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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Bitcoin Is Now Just A Ticker Symbol and Stopped Being Permissionless Years Ago

Financial market infrastructure in just one country (Source)

What is FMI?  More on that later.  But first, let’s talk about Bitcoin.

If you aren’t familiar with the Bitcoin block size war and its endless online shouting matches which have evolved into legal and even death threats, then you have probably been a very productive human being and should sell hugs and not wander into a non-stop social media dance off.

Why?  Because tens of thousands of man (and woman) hours have collectively been obliterated over a struggle that has illuminated that Bitcoin’s development process is anything but permissionless.

It also illuminates the poor fiduciary care that some VCs have towards their LPs.  In this case, more than a handful of VCs do not seem to really care about what a few of their funded companies actually produce, unless of course the quarterly KPIs include “have your new Bitcoin meme retweeted 1,000 times once a week.”

In some documented cases, several dozen executives from VC-backed Bitcoin companies have spent thousands of hours debating this size attribute instead of building and shipping commercializable products.  But hey, at least they sell cool hats and built up very large Twitter followings, right?

Fact #1: Satoshi Nakomoto did not ask anyone’s permission to launch, change, or modify the codebase she unilaterally released in 2009.

Fact #2: In 2009, when Satoshi Nakomoto issued and minted a new currency (or commodity or whatever these MLIC are) she did so without asking anyone else’s approval or for their “ack.”

In the approximately seven years since she stopped posting under her pseudonym, influential elements of Bitcoin’s anarchic community have intentionally created a permissioned developer system commonly referred to as the Bitcoin Improvement Proposal (BIP) process.  “Bitcoin Core” is the name for the group that self-selected itself to vet BIPs; involvement is empirically permissioned because you can get kicked off the island.1 There are a small handful of decision makers that control access to the code repository.

For example, if you’re a developer that wants to create and launch a new implementation of Bitcoin that includes different block sizes… and you didn’t get it approved through this BIP process, guess what?  You are doing permissionlessness wrong because you didn’t get permission from the BIP approval committee to do so.

Oh, but you realize that and still want to launch this new Bitcoin implementation with the help of other elements of the community, such as some miners and exchanges?

According to some vocal members of the current BIP approval committee (Bitcoin Core) and its surrogates, this is an attack on Bitcoin.  Obviously this is absurd because there is no de jure or legally defined process for changing or forking Bitcoin, either the chain itself or the code.

There is no terms of service or contract which explicitly states what Bitcoin is and who controls its development process.  Or more historically: if Satoshi didn’t need permission from a (non-existent) BIP approval committee to launch a cryptocurrency, then no other Bitcoin developer needs to either.

Tickers

Fast forward to this current moment in time: if the Bitcoin Cash or Segwit2X forks are an attack on network because either fork did not get ack’ed (approved) by the right people on the BIP approval committee or retweeted by the right “thought leaders” on social media, then transitively every 10 minutes (when a block is generated by a miner) arguably could be an attack on Bitcoin.

Why?  At any time a block maker (miner) could use a different software implementation with different consensus rules.  They, like Satoshi before them, do not need permission to modify the code.

Oh, but other miners may not build on top of that block and some exchanges may not recognize those blocks as “legitimate” Bitcoin blocks?

That is certainly a risk.  In fact, several exchanges are now effectively white listing and black listing — permissioning — Bitcoin-related blocks.

For instance, Bittrex, a large crypto-to-crypto exchange, has said:

The “BTC” ticker will remain the Bitcoin Core chain before the hard fork block. Bittrex will observe the Bitcoin network for a period of 24 to 48 hours to determine if a chain split has occurred and the outcome.

In the event of a chain split, “BTC” will remain the existing Bitcoin chain with 1 MB blocks until the industry and ecosystem demonstrates a clear chain preference for Bitcoin.

Bitfinex, the largest (and most nebulous) cryptocurrency exchange in the world, took this even further by stating:

The incumbent implementation (based on the existing Bitcoin consensus protocol) will continue to trade as BTC even if the B2X chain has more hashing power.

After heavy public (and private) lobbying by members and surrogates of Bitcoin Core, other exchanges have instituted similar policies favoring the incumbent.2  So what can alternative implementations to do?  Bend the knee?

Daenerys Targaryen, Breaker of Chains

Historically miners have built on the chain that is both the longest and also has the most accumulated difficulty… and one that has enough profitability to pay for the electricity bills.  It just happens that this collective block building activity is never called an “attack” because in general, most participants have been happy enough with the status quo.

Visions of what Bitcoin is and how it should be defined have clearly, empirically shifted over time.  But since this network was purposefully designed to be self-sovereign and anarchic — lacking contracts and hooks into any legal system — no one group can claim legitimacy over its evolution or its forks.

As a result, recent war cry’s that Segwit2X is a “51% attack” on Bitcoin are a red herring too because there is no consensus on the definition of what Bitcoin is or why the previous block – in which approximately 51% of the hashrate created a block – is not an attack on Bitcoin. 3

This has now morphed into what the “BTC” ticker on exchanges represents.  Is it the longest chain?  The chain with the most accumulated difficulty?  The chain maintained by Bitcoin Core or now defunct NYA developers?  If a group of block makers can build blocks and exchanges are willing to list these coins as “BTC” then that specific chain has just as much legitimacy as any other fork other miners build on top of and exchanges may list.

Furthermore, if the BIP approval committee gets to say what software miners or exchanges should or should not use (e.g., such as increasing or decreasing the block size), that could mean that existing network is a managed and even administered.  And this could have legal implications.  Recall that in the past, because block making and development were originally separate, FinCEN and other regulators issued guidance stating that decentralized cryptocurrencies were exempt from money transmission laws.

Despite what the trade associations and Bitcoin lobbying groups would like the narrative to be, I recently published an article that went into this very topic in depth and have publicly asked several prominent “crypto lawyers” to provide evidence to the contrary (they have yet to do so).  An argument could be made that these dev groups are not just a loose collective of volunteers.

Financial market infrastructure

I’m not defending S2X or XT or Bitcoin Unlimited.  In fact, I have no coins of any sort at this time.

But even if you don’t own any bitcoins or cryptocurrencies at all, the block size debate could impact you if you have invested in the formal financial marketplace.

For example, if and when the CME (and similar exchanges) get CFTC approval to list cryptocurrency-related futures products and/or the NYSE (and similar exchanges) get SEC approval to list cryptocurrency-related ETFs, these products will likely result in a flood of institutional money.

Once institutions, regulators, and sophisticated investors enter the picture, they will want to hold people accountable for actions.  This could include nebulous “general partnerships” that control GitHub repositories.  Recall, in its dressing down of The DAO, the SEC defined the loose collective building and maintaining The DAO as a ‘general partnership.’  Is Bitcoin Core or other identifiable development teams a “general partnership”?

Maybe.  In fact, the common refrain Bitcoin Core and its surrogates continually use amounts to arguments in favor of a purported natural monopoly.

For instance, Joi Ito, Director of MIT’s MediaLab, recently stated that:

“We haven’t won the battle yet. [But] I think the thing that is interesting is that Bitcoin Core has substantially more brain fire power than any of the other networks.”

This is problematic for a couple reasons.

First, Joi Ito is not a disinterested party in this debate.  Through Digital Garage (which he co-founded) it has invested in Blockstream, a company that employs several influential Bitcoin Core devs.4  Ignoring the potential conflict of interest, Ito’s remarks echo a similar sentiment he also made last year, that Core is basically “The Right Stuff” for NASA: they are the only team capable of sending humans into space.

But this is an empirically poor analogy because it ignores technology transfer and aerospace education… and the fact that multiple countries have independently, safely sent humans, animals, and satellites into space.

It also ignores how competitive verticals typically have more than just one dominant enterprise: aerospace, automobiles, semiconductor manufacturers, consumer electronic manufacturers (smart phones), etc.  Each of these has more than one company providing goods and services and even usually more than just one product development team developing those.  Intel, for example, has dozens of design teams working on many new chips at any given time of the year.  And they are just one of the major semiconductor companies.

Even in the highly regulated markets like financial services there is more than one bank.  In fact, most people are unaware of this but banks themselves utilize what is called “Core Banking Software” and there are more than a dozen vendors that build these (see image below).

It is a bit ironic that Bitcoin Core seeks to have a monopoly on the BIP process yet even banks have more than one vendor to choose from for mission critical software securely managing and processing trillions of dollars in assets each day.5

On the enterprise (non-anarchic) blockchain side of the ecosystem, there are well over a dozen funded teams shipping code, some of which is being used in pilots by regulated institutions that are liable if a system breaks.  Note: this is something I discussed in my keynote speech (slides) at the Korea Financial Telecommunications and Clearings Institute last year.

But as one vocal Core supporter in a WeChat room recently said, Bitcoin Core is equivalent to Fedwire or Swift, there is only one of each; so too does it make sense for only one Bitcoin dev team to exist.

Firstly, this conflates at least four different things: a specific codebase, with permissioned dev roles, with acceptance processes, with a formal organization.

It is also not a good analogy because there are many regulatory reasons why these two systems (Swift and Fedwire) exist the way they do, and part of it is because they were either setup by regulators and/or regulated organizations.  In effect, they have a bit of a legally ring-fenced marketplace to solve specific industry problems (though this is somewhat debatable because there are some alternatives now).6

If this supporter is equating Core, the codebase, with real financial market infrastructure (FMI), then they should be prepared to be potentially regulated.  Bitcoin Core and many other centralized development teams are comprised of self-appointed, vocal developers that are easy to identify (they have setup verified Twitter accounts and attend many public events), so subpoenas and RFI’s can be sent their way.

As I mentioned in my previous article: with great power comes great accountability.  Depending on the jurisdiction, Core and other teams could end up with regulatory oversight since they insist on having a monopoly on the main (only) implementation and process by which the implementation is managed.7

Remember that Venn diagram at the very top?  The companies and organizations that manage FMI today for central banks (RTGSs), central securities depositories (CSDs), and other intermediaries such as custodians and CCPs, have specific legal and contractual obligations and liabilities.

Following the most recent financial crisis, the G-20 and other counties and organizations established the Financial Stability Board (FSB) to better coordinate and get a handle on systemic risks (among other issues).  And while the genesis of the principles for financial market infrastructures (PFMI) had existed prior to the creation of the FSB, how many of the international PFMI standards and principles does Bitcoin Core comply with?

Spoiler alert: essentially none, because Satoshi intentionally wasn’t trying to solve problems for banks.  So it is unsurprising that Bitcoin isn’t up to snuff when it comes to meeting the functional and non-functional requirements of a global payments platform for regulated institutions.  Fact-check me by reading through the PFMI 101 guide.

When presented with these strong legal accountability and international standards that are part and parcel with running a payment system, there is lots of hand waving excuses and justifications from Core supporters (and surrogates) as to why they are exempt but if Core wants to enforce its monopoly it can’t have it both ways.  Depending on the jurisdiction they may or may not be scrutinized as FMI.

But in contrast, in looking at the evolution and development of the enterprise chain ecosystem – as I described in multiple previous articles – there are valuable lessons that can be learned from these vendors as to how they plan to operate a compliant network.  I recall one conversation with several managing directors at a large US investment bank over a year ago: maybe the enterprise side should just have CLS run a blockchain system since they have all the right business connections and fulfill the legal and regulatory check boxes.

Note: CLS is a very important FMI operator.  Maybe existing FMI operators will do just that.  Speaking of which, will Bitcoin Core (or other dev teams) apply to participate with organizations like the FSB that monitor systemically important financial institutions and infrastructure?

Angela Walch has argued (slides) that the some coders, especially of anarchic chains, are a type of fiduciary.8  Even if this were not true, many countries have anti-monopoly and anti-trust laws, with some exceptions for specific market segments and verticals.  There are also laws against organized efforts involved in racketeering; in the US these are found within the RICO Act.

Watch the Godfather trilogy

I haven’t seen a formal argument as to why Core or other development teams could meet the litmus test for being prosecuted under RICO laws (though the networks they build and administer are frequently used for money laundering and other illicit activity).  But trying to use the “decentralization” trump card when in fact development is centralized and decisions are made by a few key individuals, might not work.

Look no further than the string-pulling Mafia which tried to decentralize its operations only for the top decision makers to ultimately be held liable for the activities of their minions.9  And using sock puppets and pseudonyms might not be full-proof once forensic specialists are brought in during the discovery phase.10

Concluding remarks

Based on observations from how Bitcoin Core evolved and consolidated its power over time (e.g. removing participants who have proposed alternative scaling solutions), the focus on what Bitcoin is called and defined has landed in the hands of exchanges and really just highlights the distance that Bitcoin has walked away from a “peer-to-peer electronic cash” that initially pitched removing intermediaries.  To even care about what ticker symbol ‘Bitcoin’ is on an exchange is to acknowledge the need for a centralized entity that establishes what the “price” is and by doing so takes away the bitcoin holder’s “self-sovereignty.”11

While the power struggles between various factions within the Bitcoin development community will likely rage on for years, by permissioning off the development process, Bitcoin Core (and any other identifiable development groups), have likely only begun to face the potential regulatory mine field they have foisted on themselves.12

Historically blockchain-based systems have and still are highly dependent on the input and decision-making by people: somebody has to be in charge or nothing gets done and upgrades are a mess.  And the goal of appointing or choosing specific teams on anarchic chains seems to be based around resolving political divisions without disruptive network splits.13

The big questions now are: once these teams are in charge, what will governments expectations be?  What legal responsibilities and regulatory oversight will the developers have?  Can they be sued for anti-trust and/or RICO violations?  With billions of dollars on the line, will they need to submit upgrade and road map proposals for approval?

Endnotes

  1. Examples of developers who were removed: Alex Waters, Jeff Garzik, Gavin Andresen []
  2. Thanks to Ciaran Murray for identifying these exchanges. []
  3. Bitcoin mining is in fact based on an inhomogeneous Poisson process; a participant could theoretically find a block with relatively little hash rate.  Although due to the probabilities involved, most miners pool their resources together to reduce the variance in payouts. []
  4. According to one alleged leak, Digital Garage is testing Confidential Assets, a product of Blockstream. []
  5. According to a paper from the Federal Reserve: payment, clearing, and settlement systems in the United States “process approximately 600 million transactions per day, valued at over $12.6 trillion.” []
  6. On AngelList, there are about 3,400 companies categorized as “payments” — most of these live on top of existing FMI, only a handful are trying to build new independent infrastructure. []
  7. A key difference between Bitcoin and say Ethereum is that with Ethereum there are multiple different usable implementations managed by independent teams and organizations; not so with how Bitcoin has evolved with just one (Bitcoin Core) used by miners.  In addition, the Ethereum community early on formally laid out a reference specification of the EVM in its yellow paper; Bitcoin lacks a formal reference specification beyond the Core codebase itself. []
  8. See also The Bitcoin Blockchain as Financial Market Infrastructure: A Consideration of Operational Risk from Angela Walch []
  9. Thanks to Stephen Palley for providing this observation. []
  10. It is unclear why the current Bitcoin Core team is put onto a pedestal.  There are many other teams around the world building and shipping blockchain-related system code used by companies and organizations (it is not like there is only just one dev team that can build all databases or operating systems).  At the time of this writing Core has not publish any papers in peer-reviewed journals and many of them do not have public resumes or LinkedIn profiles because they have burned business and professional relationships in the past.  Irrespective of what their bonafides may or may not be, it is arguably a non sequitur that ‘permissionless’  coordination in open-source code development has to lead to a monopoly on said development. []
  11. Thanks to Colin Platt for this “appeal to authority” observation. []
  12. Bitcoin stopped being permissionless when developers, miners, and exchanges needed to obtain permission to make and use different code.  And likely there are and will be more other cryptocurrency development teams that follow that same path. []
  13. For an informed contrarian view on governance and distributed ledger technology, see The blockchain paradox: Why distributed ledger technologies may do little to transform the economy by Vili Lehdonvirta []
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A note from Bob on the transparency of Tether

[Note: below is a note from a friend, Bob, who is a former attorney turned tech entrepreneur who closely follows the cryptocurrency world.  This was published with his permission.]

Hope all is well.  I am writing to share some alarming signs of Bitcoin price manipulation.

Bitcoin price is about 10 times of what it was a year ago. The exchange that decisively sets Bitcoin price is Bitfinex, a secretive institution with unknown beneficiary structure and place of organization.

Bitfinex had its wire services suspended by Wells Fargo in April.  To resume trading, Bitfinex enlisted the help of Tether, another company with unknown beneficiary structure and place of organization, but based on announcements is likely under common share holder control with Bitfinex.  Tether sells crypto-tokens known as USD Tethers, or USDTs, that are purportedly backed by an equal number of US dollars.  In other words, each USDT is a digital good priced at USD 1.00.

Despite the promise of “100% reserve” and the vague reference to “24×7 access to your funds” on Tether’s website, there is no contractual right, either tacit or express, for one USDT to be redeemed for one US dollar.  It is probably through this legal construct that Tether hopes to characterize its USDTs as digital goods and not “convertible” virtual currency covered by FinCEN regulations.

The invention of USDTs led to the proliferation of numerous crypto-currency exchanges.  Examples include Bitfinex, Binance, HitBTC, KKex, Poloniex, and YoBit.  Instead of providing crypto-to-fiat trading pairs, these “coin-to-coin” exchanges offer crypto-to-tether trading exclusively.  Therefore, USDTs not only help these exchanges remove the need for formal banking arrangement, but also enables these exchanges to organize in lesser known jurisdictions (e.g., the Republic of Seychelles) and operate outside of the regulation and supervision of major economies.  Most of these exchanges claim to screen-off visitors from the United States and other countries with laws on coin-to-coin trading, but the screen-off is often perfunctory. In almost all cases, the screen can be defeated with a simple mouse click.1

It is doubtful that these exchanges perform meaningful due diligence beyond identity verification to combat money laundering, financing of terrorism, and corruption of politically exposed persons. Bitfinex, for example, requires no identity verification at all for most trading activities and imposes no trading amount limits on unverified accounts.  The enablement of these exchanges where rampant money laundering is possible is outside of the scope of this note. Instead, I would like to bring to your attention the distinct possibility that Bitfinex, as the likely controller of Tether, is a bad actor.

Strong circumstantial evidence suggests that Bitfinex is creating USDTs out of thin air to prop up Bitcoin prices.  Namely, Bitfinex is likely acting as a central bank that issues a fiat money called USDTs. The sole mandate of this central bank is to enrich itself through market manipulation.

The first image (above) attached to this email illustrates how mysterious amounts of USDTs were minted and injected into Bitfinex at precise moments when a crash seemed imminent.

The second image (above) illustrates a strong correlation (but admittedly not causation) between the total amount of USDTs in circulation and Bitcoin price.

Bitfinex released an internal memo in September to allay concerns that USDTs might have been created at will.  The memo purportedly shows that Tether maintained sufficient US dollars to match all USDTs in circulation as of a day in September.  The memo, however, is of no probative value.  Among other strange things, the author of the memo didn’t verify with banks (names redacted) that account balances from Tethers were in fact correct, couldn’t promise that the balances weren’t overnight borrowings for purposes of producing the memo, and couldn’t promise that Tether indeed had access to those funds.

I therefore urge you to consider the possibility that the current price of Bitcoin is the result of Bitfinex’s manipulation and may collapse when regulators take action.

For example, Tether is almost certainly an administrator of virtual currency — it centrally puts into and withdraws from circulation USDTs, a virtual currency squarely intended as a substitute for real currency as admitted by Tether in the internal memo.

Tether has nominally registered as a money transmitter with FinCEN, but it is unclear if they fulfill any of the BSA filing requirements (e.g., filing SARs).2 As a company, Tether’s USDTs enables large crypto-currency exchanges (including US-based exchanges like Poloniex) to exist and powers trades thereon in the amount of millions every day.  So it wouldn’t be surprising if FinCEN eventually decides to enforce its rules against Tether as it did against Liberty Reserve.

Further, CFTC approved recently various swap execution facilities, designated contract markets and derivative clearing organizations with Bitcoin flavor.  And the Chicago Mercantile Exchange is expected to launch cash-settled futures on Bitcoin soon.  Manipulation of Bitcoin prices referenced by these entities is prosecutable by the CFTC, an agency with broad statutory authority to prosecute manipulation of commodity prices under the Commodity Exchange Act (including Section 753 as amended by the Dodd-Frank Act.).

Although none of these CFTC-registered entities are currently including Bitfinex in the calculation of their Bitcoin reference rates (CME used to), it is well understood and could be easily established (partially because of the transparency of Bitcoin blockchain) that Bitfinex-initiated price movements ripple through all exchanges via manual and automated trading.3  CFTC could then have grounds to investigate Bitfinex’s possible manipulation of Bitcoin price via Tether.

If you are considering investing into Bitcoin at this time, please look closer at the exchanges involved in price discovery and give it a second thought.

References

  1. For an example, see FinCEN ruling from August 15, 2015. []
  2. Tether Limited did do a basic registration which takes around 5 minutes and about 45 dollars. But they probably didn’t do what come after the registration, which includes many other filings to FinCEN such as submitting suspicious activity reports. []
  3. The initial reference rate announced by the CME included Bitfinex.  Similarly, the Winklevoss Bitcoin ETF used a reference rate (called the “Winkdex”) whose comprising exchanges fluctuated over time.  See Comments on the COIN ETF (SR-BatsBZX-2016-30). []
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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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What’s the deal with DAOs?

[Disclaimer: I do not own any cryptocurrencies nor have I participated in any DAO crowdfunding.]

This post will look at the difference between a decentralized autonomous organization (DAO) and a project called The DAO.

Brief explanation

The wikipedia entry on DAOs is not very helpful.  However, Chapters 2 through 5 may be of some use (although it is dated information).

In terms of the uber hyped blockchain world, at its most basic kernel, a DAO is a bit of code — sometimes called a “smart contract” (a wretched name) — that enables a multitude of parties including other DAOs to send cryptographically verifiable instructions (such as a digitally signed vote) in order to execute the terms and conditions of the cloud-based code in a manner that is difficult to censor.

One way to think of a simple DAO: it is an automated escrow agent that lives on a decentralized cloud where it can only distribute funds (e.g., issue a dividend, disperse payroll) upon on receiving or even not receiving a digital signal that a task has been completed or is incomplete.

For instance, let us assume that a small non-profit aid organization whose staff primarily work in economically and politically unstable regions with strict capital controls, set up a DAO — an escrow agent — on a decentralized cloud to distribute payroll each month.

This cloud-based escrow agent was coded such that it would only distribute the funds once a threshold of digital signatures had signed an on-chain contract — not just by staff members — but also from independent on-the-ground individuals who observed that the staff members were indeed doing their job.  Some might call these independent observers as oracles, but that is a topic for a different post.1

Once enough signatures had been used to sign an on-chain contract, the escrow agent would automatically release the funds to the appropriate individuals (or rather, to a public address that an individual controls via private key).  The terms in which the agent operated could also be amended with a predetermined number of votes, just like corporate board’s and shareholder’s vote to change charters and contracts today.

The purported utility that decentralization brings to this situation is that it makes censoring transactions by third parties more difficult than if the funds flowed through a centralized rail.  There are trade-offs to these logistics but that is beyond the scope of this post.

The reason the DAO acronym includes the “organization” part is that the end-goal by its promoters is for it to provide services beyond these simple escrow characteristics such as handling most if not all administrative tasks such as hiring and firing.

Watch out Zenefits, the cryptocurrency world is going to eat your lunch!  Oh wait.

A short history

It is really easy to get caught up in the euphoria of a shiny new toy.  And the original goal of a DAO sounds like something out of science fiction —  but these undertones probably do it a disservice.

Prior to 2014 there had been several small discussions around the topic of autonomous “agents” as it related to Bitcoin.

For instance, in August 2013, Mike Hearn gave a presentation at Turing Festival (see above), describing what was effectively a series of decentralized agents that operated logistical companies such as an autonomous car service.

Several months later, Vitalik Buterin published the Ethereum white paper which dove into the details of how to build a network — in this case a public blockchain — which natively supported code that could perform complex on-chain tasks: or what he dubbed as a decentralized autonomous organization.

Timing

The impetus and timing for this post is based on an ongoing crowdsale / crowdfunding activity for the confusingly named “The DAO” that has drawn a lot of media attention.

Over the past year, a group of developers, some of whom are affiliated with the Ethereum Foundation and others affiliated with a company called Slock.it have created what is marketed as the first living and breathing DAO on the Ethereum network.

The organizers kicked off a month long token sale and at the time of this writing just over 10 million ether (the native currency of the Ethereum blockchain) — or approximately 13% of all mined ether — has been sent to The DAO.  This is roughly equivalent to over $100 million based on the current market price of ether (ETH).

In return for sending ether to The DAO, users receive an asset called a DAO Token which can be used in the future to vote on projects that The DAO wants to fund.2 It is a process that Swarm failed at doing.

An investment fund or a Kickstarter project?

I would argue that, while from a technical standpoint it is possible to successfully set up a DAO in the manner that The DAO team did, that there really isn’t much utility to do so in an environment in which censorship or the theft of funds by third parties will probably not occur.

That is to say, just as I have argued before that permissioned-on-permissionless is a shortsighted idea, The DAO as it is currently set up, is probably a solution to a problem that no one really has.3

Or in short, if you “invested” in The DAO crowdsale thinking you’re going to make money back from the projects via dividends, you might be better off investing in Disney dollars.

Why?

Putting aside securities regulations and regulators such as the SEC for a moment, most of the crowdsale “investors” probably don’t realize that:

  1. crowdfunding in general has a checkered track record of return-on-investment4
  2. crowdfunding in the cryptocurrency world almost always relies on the future appreciation of token prices in order to break-even and not through the actual creation of new features or tools (e.g., see Mastercoin/Omni which effectively flopped)
  3. that the funds, when dispersed to Slock.it and other “products,” could take years, if ever to return a dividend

Why would this pool of capital provide any better expected return-on-investment than others?

Or as Nick Zeeb explained to me:

My sense about The DAO is that it’s a fascinating experiment that I do not want to be part of. I also do not think that a committee of over 1,000 strangers will make wise investment decisions. Most good investment decisions are taken by courageous individuals in my opinion. Anything that can get past a big committee will probably not be the next Google. Imagine this pitch: “Hi I’m Larry and this is Sergey and we want to build the world’s 35th search engine.”

While it probably wasn’t the 35th search engine, tor those unfamiliar with the history of Google, Larry Page and Sergey Brin are the co-founders who created a search engine in what was then though a very crowded market.

So why the excitement?

I think part of it is quite simply: if you own a bunch of ether, there really isn’t much you can do with it right now.  This is a problem that plagues the entire cryptocurrency ecosystem.

Despite all the back-patting at conferences, the market is already filled with lots of different tokens. There is a glut of tokens which do not currently provide many useful things that you couldn’t already do with existing cash systems.5

Part of it also is that most probably think they will some become rich quick through dividends, but that probably won’t happen anytime soon, if at all.

With The DAO, only the development teams of projects that are voted and approved by The DAO (e.g., the thousands of users with DAO Tokens), will see any short term gains through a steady paycheck.  And it is only after they build, ship and sell a product that the original investors may begin seeing some kind of return.

Or in other words: over the past several weeks, the pooling of capital has taken place for The DAO.  In the future there will be various votes as to where that capital goes.  Shortly thereafter, some capital is deployed and later KPI’s will be assessed in order to determine whether or not funding should continue.  All the while some type of profit is sought and dividend returned.

Why, I asked another friend, would this pool of capital offer any better risk adjusted return-on-investment than other asset classes?

In his view:

The return might be high but so is the risk. Always adjust for risk. I think The DAO is better compared to a distributed venture capital firm. Whether that’s better or worse I don’t know — I mean you have the crowd deciding on investments. Or more realistically: nerds who know how to obtain ether (ETH) get to decide on investments.

Does that make them better VCs? Probably not. However, The DAO can decide to hire people with actual credentials to manage and select the investments, admitting its own weakness which would then turn into a strength. I think this can go either way but given the regulator is not prepared for any of this it will probably not work out in the short term.

Does the ‘design-by-giant-nerd-committee’ process work?

Over the past year we have already seen the thousands, probably tens-of-thousands of man-hours dropped into the gravity well that is known as the “block size debate.”  In which hundreds of passionate developers have seemingly argued non-stop on Slack, Twitter, reddit, IRC, conferences and so forth without really coming to an amicable decision any one group really likes.

So if block size-design-by-committee hasn’t worked out terribly well, will the thousands of investors in The DAO take to social media to influence and lobby one another in the future?  And if so, how productive is that versus alternative investment vehicles?

Redistributing the monetary base

Assuming Ethereum has an economy (which it probably doesn’t by most conventional measures), will The DAO create a deflationary effect on the Ethereum economy?

For instance, at its current rate, The DAO could absorb about 20% of the ether (ETH) monetary base.

Does that mean it permanently removes some of the monetary base?  Probably not.

For example, we know that there will be some disbursements to projects such as Slock.it, so there will be some liquidity from this on-chain entity.  And that future DAOs will spend their ether on expenses and development like a normal organization.

But we also know that there is a disconnect between what The DAO is, an investment fund, with what many people see it as: a large vault filled with gold laying in Challenger Deep that will somehow appreciate in value and they will be able to somehow extract that value.

Sure, we will all be able to observe that the funds exist at the bottom of the trench, but someone somewhere has to actually create value with the DAO Tokens and/or ether.

For the same reason that most incubators, accelerators and VC funds fail, that entrepreneur-reliant math doesn’t change for The DAO.  Not only does The DAO need to have a large volume of deal flow, but The DAO needs to attract legitimate projects that — as my friend point out above — have a better risk adjusted return-on-investment than other asset classes.

Will the return-on-investment of the DAO as an asset class be positive in the “early days”?  What happens when the operators and recipients of DAO funds eventually confront the problem of securities regulation?

So far, most of the proposals that appear to be geared up for funding are reminiscent to hype cycles we have all seen over the past couple of years.

Let’s build a product…

  • 2014: But with Bitcoin
  • 2015: But with Blockchain
  • 2016: But with DAO

Maybe the funds will not all be vaporized, but if a non-trivial amount of ETH ends up being held in this DAO or others, it could be the case that with sluggish deal flow, a large portion of the funds could remain inert.  And since this ether would not touching any financial flows; it would be equivalent to storing a large fraction of M0 in your basement safe, siloed off from liquid capital markets.

Ten observations

  1. Since the crowdsale / crowdfund began on April 30, the market price of ETH has increased ~30%; is that a coincidence or is there new demand being generated due to The DAO crowdsale?
  2. A small bug has been discovered in terms of the ETH to DAO Token conversion time table
  3. The DAO surpassed the Ethereum Foundation to become the largest single holder of ether (note: the linked article is already outdated)
  4. In terms of concentration of wealth: according to Etherscan, the top 50 DAO Token holders collectively “own” 38.49% of The DAO
  5. The top 500 DAO Token holders collectively “own” 71.39% of The DAO
  6. As of this writing there are over 15,000 entities (not necessarily individuals) that “own” some amount of a DAO Token
  7. Why is “own” in quotation marks? Because it is still unclear if controlling access to these private keys is the same thing as owning them.  See also: Watermarked Tokens as well as The Law of Bitcoin
  8. Gatecoin, which facilitated the crowdsale of both The DAO and DigixDAO was recently hacked and an estimated $2 million in bitcoins and ether were stolen
  9. Yesterday Gavin Wood, a co-founder of Ethereum, announced that he is stepping down as a “curator” for The DAO.  Curators, according to him, are effectively just individuals who identify whether someone is who they say they are — and have no other duties, responsibilities or authority.
  10. Three days ago, the Slock.it dev team — some of whom also worked on creating The DAO — did a live Q/A session that was videotaped and attempted to answer some difficult questions, like how many DAO Tokens they individually own.

Conclusion

About 17 months ago I put together a list of token crowdsales.  It would be interesting to revisit these at some point later this year to see what the return has been for those holders and how many failed.

For instance, there hasn’t really been any qualitative analysis of crowdsales or ICOs in beyond looking at price appreciation.6 What other utility was ultimately created with the issuance of say, factoids (Factom tokens) or REP (Augur tokens)?

Similarly, no one has really probed Bitcoin mining (and all POW mining) through the lens of a crowdsale on network security. Is every 10 minutes an ICO? After all, the scratch-off contest ties up capital seeking rents on seigniorage and in the long run, assuming a competitive market, that seigniorage is bid away to what Robert Sams has pointed out to where the marginal cost equals the marginal value of a token. So you end up with this relatively large capital base — divorced from the real world — that actually doesn’t produce goods or services beyond the need to be circularly protected via capital-intensive infrastructure.

Other questions to explore in the future include:

  • what are the benefits, if any, of using a centralized autonomous organization (CAO) versus decentralized autonomous organization (DAO) for regulated institutions?
  • how can a party or parties sue a decentralized autonomous organization? 7
  • what are the legal implications of conducting a 51% attack on a network with legally recognized DAOs residing on a public blockchain?8
  • will the continued concentration of ether and/or DAO Tokens create a 51% voting problem identified in the “Curator” section?

Still don’t fully understand what The DAO is?  Earlier this week CoinDesk published a pretty good overview of it.

[Special thanks to Raffael Danielli, Robert Sams and Nick Zeeb for their thoughts]

Endnotes

  1. Note: for the purposes of The DAO, “curators” are effectively identity oracles. []
  2. It appears that currently, once a quorum is achieved, a relatively small proportion of token holders can vote “yes” to a proposal to trigger a large payout. []
  3. The current line-up of goods and services are not based around solving for problems in which censorship is a threat, such as those facing an aid worker in a politically unstable region. []
  4. That is not to say that they all fail. In fact according to one statistic from Kickstarter, there was a 9% failure rate on its platform. Thus, it depends on the platform and what the reward is. []
  5. CoinGecko is tracking several hundred tokens. []
  6. ICO stands for “initial coin offering” — it is slight twist to the term IPO as it relates to securities. []
  7. An added wrinkle to identifying liable parties is: what happens when systems like Zcash launch? []
  8. This presupposes that a DAO will gain legal recognition and/or a public blockchain gains legal standing as an actual legal record. []
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Book Review: The Business Blockchain

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

William Mougayar is an angel investor who has been investigating the cryptocurrency and broader distributed ledger ecosystem over the past several years.

He recently published a book that looks at how enterprises and organizations should look at distributed ledgers and specifically, blockchains.

While it is better than “Blockchain Revolution” from the Tapscott’s, it still has multiple errors and unproven conjectures that prevent me from recommending it.  For instance, it does not really distinguish one blockchain from another, or the key differences between a distributed ledger and a blockchain.

Note: all transcription errors below are my own.

Introduction

On p. xxii he writes:

“These are necessary but not sufficient conditions or properties; blockchains are also greater than the sum of their parts.”

I agree with this and wrote something very similar two years ago in Chapter 2:

While the underlying mathematics and cryptographic concepts took decades to develop and mature, the technical parts and mechanisms of the ledger (or blockchain) are greater than the sum of the ledger’s parts.

On p. xxiv he writes:

“Just like we cannot double spend digital money anymore (thanks to Satoshi Nakamoto’s invention), we will not be able to double copy or forge official certificates once they are certified on a blockchain.”

There are two problems with this:

  1. Double-spending can and does still occur, each month someone posts on social media how they managed to beat a retailer/merchant that accepted zero-confirmation transactions
  2. Double-spending can and is prevented in centralized architectures today, you don’t need a blockchain to prevent double-spending if you are willing to trust a party

Chapter 1

[Note: recommend that future editions should include labeled diagrams/tables/figures]

On p. 11 he writes:

“Solving that problem consists in mitigating any attempts by a small number of unethical Generals who would otherwise become traitors, and lie about coordinating their attack to guarantee victory.”

It could probably be written slightly different: how do you coordinate geographically dispersed actors to solve a problem in which one or more actor could be malicious and attempt to change the plan?  See also Lamport et al. explanation.

On p.13 he writes compares a database with a blockchain which he calls a “ledger.”

I don’t think this is an accurate comparison.

For instance, a ledger, as Robert Sams has noted, assumes ties to legal infrastructure.  Some blockchains, such as Bitcoin, were intentionally designed not to interface with legal infrastructure, thus they may not necessarily be an actual ledger.

To quote Sams:

I think the confusion comes from thinking of cryptocurrency chains as ledgers at all. A cryptocurrency blockchain is (an attempt at) a decentralised solution to the double spending problem for a digital, extra-legal bearer asset. That’s not a ledger, that’s a log.

That was the point I was trying to make all along when I introduced the permissioned/permissionless terminology!  Notice, I never used the phrase “permissionless ledger” — Permissionless’ness is a property of the consensus mechanism.

With a bearer asset, possession of some instrument (a private key in the cryptocurrency world) means ownership of the asset. With a registered asset, ownership is determined by valid entry in a registry mapping an off-chain identity to the asset. The bitcoin blockchain is a public log of proofs of instrument possession by anonymous parties. Calling this a ledger is the same as calling it “bearer asset ledger”, which is an oxymoron, like calling someone a “married bachelor”, because bearer assets by definition do not record their owners in a registry!

This taxonomy that includes the cryptocurrency stuff in our space (“a public blockchain is a permissionless distributed ledger of cryptocurrency”) causes so much pointless discussion.

I should also mention that the DLT space should really should be using the phrase “registry” instead of “ledger”. The latter is about accounts, and it is one ambition too far at the moment to speak of unifying everyone’s accounts on a distributed ledger.

Is this pedantic?  Maybe not, as the authors of The Law of Bitcoin also wrestle with the buckets an anarchic cryptocurrency fall under.

On p. 14 he writes about bank accounts:

“In reality, they provided you the illusion of access and activity visibility on it.  Every time you want to move money, pay someone or deposit money, the bank is giving you explicit access because you gave them implicit trust over your affairs.  But that “access” is also another illusion.  It is really an access to a database record that says you have such amount of money.  Again, they fooled you by giving you the illusion that you “own” that money.”

This is needless inflammatory.  Commercial law and bankruptcy proceedings will determine who owns what and what tranche/seniority your claims fall under.  It is unclear what the illusion is.

On p. 14 he writes:

“A user can send money to another, via a special wallet, and the blockchain network does the authentication, validation and transfer, typically within 10 minutes, with or without a cryptocurrency exchange in the middle.”

Which blockchain is he talking about?  If it is not digital fiat, how does the cash-in/cash-out work?  To my knowledge, no bank has implemented an end-to-end production system with other banks as described above.  Perhaps that will change in the future.

On p. 18 he writes:

“Sometimes it is represented by a token, which is another form of related representation of an underlying cryptocurrency.”

This isn’t very well-defined.  The reason I went to great lengths in November to explain what a “token” is and isn’t is because of the confusion caused by the initial usage of a cryptographic token, a hardware device from companies like RSA.  This is not what a “token” in cryptocurrency usage means. (Note: later on p. 91 he adds a very brief explanation)

On p. 18 he cites Robert Sams who is quoting Nick Szabo, but didn’t provide a source.  It is found in Seigniorage Shares.

On p. 18 he also writes:

“As cryptocurrency gains more acceptance and understanding, its future will be less uncertain, resulting in a more stable and gradual adoption curve.”

This is empirically not true and actually misses the crux of Sams’ argument related to expectations.

On p. 20 he writes:

“As of 2016, the Bitcoin blockchain was far from these numbers, hovering at 5-7 TPS, but with prospects of largely exceeding it due to advances in sidechain technology and expected increases in the Bitcoin block size.”

This isn’t quite correct.  On a given day over the past year, the average TPS is around 2 TPS and Tradeblock estimates by the end of 2016 that with the current block size it will hover around just over 3 TPS.

What is a sidechain?  It is left undefined in that immediate section.  One potential definition is that it is a sofa.

On p. 20 he writes:

“Private blockchains are even faster because they have less security requirements, and we are seeing 1,000-10,000 TPS in 2016, going up to 2,000-15,000 TPS in 2017, and potentially an unlimited ceiling beyond 2019.”

This is untrue.  “Private blockchains” do not have “less” security requirements, they have different security requirements since they involve known, trusted participants.  I am also unaware of any production distributed ledger system that hits 10,000 TPS.  Lastly, it is unclear where the “unlimited ceiling” prediction comes from.

On p. 20 he writes:

“In 2014, I made the strong assertion that the blockchain is the new database, and warned developers to get ready to rewrite everything.”

Where did you warn people?  Link?

On p. 21 he writes:

“For developers, a blockchain is first and foremost a set of software technologies.”

I would argue that it is first and foremost a network.

On p. 22 he writes:

“The fact that blockchain software is open source is a powerful feature. The more open the core of a blockchain is, the stronger the ecosystem around it will become.”

Some, but not all companies building blockchain-related technology, open source the libraries and tools.  Also, this conflates the difference between code and who can validate transactions on the network.  A “private blockchain” can be open sourced and secure, but only permit certain entities to validate transactions.

On p. 24 he writes:

“State machines are a good fit for implementing distributed systems that have to be fault-tolerant.”

Why?

On p. 25 he writes:

“Bitcoin initiated the Proof-of-Work (POW) consensus method, and it can be regarded as the granddaddy of these algorithms. POW rests on the popular Practical Byzantine Fault Tolerant algorithm that allows transactions to be safely committed according to a given state.”

There are at least two problems with this statement:

  • The proof-of-work mechanism used in Bitcoin is apocryphally linked to Hashcash from Adam Back; however this does not quite jive with Mougayar’s statement above. Historically, this type of proof-of-work predates Back’s contribution, all the way to 1992.  See Pricing via Processing or Combatting Junk Mail by Dwork and Naor
  • Practical Byzantine Fault Tolerance is the name of a specific algorithm published in 1999 by Castro and Liskov; it is unrelated to Bitcoin.

On p. 26 he writes:

“One of the drawbacks of the Proof-of-Work algorithm is that it is not environmentally friendly, because it requires large amounts of processing power from specialized machines that generate excessive energy.”

This is a design feature: to make it economically costly to change history.  It wasn’t that Satoshi conjured up a consensus method to be environmentally friendly, rather it is the hashrate war and attempt to seek rents on seigniorage that incentivizes the expenditure of capital, in this case energy.  If the market price of a cryptocurrency such as bitcoin declined, so too would the amount of energy used to secure it.

Chapter 2

On p. 29 he writes:

“Reaching consensus is at the heart of a blockchain’s operations.  But the blockchain does it in a decentralized way that breaks the old paradigm of centralized consensus, when one central database used to rule transaction validity.”

Which blockchain is he talking about?  They are not a commodity, there are several different unique types.  Furthermore, distributed consensus is an academic research field that has existed for more than two decades.

On p. 29 he writes:

“A decentralized scheme (which the blockchain is based on) transfers authority and trust to a decentralized network and enables its nodes to continuously and sequentially record their transactions on a public “block,” creating a unique” chain” – the blockchain.”

Mougayar describes the etymology of the word “blockchain” specific to Bitcoin itself.

Note: a block actually is more akin to a “batch” or “bucket” in the sense that transactions are bundled together into a bucket and then propagated.  His definition of what a blockchain is is not inclusive enough in this chapter though because it is unclear what decentralization can mean (1 node, 100 nodes, 10,000 nodes?).  Also, it is important to note that not all distributed ledgers are blockchains.

On p. 31 he writes:

“Credit card companies charge us 23% in interest, even when the prime rate is only at 1%”

Which credit card companies are charging 23%?  Who is being charged this?  Also, even if this were the case, how does a blockchain of some kind change that?

On p. 32 he writes:

“Blockchains offer truth and transparency as a base layer. But most trusted institutions do not offer transparency or truth. It will be an interesting encounter.”

This is just a broad sweeping generalization.  What does truth and transparency mean here?  Which blockchains?  Which institutions?  Cannot existing institutions build or use some kind of distributed ledger to provide the “truth” and “transparency” that he advocates?

On p. 33 he writes:

“The blockchain challenges the roles of some existing trust players and reassigns some of their responsibilities, sometimes weakening their authority.”

Typo: should be “trusted” not “trust.”

On p. 34 he writes:

“There is a lesson from Airbnb, which has mastered the art of allowing strangers to sleep in your house without fear.”

This is not true, there are many examples of Airbnb houses that have been trashed and vandalized.

On p. 34, just as the Tapscott’s did in their book, Mougayar talks about how Airbnb could use a blockchain for identity and reputation.  Sure, but what are the advantages of doing that versus a database or other existing technology?

On p. 37 he writes:

“Enterprises are the ones asking, because the benefits are not necessarily obvious to them.  For large companies, the blockchain presented itself as a headache initially. It was something they had not planned for.”

First off, which blockchain?  And which enterprises had a headache from it?

On p. 39 he writes: “Prior to the Bitcoin invention…”

He should probably flip that to read “the invention of Bitcoin”

On p. 40 he writes:

“… it did not make sense to have money as a digital asset, because the double-spend (or double-send) problem was not solved yet, which meant that fraud could have dominated.”

This is empirically untrue.  Centralized systems prevent double-spending each and every day.  There is a double-spending problem when you are using a pseudonymous, decentralized network and it is partially resolved (but not permanently solved) in Bitcoin by making it expensive, but not impossible, to double-spend.

On p. 41 he writes:

“They will be no less revolutionary than the invention of the HTML markup language that allowed information o be openly published and linked on the Web.”

This is a little redundant and should probably be rewritten as “the invention of the hypertext markup language (HTML).”

On p. 43 he writes:

“Smart contracts are ideal for interacting with real-world assets, smart property, Internet of Things (IoT) and financial services instruments.”

Why are smart contracts ideal for that?

On p. 46 he writes: “Time-stamping” and in other areas he writes it without a dash.

On p. 46 he writes:

“And blockchains are typically censorship resistant, due to the decentralized nature of data storage, encryption, and peer controls at the edge of the network.”

Which blockchains?  Not all blockchains in the market are censorship resistant.  Why and why not?

On p. 48 he mentions “BitIID” – this is a typo for “BitID”

On p. 51 he writes:

“Enter the blockchain and decentralized applications based on it. Their advent brings potential solutions to data security because cryptographically-secured encryption becomes a standard part of blockchain applications, especially pertaining to the data parts. By default, everything is encrypted.”

This is untrue.  Bitcoin does not encrypt anything nor does Ethereum.  A user could encrypt data first, take a hash of it and then send that hash to a mining pool to be added to a block, but the network itself provides no encryption ability.

On p. 52 he writes:

“Consensus in public blockchains is done publicly, and is theoretically subject to the proverbial Sybil attacks (although it has not happened yet).”

Actually, it has on altcoins.  One notable occurrence impacted Feathercoin during June 2013.

On p. 54 he writes:

“The blockchain can help, because too many Web companies centralized and hijacked what could have been a more decentralized set of services.”

This is the same meme in the Tapscott book.  There are many reasons for why specific companies and organizations have large users bases but it is hard to see how they hijacked anyone; but that is a different conversation altogether.

On p. 54 he writes:

“We can also think of blockchains as shared infrastructure that is like a utility. If you think about how the current Internet infrastructure is being paid for, we subsidize it by paying monthly fees to Internet service providers.  As public blockchains proliferate and we start running millions of smart contacts and verification services on them, we might be also subsidizing their operation, by paying via micro transactions, in the form of transaction fees, smart contract tolls, donation buttons, or pay-per-use schemes.”

This is a very liberal use of the word subsidize.  What Mougayar is describing above is actually more of a tax than a charitable donation.

The design behind Bitcoin was intended to make it such that there was a Nash equilibrium model between various actors.  That miners would not need to rely on charity to continue to secure the network because as block rewards decline, the fees themselves would in the long run provide enough compensation to pay for their security services.

It could be argued that this will not happen, that fees will not increase to offset the decline in block rewards but that is for a different article.

As an aside, Mougayar’s statement above then intersects with public policy: which blockchains should receive that subsidy or donation?  All altcoins too?  And who should pay this?

Continuing:

“Blockchains are like a virtual computer somewhere in a distributed cloud that is virtual and does not require server setups. Whoever opens a blockchain node runs the server, but not users or developers.”

This is untrue.  The ~6,400 nodes on the Bitcoin network are all servers that require setup and maintenance to run.  The same for Ethereum and any other blockchain.

On p. 58 he writes:

“It is almost unimaginable to think that when Satoshi Nakamoto released the code for the first Bitcoin blockchain in 2009, it consisted of just two computers and a token.”

A couple issues:

  1. There is a typo – “first” should be removed (unless there was another Bitcoin network before Bitcoin?)
  2. Timo Hanke and Sergio Lerner have hypothesized that Satoshi probably used multiple computers, perhaps more than a dozen.

On p. 58 he writes:

“One of the primary differences between a public and private blockchain is that public blockchains typically have a generic purpose and are generally cheaper to use, whereas private blockchains have a more specific usage, and they are more expensive to set up because the cost is born by fewer owners.”

This is not true.  From a capital and operation expenditure perspective, public blockchains are several orders of magnitude more expensive to own and maintain than a private blockchain.  Why?  Because there is no proof-of-work involved and therefore private blockchain operators do not need to spend $400 million a year, which is roughly the cost of maintaining the Bitcoin network today.

In contrast, depending on how a private blockchain (or distributed ledger) is set up, it could simply be run by a handful of nodes on several different cloud providers – a marginal cost.

Chapter 3

On p. 68 he writes:

“Taken as an extreme case, just about any software application could be rewritten with some blockchain and decentralization flavor into it, but that does not mean it’s a good idea to do so.”

Yes, fully agreed!

On p. 68 he writes:

“By mid-2016, there were approximately 5,000 developers dedicated to writing software for cryptocurrency, Bitcoin or blockchains in general. Perhaps another 20,000 had dabbled with some of that technology, or written front-end applications that connect to a blockchain, one way or the other.”

Mougayar cites his survey of the landscape for this.

I would dispute this though, it’s probably an order of magnitude less.

The only way this number is 5,000 is if you liberally count attendees at meetups or all the various altcoins people have touched over the year, and so forth.  Even the headcount of all the VC funded “bitcoin and blockchain” companies is probably not even 5,000 as of May 2016.

On p. 71 he writes:

“Scaling blockchains will not be different than the way we have continued to scale the Internet, conceptually speaking.  There are plenty of smart engineers, scientists, researchers, and designers who are up to the challenge and will tackle it.”

This is a little too hand-wavy.  One of the top topics that invariably any conversation dovetails into at technical working groups continues to be “how to scale” while keeping privacy requirements and non-functional requirements intact.  Perhaps this will be resolved, but it cannot be assumed that it will be.

On p. 72 he writes:

“Large organizations, especially banks, have not been particularly interested in adopting public blockchains for their internal needs, citing potential security issues. The technical argument against the full security of public blockchains can easily be made the minute you introduce a shadow of a doubt on a potential scenario that might wreak havoc with the finality of a transaction.  That alone is enough fear to form a deterring factor for staying away from public blockchain, although the argument could be made in favor of their security.”

This is a confusing passage.  The bottom line is that public blockchains were not designed with the specific requirements that regulated financial institutions have.  If they did, perhaps they would be used.  But in order to modify a public blockchain to provide those features and characteristics, it would be akin to turning an aircraft carrier into a submarine.  Sure it might be possible, but it would just be easier and safer to build a submarine instead.

Also, why would an organization use a public blockchain for their internal needs?  What does that mean?

On p. 78 he writes:

“Targeting Bitcoin primarily, several governments did not feel comfortable with a currency that was not backed by a sovereign country’s institutions.”

Actually, what made law enforcement and regulators uncomfortable was a lack of compliance for existing AML/KYC regulations.  The headlines and hearings in 2011-2013 revolved around illicit activities that could be accomplished as there were no tools or ability to link on-chain activity with real world identities.

Chapter 4

On p. 87 he writes:

“The reality is that customers are not going to the branch as often (or at all), and they are not licking as many stamps to pay their bills.  Meanwhile, FinTech growth is happening: it was a total response to banks’ lack of radical innovation.”

There are a couple issues going on here.

Banks have had to cut back on all spending due to cost cutting efforts as a whole and because their spending has had to go towards building reporting and compliance systems, neither of which has been categorized as “radical innovation.”

Also, to be balanced, manyh of the promises around “fintech” innovation still has yet to germinate due to the fact that many of the startups involved eventually need to incorporate and create the same cost structures that banks previously had to have.  See for instance, financial controls in marketplace lending – specifically Lending Club.

On p. 88 he writes:

“If you talk to any banker in the world, they will admit that ApplePay and PayPal are vexing examples of competition that simply eats into their margins, and they could not prevent their onslaught.”

Any banker will say that?  While a couple of business lines may change, which banks are being displaced by either of those two services right now?

On p. 89 he writes:

“Blockchains will not signal the end of banks, but innovation must permeate faster than the Internet did in 1995-2000.”

Why?  Why must it permeate faster?  What does that even mean?

On p. 89 he writes:

“This is a tricky question, because Bitcoin’s philosophy is about decentralization, whereas a bank is everything about centrally managed relationships.”

What does this mean?  If anything, the Bitcoin economy is even more concentrated than the global banking world, with only about a dozen exchanges globally that handle virtually all of the trading volume of all cryptocurrencies.

On p. 89 he writes:

“A local cryptocurrency wallet skirts some of the legalities that existing banks and bank look-alikes (cryptocurrency exchanges) need to adhere to, but without breaking any laws. You take “your bank” with you wherever you travel, and as long as that wallet has local onramps and bridges into the non-cryptocurrency terrestrial world, then you have a version of a global bank in your pocket.”

This is untrue.  There are many local and international laws that have been and continue to be broken involving money transmission, AML/KYC compliance and taxes.  Ignoring those though, fundamentally there are probably more claims on bitcoins – due to encumbrances – than bitcoins themselves.  This is a big problem that still hasn’t been dealt with as of May 2016.

On p. 95 he writes:

“The decentralization of banking is here. It just has not been evenly distributed yet.”

This is probably inspired by William Gibson who said: ‘The future is already here — it’s just not very evenly distributed.’

On p. 95 he writes:

“The default state and starting position for innovation is to be permissionless. Consequently, permissioned and private blockchain implementations will have a muted innovation potential.  At least in the true sense of the word, not for technical reasons, but for regulatory ones, because these two aspect are tie together.”

This is not a priori true, how can he claim this?  Empirically we know that permissioned blockchains are designed for different environments than something like Bitcoin.  How can he measure the amount of potential “innovation” either one has?

On p. 95 he writes:

“We are seeing the first such case unfold within the financial services sector, that seems to be embracing the blockchain fully; but they are embracing it according to their own interpretation of it, which is to make it live within the regulatory constraints they have to live with. What they are really talking about is “applying innovation,” and not creating it. So, the end-result will be a dialed down version of innovation.”

This is effectively an ad hominem attack on those working with regulated institutions who do not have the luxury of being able to ignore laws and regulations in multiple jurisdictions.  There are large fines and even jail time for ignoring or failing to comply with certain regulations.

On p. 95 he writes:

“That is a fact, and I am calling this situation the “Being Regulated Dilemma,” a pun on the innovator’s dilemma. Like the innovator’s dilemma, regulated companies have a tough time extricating themselves from the current regulations they have to operate within.  So, when they see technology, all they can do is to implement it within the satisfaction zones of regulators. Despite the blockchain’s revolutionary prognosis, the banks cannot outdo themselves, so they risk only guiding the blockchain to live within their constrained, regulated world.”

“It is a lot easier to start innovating outside the regulatory boxes, both figuratively and explicitly. Few banks will do this because it is more difficult.”

“Simon Taylor, head of the blockchain innovation group at Barclays, sums it up: “I do not disagree the best use cases will be outside regulated financial services. Much like the best users of cloud and big data are not the incumbent blue chip organizations.  Still their curioisity is valuable for funding and driving forward the entire space.” I strongly agree; there is hope some banks will contribute to the innovation potential of the blockchain in significant ways as they mature their understanding and experiences with this next technology.

An ending note to banks is that radical innovation can be a competitive advantage, but only if it is seen that way. Otherwise innovation will be dialed down to fit their own reality, which is typically painted in restrictive colors.

It would be useful to see banks succeed with the blockchain, but they need to push themselves further in terms of understanding what the blockchain can do. They need to figure out how they will serve their customers better, and not just how they will serve themselves better. Banks should innovate more by dreaming up use cases that we have not though about yet, preferably in the non-obvious category.

The fundamental problem with his statement is this: banks are heavily regulated, they cannot simply ignore the regulations because someone says they should.  If they fail to maintain compliance, they can be fined.

But that doesn’t mean they cannot still be innovative, or that the technology they are investigating now isn’t useful or helpful to their business lines.

In effect, this statement is divorced from the reality that regulated financial institutions operate in.  [Note: some of his content such as the diagram originated from his blog post]

On p. 102 he writes:

“Banks will be required to apply rigorous thinking to flush out their plans and positions vis-à-vis each one of these major blockchain parameters. They cannot ignore what happens when their core is being threatened.”

While this could be true, it is an over generalization: what type of business lines at banks are being threatened?  What part of “their” core is under attack?

On p. 103 he writes:

“More than 200 regulatory bodies exist in 150 countries, and many of them have been eyeing the blockchain and pondering regulatory updates pertaining to it.”

Surely that is a typo, there are probably 200 regulatory bodies alone in the US itself.

On p. 105 he writes:

“Banks will need to decide if they see the blockchain as a series of Band-Aids, or if they are willing to find the new patches of opportunity.  That is why I have been advocating that they should embrace (or buy) the new cryptocurrency exchanges, not because these enable Bitcoin trades, but because they are a new generation of financial networks that has figured out how to transfer assets, financial instruments, or digital assets swiftly and reliably, in essence circumventing the network towers and expense bridges that the current financial services industry relies upon.”

This is a confusing passage.

Nearly all of the popular cryptocurrency exchanges in developed countries require KYC/AML compliance in order for users to cash-in and out of their fiat holdings.  How do cryptocurrency exchanges provide any utility to banks who are already used to transferring and trading foreign exchange?

In terms of percentages, cryptocurrency exchanges are still very easy to compromise versus banks; what utility do banks obtain by acquiring exchanges with poor financial controls?

And, in order to fund their internal operations, cryptocurrency exchanges invariably end up with the same type of cost structures regulated financial institutions have; the advantage that they once had effectively involved non-compliance – that is where some of the cost savings was.  And banks cannot simply ignore regulations because people on social media want them to; these cryptocurrency sites require money to operate, hence the reason why many of them charge transaction fees on all withdrawals and some trades.

Chapter 5

On p. 115 he mentions La’Zooz and Maidsafe, neither of which – after several years of development, actually work.  Perhaps that changes in the future.

On p.118 he writes:

“There is another potential application of DIY Government 2.0. Suppose a country’s real government is failing, concerned citizens could create a shadow blockchain governance that is more fair, decentralized and accountable. There are at least 50 failed, fragile, or corrupt states that could benefit from an improve blockchain governance.”

Perhaps this is true, that there could be utility gain from some kind of blockchain.  But this misses a larger challenge: many of these same countries lack private property rights, the rule of law and speedy courts.

On p. 119 he writes about healthcare use cases:

“Carrying a secure wallet with our full electronic medical record in it, or our stored DNA, and allowing its access, in case of emergency.”

What advantage do customers gain from carrying this around in a secure wallet?  Perhaps they do, but it isn’t clear in this chapter.

On p. 126-127 he makes the case for organizations to have a “blockchain czar” but an alternative way to pitch this without all the pomp is simply to have someone be tasked with becoming a subject-matter expert on the topic.

On p. 131 he writes:

“Transactions are actually recorded in sequential data blocks (hence the word blockchain), so there is a historical, append-only log of these transaction that is continuously maintained and updated.  A fallacy is that the blockchain is a distributed ledger.”

It is not a fallacy.

Chapter 7

On p. 149 he writes: “What happened to the Web being a public good?”

Costs.  Websites have real costs.  Content on those websites have real costs.  And so forth.  Public goods are hard to sustain because no one wants to pay for them but everyone wants to use them.  Eventually commercial entities found a way to build and maintain websites that did not involve external subsidization.

On p. 150 he writes:

“Indeed, not only was the Web hijacked with too many central choke points, regulators supposedly continue to centralize controls in order to lower risk, whereas the opposite should be done.”

This conflicts with the “Internet is decentralized” meme that was discussed throughout the book.  So if aspects of the Internet are regulated, and Mougayar disagrees with those regulations, doesn’t this come down to disagreements over public policy?

On p. 153 he writes:

“Money is a form of value.  But not all value is money. We could argue that value has higher hierarchy than money. In the digital realm, a cryptocurrency is the perfect digital money.  The blockchain is a perfect exchange platform for digital value, and it rides on the Internet, the largest connected network on the planet.”

Why are cryptocurrencies perfect?  Perhaps they are, but it is not discussed here.

On p. 153 he also talks about the “programmability” of cryptocurrencies but doesn’t mention that if fiat currencies were digitally issued by central banks, they too could have the same programmable abilities.

On p. 160 he predicts:

“There will be dozens of commonly used, global virtual currencies that will be considered mainstream, and their total market value will exceed $5 trillion, and represent 5% of the world’s $100 trillion economy in 2025.”

Perhaps that occurs, but why?  And are virtual currencies now different than digital currencies?  Or are they the same?  None of these questions are really addressed.

Conclusion

This book is quick read but unfortunately is weighed down by many opinions that are not supported by evidence and consequently, very few practical applications for enterprises are explained in detail.

For regulated businesses such as financial institutions, there are several questions that need to be answered such as: what are the specific cost savings for using or integrating with some kind of blockchain?  What are the specific new business lines that could be created?  And unfortunately the first edition of this book did not answer these types of questions.  Let us look again at a future version.

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AFA Presentation: Cryptocurrencies, Blockchains and the Future of Financial Services

The slideshow below was first presented at an AFA panel on January 4, 2016 in San Francisco.

References:

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Some housekeeping of events and interviews

It has been a little while since I posted the events, panels and presentations I have been involved with.  Below is some of the public activity over the past 5-6 months.

Interviews with direct quotes:

Indirect quotes:

Academic citations:

Presentations, panels and events:

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Buckets of Permissioned, Permissionless, and Permissioned Permissionlessness Ledgers

A few hours ago I gave the following presentation to Infosys / Finacle in Mysore, India with the Blockchain University team.  All views and opinions are my own and do not represent those of either organization.

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Learning from the past to build an improved future of fintech

[Note: below is a slightly edited speech I gave yesterday at a banking event in Palo Alto.  This includes all of the intended legalese, some of which I removed in the original version due to flow and time.  Special thanks to Ryan Straus for his feedback.  The views below are mine alone and do not represent those of any organization or individual named.]

Before we look to the future of fintech, and specifically cryptocurrencies and distributed ledgers, let’s look at the most recent past.  It bears mentioning that as BNY Mellon is the largest custodial bank in the world, we will see the importance of reliable stewardship in a moment below.

In January 2009 an unknown developer, or collective of developers, posted the source code of Bitcoin online and began generating blocks – batches of transactions – that store and update the collective history of Bitcoin: a loose network of computer systems distributed around the globe.

To self-fund its network security, networks like Bitcoin create virtual “bearer assets.” These assets are automatically redeemable with the use of a credential.  In this case, a cryptographic private key.  From the networks point of view, possession of this private key is the sole requirement of ownership.  While the network rules equivocate possession and control, real currency – not virtual currency – is the only true bearer instrument.  In other words, legal tender is the only unconditional exception to nemo dat quod non habet – also known as the derivative principal – which dictates that one cannot transfer better title than one has.

Several outspoken venture investors and entrepreneurs in this space have romanticized the nostalgia of such a relationship, of bearer assets and times of yore when a “rugged individual” can once again be their own custodian and bank.1 The sentimentality of a previous era when economies were denominated by precious metals held – initially not by trusted third parties – but by individuals, inspired them to invest what has now reached more than $800 million in collective venture funding for what is aptly called Bitcoinland.

Yet, the facts on the ground clearly suggests that this vision of “everyone being their own bank” has not turned into a renaissance of success stories for the average private key holder.  The opposite seems to have occurred as the dual-edged sword of bearer instruments have been borne out.  At this point, it is important to clearly define our terms.  The concepts of “custody” and “deposit” are often conflated.  While the concepts are superficially similar, they are very different from a legal perspective.  Custody involves the transfer of possession/control.  A deposit, on the other hand, occurs when both control and title is transferred.

Between 2009 and early 2014, based on public reports, more than 1 million bitcoins were lost, stolen, seized and accidentally destroyed.2 Since that time, several of the best funded “exchanges” have been hacked or accidentally sent bitcoins to the wrong customer.  While Mt. Gox, which may have lost 850,000 bitcoins itself, has attracted the most attention and media coverage – rightfully so – there is a never ending flow of unintended consequences from this bearer duality.3

For instance, in early January 2015, Bitstamp – one of the largest and oldest exchanges – lost 19,000 bitcoins due to social engineering and phishing via Gmail and Skype on its employees including a system administrator.4 Four months later, in May, Bitfinex, a large Asian-based exchange was hacked and lost around 1,500 bitcoins.5 In another notable incident, last September, Huobi, a large Bitcoin exchange in Beijing accidentally sent 920 bitcoins and 8,100 litecoins to the wrong customers.6  And ironically, because transactions are generally irreversible and the sole method of control is through a private key they no longer controlled them: they had to ask for the bitcoins back and hope they were returned.

A study of 40 Bitcoin exchanges published in mid-2013 found that at that time 18 out of 40 – 45% — had closed doors and absconded with some portion of customer funds.7 Relooking at that list today we see that about another five have closed in a similar manner.  All told, at least 15% if not higher, of Bitcoin’s monetary base is no longer with the legitimate owner.  Can you imagine if a similar percentage of real world wealth or deposits was dislocated in the same manner in a span of 6 years?8

In many cases, the title to this property is encumbered, leading to speculation that since many of these bitcoins are intermixed and pooled with others, a large percentage of the collective monetary base does not have clean title, the implications of which can be far reaching for an asset that is not exempted from nemo dat, it is not fungible like legal tender.9

As a consequence, because people in general don’t trust themselves with securing their own funds, users have given – deposited – their private keys with a new batch of intermediaries that euphemistically market themselves as “hosted wallets” or “vaults.” What does that look like in the overall scheme?  These hosted wallets, such as Coinbase and Xapo, have collectively raised more than $200 million in venture funding, more than a quarter of the aggregate funding that the whole Bitcoin space has received. Simultaneously, the new – often unlicensed – parties collectively hold several million bitcoins as deposits; probably 25-30% of the existing monetary base.10 Amazingly, nobody is actually certain whether a “hosted wallet” is a custodian of a customers bitcoin or acquired title to the bitcoin and is thus a depository.

Yet, in recreating the same financial intermediaries that they hoped to replace – in turning a bearer asset into a registered asset – some Bitcoin enthusiasts have done so in fashion that – as described earlier – has left the system ripe for abuse.  Whereas in the real world of finance, various duties are segregated via financial controls and independent oversight.11 In the Bitcoin space, there have been few financial controls.  For example, what we call a Bitcoin exchange is really a broker-dealer, clearinghouse, custodian, depository and an exchange rolled into one house which has led to theft, tape painting, wash trading, and front-running.12 All the same issues that led to regulatory oversight in the financial markets in the first place.

And while a number of the better funded and well-heeled hosted wallets and exchanges have attempted to integrate “best practices” and even third-party insurance into their operation, to date, there is only one Bitcoin “vault” – called Elliptic — that has been accredited with meeting the ISAE 3402 custodial standard from KPMG. Perhaps this will change in the future.

But if the point of the Bitcoin experiment, concept, lifestyle or movement was to do away or get away from trusted third parties, as described above, the very opposite has occurred.

What can be learned from this?  What were the reasons for institutions and intermediation in the first place?  What can be taken away from the recent multi-million dollar educational lesson?

We have collectively learned that a distributed ledger, what in Bitcoin is called a blockchain, is capable of clearing and settling on-chain assets in a cryptographically verifiable manner, in near-real time all with 100% uptime because its servers – what are called validators – are located around the world.  As we speak just under sixty four hundred of these servers exist, storing and replicating the data so that availability to any one of them is, in theory, irrelevant.13

Resiliency, accountability and transparency, what’s not to like?  Why wouldn’t financial institutions want to jump on Bitcoin then, why focus on other distributed ledger systems?

One of the design assumptions in Bitcoin is that its validators are unknown and untrusted – that there is no gating or vetting process to become a validator on its open network.  Because it is purposefully expensive and slow to produce a block that the rest of the network will regard as valid, in theory, the rest of the network will reject your work and you will have lost your money.  Thus, validators, better technically referred to as a block maker, attempt to solve a benign math problem that takes on average about 10 minutes to complete with the hope of striking it rich and paying their bills. There are exceptions to this behavior but that is a topic for another time.14

The term trust or variation thereof appears 13 times in the final whitepaper.  Bitcoin was designed to be a solution for cypherpunks aiming to minimize trust-based relationships and mitigate the ability for any one party to censor or block transactions. Because validators are unknown and untrusted, to protect against history-reversing attacks, Bitcoin was purposefully designed to be inefficient.15 That is to say attackers must expend real world resources, energy, to disrupt or rewrite history.  The theory is that this type of economic attack would stave off all but the most affluent nation-state actors; in practice this has not been the case, but that again is a topic for another speech.

Thus Bitcoin is perhaps the world’s first, commodity-based censorship resistance-as-a-service.  To prevent attackers on this communal network from reversing or changing transactions on a whim, an artificially expensive anti-Sybil mechanism was built in dubbed “proof of work” – the 10 minute math problem.  Based on current token value, the cost to run this network is roughly $300 million a year and it scales in direct proportion to the bitcoin market price.16

Thus there are trade-offs that most financial institutions specifically would not be interested in.

Why you may ask?

Because banks already know their customers, staff and partners. Their counterparties and payment processors are all publicly known entities with contractual obligations and legal accountability.  Perhaps more importantly, the relationship created between an intermediary and a customer is clear with traditional financial instruments.  For example, when you deposit money in your bank account, you know (or should know) that you are trading your money for an IOU from the bank.17 On the other hand, when you place money in a safe deposit box you know (or should know) that you retain title to the subject property.  This has important considerations for both the customer and intermediary.  When you trade your money for an IOU, you are primarily concerned with the financial condition of the intermediary.  However, when you retain title to an object held by somebody else, you care far more about physical and logical security.

As my friend Robert Sams has pointed out on numerous occasions, permissionless consensus as it is called in Bitcoin, cannot guarantee irreversibility, cannot even quantify the probability of a history-reversing attack as it rests on economics, not technology.18 Bitcoin is a curious design indeed where in practice many participants on the network are now known, gated and authenticated except the transaction validators.  Why use expensive proof-of-work at all at this point if that is the case?  What is the utility of turning a permissionless system into a permissioned system, with the costs of both worlds and the benefits of neither?

But lemonade can still be squeezed from it.

Over the past year more than a dozen startups have been created with the sole intent to take parts of a blockchain and integrate their utility within financial institutions.19 They are doing so with different design assumptions: known validators with contractual terms of service. Thus, just as PGP, SSL, Linux and other open source technology, libraries and ideas were brought into the enterprise, so too are distributed ledgers.

Last year according to Accenture, nearly $10 billion was invested in fintech related startups, less than half of one percent of which went to distributed ledger-related companies as they are now just sprouting.20

What is one practical use?  According to a 2012 report by Deutsche Bank, banks’ IT costs equal 7.3% of their revenues, compared to an average of 3.7% across all other industries surveyed.21)  Several of the largest banks spend $5 billion or more in IT-related operating costs each year.  While it may sound mundane and unsexy, one of the primary use cases of a distributed ledger for financial institutions could be in reducing the cost centers throughout the back office.

For example, the settlement and clearing of FX and OTC derivatives is an oft cited and increasingly studied use case as a distributed ledger has the potential to reduce counterparty and systemic risks due to auditability and settlement built within the data layer itself.22

How much would be saved if margining and reporting costs were reduced as each transaction was cryptographically verifiable and virtually impossible to reverse? At the present time, one publicly available study from Santander estimates that “distributed ledger technology could reduce banks’ infrastructure costs attributable to cross-border payments, securities trading and regulatory compliance by between $15-20 billion per annum by 2022.”23

With that said, in its current form Bitcoin itself is probably not a threat to retail banking, especially in terms of customer acquisition and credit facilities.  For instance, if we look at on-chain entities there are roughly 370,000 actors.  If the goal of Bitcoin was to enable end-users to be their own bank without any trusted parties, based on the aggregate VC funding thus far, around $2,200 has been spent to acquire each on-chain user all while slowly converting a permissionless system into a permissioned system, but with the costs of both.24

That’s about twice as much as the average bank spends on customer acquisition in the US.  While there are likely more than 370,000 users at deposit-taking institutions like Coinbase and Xapo, they neither disclose the monthly active users nor are those actual Bitcoin users because they do not fully control the private key.

If we were to create a valuation model for the bitcoin network (not the price of bitcoins themselves), the network would be priced extremely rich due to the wealth transfer that occurs every 10 minutes in the form of asset creation.  The network in this case are miners, the block makers, who are first awarded these bearer instruments.

How can financial institutions remove the duplicative cost centers of this technology, remove this $300 million mining cost, integrate permissioned distributed ledgers into their enterprise, reduce back office costs and better serve their customers?

That is a question that several hundred business-oriented innovators and financial professionals are trying to answer and we will likely know in less time it took Bitcoin to get this far.

Thanks for your time.

Endnotes:

  1. Why Bitcoin Matters by Marc Andreessen []
  2. Tabulating publicly reported bitcoins that were lost, stolen, seized, scammed and accidentally destroyed between August 2010 and March 2014 amounts to 966,531 bitcoins. See p. 196 in The Anatomy of a Money-like Informational Commodity []
  3. Mt. Gox files for bankruptcy, hit with lawsuit from Reuters []
  4. Bitstamp Incident Report []
  5. Bitfinex Warns Customers to Halt Deposits After Suspected Hack from CoinDesk []
  6. Why One Should Think Twice Before Trading On The Bitcoin Exchanges from Forbes []
  7. See Beware the Middleman: Empirical Analysis of Bitcoin-Exchange Risk by Tyler Moore and Nicolas Christin []
  8. This has occurred during times of war.  See The Monuments Men []
  9. Bitcoin’s lien problem from Financial Times and Uniform Commercial Code and Bitcoin with Miles Cowan []
  10. Based on anecdotal conversations both Coinbase and Xapo allegedly, at one point stored over 1 million bitcoins combined. See also: Too Many Bitcoins: Making Sense of Exaggerated Inventory Claims []
  11. See Distributed Oversight: Custodians and Intermediaries []
  12. See Segregation of Duties in the CEWG BitLicense comment []
  13. See Bitnodes []
  14. See Majority is not Enough: Bitcoin Mining is Vulnerable from Ittay Eyal and Emin Gün Sirer []
  15. See Removing the Waste from Cryptocurrencies: Challenges and More Challenges by Bram Cohen and Cost? Trust? Something else? What’s the killer-app for Block Chain Technology? by Richard Brown []
  16. See Appendix B []
  17. See A Simple Explanation of Balance Sheets (Don’t run away… it’s interesting, really!) by Richard Brown []
  18. Needing a token to operate a distributed ledger is a red herring []
  19. See The Distributed Ledger Landscape and Consensus-as-a-service []
  20. Fintech Investment in U.S. Nearly Tripled in 2014 from Accenture []
  21. IT in banks: What does it cost? from Santander []
  22. See No, Bitcoin is not the future of securities settlement by Robert Sams []
  23. The Fintech 2.0 Paper: rebooting financial services from Santander []
  24. One notable exception are branchless banks such as Fidor which is expanding globally and on average spends about $20 per customer.  See also How much do you spend on Customer Acquisition? Are you sure? []
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A blockchain with emphasis on the “a”

Over the past month a number of VCs including Chris Dixon and Fred Wilson use the term “the blockchain” in reference to Bitcoin, as if it is the one and only blockchain.1

There are empirically, many blockchains around.  Some of them do not involve proof-of-work, some of them are not even cryptocurrencies.  Yet despite this, Dixon blocked Greg Slepak on Twitter (creator of okTurtles and DNSChain) for pointing that out just a couple weeks ago.

But before getting into the weeds, it is worth reflecting on the history of both virtual currencies and cryptocurrencies prior to Bitcoin.

The past

Below are several notable projects that pre-date the most well-known magic internet commodity.

  • DigiCash (1990)
  • e-gold (1996)
  • WebMoney (1998)
  • PayPal (1998) “Bitcoin is the opposite of PayPal, in the sense that it actually succeeded in creating a currency.”  — Peter Thiel
  • Beenz (1998)
  • Flooz (1999)
  • Liberty Reserve (2006)
  • Frequent flyer points / loyalty programs
  • WoW gold, Linden Dollars, Nintendo Points, Microsoft Points

According to an excellent article written a couple years ago by Gwern Branwen:

Bitcoin involves no major intellectual breakthroughs, so Satoshi need have no credentials in cryptography or be anything but a self-taught programmer! Satoshi published his whitepaper May 2009, but if you look at the cryptography that makes up Bitcoin, they can basically be divided into:

  • Public key cryptography
  • Cryptographic signatures
  • Cryptographic hash functions
  • Hash chain used for proof-of-work
    • Hash tree
    • Bit gold
  • cryptographic time-stamps
  • resilient peer-to-peer networks

And what were the technological developments, tools and libraries that spearheaded those pieces?  According to Branwen:

  • 2001: SHA-256 finalized
  • 1999-present: Byzantine fault tolerance (PBFT etc.)
  • 1999-present: P2P networks (excluding early networks like Usenet or FidoNet; MojoNation & BitTorrent, Napster, Gnutella, eDonkey, Freenet, i2p etc.)
  • 1998: Wei Dai, B-money
  • 1997: HashCash; 1998: Nick Szabo, Bit Gold; ~2000: MojoNation/BitTorrent; ~2001-2003, Karma, etc
  • 1992-1993: Proof-of-work for spam
  • 1991: cryptographic timestamps
  • 1980: public key cryptography
  • 1979: Hash tree

Other prior art can be found in The Ecology of Computation from Huberman.2 One open question for permissionless systems is whether or not a blockchain is a blockchain if it is neither proof-of-work-based or proof-of-stake-based (“Cow system” in Bram Cohen’s terminology).  But that’s a topic for another post.

The present

About two weeks ago, /r/bitcoin learned that Bitcoin was not the creator of all this fundamental technology.  That indeed, there were over 30 years of academic corpus that cumulatively created the system we now call “a blockchain,” in this case, Nakamoto consensus.  And this has spawned a sundry of other experiments and projects that have since been kickstarted.

For example:

  • CoinMarketCap currently tracks 592 cryptocurrencies / 59 assets
  • CoinGecko tracks 225 cryptocurrencies/assets
  • Ray Dillinger’s “Necronomicon” includes over 100 dead altcoins
  • Map of Coins is currently tracking 686 derivatives of various cryptocurrencies; this includes all hashing functions (e.g., scrypt, X11, X13) and includes existing and defunct chains
  • These are just publicly known blockchains and there are likely dozens if not hundreds of private trials, proof of concepts in academia, institutions and from hobbyists (e.g., Citibank announced in July 2015 that it was testing out three blockchains with a “Citicoin” to better understand use-cases)

So it appears that there are more than one in the wild.

Yet, a couple weeks ago Fred Wilson wrote that:

If you think of the blockchain as an open source, peer to peer, massively distributed database, then it makes sense for the transaction processing infrastructure for it to evolve from individuals to large global corporations. Some of these miners will be dedicated for profit miners and some of them will be corporations who are mining to insure the integrity of the network and the systems they rely on that are running on it. Banks and brokerage firms are the obvious first movers in the second category.

He later clarified in the comments and means the Bitcoin blockchain, not others.

One quibble is that transaction processing is not clearly defined relative to hashing.  Today, bitcoin transactions are actually processed by very small, non-powerful computers (even a Raspberry Pi).

What about the pictures with entire rooms filled with computers?  Why does it cost so much to run a hashing farm then?

Because of the actual workhorse of the network: ASICs designed to generate proofs-of-work.  These hashing systems do not do any transaction processing, in fact, they cannot even run a Bitcoin client on them.3

Tangentially William Mougayar, investor and author, stated the following in the AVC thread:

Only trick is that mining is not cheap initially, and the majority is done in China. It presents an interesting energy challenge: you need lots of electricity to run the computers, but also to keep them cool. So, if you’re using solar you still need to cool them. And if you put them in cool climates like near the north pole, there is no solar. Someone needs to solve that equation.

Mining cannot be made “cheaper” otherwise the network becomes cheaper to attack.

In fact, as Bram Cohen mentioned last week, “energy efficient” proofs-of-works is a contradiction in terms.

Thus, there is no “equation to solve.”  In the long run, miners will bid up the marginal costs to which they equal the marginal value (MC=MV) of a bitcoin in the long run.  We see this empirically, there is no free lunch.  If hashing chips somehow became 50% more efficient, hashing farms just add 50% more of them — this ratcheting effect is called the Red Queen effect and this historically happens in a private seigniorage system just as it does in proof-of-work cryptocurrencies.4

organ proportionalismAs shown in the chart above, hashrate follows price; the amount of resources expended (for proof-of-work) is directly proportional to market value of a POW token.

Furthermore, in terms of Wilson’s prediction that banks will begin mining: what benefit do banks have for participating in the mining process?  If they own bitcoins, perhaps it “gives them a seat at the table.”  But if they do not own any, it provides no utility for them.

Why?  What problem does mining solve for organizations such as banks?  Or to put another way: what utility does proof-of-work provide a bank that knows its customers, staff and transaction processors?5

Permissioned Permissionlessness, BINO-style

One goal and innovation for Bitcoin was anonymous/pseudonymous consensus which comes with a large requirement through trade-offs: mining costs and block reorganization risk.

To quote Section 1 of the Nakamoto whitepaper regarding the transaction costs of the current method of moving value and conducting commerce:

These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party

Thus:

  • Bitcoin was designed with anonymous consensus to resist censorship by governments and other trusted third parties.
  • If you are running a ledger between known parties who abide by government regulations, there is no reason to pay that censorship-resistance cost.  Full stop.

Today several startups and VC funds have (un)intentionally turned an expensive permissionless system into a hydra, a gated permissioned network without the full benefits of either.  Consequently, through this mutation, some of these entities have also turned a bearer asset into a registered asset with the full costs of both.

For instance, it is currently not possible to build a censorship-resistant cash system on top of a permissioned ledger (due to the KYC requirements) yet this is basically what has attempted with many venture funded wallets such as Coinbase.

The end result: Bitcoin in name only (BINO).  In which a permissionless network is (attempted to be) turned into a permissioned network.  It bears mentioning that companies such as Peernova and Blockstack are not trying to compete with Bitcoin — they are not trying to build censorship-resistant cash.

While financial institutions can indeed download a client and send tokens around, Bitcoin was purposefully designed not to interface with financial intermediaries as it was modeled on the assumption that no one can be trusted and that parties within the network are unknown.  Therefore if parties transacting on the network are both known and trusted, then there probably is no reason to use Bitcoin-based proof-of-work.  Instead, there are other ways to secure transactions on a shared, replicated ledger.

Ask the experts

I reached out to several experts unaffiliated with Bitcoin itself to find out what the characteristics of a blockchain were in their view.

Ian Grigg has spent twenty years working in the cryptocurrency field and is the author of the Financial Cryptography blog as well as the Ricardian Contract and most recently the “Nakamoto signature.”  Below are his thoughts:

As far as *history* is concerned, it looks like just about every individual component of Bitcoin was theorised before 2009.  The last thing that I’d thought was new was the notion of a shared open repository of transactions, but it seems Eric Hughes actually proposed it in the 1990s.  And of course Todd Boyle was banging the triple entry drum in the late 1990s.

Bitcoin has no monopoly on any term except bitcoin and BTC as far as I can see. The big question is really between permissioned and permissionless ledger designs.

If you go for a permissioned ledger, then you can do some more analysis and also reduce the need for the consensus signing to be complicated. At the base level, just one signatory might be enough, or some M of N scheme. But we don’t need the full nuclear PoW-enfused Nakamoto Signature.

But also, the same analysis says we don’t need a block. What’s a block? It’s a batch of transactions that the ‘center’ works on to make them so. But if we’ve got permissioned access, and we’ve reduced the signing to some well-defined set, why not go for RTGS and then we haven’t got a block.

The block in the blockchain exists because of the demands of the networking problem – with a network of N people all arguing over multiple documents, we know it can’t be done in less than a second for a small group and less than 10 seconds for a large group. So to get the scaling up, we *have to make a block* or batch of *many* transactions so we can fit the consensus algorithm over enough tx to make it worthwhile.

Therefore the block, the Nakamoto Signature, PoW and the incentive structure all go together. That’s the blockchain.

Zaki Manian, co-founder of SKUChain and all around Bay-area crypto guru:

Cryptography is interesting right now because the primitives have matured and pre-cryptographic systems are becoming less and less robust.

Commitment schemes are widely used in cryptography. Nakamoto signatures (if Adam Back wants to concede the naming rights) are the thermodynamic commitment to a set of values. A conventional signature in attributable commitment.

A cryptocurrency is an application of a ledger. A distributed ledger needs to syndicate the order of stored transaction. There is a lot of value to syndicating and independently validating the commitments to interested parties. Generalized Byzantine Agreement, n-of-m signatures and transaction syndication decrease the discretion in the operating of systems. Ultimately, discretion is a source of fragility. I think Ian’s reference to RTGS is somewhat disingenuous. Systems with a closed set of interacting parties aren’t particularly helpful. Open participation systems are fundamentally different.

There don’t seem to be any settle lines between the properties of permissioned and permission-less systems. We have both and time will tell.

Pavel Kravchenko, formerly chief cryptographer at Stellar, now chief cryptographer at Tembusu Systems:

I’ve seen the discussion, it seems rather political and emotional. Since the term blockchain is not clearly defined people tend to argue. To make everything clear I would start from security model – who is the adversary, what security assumptions we are making, what is the cost of a particular attack etc. For now (still very early days of crypto-finane) using blockchain as a common word for such variety of conditions is acceptable for me.

Vlad Zamfir, who has helped spearhead the cryptoeconomics field alongside others at Ethereum (such as Vitalik).  In his view:

“Blockchains” are a class of consensus protocols (hence why I like to pedantically refer to them as blockchain-based consensus protocols).  They are not necessarily ledgers, although blocks always do contain ordered logs.

These logs need not be transactions – although we can call them transactions if we want, and so you can call it a ledger if you want – it’s just misleading.

Blockchains are characterized by the fact that they have a fork-choice rule – that they choose between competing histories of events.

Traditional consensus protocols don’t do this, so they don’t need to chain their blocks – for them numbering is sufficient.

Economic consensus protocols contain a ledger in their consensus state, in which digital assets are defined – assets who are used to make byzantine faults expensive.

It is much less misleading to refer to this class of protocols as ledgers, than to blockchains generally speaking – although it is still misleading.

You can make an economic consensus protocol that lets people play chess. It would have a ledger, but it wouldn’t be fair to call it a distributed ledger – it’s a distributed chess server.

Economic consensus allows for public consensus, which acts as a (crappy) public computer.

Public consensus protocols have no “permissioned” management of the computers that make up this crappy public computer.

Non-public consensus protocols have “permissioned” management of these computers.

I think the main thing that is consistently lacking from these discussions is the fact that you can have permissioned control of the state of a public consensus protocol without “permissioning” the validator set.

Robert Sams, co-founder of Clearmatics who has done a lot of the intellectual heavy lifting on the “permissioned ledger” world (I believe he first coined the term in public), thinks that:

If I were to guess, I’d say that the block chain design will eventually yield to a different structure (eg tree chains). It’s the chaining that’s key, not the particular object of consensus (although how the former works is parasitic on the latter).

I think Szabo’s use of “block chain” rather than “blockchain” is more than a question of style. Out of habit I still merge adjective and noun like most people, but it’s misleading and discourages people from thinking about it analytically.

I tell you though, the one expression that really gets on my nerves is “the blockchain” used in contexts like “the blockchain can solve problem X”. Compound the confusion with the definite article. As if there’s only one (like “the internet”). And even when the context assumes a specific protocol, “the” subconsciously draws attention away from the attacker’s fork, disagreements over protocol changes and hard forks.

Anyway this debate with people talking up their Bitcoin book and treating innovation outside its “ecosystem” as apostasy is tiresome and idle.

Christopher Allen, who has had a storied career in this space including co-authoring the TLS standard:

I certainly was an early banner waiver — I did some consulting work with Xanadu, and later for very early Digicash. At various points in the growth of SSL both First Virtual and PGP tried to acquire my company. When I saw Nick’s “First Monday” article the day it came out, as it immediately clicked a number of different puzzle pieces that I’d not quite put together into one place. I immediately started using the term smart contracts and was telling my investors, and later Certicom, that this is what we really should be doing (maybe because I was getting tired of battles in SSL/TLS standards when that wasn’t what Consensus Development had been really founded to solve).

However, in the end, I don’t think any thing I did actually went anywhere, either technically or as a business, other than maybe getting some other technologists interested. So in the end I’m more of a witness to the birth of these technologies than a creator.

History in this area is distorted by software patents — there are a number of innovative approaches that would be scrapped because of awareness of litigious patent holders. I distinctly remember when I first heard about some innovative hash chain ideas that a number of us wanted to use hash trees with it, but we couldn’t figure out how to avoid the 1979 Merkle Hash Tree patent whose base patent wouldn’t expire until ’96, as well as some other subsidiary hash tree and time stamp patents that wouldn’t expire until early 2000s.

As I recall, at the time were we all trying to inspired solve the micropayment problem. Digicash had used cryptography for larger-sized cash transactions, whereas First Virtual, Cybercash and others were focused on securing the ledger side and needed larger transaction fees and thus larger amounts of money to function. To scale down we were all looking at hash chain ideas from Lamport’s S/KEY from the late 80’s and distributed transactional ledgers from X/Open’s DTP from the early 90s as inspirations. DEC introduced Millicent during this period, and I distinctly remember people saying “this will not work, it requires consumers to hold keys in a electronic wallet”. On the cryptographic hash side of this problem Adam Back did Hashcash, Rivest and his crew introduced PayWord and Micromint. On the transaction side CMU introduced NetBill.

Nick Szabo wrote using hashes for post-unforgeable transaction logs in his original smart contract paper in ’97, in which he referred to Surety’s work (and they held the Merkle hash tree and other time signature patents), but in that original paper he did not look at Proof of Work at all. It was another year before he, Wei Dai, and Hal Finney started talking about using proof-of-work as a possible foundational element for smart contracts. I remember some discussions over beer in Palo Alto circa ’99 with Nick after I became CTO of Certicom about creating dedicated proof-of-work secure hardware that would create tokens that could be used as an underlying basis for his smart contract ideas. This was interesting to Certicom as we had very good connections into cryptographic hardware industry, and I recommended that we should hire him. Nick eventually joined Certicom, but by that point they had cancelled my advanced cryptography group to raise profits in order to go public in the US (causing me to resign), and then later ceased all work in that area when the markets fell in 2001.

I truly believe that would could have had cryptographic smart contracts by ’04 if Certicom had not focused on short-profits (see Solution #3 at bottom of this post for my thoughts back in 2004 after a 3-year non-compete and NDA)…

What is required, I believe, is a major paradigm shift. We need to leave the whole business of fear behind and instead embrace a new model: using cryptography to enable business rather than to prevent harm. We need to add value by making it possible to do profitable business in ways that are impossible today. There are, fortunately, many cryptographic opportunities, if we only consider them.

Cryptography can be used to make business processes faster and more efficient. With tools derived from cryptography, executives can delegate more efficiently and introduce better checks and balances. They can implement improved decision systems. Entrepreneurs can create improved auction systems. Nick Szabo is one of the few developers who has really investigated this area, through his work on Smart Contracts. He has suggested ways to create digital bearer certificates, and has contemplated some interesting secure auctioning techniques and even digital liens. Expanding upon his possibilities we can view the ultimate Smart Contract as a sort of Smart Property. Why not form a corporation on the fly with digital stock certificates, allow it to engage in its creative work, then pay out its investors and workers and dissolve? With new security paradigms, this is all possible.

When I first heard about Bitcoin, I saw it as having clearly two different parts. First was a mix of old ideas about unforgeable transaction logs using hash trees combined into blocks connected by hash chains. This clearly is the “blockchain”. But in order for this blockchain to function, it needed timestamping, for which fortunately all the patents had expired. The second essential part of Bitcoin was through a proof-of-work system to timestamp the blocks, which clearly was based on Back’s HashCash rather than the way transactions were timestamped in Szabo’s BitGold implementation. I have to admit, when I first saw it I didn’t really see much in Bitcoin that was innovative — but did appreciate how it combined a number of older ideas into one place. I did not predict its success, but thought it was an interesting experiment and that might lead to a more elegant solution. (BTW, IMHO Bitcoin became successful more because of how it leveraged cypherpunk memes and their incentives to participate in order to bootstrap the ecosystem rather than because of any particularly elegant or orginal cryptographic ideas).

In my head, Bitcoin consists of blocks of cryptographic transactional ledgers chained together, plus one particular approach to time-stamping this block chain that uses proof-of-work method of consensus. I’ve always thought of blockchain and mining as separate innovations.

To support this separation for your article, I have one more quote to offer you from Nick Szabo:

Instead of my automated market to account for the fact that the difficulty of puzzles can often radically change based on hardware improvements and cryptographic breakthroughs (i.e. discovering algorithms that can solve proofs-of-work faster), and the unpredictability of demand, Nakamoto designed a Byzantine-agreed algorithm adjusting the difficulty of puzzles. I can’t decide whether this aspect of Bitcoin is more feature or more bug, but it does make it simpler.

As to your question of when the community first started using the word consensus, I am not sure. The cryptographic company I founded in 1988 that eventually created the reference implementation of SSL 3.0 and offered the first TLS 1.0 toolkits was named “Consensus Development” so my memory is distorted. To me, the essential problem has always been how to solve consensus. I may have first read it about it in “The Ecology of Computation” published in 1988 which predicted many distributed computational approaches that are only becoming possible today, which mentions among other things such concepts as Distributed Scheduling Protocols, Byzantine Fault-Tolerance, Computational Auctions, etc. But I also heard it from various science fiction books of the period, so that is why I named my company after it.

The future

What about tokens?

Virtual tokens may only be required for permissionless ledgers – where validators are unknown and untrusted – in order to prevent spam and incentivize the creation of proofs-of-work.  In contrast, if parties are known and trusted – such as a permissioned ledger – there are other historically different mechanisms (e.g., contracts, legal accountability) to secure a network without the use of a virtual token. 6

Is everything still too early or lack an actual sustainable use-case?

Maybe not.  It may be the case, as Richard Brown recently pointed out, that for financial institutions looking to use shared, replicated ledgers, utility could be derived from mundane areas, such as balance sheets.  And you don’t necessarily need a Tom Sawyer botnet to protect that.

What attracts or repels use-cases then?

  • Folk law: “Anything that needs censorship-resistance will gravitate towards censorship-resistant systems.”
  • Sams’ law: “Anything that doesn’t need censorship-resistance will gravitate towards non censorship-resistant systems.”

Many financial institutions (which is just one group looking at shared, replicated ledgers) are currently focused on: fulfilling compliance requirements, reducing cost centers, downscaling branching and implementing digital channels.  None of this requires censorship-resistance.  Obviously there are many other types of organizations looking at this technology from other angles and perhaps they do indeed find censorship-resistance of use.

In conclusion, as copiously noted above, blockchains are a wider technology than just the type employed by Bitcoin and includes permissioned ledgers.  It bears mentioning that “permissioned” validators are not really a new idea either: four years ago Ben Laurie independently called them “mintettes” and Sarah Meiklejohn discussed them in her new paper as well.

Endnotes

  1. See The financial cloud from Adam Ludwin []
  2. Thanks to Christopher Allen for pointing this out. []
  3. See The myth of a cheaper Bitcoin network: a note about transaction processing, currency conversion and Bitcoinland []
  4. See Bitcoins: Made in China []
  5. Why would banks want to use a communal ledger, validated by pseudonomyous pools whom are not privy to a terms of service or contractual obligation with? See Needing a token to operate a distributed ledger is a red herring and No, Bitcoin is not the future of securities settlement []
  6. See also Needing a token to operate a distributed ledger is a red herring and Consensus-as-a-service []
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Panel with financial service professionals involved with baking shared, replicated ledgers into organizations

The last part of the PwC discussion 10 days ago involved a panel with myself moderating, Peter Shiau (COO of Blockstack) and Raja Ramachandran (co-founder of eFXPath and an advisor at R3CEV).  Robert Schwentker (from Blockchain University) also helped provide a number of questions for us.

We cover a number of topics including use-cases of distributed ledgers for financial institutions.

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Q&A regarding the Distributed Ledger Landscape

About 10 days ago I had the pleasure of speaking at Blockchain University (hosted over at PwC) regarding distributed ledgers (permissioned and permissionless).  One of the slides was intentionally taken out of context by a user on reddit and unsurprisingly the subsequent /r/bitcoin thread covering it involved a range of ad hominem attacks that really missed what was being discussed at the actual talk: what are the characteristics of a blockchain.

I will likely write a post on this topic at length in the next couple of days.  In the meantime, below is the video which incidentally pre-emptively answered a few of the questions from that thread.

Also, for those curious to know who were asking the good questions in the audience, this included: Jeremy Drane (PwC), Christopher Allen (co-creator of the TLS standard) and Nick Tomaino (Coinbase) among others.

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Needing a token to operate a distributed ledger is a red herring

Over the last few weeks a number of posts and interviews on social media have promoted the position that “you cannot separate bitcoin from the blockchain” and that only Bitcoin (and no other distributed or decentralized ledger) is the future of finance.

In prose form this includes Adam Ludwin, CEO of Chain (here), Martin Tiller (here) and many more on reddit.

Others include Jerry Brito, executive director at Coin Center, who recently tweeted:

jerry brito tweet

Source: Twitter

At the most recent Inside Bitcoins NYC event, Barry Silbert, co-founder of DCG, spoke about several myths surrounding Bitcoin (video):

[The second myth] is that the technology is great, but the currency is not necessary. […] The reason why Bitcoin blockchain is transformative is because it’s a secure ledger and you have the ability to process large amounts of transactions.

The only reason why it is secure and it has that transaction capacity is because you have thousands of miners around the world that have been provided a financial incentive to invest resources, capital to build the facilities that is what makes the ledger secure and gives the protocol the capacity to do transactions.

So if you eliminate the financial incentive which is the currency there is no incentive for miners to mine and thereby you don’t have a secure network and you don’t have the ability to process large amounts of transactions.

Why the “only-Bitcoin” narrative is (probably) incorrect for Financial Institutions

In the other corner, Robert Sams described in detail why Bitcoin will not be the future of securities settlement, Piotr Piasecki explored a couple different attack vectors on proof-of-work blockchains (as it relates to smart contracts) and even Ryan Selkis pointed out a number of problems with the Bitcoin-for-everything approach.

So why is the Bitcoin maximalism narrative at the very top probably incorrect for financial institutions?

Because these well-meaning enthusiasts may not be fully looking at what the exact business requirements are for these institutions.

  • What do financial institutions want?  Cryptographically verifiable settlement and clearing systems that are globally distributed for resiliency and compliant with various reporting requirements.
  • What don’t they need?  Censorship resistance-as-a-service and artificially expensive anti-Sybil mechanisms.

The two lists are not mutually exclusive.  I published a report (pdf) two months ago that covered this in more detail.

Bitcoin tries to be both a settlement network and a provider of a pseudonymous/anonymous censorship resistant virtual cash.  This comes with a very large trade-off in the form of cost: as the network funds mining operations to the tune of $300 million this year (at current market prices) for the service of staving off Sybil attacks.1 This cost scales in direct proportion with the token value (see Appendix B).

The financial institutions that I have spoken with (and perhaps my sample size is too small) are interested in operating a distributed ledger with known, legally accountable parties.  They do not need censorship resistant virtual cash or proof-of-work based systems.  They do not have a network-based Sybil problem.2

If you do not need censorship resistant as a feature, then you do not need proof-of-work

Recall that one of the design assumptions in the Bitcoin whitepaper is that the validators are unknown and untrusted.

In section 1, Nakamoto wrote:

What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.   Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers.  In this paper, we propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions.  The system   is   secure   as   long   as   honest   nodes   collectively   control   more   CPU   power   than   any cooperating group of attacker nodes.

And later in section 4:

To implement a distributed timestamp server on a peer-to-peer basis, we will need to use a proof- of-work system similar to Adam Back’s Hashcash [6], rather than newspaper or Usenet posts.

Financial institutions operate under completely different conditions.  They not only know the identities of their customers, staff and partners but their processing providers are also known, legally accountable entities.  There is no Sybil problem to solve for them on the network.  There is no need for proof-of-work or $300 million in annual mining costs.

If you don’t need proof-of-work, you don’t need necessarily a token to incentivize validation or secure the network

Instead, validation can be done by entities with contractual obligations that are legally enforced: known validators with real-world identities and reputations.

Permissioned distributed ledgers using this type of known validator, such as Hyperledger and Clearmatics (disclosure: I am an advisor to both), are not trying to be “cryptocurrencies” or even entrants in the virtual cash marketplace.

Nor are they trying to provide pseudonymous-based censorship resistant services.  Instead they are attempting to provide a solution for the financial institution requirements above.

But if Bitcoin has the largest user base of pseudonymous virtual cash, wouldn’t concepts like sidechains allow systems like Hyperledger to be run on a sidechain and therefore we should all focus on Bitcoin?

Again, permissioned ledger systems like Hyperledger are not a cyrptocurrency, so sidechains (as they are currently proposed) would probably not provide any benefit to them.  Bitcoin may – temporarily or permanently – have the largest mind share for cryptocurrency as whole and for censorship resistant services but this does not seem to really be a top priority for most financial institutions.

Thus, it would be comparable to saying why don’t we connect all Excel workbooks directly onto the Bitcoin blockchain?

goodyear-dirigible

Source: Gizmag

Or akin to the Wright brothers trying to sell a biplane to modern day international air carriers.  Just because you created the first proof-of-concept and own a lot of equity in the companies in the supply chain for Wright brothers wooden airplanes (because you know aeronautical vehicles is a growth industry), does not mean the first model will not be iterated on and evolved from.  Even modern day dirigibles provide different utility than large wide-body air cargo planes.

There is a case to be made that you only need a token as an incentive within proof-of-work-based (and proof-of-stake) cryptocurrency networks.  Yet as described elsewhere, there are other ways to build distributed networks and economic consensus mechanisms that do not need follow the Nakamoto design (see Vlad Zamfir’s forthcoming Reformalizing Consensus paper).

Thus, the authors cited at the beginning of this post are likely asking the wrong question.  What these writers seem to be collectively saying is: “Hey banks, you want a better settlement method?  Then you need Bitcoin.”  Instead they should be asking banks, “What problems do you have?  Would a censorship-resistant service like Bitcoin’s blockchain sustainably solve that problem?”

Financial institutions each face different problems and challenges but it is unlikely that  proof-of-work necessarily solves them.3  Nor is it the case that banks need yet another currency to manage and hedge.  Though to be even handed, perhaps other financial institutions like hedge funds will find it useful for speculation.

Blocks and miners

Not to pick on Barry Silbert (this is just an example), but his statement above is wrong: “you have the ability to process large amounts of transactions.”

Bitcoin, with the current 1MB block size, is in theory able to process about 7 transactions per second.  If some of the expansion proposals under discussion are enacted, then block sizes may increase to 20 MB in the coming year.  This, again in theory, would mean that the Bitcoin blockchain would be able to process about 140 transactions per second.

One bullish narrative has been that Bitcoin will one day be able to handle transaction processing rates on part with networks like Visa (which on average handles 2,000 – 3,000  transactions per second each day).4   For comparison, in 2013 PayPal had 128 million active accounts in 193 markets and 25 currencies around the world and processed more than 7.6 million payments every day.

Baring something like a full roll-out of the Lightning Network, is unlikely to occur without the use of trusted parties.

Thus it is unclear what metric Silbert is using when he references the “large amounts” being processed, because in practice the Bitcoin network only handles about 1.5 transactions per second on any given day, and most traffic is comprised of spam and long-chains transactions and not the actual commerce that Visa handles.

trade block 1trade block 2

Source: TradeBlock

Above are two charts from TradeBlock which recently published some analysis on block sizes and capacity.  Based on their analysis and following the current trend in block size usage, the 1 MB capacity will be reached in about 18 months, so only in December 2016 will 2.8 transactions per second be achieved.  Dave Hudson ran simulations last year and came to a similar conclusion.

Further, Visa’s network — although centralized — is actually very secure (with moats and all).  No one hacks Visa, they hack the edges, institutions like Target and Home Depot.  This is similar to Bitcoin, where it is cheaper to hack Bitstamp, Bitfinex, Mt. Gox and countless others (which have all been hacked over the past 18 months), than it is to do a Maginot Line attack via hash rate.

In fact, if we measure adoption and usage by actual end users (i.e., where most transactions actually take place), the adoption is not with Bitcoin’s blockchain, but instead with trusted third parties like Coinbase, Circle, Xapo and dozens of other hosted wallets and exchanges.  As I mentioned in my review of The Age of Cryptocurrency, one of the funnier comments I saw on reddit last month was someone saying, “You should try using Bitcoin instead of Coinbase.”

blockchain longtail

Source: the long tail usage of blockchains by Vitalik Buterin

Are permissioned distributed ledgers the solution for financial institutions?

Maybe, maybe not.  It depends on if they securely scale in a production environment..  It also depends on the specific business requirements.  It could turn out that distributed databases like Chubby or HyperDex are a better fit for some problems.

It is also hard to say that a large enterprise can axiomatically replace its existing systems with a new distributed ledger network and save X amount of money.  There are a variety of costs that have to be factored in: compliance costs, reconciliation costs, legal costs, IT costs, costs from capital tied up in slow settlement times, etc. 5  Add them all together and there is, in theory, room for large saving, but this is still unknown.  It cannot be derived a priori.

Another common claim is, “Bitcoin is a larger, better supported blockchain and therefore will win out since it has market makers and market support.”

But Bitcoin, as a censorship-resistance payment rail and virtual cash, is a solution for cypherpunks, not for financial institutions who again, have known counterparties.  A proof-of-work blockchain only matters for untrusted networks and pseudonymous validators.

It may seem repeitive, but if you are designing a semi-trusted/trusted networks, then the token itself is more akin to a receipt than an informational commodity.  Bitcoin, in its current form, likely needs a token because it needs to pay its pseudonymous validators for the censorship-resistance service.  If you operate a bank, with a state charter and KYC/AML requirements, this is probably not a must-have feature.

Either way, it is too easy to become caught up in this red herring and miss the utility of a distributed settlement system for the roller coaster ride surrounding the token.

But isn’t using known validation just centralization by any other name?

No, it could be institutionalized (which is different than centralization) in that the nodes are globally separated and controlled by different keypairs and organizations.6  In effect, distributed ledgers are a new, additional tool for financial controls — and an attempt to abuse the network would require additional compromises and collusion that the edges of a proof-of-work networks are also prone to.

Yet in the event an attack occurs on a permissioned ledger, the validators are contractually and legally accountable to a terms of service — pseudonymous validators are not and thus end users for something like Bitcoin have no recourse, legal or otherwise, and are left with options like begging mining pools on reddit.7

Conclusions

Bitcoin may be a solution to some market needs, but it is likely not the silver bullet that many of its promoters claim it is.  This is especially true for financial institutions, particularly once the costs of mining and censorship-resistance, is added into the mix.

There is room for both types of networks in this world, just like there is room for dirigibles and jumbo jet freighters.  Yet it is impossible to predict who will ultimately adopt one or the other or even both.8

But as shown in the picture below, the Bitcoin mining game (within a game) includes mining pools that are not always incentivized to include transactions.9  Which raises the question: how can you require them to since there is no terms of service?

blockchain block 1 tx

Source: Block 358739

Every day there is always one or two blocks (sometimes more) that include a lonesome transaction, the coinbase transaction. In fact, in the process of writing this post, F2Pool included no additional transactions in block 359422, this despite the fact that there are  unconfirmed transactions waiting for insertion onto the communal chain.

Mining pools have differing incentives as to whether or not to include actual transactions, to them the bulk — roughly 99.5% of their revenue still comes from block rewards so sometimes they find it is not worth processing low fee transactions and instead propagate smaller blocks so as to lower orphan races and instead work on the next hash; see for instance Chun Wang’s comment related to F2Pool and large block sizes posted last week.

I reached out to Robert Sams, CEO of Clearmatics, who has written on this topic in the past.  According to him:

To me the crux of the issue is that permissionless consensus cannot guarantee irreversibility, cannot even quantify the probability of a history-reversing attack (rests on economics, not tech).

It’s a curious design indeed where everyone on the Bitcoin network is now known and authenticated… except the transaction validators!

I also reached out to Dan O’Prey, CEO of Hyperledger.  According to him:

It all comes down to starting assumptions. If you want the network to be censor-resistant from even governmental attacks, you need validators to be as decentralised as possible, so you need to allow anyone to join and compensate them so they do, so you need to use proof of work to prevent Sybil attacks and have a token.

If you’re dealing with legal entities that governments could shut down then you don’t get past step one. If you’re dealing with a private network between multiple participants then you don’t need to incentivise validators – it’s just a cost of doing business, just as web servers are.

Fun fact: according to Blockr.io, there have been 85275 blocks with one transaction and 12438 blocks with 2 transactions (the bulk of which occurred in the first year and a half).10

Is that the type of game theoretic situation upon which to build a mission-critical, time sensitive settlement system for off-chain assets with real-world identities on top of?11 Maybe, maybe not.  Both types of networks have their trade-offs but focusing on a token is probably missing the bigger picture of meeting business requirements which vary from organization to organization.

[Acknowledgements: thanks to Pinar Emirdag, Todd McDonald, Dan O’Prey, Robert Sams and John Whelan for their feedback.]

Endnotes:

  1. This annualized number comes from the following calculation: money supply creation (1,312,500 bitcoins) multiplied by current market price (~$230). []
  2. Large institutions and enterprises may have issues with authentication and identification of customers/users but that is a separate operational security issue. []
  3. It is important to note that if the costs of mining somehow decreased then so too would the costs to successfully attack a proof-of-work network.  See The myth of a cheaper Bitcoin network: a note about transaction processing, currency conversion and Bitcoinland []
  4. Note: In the UK, Visa Europe currently settles over RTGS though Mastercard does not.  See: The UK Payments landscape []
  5. Thanks to Dan O’Prey for his thoughts on the matter. []
  6. It bears mentioning that having 15 banks in 15 different countries operating validators is more decentralized than a few mining pools in a couple of countries, although it is not a fully direct comparison. []
  7. In theory on-chain “identity” starts pseudonymously and later users can either fully identity themselves (via traditional KYC, or signing of coinbase transactions) or attempt to remain anonymous by not reusing addresses and through other operational security methods.  Miners themselves can be both known and unknown in theory and practice.  Other terminology refers to them as a dynamic- membership multi-party signature (DMMS). []
  8. Peter Todd has argued that financial institutions can take a hash from a permissioned ledger and insert it into a proof-of-work chain as a type of “audit in depth” strategy. []
  9. According to John Whelan who reviewed this post, “The science of incentives is far more complex than just ‘show me the money’.  Indeed, workplace incentive specialists have coined the term ‘total rewards of work’ that recognizes that there are many levers other than compensation that may be pulled to motivate employees to perform at their maximum potential (e.g., workplace rewards).  With distributed ledger systems there is a lot of room to gain a clearer understanding of the kinds of incentives that will motivate transaction validators or nodes that offer other services such as KYC/AML, etc.  It is definitely not a one-size-fits-all.” []
  10. For comparison, Litecoin has 245447 blocks with 1 transaction and 105765 blocks with two. []
  11. At an event in NYC last month Peter Todd opined that perhaps some firms will take this risk and will encode a series of if/then stipulations in the event that a history-reversing attack occurs. []
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The final version of the BitLicense was released

A reporter from CoinDesk reached out yesterday to ask if there were any questions I had in relation to the final version of the BitLicense being released.

They subsequently posted a follow-up story with one of the comments I sent.  Below are the remaining questions and comments that came to mind after quickly reading through the final BitLicense.

The current wording in the final version still seems to leaves a few unanswered questions:

1) When a miner (hasher) sends work to a pool, the pool typically keeps the reward money on the pool before sending it to the miner or until the miner manually removes it.  Would mining pools be considered a custodian or depository institution since they control this asset?  What if a pool begins offering other services to the miner and these assets remain on the pool? (e.g., some pools have vertically integrated with exchanges)  Update:  The mining pool BTC Guild has announced it is closing down and citing concerns over the BitLicense with respect to these issues.

2) Are there any distinguishing factors or characteristics for entities that issue or reissue virtual currencies?  For instance, both non-profit groups (like Counterparty, Augur) and for-profit organizations (like Factom, Gems) issued virtual currencies and it appears that federated nodes that operate a sidechain, in theory, will effectively (re)issue assets as well.  Are they all custodians?  In light of the FinCEN enforcement action with Ripple, do these projects need to be filing suspicious activity reports (SAR) as well?

3) How hosted wallets comply with 200.9(c) and whether startups like Coinbase violate that given this UCC filing (pdf)? (E.g., assuming the bitcoins held by Coinbase for customers are covered by the filing, it seems as if it could violate 200.9)

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Housing all financial controls under one roof, managed by one person

A new story up on FusionFormer Mt. Gox CEO: Current Bitcoin exchanges are a ‘disaster waiting to happen’ — looks at a recent post from Mark Karpeles regarding the segregation of financial controls within the Bitcoin exchange framework.  I provided a couple of quotes for some perspective.

In addition to the snippets in the article, it bears mentioning that I would disagree with his view that it is possible to make a fully decentralized exchange today due to the fact that cash is centrally created and thereupon controlled by a variety of agencies.  He is right about the intersection of AML and how some companies are unable (or more likely, unwilling) to legally comply with it due to how they operate (such as LocalBitcoins and Purse.io).

As an aside, virtually most (if not all) VC-funded, US-based hosted wallet and exchange is likely in non-compliance of a variety of custodian/depository regulations though it is unclear if/when any jurisdiction will prosecute them:

One last comment about that story, there may be ways to create financial controls to reduce the ability for maleficence to occur but as Karpeles ironically pointed out (he did not acknowledge it but probably is aware of it), by converting bitcoins into an altcoin, you effectively are delinking provenance and creating a money laundering mechanism.  Based on a number of conversations with altcoin traders I suspect that a non-negligible portion of the litecoin trading volume on a daily basis (on BTC-e and ShapeShift.io) are related to money laundering type of activities.  Though this would be hard to verify and prove without building a good network heuristic and/or access to the server logs at these companies.

See also: CEWG BitLicense comment

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In what ways does Bitcoin resemble a command economy?

I have a new article up over at Let’s Talk Bitcoin which attempts to answer that question.

The feedback I have received so far (including the comments at LTB) makes it pretty clear that many adopters simply do not understand how, in general, economics or finance works or how developing countries struggle with credit expansion.  And that is fine, but can be disastrous when making what amounts to investment decisions.  Again, a vocal minority (majority?) of these adopters think they will be lounging on yachts and private islands because the price of bitcoin reaches $1 million.

And that likely will never play out for a variety of reasons that I have described in numerous articles.

Below is a list of pieces and papers that I have published covering these issues over the past three months in chronological order:

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Outside funding of cryptocurrency and Bitcoin startups

According to CB Insights, VCs spent $74 million across 40 BTC-related deals in 2013,  the two largest rounds were Coinbase ($25m) and Circle ($9m).

Despite the increased media attention, even if these numbers are repeated again this year this may not help boost the poor performance for VC funds as a whole.1 Even with the optimistic outlook many of the VC firms apparently now have, their actual results at ~6% per annum over the past decade have underperformed the Russel 2000.2

Why?  Some VCs not as nimble at feeling out business models with actual revenue generating capabilities as many angel investors are.

Changes over four decades

Consistent with secular theme of ubiquitous adoption of open source software as well as cloud computing that has lowered the cost of developing software and more importantly the costs associated with launching new companies, so too has this trend lowered the threshold for tech investments.  Where previously the funding of start-ups was limited to deep-pocketed professional investors, namely VCs, the deflationary landscape has increasingly enabled greater numbers of individual investors, angels to compete in funding environment.

The new class of angel investors is more astute than the passive and non-tech-savvy high net worth investor of yesteryear.  Increasingly, angel investors today have deep domain experience.  Many have worked in the sector that they are funding, are entrepreneurs and experienced operators themselves and visionary at feeling out new business and innovative trends.  The historical barrier to entry for angel investing is one of risk given the magnitude of investment commitment.  With lower costs of starting businesses, this hurdle is largely gone.  Smart angels with deep operational domain expertise is disruptive to the traditional VC universe.  They may be better attuned and friendlier with terms that are less predatory than the historical VC norm.

This is not to say that VCs will not flourish once again, however as it stands most angels began as entrepreneurs and learned how to generate sales and revenue first hand.  Furthermore, as noted above, over the past decade technological costs that have driven down expenses.  For example, relatively cheap cloud services like github and Compute Engine provide services (CaaS, SaaS and IaaS) that allow many tech start-ups to be leaner than before in terms of what funding they require to cover operating costs.  On top of this are better organized angels who now have an entire ecosystem of choices to fund through such as AngelList, 500 Startups and Y Combinator.  In fact, over the past six months, BitAngels.co have invested $7 million in 12 crypto projects globally.

Another way that cryptocurrency-related startups are being funded through are crowdfunded IPOs.  This includes Mastercoin, which raised $5 million in part by 4,700 bitcoins from “investors.”3  NextCoin (Nxt) and the upcoming Ethereum IPO have also included raising funds through bitcoin transfers.  While I am not necessarily endorsing any of these particular fundraising models, this illustrates how small (and perhaps large) development teams can financially cover costs without seed funding by VCs.

See also: MoneyTree Report from PricewaterhouseCoopers and the every-growing list of funded Bitcoin companies listed on CrunchBase

[Special thanks to DA for his comments and feedback.]

  1. Kauffman Foundation Bashes VCs For Poor Performance, Urges LPs To Take Charge from The Wall Street Journal and Most venture capital funds lose money from CNN|Fortune []
  2. Venture capital kingpin Kleiner Perkins acknowledges weak results from Reuters []
  3. Backed by $5 Million in Funding (4,700 BTC), Mastercoin Is Building a Flexible, New Layer of Money on Bitcoin from MarketWired []
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No, there is no (coming) collapse of China’s interbank system

Last week I spoke with Mark DeWeaver (video) and we touched on a number of issues related to China’s financial system but did not cover the liquidity issues that have arisen the past 6-9 months.

As a consequence, I highly recommend reading through this overview from Rhodium Group that does away with hyperbole or exaggeration to explain what is really happening: China’s Interbank Squeeze: Understanding the 2013 Drama and Anticipating 2014

 

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Interview with Mark DeWeaver, co-founder of Quantrarian Capital Management

Earlier today I had the opportunity to interview a friend, Mark DeWeaver.  Mark is the author of Animal Spirits with Chinese Characteristics and wrote a very kind foreword for my own book.  He worked in China for 9 years and later co-founded Quantrarian Capital Management which is fully invested in the Iraqi Stock Market.

We discussed a number of topics including the “rebalancing” of China’s economic model, the Soviet tech industry during Gorbachev1 , technological innovations with regards to the Great Firewall (GFW) and spent the last 15 minutes discussing cryptocurrencies, smart property, trustless asset management and specifically an article written by Mr. Sheng from the PBOC.2

Other stories mentioned:

  1. See “The Soviet Machine-Building Complex: Perestroyka’s Sputtering Engine” from the Office of Soviet Analysis published by the Directorate of Intelligence []
  2. Mr. Sheng’s article on Bitcoin and cryptocurrencies is “虚拟货币本质上不是货币” []
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Cryptocurrency Cat-and-Mouse games in China

btcc voucherSeveral updates to this ongoing cryptocurrency story in China and elsewhere (each subheading below is a slightly different topic).

Yesterday Bill Bishop linked to a story posted at Sina, “虚拟货币本质上不是货币” written by Sheng Songcheng.  Mr. Sheng is the head official of investigation and statistics at the PBOC (the central bank).

Bishop’s quick comment of the article was that, “No reason the belie[f] there will be any positive news from PRC regulators about bitcoin, or that somehow the recent crackdown was good, as some of the bitcoin bulls have been trying to spin.”

Too long; didn’t read

In addition to Bishop’s nutshell, another tl;dr comment that I would add is this, because Mr. Sheng works for the PBOC, his essay pretty much encapsulates what that important organ of the government thinks. Based on his essay, they do not recognize Bitcoin’s legality (although there is no clear indicator that they see a difference between protocol and token) and according to his own words, without government oversight or backing by any country, the token itself has no value.  Mr. Sheng uses the example of the recent 60% price drop of the bitcoin token on BTCChina last month as proof that without government approval, it has little value (a correlation-causation fallacy).  Furthermore, he thinks that if there is a developing country (such as China) that does begin using it, the deflationary aspect (the fixed ‘money’ / token supply) would actually present an obstacle and hinder the country’s economy to grow.  In fact, he says that Bitcoin and other cryptocurrencies will never become a country’s major currency and as a consequence, will not be a “real” currency.  And that it could only become so in the “utopian view of technocrats and libertarians” (技术至上主义和绝对自由主义者的乌托邦).  Yes, he uses the Chinese word for idyllic libertarian  (绝对自由主义者).

From a technical viewpoint, he states all cryptocurrencies do not have a unique origin, nor are its token generation, exchange and storage methods particularly special.  Any currency that has Bitcoin’s features could replace it such as Litecoin, which the public has become familiar with.  And continuing, he states that Bitcoin does not have any physical attributes found in gold and silver nor exclusivity enforced by the law so it will be really easy to replace.  Therefore it cannot replace the role of general currency which is the medium of trading. Thus his overall attitude (and that of the PBOC) is that the central government does not recognize any specific values of the token; that it is illegal to use (though he does not specifically say who or what timeframe) and it doesn’t justify its own existence.

Again, while we can argue over the epistemological, economic and technical problems with this essay (e.g., why do economies grow, deflation versus inflation [pdf], the economics of Bitcoin [pdf], what utility cryptocurrencies have, how the protocol works, etc.) all of which have been discussed elsewhere, as Bishop noted above, this essay is hardly a positive sign for the crytpocurrency segment in China.  Thus, while speculative, after reading the article the impression readers are left with is that the PBOC will crack down on cryptocurrencies on the mainland for the foreseeable future.

Cat-and-mouse

There have been discussions over the past weeks as to how mainland exchanges could bypass the current hurdles.  One idea was to create yet another type of virtual token that could then be exchanged on exchanges.

Over the past couple of hours on reddit, users have posted a new method that BTCChina is using to get around the current depository predicament the mainland industry is currently in (e.g., all payment processors are barred from providing fiat liquidity to crypto exchanges).  However, the small stop-gap solution is for BTCChina customers internally (this is not the same thing as the online vouchers like BTCe has).  BTCC code is to allow one customer with CNY on the site to sell the CNY to another customer.  The medium is the BTCC code which is in two parts: one is for the customer the other is for the site.

Imaginary Capital Markets has a few more details and screenshots, but let me just emphasize once more that this is not a complete workaround (yet) but just a way for BTCC users to exchange CNY with one another.  My speculation: if the CEO role as sole depositor is still active, perhaps this could be a way for him/her to distribute funds to friends & family who can then exchange the fund to the wider customer base.  If this is the case, perhaps other exchanges will follow suit (assuming that the CEO can still deposit funds into the exchange through their personal account, see the explanation here for more).

[Update: Taobao has a new rule (Chinese) that will ban the buying and selling of crypto coins.  Thus it will purportedly impact vouchers such as those being offered by BTCChina]

Also regarding the CEO bank accounts I discussed the past two weeks, Eric Meng, an American attorney friend of mine currently in China explained to me that the use of personal bank accounts to do business is a huge red flag in general.   It does not mean that anything is being done illegally, but it’s something that investigators watch out for.1

Bots again

Regarding the purported fudged numbers on Chinese exchanges (discussed here), another friend (in Europe) recently wrote to me explaining that someone could easily write a bot and test the liquidity to see whether it is real or not.  It could be that some exchanges on the global stage act as a market maker (similar to the NYSE which employs “specialists” [pdf explanation] who always make sure that there is a reasonable bid and ask available and who take short term positions in order to provide liquidity).

This same friend who has both mined and then built proprietary HFT arb software on BTCe is reasonably sure that BTCe runs their own arbitrage bots with zero fees but sometimes turns them off (or they have certain limits, he is not sure).  Again, arbitrage is not bad per se and basically makes sure that you can execute your orders at a ‘fair price’ all time.  Of course it would be better if the exchanges are more forthcoming about what they do behind the scenes but as long as there are no regulations they can do whatever they want and earn some extra money.  Yet again, no one is forced to use a particular exchange so people can easily vote with their feet or open their own (transparent) exchange.

Notes in the margin

One last comment I received is from Mark DeWeaver (author of Animal Spirits with Chinese Characteristics and GWON’s Foreword) is that,

It occurred to me that the argument about bitcoin having a big “carbon footprint” is really poorly thought out.  Is the footprint really bigger than that of paper currency, which has to be transported from countless businesses to bank’s safe deposit boxes at the end of each day.  And think of all the gas people must burn on trips to ATM’s!

This is in response to my explanation of Charles Stross’ contention that cryptocurrencies are more of a burden on the environment than fiat currencies are (they are not).  Mark’s comments are empirically valid because these up-armored vehicles (typically Ford 550 chassis or similar classes from competitors) are frequently used to move fiat currencies to and from distribution centers to branch banks and ATMs.  For example, The Armored Group currently lists many used armor transportation cars for sale.  And a quick search on Fuelly gives you an idea of how much fuel the average F550 consumes in the city (~9 mpg).  This also ignores the supply chain needed to build the vehicles in the first place which is an entire logistical segment that cryptocurrencies do not need.  Nor does it include the carbon consumption of the driver and guards ferried around in the vehicles (e.g., eating, sleeping, shelter, etc.).  One can only imagine the sheer number of vehicles in developing countries where digital fiat are not nearly as common and thus paper/metal is transported more frequently.

Again, this is not to say that cryptocurrencies are mana from heaven, that they won’t be replaced or will somehow axiomatically usher in a world of milk and honey.  But these specific claims by detractors need to be backed up with real numbers as they are positive claims (e.g., burden of proof).  If you do think that the Bitcoin transaction network (the most computationally powerful, public distributed system currently)2 consumes more carbon than all ~200 fiat currencies right now, you need to prove that.  And from my quick research I detailed in my article, that does not seem to be the case (today).

Also, for other occasional commentary on crypto in China I recommend visiting my friend’s site, Aha Moments (specifically this recent post).  Drop him a note and tell him to update more.

  1. Eric also suggested I link to the following guide that potential investors conducting due diligence pay attention to in the aftermath of Madoff: Six Red Flags and Tips for Investment Risks from CAMICO. []
  2. See Global Bitcoin Computing Power Now 256 Times Faster Than Top 500 Supercomputers, Combined! from Forbes []
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What happened with the “cash crunch” in China two weeks ago?

While there have been many explanations for why the People’s Bank of China (temporarily) allowed (easy) credit to dry up, I think Mark DeWeaver has a very plausible and well-reasoned explanation.  Mark wrote the foreword to my book and is the author of Animals Spirits with Chinese Characteristics.

Below is his op-ed published two days ago in The Wall Street Journal.  Be sure to check out his predictions for why this solution probably will not stick:

Beijing’s War on Shadow Banking

China’s central bank cracks down on credit that is not under the government’s control.

On June 20, China’s central bank precipitated a major credit crisis by withholding funds from the nation’s cash-starved banking system. The People’s Bank of China’s refusal to act as liquidity provider of last resort froze lending in the interbank market. Overnight rates, which had been as low as 2.1% in early May, exploded, closing at a record 13.4%.

As rumors swirled about the solvency of China’s state-owned banks, some commentators began talking about a Chinese “Lehman moment.” But the crisis passed and the overnight interbank lending rate quickly came back to earth. By July 4, it had fallen to 3.4%.

Trouble in the interbank market had been brewing since early June, when Beijing began a crackdown on illicit inflows of foreign exchange, previously a major source of growth in the local money supply. The demand for yuan also began rising, as Chinese banks prepared for their June 30 book closings and their customers for their first-half tax payments.

The result was a growing imbalance between the supply of and demand for credit. As rumored large-scale interventions by the People’s Bank of China repeatedly failed to materialize, commercial banks realized they would have to fend for themselves. Lenders hoarded cash to guard against potential counterparty defaults, and the normal flow of funds among financial institutions quickly dried up.

The central bank’s immediate objective seems to have been to rein in China’s “shadow banking” system, which has grown rapidly in recent years and now accounts for a significant share of total Chinese credit. Shadow banking in China involves lightly regulated products that allow savers to earn more than the official deposit rate while providing financing for “subprime” borrowers.

Generally the funding is relatively short-term, which makes the business highly sensitive to liquidity conditions. Shadow lenders require inflows of new money to pay off maturing obligations. These typically come either directly from the banks—for example, via their “wealth management products”—or from entities with access to bank financing such as state-owned enterprises.

There may be a larger political game going on. The People’s Bank of China is not an independent central bank, so the order to turn off the credit spigot must have come directly from the Politburo. The central bank’s surprise attack on bank credit must therefore be understood in the context of the leadership’s current focus on improving economic efficiency. This objective will be impossible to achieve unless the central government can overcome resistance from the powerful local interests that benefit from the status quo. The Politburo’s goal may have been to starve opponents of reform into submission.

Local governments appear to be the central bank’s real targets, because they rely heavily on shadow financing to subvert Beijing’s reform initiatives. Shadow funds flow directly into local government projects that the central government views as wasteful, and the funds benefit localities indirectly by pushing up land prices. As long as this money keeps flowing, over-investment in infrastructure, heavy industry and real estate will continue unchecked and Beijing’s vision of a new economy driven mainly by consumer demand and productivity growth will be impossible to realize.

The credit crunch occurred a few days after the launch of the Communist Party’s new “mass line” campaign, which seeks to make the party more sensitive to the needs of the people by circumventing official government and party hierarchies. This idea goes back to Mao Zedong, for whom the goal was to realize “democratic centralism” and bypass bureaucratic factions that threatened his agenda. Going directly to the “masses” was a way to attack the opposition from the outside—to “bombard the headquarters” in a famous slogan of the Cultural Revolution era.

In Mao’s time, bombarding the headquarters meant unleashing a reign of terror. Today the leadership has turned to less violent means. The central bank’s strike against shadow banking will undermine today’s vested interests in a way that Mao could scarcely have imagined—simply by cutting off their financing.

There are two problems with this approach. First, the central bank’s policy will result in considerable collateral damage. Small- and medium-size private firms will be particularly hard hit. They tend to be ineligible for bank loans and often depend on shadow financing to make ends meet.

Second, attacking anti-reform factions will not be enough to generate real reform. Without radical changes in the economic role of local governments, they will quickly return to business as usual once the fallout has cleared.

The People’s Bank of China may have won a battle, but the Politburo is far from winning the war.

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A friend discusses alternative wealth management products (WMPs)

In Chapter 5 and 17 I briefly mention that due to the current legal and financial system on the mainland there are very few financial alternatives and investment vehicles to park funds.  As a consequence, wealth management products (WMPs) such as trust companies are a new type of wealth management service that collectively amounts to more than $1 trillion and is considered to be an integral part of a “shadow” banking system (e.g. off-balance sheet transactions).  According to Xiao Gang, chairman of Bank of China, there are 20,000 WMPs in circulation currently.

It should be pointed out that the term “shadow” has been hyped up and distorted by many analysts to mean the equivalent of “shady” and “fraudulent.”  In economic terms, while there may be illicit or fraudulent activity taking place (e.g., money laundering), all the “shadow” activity technically forms part of the larger informal economy.  That is to say, given continued financial reforms, some of these 20,000 WMPs could eventually integrate and become part of the formal economy.  While there may be any number of pyramid and Ponzi schemes in this segment, this is not to say that the entire $1 trillion under management will all collapse into nothingness (it could, but you cannot say it a priori).

How does it work?

I asked a Chinese friend, Kevin C, to briefly explain how he manages his assets in this alternative system.  Here is his response:

I began my first “shadow” investment in the early part of December 2012.  The “shadow” bank system offers different deposit terms ranging from 1 month to 6 months and sometimes up to12 months (which is the longest).  Most companies originally offered interest rates from 17% per year last year, however this has been reduced to 13-14% per year now.  There are more than ten public companies operating this kind of private investment path and promote it via their websites.  In order to open an account, you need to register a user ID and mobile number.  In addition, you need a Chinese National ID Number, plus your personal bank account number which will be used to transfer money back to your account.  In practice, I have placed 80% of my capital in the 1 month term,15% in a 3 month term and 5% for longer terms.

I try to choose the company carefully before make my own investment and of course there is no single website can guarantee 100% safety.  However, if it doesn’t look like a short term business for those companies which I believe, as long as they offer a one month product, I think it will be relatively safe to me.  As far as trying to fund it through debt like credit cards, I looked into taking out a simple loan and found out that the monthly interest rate that I would owe actually outpaces what I would receive in return from one of these private investment plans.  So I am actually using my own money to try this out.  So far so good.  And even though I still worry about the risk, as I said before, the one month term is the most attractive to me for this reason.

Again, I am not endorsing this service.  In fact, it is really hard to see how this particular service can provide these high rate of returns in the long term and may in fact be powered solely through speculation and exuberance.  Perhaps these 10+ firms Kevin mentions do not even reinvest the capital into actual productive projects but merely recycle the money to other customers cashing out each month.  Perhaps other customers do fund a lot of their investments through debt (e.g., borrowing to reinvest it into one of these 10 firms) and have a great deal to lose in the event one of the companies goes bankrupt.  However, this was just an example to give you an idea of what the process is like.

For more see: Examining China’s ‘Shadow Stimulus’ from The Wall Street Journal, In China, Hidden Risk of ‘Shadow Finance’ from The Wall Street Journal, Regulating shadow banking from China Daily, Uncertain foundations from Financial Times, China to tighten shadow banking rules  from Financial Times, China’s brokerages turn shadow banks from Financial Times and Don’t Worry About Wealth-Management Products, Regulator Says from The Wall Street Journal

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Chapter 5 – Financial services

[Note: below is Chapter 5 from Great Wall of Numbers]

Since Deng Xiaoping’s “Southern tour” in 1992, China has consistently been one of the top recipients of foreign direct investment (FDI), totaling $85 billion in 2010 and $574 billion overall.  In contrast, up until recently the US still led in both annually received FDI ($194 billion in 2010) and $2.58 trillion overall.  Even though its full year FDI received fell from the year before – a decline that continued through February 2013 – in the first half of 2012 China actually overtook the US for received FDI ($59.1 billion versus $57.4 billion).1

And while US firms and institutions currently invest more FDI within China than Chinese firms invest in the US (in 2011, Chinese companies invested $6.3 billion in the US representing 0.15% of total foreign investment in the US) this will probably change – despite a closed capital account (discussed in Chapter 10).234 For example, among other deals, a Chinese firm was recently granted approval in December 2012 to purchase bankrupt Massachusetts-based battery maker A123 Systems for $256.6 million.5 As a consequence Chinese outbound investment in 2012 such as mergers and acquisitions reached $8 billion for the first time in the US, globally increased to $93.09 billion (compared to $13.58 billion in 2007) and its outbound direct investment (ODI) is expected to reach $150 billion by 2015 due to deals such as A123 Systems.678 One example of continued investment is from ENN Group, one of the largest private companies in China.  Through a joint venture with CH4, a Utah-based energy company, ENN plans to open a network of 50 natural gas stations across the US this year.  Each station costs about $1 million to build and the joint venture has a goal of building 500 stations altogether.9 For comparison, the EU collectively receives twice as much FDI from China than the US currently does (due in part to political trepidation).10

Where are the potential investments that Chinese firms have looked at in the US?  For example, during the build-out of the enormous Haynesville natural gas fields in the Texarkana region, one of the investors courted by local energy companies was CNOOC (the 3rd largest oil company in China), which at the time reportedly wanted to invest $750 billion into the North American energy business.11 It is unclear as to how much they did end up investing (or if they returned a profit) but several Chinese energy companies have now moved up to Canada and invested $3 billion in a new pipeline project in the tar sands as well as put together a “$15.1 billion deal to acquire Nexen.”1213 In February 2013 the deal closed marking the completion of the largest overseas acquisition by a Chinese company.  And depending on regulatory conditions North American energy firms may or may not continue to do business with Chinese firms, yet there is one area that foreign experts can provide inside of China right now.

So what opportunities are there for foreign financial professionals?

While it has become almost cliché to say, finance is one of the industries that is undergoing “reform and opening up.”  This involves building institutions, physical infrastructure and a legal structure – all of which is thoroughly discussed in both Mark DeWeaver’s new book as well as a Brookings Institute report in June 2012.14 Yet reforms in general are always just around the corner.15

For example, because of pent up savings due to relatively few investment vehicle choices on the mainland, once larger liberalizations begin, there will be opportunities that can come from not just asset management and private equity (PE) markets but through the large expertise requirements in the relevant fields that currently do not exist (e.g., debt structuring).  As part of the once-in-a-decade leadership transition that began in November 2012, one expectation was and is that there will be a “big bang” of reforms in the coming months.1617 One immediate, visible reform was the creation of super-ministries referred throughout this book (e.g., Ministry of Health dissolving to become National Health and Family Planning Commission).18 Another case in point, on November 19, 2012 the State Administration of Foreign Exchange (SAFE) announced that it “ended 35 foreign-exchange approval rules and simplified others.”19 By reducing paperwork and shortening approval processes, such liberalizations are done with the intention of attracting FDI.  On December 12, 2012 the Shanghai stock index surged to its highest daily gains since October 2009 due to policy changes in the Qualified Foreign Institutional Investor program (QFII合格境外機構投资者).20 As a consequence sovereign wealth funds such as Qatar Holdings and central banks are now allowed to raise more than the $1 billion previously permitted for investing in the securities market.21

Another instance is on December 17, 2012, where a number of new liberalizations were implemented such as reducing regulatory approval and remittance of profits for foreign-owned companies.  Continuing this trend, on February 28, 2013, the government expanded its short-selling program which will now enable select brokerages to borrow shares from preapproved publicly traded companies.22 And on March 15, the China Securities Regulator Commission announced that effective immediately, brokerages could convert loans and other assets into securities, paving the way for securitized business.23 On a provincial level, financier Harry Ding (see below) explained to me, that pilot regions throughout China are also enacting reforms to make it easier for entrepreneurs to begin operating.  Shenzhen and Zhuhai in Guangdong announced that effective March 1st they have streamlined 18 different business licenses, created a new version of business licenses which no longer requires lengthy documentation procedures and removed some of the registered capital restrictions.24

Another specific area you and your firm may be able to literally capitalize on shortly is building a local bond market in structured debt.  Over the past several years there have been attempts to roll out local government bond markets on the mainland.  In November 2011, Shanghai issued China’s first local bond issuance yet eight months later, all of the programs were scrapped.25  Yet a year later, in November 2012, the China Securities Regulatory Commission (CSRC) approved a plan from ICBC (the largest commercial bank in China and in the world) to start a pilot program of selling bonds known as asset-backed securities (ASB) beginning in 6 months.26 The local market of this local debt, based on several estimates of over 10,000 local-government financing vehicles (entities that were set up to bypass these kinds of bans) is between $1.7 trillion and perhaps up to $5.4 trillion, which I discuss later in Chapter 17.27

Foreign firms specializing in managing distressed loans have already capitalized on opportunities on the mainland (with mixed results), including Shoreline Capital Management who raised $300 million for a new fund last year specifically to invest in distressed Chinese debt.28 DAC Capital is also in the process of raising $300 million for a new Chinese-focused fund.  The gamble is while investors in such debt may receive returns if and when a borrower repays portions of the loan, local government policies and a nebulous court system can make returns lower than they would have otherwise would have been (e.g., transaction costs and opportunity costs).

In October 2012 I spoke with Shawn Mesaros, CEO of Pamria an asset management firm located in the financial district in downtown Shanghai.29 Despite these setbacks above, in his view SOE banks will “eventually become facilitators, that they will offload debt which can then be restructured.  As a consequence there will then be a bigger market for sovereign debt.”  In addition, even though public capital (through SOEs) is currently cheaper than private capital Mesaros thinks that private equity (PE) is still a relatively good business, “it is not as easy as you think because domestic companies typically would rather not share equity in exchange for your capital.”  For perspective, according to the consultancy Bain, “the total value of mainland private equity investments jumped from US$3.7 billion in 2005 to US$15.2 billion in 2011.”30 And nearly $230 billion worth of deals were collectively completed between 2001 and 2012.31

Yet to give you an idea of the soft PE market today in China, according to a recent report from the Wall Street Journal, both foreign and domestic PE firms have been struggling over the past two years.32 The value of PE deals in 2012 declined 27% to $21.9 billion in part because of the domestic stock market performance.33 Between 2010 and 2012 the Shanghai Stock market declined roughly 37%.  Fortunes however, may continue to fluctuate in the future as the main benchmark index regained about 9% in the first six weeks of 2013 then lost 7% over the following month through mid-March.34 However because many investors cash-out of their positions through the securities exchange, fewer firms have wanted to go public.

Subsequently, private-equity firms which provide this junction have been affected as well.  In fact, in 2012 there was a 70% drop in initial public offerings (IPOs) – in the first half of 2012 alone there was a 37% drop in IPOs, from 218 during the same time last year to 138.35 PE deals as a whole “fell an unprecedented” 43% last year.36 Furthermore, of the 10,000 PE deals conducted between 2001 and 2012, 7,500 remain “unexited” as the firms cannot go public on Chinese exchanges.  And whereas PE firms in China raised 75 yuan-denominated funds in 2011 and raised another 52 yuan-denominated funds last year, only 2 new funds have been raised in 2013 (both focused on real-estate investment).37 This is in part because there has been an across the board red light from Chinese regulators since last summer (as of January 31, 2013, a record 873 companies have filed for IPOs in China yet have to wait) and Chinese firms trying to list on American credit markets are essentially persona non grata due to regulatory oversight from the SEC and disagreements with Chinese auditing regulators.383940

However despite these drops, there is still an active set of foreign and domestic PE activity, including Jiuding (the top domestic PE firm) who has averaged an internal rate of return of 30% since 2010 (an IRR is one gauge of how profitable investments are).41 Furthermore, this “softness” in the PE market may have a silver lining as well.  For example, according to Peter Plakidis of Deutsche Bank, “[a] softer equities capital market has meant that private equity is not competing as much with public money, and depressed public valuations have improved the returns for private-equity firms.  Hence, private-equity firms now have more companies on their radars as attractive investment opportunities.”42

In addition to PE, according to Mesaros, one large SOE bank on the mainland is already filling an office floor just for fixed-equity investments.  And if they are doing it, then perhaps other SOEs are close behind.  What this means to Mesaros is that eventually the big spreads “that can roll over price takers will become smaller.”  This also means that there is potential for foreign experts in this field to also train and get involved at a variety of levels within the periphery of this investment field.

Human capital

And in both the long and short-term, irrespective of growth trends on the macro side (which I discuss in later chapters), expertise in these two areas is in short supply.  At the same time, as noted above one challenge in this type of training is retention.  I was told by an another American source that a very large US bank (top 3) has trained numerous local financial experts in some of these sub fields (like forfaiting and futures) yet was unable to retain them due to an insatiable demand for such experts at mainland institutions.  Or in short, since talented human capital in certain areas is scarce, training may be a risky endeavor.43

Natalia Shuman, the new COO of Kelly Services’ in China recently explained the labor supply issues of financial experts in this region,

[…] the lack of supply and high demand is reflected in compensation.  If you look at Shanghai’s market today it’s not only financial analysts.  There are multiple positions and multiple functions where salaries are very competitive compared with global.  People are getting the same salary, maybe even higher, particularly in Shanghai and Beijing, compared to New York or London nowadays.44

And recruiting local talent for financial positions is also a seller’s market in Shuman’s view “Chinese with Western experience who are coming back here; they could easily get more money here than they would get in New York or London.”45 Further human resource constraints including retention issues are discussed later in Chapter 15.

For perspective in December 2012 I spoke with a Chinese financial manager at Fosun International (复星国际有限公司) in its Hong Kong corporate subsidiary.  Fosun is the largest privately held company in China, generating 25.73 billion RMB ($4.12 billion) in the first half of 2012.46 According to him, “I have colleagues who have a lot of career experience in the financial industry on the mainland but they currently do not have a competitive edge over their international counterparts when applying for finance positions in Hong Kong or elsewhere.  Yet simultaneously, if they want to further their career they would prefer working outside the mainland because both the experience gained and the compensation in the international marketplace is significantly higher than anywhere on the mainland.  And since the financial infrastructure and investment instruments in Shanghai still have not reached ‘critical mass’ it is basically more of a regional financial center compared with Hong Kong, which itself is filled with experienced staff in dozens of specialties that do not exist yet on the mainland.  Concurrently, because there are more and more banks in China and more and more people that have financial backgrounds and overseas educations they also want to pursue careers in this industry making it very competitive in certain specialties compared with previous years.”47

On the other hand, he still sees opportunities as “the mainland industry needs experts to train local people how to work in all areas in this growing market because there are relatively few providers doing it today.  Not just in debt markets, M&A, private equity or IPOs, but also in all forms of international trade such as letter of credit, trade finance, arbitrage and export finance.  Since there is a lot of overseas businesses that want to do business in China these banks will continually need to hire people capable of not just fulfilling relatively basic financial services today, but also the more advanced investment instruments and complex transactions in the future.  And since nearly all of corporate finance on the mainland still depends on bank loans for credit, banks typically provide most finance and capital for nearly all companies.  Thus foreign service providers can potentially bring their knowledge to our young industry for a mutually beneficial exchange.”

What are these salaries like?  A recent Bloomberg report similarly noted the demand for qualified financial professionals and experts for China, yet also found that managing directors now earn less than they would in the US and roughly “on par with those in Europe and the U.K.”48 For example, managing directors in Beijing and Hong Kong earned between $900,000 and $1.3 million in salary, bonus and stock options last year – while their counterparts in the US earned $1.2 – 2.01 million and their peers in the UK and Europe earned $850,000 – $1.77 million.

Wealth management

In November 2012 I spoke with Richard Johnsson who was the President & CEO of Soderberg & Partners in Beijing.  Soderberg & Partners is an independent financial advisory targeting high-net worth Chinese citizens since 2007.  According to Johnsson, “one of the challenges early-on was to establish a business in a field that didn’t exist in China, and few could see the benefits of independent advice.  The competition was all about returns, as opposed to for example tax planning; and the commissions were very low.  But lately, the industry has expanded very fast.  And one of the opportunities is of course that it is highly likely that the tax system and regulatory setup will look more and more like in the West.  This will mean complicated tax systems and tax deductions will make planning hard for people, thus driving sales.  On the other hand, other parts of government will try to control the industry, driving extensive compliance.49 But the former will likely come before the latter.”  All of the Big Four auditing firms and Big Three management consulting firms have long ago established mainland offices; can your firm provide similar services?

In January 2013 I also spoke with Harry Ding, a native of Guangdong who has worked as a manager in the finance industry on the mainland for the past five years.  According to him, “one of the opportunities for activities like day-trading and forex trading is that you do not need to have a PhD in finance to understand and be successful or even profitable in these segments.  As a consequence, the companies I have worked with over the past several years usually involves training new college graduates with finance backgrounds how to use econometric models and computing technology to conduct their trades.  While there are licensing and training fees as well as a learning curve, in the long-run their relatively lower labor costs usually acts as a profitable form of arbitrage.  That is to say, that because they can effectively trade on exchanges like the Toronto Stock Exchange, they are usually several times cheaper to hire and manage than local talent in Canada.”  Forex means ‘foreign exchange’ and typically involves the buying, selling and trading of foreign currencies (e.g., JPY, USD, GBP).

Ding also sees a few challenges in that, “because of the numerous restrictions on the financial industry and because of its overall developmental status, there are not as many investment tools and instruments available and those that exist can be difficult to trade profitably at large volumes.  As a result, many individuals and institutions have turned to overseas investment.  And by virtue of the fact that much of a firm’s activities are conducted overseas, it normally requires investors to transfer money out of China which oftentimes makes domestic clients feel uncertain as their assets are not physically close by, creating a psychological insecure feeling (e.g., uncertainty) especially in recent years as Western countries have had numerous financial scandals that have shaken investor trust and confidence.  In addition, China has a capital transfer restriction that strictly prevents citizens from transferring assets to a broker or investment firm outside the mainland over an annual limit of $50,000 USD.  Thus any amount beyond that requires other legal ways to process and transact it.”  These capital restrictions are discussed in Chapter 11.  Furthermore, can you or your company utilize local talent like Ding’s firms have?

Ding’s point regarding a dearth of investment instruments was recently echoed by Nick Yim head of Goldman Sachs China Market.  According to Boston Consulting Group, the total value of private investible assets in China reached $12 trillion in 2012 (a 14% increase year over year).50 Where are these assets?  According to Yim, most of his high-network clients only have “have 20% to 30% of the funds parked offshore, the rest remains onshore.”51 And because of the global financial crisis and relatively slower domestic growth, these clients “have become more conservative and now behave more like U.S. clients.”  This means they are looking for safe, conservative lower yield products.  While there are a limited number of investment products and a scarcity for seasoned bankers, which he considers to be the two biggest challenges, Yim sees a lot of growth potential due to improving legal and regulatory frameworks.  And ultimately, because China also has a single culture, currency, language and regulator, he thinks that there are a lot of opportunities for Western private banks to provide diversification, risk management and retirement planning services in what may become the world’s largest economy in the next decade.

Takeaway: With more than 57 million inbound tourists that spent $48 billion last year, the domestic Chinese tourism industries is one of the largest in the world.  Training staff and putting together a brand positioning campaign are just two areas of many that foreign expertise can bring to the growing industry (which may grow from 2 million hotels today, to 5 million in the next four years).  In addition, financial service companies may be able to find opportunities to not only to train local financial firms on bond technicalities but also provide ancillary services to fixed-equity investment programs.  And in addition to conducting your due diligence it is also recommended that you read through Chapter 10 regarding legal and regulatory risks and uncertainties.


Endnotes:

  1. See China’s Foreign Direct Investment Declines for Eighth Month from Bloomberg, China 2012 FDI suffers first annual fall in three years from Reuters and China Overtook US as main Destination for FDI in First-half 2012 –UNCTAD from The Wall Street Journal []
  2. Investment from China in US reaches record high from China Daily []
  3. According to the World Bank total overseas investment by Chinese firms reached $21.4 billion in Q1 2012.  This is substantially higher than $17.8 billion in all of 2009.  See China Buys Overseas Assets from The Wall Street Journal and China’s overseas direct investment strategy from finfacts []
  4. The Shift from East to West: Chinese Investment in North America from Firmex []
  5. See Chinese company buys battery maker that got recovery funds from The Washington Post and Investment from China rises amid concern from The Washington Post []
  6. See Chinese Investment to the U.S. Speeds Up from Caijing from Caijing, Chinese outbound investment accelerates from China Daily, Investment from China rises amid concern from The Washington Post and Make It for China to Buy U.S. Businesses from Bloomberg []
  7. Another area Chinese individuals and firms are now investing in is the US real estate and property market.  According to a recent report, “[b]uyers from China also invested almost $2 billion in commercial property in 2011, or quadruple what they spent several years ago.”  One of the recent deals was led by China’s Vanke (the largest real estate developer on the mainland) who agreed to a $620 million project in San Fransico in December 2012.  See Chinese buyers lead foreign investment in US housing market from Fox News, China Vanke Arrives in U.S. from The Wall Street Journal and Lennar Said to Get $1.7 Billion San Francisco Loan from Bloomberg []
  8. See A Gateway to the U.S. by Daniel Rosen and Thilo Hanemann, China’s outward FDI to reach US$150bn by 2015 from Want China Times and FDI with Chinese characteristics from The Economist []
  9. Chinese firm puts millions into U.S. natural gas stations from Reuters []
  10. Chinese Investment: Europe vs. the United States from Rhodium Group []
  11. After the Boom in Natural Gas from The New York Times []
  12. Another segment Chinese firms are expanding into in the US and Europe is construction equipment.  Sany is China’s largest heavy machinery manufacturer (e.g., excavators) and aims to become the largest globally in the world.  As a consequence it is looking abroad for mergers, acquisitions and joint-ventures.  Perhaps your firm could find a new partnership with them.  See Sany Tries to Gain Traction in the U.S. from The Wall Street Journal []
  13. China takes new step in oil sands from The Globe And Mail []
  14. See Animal Spirits with Chinese Characteristics by Mark DeWeaver and Achieving 2020 from the Brookings Institute []
  15. See Foreign capital rules eased from China Daily and China Capital Account Restrictions Loosened for Foreign Investors by Stan Abrams []
  16. China Big Bang Seen Like London in New Regime: Cutting Research from Bloomberg and Reins on Shanghai set to be loosened from South China Morning Post []
  17. In addition to QFII, a recent report suggests that citizens of Taiwan, Hong Kong and Macau could invest directly into mainland stock exchanges.  See Mainland to allow overseas citizens in stock market from Xinhua []
  18. Graphics: Super Ministry from Caixin []
  19. SAFE Issues New Rules to Further Relax the Foreign Exchange Controls over Direct Investment from King & Wood Mallesons []
  20. See China Scraps QFII Limit on Sovereign Funds, Central Banks from Bloomberg, China’s Stocks Drop Below 2,000 from Bloomberg and China stocks fall below 2000 to 4-year low from South China Morning Post []
  21. See Qatar granted $1b QFII quota from Reuters, China’s Qualified Success In Attracting Qualified Foreign Investors from China Bystander, China pledges to expand QFII, RQFII programs from China Daily and 64 More Institutions Enter China via QFII, CSRC Official Says from Caixin []
  22. China to Expand Short-Selling Program as Part of Reform from Bloomberg []
  23. China Allows Brokerages to Conduct Securitization Business from Bloomberg []
  24. 深圳、珠海商事登记改革3月1日起正式实施国家工商总局支持两地启用新版营业执照from Guandong Province Administration for Industry & Commerce []
  25. See Shanghai makes China’s first direct local-bond issue from Reuters and China Scraps Trial of Local Government Bonds, Studies Risks from Bloomberg []
  26. Regulator Allows Bank Subsidiary to Sell Special Bonds from Caixin []
  27. According to Shang Fulin, chairman of the China Banking Regulatory Commission, as of September 2012 the local government debt collectively amounted to $1.48 trillion.  See High local debt levels coming under control from China Daily and China averts local government defaults from Financial Times.  Other higher estimates can be found in China tells banks to roll over local govt loans: report from Reuters and Are Chinese Banks Hiding “The Mother of All Debt Bombs”? from The Diplomat []
  28. Back in Fashion: China’s Bad Debt from The Wall Street Journal []
  29. Pamria Asset Management []
  30. No exit from China Economic Review []
  31. Private Equity in China: Which Way Out? from The New York Times []
  32. Chinese Headwinds Beset Private-Equity Highfliers from The Wall Street Journal []
  33. China Private Equity Chilled by ’Old Days’ Asking Prices from Bloomberg []
  34. See China’s Stocks Slump to Two-Month Low on Property Curbs from Bloomberg, Finding Investment Opportunities in a Tough Market from The Wall Street Journal and China IPO Hiatus May Prompt Smaller Firms to Seek HK Listing from The Wall Street Journal []
  35. This decline in IPOs is not a new phenomenon; even Hong Kong has had difficulties this past year.  See Bankers See Fees Fade as China Era of Jumbo IPOs Draws to Close from Bloomberg and Hong Kong Has Tough IPO Road Ahead from The Wall Street Journal []
  36. China Private Equity Chilled by ’Old Days’ Asking Prices from Bloomberg []
  37. Doubts Over Returns Hit Fundraising in China from The Wall Street Journal []
  38. See China IPO Hiatus May Prompt Smaller Firms to Seek HK Listing from The Wall Street Journal, Private Equity in China: Which Way Out? from The New York Times, Auditing Spat Dividing U.S. and China Turns Ugly from Caixin and MNCs in China and PCAOB deregistration from China Accounting Blog []
  39. Foreign auditing firms such as the Big Four are stuck between the proverbial rock and hard place.  On the one hand the SEC requires that these firms hand over audit documents to be verified and audited by the government, yet due to Chinese laws, the same auditing firms sometimes cannot hand over some of the documents as the audit documents are considered “state secrets.”  See Deloitte sued over audits of ChinaCast Education from Reuters and MNCs in China and PCAOB deregistration from China Accounting Blog []
  40. The IPO process has been frozen for six months in China because the security regulators are currently reorganizing both the process and the personnel involved in the approval process.  See Finding IPO Alley from Caixin []
  41. The private equity (PE) market has also been directly affected by other policies recently discussed in With Great Power Comes Great Responsibility from Peterson Institute for International Economics.  On the other side of the Pacific, PE and Chinese firms were recently discussed in Chinese Firms Take Lonely Buyout from The Wall Street Journal []
  42. In China IPOs, the Upside of Scarcity for Private Equity from The Wall Street Journal []
  43. Another short term area for opportunities may be as an auditor due to the large dispute between the US and China over potential delistings of Chinese firms from US credit markets.  See What U.S.-China Auditing Dispute Means for Chinese Business Culture from The Wall Street Journal, U.S. audit watchdog chief hopeful on China dispute from Reuters, Auditing Spat Dividing U.S. and China Turns Ugly from Caixin and MNCs in China and PCAOB deregistration from China Accounting Blog []
  44. Developing a Competitive Edge from Insight []
  45. Ibid []
  46. Fosun International Announces 2012 Interim Results Revenue and Net Portfolio Value Continue to Grow from PRNewswire []
  47. For a detailed explanation of criteria and challenges regarding Shanghai’s push to become an international financial center see Achieving 2020 from the Brookings Institute. []
  48. China Bankers Earn Less Than New York Peers as Pay Dives from Bloomberg []
  49. See Starting a business in China from the World Bank and New Path for Trade: Selling in China from The New York Times []
  50. Private Banks Enter ‘Golden Period’ in China from The Wall Street Journal []
  51. Ibid []
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