Who are the administrators of blockchains?

[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 any organization I advise.  See Post Oak Labs for more information.]

On All Hallows’ Eve in 2008, an anonymous person (or group of persons) posted a short technical whitepaper on an obscure mailing list about a new virtual coin-based online-only payment system they had been designing for the last eighteen months.1 Several months later, in January 2009, this same person posted the code that created the functionality described in the whitepaper and began minting this new virtual currency.  Less than two years later, the creator walked away from the project and without ever revealing their real identity.

The creator likely stayed anonymous for a variety of reasons, including the fact that by creating and administering a new payment system they may have been violating money transmission laws in multiple countries.2 Despite multiple hoaxes, we still don’t know who this anonymous person was.  But their system – like the Ship of Theseus – continues to exist in a form referred to as Bitcoin.

But before getting to that part of the saga, let’s look at May 2013.  At the end of that month, US federal agents raided a Costa Rica-based company called Liberty Reserve due to money laundering violations (along with a list of other crimes).  Liberty Reserve was a centralized payment platform that marketed to its users the ability to anonymously send funds to one another.

According to the BBC:

The US Justice Department said the scheme had been used to process 78 million transactions with a combined value of $8bn (£5.5bn) – many of which were related to hiding the proceeds of credit card theft, identity fraud, hack attacks and Ponzi scam investment schemes.

Last year the founder of Liberty Reserve, Arthur Budovsky, was convicted and sentenced to twenty years in prison.  Several other insiders also received sentences.  Liberty Reserve had more than 5 million users including more than 200,000 in the US — it is unclear at this time if any of the users are being prosecuted.

According to some cryptocurrency fans, Liberty Reserve’s big blunder was that they attached their legal names to the payment processing enterprise.

But this misses the point.  If you play with a highly regulated industry such as financial services, be prepared for the existing stakeholders such as regulators and law enforcement to increasingly scrutinize your operations as they detect familiar activities, such as the marketing and sale of securities or operating a payment platform.

Cypherpunk cosplay uniform (mostly worn online)

If you spend your weekends cosplaying online as a cypherpunk and yet voluntarily sit on-stage wearing a name tag with your real name at public events and promote financial products and financial market infrastructure to the world at large, consider that there may be people who later watch these videos stored on Youtube. In its report on The DAO, the SEC cited two specific Youtube videos including one from Slock.it, the creators of The DAO.  Recall that Slack stores everything, including your private pump and dump strategies.  If you used cloud-based email, there is a non-zero chance that your successful solicitations and payola to coin media could be discovered after the cloud provider receives a subpoena.

What does this have to do with blockchains?  Below we discuss a few ideas that tie in with money transmission and payment processing.

“Core” development teams

Let me state from the onset that I am unaware of any current or potential criminal or civil cases specifically against developers of cryptocurrency networks.  Furthermore, regulators and law enforcement may not view development teams as administrators at all.  I am not a lawyer and this is not legal advice.

What are administrators?  At a very high level, in the United States, according to guidance published in March, 2013 by FinCEN:

An administrator is a person engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency.

The rest of the March guidance goes into a little more detail of what administrators are with respect to money exchange itself.

For the purposes of this article, and without diving too much into the technical weeds, let’s consider this hypothetical:

Bob forks/clones Bitcoin in a new GitHub repo that he alone has commit access to.  While other people can submit suggested changes, he alone has commit access to make any changes to the code.  He likes his privacy so he doesn’t actively advertise or market the repo or coin or tell anyone who he is.  And then sets up one mining node, initiates the genesis block, and begins Day 1 of Bobcoin.

Is Bob an administrator?  If so, at what point does he stop being an administrator?  When there are more than one mining nodes in operation?  When more than one developer has commit access?

That’s a decision that regulators and law enforcement will need to make but from this cursory bit of detail, Bob clearly issued his own virtual currency.  Can he redeem it?

Perhaps.3  Either way, he could unilaterally change the code and annul previous or future coins/transactions.  He could change the money supply schedule, doubling or halving it if he so pleased.   He could make a new rule that says block sizes should be arbitrarily larger or smaller.  He could make a new version that separates the digital signatures from other data in the block.  He could change the required transaction fee.  He could add functionality such as P2SH.  He could change how the difficulty setting adjusts.  And so forth.

Even if other participants added computers and joined the Bobcoin network and diluted Bob’s mining hashrate, if the new participants solely rely on the code in his GitHub repo (e.g., are unaware of and/or do not use alternative implementations of Bobcoin code), then Bob remains very influential and could still directly make changes to the network.

Does being very influential — controlling the code repo to a financial network — constitute “administration”?  Arguably yes, but there should be some objective measuring sticks as to what these attributes are (e.g., how many different people have commit access to a repo for financial market infrastructure).

In the proof-of-work-based cryptocurrency world today, we have observed a stark 180 logistical change from Bitcoin in 2009.  Whereas originally all nodes were miners and vice versa, today you have a permanent bifurcation between: fully validating nodes and the mining process itself (hash generation process).  Similarly, many participants in the market, including dozens of developers and miners, use their real legal identities through the use of verified social media accounts and the speaking circuit at fintech events.  They are no longer pseudonymous.

In order for participants to coordinate and administer these types of networks, they did not necessarily need to reveal themselves.  In fact, we still don’t know who many of the original creators of various cryptocurrency networks are that are still in operation (who is BCNext?).  But because many have publicly identified themselves, they could be served with legal process and held responsible if legally liable: hiding behind pseudonymity or anonymity is no longer an option for them.

To borrow a phrase that has been recently used by several regulators, will it come down to the “facts and circumstances” to determine whether or not an entity such as a mining pool operator or core development team is a money service business or fiduciary? 4

Either way, popular euphemisms commonly used by cryptocurrency promoters and lobbyists include supposedly supporting “open” or “public” blockchains – several feelgood words – but as we empirically observe, in many cases these networks are not open to the general public: either as an actual validator or as a developer.  Access can become gated by a clique who determines who can be involved.5

In December 2015, the individuals in the photo above allegedly represented about 90% of the Bitcoin network hashrate: Source

Command and control

According to some, the Bitcoin network is viewed as a “third party payment processor” and because no one single entity administers the network it meets FinCEN’s exemptions.6  Thus, the argument goes, cryptocurrency network creators do not need to obtain a money transmitter license in the US because each activity is separate and run by a different group of participants who meet some kind of legal or regulatory exemption.7

This may have been the case in 2009 and 2010 prior to mining pools and dedicated development teams but it may not stand up to closer scrutiny in 2017.

For instance, over the past couple of years there has been this phenomenon called the “block size” debate.  Rather than go into the different camps and what they want or demand, let’s look at how various participants actually behave and act.

To begin with, let’s look at mining.

As mentioned above, mining in 2017 is different than it was in 2009.  Whereas mining initially meant (1) validation back to the genesis block and (2) generating proofs-of-work (hashes), these two processes are fully separated today.8

Today mining pool operators pick and choose which transactions to include into blocks and validate the chain they are building their blocks, is the chain they intended to do so on.  They can (and do) censor transactions.  For a pre-arranged fee, some will include your transaction before including others, including transactions from the mining pool operator itself.  Mining pools in turn pay miners (those with hash generating equipment) a share of the block reward for the work they do.  Note: miners (hash generators) themselves do not validate blocks and in fact, the machines they use are comprised of ASIC chips, are incapable of doing anything other than some simple multiplication — they can’t even run the software needed to validate the chain, let alone software like Excel.

There is a third stake holder in the mining process; infrastructure managers, who own and operate (or lease) the physical infrastructure that houses the equipment for miners.  Very little has been published on these participants (in English) because most of this infrastructure is managed in countries where English is not the mother tongue.9 These participants negotiate electrical rates and sometimes help install and operate the electrical equipment (transformers and wiring) at the various mining facilities (or outsource and manage that to someone else).

Now let’s look at the software implementation commonly used by many Bitcoin mining pools, called Bitcoin Core.  Until very recently, most mining pools ran a reference implementation of what is called the Bitcoin Core implementation of Bitcoin.  That is to say, the software running their node which builds and validates blocks, comes from a repository managed by a collective describing itself as Bitcoin Core.  This software was originally called the “Satoshi client” (Bitcoin-Qt) and has been renamed a few times along the way to its current name of Bitcoin Core.

In October, 2017 one common refrain from the camp that collectively identifies itself as Bitcoin Core, is that miners do not ultimately operate Bitcoin.  They argue that hashrate follows price and price follows the chain that is best maintained by the best developer team.  This is empty rhetoric.  We know that there are three entities involved in mining: mining pools, hash generators, infrastructure managers.  We know their key importance because they have been lobbied non-stop by many different stakeholders (such as Bitcoin Core and Bitcoin Classic) over the past several years including both open and closed door events on multiple continents.  They have been asked to sign agreements.  And then have seen those same agreements broken.  If miners are not important, they would not be lobbied or demonized at all: they would be ignored entirely.1011

Bitcoin Core is especially interesting because Bitcoin Core proponents claim it does and does not exist.  It is a bit like Schrodinger’s cat: Core exists when it is convenient for its proponents (like rallying supporters to denounce an alternative implementation) but does not exist when it encounters accountability or responsibility for its collective decisions or the decisions made by its surrogates.

Bitcoin Core maintains a website, a verified Twitter profile, Slack and other media channels.12 It even has a public team page of some of the contributors.  It is unclear how they precisely coordinate, but they work closely together with the owners and maintainers of Bitcoin.org and Bitcoin Core GitHub repo.  Note: Bitcoin.org, Bitcoin Talk and /r/Bitcoin are all controlled by the same individual, “theymos.”13 The other channels are owned and controlled by a set of unknown participants.  This collective does not have any known trademarks or copyrights at this time.  While no one has yet identified the actual decision makers, Bitcoin Core has multiple surrogates who are publicly known and actively engaged in media.

When there are disputes over decisions, some individuals who have identified themselves on the Bitcoin Core contributor list, will come out defending Bitcoin Core.  This includes asking for Bitcoin Core alleged lookalikes and doppelgangers to stop existing.  Schrodinger’s cat strikes again: Bitcoin Core wants to own the term Bitcoin Core on social media so that others can’t use it, but do not want the accountability when the collective or someone from the collective makes a decision.  Whose identification documents were used to create a verified Twitter (KYC’ed) account?  What about the web domains?  Those people are arguably actual representatives of the collective.

Bitcoin Core does not have a trademark on the Bitcoin logo, the Bitcoin ticker symbol, etc.  The original code base was released under an MIT License and “Satoshi Nakomoto” is still the copyright owner.14 Tibanne KK (the parent company of Mt. Gox) actually has a trademark on “Bitcoin” in the UK; although since the logo was originally placed in the public domain it is unclear if Tibanne can enforce these claims.  While the representatives and surrogates of Bitcoin Core argue over alternative implementations, if the entity called Bitcoin Core sued, this could open them up for a few things:

  1. they might need to incorporate in order to have legal standing;15
  2. they’d likely have to reveal their legal names (who is the verified Twitter entity?);
  3. they could be liable for complying with state, federal and international laws around operating financial market infrastructure.

Some developers want the power to control a code repo but not the accountability that comes with it.   Source: Spider-Man

Note: if you have a few moments, Angela Walch has a great paper on this topic worth reading.  Recall one of the common refrains from multiple full-time cryptocurrency developers is that they must be conservative in how they upgrade the chain they are working on, “as billions of dollars are at risk.”  These statements are arguably self-incrimination for being a fiduciary.16

It is unclear if Bitcoin Core itself will remain pseudonymous to avoid lawsuits and countersuits.  But recall, no one currently owns “Bitcoin” — the network itself is a public good, a commons.  However, Bitcoin Core does control the GitHub repo and tightly controls the commit access, occasionally removing those that do not align with their political views.17

What is the big deal?  Isn’t this software similar to a browser?

No.  The several thousand ISPs that are connected to each other forming “the Internet” are not dependent on the existence of Firefox or Internet Explorer or any browser.  These ISPs use protocols which are developed and managed by various non-profit and for-profit entities, some with clearer governance than others (like ICANN and IETF).  Network traffic will continue to flow irrespective of what browser is being used.

Bitcoin Core (the software) is not like a browser.18  If it was, the miners could simply switch out and use a different implementation and then start building blocks based on this new implementation.  But as noted above, miners have been lobbied not to use anything but Bitcoin Core or face the consequences if they did.  For instance, this past spring a group of Bitcoin Core affiliated developers threatened to change the proof-of-work mechanism.  These same developers even created a Twitter account (hence deleted) and still maintain a website dedicated to promoting this change.

With threats like this, arguably miners aren’t really free to choose what implementation to run.  To use Walch’s description, Bitcoin Core (and other identifiable developer teams) could arguably be a fiduciary if not an administrator.

bitfury

Source: Twitter

George Kikvadze is an executive and vice chairman of BitFury, a large Bitcoin mining company based in the Republic of Georgia.  Seven months ago he tweeted the statements above in reaction to a Bitcoin Core developer that threatened to change the proof-of-work algorithm used in Bitcoin in order to punish miners for using non-Bitcoin Core code.

Neither threat was carried out but this scenario raises interesting questions: if representatives of Bitcoin Core (or other development teams) who had commit access did change the proof-of-work mechanism to something the ASIC miners that BitFury designed was no longer capable of monetizing, is Bitcoin Core (or other developer teams) itself liable for the loss in revenue suffered by BitFury and other miners?  Is it just the person who submitted the documents to get a verified Twitter account?

No terms of service

One of the fundamental challenges for any anarchic chain is coming to agreement on defining the chain in the first place.19 What is Bitcoin?  Is it the chain with the most proof-of-work?  The longest chain?  The one that gets the most retweets?  The one with the most starred repo on GitHub?

As I mentioned in a paper a couple years ago (Appendix A), because there is no de jure process to handle governance issues, the various communities and tribes rallying and fighting around their disparate visions must rely on ad hoc de facto processes, much of which spills over onto social media

Fundamentally there does not appear to be any contract rights involved in using or operating Bitcoin (the network).  Who do users have contractual relationships with?  If someone does, then you could theoretically sue them.  But there is not even a click-through agreement or EULA when downloading Bitcoin Core (or any other alternative implementation).

This is relevant because earlier this month there were several Bitcoin Core contributors and surrogates, some of whom used their real names, claimed that alternative implementations such as Bitcoin Segwit2X (and its developers) could be violating the Computer Fraud and Abuse Act in the event that Segwit2X successfully creates a new fork next month.

If the CFA Act or money transmission laws are being broken post-Segwit2X then they are probably being broken now because of how various forks and updates are currently rolled out by developers and miners.  While it is unclear if any regulators or law enforcement would see the interpretation of the CFA Act the same way as Bitcoin Core representatives do, this hypothetical legal threat raises a few interesting points:

  1. What legal standing does anyone have in the event of a fork on an anarchic chain?  Code is not law.
  2. What country has jurisdiction and who has contractual relationships with one another?
  3. Would such a lawsuit create precedence or chilling effect on anyone wanting to fork/clone code in the future?  Who is liable for orphaned blocks?
  4. What happens in the event of an accidental fork like the one in March 2013?

By pushing any interpretation of the CFA Act onto anarchic cryptocurrency networks, it could create interesting legal precedents for Bitcoin Core because once the government gets involved in deliberating which fork is and is not legitimate or which miners can or cannot participate, then you no longer have a pseudonymous anarchic network.  Recall there was no EULA or Terms of Service on purpose when Bitcoin was launched years ago.

Another recent example, a Bitcoin Core surrogate who used his real name, publicly asked the New York State Department of Financial Services (DFS) to look into Coinbase’s support of Segwit2x.  Does Coinbase violate the BitLicense for supporting one chain versus another?  Last month a Bitcoin Core contributor who also used his real name, penned a letter to the SEC about why it should not approve an ETF because the company applying for it supported Segwit2X, an alternative Bitcoin implementation.20

A couple weeks later the same author of the SEC letter publicly said:

But, yea, lets be clear, I dont know a singla significant contributor to Core who will ever work on btc1/Segwit2XCoin. If all the miners switch over, most likely some folks will buy hashrate and there will be a Bitcoin chain again to work on. If, somehow inexplicably, the entire community gives up on Bitcoin and uses 2xCoin, then most likely the vast majority of Core contributors will just move on to something other than Bitcoin, though given how 2x has been going, I find that highly, highly unlikey.

The term “2XCoin” is intended to be an inside baseball pejorative towards the developers and supporters of Segwit2X.  Other Core developers have publicly stated that other Core developers will walk away from (quit) the project if an alternative implementation successfully creates a fork.

Another common war cry during the summer was that Bitcoin Cash, a fork and airdrop of Bitcoin up to a certain block height, “was an attack on Bitcoin.”  This statement raises a number of questions:

(1) there are multiple existing forks of Bitcoin that continue to exist (such as Bitcoin Dark), were these also attacks on Bitcoin?  Where is the passionate uproar against the dozens of Bitcoin clones and forks including the ones that used line-for-line the same code but simply rebranded?

(2) Bitcoin needs to first be defined, since there is no 100% consensus or agreement on what it is (longest chain?) or even agreement on how to measure consensus, to prove that there is an attack you would need to at least agree on what Bitcoin is and what exactly was attacked.  Since Bitcoin was designed from the outset to be forked and for those with the most hashrate to decide what is and is included in a block — and the rules therein — how is Bitcoin Cash any different in terms of legitimacy than Bitcoin?

If there is a regulatory arbitrator stating which fork is the legitimate legal one, you have a permissioned network.  And I truly could talk all day about those because I popularized that term with this (now dated) paper more than two years ago and currently advise a couple companies involved in building those.  Inquire within!

The tactics used by different cryptocurrency tribes versus others is not new.  In fact, if you look as recent as the 1960s, during the Cultural Revolution in China there were struggle sessions in which the accused (class enemies) were captured and dragged out in front of the public and denounced for crimes that they didn’t commit.21

We see this type of behavior in the cryptocurrency world on a monthly basis, just look at the “Antbleed” hatchet job.  This was a manufactured controversy and coordinated attempt to discredit a company (Bitmain) that had publicly spoken out against one specific Bitcoin implementation in favor of another.2223 Nearly six months later, the original accusations (of covert usage) are still unproven yet some of the promoters of this theory, several of which who are affiliated with Bitcoin Core, continue to attack anyone who stands in the way of their own vision.  Many elements in the community thrive on both real and fake controversy in order to stay relevant: it is in a state of permanent lynching mode.

Other cryptocurrency chains

Lest I be accused of picking favorites, I should point out that future researchers could create an infographic depicting how all chains evolved over time.24

Below is a non-exhaustive list of other chains that have highly coordinated behavior between influential persons that look administrator-like:

  • Dash Core: run by a company (with a CEO no less); can identify the major participants involved and how they coordinate to make changes; they sponsor events and attempt to speak on behalf of the community while making any upgrades; they run various social media accounts
  • Ethereum Classic: this small community has held public events to discuss how they plan to change the money supply; they video taped this coordination and their real legal names are used; only one large company (DCG) is active in its leadership; they sponsor events; they run various social media accounts
  • Bitcoin Cash: an airdrop based on Bitcoin prior to a certain block height; can identify the major participants involved and how they coordinate to make changes; they run various social media accounts and events
  • Bitcoin Segwit2X: can identify the major participants involved and how they coordinate to make changes; they have met to formalize this process in multiple meetings including the New York Agreement (NYA); they run various social media accounts and claim to be the equivalent of Bitcoin Core
  • Bitcoin XT: defunct, in its terms they explicitly said one set of named individuals would be administrators
  • Litecoin: leaders are self-doxxed; have a formal Foundation as well; they run various social media accounts and events
  • Dogecoin: leaders are self-doxxed and publicly coordinated merged mining with Litecoin three years ago; there have a formal Foundation; they run various social media accounts
  • Ethereum: can identify and name specific people in the Ethereum Foundation and mining community who publicly coordinated several hard forks; these stakeholders sponsor public events and code changes; they run various social media accounts; the Ethereum Foundation has a registered trademark
  • Bitcoin Gold: an upcoming airdrop based on Bitcoin prior to a certain block height; can identify the major participants involved and how they coordinate to make changes; they run various social media accounts
  • Zcash: this was created by a company (Zerocoin Electric Coin Company); can identify and name specific people in the Zcash Foundation and mining community who publicly coordinate updates; these stakeholders sponsor public events, grants, and code changes; they run various social media accounts
  • Bitcoin: before Bitcoin Core consolidating itself, there was The Bitcoin Foundation which attempted to speak as the voice of Bitcoin… then it pretty much went morally and financially bankrupt
  • Dozens if not hundreds of others

Whereas the Bitcoin creator “walked away” (or is he lurking in the CoinDesk comment section?) most ICO issuers could have the same legal problems described above.  Even ignoring the issuance of unregistered securities through ERC20 and ERC20-like standards, many of these these ICO coins and tokens were centrally issued and administered.

One reviewer singled out Factom, Tierion, Ripple, and Stellar as well, but these communities have slightly different nuances worth looking into independent of this article.  It bears mentioning that Ripple was penalized and settled with FinCEN in May 2015, but this was due to non-compliance with BSA requirements with respect to not filing suspicious activity reports (SAR) from a side fund it operated. 25 It was not about operating the nodes on the network.26 Furthermore, centralized issuance and operation of a network through watermarked tokens (e.g., Counterparty, Omni (Mastercoin), all colored coins) is still taking place today (see Tether).

This is not to say that you shouldn’t create a cryptocurrency nor a foundation.  There are likely ways to create a new cryptocurrency and structure its governance in a legally compliant (or exempt) manner.

But some of those who issued a cryptocurrency which they centrally operate and mint could be on thin ice depending on how strict regulators and law enforcement are.27 Maybe they aren’t strict at all.

If it is centrally administered for 2 minutes versus 2 hours versus 2 years (like Satoshi did), at what point is that line crossed?  What about a network like Stellar that was originally decentralized and then in an emergency, centralized (running off of one node) due to a break in its consensus mechanism?  The Stellar organization itself operated the single validation node for months before re-decentralizing.  That is clearly administering a network especially since they issued lumens to begin with (lumens are the native currency of the Stellar network).

Forks as securities

A friend of mine that is the CEO of a Bitcoin-focused company recently hired an attorney to look at the upcoming Bitcoin Segwit2X (S2X) fork proposal and thinks there could be an argument that the fork is a security based on the Howey test.

His rationale is the following, reused with his permission:28

  • S2X is a common enterprise based on the efforts of the signers of the NYA
  • Many of the signers of the NYA have long touted the benefits and profit expectations of increasing the block size
  • S2X was assembled by a promoter/ third party: the organizers of the NYA and its signers
  • Anyone who purchased bitcoin between May 2017 and the fork date is an investor, in particular if that person bought bitcoin in anticipation / expectation of the fork

If this is true, then you could likely insert and replace S2X and NYA with various cryptocurrency developer groups (including Litecoin, Ethereum, Ethereum Classic, Bitcoin Core, Bitcoin XT and others listed in the section above) and just modify the date to argue that each of these coordinated efforts is effectively a common enterprise seeking to profit from the expectations of X, Y, or Z features.  It could be smaller or bigger blocks, sidechains, slower or faster block generation times, etc.  In other words, if Segwit2X is a security, then arguably many coordinated “soft” and “hard” forks are.29

At this time, in the US, neither the SEC nor CFTC have publicly issued their position on how a fork falls within their scope and mandate.30

However, if any regulator or court does formally publish guidance or a ruling siding with a specific fork, the cryptocurrency community will have institutionalized permissioned-on-permissionless chains.  An expensive contradiction.

Relevancy towards enterprise chains

Since you do not need proof-of-work to maintain all blockchains, enterprise focused blockchain and DLT-related companies (commonly referred to as private or permissioned chains) typically started off with the realization a couple years ago that:

  1.  In order for changes and upgrades to take place on a decentralized network, some clear governance needs to be created to manage that process;
  2.  Network validators, the nodes involved in validating transactions, would be run via known, identifiable (KYC’ed) operators who had specific contractual obligations that ultimately would rely on courts as arbiters (e.g., if there is a fork, only one chain would be deemed the legitimate de jure chain);
  3.  If an entity formally governs one of these networks it is likely that it would also be regulated under existing laws and regulations;
  4.  If an entity or group of entities has the power to coordinate and unilaterally make these changes at will without legal recourse, then this could be a single point of failure that could be abused.  How to design a network that prevents this security hole from forming yet comply with existing laws and regulations all while providing recourse to the users in the event of disputes arising?

Note: all of the vendor platforms have their own differences and nuances; from an architectural standpoint they cannot all be lumped together as a monolithic entity.

But in this case, many of these companies took roughly the same tact: one which attempts to hold validating parties accountable ultimately through the existing legal system (via contracts and if need be courts).  As a result, so far the vendors have generally gotten to bypass most of the drama around factional in-fighting described above.  But each vendor still has their own challenges ahead.  Once an enterprise chain’s mainnet is turned on in production and real value is being moved across their network, whoever administers and operates the network(s) could be legally liable for complying with a whole slew of regulations from multiple different jurisdictions.

That is why some operating models involve banks or other existing financial institution running the validating nodes — because they already have the necessary licenses and compliance structures put in place. That is also why some of the vendors created a consortium from the get-go because they foresaw the need to bring on different types of stakeholders early on.  But ignoring the consortium approach for the moment, once real legal names are touching and managing real financial instruments, regulators and law enforcement begin to pay much closer attention.

Final remarks

In the US there is no private right of action under the FinCEN guidelines.  Only FinCEN can initiate an enforcement proceeding, and based on conversations with legal experts who reviewed this article, these experts do not expect such actions right now given that FinCEN hasn’t thus far.

Can private parties initiate litigation?  Based on one conversation with an interested party, it seems that there is arguably a private right of action under the CEA, under certain state money transmission business (MTB) laws and under securities laws.  Will they?  My guess is that as more real value (e.g., real money like USD) is associated with any of these anarchic blockchains, the odds of lawsuits due to any type of fork (intentional or not), trends closer to probably.

With that said, networks such as blockchains, do not maintain themselves.  They do not upgrade themselves or automatically fix bugs that arise.  They are not anti-fragile.  They need people to do all of these pesky maintenance things.  And with people comes politics and social engineering.31

Empirically if there isn’t disharmony in a blockchain community it is because most participants agrees who the administrator or administrators are.32

If there is a disagreement, as we have seen multiple times, a political struggle often takes place and a fork or two may happen: either a fork in the chain or a fork in the community.  With hundreds of dead or zombie blockchains, it is clear that blockchains do not work without some kind of administrator and decision maker.  Whether or not FinCEN or other money transmitter regulators come to the same conclusion is a different matter.

The takeaway from this piece isn’t that no one should be formally or informally engaged with anarchic chains such as cryptocurrencies.  Or that passion and enthusiasm should be discouraged.  Rather, it is about consistency and the rule of law.  If you do not like the development or evolution in a community-without-formal-rules — such as the fractured tribes of Bitcoin — using the government as a club of convenience to get what you want and not expect consequences for their intervention on your behalf is shortsighted.

While a few dozen cryptocurrency startups have already begun using trade associations to lobby regulators on their behalf for a “hands-off” regulatory approach, at some stage the appearance of formalized governance of financial market infrastructure — even if it is marketed as self-sovereign, decentralized, open, and anarchic — could lead to increased regulatory oversight due to how the crypocurrency governance activity actually behaves in reality.  This is definitely a topic worth revisiting in a year to see if any regulator publicly opines on the topic. 33

[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: RD, CP, SP, CM, VB, DG, CK, AW.

Endnotes

  1. Both Ray Dillinger and Hal Finney have stated they analyzed and gave feedback to Satoshi on Bitcoin prior to its public announcement; perhaps there were others too. []
  2. See these two articles written by Daniel Friedberg: “FinCEN Guidance Validates Bitcoin Industry but Targets Satoshi” and “Bitcoin hard fork conspiracy treacherous” []
  3. It is possible to create a redeemable asset on Counterparty and several other platforms connected to Bitcoin. []
  4. One reviewer opined that: “I think it will be a technical legal definition that comes down to whether you can exert reasonable control before enforcing MSB rules.  Whether you are an administrator or not will be a boring court decision: they could look at whether you were mining or developing with a high enough impact. []
  5. On the mining side, the capital costs of running a mining farm and pool that actually validates blocks on many of the larger cryptocurrency networks is relatively expensive and out of reach for most users; mining pools have been documented at attacking one another on the network itself (e.g., DDOS attacks).  On the developer side, as discussed throughout this article, while it varies depending on the cryptocurrency, the control over the repo (specifically who has commit access) is often restricted to a few insiders who can permit and restrict who can be involved in the development process (e.g., they can remove a developer from mailing lists, forums, events, code repositories, etc.). []
  6. Cryptocurrency miners typically only have the ability to instruct payments of keys they control (although they can censor and/or fork as well).  Thus, it is argued, the miners typically just perform IT services. []
  7. In the UK, there is some relevant guidance from HM Revenue and Customs with respect to money laundering and money service businesses []
  8. See SPV wallets for a user-specific example. []
  9. This past summer Quartz published a series of articles detailing some of this physical infrastructure in China.  See: The lives of bitcoin miners digging for digital gold in Inner MongoliaPhotos: Inside one of the world’s largest bitcoin mines; and Take a 360 walk around one of the world’s biggest bitcoin mines []
  10. A year ago the narrative that miners were a key component of Bitcoin dramatically shifted in the minds of a group that lobbied for a change known as UASF: User Activated Soft Fork.  The proposal – which thus far has not been activated – attempts to remove miners and replace their role with nodes controlled by UASF advocates, pretty much removing Sybil protection.  Instead of buying hardware and pushing hashrate one way or the other, UASF advocates used social media to promote their views.  Incidentally some of the same people promoting “no2x” (opposed to Segwit2x) were actively part of the “UASF” campaign. []
  11. One reviewer mentioned that: “It’s worth noting that in Ethereum, miners actually don’t have a large role in decision-making. Ironically enough, I think the reason for this is that Bitcoin prefers soft forks for governance, whereas Ethereum prefers hard forks, and soft forks naturally depend more heavily on miner support in order to succeed.” []
  12. Its Twitter account actively retweets and highlights specific content from a common group of promoters, advocating and endorsing their viewpoints. []
  13. “theymos” is his/her username; his real name is allegedly Michael Marquardt but little is publicly known about who he is beyond his control of the most highly trafficked Bitcoin-specific developer sites.  Other pseudonyms that co-own some of these domains include “cobra.” []
  14. In the US, copyrights are unregistered.  The copyright owner of the original source code still belongs to “Satoshi Nakomoto” however as of this writing, no one has stepped forward to claim this copyright ownership. []
  15. Alternatively they could be a “general partnership;” this was discussed in the SEC paper on The DAO (pgs 14-15). []
  16. One reviewer provided a counterpoint: “There’s a difference between voluntarily taking on responsibility and being legally assigned it. For example, if I suddenly decide that I feel morally obligated to make sure all children in some village in Africa are properly fed, I do not become their legal guardian.” []
  17. Alex Waters, Jeff Garzik, and Gavin Andresen (among others) have been removed in this fashion. []
  18. If we replaced “browser” with “TCP/IP” that would likely create massive economic disruption and finger pointing for blame. []
  19. See also: Emochain and Statistchain []
  20. I touched on this same issue last year in a paper, see Comments on the COIN ETF (SR-BatsBZX-2016-30) []
  21. One reviewer pointed out that: “If you’re looking for parallels with authoritarian regimes, there are many. Bitcoin Core’s arguments that there must be only one reference implementation to “preserve stability”; them playing linguistic games to deny the opposition legitimacy, high levels of censorship, etc. There are also parallels on the other side of this, where the “opposition parties,” despite having many legitimate grievances, are all good at protesting but focus on negativity and are not nearly technically competent enough to effectively form their own “government”. This happens in Russia, to some extent Singapore, China (think Hong Kong independence movement), etc. You can probably expand this out into an entire blog post.” []
  22. Bitmain is the largest manufacture of mining equipment, Antminer is the brand of one of its product lines. []
  23. See also Just How Profitable is Bitmain? by Jimmy Song and Former Bitmain Chip Designer Seeks to Revoke Mining Giant’s Patent from CoinDesk []
  24. One reviewer suggested that future researchers and analysts could also look at several other attributes: (1) Basing oneself in a country as an incorporated entity; (2) Having developers heavily concentrated in a country; (3) Heavily marketing in a country, especially if it’s the same country as above; (4) The operation of a chain being controlled by one implementation and one company (as opposed to Ethereum’s geth/Parity/now harmony split []
  25. One reviewer opined that: “Though it is worth noting that their ability to operate the network in a way that gives users permissionlessness was compromised as a result of these side activities. A useful cautionary tale.” []
  26. XRP Ledger Decentralizes Further With Expansion to 55 Validator Nodes from Ripple Insights []
  27. One reviewer commented that: “I think it’s worth making a distinction here between convertibility and central administration of tech. Bitcoin, Bitcoin Cash, Ethereum, Ethereum Classic, Dash, etc are all not immediately convertible; the portion of tokens that actually are convertible is relatively low and I think everyone already agrees that those are regulated.” []
  28. Private correspondence on October 16, 2017. []
  29. For a related discussion see, Are Public Blockchain Systems Unlicensed Money Services Businesses in Disguise? from Ciaran Murray []
  30. One reviewer mentioned that in the event a fork occurs, there could be legal repercussions pursuant to Commodities Exchange Act (namely, section 6(c), rule 180). []
  31. Even some of the proposed “self-governing” blockchains ultimately start out fairly centralized, arguably as administrators and MTBs.  And due to the amount of coins that insiders and creators of these chains have, they could heavily influence the direction of votes (e.g., in a staking model, large coin holders are politically powerful entities who could coordinate and collude to fork in their own interest).  Will they always remain as administrators? []
  32. Many thanks to Ciaran Murray for providing this observation. []
  33. One of the reviewers asked how several current and proposed proof-of-stake coin-based projects would fit in here as potential solutions.  Since most of these are young and/or not even launched, see footnote 31 above.  Some have governance challenges already, see Backroom battle imperils $230 million cryptocurrency venture from Reuters.  Another reviewer opined that: “Systems like Bitshares, EOS, Tezos, et al will in practice be secure primarily precisely because there are large premines held by the foundations and developers themselves. It’s like a kind of ‘centralized administration without looking like centralized administration.'” []
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Self-doxxing, dynamic block making and re-decentralization of mining

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

This includes the unchallenged statements that:

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

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

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

Named block makers

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

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

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

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

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

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

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

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

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

For instance:

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

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

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

Hashrate distribution

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

What about beyond 4 days?

Blocktrail

Source: Blocktrail

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

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

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

What does that mean?

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

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

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

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

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

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

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

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

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

Non-existent re-decentralization

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

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

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

Specifically the following factors:

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

What will happen after a block reward halving?

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

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

Why?

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

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

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

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

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

Other public blockchains

What do mining pool distributions look like for other cryptocurrencies?

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

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

Ethereum mining pool

Source: Etherchain

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

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

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

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

China

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

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

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

According to him:

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

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

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

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

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

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

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

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

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

What about ‘subprovincial’ locations?

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

No service-level agreements

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

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

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

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

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

Or as one redditor adroitly pointed out:

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

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

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

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

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

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

How else is this visualized?

scaling bitcoin panel

Source: Jameson Lopp

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

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

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

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

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

Conclusion

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

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

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

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

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

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

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

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

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

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

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

[Special thanks to Antony Lewis for his constructive feedback]

Endnotes

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

queen bitcoinAccording to public announcements, approximately $790 million has been raised by Bitcoin-related companies over the past three years (and really in earnest since the San Jose conference two years ago).

Where did that funding go?  And how did that impact the price of cryptocurrencies?

Below I attempt to break down the numbers to answer both of the questions.

The tl;dr is that there are multiple unseen cost centers that have likely absorbed capital that would have otherwise been more productively deployed elsewhere.  Some of these costs were related to compliance — which many startups assumed would not exist or could be ignored.  Others included denial of service (DOS) and ransomeware which no one besides Bruce Schneier could have predicted or thought of years ago.

In addition, consumer behavior — or as Buck Turgidson would label “the human element” — is not behaving based on the initial assumptions of many entrepreneurs, enthusiasts and VCs.  Whereas 18-24 months ago cryptocurrency-based payment processors proclaimed that consumers would flock to Bitcoin and other altcoins as a payment rail, this has not occurred (yet).1 Stagnant tokens left in cold storage therefore impacts multiple verticals, especially those relying on large aggregates of transaction fees to fund growth as they scale up.

Mining

Investing in mining and hashing is effectively taking out a short position on fiat and long on a cryptocurrency, in this case usually USD for BTC.  It is a foreign exchange play as it enables investors to turn fiat into magic internet money without typically needing to abide by foreign exchange regulations or institutional registration requirements.  For instance, a venture capital firm is typically not permitted or allowed to use LP funds on the open market to purchase forex, or in this case cryptocurrencies — but by funding a mining company they effectively fall within a “loophole” (or at least that is how some pitch it).

What does this look like?

Listed on the continually updated – though slightly inaccurate – CoinDesk Venture Investment spreadsheet are the following capital raises specific to mining:

  • Spondoolies Tech: $10.5 million
  • Avalon Clones: $3 million (likely clones of the Avalon chip)
  • Bitfury: $40 million (in two public rounds)
  • Hashplex: $0.4 million
  • KnC miner: $29 million (in two public rounds; note that KnC however had a pre-tax loss of $4.4 million last year)
  • Peernova (raised $19 million, however they are no longer in the Bitcoin mining space and didn’t raise the Series A round based on mining products)

Not included are funding from:

  • 21inc: according to Nathaniel Popper it has raised $121 million over at least three rounds (perhaps more) and is now building Tom Sawyer botnet hashing chips — consumers are expected to collectively absorb the operating costs such as electrical and administrative costs thereby painting the proverbial white fence; consumers socialize the costs and 21inc privatizes the gains
  • Bitmain: is the largest independent manufacturer, has taken no VC money to date (fully financed via private sources)
  • CoinTerra: bankrupt, previously raised $2.2 million
  • Hashfast: bankrupt, owed creditors over $40 million, “acquired” by a Venezuelan politico
  • Alidyan: part of CoinLab, now bankrupt, spent $4 million building hashing machines
  • Butterfly Labs: sued by FTC for failure to deliver product to customers, collected between $20 million to $50 million in pre-orders, currently sending some refunds
  • Avalon: successfully pre-sold the first commercially available ASICs (see interview with Yifu Guo from Motherboard); Guo is no longer involved with Avalon and the company is now called Canaan Creative
  • ASICMINER: “Friedcat” is the Chinese businessman who created an immersion mining facility in Hong Kong and custom ASIC chip, allowing those with bitcoin to exchange bitcoins for ASICMINER shares; despite allegations, it is still unclear if he absconded with the funds of a new project called AMHash
  • Gridseed (recently merged to become SFARDS): built both SHA256 and scrypt hashing equipment; in late July 2014 they purportedly owned 20 billion dogecoins (via mining) and as recently as April 2015 still supposedly controlled 60% of the hashrate for dogecoin (the management team led by Li Feng was allegedly under pressure by investors to somehow reverse the bear market)
  • ZeusMiner: shifted from building SHA256 ASICs to scrypt (dogecoin, litecoin, etc.)
  • Genesis Mining, Mega Big Power, RockMiner and a variety of small actors in the manufacturing/proprietary farm/pool business
  • DiscusFish, consistently one of the largest pools, may or may not produce some of their own hardware
  • A smorgasbord of cloudhashing scams that didn’t actually have the actual hardware (e.g., GAW mining)

So of the ~$790 million so far:

  • $82.9 million is comprised by known mining manufacturers
  • plus $121 million from 21inc (but misclassified as “Universal” in the spreadsheet)
  • but cannot include the $19 million from Peernova (this is misreported on the spreadsheet and again, they are no longer in that specific vertical)

This comes to: $203.9 million, or about 25% of the publicly known funding has gone directly into converting one currency (fiat) into another (bitcoins, litecoins, etc.).  How much of the capital has been fully deployed to date is unclear.

bitcoin funding

Data source: CoinDesk

Can this full amount impact the market price of specific cryptocurrencies?  We will try to answer that question later below.

Startup life

There are multiple budgetary components to any startup that are not unique to Bitcoinland.

For instance, irrespective of locale, the cost of living for an employee can typically be broken down into:

  • Housing/Rent
  • Utilities (electricity, gas, internet access)
  • Phone
  • Food and clothing
  • Auto/house/health insurance
  • Discretionary income (entertainment, luxury items, vacations, investments, etc.)

We will come back to these later.

For an entrepreneur in Bitcoinland, in addition to the labor costs above, some of the company-specific costs include:

  • Domain name: a large Bitcoin API company is rumored to have spent $350,000 on a five character dotcom domain; for perspective Roger Ver rents out (domain squats?) Bitcoin.com for roughly $120,000 a year (in 2012 the highest valued domain fetched $2.45 million)
  • Legal fees: some of these are delayed via equity swap deals with law firms, e.g., independent lawyers as well as firms such as Perkins Coie may provide some legal assistance for X% of equity via convertible note; similarly regulatory consultants such as Promontory have done pro bono work to assess the lay of the land for the whole space likely with the goal of converting promising clients into retainers and so forth
  • Office rent/lease/mortgage: co-working spaces are increasingly common for many seed stage companies in order to stay lean and limit the burn rate
  • Utilities and internet access: particularly important for mining farms/pools
  • Attending events: flying to conferences and meetups (which are incidentally, probably one of the few legal, profitable areas for Bitcoin right now; Mediabistro pivoted to focus on this space)
  • Event sponsorships: food and speaker honorariums; e.g., Chain.com was a lead sponsor for the O’Reilly Media Bticoin & Blockchain event, BitPay sponsored the ill-fated, one-and-done Bitbowl (Platinum sponsorship at the NYC InsideBitcoin event was $13,000 and $12,500 for Singapore)
  • Marketing and advertising: user acquisition, lead generation, brand awareness, e.g., Gyft, eGifter, and BitQuick.co purchase many of the ad slots on reddit, various “rebittance” companies purchase ad slots on Facebook, itBit is everywhere on Twitter, ChangeTip attempted to capitalize off of the Nepal earthquake and curates sock puppet spam (BashCo, a reddit moderator now works for ChangeTip)
  • Front-end design: can reach $75,000 to $100,000 and there are now companies such as Humint and Bitsapphire catering to cryptocurrency-related startups
  • Advisory fees to banks: American Banker recently explored the rumors that banks such as SVB charge its clients (such as Coinbase) a monthly “advisory fee” (payola?) which could range $20,000 – $60,000 per month
  • Lobbying special interest groups: a number of Bitcoin-related startups donate to non-profit organizations which in turn pays the salaries for staff at Coin Center, Chamber of Digital Commerce, The Bitcoin Foundation and others in order to influence policy making
  • Board of Directors and Advisors: Larry Summers (Xapo, 21inc), Arthur Levitt (BitPay, Mirror), Sheila Blair (itBit), Gene Sperling (Ripple Labs), and several other VIPs; while some of these relationships are in exchange for equity (0.5%-2%) others may be in the form of cash ($5,000-$10,000 per month) — either way, not free
  • Company outings and vacations: ChangeTip flew out to Argentina, another well-heeled group went to Malta, while others have had traditional typical perks (e.g., company lunches and dinners)
  • Money transmitter licenses: in addition to maintaining a compliance team that regularly submits SARs, it currently costs about $2-4 million to obtain the necessary MSB licenses to operate in all states within the US (recommend readers chat with Faisal Khan and Juan Llanos for more info)
  • Insuring virtual currencies that a company may hold in custody: Xapo, Coinbase, BitGo, Gemini and others now advertise that the holdings (of some kind) are insured by third parties (and purportedly even the FDIC in the case of itBit)
  • Acquiring and maintaining an inventory of cryptocurrencies: many wallets and exchanges need to maintain some kind of ‘hot wallet’ so that customers can quickly transfer their virtual assets.  For instance six days ago the hot wallet at Bitfinex was compromised and a hacker stole 1,459 bitcoins, earlier this year Bitstamp’s hot wallet was hacked and lost 19,000 bitcoins, Coinfloor stated two weeks ago it holds 5,081 bitcoins on behalf of customers and as of this writing Bitreserve states it has $1,716,030 obligations to its customers.  In addition many exchanges run prop desks to trade liquidity with partners (e.g., most VC-funded exchanges have an OTC team that handles large block trades)
  • Customer service and bug bounties: reimbursing customer for problems with R values/RNGs.  For instance, in December 2014, Blockchain.info used untested code in a production environment that cost customers at least 267 bitcoins (and again on May 26, 2015).  In April 2015, reddit user vytah fixed a BitGo integer overflow error that cost a customer 85 bitcoins
  • Denial of service (DOS) vandalism and extortion: commonly happens with mining pools (competing pools threaten to do a denial of service unless a certain amount of bitcoins is paid) — in March 2015 at least five different pools were targeted; also happens with media sites such as when Josh Garza (from Paycoin/GAW mining) allegedly attacked Coinfire to prevent stories regarding scams/fraud from surfacing
  • Ransomeware: as noted last month while this type of malware has existed for several years, CryptoLocker itself stole nearly 42,000 bitcoins in the fall of 2013, thus signaling to market participants that this successful method of attack could be copied.  According to Dell, during a six month time frame last year, “CryptoWall infected more than 625,000 computers worldwide, including 250,000 in the United States. During that time, the gang that operated CryptoWall raked in about $1 million in ransom payments.”  Currently hackers are targeting smaller and more marginal actors.  For instance, two months ago the network for Swedesboro-Woolwich School District in New Jersey was held hostage for a 500 bitcoin ransom.  And the Tewksbury Police Department system in Massachusetts recently became just one of many public organizations that has paid similar ransoms in bitcoin.

It is still unclear how much of these variables will ultimately absorb the budgets of each startup.  Not everyone is targeted with ransomeware, some startups eschew conferences and others are uninterested in building consumer facing products.  Similarly, some early employees are content with living in a SOHO or communal setting, thus reducing a rent component for someone.

At some point as the industry matures, as companies are acquired or even go bankrupt, we will likely have a better picture of percentages for each of these categories.  It could be the case that as Bitcoin-related custodians and depository institutions grow and merge, they will continue to absorb the costs borne by the traditional financial industry.

Ignoring the cryptocurrency-related challenges (such as securing hot wallets), perhaps several of these entities named above will end up needing to acquire the same licenses and charters as their peers (banks) do and thus could materially impact their balance sheet and growth targets.2  Thus it will be worth revisiting these shifting characteristics again at the end of the year if not sooner.

Converting salaries into bitcoins

bitwageAnother bullet point that is of interest to this conversation yet falls in the cracks between employer labor costs and employee discretionary income are: those individuals who convert part, or all of their salaries into bitcoins.

Most, if not all, Bitcoin-related organizations now offer some method to convert fiat-based salaries into cryptocurrencies.  Bitwage is a startup that provides a conversion service to do so.  Prior to this service (which BitPay also does), some organizations like The Bitcoin Foundation, at one point (perhaps it still does) offered to pay salaries based on a 30-day rolling average of bitcoin-to-fiat.

Another tangential example: one VC-funded Bitcoin company that raised more than $20 million late last summer bought a tranche of bitcoins (then valued at around $1.5 million) to lay aside for employee benefits.  Their employee deal is to hand over some options in future bitcoins so they wanted the bitcoins locked in to handle the employee liability.

In another instance, it is also worth noting that the $30.5 million Blockchain.info round (the largest Series A so far) that was announced in October 2014, was a mixture of bitcoin and USD (primarily USD).

What is the impact on the price of cryptocurrencies if all the employees at these startups converted their salaries into cryptocurrencies?

This has not been analyzed due largely to a lack of public information yet but it bears mentioning that it is likely that most, if not all, employees cannot fully convert their entire salary into cryptocurrencies because, for example, their land lord or utility company likely does not accept it for payment.  Perhaps this will change in the future, until then however: rent, utilities, phone service, food and insurance are probably still largely paid for with fiat.

Recall that each startup also has its own cost structure, some attempt to position themselves as a “just” a software company while others try to compete in the compliance-heavy and saturated exchange/wallet market place.  Thus the types of costs each company has is not uniform.  What this also means is that some portion of the VC funds that have gone into these companies is likely, ultimately kept in fiat and not converted into cryptocurrencies.

But, there is still more to look at.

The on-going Bitcoin crowdsale

Approximately every 10 minutes the Bitcoin network generates 25 bitcoins.  Miners (collectively in the form of mining pools) compete with one another over winning these tokens.  They do this by coordinating with hashing farms which consume large quantities of capital (primarily electricity) to rearrange a few attributes with the goal of finding a target value below a certain threshold.

In a sense, Bitcoin mining is an on-going auction, or crowdsale, to convert one currency for another.  And miners continually bid up to an equilibrium threshold in which the marginal costs of creating a bitcoin equals the market value of a bitcoin (i.e., in the long run it costs a bitcoin to create a bitcoin).34

In theory, over the past two years roughly 2,625,000 bitcoins were created.  In practice the actual amount is about 10% larger due to the fact that blocks are not being created at 10 minute intervals but much quicker, as fast as 7 minutes during October 2013 (as of this writing it is roughly every 8-10 minutes; see Appendix B).  Thus, whereas block reward halvings were expected to take place once every four years, this has accelerated by several months.

The first halvening occurred in late November 2012 and the next one is expected to occur at the end of July or early August 2016.

How does this impact the fiat-denominated price of bitcoin?

If the average weighted fiat value of bitcoin over the past 24 months has been $400 then based on the theoretical growth in money supply approximately $1 billion in bitcoins have been auctioned off to mining pools over the past two years.  Yet because the supply has increased 10% faster than the actual number is probably closer to $1.1 billion.

What does this mean?

This means that the capital spent on mining — primarily a wealth transfer to utility and manufacturing companies — still far outpaces VC investments, especially once mining-related investments are accounted for.  Altogether, once publicly announced mining investments are removed this amounts to $590 million, not $790 million.

Or in other words, since mining pools, farms and hashing participants ultimately have to sell their $1.1 billion in block rewards to pay for land, labor, taxes, equipment and electricity there is a continuous sell-side pressure on bitcoin that even all of the publicly announced VC financing cannot fully absorb even if it were allowed to.  But that does not mean it has not been dampened.  And it is also known that some of the farms and pools have  attempted to hold onto large bitcoin holdings with the expectation that these will appreciate or due to the inability to find reliable OTC partners to liquidate them without slippage.

Based on known figures above, in percentage terms, the acquisition of block rewards via VC mining investment represents about 18.5% of the $1.1 billion rewarded to miners.

While we may not know the exact numbers that venture backed firms, their employers and their investors have spent acquiring tokens, it is likely that the amount is non-negligible and perhaps even has much as several hundred million if not more.

For instance, Tim Draper publicly bought around 32,000 bitcoins last year (from the DPR/Silk Road auction, not freshly mined coins).  While it is unclear where these bitcoins will go, Boost VC (run by his son Adam Draper) is investing an additional 300 bitcoins in each startup that completes demo day (there were 24 startups in the most recent tribe, 21 of which are Bitcoin-related).  Entities like Seedcoin (renamed Coinsilium) have also tried funding startups this way.  This type of fiat conversion into bitcoin could absorb some of the sell-side pressure that comes from seizures, payment processors, miners, ransomeware and scammers liquidating their holdings (see Flow of funds).

There is some added historical precedence to this.  For instance, and as copiously noted in Nathaniel Popper’s new book, between January through March 2013, at least a dozen or so high-net-worth individuals such as Wences Casares, executives at Pantera and the Winklevoss twins collectively bought tens of millions of dollars worth of bitcoin.  The demand of which resulted in a rapid increase in market prices.  On the other hand, a few years from now when we have more data, there may not be a direct causality between outside investment and what effect that had on the price of cryptocurrencies.

Yet, with $1.1 billion in mining rewards virtually popping onto the scene, why is the community still relying on venture capital funding at all?  This native pool of virtual capital created in the past two years alone surely is capable of funding internal improvements and enhancements to the ecosystem?

To be even handed, it is also about having access to the capital (irrespective as to whether it is virtual or fiat-based)..  In practice an individual with an idea is unable to approach miners and ask for capital — many of the pools and farms are not set up or positioned to act as investors and many prefer to remain unknown.  Thus in practice it is probably easier to raise from dedicated firms that advertise the fact that they fund startups (like incubators and accelerators).

A year ago at the May 2014 Amsterdam conference, Robert Sams elaborated on this issue:

There is a different reason for why we maybe should be concerned about the appreciation of the exchange rate because whenever you have an economy where the expected return on the medium of exchange is greater than the expected return of the underlying economy you get this scenario, kind of like what you have in Bitcoin.  Where there is underinvestment in the actual trade in goods and services.  For example, I don’t know exactly how much of bitcoin is being held as “savings” in cold storage wallets but the number is probably around $5 billion or more, many multiples greater than the amount of venture capital investment that has gone into the Bitcoin space.

Wouldn’t it be a lot better if we had an economy, where instead of people hoarding the bitcoin, were buying bitshares and bitbonds.  The savings were actually in investments that went into the economy to fund startups, to pay programmers, to build really cool stuff, instead of just sitting on coin.  I think one of the reasons why that organic endogenous growth and investment in the community isn’t there is because of this deflationary nature of bitcoin.  And instead what we get is our investment coming from the traditional analogue economy, of venture capitalists.  It’s like an economy where the investment is coming from some external country where Silicon Valley becomes like the Bitcoin equivalent of People’s Bank of China.  And I would much prefer to see more organic investment within the cryptocurrency space.  And I think the deflationary nature of bitcoin does discourage that.

It is likely the case that VC funding, and therefore LP funding, is currently propping up both the ecosystem and maybe even the price due to the fact that consumer demand, via transactions remains muted.

How do we know this?

The majority of bitcoins, 96% to be precise, stored in Xapo are inert and that a similar amount is likely left inactive in Coinbase (both of whom store investor and venture partner funds as well).   We also know this is the case indirectly via payment processing figures such as BitPay (as shown below), which have effectively plateaued.

In short, because of a dearth of transactional demand, the internet commodity is reliant on speculative demand to fulfill any movement in market prices.  Perhaps this will change in the future with projects such as BitX, Coins.ph and Alliance Commerce which have been gaining genuine traction.

What, as Sams suggests, would it look like to actually fund internal improvements or other projects with this virtual currency instead of relying on the People’s Bank of China, Silicon Valley or other outside entities?  Where, as economist might say, is the circular flow of income?

Crowdfunding altcoins and altchains

What about non-VC funded startups in this overall space?  What are some examples of people attempting to put to work the virtual capital without relying on exogenous sources?

In early January I looked at a number of the “initial coin offering” (ICO/ITO) that have occurred over the previous 18 months.  The list included:

  • Mastercoin raised 4,740 BTC in August 2013
  • NXT raised 21 BTC in November 2013
  • Maidsafe raised 7,368 BTC and “95,000 MSC” / BitAngels ‘loan’ in April 2014
  • Swarm raised 1,252 BTC in June 2014
  • Bitshares AGS raised 5,621 BTC and 415k Protoshares in July 2014
  • Viacoin raised 610 BTC in July 2014
  • Ethereum raised 31,529 BTC in August 2014
  • StorJ raised 910 BTC in August 2014
  • SuperNET raised 1,201 BTC and “4,536 BTC equivalent” in Sept 2014
  • Peertracks (Bitshares music) raised ~1,436 BTC in November 2014
  • Bitbay raised 5,000 BTC in November 2014
  • Ziftr raised around “2,000” BTC (more than $650k) in Dec 2014
  • Gems raised 2,600 BTC in Dec 2014

Since then, there has been at least one other large token sale, through Factom.  Over the past two months it has received 2,278 bitcoins.

Altogether this amounts to 66,566 bitcoins raised by 14 projects in about 21 months.5

This may sound like a lot, and perhaps it is relative to the illiquid altcoins it represents (such as Mastercoin which has been rebranded as Omni), but for perspective the Bitcoin network generates roughly 3,600 bitcoins per day — an on-going token sale that continually absorbs more real-world capital and resources than most of these projects collectively do.

Yet despite this level of external funding, participants still prefer to store and hold and not actually spend due to a variety of reasons including low time preferences and the expectation that token value will increase. Perhaps that will change in the future.

Furthermore, it bears mentioning that crowdsales such as those above, are not circular.  Costs nearly always end up being paid for by selling the received currency (bitcoin mostly) for fiat.  In practice it is less of a circle and usually just an added step: bitcoin wallet -> altcoin crowdsale -> convert to fiat -> pay real-life costs.

While a number of these projects are still less than a year old, where are the scorecards for other cryptocurrency-only projects?  For example, in 2012, administrators at Bitcoin Talk raised nearly 7,000 bitcoins to build a new forum.  What about other projects that are paid for directly with other cryptocurrencies such as those on Lighthouse?

Open questions about the circular flow of LP funding

flow of investment funds in bitcoinland[Note: the image above is a variation of my previous illustration on the movement and source of funds within Bitcoinland]

There are a number of popular predictions percolating on the tubes including Bitcoin investments which are on pace to reach $1 billion by the end of the year.

Perhaps that will take place, however at some point these companies will need to generate some kind of actual non-sock puppet traction and returns to justify their 4x, 5x, even 6x valuations.  If not, then VC funding could decline as they did with cleantech.

How would a decline impact services?

For instance, it is unlikely that more than a handful of non-VC funded companies or individuals are actually paying for API access at platforms such as Chain.com, Gem or BlockCypher (not to pick on them, just an example).  Perhaps this will change in the future.

Yet by looking at the customer list at API companies we notice two things: 1) these customers are similarly VC-funded startups, 2) most of these services have no real traction yet either and are themselves reliant on VC-funded customers.

If and when VC funding dries up this could have a knock-on effect on both of these as the solvency of other virtual currency startups is heavily reliant on a VC-subsidized customer base and the price of bitcoin itself (if it does not dramatically rise by several orders of magnitude then the forex play does not pan out).

Or in other words, what economists would want to see is a circular flow of income yet what we see occurring is a circular flow of VC funding (or rather LP funding).6

If VC funding withdrew it could not only impact the hashrate (as VC funded miners are turned off) it also could impact the fees to miners.  Why?  Because VC funded companies are more likely to send higher fees because they can dig into what amounts to VC subsidies which currently masks some of the dysfunction in the fee system.

In addition, recall that nearly half of BitPay’s volume last year were miners selling block rewards and other people buying IT services (which could be GPU-based mining gear).  If this extends to the rest of the active, non-cold storage Bitcoin economy as a whole, then the miners collectively account for a large portion of the supply and perhaps even the demand of bitcoins (due to keeping tokens on their books as long-term bets on the appreciation of the token).  People in general are excited about the forthcoming halving because it decreases supply and therefore sell-side pressure, but if the mining industry shrinks, its ripples then impact those dependent on its sales such as non-diversified payment processors.

Conclusions

move_fast_and_break_things

Source: XKCD

Perhaps as the bullish narrative states, increased consumer demand is around the corner and the trends above will drastically change.

In the meantime some startups in this space are still typically trying to evolve along the lines of an early stage social media app: build an MVP, raise a seed, acquire users, rapidly introduce new features, manage a rational head count and steady burn rate for 12 months before raising the next round all while trying to allegedly build Wall Street 2.0.

While the “move fast and break things” mantra may work for certain sectors of the economy, it probably does not work as effectively with finance.  And contrary to the wisdom from some venture capitalists in this space, nearly all the verticals in the Bitcoin-space are attempting to recreate a financial product or service of some kind that is based on the success of the currency being widely adopted/transacted/used.  Forex plays.

What does that mean?

Last November I made a trip to Singapore and heard a Los Angeles-based VC claim that “Bitcoin and Hashcash reinvented economics” and that we could ignore the world of finance and economic gurus.

Perhaps she is right.  But probably not.

Trying to reinvent hospitals without talking to doctors or nurses would be short sighted just as building a car without talking to mechanics and engineers would likely be asking for problems.

Bitcoinland is filled with hundreds of very bright computer scientists and entrepreneurs who are being funded by well-intentioned capitalists with a mandate to take risks and attempt to disrupt incumbents everywhere.  For instance, who would have guessed three or four years ago that conditions in mainland China, when coupled with guanxi in exchange for sweet land and energy deals, would incentivize a cottage industry of pools and farms to set up shop and pump out more than half the network hashrate?7

However, while this topic is beyond the scope of this article, Bitcoin itself does not natively replicate the plethora of financial services or instruments that the real world currently provides; and its current internal monetary system incentivizes users not to actually spend magic internet beans as they would actual currency but rather store them indefinitely.

Instead it has come down to limited partners — pension funds, insurance companies and high-net worth individuals — whom are directly trying to build a new financial ecosystem yet who, as shown in the flow chart above, indirectly end up owning a lot of this economic dead weight in the form of frozen virtual beans.  These tokens, like gold before them, do not provide dividends or interest, they cannot be natively relent without introducing a new trusted third party and thus are unable to generate additional wealth.8

Again, trends can always change, perhaps linear growth will indeed catalyze into exponential curves.  Perhaps rumors of “major deals” between Bitcoin companies and large banks will eventually germinate and DCG or the Argentinian community buys Necker Island with a few satoshis next year.910 Yet so far, about the only two exponential phenomenon we can empirically observe thus far is the usage of the terms “exponential” and “network effect” at conferences and in media.  Just three more to go and we can finally get a bingo.

[Acknowledgments: thanks to Pascal Bouvier, Ben Doernberg, Dave Hudson, AL, Jake Smith and Fabio Federici for their feedback]

Endnotes

  1. Or in short, the only real activity that seems to be going on still is day trading and arbing, no real above-board commerce yet. []
  2. It bears mentioning that there has been a lot of bonafide innovation and traction around multisig security.  This includes firms such as BitGo, GreenAddress and CryptoCorp as well as hardware “wallets” such as Ledger, Case and if the definition is slightly stretched, Trezor.  Note: as of this writing that an increasing portion of bitcoins have moved to P2SH. []
  3. There are exceptions to this rule, some farms such as those operated by Bitfury and by independent groups in China have “bumper” coins, their costs are significantly lower than competitors and therefore their profit margins are larger. []
  4. See The myth of a cheaper Bitcoin network: a note about transaction processing, currency conversion and Bitcoinland []
  5. The Bitcoin network creates roughly the same amount of tokens in just under 19 days. []
  6. Perhaps this is part of the “fake it till you make it” strategy and some could be argued that this is needed during the journey across the chasm.  And perhaps the VCs pushing this could be right in the long run.  Everyone likes line charts that go up, even if you or others in your industry are paying to make the line rise. []
  7. See Chapter 5 and Bitcoins: Made in China []
  8. See Can Bitcoin’s internal economy securely grow relative to its outputs? []
  9. In addition to pilots from Tembusu, Eris, Ripple Labs and other distributed ledger groups (which are not Bitcoin related), some notable startups trying to bridge Bitcoin directly and specifically with the world of finance include TeraExchange, SolidX, LedgerX, Mirror, Gemini, Open Assets (which NASDAQ is apparently trialing out), TradeBlock, ChromaWay and Hedgy.  See also No, Bitcoin is not the future of securities settlement by Robert Sams []
  10. For some observations on Argentina see also Can Bitcoin Conquer Argentina? by Nathaniel Popper []
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The Continued Existence of Altcoins, Appcoins and Commodity coins

Yesterday I gave a presentation at a Bitcoin Meetup held hosted by Plug and Play Tech Center in Sunnyvale.

I discussed the economic incentives for creating altcoins, appcoins, commodity coins and also covered several bitcoin 2.0 proposals.  The slides and video from the event are viewable below.  Download the deck for other references and citations.

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

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

(Paper) (Slides)

Abstract:

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

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

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

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

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

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

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

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

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

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

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

The chart below is a visual representation of this phenomenon.

bitcoinhashrate

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

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What is an atomic transaction?

I received an email earlier today asking clarification of the term “atomic transaction.”  Occasionally you may see this used in an article describing a unique advantage that cryptocurrencies such as Bitcoin have.  Angel investor, Ben Davenport, used it in a quote that I published over at CD last week:

“[I]magine the power of being able to make a trustless trade of stock for bitcoin with a stranger, at a distance, with no third party involved. With colored coins, I can construct a single atomic transaction which encodes such an exchange. That, to me, is the most important basic thing that colored coins can enable.”

In short, when exchanging one cryptocoin with another (such as a Bitcoin for a Litecoin or colored coins), either the trade occurs or it does not.  Michael Goldstein explains this concisely over at Lex Cryptographia:

Two parties agree to exchange one cryptocurrency for another, and the transaction is done in such a way that neither side can execute their portion of the trade without releasing funds to the other party. The trade either happens in its entirety, or not at all, which means nobody can walk away empty-handed. The worse possible outcome is that no trade occurs at all and everybody keeps what they had.

The key is the nLockTime function described in Atomic cross-chain trading.  I also recommend looking through the Bitcointalk thread Alt chains and atomic transfers.

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Charlie Lee on Litecoin: “People like choices”

This past weekend there was a large Bitcoin conference held in Miami that attracted many of the major crypto developers, programmers, journalists and userbase for seminars and workshops.

Charlie Lee, creator of Litecoin, gave a very interesting presentation on the history of altcoins from 2010-2011.  He discusses some of motivations for creating an alt coin (such as Litecoin) as well as what unique features a few of them have that differentiates themselves from others.

During the Q/A at the end, someone mentions that Adam Back, the creator of HashCash, purportedly said that the ecosystem should just have one cryptocurrency, Bitcoin.  Otherwise new participants and laymen get confused and turned off when they learn there are hundreds of cryptocoins.

Charlie’s response was that he agreed with this position, that it would be helpful for the development, the marketing and the dispersion of the crypto meme, but that ultimately “people like choices.”  And that if it was not Litecoin that was the 2nd largest, some other token would be.  And thus Bitcoin users should be happy that Litecoin is the 2nd and not some other, like Dogecoin which has no actual development team.

[Note: the first few minutes of the video are missing. The slides are located here.]

Charlie also did an interview last summer with Newfination which covered Litecoin, Bitcoin and Coinbase:

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Ethereum’s potential: a cursory look

If you haven’t done so yet, I highly recommend reading Vitalik Buterin’s overview of Ethereum published earlier today.  It is very lofty, seemingly feasible and I don’t detect much hyperbole.  He is clearly aware of the short-comings of all the different 1.0/2.0 projects and is pretty much trying to make this stand out by otherwise fulfilling Newton’s, “standing on the shoulders of giants.”  I’d be interested to see what other project leaders from 2.0 initiatives have to say.

A few technical concerns I haven’t really seen addressed but I’m sure are being discussed somewhere:

1) Botnets.  While ASICs do create potential long term centralization problems, Botnets will jump all over the ability to use CPUs again to mine.  How can this be prevented/mitigated?  Can it?  Is there a way for Ethereum the org to prevent miners from participating (if so, can it be abused?)?  [Note: I have discussed mining previously in the Litecoin category.]
2) Even though the money supply is mathematically known, I’m not entirely sure the linear money supply will necessarily have the zeroing effect apriori.  It could, and probably will but obviously this is aposteriori.  For perspective, the token supply in LTC and BTC are significantly higher the first decade than Ether is.
3) While Script is not Turing-complete this also prevents viruses from being created and wreaking havoc on the blockchain.  CLL sounds great on paper in terms of robustness and utility, but how do you fight HNWI hackers who want to cause mischief?

Two other points of interest regarding the business side of this project:

1) I do think that eventually someone, somewhere will create a distributed, encrypted dropbox for global use.  How that is incentivized, or rather, how individuals pay for the resources (bandwidth & space) obviously will be another matter altogether.  Bitcloud is one project that is trying to tackle that (through proof-of-bandwidth).  Perhaps, as part of what Mike Hearn described 2 years ago, users will eventually be able to use microtransactions (e.g., 0.01 BTC) to pay random WiFi hotspots to create adhoc mesh networks — distributed encrypted dropboxes could just as easily follow similar paths in terms of payment/compensation.  Shades of Snow Crash and The Diamond Age

2) Even though I am pretty pro-alt coin/chain/ledger/etc. I do think parts of the Humint project are probably not going to work as initially planned in their press releases this week.  Assuming that Cocacolacoin is not part of the Ethereum blockchain but rather uses its own independent blockchain, it’s hard to imagine how to incentivize network hashrate (which creates network security which prevents a 51% attack).  I’m not saying it won’t work apriori, but from a business model it is difficult to believe that Bob the Miner will want to exchange hashrate for Coca-cola swag.  Obviously stranger things have happened, like the recent “success” of meme-related Dogecoin (wow! so cool! much awesome!); I do think not using the term “coin” will be a better marketing strategy as it is too loaded at this point (I prefer token or ducat).  Other obvious uses within the Ethereum blockchain are Frequentfliercoins from Alice Airlines, could probably help prevent and mitigate the risks involved in travel hacking (FYI: United Airlines frequent flier miles were downgraded effective February 1, 2014 due to rampant inflation).

For example, I think Alice Airlines could utilize the “contract” system by using some amount of Ether (0.01), creating a “contract” which defines a set amount of Mileage (which itself will likely have some predefined expatriation dates).  Assuming this is in the future and flyers are using Ether wallets (oh the 19th century irony) and provide the airline with their wallet address, the user will be able to receive the Mileage amount in their wallet (more than likely it will be an embedded URL that sends you to a screen on Airline Alice with the actual amounts + Terms of Service).  This is what colored coins are, but Ethereum seems to be both more elegant as this is native built-in functionality and in terms of transfer speed (3-30 seconds is the stated goal versus 10 minutes for 1 BTC confirmation).  This is subject to change, but just one potential use of the platform.

It will also be interesting to see how Dark Wallet and Zero Coin projects will react to this announcement (Ethereum is currently stating it is not an anonymous solution though through the “contracts” system this can be obfuscated).

Other resources to peruse:

– Ursium has a live update of publicly known tidbits.
– The Ethereum blog has some interesting info, especially about DAOs

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12 Step Guide: Easiest and fastest way to start mining Scrypt-based tokens for Litecoin and Dogecoin

This past year I have received a lot of emails asking me about how to mine a cryptocurrency.  There are lots of good guides out there for setting up real mining rigs.  I used this consolidated guide last year but I recommend Cryptobadger for all current setups.

But if you really want to just test the waters with a machine you have laying around, I put together a very simple guide involving the least amount of technical prowess.

Step 1: Find, build or borrow a computer with a discrete video card made by either ATI (now AMD) or Nvidia.  Radeon cards perform the best usually by an entire order of magnitude.  Do not use a laptop because it will likely overheat and you may end up causing permanent damage to the machine (the only exception is a gaming laptop with fans/exhaust).

Step 2: Look at the Litecoin mining hardware comparison chart (even though it says Litecoin, you will end up with the same hashrate with Dogecoin or other Scrypt-based cryptocoins).  Make sure to see what parameters and settings your discrete card functions best at.

Step 3: Download the GUIMiner fork for Scrypt-based cryptocurrencies (Litecoin and Dogecoin are the two largest in this space).  Note: the original GUIMiner is designed for Bitcoin and will not work if you point it to a Scrypt-based pool.

Step 4: Look for a pool.  You will unlikely be able to “discover” one of the blocks solo-mining with your own computer at this point, thus virtually everyone connects to a pool (a group of other miners) in which you collectively are rewarded for your share of hashing.  For Dogecoin there are numerous pools, the one I’ve mentioned to my friends is Dogehouse.  For Litecoin there are also many to choose from.  The one I personally used in China was Coinotron.  Note: pay attention to pool fees.  Some of the fees can be relatively high, 5%.  This is likely due to maintenance costs to prevent DDOS attacks from taking down the pool.  Also PSA: if you plan to add a lot of hashrate I recommend joining a P2Pool to help decentralize mining.

Step 5: Sign up for a pool.  When you register at one of the pools, be sure to use a password that only you know for the front-end otherwise someone can log in and modify the remittance address to their own.  Once you have registered, you need to do two things:

1) Create a worker unit with a name like Alice.1 and give it a simple password like X.  It doesn’t matter if someone knows that unit name or password, in fact they could actually point their cards to that address and help you mine, but that is unlikely : )

2) Look at the Getting Started section of the pool website.  There you will find the information about stratum and pool connection info.  You need to insert this information into the appropriate sections on GUIMiner.

Step 6: Insert settings.  Again, find out what kind of video card your computer is using and look at the comparison chart (above) to find out what the best settings are for that card.  If you use a Radeon you can use GUIMiner’s drop-down option and it will automatically insert the setting values.  Otherwise you should just Google your video card and type “litecoin mining” or “dogecoin mining” (e.g., Radeon 7950 litecoin mining settings).  It is important to look at the specific brand as some are better than others.  CryptoBadger has a list of the best available to buy (or used).

Step 7: Test the settings.  Once all of the fields are filled in GUIMiner and you have registered at a pool, be sure to click Start on the stratum server.  Then move to the first tab and start the worker unit (GPU).  You will instantly know whether or not the stratum connection is invalid as there will be a warning statement at the bottom with “Not Connected” next to it.  If your card is actually working, you will audibly hear the fans blowing much faster and in the bottom right hand corner of GUIMiner you will see a hashrate (e.g., 600 kh/s).  If you do not see a hashrate, it is not mining.  If the Stratum connection is not working, you will not be credit with valid shares.  In the bottom left of GUIMiner it will say how many shares have been accepted as well as stales/invalid.  You can also check the mining pool interface/dashboard to see how each mining unit is doing.

Step 8: If the system is working, have it run for 5-10 minutes.  See if it crashes.  If it crashes, try to diagnose the reasons why.  Did you try to run other applications at the same time?  You will likely be able to utilize the system for any productive work as the GPU, CPU and system memory are preocuppied solving these “proof-of-work” math problems.  So do not use your main work system.  If your system crashes, you can ask the community websites (like LitecoinTalk) for help in troubleshooting the cause.  In my experience the three most common problems are 1) heat dissipation, 2) power supply & 3) intensity settings are too high.

1) Heat dissipation.  Most beginners do not realize that these GPUs will, at full load and intensity heat up to 70C+.  My own reached over 80C and operated there non-stop for months.  You need a way of dissipating this heat, either by cooling it down within a case (e.g., lots of fans or liquid cooling) or by building an open-air case (like a milk crate).  If you are using more than one GPU you will also likely need a PCI-e riser to allow air flow in your system — if the cards are next to one another they will likely crash due to heat issues.  Here is a how-to guide for installing risers.  If you want to try liquid cooling, you can follow how my friend Silas did it several years ago with Bitcoin.

2) Do not underestimate how much electricity your GPUs will suck up.  If tweaked properly for undervolting (using various software tools like MSI Afterburner and/or Trixx) you can reduce power consumption however if you’re a beginner you will likely need some spare wiggle room.  There are endless threads about the best setup but do not skimp on a good PSU.  A 750W from Corsair will power two Radeon 7950s without a hiccup.  A 600W will likely not (perhaps creating a dangerous environment).  Do not use any molex connectors or converters.  Use a real power supply that has enough native PCI-e connectors to the board.

3) Each card has its crashing point.  Push it too hard with too much heat or fail to give it enough electricity and it will crash.  Another issue, and this involves guess-and-check is to incrementally increase the workload and intensity on the GPU.  So if this is your first time, start at an intensity of 14 and build up from there.  If you start at 20 you will likely crash the system and not be able to know exactly why (e.g., did it get too hot?).  Pay attention to GPU temperature during this time, if it gets past 90C or increases from room-temperature very rapidly, it will likely crash due to heat-related issues.

Step 9: This short guide was to help you just test and start mining with whatever gear you had laying around.  If you want to throw some real money at this endeavor, I recommend looking through CryptoBadger’s site and some of the mining forums out there.  The Radeon 7950 is still probably the best value / hash / watt — but they are no longer made or sold in most countries (the exception is the HIS brand from Taiwan which can still be bought online sometimes).  You can find others on Ebay and Craigslist (or 58.com if you’re in China).

Step 10: Install a remote-login tool such as LogMeIn so you do not have to connect your system permanently to a monitor or keyboard (do not give anyone that log in info).  In most cases you can just leave the rig in a corner of a room near a window and check on it once or twice a day via the remote login.

Step 11: Calculate your hashrate and plug it into a Litecoin difficulty rating calculator.  Then look to see how much it costs in electricity to operate your rig.  Even if you are still generating dogecoin or litecoin each day, your electrical costs may create an unprofitable scenario (unless of course the tokens appreciate and/or the difficulty rating decreases).

Step 12: You have a binary decision making process.  Either turn off the rig (remember, this was supposed to be just a test run) or leave it on.  It can be a fun experiment to show your friends and family how distributed cryptoledgers actually work in terms of infrastructure, but you most likely do not want to bet the farm to build a server farm of these. [Don’t forget to get a Litecoin wallet or Dogecoin wallet to put those mined tokens in]

Coda:

I have written a few other articles on mining before (see here and here).  If you came here looking for Bitcoin mining, you are a couple years too late.  For independent hobbyists, ceteris parebus it is mathematically impossible to profit off of GPU mining for Bitcoin.  You can buy an ASIC but again, those are problematic in that there is a waiting list and you will likely not receive it in time to generate enough BTC to pay for the machine plus electrical costs.  If you want to experiment you can buy a USB ASIC for Bitcoin mining (such as a Bi•Fury) that simply plugs into a USB slot and goes to work (you do need to manage the software, I recommend Bitminter as it is the easiest to setup with.)

Another problem with the ASIC from an investment standpoint is that it is a depreciating capital good.  As the competition for hashrate continues (see this recent Bloomberg cover story) the network difficulty for Bitcoin increases dramatically by 10-30% at each reset (essentially every 2 weeks).  Thus even if you do mine enough BTC and/or it appreciates in value to the point where you pay off the initial capital costs, you will unlikely be able to resell the ASIC to anyone (because why would a buyer want to purchase a product that is no longer profitable in hashrate?).  Thus the only option you then have is to turn the ASIC box on to work on a different SHA256d proof-of-work cryptocurrency.  CoinMarketCap has a list of other altcoins, nearly all of the ones currently listed after #15 are SHA256d-based.

And if you want to try and use CGMiner or cudaMiner (for Nvidia cards) but are not sure how to, I recommend watching this video:


See also:
Should you buy an Alpha Technology ASIC for Litecoin mining?
Why it is impossible to profitably mine bitcoin (BTC) with GPUs — but still quite profitable to mine litecoins (LTC)
Dogecoin faucets list

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Building Smart Property Applications: Colored Coins and Mastercoin

[Note: below is my recent article published on CoinDesk.]

Cryptoledgers such as those utilized in cryptocurrencies like Bitcoin and Litecoin have the ability to be employed in other capacities.  They are not merely one-dimensional, one-trick ponies relegated to simple fiat-only exchanges.

For example, last week Kyle Torpey published an overview of several upcoming projects that utilize the Bitcoin blockchain to provide new features and financial instruments for users globally.  While it is uncertain that any or all will be successful in accomplishing their goals, these new innovations, like Namecoin before it, show that cryptoledgers can be integrated to provide rich functionality beyond the current token system.

For those unfamiliar with Namecoin, it currently acts as a decentralized DNS system that makes domain name censorship difficult, if not impossible.  It was created in 2010 as a modified version of Bitcoin and in 2011 the mining of Namecoins (after block 19200) was effectively merged with Bitcoin through a software update (e.g. pools had to use a new software release).  While Namecoin provides DNS functionality it can also be utilized to be used as a messaging system, torrent tracker and even as a notary (which other cryptocurrencies can do as well).

The next release of Bitcoin currently being developed, version 0.9, will include a number of changes.  In the words of lead developer Gavin Andresen it includes the ability for “developers [to] associate up to 80 bytes of arbitrary data with their transactions by adding an extra “immediately prune-able” zero-valued output.”

What this allows for is a little more space in the output section to provide users the ability to add some new data (such as a distributed contract) to be included via a hash.

Why is this important?

In 2012, Mike Hearn (a Bitcoin developer now on the board of Circle) gave a presentation in London in which he describes other financial instruments and practical business uses that a cryptoledger can provide through the use of “timelock” (technically referred to as nLockTime).  This makes it possible to build ‘smart property’ or contracts that in turn create a distributed digital verification system that bypasses the need for a central repository.   A couple examples Mike gives are the transfer of goods (such as a car) and the execution of a trust fund (through a will), both of which can be conducted without many additional intermediaries.  For example, if a car ignition system is reengineered to connect with a cryptoledger protocol, it could enable car owners to buy and sell vehicles remotely via trusted timestamping.  The execution of a will (e.g. disbursement of a trust fund) is also possible, albeit slightly more complicated in that someone would need to build a system that can scan obituaries for deaths and notify the blockchain of any changes.  In actuality the potential applications can be expanded to anything that involves rights verification such as stocks, titles to houses, digital media as well as the keys to houses and cars.  In fact, this past fall Mike gave another interview describing these potential applications in more detail.

Coloring within the lines

Another potential way to utilize a crypto blockchain to verify wares is through a process being developed called Colored Coins.  In a nutshell this endeavor allows users to “color” a token to represent a specific asset such as a car, home, boat, commodity, shares, bonds – virtually any type of asset (e.g., 0.5 BTC colored green to represent your home).  These tokens can then be exchanged, just like bitcoin tokens, by anyone anywhere.  This enables a decentralized, trustless form of asset management that uses a blockchain as both a ledger and transportation mechanism.

I spoke with Alex Mizrahi, who is leading the development of the Chroma Wallet used by the Colored Coin project.   According to him, “It is going to be very easy for the asset management industry as a whole to use Colored Coins.  For example, some of the first places we are going to have adoption will likely be real-estate and portfolio management.  In fact, for any type of asset management it’s going to be simple to issue his own color that represents his goods.  A portfolio manager can issue one color that represents a portfolio of stocks backed by the real holding and sell it globally.  If he is savvy and his products are good, his colors are going to have demand.  So transferring ownership is very easy, quick and safe — just like bitcoins.  In the real estate industry someone can issue their apartments using colored coins and have them float on the blockchain, or manage time-sharing based on color.”

I also spoke with Amos Meiri, head of dealing at eToro and also a member of the development team for the Colored Coin project.  I specifically asked him if it would be easier to simply conduct all trade privately at the centralized exchange where it will be more scalable and private.  In his view, “Centralized exchanges definitely have their advantages, but colored coins can be useful for following reasons.  First, users do not need to trust their bitcoins to a centralized exchange.  Companies cannot manipulate ownership records (to commit fraud, for example).  So basically, if somebody gives you an IOU, it isn’t a good idea to leave it with the person who issued it or to affiliated parties.  Another reason is that companies cannot control how its shares are being traded, thus it cannot block trade.   And lastly, there is no need to maintain servers or manage security due to its integration with the blockchain.”

While this is obviously easier said than done, as noted above, this idea of using cryptoledgers to manage smart property has inspired and motivated numerous other groups to work on similar efforts.  For example, Counterparty.co was recently launched this month.  Its mysterious, relatively anonymous development team has released similar open-source applications, documents, binaries and tools that allow users and entrepreneurs to build smart property functionality such as derivatives and dividends in a decentralized manner.  And three days ago, Jon Southurst discussed several other groups including Reality Keys which can utilize a crypto protocol to build a predictions market or a way to hedge against currency fluctuations.

Masters of the cryptoverse

This past week I spoke with Taariq Lewis, the founder and CEO of BitcoinBusiness, a Bitcoin Advisory firm and he is also the Smart Property and Business Development Lead of the Mastercoin Project.  Mastercoin is a crowdfunded, non-profit endeavor to create an open-source  distributed exchange protocol for Bitcoin.  The MC project has received more than $3 million in crowdfunding which has been used to pay for bounties, build tools and write documentation all of which is ultimately released open-source.

According to Taariq, “We are on the tip of the iceberg of the democratization of upper level finance and investment management.  One apt analogy is that the current system involves a highly siloed, highly centralized organization reminiscent to the music industry prior to P2P innovations.  We are now approaching the first wave of people being able to distribute financial products to each other on a peer-to-peer basis.  While this obviously has regulatory repercussions such as the SEC and CFTC oversight in the US, there is no ‘Wolf of Wall Street’ in crypto.  In fact, projects like Colored Coin, Counterparty and Mastercoin will create applications that will decentralize stock and bond exchanges allowing individuals and entrepreneurs to build dividend products and distribute the assets without middlemen.”

I also spoke with David Johnston, managing director of BitAngels and a board member at Mastercoin.  In his view, “Cryptocurrencies are more than a payment network, it is more than a new type currency or store of wealth.  It is a whole new platform and is a way for people to now make programmable money and that gives rise to smart contracts.  Now that this money is programmable I can put it into applications, I can create other digital tokens.  That’s what really gets me excited where anyone can build anything.”

The Mastercoin platform is still a work in progress and has gone through several iterations based on community feedback.  It also faces market competition from several others in this space such as Open-Transactions, Invictus (formerly BitShares) and potentially many others that learn of the potential business opportunities.   And as a consequence, it looks like a promising area for Christensen-style innovation.

Outside the dev world

For perspective I had an email exchange with Ryan Orr who is a professor at Stanford University (teaching Global Project Finance and Infrastructure Investment) and chairman at Zanbato.   He noted that, “with the recent wave of regulatory actions, I am personally feeling quite excited about how the “smart property” projects evolve in 2014.   It is starting to feel like smart property could be a much lower path of resistance for the bitcoin protocol as it establishes a “non-monetary” form of use that fulfills a valuable social purpose.  And thus it should not be viewed as a direct threat by regulators who are afraid of losing monopoly control of money. It is the “duality” of purpose of gold, where people can hold it under the auspices of non-monetary purposes, but also hold it for monetary purposes (eg. a hedge against inflation), that makes it so difficult for the governments to totally eliminate it as a form of money (even though the US government did try to do so in 20th Century).  If bitcoin can develop a similar duality, where the ‘smart property’ use makes it legitimate, and then people also can secretly hold it as an uncorrelated hedge against government dysfunction, then that could be pretty interesting.  In sum, it feels like the ‘smart property’ could become the ‘formal, legal, legitimate’ face to the project that can develop independent of how the regulators rule on the use of Bitcoin for monetary purposes.”

In addition, I also spoke with Ben Davenport, an angel investor and a member of the monetization team at Instagram.  While he does not necessarily endorse one specific project, in his view, “colored coin technology allows such centralized assets to be traded in a completely decentralized way.  Every single equity in the world has a central issuer — the company itself. But imagine the power of being able to make a trustless trade of stock for bitcoin with a stranger, at a distance, with no third party involved. With colored coins, I can construct a single atomic transaction which encodes such an exchange. That, to me, is the most important basic thing that colored coins can enable.”

The disruptive potential of smart property for the entire financial industry, not just fiat credit facilities, is enormous.  Charles Stross, the British Scifi author, recently criticized Bitcoin and the cryptocurrency endeavor, wishing that it die a quick death (in fire no less).  While his contentions were fallacious on a number of counts (especially regarding the environmental impact), ironically, he previously predicted seven years ago that near-future scifi authors are still probably missing something disruptively as large as the Internet 20 years ago or the smartphone was this past decade.

In other words, just as rewatching older scifi films that failed to foresee drones and self-driving automobiles seems dated, the portrayal of centrally managed financial products may one day be viewed as an anachronism of our not-so-quaint analog past.  Thus, Stross’ prediction of another unforeseen invention could very well be these smart property applications and digital financial instruments that are managed and transported by the very same cryptoledgers he dreamt of burning.

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SilverFish, a Chinese Scrypt-based ASIC mining company, has vapor-like attributes

[Note: This is a slightly updated version of a post I made on reddit yesterday]

A new ASIC service/product just hit Sina Weibo (though it is not currently trending on Baidu or Weibo). They have announced that their ASIC mining systems for Scrypt will be turned on around June 1, 2014. They estimate that their product is faster than GPU mining in terms of hash / power consumption (~300 kh/s at 5W versus 160W for a Radeon 7850).

SF are accepting pre-sales for shares into this company (similar to ASICMiner business model). For 0.5 BTC you can buy 1 share of stock (until January 20th, today, when it goes up to 0.7 BTC).

Very little is known about the company, there are no personal names (the laoban could be Li Jun, 李钧) or business addresses attached to it. If you create an account and log into the system the share availability fluctuates widely but it is not clear why.  Yesterday it went from 690 to 802 in about 10 minutes and it is currently, as of this writing, at 1022.

According to his Weibo account, the founder of SilverFish is purportedly the same guy who founded a large Chinese BTC and LTC mining pool, F2Pool and another major website yibite.com.1  Both he and the operations are located in Beijing.

According to ifeng.com (a Chinese financial news site), the CEO of Yibite.com is 李钧 (Li Jun).  And according to a comment on reddit, this same mysterious CEO/COO also supposedly worked on Avalon / 阿瓦隆, the first successful ASIC mining machine for BTC.  Perhaps Guo Yifu (郭义夫) may know who if Li Jun is the mysterious CEO/COO since he also works on the Avalon project.

However, until they show a video of the actual chips with screenshots of the hashing results, do your due diligence.  For example, one other comment mentioned the boondoggle that was/is ScriptASIC.org. And another example, a couple weeks ago I wrote an in-depth article about similar credibility and claims issues with the Alpha Tech Scrypt ASIC.  I will update this post if I find anything new.

  1. A reddit comment says it is one of the biggest pools, it may be, at least as the hashrates could collectively be part of P2Pool. However if you look at the hashrate pool comparison charts LTC / BTC, F2Pool is not listed. Thus it is likely part of P2Pool. []
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Colored Coins and other ‘smart property’ extensions

I am not necessarily endorsing the use of this specific project but Colored Coins (Chrome Wallet) illustrates some of the cool potential features that a crypto protocol like that of Bitcoin (or Litecoin) can be used for.


Kyle Torpey has also written an excellent summary of the major known projects in this piece: Bitcoin 2.0 Explained: Colored Coins Vs Mastercoin Vs Open Transactions Vs Protoshares

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New Taobao rule banning the buying and selling of crypto currencies

Taobao is one of the largest ecommerce platforms in China (it is part of the Alibaba group that also own Tmall).  I have written about it in the past (1 2 3 4) and recommend readers peruse a good piece from The Economist detailing the ecommerce empire that is Alibaba.  In addition, I do not think the analogy that “Taobao is the ebay of China” is entirely accurate — the WSJ has a detailed explanation for why this is a poor analogy (different business model involving ads).

Earlier this week Taobao published a new rule (Chinese) which goes into effect on January 14th.  The new rule bans the buying and selling of bitcoin, litecoin and any other crypto currencies (it actually includes a long list of altcoins).  It also bans the buying and selling of any crypto currency mining tutorial and guide as well as any hardware and software related to mining.

There are a couple threads on reddit that discuss the potential impact for the exchanges and what kind of wiggle room they may have (1 2).

Again, while the word “voucher” is not mentioned, this new policy probably will not help the recently created voucher workaround that BTCChina just implemented.  Thus the cat-and-mouse game continues.

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Why are exchanges in China still allowed to operate?

I am asked this question frequently and currently I cannot give you a non-speculative answer.

My guesses are thusly:

1) That policy makers, despite knowing Bitcoin/Litecoin has the ability to bypass capital controls would still like to see if there are other potential “legitimate” uses for it.  Remember, this is a developing country that is trying to turn Shanghai into a real international financial center (pdf) through initiatives like the new Free Trade Zone.   So for example, maybe they have been briefed on the ‘smart property’ features of the crypto protocols (e.g.,  secure time-stampingproving ownership of tangible propertydecentralized DNS and new ways to sign contracts).  I doubt this is the case though.

Or:

2) Instead of being relegated to a paltry few options such as owning multiple apartments and/or sometimes sketchy wealth management products (WMPs) perhaps they would like to permit residents to diversify and try out new financial instruments.  And as happenstance cryptocurrencies are seen as a new alternative asset class.  While the PBOC officially stated that private ownership and public participation are okay for now, they do not seem to view cryptos as meeting their criteria as a “legitimate” asset class, withholding their stamp of approval.12

Remember, because of strict capital controls [pdf], PRC nationals cannot transfer more than $50,000 in foreign currency abroad each year, the domestic banking system has a very large captive consumer base from which to essentially extract rents from (e.g., no need to innovate as the market is essentially walled off from outside competition).  Again, these limitations are expected to change over the next decade, though officials and analysts have been saying that since at least 2008 when I first arrived in China.3

Or:

3) Perhaps I am an incorrect in my assessment of the PBOC which has been based on the stern comments from Sheng Songcheng, head official of investigation and statistics at the PBOC (see his recent essay “虚拟货币本质上不是货币” as well as my commentary here).  In contrast, my friend over at Aha Moments wrote this past week:

Of course, to a certain extent this merely reflects the general laissez-faire approach which characterizes the Chinese government’s approach to private wealth, an aspect of Chinese reality which understandably attracts little coverage in countries with more voracious governments. The reality on the ground is in fact almost unimaginable to younger inhabitants of, say, the United States or Western Europe. Not only is there is no capital gains tax in China, but C2C bank transfers are for the most part instantaneous and unlimited. I can send 50000 yuan to my buddy in Xinjiang and he will have it in seconds, all for a token transmission fee. You can also walk into any bank in China with the equivalent of one million euro in cash and deposit it with no questions asked. Simply put, the government’s policy is to leave people and their money alone. While they do endeavor to tax some income at the source, for the most part that’s about as far as they go.

Aha does have a valid point in terms of the C2C transfers, it was always easy for me to transmit this specific type of transaction nearly instantaneously (assuming you are using ebanking or an ATM — face-to-face service is still quite slow and tedious).  So perhaps there is a liberalizing strain within the PBOC policy making that has remained in the background regarding cryptocurrencies.  I don’t buy that though either.4

Or:

4) That policy makers are biding their time to see what, if any, international consensus is built around the regulation and management of exchanges.  There is no global standard yet, Singapore’s government is taking a hands off approach towards cryptocurrency right now whereas Denmark plans to regulate and oversee its use.  In the US, all fiat exchanges have shut down with the exception of Coinbase and that is because its founders had previous business relationships with Silicon Valley Bank (the partner bank).5 And even with this exception, Coinbase technically is not an exchange per se, but rather receives its coins through other sources like Bitstamp.net.

I think this is the most likely, as regulators can put a squeeze on the industry as a whole, forcing artificial consolidation and/or bankruptcies quickly.6 Then the PBOC and other peer organs will only have to worry about a handful or participants instead of 20+.  We already see the verification process being rolled out as customers at large exchanges such as BTCChina and OKCoin require national ID names and numbers in order to register and conduct transactions.  This will likely allow the PBOC and other departments to track capital flows to specific individuals.

A sell signal?

Yesterday the Financial Times published a report detailing the Chinese regulatory environment for cryptocurrencies.  It reconfirmed what I discussed a couple weeks ago, that fiat deposits at several exchanges, notably Huobi, are being transmitted through the CEOs personal account.

What struck me however was how several entrepreneurs went on record with FT, using their own identities to explain how they were bypassing regulations and/or finding loopholes.  Of course the inner libertarian in me cheers for a liberalized, self-organized world but a couple of their viewpoints seemed naive, short-sighted and wishful thinking.  And will likely end bad for them.  In fact, yesterday I was corresponding with Vijay Boyapati (who incidentally is the same person who convinced me of the long-term merits of cryptocurrencies and their protocols) and he asked me about the recent rise in price levels and if had to do with liquidity from China.

Here was my response:

I do think that the added liquidity (or at least the appearance of liquidity, who knows how deep it is on the Chinese exchanges) is helping buoy the price levels.  I don’t think it will last on the Chinese side, especially with articles like that from the FT.  PBOC staff read that newspaper, those comments are just going to make the officials want to close all the loopholes even more — at least that’s my guess.

24 hours later and the price for BTC token has dropped from ~5800 RMB to 4900 RMB and LTC token from 180 RMB to 145 RMB.  Who knows why, perhaps it will jump back up to those heights again tomorrow.  Self-reported volume on OKCoin and Huobi are still roughly the same as they have been the last few days.  Perhaps it is just the typical volatility.7

Yet the longer term issue still remains unresolved for several of these exchanges named in the FT piece: how to legally keep fiat liquidity flowing in both directions.  Are investors at exchanges prepared for the possibility of yet another December panic sale or hedged against a possible lower liquidity environment?  What about the personal liability issues that someone like Li Lin is now potentially facing in the event that a future audit takes place?  Perhaps now is the time to contact a risk management attorney to see if there other upsides (or downsides) to this nebulous guidance.8

  1. Getting an official seal, or chop, is very important for tax purposes in China.  See Chinese Chops Or Seals from About.com and What is a Chinese “Chop” or Seal? from Yahoo! []
  2. For more specifics and commentary about the PBOC notice on December 5th readers are encouraged to view: China’s Statement on Bitcoin is Open to Interpretation from CoinDesk and Despite panic, China’s regulation of Bitcoin leaves room for optimism from Tech In Asia []
  3. HNWI and financially savvy individuals can bypass some of these regulations by sending RMB-denominated funds through Hong Kong.  See This issue was directly discussed in Getting Money Out Of China. That’s Illegal. from ChinaLawBlog and In Reversal, Cash Leaks Out of China from The Wall Street Journal []
  4. This current stance by the PBOC seems to have taken many by surprise.  For example, back in October 2013 Bobby Lee was interviewed on a local station called International Channel Shanghai (video).  At the 12:38 minute mark Bobby says: “I hope personally to see more government regulation on bitcoin to clarify what businesses can and cannot do with bitcoin, to clarify how individuals can and cannot buy and sell bitcoins.”  Again, I have not spoken with him, but I doubt what he had in mind was what the PBOC and other organs announced/enforced last month regarding banning 3rd party payment processors. []
  5. See Regulatory risks, challenges and opportunities of cryptocurrencies in China and elsewhere []
  6. This is all speculative but there may still be time for new market entrants to enter the industry and merge/acquire with competitors. []
  7. One new story that came out today is that 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. []
  8. I do not know if law firm Harris & Moure has any particular advice on these issues at this time, but Dan Harris publishes a popular site: China Law Blog that discusses many legal issues regarding the mainland. []
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Should you buy an Alpha Technology ASIC for Litecoin mining?

alpha technology viper

Short answer, probably not unless you point it to another Scrypt-based token like dogecoin.  I’ll show you the math and hypothetical situations below, but quick story.

This past spring I helped build a couple simple Sapphire 7950-based mining rigs in Shanghai for a few friends.  At the time the new Vapor-X cards cost around $300 each and could be tweaked to run at around 600 kh/s (in line with these hardware expectations). [Note: This was also just before Cryptobadger, who has a great series of how-to guides, highly recommended if you’re interested in doing-it-yourself.]

Fast forward to early December, virtually all physical stores in any big city throughout China were sold out of the following Radeon models: 7950, 7970, R280, R280X.  My friends spent hours calling up and chatting to online shops from Taobao and Tmall to try and locate any supplier with product.  But all were backlogged for the next couple of weeks.  Why?  What had happened is that the price of litecoin tokens had popped on exchanges (namely BTCe and OKCoin) by a factor of 10x in less than 3 weeks ($2 to $20).  Yet the difficulty rating was still (temporarily) at around a mere 1,000 meaning that the return-on-investment for even a small rig composed of 7950s was relatively quick.  However that capital expenditure / token profit information traveled rather quickly, ending up on a variety of domestic evening newscasts.  And thus, there was a mad dash to get these GPUs.  As a consequence, I spent one early December weekend during this time combing the PC malls in Changning district trying to find any owner who could supply a couple dozen 7950s all in an effort to help some of my friends build a litecoin mining farm.  Yet each laoban explained (with a smile) that some large buyer had bought the remaining stock en masse — store by store.

We didn’t build that farm and in the short-run that may be okay.  While some miners simply look at the short-term seigniorage of flipping a few blocks, long-term mining operations probably will hold onto whatever tokens with a view that the tokens will appreciate by an order of magnitude.  Thus, while the collective hashrate for the capital expenditures for the 50 GPU cards my friends wanted to buy would have certainly been considered a profitable investment at the 1,000 difficulty rating, the longer term capital risks are substantially higher because the spread in crypto mining, like other commodity gathering, tends towards equilibrium (e.g., the cost of mining eventually equals the financial returns).  That is to say, the extra units of profitability (or unprofitablity) sends a signal to market participants to either continue one particular activity (like mining) or to shut down mining operations altogether.  You see this frequently in other capital intensive resource gathering spaces such as petroleum extraction as well as precious metals (e.g., if the revenue / barrel increases, other competitors will invest in new extraction techniques and/or open fields for development yet if the revenue / barrel decreases, competitors may shut off all production in a particular field).1

Again, crypto mining involves a scarce resource (block discovery in which the coin or token are part of) and in order to mine you need capital investment, in the form of a GPU.  Thus the same issues of supply, demand, price discovery and profitability now exist.2

ASIC mining

In 2011, Scrypt was adopted as the proof-of-work mechanism used by the Litecoin protocol.  It was purposefully chosen by Charlie Lee due the understanding that it was more resistant (not necessarily immune) to GPU and ASIC mining than the SHA256d proof-of-work used by the Bitcoin protocol.  And after two years into this altcoin experiment this assumption seems to have empirically played itself out as there have been no known litecoin ASICs.

Yet now that litecoin tokens are trading at ~$25+ each, the return-on-investment for physical design engineers (the people who actually design integrated circuits) to develop an ASIC has become within the realm of profitability for even something designed to be resistant such as litecoin.  That is to say, some group of investors believes that the capital costs of hiring a team to design, fab and sell an ASIC to litecoin miners is profitable (otherwise they wouldn’t do it).

At the end of last month, Alpha Technology in the UK announced that they were at the finishing stages of design for two products, a 5 MH/s and 25 MH/s ASIC for litecoin (remember, the ASIC you buy and use for bitcoin mining cannot be used for litecoin mining because it is designed specifically to work on one particular proof-of-work).  The 5 MH/s is expected to need 100W and the 25 MH/s version is targeted at 600W.

According to the announcement, the cost for the Viper 5 MH/s is £1350 ($2209) and the 25 MH/s is £5450 ($8918).  Not including electricity, taxes, shipping and pool fees, the top Viper at 25 MH/s works out to be around 2.8 khash per dollar.  This compares with a ~$300 for a new Sapphire Vapor-X 7950 @ 600 kh/s which is around 2 khash per dollar. [Note: most 7950s are no longer assembled as such and are now rebadged as R280, the big exceptions are HIS from Taiwan.  Cryptobadger has a run-down of the best cards available.]

Risks and variable factors

Despite looking legitimate through press releases and 3D renderings, the product might never come out.  Or when it does get released (probably late), the real numbers might be way off the estimates.

For example, last March a good friend of mine paid 50 BTC for 100 GHash/s ASIC from Butterfly Labs.  He received it more than 6 months later at the end of November.  If instead he had held that 50 BTC he would have been able to sell for $40,000 – 50,000 on many exchanges.  Instead, if you plug that 100 GH/s rate into a mining calculator, he will not even be able to mine 1 BTC for the next year at the current difficulty rating let alone ever be able to mine 50 BTC it cost to buy them.

So here is the likely scenario with Alpha Technology.  They will not ship for at least another two months.   Why?  The inner engineer in me asks: Has it passed verification process?3 Has it been taped out? What about maskmaking?  Those they do ship to are those who ordered first and there is a wait list (here’s a widely inaccurate waitlist).  Each minute you wait is another minute someone else will be ahead of you.

Now, assuming you were able to get the Viper 25 MH/s today, looking at the mining calculator to see how many litecoin tokens you would receive at the current difficulty (3366.7), the number is: 2408 LTC / year.4 Assuming the network hashrate does not collapse, that is the most optimal scenario you have this year.  And the highest price an LTC has gone for on an exchange so far was $50-$60 back in late November/ early December last year.  If this price level is ever reached again and the difficult rating never changed, then you would stand to make ~$125,000 which would make your $8,918 investment very fruitful!

But alas, this is not how it works.  Again, assuming the product is made and even shipped on time, the difficulty rating will continue to increase proportional to the additional hashrate.  So as more and more of these Viper’s (and/or other GPUs, FPGAs and ASICs) are added to the network, the higher the difficulty rating is adjusted to.

The next estimated difficulty rating is expected to be 3700 which knocks off 20 LTC more a month, dropping you down to around 2150 LTC / year.  But this is not the entire story.  You still need to factor in electricity costs, the transportation and shipping fees (unless you live next to the manufacturing and distribution center) as well as the pool fees.  Some pool fees, like at Coinotron which I used are 5% (it is this high in part because of the maintenance and admin costs needed to protect against DDOS attacks). 5

In all likelihood, unless you are the very first person on the list when the product ships, you would be better off either building an off-the-shelf GPU mining solution or buying LTC on an exchange and either hold for speculation and/or arbitrage.

Why?

Even if your electricity was free, you lived in the UK/India/China where they are manufactured and were the first person on the pre-order list, your first mover advantage would be quickly eroded by other Viper owners.  To give you an idea why, look at the current Litecoin Mining Pool hashrate.  If 200 other consumers bough 1 of each Viper, they would collectively add 6,000 MH/s which would place these ASICs alone as the 6th largest pool, increasing the hashrate proportionally (this is actually conservative because difficulty typically trails hashrate).

If litecoin difficulty doubled to 6,000 at current price levels ($27) and a 25 MH/s hashrate you would generate 125.7 LTC / month and earn enough monthly ($3,423) to pay for the machine in 3 months.

But instead, let’s assume for the moment that other market participants have access to similar mining calculators and how-to Cryptobadger guides.  And that over the next 6-9 months the difficulty rating jumps to 30,000 (9x the level today).  Impossible you say?  Last April when I got the initial litecoin rigs up and running, the difficulty rating was 300.  So in less than 9 months the rating has gone up 11x.

If it reaches 30,000 you would only generate 25.15 LTC / month which at ~$27 / token would generate $684 / month.  That means you would likely only generate enough litecoins (at current prices) to cover the costs for the Viper in the first year (ignoring all other pool fees, electricity costs, taxes, duties, etc.).

Sure the tokens could appreciate and increase in value, but as we continue to see, if price levels increase so too would competitor hashrate as others see a similar seigniorage opportunity.

That said, if these numbers are real, this Viper ASIC is only 40% better than GPUs in terms of hash/dollar. Of course this is just the first generation and other companies might be able to make more efficient chips. But this definitely is a positive sign that Scrypt hashing might be able to keep ASICs from totally dominating mining like it does with sha256d.

Money well spent?

One thing to constantly remind yourself is that like any investment, you should only spend money you can lose.  That is to say, as bullish as you may be on any particular asset class (including cryptocurrencies) there is always a statistical possibility that its liquid price could sink below whatever level you have bought at (e.g., underwater).  Perhaps even falling to zero.

If history is any guide (and perhaps it is not) looking back at the California Gold Rush (the 49ers) the firms who ended up financially in the black were merchants and service companies such as Samuel Brannan, Philip Armour, John Studebaker, Levi Strauss and Wells Fargo.6 Those who also made and sold mining equipment (picks, axes, shovels, sluices) had mixed results.  Yet the group of people who typically fared the worst financially were the miners themselves as they were nearly all exposed to various types of risks (upfront capital costs, land title lawsuits, inclement weather, sickness, etc.) and as a consequence, most ended up bankrupt.

Does this mean you should not purchasing crypto mining equipment?  No, but you are probably more exposed to risks with fewer potential upsides than downsides.  Your capital is tied up into a depreciating asset, a machine which unlike a GPU that can be resold, has a singular use that may or may not be delivered on time with unknown hashrate performance deltas.  Or you could be thinking, just like the first people who managed to get an Avalon batch last winter or a KnC miner when they ship new updates throughout the year (like the upcoming Neptune), perhaps you might be lucky enough to get a Viper that lives up to its paper reputation.7  But the odds are you won’t, especially if you are reading this and have not pre-ordered it.

One other option for HNWI is that you could invest in an IC design company such as Alchip which does the physical design for KnC.8 Or create your own engineering team to build ASIC machines for internal use only and sell public shares just like ASICMiner in Guangdong did last year.

Lastly, for entrepreneurs there are other areas to focus on beyond the token such as the financial instruments and applications discussed by Mike Hearn in 2012 that utilize the Bitcoin or Litecoin protocol (e.g.,  secure time-stampingproving ownership of tangible propertydecentralized DNS and new ways to sign contracts).9

Exhibit A:

Below is a very rudimentary table that utilizes this Litecoin difficulty calculator.10  The calculator is nowhere near advanced as the dynamic dashboard over at Genesis Block (which is BTC only).  In fact, this chart below does not include in its calculations the long tail of the difficulty curve.  It is an end-to-end snapshot (what it is today versus what it will be 6 months from now).  But that is unneeded as this shows you that in every instance, building GPU-based systems instead of buying the ASIC is probably more profitable in the first 6 months.  In some cases, merely buying LTC and holding is actually more profitable.

I should point out that for this activity I negated electrical costs which obviously are non-negligible especially for a large GPU farm.  Obviously an ASIC will come out per watt more efficient, so feel free to factor in whatever electrical costs you may pay on a monthly basis in your region.  I also assumed the consumer would be able to buy 32 new or used Vapor-X 7950s for $200 each and then simply build a barebone system using milkcrates as per Cryptobadger (Friendly reminder: anything that is not the GPU is not generating tokens and is therefore a money sink — you do not need fancy cases or i7 CPUs).  It is probably very difficult to locate 32 of these GPUs, let alone 42 for Scenario 4.  But you could likely find batches of used versions on eBay, Craigslist and other etailers.  They do not even need to be the Sapphire brand; see this chart for more comparisons.

The biggest difficulties for a massive GPU farm like that however will be logistics, cooling and storage.  You would need to have access to reliable power and internet sources.  You would also need to keep an eye on each of the GPUs throughout the day to make sure they are performing up to snuff (I actually used LogMeIn but I think Cryptobadger’s method is much more efficient).

Still, I would speculate that in all likelihood, the Viper is unlikely to be delivered to your door within the next 90 days.  If that is the case your two profitable options (based on this chart) are to buy and hold LTC and/or build a rig or two (depending on if you can get them used and what your electrical costs are).

One last note, I do not predict that LTC price levels will reach the numbers listed in this chart this year (if ever).  These are for illustrative purposes only.  In contrast, if price levels do continue to increase I would expect the difficulty rating to increase in a corresponding manner and that the lopsided disconnect in the last column would never germinate.  Baseline difficulty is 3300 and starting LTC price is $27.

Investment Option ETA Setup cost in USD and LTC Difficulty increases same as 6 mo. historical avg and LTC stays at current price Difficulty increases same as 6 mo. historical avg and LTC increases at 6 mo. historical avg Difficulty increases less than 6 mo. historical avg and LTC increases at 6 mo. historical avg Difficulty increases more than 6 mo. historical avg and LTC increases at 6 mo. historical avg Difficulty increases same as 6 mo. historical avg and LTC increases at less than 6 mo. historical avg Difficulty increases same as 6 mo. historical avg and LTC increases at more than 6 mo. historical avg
Difficulty x4 @ 13200, LTC @ $27 on July 6th 2014 Difficulty x4 @ 13200, LTC x9 @ $243 on July 6th 2014 Difficulty x2 @6600, LTC x9 @ $243 on July 6th 2014 Difficulty x8 @ 26400, LTC x9 @ $243 on July 6th 2014 Difficulty x4 @13200, LTC x4.5 @ $121.5 on July 6th 2014 Difficulty x4 @13200, LTC x13.5 @ $364.5 on July 6th 2014
Scenario 1 Preorder 25MH/s Viper today  1/6/2014 Delivered in April $8900 or 329.6 LTC (no fees) Begin April 6th and after 3 months hashing = $4,890 or 171.45 LTC $41,662 or 171.45 LTC $83,324 or 342.9 LTC $20,511.63 or 84.81 LTC $20,831.17 or  171.45 LTC $62,493.52 or 171.45 LTC
Scenario 2 Preorder 25MH/s Viper today  1/6/2014 Delivered in July $8900 or 329.6 LTC (no fees) 0 0 0 0 0 0
Scenario 3 Buy mining rig with OTS GPUs worth $8900 today Start mining in 1-2 weeks $8900 or 329.6 LTC (no fees) 32 Vapor 7950s (Milkcrates) after 6 months hashing =  $7512 or 263.34 LTC $63,991.62 or 263.34 LTC $127,983.24 or 526.68 LTC $31,995.81 or 131.67 LTC  $31,995.81 or 263.34 LTC $95,987.43 or 263.34 LTC
Scenario 4 Buy mining rig with OTS GPUs @ 25 MH/s today Start mining in 1-2  weeks $8900 or 329.6 LTC (no fees) 42 Vapor 7950s (Milkcrates) after 6 months hashing =  $9780 or  342.9 LTC $83,324.7 or 342.9 LTC $166,649.4 or 685.8 LTC $41,662.35 or 171.45 LTC $41,662.35 or 342.9 LTC $124,987.05 or 342.9 LTC
Scenario 5 Invest $8900 (cost of Viper) into LTC today Buy and hold 329.6 LTC $8,900 $80,092.8 or 329.6 LTC $80,092.8 or 329.6 LTC $80,092.8 or 329.6 LTC $40,0046.4 or 329.6 LTC $120,139.2 or 329.6 LTC

See also: Why it is impossible to profitably mine bitcoin (BTC) with GPUs — but still quite profitable to mine litecoins (LTC)

  1. The Mountain Pass rare earth mineral mine is an example of a mine that was recently restarted due to these economic conditions of supply, demand and profitability. []
  2. While you can read through the developmental history of both Bitcoin (the network) and bitcoin (the token), the original miners and early adopters from 2009 and 2010 mined for a variety of reasons and motivations.  Perhaps accumulation and appreciation were among those, yet the first “real” exchange didn’t occur until May 21st, 2010 — a $25 pizza was exchanged for 10,000 BTC.  See This Pizza Cost $750,000 from Motherboard. []
  3. See Automate and Control the Functional-Verification Process from Chip Design, Interview: Adnan Hamid Addresses Trends In Chip Verification from Electronic Design and Chip verification made easy by Laurent Fournier []
  4. Difficulty rating for Bitcoin adjusts every 2016 clocks or roughly every 2 weeks []
  5. Not to mention there is always the potential downtime in the even there is a net outage or electrical problem where the machine is located.  Unless you put it in a colocation, your machine’s uptime will be directly effected by where you live. []
  6. Contrary to popular myth Sears & Roebucks did not exist at this time and in fact was founded much later in its modern form in 1893.  It was Richard Sears’ father, James who went to California during the gold rush and failed to become rich. []
  7. See Engineering the Bitcoin Gold Rush: An Interview with Yifu Guo, Creator of the First Purpose-Built Miner from Motherboard and That Swedish Bitcoin Mining Company Has Sold $28 Million-Worth Of Its New Mining Hardware from Business Insider []
  8. See Alchip, KnCMiner team up for Bitcoin mining machine with 28nm ASIC from DigiTimes []
  9. There may also be other opportunities for a startup to focus on: hedging exposure, quantifying and qualifying risks and perhaps even insuring or re-insuring []
  10. I recommend reading through this Litecoin community thread which includes a very detailed chart based on estimated hashrates and difficulties. []
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Interview with Litecoin’s Charlie Lee & Warren Togami

I’ve mentioned Litecoin throughout this past year and while most altcoins are complete scam pump-and-dumps, the Litecoin community continues to grow and reach new milestones.

Here is the latest interview from a few days ago with the core dev team (Charlie is the creator, used to work at Google and is now over at Coinbase; Warren is the creator of Fedora and is over at Redhat). [Reddit has the topic time codes]

I also recommend looking through this Litecoin dev reddit AMA from this past October.  Very interesting timeline and goals.

See also: Ex-Googler Gives the World a Better Bitcoin from Wired

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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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How to detect if a cryptocurrency exchange is fudging numbers

Huobi versus incumbents

Crypto volumes in China

This picture has been making the rounds.  The top section is the volume of LTC at OKCoin.  The middle of BTC volume at BTCChina and the bottom is the BTC volume at Huobi.  The yellow line is when the PBOC stepped in and told 3rd party payment processors / intermediaries they could no longer transfer RMB into crypto exchanges.

In the last post I mentioned that there are speculative reports that exchanges in China (and probably globally) are fudging their volume numbers (e.g., why the sudden dramatic drop-off at certain sites relative to others).

Why is this done?  Before answering that I should point out that it is quite simple to create a server-side app that dynamically reports a volume number during specific periods of the day (e.g., higher during the work day to mimic traditional stock exchange peaks and troughs).  Exchanges currently have an incentive to fudge these numbers in an effort to attract eyeballs by claiming they have the biggest volume.  This then becomes a self-fulfilling prophecy as market participants (e.g., speculators, day traders, etc.) discover this volume number through a news source and then setup accounts to begin trading on the exchange.

How can you tell whether or not this is the case in China or elsewhere?   Merely looking at blockchain.info would be pointless because the transactions at exchanges are internal and do not affect the blockchain until there is a deposit or withdrawal.  And after all, lots of investors like day traders never actually withdraw their bitcoins each and every day due to transaction fees.  Thus the only verifiable way is to actually go inside an exchange and look at their accounting / exchange database to see the true turnover.

How to fake (some) numbers

Because exchanges merely self-report whatever they want to, ultimately this kind of fakery is easy to spot if you publicly expose your market depth.

Another way is if you, the exchange operator, run your own bots which arbitrage to make extra profit yet your bots do not pay any fees.  Whether that is actually fake is arguable (see below), however since the trades are actually conducted this kind of activity is typically not practiced in many “real” securities exchanges (e.g., akin to NASDAQ operating the exchange and yet maintaining an internal trading desk whereupon it does not have to pay fees).

And another way is to simply mirror other exchanges and if you are mirroring, you may be fudging the numbers to disguise it, or not. You might execute the mirrored trades or just have them for show.  In fact, you do not copy all the orders exactly, you randomize the quantities and prices slightly.  The trick is to randomize the numbers, but keep your risk low by minimizing arbitrage opportunities (this can all be done via an HFT system).

So again, sites like BTC123.com aggregate Chinese volume numbers and assume that the self-reported numbers are valid.  Maybe they are, but there is no real transparency currently.  And I’m not sure how you can add transparency either.  And more seriously, how can you (the exchange) going forward publish accurate information and get the same audience that has been misinformed in the past to believe you once again?

It should also be noted, it is not always clear what is or is ethical / fake with this speculation.  As suggested above with the NASDAQ example, the lines between the trading exchange and the banking institutions that utilize it may be blurry (e.g., conflict of fiduciary responsibilities in the event you have duties at both).1.

Blatantly lying about your volume is obviously fraud.  But is trading in your own exchange (with bots or otherwise) wrong?  Is mirroring (as long as you are willing to execute the mirrored trades) wrong?  It is not clear whether that is wrong / fake, perhaps at some point a guideline of best-practices will become adopted industry wide that clarifies this.

At the end of the day, what counts is whether or not I can get a fill at or close to market price.  Thus, as a trader, I care if you just make up the ticker numbers.  But I may not care about mirrored trades, as long as I can still trade against them.  One last point: using bots and/or mirroring trades enough to have large volume is expensive and risky.  It takes millions of dollars to copy the same volume as the major exchanges and increases as the price of tokens increases.  And in all likelihood, many investors only have accounts with one exchange.  Otherwise the arb opportunities could not be so relatively frequent as they have been the past 6 months.

Market makers

Perhaps the only other individuals who have the ability to test and audit volume numbers are market makers.  This could be a HNWI or a coordinated group of day traders consisting of as little as a few bored housewives who have money to burn (e.g., xiaosan).  What a market maker could do is video tape the entire buying and selling of chunks of 30-50 or more BTC to see whether or not the buy and sell orders are filled (e.g., if the liquidity does not exist, the orders could not be filled).  Note: this type of empirical activity can only be done going forward in time.  Unless you have access to a Psychohistory device, there is no way to verify who was fibbing in the past.

If you are willing and able to fulfill this pro bono role, you could test out volume claims at the three exchanges listed above throughout the forthcoming days and weeks and report your findings which would either way qualify one variable known unknown.

In fact, it would be in the exchange owners best interest to implore investigative journalists to  randomly place and fill buy / sell orders throughout a series of video taped interviews.  Specifically, large orders at several random hours each day (that are unannounced to anyone at the exchange).  This then could be repeated over a period of weeks to prevent any kind of rigging (e.g., exchange owners depositing and withdrawing cash simultaneously as known trades occur).

Finding volunteers for such a task would be difficult but it would likely work with roughly $100,000 based on current token prices (~$750).  Any large trader (who is willing to show you the their trades) could tell you whether the market volume is legitimate.  And ultimately, if you can fill a $100,000 trade, it is legit to you, regardless of what fakery the exchange operator may be doing.

[Special thanks to David Veksler and Scott Freeman for their thoughts and comments constructing this post.]

  1. To clarify, this activity is not related to the actions of Bernie Madoff.  He committed fraud and violated his fiduciary responsibilities but not by using an internal desk at an exchange.  On the other hand, if the exchange utilizes its knowledge of customers book orders to front run, this could bring legal liabilites to the exchange.  Nor does this imply that HFT systems (small or large like the new one built by the NYSE in New Jersey) tied into cryptotrading are axiomatically front-running as they are unable to see other customer buy/sell orders. []
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Another Brick in the Wall: Link Edition #54

The biggest news this past week has been the huge rise in cryptocurrency prices (BTC & LTC) pushed in part by the Chinese exchanges.  Both BTCChina and OKcoin now have higher volume/liquidity than any other market and region on the globe.  To give you an idea of what that competitive niche is like, check out BTC123 and Hao123 (both in Chinese).

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Why it is impossible to profitably mine bitcoin (BTC) with GPUs — but still quite profitable to mine litecoins (LTC)

I recently had a conversation in which someone asked me to help build them a bitcoin mining machine.  I explained that looking at the mining configuration hash rates, they should not bother unless they had access to a new ASIC miner.

The problem is even if they do not have to pay for electricity (e.g., it is “free” somehow) the difficulty rating is rising so fast (double digits at every adjustment) that even a top of the line ATI GPU is equivalent to “old school” CPU mining at this point.  They would get mere fractions of BTC even if they set up two or three ATI 7970s.

For example, check out this bitcoin mining profitability calculator and plug in the numbers… only gigahash (and now terahash) producing ASICs will get anything useful out of it.

A souped-up, overclocked Radeon 7970 will do around 700 Mhash/s for BTC.  So let’s say you connect three of the best Sapphire Vapor-X, they are listed at $440 a piece.  Factor in the rest of the system (cheap hard drive, ram, cpu, stable power supply, milk crate) and you are pushing at least $1,700 yet only producing 2100 Mhash/s.

Plug that into the calculator, the break even will be >10,000 days because you are only mining 0.0017 BTC a day.  Assuming you did it for 365 days and the rating difficulty didn’t increase (which it does at double digits every reset) you would end up with 0.6205 BTC in one year.  But again, this wouldn’t happen, more than likely you would get less 0.1 BTC the first year.  And nothing at all the year after.  Why?  Click here to see the visualization of the bitcoin difficulty rating this past year.

Again, you would be much more profitable mining Litecoin, for example, if we use that same system you would end up doing about 2100 KHash/s and generate about 1.42 LTC / day (here is a litecoin estimation calculator).  Note: LTC mining is extremely memory intensive, hence the substantially fewer hash/sec.

But even then, this would decline as the difficulty rating increases each reset.  Best case scenario, that rig would get about 400 LTC/year.  The highest a LTC has sold for thus far this year has been about $20, so you could earn $8,000 in a year (assuming you sold the coins and didn’t save or reinvest them).

Thus, it is far more profitable to mine LTC than BTC.

But let’s go back to the 0.0017 BTC you would make if you set up that system today.  Even in the rosiest of conditions, where one BTC was worth $1 million, .1 would be $100k, .01 would be worth $10k and .001 would be worth $1k.

Therefore, even in the most optimal scenario, there is no GPU solution that is profitable mining BTC, even if the electrical costs were free.

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One litecoin now worth more than one ounce of silver

Today, for the first time, one litecoin sold for more than one ounce of silver on the exchanges.

On Okcoin it is 132 RMB ($21.38) and on BTC-e it is $20.10 — versus the spot price of silver that is just around $20.

This of course is merely coincidental symbolism but this also begins the countdown until one BTC (~$860) passes one ounce of gold ($1255).

Wonder how long it will take either to surpass the inflation-adjusted historical record of both?

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Bitcoin in China: Fall Edition

I’ve discussed BTC and cryptocurrencies and their adoption in China before (here), time for a quick update.

A local channel out here called International Channel Shanghai (ICS) recently broadcast an English-based profile of BTC (and LTC) on its program called Money Talks (click here to watch it).

Overall its a fairly in-depth and accurate explanation of Bitcoin and doesn’t really devolve too much into scaremongering (though it does talk about all of the risks/regulations in the US and elsewhere).

According to the show there are now 14 exchange sites on the mainland that have been set up in the past 2 years (the two it mentions are BTCChina and 796.com).

The show found a professor (Yang Qing) at Fudan here in Shanghai who thinks that the government will be hands off for now because the overall market is very small.

They also interviewed another professor who errs as to why Bitcoin is not money: because there is no physical army backing it up.

Again, it is about 20 minutes and does a decent job of presenting it to the audience without fearmongering.  (FWIW, Bobby Lee, the CEO of BTCChina is the brother of Charles Lee, the creator of LTC who is over at Coinbase now, see this recent Wired profile on him).  Lastly, Jesús Huerta de Soto is name dropped at the end; for those of you unfamiliar with him, he’s an economist who has written a number of books on banking policies, credit and finance.

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Regulatory risks, challenges and opportunities of cryptocurrencies in China and elsewhere

On Monday I had lunch with a couple of tech investors based in Shanghai.  We chatted about a number of topics but spent the bulk of the time discussing Bitcoin and specifically Bitcoin-related opportunities in China.  As an aside, a few months ago I wrote a post about the small BTC community in China.

As enthusiastic as I might be regarding the positive merits cryptocurrencies such as Bitcoin and Litecoin offer, I do think that regulatory oversight specifically in the form of Known Your Customer (KYC) and Anti-money Laundering laws (AML) will present serious hurdles for the entire ecosystem.  (Here is a podcast I did with David Veksler back in April regarding some of these challenges.)

In fact, all Bitcoin money exchanges based in the US have closed down and Mt. Gox, the largest exchange has recently suspended US dollar withdrawals for the next couple of weeks.  This is not to say that the cryptocurrency experiment is doomed to fail but it does mean that going forward all entrepreneurs and investors should be cognizant of the fact that the state — globally — has its eye on it.

Below are some links to relevant news stories about various exchanges and money transmitters being shut down/suspended:

In terms of the volume of various exchanges, Bitcoin Charts has an up-to-date spread of the major exchanges for BTC.  And based on CryptocoinCharts it appears that BTC-E has the lionshare of volume for Litecoin right now (~90%).

If you have a VPN or are based outside of China you can listen to a recent interview with Charles Lee, the creator of Litecoin (here was the first public announcement of Litecoin back in October 2011 made by Charles).  And if you are interested in visualizing the profitability and popularity of mining other alternative cryptocoins, visit CoinWarz.

Reader who were wondering who the lead developer of Bitcoin was now, his name is Gavin Andresen.  A few weeks ago the WSJ published an in-depth profile of him as did HuffingtonPost here as well.  Warren Togami is currently part of the core development team of Litecoin, he also works at Red Hat developing Fedora (he put together a LTC fundraiser the past couple months).

Lastly if you’re interested in knowing exactly what FinCEN announced back in March, here is the full guidance notice and the American Banker recently interviewed Jennifer Calvery, the director at FinCEN for her thoughts on cryptocurrencies.

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Let’s Talk: Interview with creator of Litecoin

Very informative interview with Charles Lee, the creator of Litecoin, the largest and most popular alt-coin spinoff of Bitcoin (it’s market cap is around ~$65 million right now). Be sure to check out CoinWarz to visualize the profitability in mining and speculating on alternative cryptocoins.

If you have some free time, listen to other interviews from Stephanie Murphy, the host of Let’s Talk Bitcoin.

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