC/AML on cryptocurrencies that are directly exchanged for other cryptocurrencies (e.g., Shapeshift).  Furthermore, as highlighted in the past, there are gaps in compliance when it comes to certain fiat-to-cryptocurrency exchanges such as BTC-e and LocalBitcoins. []
  7. This is in USD equivalence, usually not in USD itself. []
  8. OctaCoin is interesting in that the operators behind it claim that it is financed from revenue streams of 3 online casinos who purportedly payout users on a regular basis. Note: gambling in China is a bit like golf in China: it’s illegal but everywhere. It is only legal in a few internal jurisdictions such as Hainan and Macau and elsewhere on the mainland only a couple of state-run lotteries are given legal status. []
  9. Note: stealing electricity to mine bitcoins has occurred in other areas of the world too, including in The Netherlands. []
  10. The official motivation for developing Confidential Transactions is to enable more user privacy which then leads to more fungibility. As one source pointed out: “At the end of the day it’s a balance between privacy and security. Basically the story goes ‘just because I don’t what anyone to know what I’m buying, doesn’t mean I’m a drug dealer.'” []
  11. Marquardt also allegedly co-owns both Bitcoin.org and Blockexplorer.com, and co-manages the Bitcoin Wiki. []
  12. Here’s another video showing some of those transactions. []
  13. The Craig Wright / Satoshi saga is interesting because in a recent interview Craig admittedly used Liberty Reserve which was an illicit exchange based in Costa Rica shut down by the US government.  According to the interview he also had ties to Ross Ulbricht, the convicted operator of Silk Road. []
  14. See The Law of Bitcoin, Section 1.5 in the United States chapter from Ryan Straus.  There are exceptions, see UCC Article 2 – sale of goods. []
  15. See also: Learning from the past to build an improved future of fintech []
  16. Interestingly, SharedCoin.com (sometimes referred to as Shared Send) used to be a mixer run by Blockchain.info, a venture-backed startup.  It was recently shutdown without any notice and the domain now redirects to the CoinJoin wiki entry.  They also pulled the SharedCoin github repo and any material that links it back to Blockchain.info. []
  17. One reviewer mentioned that: “Ponzi schemes will always exist and should probably be fought not just in the crypto space but where in other industries too; requiring continuous education.  It would be way simpler and more effective to shut down domains owned by MMM than it would to be to do anything else, but here you actually meet the pseudonymity feature of the Internet.  Try to do that internationally – it is not easy!” []
  18. From between September 2011 to September 2012 market prices more than doubled.  See SEC vs. Trendon Shavers []
  19. Note: this is a similar argument that Rick Falkvinge made three years ago. []
  20. There are probably several dozen advocacy groups and non-profit working groups scattered across the world.  Each has different goals.  For instance, ACCESS in Singapore works with some regulators in SEA.  While others are merely trying to create technical standards. []
  21. Most of the criminals that are convicted are found guilty of money laundering and interaction with illicit trade, not theft of bitcoins themselves. []
  22. Two months ago, the Financial Times briefly covered this story and Marcus wrote about some of it in March as well. []
  23. There were some early warning signs for that industry.  For instance, according to a Bloomberg story in February 2015: “The value of China’s peer-to-peer lending transactions surged almost 13-fold since 2012 to $41 billion last year, according to Yingcan Group, which tracks the data,” notes Bloomberg. However, 275 of the more than 1,500 lending went bankrupt or had trouble repaying money in 2014, an increase from 76 just a year earlier, according to Yingcan. []
  24. No one has proven this allegation.  Furthermore, there are multiple exchanges to short cryptocurrencies. []
  25. Much of the technology needed to implement these type of processes, such as PKI anchored by certificate authorities. []
  26. For example, see HIPAA and EU-US Privacy Shield []
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Self-doxxing, dynamic block making and re-decentralization of mining

There are currently two popular interrelated narratives on social media surrounding participation of the block making process on a public blockchain.  The stories are most pronounced within the Bitcoin community but are also reused by Litecoin, Ethereum and other cryptocurrencies too.

This includes the unchallenged statements that:

(1) anyone can still participate in block making, it is ungated and “permissionless”

(2) following a reward halving (“halvening”), networks become more decentralized because large, centralized farms and actors split apart due to economic pressures

This post looks at both of these and show that in practice neither is really true as of April 2016.

Named block makers

A year ago I reflected on some of the debate surrounding permissioned and permissionless blockchains.  Part of that post involved looking at how the mining market actually evolved in practice; not just based on the generalized claims made by enthusiasts at conferences.

For instance, based on block height below is a list of the first time a pool self-doxxed and signed a coinbase transaction, courtesy of Organ of Corti.  Only the first 50 are chronologically included:

Pool name                Block height                   Date
Eligius 130635 14-Jun-11
BitMinter 152246 7-Nov-11
BTC Guild 152700 10-Nov-11
Nmcbit.com 153343 15-Nov-11
YourBTC 154967 27-Nov-11
simplecoin.us 158291 20-Dec-11
Ass Penny Pool 161432 10-Jan-12
btcserv.net 163672 25-Jan-12
Slush 163970 27-Jan-12
BitLC 166462 12-Feb-12
pool.mkalinin.ru 170937 13-Mar-12
Bitclockers 173863 1-Apr-12
MaxBTC 174819 9-Apr-12
Triplemining 175144 11-Apr-12
CoinLab 180947 21-May-12
wizkid057 184148 12-Jun-12
Generated by General 194247 17-Aug-12
HHTT 197602 7-Sep-12
Ozcoin 207017 8-Nov-12
EclipseMC 208419 18-Nov-12
MTRed 219115 2-Feb-13
50BTC.com 219933 7-Feb-13
Bitparking 226272 17-Mar-13
Discus Fish 236494 17-May-13
ASICMiner 237050 20-May-13
ST Mining Corp 238456 29-May-13
Satoshi Systems 245445 8-Jul-13
GHash.IO 250205 5-Aug-13
175btc.com 253884 24-Aug-13
For Pierce and Paul 259214 21-Sep-13
Alydian5335 261051 1-Oct-13
Megabigpower 261530 4-Oct-13
GIVE-ME-COINS 267919 4-Nov-13
Polmine 282943 29-Jan-14
KoiSystems 285715 14-Feb-14
AntPool 286681 19-Feb-14
MMPool 294747 8-Apr-14
KNC Miner 300700 14-May-14
Bitfinex pool 306406 18-Jun-14
BitAffNet 309657 8-Jul-14
Bitfury 311333 18-Jul-14
Hashmine.io 313882 4-Aug-14
Solo.ckpool 319980 10-Sep-14
Kano.is 325306 14-Oct-14
BTCChina Pool 327211 27-Oct-14
Tangpool 339210 16-Jan-15
For Pyra 339547 19-Jan-15
BW Pool 341167 30-Jan-15
Huobi 341760 3-Feb-15
Dot pool 342104 6-Feb-15

Recall that even though it didn’t initially sign coinbase transactions, Slush began publicly operating at the end of November 2010.  Eligius was announced on April 27, 2011.  DeepBit publicly launched on February 26, 2011 and at one point was the most popular pool, reaching for a short period in July 2011, more than 50% of the network hashrate.

While many enthusiasts claim that “anyone can mine,” in practice, very few choose to for a number of reasons that will be discussed below.

But more to the point, the reason cryptocurrencies allegedly have a “permissionless” characteristic in the first place has to do exclusively with the fact that there is no administrative gating or vetting process for allowing actors on the network to participate in the block making process.  In 2009 there was no whitelist, blacklist, KYC or KYM (know your miner) process.

That is to say, those wanting to create a block did not need permission from a network administrator.1  That is the sole context of the term “permissionless.”

It is not related to developing other platforms that plug into the network.  It is not related to whether the network codebase is open source or not.  It is not related to being able to build software products that somehow utilize the network.  It is not related to being able to view or not view transactions.

Yet due to how the market evolved, today in 2016 while everyone is still paying for the high marginal costs to maintain a network designed for pseudonymous and anonymous interaction, few participants, specifically block makers, are actually capitalizing off of that utility.

For instance:

(1) Acquiring the necessary hardware to become a profitable miner invariably leaves a paper trail.  If instead you acquire the hardware on the second-hand market — in order to remain anonymous — you will still likely leave a paper trail with your legal identity in order to pay for the large energy bill and property taxes.  This is one of the reasons why miners in locations such as China do not publicize their fundraising activities or annual revenue: they don’t want to leave a paper trail to pay any extra taxes.2

(2) The other main mechanism for vetting miners now is through the use of data science itself.  Roughly 10 companies globally provide law enforcement, compliance teams and regulators access to relatively robust analytics tools to track provenance of bitcoins (or other cryptocurrencies) back to coin generation itself.  And in order to sell these mined bitcoins (e.g., to pay for the electricity and the mining hardware), nearly every bitcoin conversion to fiat marketplace now requires some compliance of local KYC and AML regulations.

While there are workarounds such as LocalBitcoins and SharedCoin, generally speaking the pseudonymous network itself in 2016 has largely become doxxed.  Yet the high costs of maintaining pseudonymity, via proof-of-work, still remain.

Hashrate distribution

Above is a pie chart that estimates the hashrate distribution among mining pools over the past 4 days (as of late April 2016).  The 10 largest pools collectively made 97% of the blocks during that time period.3

What about beyond 4 days?

Blocktrail

Source: Blocktrail

Above is the pool distribution of the past year based on coinbase data aggregated by Blocktrail.

The 10 largest pools collectively account for roughly 91.6% of all block making activity.  There is also a relatively long tail that includes roughly another 60 entities (some of whom do sign coinbase transactions) that represent the remaining 8.4% of all block making the past year.

Why do any actors sign transactions at all, after all, isn’t a core characteristic of a public blockchain pseudonymous consensus?  To my knowledge, no one has formally published a thorough explanation for the reasons why.  But one repeated rationale is that pools do so in order to prove to the miners (hashers) connected to the pool what the provenance of the block reward income is.

What does that mean?

For those who have never partaken in the mining process before, a quick history lesson: within the first two years of Bitcoin’s existence a division of labor arose in which block making became separated from hashing itself (e.g., generating proofs-of-work).

That is to say, the security of network security was outsourced to entities who create proofs-of-work and who are colloquially referred to as miners.4  Miners, in return for steady payouts of income, send their work to a pool operator who subsequently batches transactions together into blocks and pays workers based on a pre-arranged agreement (usually proportional, share-based).5

Today, if average Joe buys ASIC mining equipment, he typically does not connect them to his own pool but instead connects them to a pool run by Bob the devops professional.6  And how can Joe trust Bob not to shave off pennies from each share of work that Joe submits?

Block signing in theory provides some semblance of transparency: letting the hashers know if pool operators are skimming off the proceeds by not accurately reporting blocks found (e.g., income).

For instance, if a pool operator makes a block based off of the proof-of-work submitted by one of the hashers connected to a pool, such as Joe, but does not sign the coinbase, the pool operator can try to pretend that it didn’t win the block reward in the first place and therefore would not have to pay the workers (hashers).  This was allegedly more commonplace prior to 2013, before the advent of VC financed farms and pools.7 Now many of the medium and large hashing farm operators want to know the exact revenue number and hear good reasons for why some is missing or if the pool was just “unlucky.”8

Why doesn’t everyone become a block maker, after all, the process is billed as being “open” to all?

There are multiple reasons why, but the most important reason boils down to economics.  Dave Hudson has written about 10 different articles on the baked-in variance (inhomogenous Poisson process) that motivates individuals to continually pool  their mining effort versus solo mine.9 Spoiler alert: you are likely to be struck by lightning before you will ever create a block and reap a block reward by solo mining off of your laptop at home.

Other reasons for why few decide to become block-makers include: the added costs of providing DOS protection to your pool and the need to hire competent staff that can prevent and be on the lookout for problems like BGP hijacking which results in lost revenue.

This has not changed for multiple years and will likely not change for reasons discussed below.

Non-existent re-decentralization

With the upcoming Bitcoin block reward halving that is expected to take place in mid-July, there is a growing chorus of ‘hope’ that it will somehow lead to fewer large mining farms and pools.

This probably won’t occur for several simple reasons, namely due to economic incentives.

Recall that the major reasons why mining activity itself has gravitated to locations such as China isn’t due to conspiracy theories involving lizards but instead ancillary costs.

Specifically the following factors:

  • relatively low labor costs (e.g., professional hashing facilities need to be maintained by a workforce 24 x 7 and wages in China are lower than Russia and the US for this activity)
  • relatively low property costs (e.g., if you have good guanxi, you can utilize and own land at rates below those found in parts of Russia and the US)
  • lower energy costs; I and others have frequently written about this10
  • first-to-market with hardware; because a lot of the final assembly of hashing equipment takes place in southern China, in terms of logistics and transportation end-users have a lead-time advantage over other geographical regions
  • close personal connections with hardware manufacturers and fabrication plants in China and Taiwan; acquiring hardware for mining cryptocurrencies is just as relationship driven as other specialized non-commoditized industries.  Because medium and large miners know who the chip design teams are and what the ASIC roadmaps will be, they can stand in line at the front and acquire hardware before others.

What will happen after a block reward halving?

Just as oil producers with the highest marginal costs have been forced to exit the fracking market over the past couple of years, Bitcoin miners with the thinnest margins will likely exit the market immediately.

What this actually results in, at least the short run, is a more concentrated group of larger hashing farms and pools.

Why?

Because miners as a whole are effectively being given a 50% pay cut to provide the same utility as before.  And ceteris paribus, if Alice doesn’t currently have thick 50% margins, then she will likely exit the market.

In contrast, some of the most profitable miners in China and Republic of Georgia are now operating — even with the large difficulty rise over the past 6 months — with 50+% margins.  They may be squeezed, but they do not have to exit the market.

Basically, the less efficient players will be squeezed out and the more efficient players will remain.  Who is likely be be more efficient?  Larger farms in cheaper locations, or smaller pools made up of less sophisticated players with less capital?

But if the price of cryptocurrencies rise — in this case bitcoins — then won’t former miners come back into the market?

Maybe, but recall, we have seen this song and dance before and it is likely that the block reward halving is already factored into both the current market price and the hardware replacement cycle and as a result there probably will not be a doubling of the market price of bitcoins.  However, that is a topic for a different post.

Other public blockchains

What do mining pool distributions look like for other cryptocurrencies?

Above is the distribution of mining pools for Litecoin over the past day.  Interestingly, Coinotron — a pool I used when mining 3 years ago — currently represents 2.8% of the block making during that time frame.  Two years ago, in May 2014, it represented about 50%.

In August 2015, Litecoin underwent its first block reward halving.  Contrary to popular belief, its market price did not double.  In fact, nine months later the price of a litecoin measured in USD is just fifty cents higher than what it was pre-halving.11

Ethereum mining pool

Source: Etherchain

Above is the distribution of mining pools for Ethereum over the past day.

Interestingly Ethereum formally launched in August 2015 and has seen the same consistent pattern of 3-4 pools representing the majority of block making activity as other cryptocurrencies have witnessed.

In fact, Dwarfpool, despite its name, has flirted with the 50% threshold several times, most notably in March.  The Ethereum development team plans to transition the network from proof-of-work to proof-of-stake (Casper) later this year; it is unclear if the “staking” process will result in similar centralization.

Other cryptocurrencies continue to face similar pool centralization. This includes Namecoin which last year saw one pool, F2Pool provide more than 50% of the network hashrate for multiple months.  While it does not appear that F2Pool behaved maliciously, the fact that one block maker could potentially rewrite history by doing block reorgs motivated Onename to migrate away from Namecoin.

China

It is surprising that with the 60%+ hashrate located in China that there is scant detail in English about how that ecosystem works.  But there are reasons for this.

Recall that based on the current 25 BTC block reward, roughly $450 million in mining rewards has been divvied out over the past year to miners.  On paper that would mean that China-based miners received more than $270 million in revenue, which cements this industry as one of two that continually see large annual revenue flows (the second being exchanges themselves).

I contacted a mining operator in China that currently operates about 40 petahashes per second in equipment.  Note: miners use the abbreviated term ‘P’ and ‘PH’ to denote petahashes per second.

According to him:

“Our public hashing number is based on all our own hardware. This includes two facilities in western Sichuan plus a new Xinjiang site. All of these machines were originally S3’s from Bitmain but we have replaced them with S7’s.  We want to build larger operations than what we have today, but our goal is to maintain a specific percentage of the entire network.”

“Remember our electric rates changes from season to season: different time of year and that hydro power has problems in the winter because of less melt water which results in an energy price that is twice as the rate in the summer.”

“The land is basically free because it is in the mountains and no one is interested in buying property there. So all it takes is construction materials and labor. We hired 10 people last year. We intentionally hired more than we needed so we can build a team and send them places. Our front end operation probably only needs 4-5 people and we pay them $1,000 a month which is actually very competitive for that region.”

“We know a Chinese guy, Mr. LY.  He lives in Sichuan and was originally a hydroelectric operator but now owns his own hydro power station. He learned he could make more money mining than just running the station.”

“Why are people like us able to be competitive?  In Yunnan, Guizhou and Sichuan there was an overinvestment in hydropower last decade and now there is a surplus of electricity.12  Dam operators couldn’t sell the electricity generated so that’s where Bitcoin miners moved to. Also, in Liaoning, some people can free electricity because of the proximity to oil fields – they are given cheap electricity to local residents as compensation for confiscated land/polluting the environment — it is subsidized electricity.”

“No one really pays taxes because miners don’t generate something considered valuable. That’s to say from the perspective of taxpayer, miners don’t generate something of value, because the government doesn’t really recognize bitcoin. Bitcoin mining isn’t illegal, we still pay a small amount of taxes but it’s like running a company that doesn’t make money. Instead a miner just pays a small amount of taxes and all the profit is invisible to the law as it stands today.”

I also reached out to another mining operator based in southern China who explained that in practice, mining farms that produce 1 PH or more are usually not based in cities:

“Most of the time they are not in cities, more like in the middle of nowhere and it would be inaccurate to name towns.”

Instead he listed provinces where they are spread out including: Heilongjiang,Liaoning, Hebei, Sichuan, Tianjin, Anhui, Jiangsu, Ghuizhou, Inner Mongolia, Shanxi, Guangdong.  “Shenzhen for sure, there are testing facilities that are easily over 1P.”

What about ‘subprovincial’ locations?

“It is inaccurate to present information that way.  A lot of the time, the sites are between borders because it’s in the middle of nowhere.  And it normally spreads over lots of sites.  One place has nearly 200 sites crossing two provinces; a lot of small ones representing about 100KW of power each.  They are spread over several hundred kilometers; no economy of scale after a certain point.”

No service-level agreements

This type of self-doxxing, quasi-dynamic environment has led to another interesting phenomenon: ad hoc customer service via social media.

For example, two days ago, a user sent approximately 291.2409 bitcoins as a mining “fee.”13  A small pool called BitClub Network built the block that included this fee.  This fee is equivalent to about $136,000.

The community as a whole then began a crowdsourced investigation into who may have sent this fee and the motivations for doing so, with many believing it to be a mistake.  After all they reasoned, a typical “fee” that most mining pools require in order to be included in the next block is usually less than 25 cents on most days.

A user affiliated with BitClub has since publicly stated it would like to return the fee to the original entity that sent it, though it is unclear if he is speaking with any authority or if the whole thing was a ruse to begin with.

But, as I have argued before, this not only sets a bad precedent for miners as a whole due to a loss of revenue from the forthcoming ‘halvening,’ but the ability to contact a block maker sets a dangerous precedent for the core utility of the network: the disappearance of pseudonymous consensus.

Or as one redditor adroitly pointed out:

Or in other words, if block making was actually pseudoymous and decentralized, with 100+ unidentified pools creating blocks each day, it would be difficult if not impossible to locate and provide timely customer service to a user who made a mistake.

For instance, the most well-known block reorg occurred in March 2013 and it was only resolved when miners, including Slush and BTCGuild, contacted and coordinated with one another via IRC.  If the network was more decentralized and pseudonymous, this coordination would have been very difficult to do, and this was by design.

I pointed out this irony on Twitter earlier this week as well: that there are trade-offs with this approach and the downside of using a bearer asset-based system that had no service level agreement, no EULA, no terms of service results in a world in which users who make mistakes have to complain on social media and hope someone is charitable.

And this happens on a regular basis: earlier this month a user accidentally sent 13.65 bitcoins to the BTCC pool and used reddit as his customer service forum.

That type of friction is not what most consumers want.14  It is a poor user experience which has gradually led to the creation of ‘trusted’ intermediaries in this ecosystem which as described in previous posts, recreates the existing financial system but without the same level of oversight and financial controls.

The cryptocurrency community is learning the hard way why intermediaries exist, why SLAs exist, why legal identities are required for financial transactions, why consumer protection laws arose and so forth.  Pointing out these patterns is not malice or due to a lack of understanding of how cryptocurrencies work, but rather it serves as illustrations for why it has been hard to find real sustainable traction in the space.

How else is this visualized?

scaling bitcoin panel

Source: Jameson Lopp

This past December an event was held in Hong Kong called “Scaling Bitcoin.”

One of the sessions involved a panel comprised of the world’s largest mining farm and pool operators.

The individuals in the photo above allegedly represent about 90% of the network hashrate.

Thus, for all the hype around “trust anchors” tied into public blockchains such as Bitcoin, claims of decentralization and “trust-lessness” are empirically untrue.

In practice, due to centralization and identity leakage, the cost to successfully reorganize a block isn’t through a Maginot Line attack (e.g., via hashrate), but through cheaper out-of-band attacks, such as hosting events in which self-doxxed miners participate.  But that is also a topic for a different post.

Conclusion

16 months ago, Vitalik Buterin and others jokingly quipped that the trends towards centralization in Bitcoin mining (and other cryptocurrencies) resulted in a world where each coinbase transaction effectively arose from a multisig process.

To quote Buterin: “with Bitcoin, we’re paying $600 million a year on a 5-of-10 multisig.”

10 is roughly the amount of quasi-permanent block makers in a given day.  And $600 million was the amount of revenue that miners received at that time due to the higher market value of bitcoin.

In theory, anyone can turn on their computer and hope to become a block maker on a public blockchain — no one has to register with a “Blockchain Admin” because there is no admin.  However, in practice it requires a certain amount of technical knowledge and more importantly, capital, to profitably and sustainably operate a mining farm and pool.

And in order to scale this profitably, in practice, most miners at some point reveal their legal identities thereby negating the core characteristic of a public blockchain: pseudonymity.  How?  Miners, after having erected purpose-built facilities or to liquidate their holdings, may be required by external authorities to go through a gating / vetting process (such as KYC).

Ironically, a substantial increase in cryptocurrency prices may inevitably result in self-doxxing of all major farms. How?  As market prices increase, miners in turn expend more capital to increase their own hashrate to chase the seigniorage rents.

Because of the KYC requirements of utilizing resources like electricity at a hydroelectric dam and the subsequent identity leakage, this turns the block making process itself into a mostly known, permissioned activity.  Consequently, based on this past history, the term DMMS should probably be qualified with a “quasi” modifier in the front: QDMMS.

Similarly, while many enthusiasts have been led to believe a block reward halving will somehow re-decentralize the mining ecosystem, the fact of the matter is chip performance (as measured in hashrate efficiency) is only one factor in the total calculation that professional miners must account for.15

Furthermore, semiconductor engineering itself is effectively on a known, mature trajectory and which appears to be lacking any significant leaps in technological improvement.  The largest entities, such as Intel, see this relatively static path which is one of the reasons why they have formally abandoned their tick-tock roadmap and now plan to lay off 12,000 people.

In contrast, energy prices, land prices, labor costs and taxes are among other major components that professional mining operators look at as a whole and decide whether to stay in a market or not.  Even if there is some price increase after the halvening, home mining by amateurs outside of China will likely continue to remain unprofitable after July.

Thus a year from now the mining ecosystem will probably look a lot like it does today, with most farms and pools being self-doxxed and relatively centralized.16

[Special thanks to Antony Lewis for his constructive feedback]

Endnotes

  1. Censorship-resistance is an emergent property that arises from this design.  See also: Settlement Risks Involving Public Blockchains []
  2. There are other reasons too including not wanting to divulge any comparative advantage they might have that would incentivize new entrants to come into the market. []
  3. Note: it is believed that some large mining operators, such as Bitfury, may actually spread some of their hashers (workers) across multiple pools, in order to reduce their own pool percentage and thereby reduce the concerns over centralization.  This can only be proven with an on-site physical audit. []
  4. There has been research done on non-outsourceable block making. See Nonoutsourceable Scratch-Off Puzzles to Discourage Bitcoin Mining Coalitions by Miller et. al. []
  5. Analysis of Bitcoin Pooled Mining Reward Systems by Meni Rosenfeld []
  6. Most of the pools in operation do not require documentation of equipment or legal identification of miners. []
  7. Note: technically speaking nothing is stopping mining pools from signing blocks and in fact, some do it for advertising purposes. []
  8. There is also a term-of-art called “luck” which Organ of Corti and others analyze on a regular basis. []
  9. Incidentally for those wanting access to the block-making superhighway, to reduce orphan rates, there exists a centralized service: Bitcoin Relay Network. []
  10. See also Appendix B and Section 2 []
  11. Note: Dogecoin began to merge mine with Litecoin in September 2014 and in terms of hashrate the two have moved in tandem with one another ever since. []
  12. China’s water hegemony in Asia from Livemint []
  13. Note: a fee implies something that is mandatory.  The discussion surrounding what is and is not a fee or how it should be calculated and applied is a contentious topic in the cryptocurrency community. []
  14. Cryptocurrencies are effectively designed ‘for cypherpunks by cypherpunks.’  While caveat emptor may be desirable to certain demographics, others prefer consumer protection which bearer-based systems do not have. []
  15. Note: in terms of efficiency, 28nm chips are usually in the range of 0.25-0.35 watts/(gh/s), while the newer 14nm or 16nm ones are more likely 0.12 watts/(gh/s) or less. []
  16. See also: Permissioned-on-permissionless []
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A few known Bitcoin mining farms

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Liquid Bitcoin

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

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

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

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

May Bitcoin Fee

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

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

Do we know about other farms?21

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

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

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

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

HaoBTC

HaoBTC staff installing hashing equipment. Source: Eric Mu

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

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

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

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

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

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

Are there any other known facilities outside of China?32

Genesis Mining

Source: Business Insider / Genesis Mining

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

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

What does this have to do with colored coins?

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

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

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

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

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

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

A couple days ago, on Monday, I was on a panel hosted at Stanford University as part of the “Blockchain Global Impact” conference.  The panel covered remittances, unbanked residents and financial inclusion.

Below is a presentation I put together based on research for Melotic, for SKBI in Singapore and in preparation for the panel.

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Air pollution and the environment in China

About two weeks ago an in-depth investigative report covering the impact of pollution on the environment in China was uploaded and published on a number of Chinese video streaming sites.  It is called “Under the Dome” (based on the TV show).  It was an instant hit and reached over 200 million views within its first week — thereupon it was removed, scrubbed from the Chinese internet by censors.

I lived in three different cities during my five-year stay in China and the pollution varied from location to location.  Fortunately I spent the vast majority of the time in the south — which has its own issues — but the air was almost always better than the type found in the north and specifically in the Beijing metro.

This is not to say there were not very bad air pollution days too.  I recall my last week in Shanghai, in December 2013 (prior to moving to California), that in the twilight hours the smog was so thick that I couldn’t see the flashing red lights atop of the apartment I lived in.

It was bad enough that it earned its own Wikipedia entry and a number of news outlets wrote a few stories on it:

Below is the full version with English subtitles:

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The concept of night and day are archaic to a network that never sleeps

I have a couple new articles published over the past few days.

The first one, “The Rise and Rise of Lipservice: Viral Western Union Ad Debunked” is over at CoinTelegraph and deals with the remittance industry.  Note: my original title included just the first 6 words, CT added the remainder including “debunked” which is probably apt.

Why spend time writing about this?  Because it is increasingly clear that keynote speakers in this industry are factually wrong about many things, including the various margins that money service organizations (MSO) like WU have.  For instance, yesterday there was a really good thread on reddit that broke down the erroneous claims from Andreas Antonopoulos regarding the margins that WU and others have, it is wrong by an entire order of magnitude.

The second article is, “Too Many Bitcoins: Making Sense of Exaggerated Inventory Claims” at CoinDesk.  Note: original working title was “Where is the inventory? Making sense of disaggregated inventory pools and financial controls” — I do have to say I like the CD editors choice, it’s much better!

Over the past year as I conducted interviews for my research I would often hear stories of how such and such owned X amount of bitcoins.  In just a six month period it became pretty clear that someone somewhere was embellishing because there just aren’t that many bitcoins around.  This was especially true once you start hearing rumors of the amount of bitcoins that large holders in China claim to have.  Which side of the Pacific is exaggerating more?

A few things were cut in the 2nd article to slim it down a bit and also because it meandered a little.  Here are a few of the items:

  • While an imperfect facsimile a UTXO (unspent transaction output) or bitcoin, is not equivalent to equity.
  • Remember, pre-Artforz, miners and hashers were one and the same, so a DMMS was not a farm or pool back then as it is today.
  • Some of these exchanges started within a niche such as futures speculation. For example, Bitfinex originally shared (mirrored) the Bitstamp order book and later, after growth, established their own thereby allowing their customers to partake in price discovery through the spot market (e.g., providing bids and asks). Others such as Coinbase effectively operate what Coindesk calls “a Universal” — that is as a hosted wallet, merchant processor and exchange — albeit without a users ability to speculate on the bid/ask of a token (in most cases Bitstamp acts as their liquidity provider who in turn receives coins from miners and so on).
  • This year alone, several exchanges have been hacked and/or customer funds were stolen by insiders, including Mintpal, BTER, CoinEx, Coinmarket.io, Neo & Bee (it wasn’t an exchange per se, it collapsed too soon to figure out what they meant, if at all, to do) and most prominently, Mt. Gox.  Despite a spectrum of counterparty risks and the advent of decentralized and multisig trading (eg the Counterparty DEx and Coinffeine), traders, on the whole, still prefer to use centralized exchanges due to their trading speeds (milliseconds instead of 10+ minutes).
  • ~300 ATMs globally

Lastly, a friend of mine, Anton Bolotinsky sent me some additional feedback that may be of interest to some readers:

The statement: “Also, withdrawal time from an exchange is not necessarily related to the price of bitcoin.” Seem to be out of context.

I’d assume it’s about market phenomena – which will move price if people withdraw both btc and fiat positions from exchange. They would either have some very fast cash deposit/withdrawal mechanism to be able to do it daily. Alternatively, at the end of the day, they would convert fiat to btc, and withdraw btc. This would move the price.
If fiat positions are not liquidated, withdrawing only btc, will reduce risk exposure to 50% on average. And will create evening & morning blockchain transactions spike – btc from exchange to wallet, and back. I can’t see anything like this happening.

Another thing that somebody will probably comment: btc exchanges, unlike NYSE, work 24/7, nothing besides trading volumes (maybe) changes. So notion of doing something for night might be archaic:)

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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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Explaining trading volumes in China

CoinDesk recently reached out to me to ask and see if I had any views on the divergent Bitcoin trading volumes between China relative to the rest of the world.  The piece they ran included a few of my comments as well as some from several other traders and exchange operators, “China’s Market Dominance Poses Questions About Global Bitcoin Trading Flows.”

Readers may also be interested in a few other comments I provided them, a few of which are slightly edited (removed some names and numbers):

  • I should preface this by saying that the OTC/off-chain liquidity/inventory is something that is not being factored into most of the overall discussion on trade volume.  I know that all the mining farms in China have liquidity partners (usually with the big three exchanges) and I could introduce you to one in particular who might be willing to talk on the record, or at least give you color.  The reason I mention this is because if you can some how dig up the OTC/dark inventory numbers, the aggregate volume might actually be larger in USD than RMB (at least, that would be my guess).
  • To answer your first two questions I think it bears mentioning that there really hasn’t been any new VC-backed exchange that has setup in the US in the past 6 months or so (itBit moved its SG operations to NYC).  Perhaps once the legal issues are more defined this can change.
  • In addition to having no fees on trades, I think this short comment on reddit describes some of the internal structural differences at the Chinese exchanges for question #3.
  • They’re busily trying to answer question #4 with a variety of value-added services like margin trading and issuing of derivative products as well as integrating with API services and even building out support for mining contracts (BTCChina apparently just acquired a mining pool/farm to do just that).
  • As far as your last question, I think it would be fair to say that public/open consumer-based exchanges are centered in China, but based on the OTC numbers that I hear throughout each month, USD is still probably bigger.  For instance, BitPay sells around XXXX BTC a day to its liquidity partners. That’s usually more than ______ does (at least this past summer).  Their daily sales are chopped/sliced up and sold to liquidity partners.  Charlie Shrem briefly touched on this a week or so ago.
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False analogies in Bitcoinland plus Alibaba

Saw two analogies used today that are inaccurate.

Writing at Forbes, Eric Mu interviewed Jake Smith, better known as “The Coinsman.”  Jake was responding to a comment I wrote last month:

Tim Swanson, the author of The Anatomy of a Money-like Informational Commodity, recently said that you missed the “unseen calculation, the economics of extracting and securing rents on this ledger unit, which consume scarce resources from the real economy.” – Do you think he is wrong?

I think attacking mining from an environmental point of view is quite silly, because pretty much everything in the modern era relies on resource consumption, and for the vast majority of those things society has decided that the trade-off is worth it. I think Bitcoin is one of the most valuable and revolutionary inventions the world has ever seen, so even if it is using a lot of electricity I don’t think that’s a valid criticism against it. The internet uses vastly more electricity than Bitcoin, no one is bashing the internet for using resources.

Swanson’s quote would also imply that Bitcoin is not part of “the real economy”. I would say that by virtue of its existence, it is.

Further, Bitcoin’s value is derived in part from the fact that it is difficult to create.

The biggest problem with the analogy above, which is commonly used by Bitcoin advocates, is that it is not an apple’s to apple’s comparison.  In this instance, Bitcoin acts as a distributed Excel workbook, a spreadsheet application that uses the internet to distribute itself.  Thus it is incorrect to equate it with the much broader umbrella that is the entirety of the internet.

This same problem happens when people claim that Bitcoin can and/or will replace the banking system.  For instance, last month Jake interviewed Nan Xiaoning, CEO of Bitocean:

I think Satoshi had a lot of foresight in this regard. He wasn’t a dummy, I’m sure he considered different ways of distributing coins.

Some people say that bitcoin wastes a lot of electricity. But the banking industry surely uses more resources than bitcoin does. But bitcoin is a peer-to-peer system. I think using resources to guarantee its security and stability is the way it should be.

Another inaccurate analogue/comparison.  Bitcoin’s protocol does not provide any of the functionality of the banking system beyond a security lock box (that should not be confused with a distinctly different term, a savings account) and a corresponding ledger of access and usage (the debate over whether or not someone “owns” a privkey corresponding to a UTXO it is still being argued over by lawyers globally).  The current protocol does not natively allow for lending, saving, notary, underwriting debt and equity or setting of interest rates (among many other services real banks actually provide).

In both cases above the examples above miss the forest from the trees.  As Robert Sams pointed out a few days ago, the proof of work mechanism used in Bitcoin was designed to make Sybil attacks expensive.  The verification process is a marginally trivial task and can be handled (and in practice actually is handled) by mining pools via small computers such as a Pi-based box.

How specialized is the hashing (not verification) process?  A good comment on reddit yesterday noted that:

Rather than taking the whole header, they mine using something called a midstate. Due to the nonce being at the end of the header, the software hashes up to just before the nonce, and then sends that (called a “midstate”) to the mining chip. The mining chip then only needs to add a nonce, do the end of a SHA256 round, and then one more, and then check if the result is good enough. Rather than returning data, they just return nonces which look to be valid.

Instead, a more accurate way to look at this issue is from the spectrum of centralized to decentralized (which was also discussed by the Hyperledger team in an interview a couple days ago).

Centralized tools and services have certain vulnerabilities (e.g., single point of failure and potential abuse) but its cost basis is different than say, a decentralized entity.  The economics of both need to be accounted for (and are) when rolling out a new system internally (this is called the Total Cost of Ownership).

On the other end, decentralized systems are less vulnerable to some of the same issues that centralized systems are, yet to make them less vulnerable in fact requires consuming scarce resources that centralized solution do not have to (because they are trusted networks).  In the case of Bitcoin, bitcoin miners (or technically hashers) effectively destroy (or “burn”) a corresponding amount of energy (technically exergy) to protect the network from Sybil attacks on an untrusted network.  This is a real cost that cannot be ignored yet as shown above, is often handwaved away.

[Note: as an aside, most miners, mining farms and mining manufactures do not pay for their capex or opex in bitcoins, nor is this likely going to change anytime soon.  Instead they must rely on and permaborrow the unit of account of fiat (typically a USD or RMB) to effectively measure and allocate resources.  This unit of account issue — wherein economic activity within the Bitcoin world is measured with the unit of account that is fiat to create this network — was also broached by Robert Sams several months ago.]

Furthermore, as I mentioned in chapter 8, if the TCP/IP analogy was correct then the marginal revenue for ISPs would split in half every 4 years.  And that through competition the marginal cost of protecting and sending packets would equal the marginal value of those packets.  This would not be an effective way to run a business let alone design a network topology.

In the real world, the marginal costs of running an ISP, which is centralized, have to be less than the marginal revenue otherwise they go bankrupt as they could not pay for overhead.  So yes, in fact, ISPs do try to actually mitigate the leakage, wastes and otherwise inefficiencies in its own internal network and they do this through a myriad of ways.

Bitcoin’s existence is on the other side of the spectrum.  Bitcoin was purposefully designed to make it cost prohibitive to spam ownership change on a public, untrusted network — the complete opposite in organization that an ISP is designed to operate as.  The average person would likely see this as inefficient, but that is because up until the past decade — with the advent of Bittorrent and other distributed systems — the public at large was unfamiliar with how these systems are designed.  And as Sams pointed out, using the word “efficient” versus “inefficient” may not be the most accurate terminology, because each model has different attack vectors they have to account for.

Thus again, it is not about being pro or anti proof-of-work.  Rather it is acknowledging that proof of work requires a certain economic model that have real costs that scale with token value and in the case of Bitcoin, is not environmentally “greener” than some centralized solutions (e.g., ApplePay).

The case of Alibaba

Over the past couple of days some Bitcoiners have recently claimed that the recent dip in market prices for bitcoins is because of the Alibaba IPO; “Alibaba’s US IPO May Have Crashed the Bitcoin Price.”

Not only does this show that several vocal Bitcoiners are unfamiliar with how real IPOs work (underwriters typically represent the lion’s share of additional equity ownership and the date is fixed weeks and months ahead of time) but that it illustrates how some Bitcoiners like to blame people and go on a witch hunt when prices decline but then reassure themselves that they are investment geniuses when prices trend northerly.

In point of fact, the Alibaba IPO was not a surprise to anyone, the investors are all large financial institutions and not hoi polloi.  The IPO was oversubscribed and not even well heeled, well connected HNWIs could get into an allotment — only banking institutions were able to because of the enormous demand.  And none of those institutions are: 1) large bitcoin holders and 2) needed to sell bitcoins to raise funds to buy Alibaba shares.

Perhaps this will change in the future, but that is not the case in this instance (be sure to also check out Izabella Kaminska’s lively twitter feed).

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Cryptocurrency in the news #26

Closing tabs.  Some China related news scattered below as well.

The Bank of England published a couple of papers that have been making the rounds.  One area of contention, by some, is a section in the 2nd paper The sustainability of digital currencies’ low transaction fees which discusses some of the issues brought up in Chapter 3.

Link is not an endorsement of service or coin.

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Some costs and pictures of Bitcoin mining in China

Jake Smith has another good article / overview of a large Bitcoin mining operation in China, “Inside one of the world’s largest bitcoin mines.”

The article states that this operation’s output is roughly 5% of the entire network hashrate and the electrical costs for it are about $1 million per month.

A couple guys on reddit did the math and came up with these other two numbers:

  • $1 million electric bill per month = $33000 per day/$500(price of btc) so they need to mine 66 btc/perday just to cover electricity.
  • If they have 5% of the network, then it’s 3600*0.05 = 180 bitcoin per day, or about $90k.

So they are generating $90,000 in revenue per day yet fully 1/3 of the costs are soaked up by electricity.  Note: Last month, the  bottom line price at a farm like this, to “create” a bitcoin was 2700 RMB ($444).

What this means is that if this is the most efficient set up possible (economies of scale via low labor costs, quick installation from manufacturer, relatively cheap land prices, relatively competitive electrical rates) then to power the rest of the Bitcoin network with similar data warehouses, the global cost for electricity alone would be around $240 million a year.  Obviously this may not be the case as each geographic region and jurisdiction have several variables that could impact and move this final amount up or down, yet that is probably a relevant range.

Similarly, the hardware costs would likely double, triple or perhaps quadruple the costs as well.  Add on costs of maintenance (things break), rent, etc. and this pushes the world wide costs of bitcoin mining upwards into the $1 – $2 billion per year range, which as copiously detailed in Chapter 3, is what theory predicts (MV=MC).  This does not also take into account all the various exceptions to the rule of miners mining at losses to get “virgin” coins, or researchers externalizing costs onto government run computers, etc.

This dynamic could change as market prices for bitcoins fluctuate, see further discussion from Dave Hudson on this.

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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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The advantages and challenges of mining bitcoins in China

I received some feedback from a veteran of the mining subindustry in China regarding my previous research on this space.

According to him there are a number of other moving pieces at play that are fluid will not necessarily last.

For instance, providers such as HashRatio have succeeded, not by designing their own chip but by figuring out the best combination of system and power configurations.  Going from chip to working system is non-trivial.   The end result are systems which are not necessarily pretty to look at, but they work.

One of the issues this new source had with my report was that because of guanxi is relatively hard to quantify, knowing whether or not you have the best price of a particular resource (like energy) is always a lingering question.  That is to say, even if Alice knows the boss of a coal mine, another competitor, Bob, may know his bosses boss which gives Bob even cheaper rates than what you thought you were receiving.  Improving guanxi is a millennia old Herculean task.

Some other highlights according to the source:

  •        If Alice’s metric is purely dollars per ghash, the analysis was correct. This is because there are two important figures: Alice’s new ASIC kWh/hash multiplied by her electricity cost / kWh.
  •        While Moses Lake is quoted in many news reports at being 1.7 cents per kWh, there are many other parts of the state which are very low, some averaging 2.3 cents per kWh.  And Washington has a much better infrastructure (both for electricity and internet) than China which makes it a very competitive geographic region.
  •        Similarly, Russia is 1 to 1.2 cents per kWh, though, you would be in Russia.
  •        China is cheap relative to a lot of countries, but relative to Washington and Russia the community capacity is still limited by State Grid, a large state owned enterprise (SOE) with a flat rate of 0.3 RMB kWh buying in any power station linked to it.  Miners will likely be unable to go under that.
  •        While Alice can do some meter fiddling or go off grid power, those options are hard to find and probably will not last long.
  •        State Grid has likely heard of bitcoin mining, but the wattage usage is not big enough to pique their interest or oversight.
  •        Inner Mongolia, as part of China, has overinvested in wind farms.  Yet there are large areas that are not linked to the grid yet.  And due to the unstable nature of wind, as well as poor internet infrastructure, none of the mining pools has gone there yet.  And it is sparsely populated which leads to potential difficulties in sourcing human capital and talent to run a pool.
  •        Mongolia, the country, imports roughly 10-20% of its electricity from Russia, so Bob might as well go to Russia if he is willing to set up a facility in Mongolia.
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How much energy is used to secure a $1 million bitcoin?

I have a new article over at Bitcoin Magazine called, Bitcoin: Made in China.

It’s based off a paper (pdf) I have been working on and is the culmination of numerous exchanges and conversations I have had over the past couple of weeks.

Another interesting article on this subject of capital costs is this recent one by Dario Di Pardo, $46K Spent on Mining Hardware: What Happened Next?

There are several people to keep your eye on for analysis in this space (such as those in the acknowledgements portion of the piece).  Dave Babbitt is working on his master’s thesis on this specific issue (hence his up-to-date numbers), Jonathan Levin is about to defend his thesis (which goes into several mining models), Robert Sams is brilliant with both econometrics and with understanding incentives and Cal Abel speaks in a whole new different league.  I also had some illuminating exchanges with John Ratcliff (he posted some subsequent comments over here).  Andrew Poelstra has a very critical eye and sharp mind for any logical errors and Bryan Vu is both articulate and provided some good counter-points to the hypothetical trend lines.  Dan Forster and Karl Holmqvist helped spark the initial barage of questions, Joseph Chow helped tweak the responses and Petri Kajander made sure my writing was coherent.  Also, thanks to Ruben Alexander, editor at Bitcoin Magazine for his encouraging words.

Lastly, my sources in China including Weiwu are without a doubt, resourceful and survivors.  That region of the world is a very tough market and unfortunately doesn’t receive the respect it deserves.

For instance, below is a Figure 4 from the new U.S.-China Economic and Security Review Commission (pdf) by Lauren Gloudeman.

chinacongress

Thus the next time you hear someone on reddit complain about China in relation to Bitcoin or tell you how Chinese demand did not impact prices, show them this diagram.  Who will replace the Chinese whale?  Maybe Wall Street.

Also send them here: Fairweather fans in bitcoinland disowning China

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Interest rates and currency appreciation in China

My friend Mark DeWeaver, author of Animal Spirits with Chinese Characteristics (and who wrote the foreword to my book on China) has a very insightful op-ed over at the WSJ today: Overvaluing the ‘Undervalued’ View of the Yuan

If you’re interested on unbiased, objective information about China without theatrics and hysteria I recommend tuning into the following people:

Massimo Ceccarelli also has a good round-up of China-related stories each day.

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Fairweather fans in bitcoinland disowning China

fair weatherWhile I am not endorsing bitcoin as an investment (I don’t actually), a vocal minority of English-speaking Bitcoin adopters on reddit and Bitcoin Talk are proverbial bandwagon fans.

In November, when Chinese consumers exploded onto the Bitcoin scene, many commentators cheered them on, welcoming them into the big leagues.

Ever since bitcoin prices peaked in early December (corresponding with the December 5th notice (Chinese) from the PBOC), many of these same armchair commanders / evangelical adopters have thrown all of China under the bus.

For instance, on Friday CoinDesk published a story about FXBTC (a Chinese bitcoin exchange) closing down next week.  The very first comment was the following:

The rest of the world would be better to ignore these PBOC reports. Bitcoin will go stronger once that happens.

Throughout each week similar such comments are posted on reddit (here) and Bitcoin Talk (here). The truth is, Chinese consumers created enormous demand that drove up the prices in late November and early December.  And the price has fallen measurably since the peak five months ago a peak which corresponded with the first “crack down.”

This may not be something you want to hear as an investor, but it is the truth of the matter.  While some claim that Chinese exchanges were fudging their volume and liquidity, extraordinary claims require extraordinary evidence.  I wrote an article 4 months ago (that was republished by Business Insider) that discussed several ways to purportedly fake the volume, yet even I do not have a smoking gun (yet).  In fact, post-December 5th I think most of the big exchanges (like Huobi and OKCoin) were probably posting real numbers. And in all likelihood, correlation is causation: the PBOC is a force to be reckoned with, they enacted (caused) new regulations and guidance which scared both smart money and Chinese day traders away which correlates with the continual drop in prices.

To compound this issue are enthusiastic Bitcoin advocates in China, especially exchange and merchant developers who spread their own counter-propaganda that is wholly without evidence.  The fact of the matter is, there has been a cat and mouse game going on for months now and while exchange operators have found temporary workarounds, the writing is on the wall: Bitcoin exchanges are for the time being persona non grata on the mainland.  There may be a few other loopholes and workarounds (which are quickly removed), but to believe otherwise is wishful thinking.  No amount of marketing spins or gimmicks like ATMs will likely change that in the short-run.1

Perhaps these types of inflammatory we-love-you-now-we-hate-you comments only represent a vocal minority, but it is pretty clear that most tokenholics do not care about utilizing a trustless consensus mechanism to empower the underbanked in developing countries such as China.2

Instead of loathing China, the community as a whole should sympathize with the loss of a comrade.  I do not expect this to happen though.  I briefly mentioned this in my Q/A at Stanford on Monday.  The Chinese government is opaque but the worst thing they could do is go all draconian (like blocking websites or arresting entrepreneurs) which they haven’t and egging them on, as endless threads on reddit do, is only hurting the very people Bitcoin was purportedly designed to help.

Will Hong Kong be the saving grace?

Most Chinese operations now have accounts in Hong Kong but they cannot operate as bitcoin businesses; the Hong Kong Monetary Authority (HKMA) has asked Hong Kong banks to report any account related to cryptocurrencies so most of the accounts are usually not open about the true nature of the operations.  Some are still openly related to bitcoin but for mining investments (hardware purchases) or merchant investments and there is still pressure on those.

If you only care about the value of the token, the ledger entry, the UTXO, etc. then you are going to need a bigger whale.  China was a huge whale.  Perhaps in a bit of irony, this summer funds from Wall Street (from bitlicensed firms) could end up driving up the price once again, effectively bailing out some of the reddit bitcoin holders who are now underwater.  Cui bono.

[Note: Weiwu Zhang has been posting some interesting analysis over the past few months at a German Bitcoin site.  His prediction are not always correct, but it is a fresh perspective that seems more grounded than the typical “invest on hope” mantra.]

Update: Just found out that all of the Bitcoin exchanges in China have pulled out of the upcoming Global Conference in Beijing on May 10th.  They are taking the PBOC notification / guidance very seriously and do not want to irk policy makers.  So they will not give presentations or show up in any official capacity (their sponsorship continues though — money has already been paid).  This is sad news.

Update 2: I have had three different independent confirmations to the first update.  The Global Conference website is slow to update the changes to the schedule. This article (Chinese) is apparently the one that asymmetrically influenced the entire segment a week ago.  Its message of “don’t irritate the PBOC” went viral with about 30,000 hits (which is probably a decent estimate of how many people actually use bitcoin on-chain in China).  The exchanges met later and then decided not to attend in official capacity.  The article mentions that the PBOC does not want China to be the largest market (as it has been) and actually mentions an upperbound target of 3000-8000 BTC daily volume for the entire country.  The actual number is unimportant, the attitude is.  The PBOC (and China) does not want to be a leader but rather as a follower based on the regulations and outcomes from the US and other jurisdictions (like Germany and Canada).

Update 3: the big exchanges just issued a joint statement (Chinese) saying they will adhere to the new PBOC guidance. They did not clearly say what that exactly means and will continue to operate (function as an exchange).

Update 4: CoinDesk just published a new story on the exchanges that pulled out of the conference.

  1. Bitcoin ATMs are likely underutilized globally, many are probably unprofitable too, hence the lack of public boasting by ATM operators. []
  2. The title of the white paper and the first section of the white paper are specifically identify peer-to-peer payments as a way to reduce friction and trust of the traditional banking system. []
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Quote of the day: depreciating value of exported electronic goods from China

A rail cargo line has been “relaunched” between Europe and China that is one month faster than traveling by sea and costs 20% the price of air cargo.

What is the motivation for restarting this potential time + cost savings?  Because:

In a month, the export value of one consignment of electronic products might devalue by about two percent, about several tens of thousands of dollars.

This actually relates to Bitcoin/Litecoin mining as well.  Most ASICs today have less than a 6 month profitably window before they need to be dumped or pointed to another profitable altcoin.  The sooner you ship a batch, the quicker the receivers can recoup the costs.

See China-Europe railway relaunches from China Daily

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Are the rumors true about China banning cryptocurrencies?

Received a few emails the last few days.  Here is one response I sent this morning to some friends:

This policy tightening, specifically based on this market-moving story from Caixin last week, comes amidst a larger shift: pressure from SOE incumbents that are concerned with the entire mobile payment / independent payment systems that have been setup over the past 3-4 years.  Quartz has a good overview on how the state-owned banks have essentially pressured policy makers into stymieing further growth of alternative services from Alipay & Tenpay.  Similarly three weeks ago the PBOC placed a “temporary” ban on payments made by scanning QR codes, mostly likely to protect UnionPay (an SOE) against the competition of Alipay & Tenpay.  In fact, this past week Chinese SOE banks posted their weakest annual profit growth, and they like those margins.

With respect to Bitcoin, I doubt it has anything to do with capital controls or flight.  Despite the fact that Bitcoin can be used as a vehicle to avoid capital controls, but have not seen any actual numbers on that so I could be wrong (maybe they all use RealityShares).  Yet even if it were the case, China is the 2nd largest source for remittances received ($60 billion in 2012), making it unlikely that the trend reversed and somehow China now exports more funds than receives during those 2 years (and I doubt that it is being used for domestic remittances for migrants to the inner provinces either).  For perspective, there are common ways to use UnionPay and art auctions to avoid capital controls (those links have interesting stats).

In addition, here is an updated summary of notices the different exchanges in China have received and their responses.  In addition, Rui Ma provided info on the most recent CoinDesk news piece on this issue yesterday.

Interestingly enough, I was told a couple days ago, in the event that the rumors of the PBOC clamp down on electronic deposits beginning 4/15 are true, one alternative is that Huobi (and others) would allow users to go to their office to deposit directly with them.  Bobby Lee from BTC China and others have said the same thing as well. Yet, what’s to prevent Alice from sending funds to some third party “cash delivery service” that then delivers them the cash?  And in any case, if the PBOC actually wanted to stop the business, it would be very simple – just (a) block the websites and (b) send in the PSB to close them down.

In any case, I can just imagine nerds with wheel barrows full of RMB lining the sidewalk of corporate offices…

That said, we (the public) probably will not know until we do.  Chinese regulators have used this strategy before: release or “leak” some information to test the reaction of the market.  If the reactions are severe, they may change the policy.  If you believe your investments will be impacted, aside from somehow “getting” some emergency guanxi, the best thing you can do is prepare for a Plan B, likely utilizing Hong Kong.

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What about English in China?

A director of studies (DoS) for a foreign education company in China contacted me today and we discussed the conundrum of college education, specifically English education, in China.  I devoted part of chapter 9 in GWON to this segment.

His view was that there are indeed opportunities and reasons for why English learning should be encouraged, that professions that interface with foreigners and foreign companies need to be proficient in English.  This is true, but the reality is that there are not that many positions that do this, perhaps just a few million such positions including notably the hospitality industry and IT off-shoring companies.  For comparison there are approximately 300 – 390 million English language learners in China and roughly 600,000 – 650,000 foreigners permanently residing in China.1

This is not to say that students in China should not have the option to learn or should not be encouraged to learn other languages, such as English.  Rather this is to say that learning English is no longer an end in itself.  It is not a “get rich quick scheme” yet much of the marketing done in the segment continues to promote this view.  Whereas 20 years ago being a fluent English speaker or an EFL company, may have been a very profitable profession and sub-industry, today it is quite competitive and very mature with salaries being arbitraged to international labor rates.  Instead, learning English is just another tool for high-skilled workers, to interface with their international peers and colleagues.  If you do not work in such a position or have such skills in the first place (e.g., semiconductor engineering) but instead interface solely with Chinese colleagues in China, you will likely have no additional monetary incentives for mastering a foreign language.

This ties in with the conversation with the DoS because he planned to give a presentation to several college groups about the utility of learning English.  I had previously given a presentation last December (video) (slides) and discussed some of the challenges that college students currently face, including a skill-set gap that exists.

For example, according to the Los Angeles Times:

By some accounts, the unemployment rate for Chinese college graduates age 21 to 25 is 16%, nearly four times that of blue-collar workers. An Education Ministry survey of 500 firms found that employers had trimmed the number of jobs available for new hires this year by about 15%. In Beijing, an estimated 98,000 jobs are available for the 229,000 new graduates, a city education committee study found.

“The manufacturing sector is still seeing labor shortages,” said Geoffrey Crothall of China Labour Bulletin, a Hong Kong-based research group. But many college graduates in major cities are ending up taking poorly paid jobs in areas such as telemarketing or real estate sales, he said, “and often these wages are lower than a factory worker in Shenzhen.”

I have written about this skill-set mismatch several times before.2 It is currently exacerbated by social promotion within institutions (e.g., degree inflation) and will likely continue into the near future.  One of the problems that the company the DoS represents is that the bulk of its operations is still geared towards traditional brick-and-mortar facilities.  While it was not mentioned in the conversation, two years ago the company had intended to grow and open several hundred training centers on the mainland.  This has not happened for several reasons:

  •  the EFL education tuition is unaffordable to most of the target audience (urban middle-class consumers)
  •  on top of inflation which erodes their purchasing power, a relatively “slow” economy has put pressure on wages of these working adults who have to cut back on services such as EFL education
  •  lack of a visible return-on-investment for most customers (i.e., after taking the courses it does not lead to instant seniority or new career opportunities)

However, there are other areas for businesses to expand, including the online sector, which is expected to grow by leaps and bounds.  In fact, TutorGroup (which the DoS does not work for) just closed its Series B round of financing last month, raising $100 million to build out its online language education platform that targets (among others) Chinese seeking to learn English.

According to its write-up of the funding announcement, TechCrunch noted that:

TutorGroup says that it expects the adult English language-learning market within China to grow 25% annually and reach more than $21 billion by 2015. In China alone, the company expects sales to experience a triple-digit annual growth rate in the next few years.

According to Ambient, a competitor:3

China is now the top buying country of digital English language learning products, not only in the Asia region, but in the world, according to a new Ambient Insight report called “The 2013-2018 China Digital English Language Learning Market.” The five-year compound annual growth rate (CAGR) for digital English language learning products in China is 23.6% and revenues will nearly triple over the forecast period. […] Revenues for these products will spike to a breathtaking $931.8 million in 2018, up from the $323.1 million reached in 2013.

Thus, these two data points suggest that there may still be opportunities in the education and training segment, but likely in the online-only space an area that the DoS’ company is trying to rapidly expand (by opening up a new Boston office for freelance instructors).

What does this have to do with English-learning?  I suspect that the online segment will likely benefit and recoup the costs of the investment due to the always-on nature of the urban consumer willing to try out one of these new platforms.  Yet whether or not the language and educational knowledge transfers over and translates into higher productivity or more proficiency is another matter entirely.

The last example that ties into this is based on a conversation I had last November with a center manager at the same company that the DoS works at.  The manager explained that the ayi (阿姨), an “auntie” custodian, at the headquarters office he worked in paid 20,000 RMB (~$3,400) to learn English through the company’s internal program.  Less than six months later she was burned out due in part to the unrealistic expectations (i.e., “overpromised and underdelivered”) that is unfortunately the modus operandi that this segment in China still suffers from.  This will likely change as the industry continues to mature, yet it would be in the students best interest to hear the challenges — in addition to the opportunities — that a second language can provide.

Tangential coda: in a slight twist, while English tutoring has been a relatively low-barrier to entry position in China, it looks as if Shanghai is now exporting math instructors to England.4 The UK is spending $18 million to fly 60 Chinese math teachers (proficient in English communication) to help improve the math abilities and scores of learners in England.5

  1. A census was conducted and the results were published 3 years ago, see Almost 600,000 foreigners counted in China from China Daily.  Another unsourced estimate is that 80% of the approximately 650,000 foreigners in China work as teachers, see China Average Pay & Salaries For Expats & Foreign Teachers… from Salon []
  2. Are MOOCs a solution for the skillset mismatch? and The market for massive open online courses in China []
  3. China Digital English Language Learning Market Booming from PRNewswire []
  4. See English tutors in China — well-paid, not always qualified from UPI and Shanghai teachers flown in for maths from BBC []
  5. Chinese teachers sent into English schools to boost results from The Telegraph []
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