Tim, why don’t you send yourself to a provably unspendable address?

Jeffrey Robinson is the author of over 20 books  This past week he published a new book that looks at the history and some characters of the Bitcoin ecosystem called “BitCon: The Naked Truth About Bitcoin.”  Earlier this summer he contacted me and asked me several questions, the answers of which appear in several spots in the book.

If you are tired of the continuous pumping on reddit, Twitter and conferences you will likely enjoy his challenges to cliche arguments.

For instance he pointed out that all the wars in the 16th, 17th and 18th century were not funded by central banks therefore it is unlikely that in the event Bitcoin did somehow take over the world, it probably would not make war disappear.  The term he uses to identify “true believers” that make such argument is Planet-Bitcoin — a place where this vocal group of people reside.  Speaking of which, probably the best quip throughout the book was at the end when a “true believer” calls him a “currency denier.”   Is that a thing now?

Two errors that stood out that I noticed: the Icelandic government actually ignored auroracoin entirely (it was just some random people that did the “airdrop”).  The other part is he stated, “So much so that amateurs have been thrown overboard by mining pools who can afford the ever-increasingly gigantic […]”  Technically these are farms not pools.

Two economic terms that are frequently glossed over by many digital currency advocates:

Recreating a circular flow of income when there are already dozens of competing currencies (e.g., USD, euro, yen) that currently fulfill this task will always be an ongoing hurdle for Bitcoin-like digital currencies.

Regarding my last quote in the book, I should point out that Ripple may not necessarily be a “better” protocol, it just solves different needs in different circumstances.  Though for some of the purposes for which Bitcoin is being shoe horned for, Ripple may be a better solution of the two.  However this is an empirical issue, we cannot know a priori and a TCO analysis should be undertaken by each enterprise.  As far as the fate of Bitcoin — that it can survive because its big holders will subsidize it — perhaps this could be the case, but it is also hard to say how long “whales” or big holders will be willing to subsidize any chain.  It is also unclear how many coins that purported whales actually control still (versus how much they have cashed out) — I have heard all sorts of ownership numbers and if you add them all up, they total more than 13.2 million coins that have been mined so someone at these conferences is embellishing.

A taste of quotes

While the user adoption, merchant adoption and transactional volume numbers will likely change in the coming weeks and months, it is a quick read and below are some choice quotes that stuck out to me.

On first-movers and fads:

The Dot-Com boom, and subsequent bust, of the 1990s rewrote that script. So did Betamax, mood rings, semi-automatic transmissions, floppy disks, 8-Track, Amphicars, Apple Lisa, WebTV, IBM PCjr, Zune, and the Segway.

On the externalizing the costs of mining:

Some miners even employ methods that are not exactly “cricket.” There was one in Holland who literally stole the electricity he needed to run 21 rigs. He eventually got caught. (source)

Regarding the continually misquoted numbers pulled from Coinometrics, Robinson asks co-founder Jonathan Levin for clarification:

“[…] It was right around the December price increase, so there was lots of stuff going on in the press about bitcoin, and all over social media, as well. Everyone was using social media to promote bitcoin Black Friday. It was a massive promotion and it paid off with big sales. But the numbers I’ve got for that period worked out at around 5%. So when you’re talking about comparing PayPal and Western Union with bitcoin the rest of the time, then only about 3% are for goods and services. That puts you at one-hundredth of any other network.” A good reason why, Levin says, might be because, “Bitcoin is terribly inefficient. It’s all about decentralized trust. But if you don’t need to have decentralized trust, updating a spreadsheet in a bank is far more efficient. The cost of updating the ledger is more expensive with bitcoin and takes much longer than any system in the world.” With bitcoin verifications taking up to 10 minutes, he asks, “What happens with Visa? How quickly do they reconcile their database? Instantaneously. Bitcoin introduces the ability to cut out the middleman. That’s fine. But the paradigm is that while the blockchain technology offers decentralization, it doesn’t give you a more efficient system.” That’s not bitcoin’s only “bragging rights” problem. According to Levin, “There is no correlation with the increase of merchants allowing customers to pay with bitcoin and the amount of bitcoins being used for transactions. It’s linear.”

On his use of imagery:

The New York Post’s Sunday business editor Jonathon Trugman wittily describes bitcoin as, “The Tinkertoy crypto-currency,” likening it to, “A modern-day game of three-card monte, with a little Sudoku thrown in, just to add a touch of mystique.”

On putting the theft at Mt. Gox into perspective:

If it turns out to be true that $ 400 million has been stolen, it’s more than the sum total of all the bank robberies in the US for the past seven years.

Regarding the hype of adoption and ATMs in Canada:

However, the Canadian Payments Association reported in April 2014 that while Canada is estimated to account for as much as 4% of bitcoin’s global transactions – ranking it number two in the world, behind the United States but  ahead of China – the volume of bitcoin transactions represents a mere 0.01% of Canada’s total debit and credit-based transactions.

“[…] not just that his is the largest company to do that, but a fast check of Google reveals there are actually more piano tuners just in Canada than there are businesses anywhere in the world of any size, keeping bitcoins on their books.

On the continual problem surrounding the ‘circular flow of income‘:

Dr Yanis Varoufakis, a political economist at the University of Texas and the University of Athens, says speculative demand for bitcoin outstrips transactional demand, “By a long mile. Bitcoin transactions don’t go beyond the first transaction. The people who have accepted bitcoins don’t use them to buy something else. It gets back to the circular flow of income. When Starbucks not only accepts bitcoins but pays their workers in bitcoins and pays their suppliers in bitcoins, when you go back four of five stages of productions using bitcoin, then bitcoin will have made it. But that isn’t happening now and I don’t think that will happen.” Because it isn’t happening now, he continues, and because so many more people are speculating on bitcoin rather than transacting with it, “Volatility will remain huge and will deter those who might have wanted to enter the bitcoin economy as users, as opposed to speculators. Thus, just as bad money drives out good money, Gresham’s famous law, speculative demand for bitcoins drives out transactional demand for it.”

On the odds that Bitcoin will supplant the state:

Professor Stephen Mihm, who teaches economic, cultural and intellectual history of 18th and 19th century America at the University of Georgia, is convinced that bitcoin will not survive, because it cannot survive. He’s written, “Anyone who thinks that bitcoin will triumph, has to believe that it will succeed where earlier generations of private currencies failed, that bitcoin will, improbably, manage to overthrow more than centuries’ worth of accumulated state power, jealously guarded and ruthlessly enforced. That’s a preposterous fantasy, and a dangerous one if you’re an investor. Indeed, people who believe that governments of the world will let a stateless crypto-currency usurp their hard-won monetary prerogatives aren’t forecasting the future. They’re living in the past.”

More on whether or not it will supplant the state:

He says, another reason why bitcoin won’t be the one is because, “The misguided notion that you can free government from currency. Governments regulate money. They put certain constraints on it that you have to follow. So the technology that evolves must be ready to accommodate that. Most commerce will still be done in dollars. Currency is backed by the full faith and credit of a government. Bitcoin is backed by the full faith and credit of wasted computer time.” Seeing The Faithful, “Like a tribe,” he likes to think that their enthusiasm will, somehow, someday, “Help make progress towards a more rational digital currency. But, ultimately the providers of those currencies are probably going to be governments.” At this point, Borenstein argues, “No one should see blockchain technology as an end to a means. No one should look on it as a single achievement. Instead, it should be seen as a point on a spectrum. We may be long gone when bitcoin finally dies, but that doesn’t mean it’s been a success.”

On volatility:

David Yermack, a professor at New York University’s Stern School of Business, and director of the Pollack Center for Law and Business, believes that bitcoin resembles a speculative investment similar to the Internet stocks of the late 1990s. Writing in the MIT Technology Review, he summed up bitcoin’s problems this way: “During 2013 its volatility was three to four times higher than that of a typical stock, and its exchange rate with the dollar was about 10 times more volatile than those of the euro, yen, and other major currencies. Bitcoin’s dollar price exhibits no correlation with the dollar’s exchange rates against other currencies. Nor does it correlate with the value of gold. With a currency whose value is so untethered, it is nearly impossible to hedge against risk.”

Even if volatility subsided and bitcoin somehow found a place as a global payment system, because there can only ever be 21 million bitcoins, Yermack pointed out, it is inherently deflationary. “A fixed money supply is incompatible with a growing economy. Workers would have to accept pay cuts every year, and prices for goods would gradually fall. Such conditions might lead to public unrest reminiscent of the late 19th century’s free-silver and populist movements — an ironic consequence of a currency known for its futuristic cachet.

On the talk of losing purchasing power over the past century:

Levine shrugs that off. “Talk of 1913 dollars is completely meaningless. You need a small amount of consistent inflation because the effects of deflation are so awful. Why is everyone holding onto their bitcoins instead of spending them or lending them? Because they think it will be worth more. Back in the 1800s, people put cash in the mattress because nobody was managing the currency and there were no credible markets, except in Britain. These days, only a nitwit puts cash in the mattress.” He throws back at them the classic dilemma that the Founding Father’s faced in the 18th century – the bankers versus the farmers. “Historically, the bankers wanted hard money, which meant gold, so that their dollar denominated assets would become ever more valuable. The farmers, who were always in debt, wanted cheap money, which in the 1800s meant silver, because they wanted some inflation so they could pay off all their loans. This argument starts with Hamilton and basically doesn’t end until we get off the gold standard. Bitcoin is a world where everybody wants to be a banker and nobody admits he’s a farmer.”

Is it similar to how the internet evolved?

I then asked Borenstein what he thought about The Faithful’s often quoted comparison – that the birth and development of bitcoin mirrors the birth and development of the Internet. He wasn’t having any of it. “The Internet was designed by the most open process known to man, there’s not even an organization behind it. Thousands of people are responsible for making the Internet work through endless sessions of technical minutiae where everybody agrees to do something the same way. That does not sound like bitcoin. There may be all sorts of similarities that don’t matter. The same language, the same open source modules, but I don’t see it as being anything at all like the same.” While he remains hopeful that, one day, we will see widespread use of digital currencies, he confidently predicts, “Bitcoin won’t be it. The technology must be configured in such a way as to meet the national, political and social goals of the people who are going to run that currency. You could lay that universal framework at the software level, the systems that will inevitably be out there, to make them interchangeable. If that happens, I doubt that bitcoin’s code will be very useful.”

On hype and irrational exuberance:

Tech guru John Dvorak described it perfectly in one of his columns: “The amount of money squandered during the Dot-Com era because of ‘paradigm shifts’ and ‘new economies’ is staggering. People actually believed that all retailing would be online and that all groceries would be delivered to the home as they were in the 1920s, despite changes that make delivery impractical. Who cares about reality?”

On the wisdom of trying to short exuberance:

Referring to bubbles as “spontaneous optimism,” John Maynard Keynes pointed out, “The market can stay irrational longer than you can stay solvent.”

On the difficulty of creating other derivative products:

His answer to the first question is no. His answer to the second is yes. Bitcoin mining is very expensive, he explains, and most miners barely break even. Then, because the technology is designed to produce fewer and fewer bitcoins, he is concerned with who’s going to pay for verifying each transaction? “Eventually, as the supply of bitcoin diminishes, those fees will increase to cover the cost of authenticating the transactions, and will become competitively close to the fees for international bank wires. The arithmetic is really simple. I don’t see any way around it.” Levine shares Krugman’s doubts about bitcoin as a currency – “For a while I thought it was like Pet Rocks without the rocks” – but now he wonders, “Would you be willing to take out a mortgage written in bitcoin? The volatility suggests no one would. And, what does it say about bitcoin as a currency when nobody is willing to do anything with it besides a spot transaction?”

On MintChip and building things before there is enough demand for it:

The idea of electronic payment systems has been around for a while, but it wasn’t until 1990 that it actually got off the ground. That’s when Dr. David Everett in the UK invented the first “electronic purse.” His system was called Mondex. Developed with National Westminster Bank, it was a revolutionary idea for its day. The cash was your smart card and you spent it at point of sale terminals. For a while it got a lot of attention, then eventually, fizzled out. Everett was severely disappointed.

“I’m afraid it was way before it’s time. Just too early. In hindsight, there was nothing really broken about payment systems at the time. The Internet didn’t really exist yet. Mobile phones didn’t really exist yet. The focus we had was paying at point of sale. It was very good for the merchant, but in the end it was not so for the consumer who argued, why would I bother?” A world expert on payment systems, coding theory and cryptography for the protection of data, Everett is CEO of the Smart Card Group, technical director of Smart Card News and a man who says that his mission in life is still electronic cash. “I am an enormous believer in electronic cash.” When the Canadians asked him to help them design MintChip, he jumped at the opportunity. “MintChip was almost ten years after Mondex and I was convinced about that one too.” The idea that a Mint would produce electronic cash, “Just seemed so logical,” he says. “That’s what mints do. They mint cash.” As technical architect for the project, Everett was looking to reproduce the ease would want to do, so now you’re into merchants. Maybe a big retail chain. Say Walmart. The cost of managing cash for them is quite high, and credit and debit cards carry with them transaction fees. For big merchants, electronic cash is ideal. Here’s a way of handling payments at a fractional cost of handling cash. Walmart Dollars would work very well and if they did it, everyone would follow.” Ideally, he says, whatever the next stage is, it would not be linked to a bank account or a debit card. “We need to be unconnected. In that sense it is like bitcoin because bitcoin is unconnected. But what I want to see is a real electronic object representing cash. That’s very different from bitcoin.” For him, bitcoin is, “A new form of gold. It is electronic gold. Whereas Mondex and MintChip is equivalent to real currency, a real pound or a real dollar. I think there are a lot of nice things in the bitcoin technology, but I don’t think it’s very good for cash. It doesn’t really lend itself to immediate payments. I’m surprised bitcoin has gone as far as it has.”

On the faux news that Mastercard would be adding support for bitcoin as well as a recent patent filing:

[…] assured me Mastercard wasn’t doing anything of the kind. He explained, the application was filed to protect Mastercard’s intellectual property and did not indicate any commitment to bitcoin. “There is no obligation to ever build anything that a patent application covers.” JP Morgan had done a similar thing with a payments’ patent, putting bitcoin in there, and The Faithful reacted in kind. A spokesperson for Morgan gave me much the same answer as Mastercard. Now I brought it up with Borenstein. A man who still spends a large part of every day working on patents, he says that neither company has any intention of ever accepting bitcoins. Instead, he suggests, they harbor more sinister intentions. “Every patent has to describe all the different storage technologies it might reside on. Which really means, they’re arming themselves for a possible war. Just in case bitcoin ever poses a real threat. They’ll do what they can to wipe them out.”

Cryptocurrency in the news #28

Much like “The Singularity” was en vogue 10 years ago for a slew of reasons that haven’t really materialized (i.e., “an idea before its time”), it is equally unclear how or why blockchains + the Internet of Things has been receiving so much attention. For instance, IBM recently published: “Device democracy: Saving the future of the Internet of Things.”

Let’s be quite clear: yes this technology could develop to work as stated in the next decade.  However, it is unclear why Ethereum, which has still not launched despite 8 months of non-stop marketing, is being cited as the test bed.  I am skeptical that when it does launch, that its economic model will be able to fuel the use-cases that everyone seems to throw at it.

In the meantime, other stories this past week:

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.

False analogies in Bitcoinland plus Alibaba

Saw two analogies used today that are inaccurate.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The case of Alibaba

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

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

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

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

Why do prices fluctuate #2?

Yesterday CoinDesk asked for my take on the current downtrend in market prices.  Incidentally, nearly a month ago, this same question was sent to me (here was my response then).  I sent them a statement and they published a couple of the comments in a new article, “Downward Pressures Persist as Bitcoin’s Price Declines to Near $400.”

Readers may be interested in a few of the other comments I mentioned to CD below:

Charlie Shrem made some interesting comments about OTC liquidity earlier today.  However, the fact that merchants and some miners are not dealing with exchanges directly, does not mean they cannot move the price.  That is what we are seeing now — it may not matter how many people are “buying off-chain” or “off-market” because no one wants to lose money.

And in other cases, an OTC buyer can affect exchange via “buy pressure.”  If he begins buying directly from an OTC provider, avoiding an exchange, the exchange loses its buy wall thus affecting price.  The sell pressure forces the price down and once a large buyer goes “off-market,” he is weakening the buy pressure.  If all the buyers and sellers are “off-market,” we can say that exchange price and price discovery is distorted.  As my friend Raffael Danielli recently said, “Information is never off-chain and ultimately information makes the price.”  Consequently today information spreads very quickly and if a broker can make money because he facilitates “off-chain” transaction and knows “better” what the real price is then game theory dictates he should take advantage off this (investment banks do the same with OTC).

So in addition to partnership agreements, they probably also sell somewhere else to mitigate exposure to this volatility.  In addition, many miners have to finance their operations and at current prices of $410, roughly $1.6 million is created every day via block rewards and it has to go somewhere.  Fewer people buying?  Down we go.

People are always rationalizing things in a down turn.  Maybe an early adopter bought a house or car and cashed out a couple of million worth the past couple of days.  Or maybe some of the dev teams that recently raised funds via crowdsales need to sell in order to fund development.  Just because the ticker price says $410 doesn’t mean every bitcoin in the world is worth $410.  It is temporal and the public market is still very illiquid, so start cashing out and see what happens to market prices.  Again, it is only as valuable as another party is willing to pay for it.  And in theory, it will only stop once the marginal cost of creating new coins equals the current price (MV=MC), which Robert Sams wrote about earlier this week..  Though in practice, some miners can operate at loss to recover at least some funds — however it would be in their best interest to simply turn off their equipment instead and buy bitcoins with the expectation of price appreciation.  It also depends on how much they’re leveraged at places like Paymium, BTCJam and Bitfinex.

Cryptocurrency in the news #25

Closing tabs.

If you’re interested in a blast from the past — to see just how fast the cryptocurrency space has moved in the past 16 months, look at the list of Panelists and Speakers from the San Jose 2013 conference and the projects they were working on.  Or is the more appropriate word, “pivoting?”

Below are links of interest and are not an endorsement for services:

A panel on smart contracts with industry developers and educators

Earlier today I participated in a virtual panel covering smart contracts called, “Let’s Talk Smart Contracts.”

The panel included: Adam Krellenstein (Counterparty), Oleg Andreev (CoreBitcoin), Pamela Morgan (Empowered Law), Stefan Thomas (Codius, Ripple Labs), Stephan Tual (Ethereum), Tim Swanson (Of Numbers), Yurii Rashkovskii (Trustatom) and it was moderated by Roman Snitko with Straight.

Below are some transcribed notes of my own statements.

Introduction starting at 09:06:

Hey guys, great to be here.  Thanks for the invite, thanks for organizing this.  So I’m here because you guys needed another white guy from Europe or something like that (that’s a joke).  So the definition I have of smart contracts, I have written a couple books in this space, and the definition I use is a smart contract is “a proposed tool to automate human interactions: it is a computer protocol – an algorithm – that can self-execute, self-enforce, self-verify, and self-constrain the performance of a contract.”  I think I got most of that definition from Nick Szabo’s work.  For those of you who are familiar with him, look up some of his past writings.  I think that the primary work he is known for is the paper, “Formalizing and Securing Relationships on Public Networks.”  And he is basically considered the [intellectual] grandfather of this space.  I’m here basically to provide education and maybe some trolling.

From 22:02 -> 24:15

I think I see eye-to-eye with Adam here.  Basically the idea of how we have a system that is open to interpretation, you do have reversibility, you do have nebulousness.   These are things that Nick Szabo actually discussed in an article of his called “Wet code and dry” back in 2008.  If you look back at some of the earlier works of these “cypherpunks” back in the ’90s, they talked about some of these core issues that Oleg talked about in terms of being able to mitigate these trusted parties.  In fact, if you look at the Bitcoin whitepaper alone, the first section has the word “reverse” or “reversibility” around 5 times and the word “trust” or “trusted” appears 11 times in the body of the work.  This was something that whoever created Bitcoin was really interested in trying to mitigate the need for any kind of centralized or third party involved in the process of transactions to reduce the mediation costs and so forth.

But I suppose my biggest criticism in this space, it is not pointed to anyone here in particular, is how we have a lot of “cryptocurrency cosplay.”  Like Mary Sue Bitcoin.  I’m not sure if you guys are familiar with who Mary Sue is: she is this archetype who is this kind of idealized type of super hero in a sense.  So what happens with Bitcoin and smart contracts is that you have this “Golden Age” [of Comics] where you had the limited ideas of what it could do.  Like Superman for example, when he first came out he could only jump over a building and later he was pushed to be able to fly because it looks better in a cartoon.  You have only a limited amount of space [time] and it takes too long to jump across the map.  So that’s kind of what I see with Bitcoin and smart contracts.  We can talk about that a little bit later, just how they have evolved to encompass these attributes that they’re probably not particularly good at.  Not because of lack of trying but just because of the mechanisms of how they work in terms of incentives for running mining equipment and so on.  So, again we can talk about that later but I think Adam and Oleg have already mentioned the things that are pretty important at this point.

40:18 -> 41:43

I’m the token cynic, huh?  So actually before I say anything, I would like to mention to the audience other projects that you might be interested in looking at: BitHalo; NotaryChains is a new project that encompasses some of these ideas of Proof of Existence created by Manuel Araoz, he is the one who did POE.  NotaryChains is a new project I think that sits on top of Mastercoin.  The issue that people should consider is that proof of existence/proof of signature: these are just really hi-tech forms of certification.  Whether or not they’re smart contracts I guess is a matter of debate.

There is another project: Pebble, Hyperledger, Tezos, Tendermint, Nimblecoin.  With Dogethereum their project is called Eris which apparently is the first DAO ever.  A DAO for the audience is a decentralized autonomous organization, it’s a thing apparently. SKUChain is a start-up in Palo Alto, I talk about them in chapter 16.  They have this interesting idea of what they call a PurchaseChain which is a real use-case for kind of updating the process from getting a Letter of Credit to a Bill of Lading and trying to cut out time and mediation costs in that process.  There are a few others in stealth mode.  So I really don’t have a whole lot to add with cynicism at this point, we can go on and come back to me in a little bit.

59:41 -> 1:02:35

The go to deficiency guy, huh?  They’re not really saying anything particularly controversial, these things are fundamentally — at least from an engineering perspective — could be done.  The problem though I think runs into is what Richard Boase discussed in — if listeners are interested — he went to Kenya and he did a podcast a few weeks ago on Let’s Talk Bitcoin #133.  I really recommend people listen to it.  In it he basically talks about all of these real world issues that run into this idealized system that the developers are building.  And as a result, he ended up seeing all of these adoption hurdles, whether it was education or for example tablets: people were taking these tablets with bitcoin, and they could just simply resell it on a market, the tablet itself was worth more than they make in a year basically; significant more money.  He talked about a few issues like P2P giving, lending and charity and how that doesn’t probably work like we think it does.

I guess the biggest issue that is facing this space, if you want issues, is just the cost benefit analysis of running these systems.  There is a cost somewhere to run this stuff on many different servers, there is different ways to come up with consensus for this: for example, Ripple, Stellar, Hyperledger, they’re all using consensus ledgers which require a lot less capital expenditures.  But when you end up building something that requires some kind of mining process itself, that costs money.  So I think fundamentally in the long-run it won’t be so much what it can do but what can it economically do.

So when you hear this mantra of let’s decentralize everything, sure that’s fine and dandy but that’s kind of like Solutionism: a solution looking for a problem.  Let’s decentralize my hair — proof of follicle — there is a certain reductio ad absurdum which you come to with this decentralization.  Do you want to actually make something that people are actually going to use in a way that is cheaper than an existing system or we just going to make it and throw it out there and think they’re going to use it because we designed [wanted] it that way.  So I think education is going to be an issue and there are some people doing that right now: Primavera De Fiillipi, she’s over at Harvard’s Berkman Center — she’s got something called the Common Accord program.  And also Mike Hearn; listeners if you’re interested he’s made about 7 or 8 use-cases using the existing Bitcoin blockchain including assurance contracts — not insurance contracts — assurance contracts.  And he’s got a program called Lighthouse which hopes to build this onto the actual chain itself.  So there are things to keep in mind, I’m sure I’ll get yelled at in a minute here.

1:23:58 -> 1:28:10

Anyone listening to this wanting to get involved with smart contracts: hire a lawyer, that’s my immediate advice.  I will preface by saying I don’t necessarily agree with policies that exist and so on; I don’t personally like the status quo but there is no reason to be a martyr for some crusade led by guys in IRC, in their little caves and stuff like that.  That’s not towards anyone here in this particular chat but you see this a lot with “we’re going to destroy The Fed” or “destroy the state” and the reality is that’s probably not going to happen.  But not because of lack of trying but because that’s not how reality works.

Cases right now are for example: DPR, Shavers with the SEC, Shrem now with the federal government, Karpeles [Mt. Gox] went bankrupt.  What’s ended up happening is in 2009, with Bitcoin for example, you started with a system that obviated the need of having trusted third parties but as users started adopting it you ended up having scams, stolen coins, people losing coins so you ended up having an organic growth of people wanting to have insurance or some way to mediate these transactions or some way to make these things more efficient.  And I think that it will probably happen — since we’re guessing, this is speculative — I think that this will kind of happen with smart contracts too.  That’s not to say smart contracts will fail or anything like that.  I’m just saying that there will probably just be a few niche cases initially especially since we don’t have much today, aside I guess from Bitcoin — if you want to call it a smart contract.

What has ironically happened, is that we have created — in order to get rid of the middlemen it looks like you’ve got to reintroduce middlemen.  I’m not saying it will always be the case.  In empirical counter-factual it looks like that’s where things are heading and again obviously not everyone will agree with me on that and they’ll call me a shill and so on.  But that’s kind of where I see things heading.

I have a whole chapter in a book, chapter 17.  I interviewed 4 or 5 lawyers including Pamela [Morgan] of different reasons why this could take place.  For example, accredited investor — for those who are unfamiliar just look up ‘accredited investor.’  If you’re in the US, in order to buy certain securities that are public, you need to have gone through certain procedure to be considered a ‘sophisticated investor.’  This is one of the reasons why people do crowdsales outside of the US — Ethereum — because you don’t want to have to interact with the current legal system in the US.  The reason I mention that is because you end up opening yourselves to lawsuit because chains — like SWARM — cannot necessarily indemnify users.  That’s legal terminology for being able to protect your users from lawsuits from third parties; they just do not have the money, the revenue to support that kind of legal defense.  Unlicensed practice of law (UPL) is another issue.  If you end up putting up contracts on a network one of the issues could be, at least in the US, are bar associations.  Bar associations want to protect their monopoly so they go after people who practice law without a license.  I’m not saying it will happen but it could happen.

My point with this is, users, anyone listening to this should definitely do your due diligence, do your education.  If you plan to get involved with this space either as an investor or developer or so on, definitely at least talk to a lawyer that has some inkling of of an idea [on this].  The ones I recommend, in addition to Pamela here are: Ryan Straus, he is a Seattle-based attorney with Riddell Williams; Austin Brister and James Duchenne they’re with a program called Satoshi Legal; and then Preston Byrne, who’s out in London and he’s with Norton Rose Fulbright.

1:52:20 -> 1:54:43

Guys look, I understand that sounds cool in theory and it’s great to have everything in the background, but the reason you have to see these “shrink wrapped” EULAs [end user license agreements] and TOSs [terms of service] is because people were hiding stuff inside those agreements.  So if you hide what’s actually taking place in the contract you end up making someone liable for something they might not actually agree to.  So I’m not sure, I think it’s completely debatable at this point.  If we’re trying to be transparent, then you’re going to have to be transparent with the terms of agreement.

I should point out by the way, check out Mintchalk.com, it’s run by guys named James and Aaron in Palo Alto, they’re doing contract building.  ACTUS is a program from the Stevens Institute, they’re trying to come with codified language for contracts.  Mark S. Miller, he’s got a program over at Google, he does something with e-rights.

I mention all of this because, we already have a form of “polycentric law” if you will in terms of internationally with 200 different jurisdictions vying for basically jurisdiction arbitrage.  Ireland and the Netherlands have a tax agreement that Facebook, Google, Pfizer they take advantage of.  It’s this Double Irish With a Dutch Sandwich.  In fact my own corporation is incorporated in Delaware because of the legal arbitrage [opportunities].  Obviously smart contracts might add some sort of new wrinkle to that, but people who are listening to this, don’t expect to be living in some Galt’s Gulch tomorrow or something like that.

For example, when you have something that is stolen, there is something called Coinprism which is a colored coin project.  They can issue dividends on stock.  The cool thing with that is, “hey, you get to decentralize that.”  The double-edged side of that is if that when that get’s stolen: people steal stuff like bitcoins and so forth, what happens to the performance of that dividend?  If the company continues paying that dividend in knowing that the person had been stolen from: if somebody stole from me and I tell the company, “hey, it was stolen” and they continue paying, then I can sue them for continuing to pay a thief.  If they stop paying then it defeats the purpose of decentralization because anonymity is given up, identity has taken place.  Obviously this moves into another area called “nemo dat” it’s another legal term talking about what can be returned to the rightful owner, that’s where the term “bona fide” comes from.  Anyways, I wanted to get that out there.  Be wary of disappearing EULAs, those have a purpose because people were being sued for hiding stuff in there.

2:10:05 -> 2:12:23

So I think everybody and all these projects are well-intentioned and have noble goals but they’re probably over-hyped in the short-run, just like the Segway was.  It eventually leads to some kind of burnout, or over-promise and under-delivering.  I’m not saying this will happen, I’m just saying it could happen.  I actually think the immediate future will be relatively mundane, such as wills and trusts kind of like Pamela was talking about.

One particular program is in Kenya there is something called Wagenitech which is run by Robin Nyaosi and he is wanting to help farmers move, manage and track produce to market to bypass the middleman.  That doesn’t seem like something really “sexy,” that doesn’t seem like the “Singularity” kind of thing that everyone likes to talk about.  But that is needed for maybe that particular area and I think we might see more of that along with PurchaseChain, NotaryChains, some of these things that we already do with a lot of the paperwork.

Again, blockchains and distributed ledgers are pretty good at certain things, but not everything.  It has real limitations that vocal adopters on the subreddit of Bitcoin like to project their own philosophical views onto it and I think that it does it a very big disservice to this technology long-term.  For example, LEGO’s can be used to make a car but you wouldn’t want to go driving around in one.  A laptop could be used as a paper weight but it’s not particularly cost effective to do that.  And so what I think we’ll end up running into a tautology with smart contracts, it’s going to be used by people who need to use them.  Just like bitcoin is.  So what we’re going to have is a divergence between what can happen, this “Superman” version of Bitcoin and smart contracts, versus the actual reality.

So for example, people say it’s [Bitcoin] going to end war.  You had the War of Spanish Succession, there was a Battle of Denain, a quarter million people fought that in 1712 and it was gold-based [financed by specie].  Everyone that says bitcoin is going to destroy fiat, if the state exists as it does today there’s always going to be these institutions and types of aggression.  I do think smart contracts do add collateral and arbitration competition and it does take away the problem of having trust in the system itself, but the edges are the kryptonite.  And always will be.  So we need to focus on education and creating solutions to real actual problems today with the actual technology and not just some hypothetical “Type 2” civilization where we are using [harvesting] the Sun for all of our energy.

Cryptocurrency in the news #22

Closing tabs.

Two things:

1) I contacted Wedbush Securities about their new report and asked them what their citation for their first point regarding payments was.  They responded by saying they used the Blockchain.info transactional volume chart.  The reason this is interesting is because based on the past 8 months, that chart does not actually support their argument.  Perhaps this will change in the future, but it may not.

2) I have a short article about the unseen costs/subsidies in the mining space, it is mostly a rehash of chapter 3.  I suspect that once we have “Peak Hashrate” prior to the next block reward halving in 2016, some of the hand waivers will begin to realize what the real costs of securing and transacting is: How many bitcoins does it cost to maintain the Bitcoin network?

Jae Kwon on other economic attack challenges

Apropos the responses of BINO and the other responses to Downplaying Risks, Jae Kwon (author of the Tendermint protocol) pointed to an interesting thread on Reddit:

How to double spend PoW coins for fun and profit.

You don’t even need major pools to subvert the security of the blockchain and double spend.

Let’s say that you want to doublespend a transaction that was included at height H. Simply put out a bounty for more than the mining reward for the first miner to mine an alternative block at height H. Then, you reward the (traitor) miner on the existing blockchain. As long as the instigator is trustworthy, rational greedy miners would switch because the expected reward is higher. Then you do the same for height H+1 and so on, until the fork wins.

Jae also had some more comments related to blockchain forks and he gave me permission to have them reposted:

I actually wrote a prototype of an exchange engine, and the hardest part was dealing with logic pertaining to block chain forks.  It’s just so easy to get wrong, and it’s not even clear when a transaction should be deemed “irreversibly committed”.  So I ended up having to write tricky edge cases, where, I can imagine bugs can emerge.  This isn’t something that will connect with most users, so I doubt that people will even “get it”, but my assessment is that Bitcoin has these fundamental design issues that may end up hurting its adoption rate compared to other designs..

Another thought is that we probably want  to see a multi-coin future where no single coin has global dominance.  If you want a future with many multiple competing cryptocurrencies, then you probably want to get away from a consensus algorithm that relies on energy.

And in terms of the speculation surrounding the Ethereum team working together with the BitShares team and potentially using Delegated Proof of Stake (DPOS), Jae thinks that:

I don’t know enough about BitShare’s DPOS scheme to list specific vulnerabilities, but here’s a rule of thumb that I use to evaluate consensus algorithms:

The amount of value at stake that is lost in the event of a fork is roughly the amount of security afforded.

In the PoW vulnerability that I mentioned, what is at stake is the electricity spent mining blocks.  Large transactions need to be vetted by waiting a proportional amount of confirmations, potentially much longer than the original 6 confirmations as cited in Satoshi’s paper for transactions over hundreds of BTC.

In any delegated PoS model, if Carl can delegate his stake to someone without the risk of losing that stake, then Carl can be bribed by Malory to delegate his stake to Malory’s puppet account.  On the other hand if Carl can lose his stake in the event that the delegated signer does something bad (e.g. enable a double spend by forking the blockchain), then Carl probably wouldn’t want to delegate his stake to anyone, and instead would opt out of the consensus process or become a validator himself.  For this reason I don’t find delegation models to be very interesting.  It may provide some utility as long as delegated coins are “at stake”, but the foundational consensus algorithm (minus the delegation part) must be secure first.  Delegation cannot fix a broken algorithm.

Lastly, Peter Todd suggested that I emphasize that there is a difference between hard forks, soft forks and SPV soft forks.  Last fall Todd wrote an overview on this titled On soft-forks and hard-forks.

Robert Sams on rehypothecation, deflation, inelastic money supply and altcoins

The Bitcoin Foundation held a conference in Amsterdam back on May 15-17.  The video of the events was not uploaded until recently.  The one below covers the panel on economic theory.

Panel: Robert Sams (Founder, Cryptonomics) Robin Teigland (Associate Professor, Stockholm School of Economics) Peter Surda (Economist, Economicsofbitcoin.com) Konrad Graf (Author & Investment Research Translator) and moderator Jon Matonis (Executive director of the Bitcoin Foundation)

Over the past several months, Robert Sams has helped act as a non-partisan sounding board to discuss these issues as I did research on these topics.  He also recently launched a start-up in this space called Swiss Coin Group which acts as a liquidity counterparty (see also SCG’s announcement video from Coinsummit last month).

I finally had a chance to watch the panel on economic theory of Bitcoin (above) and below are some transcribed portions of comments by Robert Sams.

Regarding the ‘regression theorem‘:

The idea that something needs to have some underlying use value before it can gain liquidity and become a medium of exchange, first of all it has always struck me as not a derivation of logic and therefore not a theorem but an empirical hypothesis and one that I think that the very existence of Bitcoin has conclusively falsified.

On competing altcoins being sorted out:

I think eventually there is only room for a handful, 3, 4, 5, maybe ten competing cryptocurrencies.  Each filling a niche that satisfies some area of demand, some might have a richer scripting function for smart contracts, one might be embedded in a different kind of protocol.  So there is definitely room for multiple currencies but the very nature of hash-based proof of work, where the security of the network is arrived at by people literally burning money is one that can’t be evenly distributed over a large number of alternative cryptocurrencies.  It’s what you see, eventually most of the altcoins will fail and people will stop mining them, they won’t have any exchange value.  But there will still be room for quite a few.  And you already see it in the distribution of the market capitalization of these things, they follow a power law and I would expect that to continue.

What about altcoins in local communities?

That’s an interesting question.  I think the more local the currency becomes the harder I think it is to use hash-based proof of work as a solution.  Although other types of distributed consensus mechanisms could be used.  Because if as a community currency the overall monetary value of that thing is going to be much much lower, so the amount of seigniorage that comes from the mining award to reward the miners is much lower, so the amount of electricity that is spent securing it, it is something that will be alot easier for someone on the outside to attack it if they wanted to.  On the other hand, the incentive of attacking some small community currency might not be there, so not much of an issue.  So it’s an open question.

Thoughts on fractional reserve banking with bitcoin:

I don’t think it is actually possible to construct fractional reserve banking within Bitcoin.  Because fractional reserve banking, especially in the modern era, it’s one of the great scandals of modern finance is based on an illusion — this 1:1 fungibility between bank deposits and cash.  And you can do that in the conventional analog world because you have this whole institutional framework of deposit insurance, lender of last resort function of the central bank, you can bail out the banks if they fail in order to maintain this illusion that a loan to the bank — an unsecured loan to the bank which is basically what a bank deposit is — is the same thing as cash, and they are not.  And there is not anyway within the crypto space to express such an arrangement.  Sure there will be lending done in Bitcoin, I was talking to a guy last night who is doing just that, that’s fantastic.  But the relationship between the lender and the borrower isn’t one of “well I had some ownership of a pool of loans to people” — that’s something that has a floating net asset value.  It is not treated as a cash equivalent, I can’t use it as a medium of exchange or maybe I could but it would be a medium of exchange that trades like a credit instrument rather than risk free cash.  So I don’t think its even possible to express fractional reserve banking in bitcoin and I think that’s a good thing.

Konrad makes a really interesting point about trusted fourth parties and trusted fifth parties.  You know, it’s not just about being fractional reserve banking, the bank deposit versus cash, it’s about all assets within the financial system: the clearing banks, custodians — also play a fractional reserve-like role.  Most people don’t realize that.  Securities that are on deposit with a custodian bank can be lent out to those who want to sell them short; bonds, the same thing happens.  So that something that is called rehypothecation, these assets get lent and relent and relent, they multiply throughout the system.  So like some particular bond that’s in the system, there might be $2 billion of it outstanding, but the actual quantity of people who own that bond on their balance sheet is like a factor of 10 times that.  It’s just like the multiplication of base money in the banking system and the whole thing creates a systemic instability because the lack of clarity about this relationship between the guy who is entrusted his assets for safe keeping in some clearing bank and exactly do what that clearing bank can do with it.  Now the theory you think that it is governed by the law and the like but when Lehman bankrupt, there were a lot of fund managers and hedge fund managers who didn’t actually realize that their clients money which was supposed to be in a segregated client account was actually rehypothecated and they had to queue up in the bankruptcy courts in order to recover that money.  And one of the things that crypto does is make the sure technical nature of the transference being done by digital signature means that there is no way that you can create these rehypothecation arrangements without making them explicit.  And I think that is great.

Would you take out a 5 year loan in bitcoin knowing you had to pay it back in bitcoin?

No.  Well, it depends, I guess if I were selling it short.  But no.  If there was a lending market in bitcoin its most likely to flourish initially as being something that’s denominated in fiat money rather than nominal bitcoin.  Unless the borrower is using it as a vehicle to speculate on a climb in the exchange rate.

On deflation:

I think the deflation criticism of Bitcoin is usually misguided, it usually comes from the economics profession.  The arguments that are made don’t really apply because, the arguments about sticky prices (good’s prices fall faster than wages), about balance sheet effects of debtors being punished because an increase in the purchasing power, none of those really apply in Bitcoin because bitcoin isn’t yet a unit of account.  Contracts and prices are still priced in the fiat currency and expressed in bitcoin by reference to some exchange rate.  So the traditional arguments like, “is deflation is a bad thing” don’t really apply in a bitcoin world.

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.

What about issuing coins after 21 million limit, that would be called Keynes coin?

I wouldn’t call it Keynes coin, not just because of the marketing but conceptually I don’t think it would be either.  This is controversial and difficult.  There are algorithmic, distributed ways of working within cryptocurrency protocol to change the money supply in proportion to the change in its exchange value.  And that can be done, it doesn’t require a central bank, it doesn’t require some cabal of guys deciding what the monetary policy can be, it can be done completely anarchic and distributed way and it would have the property of stabilizing the price of cryptocurrency.

I think the issue if should you have more elastic supply or not it just really comes down to the fact that if you have a fixed supply of something, the only way that changes in demand can be expressed is through the change in price.  And people have expectations of increased demand so that means those expectations, expectations of future demand get translated into present day prices.  And the inelastic supply creates volatility in the exchange rate which kind of undermines the long term objective of something like cryptocurrency ever becoming a unit of account.  And forever it will be a medium of exchange that’s parasitic on the unit of account function of national currencies.  So I do think the issue does need to be addressed.

Audience question on 100% reserve versus fractional banking:

There is a movement underway in the economics profession called limited purpose banking or 100% reserve banking.  It’s not just in the cryptocurrency world that we criticize fractional reserve.  Even Mervyn King before he left his chairmanship with the Bank of England he suggested that this is something that we should look into.  So yes, it is quite possible, there could be consensus — broad base consensus — around taking away the banks ability to create private money.  What do we use to replace that, one side of the argument is going to be that the banks should take the role of issuing the currency they just have to have 100% reserves and ‘gosh those things should be risk free government bonds.’  I think there is an alternative argument that can be made from the cryptocurrency space is that we don’t actually need the banking system to fulfill those functions at all.  And the demand for some medium of exchange in the absence of bank created money will be met spontaneously within the cryptocurrency space.

Audience question, does buying bitcoin and holding them benefit the community?

It’s an interesting question.  I don’t think so.  You could argue indirectly the fact that people buy and hold bitcoin, the price goes up and that attracts all the interest into this space and to some extent that’s true.  So yes, it does provide some investment.  But I think it doesn’t provide as much investment as would be the case in the alternative world where Satoshi implemented the exact same thing but had a different money supply rule.  My view counterfactual is that we would actually see a lot more underlying economic activity in the cryptocurrency space and a lot more investment.

Bitcoin’s PR challenges


Source: agmarketing.com.au

What kind of feedback has my book received over the past week?  Here are a few threads on reddit:

I am called any number of names on these threads and stylistically was equated with “Gish Gallop” and a “word soup” thesauri.

Hass McCook (“Bit_by_Bit”) weighs in at one point in the first thread saying that these claims are only valid in August 2014.  McCook had similar sentiments as noted in Chapter 3.  However, no word on the MV=MC issue that was brought up in that same chapter, it will always apply no matter what the efficiency of the mining equipment.  This cost basis was also independently confirmed by a miner.

Today a friend pointed to a new post by Mircea Popescu which takes aim at me (not my book): “No, you don’t have something to say on the topic.”  In it he claims I am a “boneheaded teenaged male approach to learning.”  Not a word about the marginal costs of mining.  In fact, he also claims that there is no data “per se” in the book which is curious since there is actually a lot of data in the book.

This is a common rejoinder; some vocal advocates not looking at actual data from the blockchain.  In some ways their timeline looks like this:

  • 2007: First lines of BTC code written
  • 2008: Whitepaper revised and published
  • 2009: Blockchain put into production
  • 2009 – 2014: data created, but the only valid data is fiat prices, the rest is not real data “per se”

Other responses

Aside from the ad hominem’s above what has been the criticism?

Peter Surda, a researcher, disagreed with my points on inelastic versus elastic money supply but didn’t go into many details in a short email exchange.

I received a number of encouraging emails from a variety of readers and was named one of thirteen “Big Thinkers” in this space, though I doubt some of the other candidates would like me to remain in company with them.

I have had some responses with a couple others, including L.M. Goodman (creator of Tezos), on Twitter this past weekend — though this is largely unrelated to the book itself.

What does this mean?

Partisanship may be impacting scholarship, especially the Myth of Satoshi variety.

No, Leah Goodman did not uncover who Satoshi was.  But one thing was clear from that episode in February was that some partisans do not want the individual who created Bitcoin to be taken down from the pedestal they have put him on; they want their caricature to be immutable.  Just like some historians have tried to revise history to make their heroes look impeachable, so to has the veneration of Satoshi.  If Bram Cohen had anonymously released BitTorrent a decade ago, would BitTorrent have had a similar following due to its mysterious beginnings?

I hold no ill-will to the person or group that comprised Satoshi, but it is clear from the evidence cited in chapters 9 and 10 that he, she or they did not consult an actual economist or financial professional before they created their static rewards and asymptote money supply.  This is a mistake that we see in full force today in which the quantity of money available has shrunk due to theft, scams, purposeful burning, accidental destruction, etc.  Satoshi recreated a deflationary inelastic economy and much to the chagrin of the self-appointed purity police, it is not being used the way he expected it to (actual commerce) and is instead being used for things it is relatively useful for (e.g., donating to Wikileaks, gambling).

What other economic and environmental issues are still being ignored?

Jake Smith, creator of Coinsman recently published a new article on mining in China.  Yet despite being, in his own words, a “true believer” and interviewing other “true believers” in the mining space, he missed the unseen calculation, the economics of extracting and securing rents on this ledger unit which consume scarce resources from the real economy.  This is not something that it is unknown, there is an economic formula to explain it: MV=MC (as described copiously in Chapter 3).  There is nothing magical or mysterious about mining as other people in the reddit thread point out how mining is currently an environmental albatross or as Fred Trotter dubs it, a “black hole.”

Moving forward

Today the Consumer Financial Protection Bureau (CFPB) issued its Consumer advisory: Virtual currencies and what you should know about them.  The advisory (PDF) gives a cursory look, in layman’s terms of what are the challenges and risks of participating in this space.

What does this mean?

While it is unclear as to the motivations of some of the “true believers” are, they collectively did underestimate the costs of consumer protection and/or did not put it as a top priority for mass consumer adoption.  But why would they?  Consumer protection is usually expensive, its unglamorous and its centralized (which apparently is a “no-no”).

For example, generally speaking, most people do not like having their possessions stolen.  And in the event something is stolen, in practice, individuals prefer to take out insurance and even sue those responsible for damage (torts). If instead of promoting and building illicit markets (like Dark Market and Dark Wallet), these same developers and early investors had funded a start-up that helped track down these stolen funds, or start a non-profit to help get stolen coins, it would have been an amazing public relations coup.

To be balanced, theft takes place across the spectrum of services.  It also happens on the edges of Visa’s network. The difference is Visa offers insurance which is built into their cost structure (highly recommend reading Richard Brown’s recent post).  Insurance alone is just another product and has nothing to do with the protocol.  And this specific point (for the individual user) could be resolved sooner or later (e.g. Xapo already offers some home-made insurance).  However, insurance does not change the economics behind Bitcoin, especially since lost coins are permanently and constantly removed from the money supply.

Then again, there is a built in incentive to allow this theft to occur — stolen coins need mixers and exits which could potentially benefit developers and investors of those services; and simultaneously as more coins drop out of circulation this increases the value for those holding the remaining supply.

In addition, a vocal group of these “true believers” do not think Bitcoin has an image problem.  Yet it has a massive PR problem, for similar (albeit smaller) reasons that Tylenol had in 1982: customers and their families do not like getting burnt.  The only group I am aware of that tried to immediately help the victims of the Mt. Gox debacle was Goxcoin (here’s the LTB interview of it).  In contrast, thread after thread on reddit was filled with bullies saying “no big deal.”   It is a big deal to normal people with real responsibilities beyond downvoting skeptics on reddit and pumping stories about Bitcoin curing cancer and ending wars.  And Mt. Gox liabilities won’t be resolved for at least another year.  Instead of cyber bullying merchants into adopting bitcoin payments, these same hectors could have created a company catering towards recovering stolen property (e.g., loss recovery specialists).  It was a lost opportunity.

my wallet transaction volume

Source: Blockchain.info

In contrast, Blockchain.info has a mixing service called SharedCoin based off the CoinJoin feature from Greg Maxwell.  Blockchain.info recently crossed the 2 million ‘My Wallet’ mark but as I noted in Chapter 4, the vast majority of these likely go unused.  This past spring, one of their representatives claimed that they receive about 15 million visitors a day, but what this actually is, is largely API traffic (external websites pulling charts from their site). They probably do not have close to 2 million users let alone 15 million visitors.

How few?  We have an idea based on their own internal numbers, MyWallet transactions is flat over the past 12 months.  If there were 2 million or 15 million users, we would probably see a gigantic uptick in usage elsewhere on the blockchain (e.g., TVO would skyrocket, tx fees to miners would skyrocket, etc.).

What this all means is that, while they do not release actual user numbers, that at least a minority of wallets are probably ‘burner wallets,’ dumped immediately by individuals wanting to mix coins.  This is great for those who need to mix coins but not so great for consumers who just had their coins stolen.  How to resolve this going forward?

Incidentally in May, Roger Ver (an angel investor including in Blockchain.info) was extorted by a hacker who had figured out a vulnerability in Ver’s security.  Ver put a 37.6 bitcoin bounty on the hacker and the hacker eventually backed down; Wired and CoinDesk each did an article on it.  Yet during the same month, coins were stolen from others and when the users came to reddit for help, they were ridiculed for not having done the 27 steps to make a paper wallet.  No Wired article was written for them and in turn — speculatively — their coins could have been mixed on a site like Blockchain.info.  As a result, why would normal consumers ever want to use Bitcoin after that experience?

Perhaps user behavior and therefore the data will change in the future.  Consequently blockchains in general will probably find other niches beyond what Bitcoin is being shoehorned to do today.  This includes, other chains and platforms that may be able to help firms like Wageni Tech accomplish its goals in Kenya by helping farmers move, manage and track produce to market in an attempt to bypass middlemen and introduce transparency.  Bitcoin may be able to do that one day, but maybe not at the current $40 per transaction cost structure.  Start-ups such as Pebble, Hyperledger, Tezos, Tendermint, Dogethereum (Eris), Salpas, SKUChain, Stellar and several other funded projects in stealth mode may be able to as well (remember, Google was the 15th search engine and the iPod was at least the 9th MP3 player).

This is not to say that “Bitcoin” has collapsed or will collapse, nor is this to single out Ver (he has done a lot to try and create value in this space and even donated 1,000 bitcoins to FEE last year).  Instead it may continue to evolve into is something called Bitcoin-in-name-only, (or BINO as I refer to it in chapter 16) and it probably will continue to be used for what most risk-tolerant consumers use it for today: as a speculative commodity and as a way to pay for things that credit cards cannot be used for.

My thoughts on Stellar

Yesterday Wired magazine asked me a few questions for an article they ran this afternoon about Stellar, a new startup (non-profit) in San Francisco: New Digital Currency Aims to Unite Every Money System on Earth

I suspect for brevity they had to boil down everyone’s comments to a few nuggets, which is an unenvious job to have, after all, most readers don’t have time to read hundreds of pages each day.

For those that are interest, here are the comments I provided them:

My interactions with people on the Stellar team has been positive, they are genuinely passionate.

I think the major limitation long term, and this is what Bitcoin startups continually run into, will be establishing relationships in the banking and financial industries as well as complying with whatever digital currency licensing requirements each jurisdiction has.  Those are not going away.  Stripe, its lead investor, has been very successful as a payments processor, but financial relationships take months and years to build — it is not something that can be replicated with a viral link that is upvoted or emailed.

I think the fact that they decided to go with a consensus ledger instead of proof-of-work was a wise but double-edged decision.  On the one hand it avoids the Red Queen treadmill and environmental issues that Bitcoin and its progeny have. And is a vote of confidence in the code base that Jed and his cofounders at Ripple put together.  But on the other hand identity fraud and preventing Sybil attacks are a hard nut to crack for distributing coins; incidentally proof-of-work was one way to resolve that (though not the only way to do so).

For instance, while it is still early on, one challenge they are currently facing is fighting identity abuse.  KYC is essentially done through Facebook, which is clever way to also distribute tokens but is vulnerable to fake accounts from Mechanical Turk; Everett Forth racked up 2 million stellar in one day alone. It’s worth pointing out that this is a problem that Ripple Labs tried to solve with Computing For Good, but botnets abused this faucet and Ripple Labs shut it down at the end of April.

Consumer facing products in retail will be hard to do in the developed world, in the OECD because of the competitive forces from Visa and Mastercard.  It’s very capital intensive and hard to compete against their POS integration and margins (Richard Brown has good article about this hurdle).

Yet, the more competition, the merrier.  Consumers globally will have more choices — the market will end up deciding the best solution and we will all be better off.

Published new book: The Anatomy of a Money-like Informational Commodity: A Study of Bitcoin

After several weeks of editing, I have finished compiling all of my previous research from this past spring into a new book.  It also includes a considerable amount of new content as well.

It is all available for free in PDF and Scribd formats (there is also a Kindle version).

The Anatomy of a Money-like Informational Commodity

In what ways does Bitcoin resemble a command economy?

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

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

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

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

Ray Dillinger discusses block reward halving

Ray Dillinger has been around in the Bitcoin space for years, in fact, he was on the same cryptography mailing list that Satoshi announced Bitcoin back in 2008.

Over the years he has made a number of comments over at Bitcoin Talk.  Below are several related to the challenges facing this cryptoledgers especially related to the block rewards (seigniorage subsidies).  Recently he noted:

For what it’s worth, I’ve been looking at the question of mining (and premines, etc) a bit differently.

In my estimation, the block subsidies and transaction fees are what the investors (or holders) pay the miners to keep the blockchain secure.  If these payments get too low relative to the value secured, then the blockchain becomes insecure and you get 51% attacks etc.

In that light the “standard” model we’ve been pursuing of block subsidies halving as the value secured grows larger seems dangerous.  As the value we’re trying to secure grows larger, we intend to pay less for security.  We shall, in that event, GET less security. I’ve been watching alt chains with faster halving periods dying like flies, and I can tell you for sure that this is something that’s real.

That brings us to transaction fees.  We are paying to secure value, and we are not paying transaction fees relative to value.  We are paying transaction fees relative to space.  Space – which is to say hard drive sectors and network bandwidth – is not what secures our value; what secures our value is a monetary hardware investment in ASICs and powerplants.  Which we need in proportion to the value we’re trying to secure.  And which we will not get in proportion to the value we’re trying to secure by paying for space instead.

My conclusion is that if we want to keep the network at zero inflation and pay for security out of  transaction fees, we should be paying transaction fees relative to the value of each transaction.  And if we want to keep the network going without transaction fees that cost a percentage of the transaction, we should accept an inflationary model where each year the block rewards are, eg, 5% larger than they were the previous year.  So, in the long run that approaches 5% inflation.

Both of these options are not popular with the current crop of BTC holders.

Another germane, sobering comment:

Colored Coins etc. make it much harder to know how much value we need the blockchain to protect.  The fact that these values are essentially “hidden” from the protocol means we can’t tell what we need to do to maintain any kind of parity with them.

One popular (and possibly correct) view of things is that in the long run the cheapest available price of electricity times the amount of electricity spent per block, will approach the value of the block reward in a PoW system.

Right now we have a Bitcoin block reward worth approx. $12000.  If this view is correct, we should expect, worldwide, to see about $12000 worth of electricity (increasingly concentrated where electricity is cheapest) expended per block by hashing rigs.

Right now transaction fees are providing a very small percentage (one third of one percent?  I think?) of the block rewards.

At  some point in the future, moving to transaction fees as a primary source of mining revenue, implies that each kilowatt-hour of electricity invested in securing the blockchain will have to secure three hundred times as much value (relative to its own value) from attack as it does now.

I’m convinced that’s not really enough.  If we stick with Proof-of-work, we’re going to have to start charging transaction fees based on how much value is changing hands, because we want to buy security proportional to the value we’re trying to secure, not proportional to the amount of space it takes to store the transaction.  And that means the amount of value changing hands has to be visible, and that therefore Colored Coins etc will have to be more ‘transparent’ in terms of the protocol knowing how much they’re worth (and therefore how much security we need to buy to keep them secure).

The potential death of certain of proof-of-work altcoins:

The hash power devoted to securing altcoin chains is orders of magnitude smaller than the hash power devoted to bitcoin, and the cost of an attack in general is therefore orders of magnitude smaller.  Doge got a special mention because it was used as an example recently of the economic effects of reward halving on hash power distribution – the author of that paper made the point that every time doge cuts their block subsidy in half the hashing power devoted to securing their blockchain will also be cut in half.  Doge was mined too quick; its block reward is cut in half many times more often than Bitcoin’s.  But it isn’t the quickest-mined coin out there by any means; just one that’s a bit remarkable for the size of its current market cap.  All of the quick-mined coins have this problem, and many of them are already gone.  But that’s only the technical side of blockchain safety, and unfortunately that isn’t even the main type of risk.

Altcoins, in general, are a cesspool right now.  In fact it would not be too much to say that the *AVERAGE* altcoin is a scam.  Exchanges are openly taking bribes to list altcoins regardless of merit. Some of them are even developing their own altcoins in house for the sole purpose of trading fraud.  Other people are more or less openly accepting payments to hype coins on Reddit, Twitter, etc, then engaging in blatant price manipulation in order to drive prices up on a particular day so scammers can sell their premines at maximum profit. Several coins a week that are doing “crowdfunding” or “IPO” to sell their initial distribution of coins are simply scammers who then disappear with the money.

If you even consider investing in altcoins, you should first have a definite reason to believe that the one you’re investing in isn’t a scam.  You should second have legal recourse (meaning, you know AND CAN PROVE exactly who the scammers are and where they live) if it does turn out to be a scam.  If you have trouble following that second rule, it’s not because it’s an unreasonable rule; it’s because scams ARE THE NORM in the altcoin world and scammers will not give you enough information for legal recourse.  While some non-scam coins exist, they are rare exceptions.  Nobody in that business is entitled to the benefit of a doubt.

That’s a completely separate issue from chain security w/r/t large (or small) transactions – but once again, if you don’t fully understand why a blockchain is (or isn’t) secure and what resources are required to attack it – then you don’t know enough to even evaluate the security of an altcoin that’s operating with different rules, and if you can’t evaluate the security of its blockchain, then you shouldn’t be investing in it even if it’s a non scam.

On the possibility of failure for a variety of “coins” (including appcoins):

A coin which can survive has at least the following properties.

1.  The dev is not anonymous.  If a coin has an anonymous dev, it’s about three times more likely to be a scam than not. Further, if the dev is not anonymous, there are things you can legally do if it does turn out to be a scam and if the dev is anonymous there aren’t.

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

3.  It isn’t an IPO where you’re supposed to “buy” coins for some other form of money.   A few of those are honest, but most turn out to be scams.

4.  The dev actually knows how to fix problems in the software.  This is hard to judge straight out of the gate.

5.  There’s a point.  To put it gently, in order for it to be reasonable for someone who’s not scamming to release an altcoin, there has to be something wrong with Bitcoin and they have to believe that they can do better.  In order to believe any altcoin has a long-term future, there has to be something wrong with Bitcoin and that altcoin has to be able to survive where Bitcoin cannot.  Anytime there’s an alt, ask what it does that bitcoin cannot do.  Then ask, does that enable it to survive where bitcoin cannot?

6.  Don’t be taken in by talk of philanthropy.  Money, when functioning as money, has no morals whatsoever, good or bad.  It flows in the reverse direction of the profitable allocation of resources.  Any money that attempts to do anything else will cause market distortions that cripple the economy it’s working in and ultimately cause it to function less well than its competition.

7.  If there’s a premine, be sure that the devs are absolutely honest about the premine.  If they claim that it’ll be used for the good of the community, then the community is entitled to know how every last dime of it gets spent.

8.  If there is any difference at all between the block reward structure they advertise and the one they implement, stay away.

On Nicolas Courtois’ paper (self-termination chains):

It’s true that we don’t know how to implement some of the author’s proposed solutions, but he has a pretty good grasp of some very serious problems.

In particular, he has a good point about what happens when block rewards are multiplied by half.

There’s an investment (in ASIC mining equipment) constantly seeking its most profitable allocation.  That allocation is an equilibrium in which each option pays identically.

At the point where there’s a block reward halving, one of the allocation options has its return cut in half, and the equilibrium has to find a new balance point.

If you’re UNO, and you cut your block reward in half, the total rate of return is hardly affected at all because you represent such a tiny fraction of the total available income.  The allocation of that investment to mining your blockchain, though, gets cut approximately in half, because that’s the point at which the return for mining it remains competitive.

If you’re BTC, and you cut your block reward in half, the total rate of return is cut by almost half.  Suddenly, every *other* allocation opportunity is suddenly worth twice as much of the miner’s remaining hash power investment as it was before, because that’s the rate at which the return for mining it stays competitive with BTC.

Of course, the latter doesn’t account for mining rigs that are no longer profitable to run at all….

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)


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.

Dalio explains what credit is and how it works

After receiving some feedback on a variety of articles this past month it has been pretty sobering to realize that many Bitcoin advocates simply have no idea how the current economic system works, especially what credit is, where it comes from and how it functions.

Ray Dalio, founder of Bridgewater Associates (the largest hedge fund in the world), put together a short guide called Principles (pdf) and later developed the video below to help explain “How The Economic Machine Works”:

Digital currency usage in the developing world

[Note: a revised version of this interview appeared on CoinDesk.  I hold no equity in the company nor is this an endorsement to use the service.]

This past week I spoke with Ron Hose, co-founder and CEO of Coins.ph, the leading Bitcoin exchange in the Philippines. Hose is a graduate of Cornell, a founding partner at Innovation Endeavors and previously co-founded Tokbox which was acquired by Telefónica Digital in 2012.

While Coins.ph began trading late last year, the actual exchange launched publicly in February. According to Hose, “In terms of volume, we have been doing pretty well in growth so far – high double digit, triple digit growth which is a very encouraging sign.” The main reason he credits this success is that, “we focus on building trust with customers through fast customer service. They care about this when dealing with bitcoin – they care that the money is safe. And because emerging markets are more different than developed countries, we had to provide a positive customer service process to where they can trust turning bitcoins into cash and cash into bitcoins. As a consequence we built out a physical network and actually deliver cash through retail locations and even conduct do door-to-door deliveries too.”

Because the team has an active exchange they can now see what customers use it for and have begun building a second layer of applications on top of it creating banking services to those who do not have traditional banking services. “In contrast to developed countries,” noted Hose, “where bitcoins as a payment method are more of a novelty – here it is serving a real problem. For instance, credit card penetration in the Philippines is 3%. Only 3 out of 100 customers that land on an ecommerce site have an immediate way to pay for it. Others have to travel to a bank for 45 minutes on bus, wait in line and then return back on the bus. Before you know it, it takes 3 hours to pay for something online.”

According to Hose there is even a larger pain point: sending and receiving money abroad. With about $25 billion a year the Philippines is the 3rd largest recipient of remittances – roughly half the size of its gross domestic exports. And these funds are predominantly going to people who do not have bank accounts and thus have to pick money up at retail locations like Western Union and consequently pay an average of 9% in fees. “The reason they pay this 9%,” explained Hose, “is because they don’t have a bank account and likely will never have a bank account because they do not have enough savings. Banks have a cost structure (location, tellers, rent) and if you do not have sufficient savings on the first day when you open an account, the bank is already losing money. This pain point is an area where mobile banking and bitcoin can help out. For instance, if a relative abroad sends money to you and you have to pay a transaction fee to a retail location, then that is equivalent in 3-4 days of income that you paid just to pick up your money.”

And, in his view, what differentiates and sets his team apart from other local competition, “we have a well-seasoned Silicon Valley team. And even though Bitcoin is not yet regulated in the Philippines, as well as neighboring countries is that we treat it as if it was regulated. We work to comply with industry standard KYC/AML regulations; we are self-regulated and assume that we are being regulated.” As far as operating in an uncertain environment, “there are definitely a lot of very particular challenges related to working in an emerging markets (for example, there is no automated way for us to do bank-to-bank money transfers here, we actually have someone going to the bank, withdraw cash, and deposit it at another bank.”

So then, what is the most important issue in operating the exchange? In Hose’s view, “again, customer service is the most important area. For instance, they might see my profile or cofounder profile on the website yet there is a lot of trust involved. And so I tell my team, “we are only as good as our last transaction.” Thus we have to make sure the funds go in the right time window.”

According to Hose, virtually anyone can come to Coins.ph, cash out their bitcoin and in turn receive cash at 12 major banks, thousands of retail locations or even have it sent door-to-door by messenger. For its first market, the team launched in the Philippines. However they see themselves as a regional player, aiming towards providing similar services to other markets in the area – expanding into places like Thailand, Malaysia, Indonesia and Vietnam. In addition to a foot network (sneaker net), the team is still quite lean, roughly 10 people – half in engineering and the other half in operations.

To accomplish its goal domestically, the team has built a large physical network and the next step is opening up this network up with an API (a sneaker net API) providing Bitcoin ATM makers the ability to use this infrastructure to send money anywhere else in the Philippines. In terms of physical throughput, Hose noted, “users can put in who they want to receive the funds and when they want to receive it. Next day delivery. We have providers that can do same-date, however we only guarantee next day as it is important to not overcommit to our customers. Part of providing good service is giving people the proper understanding what will happen and standing up for it 100% of the time.”

Concluding, Hose mentioned he was recently on a panel in Singapore (Echelon 2014), and was asked what is going to drive Bitcoin adoption. In his view, “the thing that will drive digital currency adoption is the use-case. It must solve a real problem; there has to be something that is painful enough to convert, somewhere there is enough friction, the thing about emerging markets is that pain exists – you don’t have a bank account or you have to pay 9% to transfer money to your family – so it is much easier to make that leap. And if we can make it so their friend had a positive experience, then through word-of-mouth they have a reason to try and use it as well.”

Separating activity from growth on Bitcoin’s network

[Note: the following article was reposted on Business Insider, a PDF version is available]

One of the contentious areas of writing about Bitcoin data and emerging markets, is discussing what conclusions and interpretations (if any) can be drawn from say, transactional volume.

Let us put that aside for a moment and consider ways to estimate real commercial volume. Are there any other ways to do so besides a full traffic analysis?

Sell side pressure

On any given day there are at least three entities that continuously sell bitcoins onto the market: merchants (and merchant processors), miners and mining manufacturers (who are sometimes paid in bitcoin).

As I noted in my previous article, last month BitPay announced that it was processing about $1 million in daily payments. It is unclear what amount of bitcoins that constitutes, depending on the time frame and therefore price levels (early December or the month of May) it could represent 1,000-2,000 tokens per day.

Let us assume that the other merchant processors such as Coinbase and BIPS are also processing a similar amount. And that altogether between 5,000-10,000 bitcoins per day are collectively being spent on commercial activities through these processors.

This puts pressure on the sell side of the price equation. That is to say, to minimize exposure to volatility, nearly all merchants elect to immediately convert bitcoins into fiat and those bitcoins are sold onto the market (both Ben Edelman and David Evans have written on this before).

Similarly, because miners have to pay real costs – capital and operating costs – they too sell their mining rewards on the market: around 3,600 each day (because again, MV=MC).

It is unclear how much mining manufacturers have to sell each day to fund their own developmental and logistical operations, but for the sake of simplicity and roundedness, let us say 1,400 bitcoins (it could also be as little as zero).

Thus altogether, there is a regular 10,000 – 15,000 bitcoins representing commerce that are sold daily on the market today. It also bears mentioning that, although technically the miners receive money, virtually all of it is spent towards utility (electricity) and hardware, not on the bitcoin ecosystem itself. While it is unclear how much other positive-sum value exchange is taking place (such as remittances, houses or cars) we can see that the transactional volume of potential commerce has remained flat during the past six months:

excluding popular addressesIs there a chart that shows this amount of transactions?

In my last article, I mentioned Total Volume Output – the total value of all transaction outputs per day – yet this includes coins which were returned to the sender as “change” and thus the real number trying to be measured is substantially less. And taken to its maximum readings, roughly 1,000,000 bitcoin outputs (UTXOs) are used each day.

If only 10,000 – 15,000 bitcoins are being used in real commercial activities (instead of merely zero-sum activities like gambling, mixing of coins or cybercrime), then the perceived Total Volume Output is potentially two orders in magnitude larger than the real economy.

What is the real economy? While the debate over what percentage of bitcoins are being spent in positive-sum activities, between October 15 and December 18 of last year, 41,928 bitcoins were sent to addresses controlled by Cryptolocker (a type of malware) – this is not real economic growth, in fact it is negative-sum. And because it signaled to the market that it was a successful way of generating (stealing) wealth, there are numerous copycats using similar methods (including CryptoDefense and Cryptolocker 2.0).

The cost of information security

For the moment, let us ignore the buy side of the equation, that in order to keep the same price level, at least 10,000 – 15,000 bitcoin are being acquired by other parties each day (primarily high-net worth individuals and institutions through OTC brokers).

What this actual activity translates into is the following:

Miners are the labor force that secures and processes transactions. And because this labor force has real depreciating capital costs and operating expenses, in theory, the cost for their services amounts to roughly $2 million per day (3,600 bitcoins X $600 per bitcoin).

In practice however, most miners are operating at losses. In fact, the network is vastly oversecured by miners operating at losses probably by a factor of 2-5x (described in Estimated costs). For instance, according to a recent report from the National Science Foundation (NSF), a now-banned researcher used, “about $150,000 worth of NSF-supported computer use at the two universities to generate bitcoins worth about $8,000 to $10,000.” Or in other words, the researcher externalized the real costs of mining (energy and capital deprecation) onto another party (the NSF and therefore taxpayers). This is inefficient, yet there are many cases of such activity taking place each day.

Thus while the Bitcoin ‘trust fund’ (a more accurate description for the network which divvies out a finite amount of block rewards) pays out security of $2 million each day, the labor force is providing significantly more security than they are being paid, probably closer to $6 – $10 million if not more (Hass McCook has additional estimates).

Simultaneously, they are providing these services for commercial activity that ranges from as little as 5,000 bitcoins to perhaps as high as 15,000 bitcoins. Or $30 million to $90 million respectively in today’s prices.

For comparison, MasterCard spent $299 million on their capital expenditures in 2013. As part of these expenses, it builds data centers similar to the “fortresses” (with moats) that Visa has also built. In 2013, MasterCard and Visa processed a combined $7.4 trillion in purchases.  Together with American Express and Discover, these four companies generated $61.3 billion in revenue during the same period.

While this is not an entirely apples-to-apples comparison, what this means is that the Bitcoin network is enormously oversecured compared with other transactional platforms. The reason this is, is because it is decentralized which creates overhead (since all the nodes have to process and verify the transactions). Yet, as shown with GHash.io over the past month, the network is qualitatively insecure due to economies of scale. That is to say, so as long as the proof-of-work mechanism can be economically scaled, this leads towards centralization. No amount of white papers or tweets will change that.

If the labor force of bitcoin is spending $10 million on protecting the network yet real commerce is only $30 million, this would be equivalent to a mall issuing 1 out of 3 customers a personal security detail to go shopping. Or in other words it is, arguably, quantitatively oversecure (it is not qualitatively trustless as shown by GHash.io and previously, Deepbit). Perhaps this mix will change over time. However one thing to consider is that some bullish advocates contend that the Bitcoin network will one day supplant and compete head on with Paypal and even Visa. In order to do so, the Bitcoin labor force are still (assumedly) being paid a fixed income to provide the same services. Thus perhaps in the future, the opposite will occur – the network could become undersecure due to disproportional rewards.

I spoke with Greg Simon, co-founder of Cryptowerks who worked as head of International Equity Sales for JP Morgan in Japan. According to him,

Cryptoledger miners are Japanese banks. They are producing an oversupply of crypto trust relative to an under supply of borrowers of that trust. Their only solution, producing an ever increasing supply of crypto trust, is making the problem worse, not better. It is the equivalent of central bank QE [quantitative easing], or pushing on as string. Just as an oversupply of central bank produced money causes the value of each unit of money to decline, so does an oversupply of crypto ledger miner produced crypto trust cause the value of each unit crypto trust, which we can measure in units of ghash, to decline. The problem is not the aggregate supply of crypto trust. The problem is aggregate demand for crypto trust. Until demand for crypto trust improves, either from monetary or non-monetary borrowers, we can expect the same fate for crypto trust in the crypto economy as we are seeing for fiat money in the legacy central bank fiat economy.

Another way to visualize this phenomenon is the chart below:

age of last send transactionJohn Ratcliff recently published an explanation about zombie bitcoins (coins, or rather UTXOs, that have not been active in more than 18 months) which is where the chart above comes from. Each color band represents the last time a private key corresponding to these UTXOs was used.

Thus, one take-away from this chart is that liquidity – as shown by the One Day, One Week and perhaps One Month bands – represents between 100,000 to 2,000,000 bitcoins. What is the actual number? Without a full traffic analysis we probably will never know.

But we can tell from spikes that the largest movements take place during volatile time periods, specifically during price run-ups. So, for instance, in the spring of 2013 there was enormous Western media attention and a subsequent boom that peaked in mid-April (when Mt. Gox had to temporarily shut down). Similarly, in November and early December corresponds with additional global media coverage and Chinese adopters coming online – with prices peaking on December 4th. Or in other words, transactional volume rises and falls with price levels – that the bulk of on-chain activity corresponds primarily to day trading and speculation. This, despite the fact that Ratcliff notes, that prices during this 18 month time span increased 4,000%.

That is to say, even though there are more than 100,000 merchants that accept bitcoin and even though token valuation has risen logarithmically, UTXO holders as a whole prefer speculating over conducting actual commercial activity. What could change this behavior?

Maybe nothing will because Bitcoin is a recreation of a medieval agrarian economy; few people spend, in part because the network codifies what is essentially negative time value of money.

Money and credit

There is an endless stream of papers and books on the topic of what constitutes and attributes of money. Arguably one of the most thorough explanations of what money is and how it arose is, The Ascent of Money by Niall Ferguson which was later turned into a good PBS series.

Despite what some Bitcoin advocates claim, gold itself was not used on a large scale since time immemorial. In practice, there were numerous types of physical assets ranging from metals to stones. England even used a system of money known as tally sticks for several hundred years. And the reality is that prior to the birth of civilizations, many tribes and villages operated with barter and gift systems with themselves and one another (some never even created something akin to “money”).

As noted by Ferguson, up until the Renaissance, there were no real financial instruments or professionalized banking or hedging methods in the West. Bonds, joint-stock corporations and insurance companies evolved throughout time (all post-Fibonacci). And consequently, this is reflected in the dearth of economic output at the time. That without a way to expand credit – to create loans to start businesses – the pie cannot be enlarged. In his words, “Credit and debt, in short are among the essential building blocks of economic development, as vital to creating the wealth of nations as mining, manufacturing or mobile technology.” In contrast, poverty (subsistence) more often, “has more to do with a lack of financial institutions, with the absence of banks, not their presence.”

Thus, I would argue that ultimately Coinbase could turn into a fully-fledged bank, providing interest to bitcoin holders to be able to loan out bitcoins (much like BTCJam does). And they could do this through a fractional reserve process. In fact, Huobi’s new Hong Kong branch (BitVC) is heading in that direction; users can lend funds to Huobi for interest and Huobi will then lend it out to users to trade on margin. Contrary to what many Bitcoin adopters contend, fractional reserve banking itself is not inherently a bad thing but that is a topic for another article.

However, for the time being, Coinbase and others – while on-ramping a lot of new users and providing utility through ease-of-use functionality – have a long way to go before this occurs. For instance, this past week Coinbase announced instant buyback (once you spend bitcoins, you can buy more). However, the reddit comment below sums up actually what happens:

coinbaseAgain, there is a difference between the economy Bob wants to have versus the economy Bob currently has. Today Bitcoin, as I have argued, is at most an emerging market akin to a pre-industrialized agrarian economy with enormous frictions. Internally it is an inflexible command economy that outsources and arbitrarily rations its scarce resources (block rewards) irrespective of economic conditions (e.g., Bob, the miner, is rewarded whether or not he processes transactions).   Front loading rewards the first four years without processing any transactions is an unsustainable activity. In fact, as Jonathan Levin, co-founder of Coinometrics, notes in his upcoming paper, Creating a decentralised payment network, he found that “[i]n total over the network history there have been 84,469 blocks with no transactions.” Yet because there is no one at the helm, no entrepreneur to rationally allocate block rewards or market value for those rewards the first year, ultimately 4.2 million bitcoins were given out for naught.

Many adopters note that this was done to help bootstrap the economy and that the initial distribution of bitcoins through the block reward is purportedly not how bitcoin will operate in the long run. And that at some point Bitcoin’s internal economy will somehow be incentivized by transaction fees only – or at least that is theoretical transition (see Reducing and removing block rewards). But the fact that miners were rewarded irrespective and arbitrarily of their actual work is very similar to how top-down command economies work rationing wages. This is a topic that will likely be debated over the coming years.

For additional perspective I spoke with Martin Harrigan, a software developer and founder of Quantabytes, a cryptocurrency analytics start-up. In his view:

The initial distribution of bitcoins is a one-time process that is distorting our understanding of the Bitcoin economy. I think that the peaks in transaction volume during the price run-ups are a form of secondary distribution: early adopters are distributing their bitcoins, for profit, to new users. This is a vital part of Bitcoin’s distribution process and may continue for as long as there are periods of significant price increase. It may be that institutional investors will take-over a significant portion of this process for several years. Then, at some point, when the technology, infrastructure, regulatory frameworks, and our understanding of cryptocurrencies has matured, the price will stabilise and Bitcoin will return to individual users as a stable transactional currency in the traditional sense.

Of course, I’m speculating wildly here. My point is that we don’t have a good null model. We’re not seeing “hockey stick growth” but maybe that’s okay. Many start-ups need this type of growth to survive — I don’t think Bitcoin does. During the Bitcoin crash of 2011 the price dropped 93% and didn’t recover until 2013. The difficulty also dropped and remained stagnant for a year and half. Although I can’t quantify it, the “mood” on the Bitcointalk forums was grim. The equivalent event would have been fatal to most start-ups.

Perhaps at Harrigan noted, this will change in the future. And perhaps those frictions are still lower than the cost of doing business in certain regions (like the Philippines). And this is not to single-out Coinbase. I still think they are one of the best companies in this space, I even consider them one of the most promising in part because they are trying to create value (and have). But that does not mean this particular service is frictionless. For instance, David Evans recently delved into the specific transaction costs of various platforms and explained how the actual roundtrip cost of Coinbase is 2% + $.15, not the 1 percent that is frequently cited (Evans also had another good explanation of how Coinbase and merchants like Overstock work).

Building a continuous series of bubbles or building utility

One of the common refrains about altcoins and appcoins in general is that none of the underlying systems are able to give out real equity and thus cannot have P/E expectations – neither does bitcoin, nor will it. This is a bug and it is why I argue that using the “TCP/IP” analogy is probably incorrect.  The internet is an amalgam of private-public intranets cobbled together and cost real capital to build.  It was not built with magic; real incentives had to be provided to build it.  Imagine if those incentives decreased 50% every 4 years?  That’s Bitcoin’s internal economy. The Bitcoin network cannot operate without bitcoins – the app or currency or commodity (choose your definition). The two are united together. Yet TCP/IP, the protocol, can still work even if substantial portions of the network fail; it is not tied to a specific set of hardware or token (TCPIPCoin).

This is not the first time a set of unrealistic expectations have been created in the past 10 years.

cleantechSo what kind of bubble is bitcoin then? Some claim that it “crashes upwards” which makes no rational sense at all. Bitcoin (the token) is not immune to the laws of economics. Perhaps as illustrated above (source), the current investment cycle in Bitcoin is more akin to Cleantech circa 2005? What this means is that, as noted in my previous article, even though many of the startups are clever, they may lack sustainable business models. Once this froth is removed, the businesses that survive will likely be those that are actually creating real pain killers (utility) to real needs; perhaps reusing the infrastructure of the network (like merged mining proposed by Blockstream or that of Cryptowerks) to process contracts and titles. Again, all of this is speculative, yet it warrants attention because Cleantech also had a similar dedicated ideological group of early adopters that created economic activity (though, not much growth yet) and wanted to change the world. And despite their best efforts it popped.

In conclusion, expanding credit alone is not the answer to Bitcoin’s stagnant economy. For instance, China’s money supply grew leaps and bounds since November 2008 (when it implemented a series of stimulus packages). It also signed bilateral currency agreements with new countries every year which led many outside commentators to erroneously conclude that this somehow leads to mass adoption of the RMB. Yet the stark reality is that the RMB only accounts for 1.4% of global payments compared with the dollar at 42.5%. This is unlikely to change either. However, even in its current doldrums, the Chinese economy still produces real goods and services to the tune of trillions of dollars per annum. Obviously it is unfair to compare Bitcoin, a five-and-a-half-year old “startup” to China. Yet the emerging market aspect, the reuse of capital stock, the implementation of new financial instruments, the training of unskilled laborers and ultimately the creation of needed utility to outside parties can be viewed as facsimiles to learn and grow from.

As noted by John Kenneth Galbraith in the last article, there is only so much capital that can be extracted from the “fleece-me” crowds of reddit. Significantly more capital is needed to scale operations to enterprise-level reliability. While some advocates believe eschewing the ancien regime of venture funds and private equity is the way to move forward, this is short-sighted.

Below is a list of companies I think have potential to create value in this digital ecosystem – embryonic solutions to this quagmire (I hold no equity in them):

Modeling economic growth and zero-sum games in Bitcoin

lotteryI have a new article that went up over at Let’s Talk Bitcoin yesterday called, Can Bitcoin change from a bubble economy into a growth economy? (pdf).  It is essentially part 2 to the previous piece and put together based on feedback I received this past week.

I should mention that while I did use an equation in the middle of the article to describe prices, I do not think the regression itself is valid.  As my friend RD mentioned, the error term does not seem random. There is a deterministic trend that would have to be filtered out first.  It is the same problem with modeling long term GDP growth.  After all, why would we need all these economic models if we can simply draw a straight line and predict GDP using high school math?  Many things follow an exponential growth curve, that is nothing new. The exciting thing is to forecast it in the short term, which this method is extremely bad at (the same criticism can be lobbed at models like Elliot wave theory).

Over the last 12 hours I have received some criticism about one particular point: zero-sum games and gambling.

In one email exchange, Bob disagreed that gambling was zero-sum, stating:

Gambling in and of itself does not create productivity, but the businesses that surround gambling certainly can. See: casinos, bitcoin mixing services.

Also, if the house makes a bunch of money, and the owning entrepreneur uses those funds to start another, productive business, then in some sense the gambling has facilitated economic development by liberating wealth from unproductive suckers who participate in online gambling to a highly productive entrepreneur. This was, of course, exactly the case with the most popular bitcoin gambling website.

The issue here is a measurable one.  A zero-sum game is one in which wealth is merely redistributed and not grown.  What Bob described above is economic activity but not economic growth.  Gambling is zero-sum game as is speculating on stocks or cryptocoins, no new utility itself is created.  Tokens are simply being moved from person to person. Eventually many people are left with assets that they cannot sell because all the demand has been fulfilled, and at that point the price may actually crash.  In other words, to make money in a zero-sum game, it is only because others have lost an equal amount.  In fact, in many cases, value diminishes because of interchange fees or in the case of mixing services, transaction fees.

This touches on an economic principle of opportunity costs (the “seen” and “unseen”) — the traditional example used is Alice throwing a brick through a shop keepers window.  While the seen result is a repairman being hired to fix the window, thus spurring economic activity, this does not actually create economic growth because the shop keeper must now forgo certain opportunities to spend repairing existing physical stock.

Note: Gambling has the name “math tax” because it is a tax on people who are not good with statistics (49.5% odds means in the long-run, you will always lose to the house).  This is derived from Ambrose Bierce’s quote, “Lottery: A tax on people who are bad at math.”

After a quick Google scholar search, I think there is more concise explanation of this phenomenon in Gambling and speculation, by Borna & Lowry:

Unproductive nature of gambling

For players, gambling, at best, is a zero-sum game, i.e., the aggregate wealth of the players will not be altered due to a gambling activity. The losses of one party are precisely equal to the gains of the other participants. Of course, if the gambling activity were taxed by the government, or there were other ‘leakages,’ then the expected value of winning would be negative, i.e., the aggregate wealth of the players after the play would not be equal to their original wealth.

Although gambling is a sterile transfer of money or goods among individuals creating no new money or goods, it nevertheless consumes the players’ time and resources and may subtract from the national income. From a macro-economic point of view, the aggregate wealth of the players will change, in the long run, due to the fact that the transfer of wealth is usually among unequal productive sources. It may be argued that the productivity lost due to a transfer of money from one player will be offset by an increase in the productivity of the other player. This assumption is true only if both the winners’ and losers’ production schedules were assumed to be identical and linear.

One last note: there are a number of people I would like to thank for their comments included in this article; this does not mean they agree with or endorse my view.  This includes: Dave Babbitt, RD, Mark DeWeaver, Dave Hudson, JL, Taariq Lewis, CK, Petri Kajander and Chris Turlica.

Cryptocurrency in the news #16

Some relevant news of interest as I close some tabs:

Interview with core developer, Peter Todd

A new interview is up with IamSatoshi Network and Bitcoin core developer, Peter Todd.  While the first part explains the politics of getting code into (or out of the protocol) — which many enthusiasts gloss over — I especially found Peter’s discussions in Part 2 of germane interest due to the sky-is-falling on reddit surrounding Ghash.io the last few days.  Here is one such comment thread.  And I think this comment sums it up the best:

If a 51% can occur, all trust in bitcoin should be lost forever. An investment that relies on people begging random strangers on reddit not to ruin it every couple of weeks is not really something that seems like a great thing to pour actual money into, tbqh.

Tbqh means “to be quite honest” (that same user made other good points about this issue too).  And here is also another interesting subthread (mulligan for that decentralization + neutrality notion…).

Ghash.io is the largest mining pool on the Bitcoin network (it actually supports merged mining for Devcoin, Namecoin and Ixcoin as well) and it hit 48% of the network hashrate this past weekend (it is now 43%, see this chart).  Its parent operating company is Cex.io and the system is run in a cloudhashing manner — customers rent hashrate by purchasing contracts with bitcoin.  Interestingly enough, the cost of these contracts is now more than what you receive as a reward for hashing, leading to the joke that Ghash (and other such services) are pay-for faucets.  That is to say, faucets are way to distribute tokens, for free (usually by filling out some Captcha once a day).  Yet in this case, because of bitcoin volatility the past 5 months, users are actually paying to receive a minute amount of bitcoins — they might as well terminate their contracts and buy bitcoins on the open market.

One common refrain that some Bitcoin advocates say about mitigating 51% attacks is that hashers in mining pools can simply move and/or point their hashing equipment at another pool.  This may be possible in the “early” days of today, yet there are two problems as time goes on:

1) As we approach the top of the S-curve in ASIC tech improvements, mining farms (and pools) will gravitate to locations with the best and cheapest network and energy infrastructure.  This itself creates centralization risks that I and many others have written about.  If you are renting out equipment (hashing systems) from a cloud provider at one of these locations, you can no longer physically move the equipment to another farm and perhaps in some cases, you may not be able to direct your miner to other farms (there is one proposal by Greg Maxwell that hasn’t been reported on involving tamper resistant private keys physically built into the gear, but that’s a story for another post).

2) Block size increases.  In order to make the Bitcoin network more competitive as a payments and transportation network, there have been many proposals to increase the hard cap of 1 MB block sizes by several orders of magnitude.  To date however, the average block size is around 350 KB, with an average of 0.7 transactions per second — thus the need to increase it is low (primarily because few people actually use the chain for much activity such as commerce).  If block sizes are increased, without the use of something like tree chains, then centralization will occur because miners (and fully validating nodes) will need to pay for larger bandwidth options, larger hard drives, etc. which squeezes out marginal players.  This is a known issue but Peter Todd highlights this as a hurdle for hashers wanting to move to another pool for the same reasons mentioned in point #1.

Thread of the day: List of all the known dead altcoins

The past year has seen what some the “Cambrian explosion” in altcoins.  Most are complete pump-and-dump scams.  Others experimentally toy with a couple variables and a remote few actually bring something genuinely new to the scene (like proof-of-transaction in Fluttercoin).

Wouldn’t it be neat to see a list of all the known altcoins and a little bit about what they were before they became ledger rot?

For the last couple of months Ray Dillinger on Bitcoin Talk has been attempting to chronicle this digital death in: Necronomicon thread: Altcoins which are dead.  I wonder who holds the record for creating the most alts?  Is that something you brag about at a bar?

Furthermore, here are some patterns that Ray sees are emerging based on alts that are not (completely obvious) scams:

  • Alts have a plethora of different hashing algorithms, but there are really only three divisions that matter between their proof of work.  Either they are CPU dominated, GPU dominated, or they are mined with a particular kind of algorithm-specific ASIC.  ASICs exist for SHA256D coins like bitcoin and for Scrypt coins like Litecoin.  No other algorithm-specific hardware exists, so no other difference in hashing algorithm matters.
  • Within each division, coins rapidly reach an equilibrium where whichever hardware generates their proof of work is allocated in direct proportion to the financial reward per minute of the block reward.   Usually this means that halving the block reward of an alt, other things being equal, halves the hashing power securing its block chain.
  • Most alts become unstable when 3/4 or more of their coin supply has been mined (second reward halving), even if no other factors have made the cryptocurrency unstable prior to that time.  If the value being secured exceeds the block reward by too great a fraction, 51% attacks and forks are to be expected.
  • “Burst mining” or “automatically switching multipools” act like positive feedback amplifiers with a delay loop in mining – they make it VERY difficult for an alt to maintain a ‘stable’ block rate when its hash rate gets too small relative to the pool (GPU, CPU, or specific ASIC type) of hashing power it belongs to.  This is a heavy contributing factor in the 51% attacks and forks mentioned above.
  • Several alts switched to proof-of-stake after to this instability led to bad forks or “stuck” block chains where miners essentially had given up due to a burst miner leaving the chain at a ridiculously high difficulty level.
  • A shift from proof-of-work to to proof-of-stake, whatever its effect on market value, has usually led to stagnation or decline in the community surrounding the alt.  In turn this usually leads to a collapse in value of the alt, unless heroic measures (such as direct giveaways by stakeholders to non-stakeholders) are used to bring people into the community.

See also: Different proof-of-work mechanisms and several altcoins that have been hit with a 51% attack

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.


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

Will colored coin extensibility throw a wrench into the automated information security costs of Bitcoin?

[Note: a version of this appeared at Business Insider.  A PDF is also available of the version below.]

The cost of securing the Bitcoin network for a given length of time is roughly equivalent to the value of the block reward over the same time. In economic terms this reads as MP = MC. In Bitcoin and most of its descendants, the labor force (called miners) are provided a hard-coded wage, a seigniorage subsidy called a block reward roughly every 8-10 minutes in consideration for their providing security and processing transactions. In return, this labor force provides the security in a method called “proof-of-work” – hashing through benign math work until it finds a special number, broadcasting that solution to the network (the other laborers) and, once a block is found, repeating the cycle once again.

Is there an economic flaw of proof-of-work as it relates to security?  For instance, on most cryptocurrency chains the asset value of the chain has to be proportional to the proof-of-work otherwise this could lead to an economic incentive to attack the chain. Compounding this issue are new financial instruments such as metacoins, colored coins and smart contracts that can be exchanged on the same chains and unquestionably increase the enterprise value of the chain, yet which do not proportionally incentivize security beyond the existing seigniorage subsidy.

Economically rational laborers will not spend more than the value of a bitcoin to extract the rents of that bitcoin. Because mining rewards were fixed with the genesis block in 2009 (providing a fixed income on a scheduled time table), and market participants are able to determine the percentage of the overall hashrate at a given time that their mining equipment represents, only relatively simple calculations are required to gauge the potential profitability of their mining activities.

In practice, laborers on the Bitcoin network must account for the capital costs of their hashing equipment, rent for the land, administrative overhead, taxes and increasingly important, the energy costs which can be very specific to their locality, depending on the equipment’s geographic location. All of these costs are tallied against an inelastic wage which can only be attained if the hashing equipment they control is able to outcompete other such miners – it is a zero-sum game. And it can be scaled.

The Hashrate Wars

This subsequent escalation, dubbed a “hashrate war” (the competitive fight for ever increasing hashing equipment) created a technological S-curve that looks similar to the chart below:

hashrate over time

The vertical axis in the chart above is logarithmic and illustrates the hashing rate (showing that it will slow down once ASICs hit fabrication node limitations). The horizontal axis projects two years into the future (see also Bespoke Silicon).

Ignoring all of the various issues related to public goods challenges and game theory (such as “selfish mining”), this system has served the bootstrapping phase with relative ease. If it continues to expand at its current rate, the hardware side could potentially become commoditized in the next 3-4 years whereupon a miner’s competitive advantage will solely lay in energy arbitrage. In fact, Satoshi Nakamoto, the pseudonymous creator of the protocol foresaw this noting in the original FAQ that “When Bitcoins start having real exchange value, the competition for coin creation will drive the price of electricity needed for generating a coin close to the value of the coin.”

Thus the relationship between enterprise value and hashing power has been known for some time.

A challenge however, presents itself when this seigniorage subsidy is halved, a structural feature of most cryptocurrencies. With Bitcoin, every 4 years (or every 210,000 blocks) the subsidy is reduced by 50%. This is equivalent to the miners – the labor force – being told they would receive a 50% pay cut. While this issue typically remains hidden and muted when token values appreciate and rise, in the long run continual halvings discentivize laborers from providing security and utility to the network. There have been several “cryptocurrencies” whose labor force fled after their profitability period was over – most notably with Auroracoin – and as a consequence the network was left insecure and vulnerable to double-spending attacks (called a 51% attack).

One such popular token that is currently facing this dilemma is Dogecoin, which is losing 20-30% of its security force every 2 months. While there are potential solutions Dogecoin developers could adopt, incorporate or migrate to, because Dogecoin is still relatively young it has the flexibility of moving towards a different security mechanism. This issue has the potential to become systemic – and thus more difficult to address – in other digital currency ecosystems.

dogecoin comparison chart

Are there any other areas of asymmetric, unbalanced security?

Colored coins, metacoins, smart contracts and user-created assets are buzzwords trumpeted by many cryptocurrency enthusiasts this past year. I even wrote a short book about these groundbreaking possibilities. Considerable publicity has been dedicated to new functionality which promises to expand the extensibility of cryptoprotocols to go beyond tracking ledger entries for just one specific blockchain-managed asset (a coin) and allows users to instead “colored” tokens to represent cars, houses, commodities, stocks, bonds and other financial instruments and wares. For example, there are several colored coin projects currently in beta that allow users to take a fraction of a bitcoin, such as 0.001 BTC and “color” it “blue” (or any other arbitrary color) which represents say, a specific make and model of an automobile like a 2010 Camry LE. The user can then transfer that asset, the title of the Camry, along a cryptoledger (such as the Bitcoin network) to other individuals. Instead of having to transfer tens, hundreds or thousands of bitcoins in exchange for a good or service, users can instead exchange and manage entire asset classes in a trustless, relatively decentralized framework.

However, in this model the labor force providing security has no incentive to consume more capital or create additional hashrate just because the market value of colored coins is in excess of the uncolored value (since the value of miners’ new coins will be solely based on uncolored exchange value). Just because social conventions on the edges of the network add value perceptions to the network, based on the current code, miners do not automatically receive any additional value for providing that security.

So we should ask: does this raise the risk of a double-spend? Perhaps, because more hashrate is required for a proof-of-work blockchain with additional color value transactions on the chain. Yet, there is no automatic mechanism to do reward this additional labor leading a (remote) possibility of having to remove some Script’s altogether. Script is the built-in scripting language used for creating and customizing transactions.

The gap between mining value and enterprise value

For instance, assuming this colored coin technology works and is adopted by 1,000 people the following scenario could take place. The total market value of a block reward (currently 25 bitcoins) is roughly $12,500 (or $500 per bitcoin), thus ceteris paribus the labor force is only spending $12,500 every 10 minutes to secure the blockchain (in practice it is a lot more, there are several exceptions). One such exception is the expectation of token value appreciation – that is to say that if Bob the miner believes that a bitcoin’s value is $1000, but the price is currently $500, Bob is still willing to expend up to $1000 for mining each bitcoin, discounted by his internal calculation for the probability that bitcoin will rise to that price. However, if colored coins are adopted and used via the built-in scripting methods, there is potential for a seemingly unlimited amount of assets to be traded on the Bitcoin network. If these several thousand colored coin users add additional value, this creates an incentive for attackers to attack the network through colored coin-based double-spending attacks.

For example, where each of these 10,000 users places the title of a 2010 Camry each valued at $10,000 that would theoretically add $100 million in value that the network is transferring, but for which miners are not being proportionally rewarded or paid to secure those assets. As a consequence, over time as tens of thousands of assets – and functionality – are added to the network, the gap between mining reward value and enterprise value widens which creates a vulnerability, an economic incentive for criminals to use hashrate to attack the network. A rogue attacker could sell an asset and build a competing tree (consensus in Bitcoin is based on whatever is the longest tree of blocks). After a successful 51% attack, the rogue attacker could then broadcast a fake chain built without the corresponding asset, having switched it out thus effectively double-spending. And if the total value that the network is transacting is at least twice as much as bitcoin value is, then there is a financial incentive for rogue participants to attack the network. The impact of a successful attack involves a lot of speculation and will likely fill continue to provide researchers many more volumes of conjecture and modeling.

Money for nothing

This scenario raises the question: what then is the potential divergence in value between bitcoin the currency and bitcoin the network (which can transfer and protect other data)? This issue only presents itself now as, previously, only bitcoins – and no other apps, assets or instruments – existed on the network. This gives rise to a coordination problem because miners would have to also keep track of the color, keep track of the exchanges the color is being traded on, and keep track of the settlement price (if there is such a thing) so that they could adequately gauge market clearing prices and readjust the coinbase reward every 10 minutes.  Again, even if this coordination problem is solved the seigniorage reward does not increase – the current fixed income does not reflect the actual value being transacted on the network.  So colored coins on a fully decentralized network could end up on an undersecured network of their own making with the only solution: recode the block rewards based on the value of the color and this presents a number of technical and social engineering challenges. In some ways this issue is related to the hypothetical economic disconnection between blacklisted and whitelisted tokens (due to Coin Validation) – a blacklisted token would be sold for less than what a whitelisted token would sell for.

A follow-up question that the community will likely debate is: Why wouldn’t the value of a bitcoin increase as items of value are transferred on the blockchain via colored coins or another protocol, such that the miner’s block rewards would adequately compensate the miners? According to Preston Byrne, a securitization attorney in London the answer to this is “that the value of bitcoin used in a colored coin transaction does not need to bear any relationship to the value of the associated asset – the network is being used to transmit information, and that information represents rights, and is the rights – not the token – which are valuable.” If the price of bitcoin does not adequately incentivize the miners, then there will be a difference between value of a bitcoin and the network and then some entity will have to step in to compensate for that difference. Whether collective action is sufficient to provide this compensation is currently unknown but there are coordination problems inherent in this model that would make this difficult.

In contrast, the Ripple protocol, sidechains and perhaps even a proof-of-stake system could probably alleviate at least this specific concern. These alternative consensus mechanisms have one advantage to hash-based proof of work systems like Bitcoin, at least for the transfer of non-crypto value (i.e., colored coins).  For instance, Ripple’s distributed consensus mechanism allows users to exchange assets via gateways without needing to proportionally incentivize the security labor force. This is not necessarily an endorsement of this particular platform, rather it serves as examples of how it is immune to that particular attack vector.

Alternative approaches to network security

I reached out to several experts for their views on this issue. According to Robert Sams, founder of Krtyptonomic and Cryptonomics:

One of the arguments against the double-spend and 51% attacks is that it needs to incorporate the effect a successful attack would have on the exchange rate. As coloured coins represent claims to assets whose value will often have no connection to the exchange rate, it potentially strengthens the attack vector of focusing a double spend on some large-value colour. But then, I’ve always thought the whole double-spend thing could be reduced significantly if both legs of the exchange were represented on a single tx (buyer’s bitcoin and seller’s coloured coin).

The other issue concerns what colour really represents. The idea is that colour acts like a bearer asset, whoever possesses it owns it, just like bitcoin. But this raises the whole blacklisted coin question that you refer to in the paper. Is the issuer of colour (say, a company floating its equity on the blockchain) going to pay dividends to the holder of a coloured coin widely believed to have been acquired through a double-spend? With services like Coin Validation, you ruin fungibility of coins that way, so all coins need to be treated the same (easy to accomplish if, say, the zerocoin protocol were incorporated). But colour? The expectations are different here, I believe.

On a practical level, I just don’t see how psudo-anonymous colour would ever represent anything more than fringe assets. A registry of real identities mapping to the public keys would need to be kept by someone. This is certainly the case if you ever wanted these assets to be recognised by current law.

But in a purely binary world where this is not the case, I would expect that colour issuers would “de-colour” coins it believed were acquired through double-spend, or maybe single bitcoin-vs-colour tx would make that whole attack vector irrelevant anyway. In which case, we’re back to the question of what happens when the colour value of the blockchain greatly exceeds that of the bitcoin monetary base? Who knows, really depends on the details of the colour infrastructure. Could someone sell short the crypto equity market and launch a 51% attack? I guess, but then the attacker is left with a bunch of bitcoin whose value is…

The more interesting question for me is this: what happens to colour “ownership” when the network comes under 51% control? Without a registry mapping real identities to public keys, a psudo-anonymous network of coloured assets on a network controlled by one guy is just junk, no longer represents anything (unless the 51% hasher is benevolent of course). Nobody can make a claim on the colour issuer’s assets. So perhaps this is the real attack vector: a bunch of issuers get together (say, they’re issuers of coloured coin bonds) to launch a 51% attack to extinguish their debts. If the value of that colour is much greater than cost of hashing 51% of the network, that attack vector seems to work.

In other words, while these new financial instruments could technically be exchanged in a trustless manner, the current protocol cannot automatically incentivize their protection or account for their enterprise value, the equivalent of using a mall security guard to protect Fort Knox. While miners may be able to protect against amateurish shoplifters or even unorganized cat burglars, once organized criminals calculate and realize that one “color” asset is worth the economic effort of attacking the vault they may try to do so.   And because the blockchain is public and color assets could be known to the world-at-large, taking the Fort Knox analogy further, this would be like a mall cop standing in front of the contents of Fort Knox piled up on an open field (or behind a see-through glass vault). It is an attempt to guard the Crown jewels not in a fortress with armed guards, tanks and turrets, but with Paul Blart.

On this point, Jonathan Levin, co-founder of Coinometrics explained that:

We don’t know how much proof of work is enough for the existing system and building financially valuable layers on top do not contribute any economic incentives to secure the network further. These incentives are fixed in terms of Bitcoin – which may lead to an interesting result where people who are dependent on coloured coin implementations hoard bitcoins to attempt to and increase the price of Bitcoin and thus provide incentives to miners.

It should also be noted that the engineers and those promoting extensibility such as colored coins do not see the technology as being limited in this way. If all colored coins can represent is ‘fringe assets’ then the level of interest in them would be minimal. Time will tell whether this is the case. Yet if Bob could decolor assets, in this scenario, an issuer of a colored coin has (inadvertently) granted itself the ability to delegitimize the bearer assets as easily as it created them.  And arguably, decoloring does not offer Bob any added insurance that the coin has been fully redeemed, it is just an extra transaction at the end of the round trip to the issuer. That is an implicit negative for investors and users.  This raises some concerns in the future, if a party had the ability to invalidate Bitcoin accounts based on their own criteria that the miners might gain an influence over the colored coins and may bias various aspects of the economy incentivized through some kind of backchannel payment.  For instance, BitUndo is a new “double spending as a service” project that is trying to do just that, provide a way for users to send transactions to a mining pool in an attempt to reverse transactions something that has created a flurry of reactions in the community. In the end, colored coins ends up being expensive through imposed TX fees, and thus becomes less attractive to issuers and users.

According to Alex Mizrahi, lead developer of Chromawallet a colored coin project:

It is true that currently block subsidy has a significant impact on network’s security, but it is not meant to work this way in the long run.

We’ll go through 5 subsidy halvings in next 20 years, at that point block subsidy will be around 0.78 BTC. Reward miners get from fees is already on that scale (e.g. 0.134 BTC here) even though blocks aren’t full yet.

So transaction fees are going to play bigger role than subsidy. And value of those fees is linked to usefulness of transactions (i.e. value of those transactions) rather than to exchange rate.

Colored coins increase incentive to attack, but they also increase usefulness of transactions, thus it isn’t clear whether they will have negative or positive impact on network security.

A couple other comments: “Script” is not required for colored coins, they work with very plain bitcoin transactions too. The incentive structure for bitcoin mining sucks from security perspective anyway, so I hope we’ll eventually upgrade to a better protocol (e.g. including proof-of-stake) regardless of colored coin woes. And merged-mined sidechains will have even worse problems unless they are ‘hardened’ in some way.

I also contacted Jack Wang, co-founder of Bitfoo, a hosted wallet that was the first to implement proof-of-reserves. In his view:

The security of the network depends on the aggregate hashing power.  In one method of implementation, if Colored Coins could pay just one pool, say Eligius, extra to prioritize their transactions, but Eligius had only, say 25% of the network power, then the rest of the network could collectively decide to exclude the blocks that Eligius mined.  This makes some sense to me since Eligius itself couldn’t secure the network, yet is the only pool extracting the extra value out of Colored Coins.  Colored Coins would need to distribute the extra rents to at least 50% of the network, and unless this lies within one pool then this is a danger to the Bitcoin network, but if it is 2 or more, this requires coordination and introduces potential holdout problems.

A more natural way to implement this would be that colored coins users would pay higher transaction fees on their own so that any and all miners that included those transactions in their blocks would get more fees. But unless those fees are mandated by colored coins, what is the incentive for individual colored coins users to pay extra?

Towards a more functional future

While this is a speculative issue, what is knowable is that the economics behind it are math-based and built into these protocols. What is also known is that some proposed solutions should be easier to implement than others. For instance, Bitcoin developers could fork the code and create a proof-of-stake ledger proposed by Stephen Reed. Alternatively, because this new extensibility could create fungibility issues, a different – and admittedly impractical – solution might be for mining pools to utilize a trusted Oracle data feed to colored coin exchanges and adjust mining rewards accordingly. Perhaps removing scripts entirely and relying on merge-mined sidechains, instead, could alleviate this potential pain point as well.

What is definitely known is that market participants have every incentive to keep miners mining. If fees are floated users will likely pay higher transaction fees if they do not want miners to go elsewhere. While speculative, colored coins users could become the biggest payer of transaction fees, though in practice, most users do not like paying any fee. Over the past several months this is an issue that Mastercoin and Counterparty developers have promoted: pay the miners higher fees for access to these new platforms because miners expect the value of these special transactions to go beyond the excess of bitcoin transactions. Miners could potentially auction block priority to these transactions over regular bitcoin transactions. One pool, Eligius, operated by Luke-Jr is already filtering out specific bitcoin transaction today. In conclusion, the interaction between second-generation blockchain technology and first-generation incentive mechanisms will continue to be thought-provoking. It is certainly an issue to keep one’s eye on in the coming years.

[Note: I would like to thank Preston Byrne, Petri Kajander and Taariq Lewis for their comments; and Joshua Zeidner for bringing this issue to my attention and for his extensive feedback.]