Buckets of Permissioned, Permissionless, and Permissioned Permissionlessness Ledgers

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

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Learning from the past to build an improved future of fintech

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why you may ask?

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

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

But lemonade can still be squeezed from it.

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

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

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

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

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

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

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

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

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

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

Thanks for your time.

Endnotes:

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

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

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

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

The past

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

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

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

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

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

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

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

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

The present

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

For example:

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

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

Yet, a couple weeks ago Fred Wilson wrote that:

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

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

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

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

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

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

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

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

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

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

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

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

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

Permissioned Permissionlessness, BINO-style

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

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

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

Thus:

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

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

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

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

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

Ask the experts

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The future

What about tokens?

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

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

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

What attracts or repels use-cases then?

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

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

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

Endnotes

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

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

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

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

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Bram Cohen: “Removing the Waste from Cryptocurrencies: Challenges and More Challenges”

Bram Cohen, the creator of BitTorrent, has opined on Bitcoin over the years on social media (such as Twitter).  Over the last couple of weeks he has been increasingly vocal on some hurdles such as the increase in block sizes (via a hard fork) and the dangers of accepting and institutionalizing zero-confirmation transactions.

Last week he gave a presentation at the SF Bitcoin Dev meetup in which he covered a variety of alternatives to proof-of-work such as proof-of-steak (which he dubs “Cow systems”).

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Book review: The Age of Cryptocurrency

On my trip to Singapore two weeks ago I read through a new book The Age of Cryptocurrency, written by Michael Casey and Paul Vigna — two journalists with The Wall Street Journal.

Let’s start with the good.  I think Chapter 2 is probably the best chapter in the book and the information mid-chapter is some of the best historical look on the topic of previous electronic currency initiatives.  I also think their writing style is quite good.  Sentences and ideas flow without any sharp disconnects.  They also have a number of endnotes in the back for in-depth reading on certain sub-topics.

In this review I look at each chapter and provide some counterpoints to a number of the claims made.

Note: I manually typed the quotes from the book, all transcription errors are my own and should not reflect on the book itself.  See my other book reviews.

age of cryptocurrencyIntroduction

The book starts by discussing a company now called bitLanders which pays content creators in bitcoin.  The authors introduce us to Francesco Rulli who pays his bloggers in bitcoin and tries to forbid them from cashing out in fiat, so that they create a circular flow of income.1 One blogger they focus on is Parisa Ahmadi, a young Afghani woman who lacks access to the payment channels and platforms that we take for granted.  It is a nice feel good story that hits all the high notes.

Unfortunately the experience that individuals like Ahmadi, are not fully reflective of what takes place in practice (and this is not the fault of bitLanders).

For instance, the authors state on p. 2 that:

“Bitcoins are stored in digital bank accounts or “wallets” that can be set up at home by anyone with Internet access.  There is no trip to the bank to set up an account, no need for documentation or proof that you’re a man.”

This is untrue in practice.  Nearly all venture capital (VC) funded hosted “wallets” and exchanges now require not only Know-Your-Customer (KYC) but in order for any type of fiat conversion, bank accounts.  Thus there is a paradox: how can unbanked individuals connect a bank account they do not have to a platform that requires it?  This question is never answered in the book yet it represents the single most difficult aspect to the on-boarding experience today.

Starting on page 3, the authors use the term “digital currency” to refer to bitcoins, a practice done throughout the remainder of the book.  This contrasts with the term “virtual currency” which they only use 12 times — 11 of which are quotes from regulators.  The sole time “virtual currency” is not used by a regulator to describe bitcoins is from David Larimer from Invictus (Bitshares).  It is unclear if this was an oversight.

Is there a difference between a “digital currency” and “virtual currency”?  Yes.  And I have made the same mistake before.

Cryptocurrencies such as bitcoin are not digital currencies.  Digital currencies are legal tender, as of this writing, bitcoins are not.  This may seem like splitting hairs but the reason regulators use the term “virtual currency” still in 2015 is because no jurisdiction recognizes bitcoins as legal tender.

In contrast, there are already dozens of digital currencies — nearly every dollar that is spent on any given day in the US is electronic and digital and has been for over a decade.  This issue also runs into the discussion on nemo dat described a couple weeks ago.

On page 4 the authors very briefly describe the origination of currency exchange which dates back to the Medici family during the Florentine Renaissance.  Yet not once in the book is the term “bearer asset” mentioned.  Cryptocurrencies such as bitcoin are virtual bearer instruments and as shown in practice, a mega pain to safely secure.

500 years ago bearer assets were also just as difficult to secure and consequently individuals outsourced the security of it to what we now call banks.  And this same behavior has once again occurred as large quantities — perhaps the majority — of bitcoins now are stored in trusted third party depositories such as Coinbase and Xapo.

Why is this important?

Again recall that the term “trusted third party” was used 11 times (in the body, 13 times altogether) in the original Nakamoto whitepaper; whoever created Bitcoin was laser focused on building a mechanism to route around trusted third parties due to the additional “mediation and transaction costs” (section 1) these create.  Note: that later on page 29 they briefly mentioned legal tender laws and coins (as it related to the Roman Empire).

On page 8 the authors describe the current world as “tyranny of centralized trust” and on page 10 that “Bitcoin promises to take at least some of that power away from governments and hand it to the people.”

While that may be a popular narrative on social media, not everyone involved with Bitcoin (or the umbrella “blockchain” world) holds the same view.  Nor do the authors describe some kind of blue print for how this is done.  Recall that in order to obtain bitcoins in the first place a user can do one of three things:

  1. mine bitcoins
  2. purchase bitcoins from some kind of exchange
  3. receive them for payments (e.g., merchant activity)

In practice mining is out of the hands of “the people” due to economies of scale which have trended towards warehouse mining – it is unlikely that embedded ASICs such as from 21 inc, will change that dynamic much, if any.  Why?  Because for every device added to the network a corresponding amount of difficulty is also added, diluting the revenue to below dust levels.

Remember how Tom Sawyer convinced kids to whitewash a fence and they did so eagerly without question?  What if he asked you to mine bitcoins for him for free?  A trojan botnet?  While none of the products have been announced and changes could occur, from the press release that seems to be the underlying assumption of the 21.co business model.

In terms of the second point, nearly all VC funded exchanges require KYC and bank accounts.  The ironic aspect is that “unbanked” and “underbanked” individuals often lack the necessary “valid” credentials that can be used by cheaper automated KYC technology (from Jumio) and thus expensive manual processing is done, costs that must be borne by someone.  These same credential-less individuals typically lack a bank account (hence the name “unbanked”).

Lastly with the third point, while there are any number of merchants that now accept bitcoin, in practice very few actually do receive bitcoins on any given day.  Several weeks ago I broke down the numbers that BitPay reported and the verdict is payment processing is stagnant for now.

Why is this last point important to what the authors refer to as “the people”?

Ten days after Ripple Labs was fined by FinCEN for not appropriately enforcing AML/KYC regulations, Xapo  — a VC funded hosted wallet startup — moved off-shore, uprooting itself from Palo Alto to Switzerland.  While the stated reason is “privacy” concerns, it is likely due to regulatory concerns of a different nature.

In his interview with CoinDesk last week, Wences Casares, the CEO and founder of Xapo noted that:

Still, Casares indicated that Xapo’s customers are most often using its accounts primarily for storage and security. He noted that many of its clientele have “never made a bitcoin payment”, meaning its holdings are primarily long-term bets of high net-worth customers and family offices.

“Ninety-six percent of the coins that we hold in custody are in the hands of people who are keeping those coins as an investment,” Casares continued.

96% of the coins held in custody by Xapo are inert.  According to a dated presentation, the same phenomenon takes place with Coinbase users too.

Perhaps this behavior will change in the future, though, if not it seems unclear how this particular “to the people” narrative can take place when few large holders of a static money supply are willing to part with their virtual collectibles.  But this dovetails into differences of opinion on rebasing money supplies and that is a topic for a different post.

On page 11 the authors describe five stages of psychologically accepting Bitcoin.  In stage one they note that:

Stage One: Disdain.  Not even denial, but disdain.  Here’s this thing, it’s supposed to be money, but it doesn’t have any of the characteristics of money with which we’re familiar.

I think this is unnecessarily biased.  While I cannot speak for other “skeptics,” I actually started out very enthusiastic — I even mined for over a year — and never went through this strange five step process.  Replace the word “Bitcoin” with any particular exciting technology or philosophy from the past 200 years and the five stage process seems half-baked at best.

On page 13 they state:

“Public anxiety over such risks could prompt an excessive response from regulators, strangling the project in its infancy.”

Similarly on page 118 regarding the proposed New York BitLicense:

“It seemed farm more draconian than expected and prompted an immediate backlash from a suddenly well-organized bitcoin community.”

This is a fairly alarmist statement.  It could be argued that due to its anarchic code-as-law coupled with its intended decentralized topology, that it could not be strangled.  If a certain amount of block creating processors (miners) was co-opted by organizations like a government, then a fork would likely occur and participants with differing politics would likely diverge.

A KYC chain versus an anarchic chain (which is what we see in practice with altchains such as Monero and Dash).  Similarly, since there are no real self-regulating organizations (SRO) or efforts to expunge the numerous bad actors in the ecosystem, what did the enthusiasts and authors expect would occur when regulators are faced with complaints?

With that said — and I am likely in a small minority here — I do not think the responses thus far from US regulators (among many others) has been anywhere near “excessive,” but that’s my subjective view.  Excessive to me would be explicitly outlawing usage, ownership and mining of cryptocurrencies.  Instead what has occurred is numerous fact finding missions, hearings and even appearances by regulators at events.

On page 13 the authors state that:

“Cryptocurrency’s rapid development is in some ways a quirk of history: launched in the throes of the 2008 financial crisis, bitcoin offered an alternative to a system — the existing financial system — that was blowing itself up and threatening to take a few billion people down with it.”

This is retcon.  Satoshi Nakamoto, if he is to be believed, stated that he began coding the project in mid-2007.  It is more of a coincidence than anything else that this project was completed around the same time that global stock indices were at their lowest in decades.

Chapter 1

On page 21 the authors state that:

“Bitcoin seeks to address this challenge by offering users a system of trust based not on human being but on the inviolable laws of mathematics.”

While the first part is true, it is a bit cliche to throw in the “maths” reason.  There are numerous projects in the financial world alone that are run by programs that use math.  In fact, all computer programs and networks use some type of math at their foundation, yet no one claims that the NYSE, pace-makers, traffic intersections or airplanes are run by “math-based logic” (or on page 66, “”inviolable-algorithm-based system”).

A more accurate description is that Bitcoin’s monetary system is rule-based, using a static perfectly inelastic supply in contrast to either the dynamic or discretionary world humans live in.  Whether this is desirable or not is a different topic.

On page 26 they describe the Chartalist school of thought, the view that money is political, that:

“looks past the thing of currency and focuses instead on the credit and trust relationships between the individual and society at large that currency embodies” […] “currency is merely the token or symbol around which this complex system is arranged.”

This is in contrast to the ‘metallist’ mindset of some others in the Bitcoin community, such as Wences Casares and Jon Matonis (perhaps there is a distinct third group for “barterists”?).

I thought this section was well-written and balanced (e.g., appropriate citation of David Graeber on page 28; and description of what “seigniorage” is on page 30 and again on page 133).

On page 27 the authors write:

Yet many other cryptocurrency believers, including a cross section of techies and businessmen who see a chance to disrupt the bank centric payments system are de facto charatalists.  They describe bitcoin not as a currency but as a payments protocol.

Perhaps this is true.  Yet from the original Nakamoto whitepaper, perhaps he too was a chartalist?

Stating in section 1:

Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non-reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.

A payments rail, a currency, perhaps both?

Fun fact: the word “payment” appears 12 times in the whole white paper, just one time less than the word “trust” appears.

On page 29 they cite the Code of Hammurabi.  I too think this is a good reference, having made a similar reference to the Code in Chapter 2 of my book last year.

On page 31 they write:

“Today, China grapples with competition to its sovereign currency, the yuan, due both to its citizens’ demand for foreign national currencies such as the dollar and to a fledgling but potentially important threat from private, digital currencies such as bitcoin.”

That is a bit of a stretch.  While Chinese policy makers do likely sweat over the creative ways residents breach and maneuver around capital controls, it is highly unlikely that bitcoin is even on the radar as a high level “threat.”  There is no bitcoin merchant economy in China.

The vast majority of activity continues to be related to mining and trading on exchanges, most of which is inflated by internal market making bots (e.g., the top three exchanges each run bots that dramatically inflate the volume via tape painting).  And due to how WeChat and other social media apps in China frictionlessly connect residents with their mainland bank accounts, it is unlikely that bitcoin will make inroads in the near future.

On page 36 they write:

“By 1973, once every country had taken its currency off the dollar peg, the pact was dead, a radical change.”

In point of fact, there are 23 countries that still peg their currency to the US dollar.  Post-1973 saw a number of flexible and managed exchange rate regimes as well as notable events such as the Plaza Accord and Asian Financial Crisis (that impacted the local pegs).

On page 39 they write:

“By that score, bitcoin has something to offer: a remarkable capacity to facilitate low-cost, near-instant transfer of value anywhere in the world.”

The point of contention here is the “low-cost” — something that the authors never really discuss the logistics of.  They are aware of “seigniorage” and inflationary “block rewards” yet they do not describe the actual costs of maintaining the network which in the long run, the marginal costs equal the marginal value (MC=MV).

This is an issue that I tried to bring up with them at the Google Author Talk last month (I asked them both questions during the Q&A):

The problem for Vigna’s view, (starting around 59m) is that if the value of a bitcoin fell to $30, not only would the network collectively “be cheaper” to maintain, but also to attack.

On paper, the cost to successfully attack the network today by obtaining more than 50% of the hashrate at this $30 price point would be $2,250 per hour (roughly 0.5 x MC) or roughly an order of magnitude less than it does at today’s market price (although in practice it is a lot less due to centralization).

Recall that the security of bitcoin was purposefully designed around proportionalism, that in the long run it costs a bitcoin to secure a bitcoin.  We will talk about fees later at the end of next chapter.

Chapter 2

On page 43, in the note at the bottom related to Ray Dillinger’s characterization that bitcoin is “highly inflationary” — Dillinger is correct in the short run.  The money supply will increase by 11% alone this year.  And while in the long run the network is deflationary (via block reward halving), the fact that the credentials to the bearer assets (bitcoins) are lost and destroyed each year results in a non-negligible amount of deflation.

For instance, in chapter 12 I noted some research: in terms of losing bitcoins, the chart below illustrates what the money supply looks like with an annual loss of 5% (blue), 1% (red) and 0.1% (green) of all mined bitcoins.

lost coins

Source: Kay Hamacher and Stefan Katzenbeisser

In December 2011, German researchers Kay Hamacher and Stefan Katzenbeisser presented research about the impact of losing the private key to a bitcoin. The chart above shows the asymptote of the money supply (Y-axis) over time (X-axis).

According to Hamacher:

So to get rid of inflation, they designed the protocol that over time, there is this creation of new bitcoins – that this goes up and saturates at some level which is 21 million bitcoins in the end.

But that is rather a naïve picture. Probably you have as bad luck I have, I have had several hard drive crashes in my lifetime, and what happens when your wallet where your bitcoins are stored and your private key vanish? Then your bitcoins are probably still in the system so to speak, so they are somewhat identifiable in all the transactions but they are not accessible so they are of no economic value anymore. You cannot exchange them because you cannot access them. Or think more in the future, someone dies but his family doesn’t know the password – no economic value in those bitcoins anymore. They cannot be used for any exchange anymore. And that is the amount of bitcoins when just a fraction per year vanish for different fractions. So the blue curve is 5% of all the bitcoins per year vanish by whatever means there could be other mechanisms.

It is unclear exactly how many bitcoins can be categorized in such a manner today or what the decay rate is.

On page 45 the authors write:

Some immediately homed in on a criticism of bitcoin that would become common: the energy it would take to harvest “bitbux” would cost more than they were worth, not to mention be environmentally disastrous.

While I am unaware of anyone who states that it would cost more than what they’re worth, as stated in Appendix B and in Chapter 3 (among many other places), the network was intentionally designed to be expensive, otherwise it would be “cheap to attack.”  And those costs scale in proportion to the token value.

As noted a few weeks ago:

For instance, last year O’Dwyer and Malone found that Bitcoin mining consumes roughly the same amount of energy as Ireland does annually.  It is likely that their estimate was too high and based on Dave Hudson’s calculations closer to 10% of Ireland’s energy consumption.23 Furthermore, it has likely declined since their study because, as previously explored in Appendix B, this scales in proportion with the value of the token which has declined over the past year.

The previous post looked at bitcoin payments processed by BitPay and found that as an aggregate the above-board activity on the Bitcoin network was likely around $350 million a year.  Ireland’s nominal GDP is expected to reach around $252 billion this year.  Thus, once Hudson’s estimates are integrated into it, above-board commercial bitcoin activity appears to be about two orders of magnitude less than what Ireland produces for the same amount of energy.

Or in other words, the original responses to Nakamoto six and a half years ago empirically was correct.  It is expensive and resource intensive to maintain and it was designed to be so, otherwise it would be easy to attack, censor and modify the history of votes.

Starting on page 56 they describe Mondex, Secure Electronic Transaction (SET), Electronic Monetary System, Citi’s e-cash model and a variety of other digital dollar systems that were developed during the 1990s.  Very interesting from a historical perspective and it would be curious to know what more of these developers now think of cryptocurrency systems.  My own view, is that the middle half of Chapter 2 is the best part of the book: very well researched and well distilled.

On page 64 they write:

[T]hat Nakamoto launched his project with a reminder that his new currency would require no government, no banks and no financial intermediaries, “no trusted third party.”

In theory this may be true, but in practice, the Bitcoin network does not natively provide any of the services banks do beyond a lock box.  There is a difference between money and the cornucopia of financial instruments that now exist and are natively unavailable to Bitcoin users without the use of intermediaries (such as lending).

On page 66 they write:

He knew that the ever-thinning supply of bitcoins would eventually require an alternative carrot to keep miners engaged, so he incorporated a system of modest transaction fees to compensate them for the resources they contributed.  These fees would kick in as time went on and as the payoff for miners decreased.

That’s the theory and the popular narrative.

However, what does it look like in practice?

Above is a chart visualizing fees to miners denominated in USD from January 2009 to May 17, 2015.  Perhaps the fees will indeed increase to replace block rewards, or conversely, maybe as VC funding declines in the coming years, the companies that are willing and able to pay fees for each transaction declines.

On page 67, the authors introduce us to Laszlo Hanyecz, a computer programmer in Florida who according to the brief history of Bitcoin lore, purchased two Papa John’s pizzas for 10,000 bitcoins on May 22, 2010 (almost five years ago to the day).

He is said to have sold 40,000 bitcoins in this manner and generated all of the bitcoins through mining.  He claims to be the first person to do GPU mining, ramping up to “over 800 times” of a CPU; and during this time “he was getting about half of all the bitcoins mined.”  According to him, he originally used a Nvidia 9800 GTX+ and later switched to 2 AMD Radeon 5970s.  It is unclear how long he mined or when he stopped.

In looking at the index of his server, there are indeed relevant OpenCL software files.  If this is true, then he beat ArtForz to GPU mining by at least two months.

solar pizza

Source: Laszlo Hanyecz personal server

On page 77 they write:

Anybody can go on the Web, download the code for no cost, and start running it as a miner.

While technically this is true, that you can indeed download the Satoshi Bitcoin core client for free, restated in 2015 it is not viable for hoi polloi.  In practice you will not generate any bitcoins solo-mining on a desktop machine unless you do pooled mining circa 2011.

Today, even pooled mining with the best Xeon processors will be unprofitable.  Instead, the only way to generate enough funds to cover both the capital expenditures and operating expenditures is through the purchase of single-use hardware known as an ASIC miner, which is a depreciating capital good.

Mining has been beyond the breakeven reach of most non-savvy home users for two years now, not to mention those who live in developing countries with poor electrical infrastructure or uncompetitive energy rates.  It is unlikely that embedded mining devices will change that equation due to the fact that every additional device increases the difficultly level whilst the device hashrate remains static.

This ties in with what the authors also wrote on page 77:

You don’t buy bitcoin’s software as you would other products, which means you’re not just a customer.  What’s more, there’s no owner of the software — unlike, say, PayPal, which is part of eBay.

This is a bit misleading.  In order to use the Bitcoin network, users must obtain bitcoins somehow.  And in practice that usually occurs through trusted third parties such as Coinbase or Xapo which need to identify you via KYC/AML processes.

So while in 2009 their quote could have been true, in practice today that is largely untrue for most new participants — someone probably owns the software and your personal data.  In fact, a germane quote on reddit last week stated, “Why don’t you try using Bitcoin instead of Coinbase.”

Furthermore, the lack of “ownership” of Bitcoin is dual-edged as there are a number of public goods problems with maintaining development that will be discussed later.

On page 87 they describe Blockchain.info as a “high-profile wallet and analytics firm.”

I will come back to “wallets” later.  Note: most of these “wallets” are likely throwaway, temp wallets used to move funds to obfuscate provenance through the use of Shared Coin (one of the ways Blockchain.info generates revenue is by operating a mixer).

Overall Chapter 3 was also fairly informative.  The one additional quibble I have is that Austin and Beccy Craig (the story at the end) were really only able to travel the globe and live off bitcoins for 101 days because they had a big cushion: they had held a fundraiser that raised $72,995 of additional capital.  That is enough money to feed and house a family in a big city for a whole year, let alone go globe trotting for a few months.

Chapter 4

On page 99 they describe seven different entities that have access to credit card information when you pay for a coffee at Starbucks manually.  Yet they do not describe the various entities that end up with the personal information when signing up for services such as Coinbase, ChangeTip, Circle and Xapo or what these depository institutions ultimately do with the data (see also Richard Brown’s description of the payment card system).

When describing cash back rewards that card issuers provide to customers, on page 100 they write:

Still it’s an illusion to think you are not paying for any of this.  The costs are folded into various bank charges: card issuance fees, ATM fees, checking fees, and, of course, the interest charged on the millions of customers who don’t pay their balances in full each month.

Again, to be even handed they should also point out all the fees that Coinbase charges, Bitcoin ATMs charge and so forth.  Do any of these companies provide interest-bearing accounts or cash-back rewards?

On page 100 they also stated that:

Add in the cost of fraud, and you can see how this “sand in the cogs” of the global payment system represents a hindrance to growth, efficiency, and progress.

That seems a bit biased here.  And my statement is not defending incumbents: global payment systems are decentralized yet many provide fraud protection and insurance — the very same services that Bitcoin companies are now trying to provide (such as FDIC insurance on fiat deposits) which are also not free.

On page 100 they also write:

We need these middlemen because the world economy still depends on a system in which it is impossible to digitally send money from one person to another without turning to an independent third party to verify the identity of the customer and confirm his or her right to call on the funds in the account.

Again, in practice, this is now true for Bitcoin too because of how most adoption continues to take place on the edges in trusted third parties such as Coinbase and Circle.

On page 101 they write:

In letting the existing system develop, we’ve allowed Visa and MasterCard to form a de facto duopoly, which gives them and their banking partners power to manipulate the market, says Gil Luria, an analyst covering payment systems at Wedbush Securities.  Those card-network firms “not only get to extract very significant fees for themselves but have also created a marketplace in which banks can charge their own excessive fees,” he says.

Why is it wrong to charge fees for a service?  What is excessive?  I am certainly not defending incumbents or regulatory favoritism but it is unclear how Bitcoin institutions in practice — not theory — actually are any different.

And, the cost per transaction for Bitcoin is actually quite high (see chart below) relative to these other systems due to the fact that Bitcoin also tries to be a seigniorage system, something that neither Visa or MasterCard do.

cost per transaction

Source: Markos05

On page 102 when talking about MasterCard they state:

But as we’ve seen, that cumbersome system, as it is currently designed, is tightly interwoven into the traditional banking system, which always demands a cut.

The whole page actually is a series of apples-and-oranges comparisons.  Aside from settlement, the Bitcoin network does not provide any of the services that they are comparing it to.  There is nothing in the current network that provides credit/lending services whereas the existing “cumbersome” system was not intentionally designed to be cumbersome, but rather is intertwined and evolved over decades so that customers can have access to a variety of otherwise siloed services.

Again, this is not to say the situation cannot be improved but as it currently exists, Bitcoin does not provide a solution to this “cumbersome” system because it doesn’t provide similar services.

On page 102 and 103 they write about payment processors such as BitPay and Coinbase:

These firms touted a new model to break the paradigm of merchants’ dependence on the bank-centric payment system described above.  These services charged monthly fees that amounted to significantly lower transaction costs for merchants than those charged in credit-card transactions and delivered swift, efficient payments online or on-site.

Except this is not really true.  The only reason that both BitPay and Coinbase are charging less than other payment processors is that VC funding is subsidizing it.  These companies still have to pay for customer service support and fraud protection because customer behavior in aggregate is the same.  And as we have seen with BitPay numbers, it is likely that BitPay’s business model is a losing proposition and unsustainable.

On page 103 they mention some adoption metrics:

The good news is found in the steady expansion in the adoption of digital wallets, the software needed to send and receive bitcoins, with Blockchain and Coinbase, the two biggest providers of those, on track to top 2 million unique users each at the time of the writing.

This is at least the third time they talk about wallets this way and is important because it is misleading, I will discuss in-depth later.

Continuing they write that:

Blockchain cofounder Peter Smith says that a surprisingly large majority of its accounts — “many more than you would think,” he says cryptically — are characterized as “active.”

This is just untrue and should have been pressed by the authors.  Spokesman from Blockchain.info continue to publish highly inflated numbers.  For instance in late February 2015, Blockchain.info claimed that “over $270 million in bitcoin transactions occurred via its wallets over the past seven days.”

This is factually untrue.  As I mentioned three months ago:

Organ of Corti pointed out that the 7 day average was indeed ~720,000 bitcoins in total output volume (thus making) the weekly volume would be about “5e06 btc for the network.”

Is it valid to multiply the total output volume by USD (or euros or yen)?  No.

Why not?  Because most of this activity is probably a combination of wallet shuffling, laundering and mixing of coins (e.g., use of SharedSend and burner wallets) or any number of superfluous activity.  It was not $270 million of economic trade.

Blockchain.info’s press release seems to be implying that economic trade is taking place, in which all transactions are (probably) transactions to new individuals when in reality it could simply be a lot of “change” address movement.  And more to the point, the actual internal volume looks roughly the same as has been the past few months (why issue a press release now?).

Continuing on page 103 they write:

“For the first eight months months of 2014, around $50 million per day was passing thought the bitcoin network (some of which was just “change” that bitcoin transactions create as an accounting measure)…”

There is a small typo above (in bold) but the important part is the estimate of volume.  There is no public research showing a detailed break down of average volume of economic activity.  Based on a working paper I published four months ago, it is fairly clear that this figure is probably in the low millions USD at most.  Perhaps this will change in the future.

On page 106 they write about Circle and Xapo:

For now, these firms make no charge to cover costs of insurance and security, betting that enough customers will be drawn to them and pay fees elsewhere — for buying and selling bitcoins, for example — or that their growing popularity will allow them to develop profitable merchant-payment services as well.  But over all, these undertaking must add costs back into the bitcoin economy, not to mention a certain dependence on “trusted third parties.”  It’s one of many areas of bitcoin development — another is regulation — where some businessmen are advocating a pragmatic approach to bolstering public confidence, one that would necessitate compromises on some of the philosophical principles behind a model of decentralization.  Naturally, this doesn’t sit well with bitcoin purists.

While Paul Vigna may not have written this, he did say something very similar at the Google Author Talk event (above in the video).

The problem with this view is that it is a red herring: this has nothing to do with purism or non-purism.

The problem is that Bitcoin’s designer attempted to create a ‘permissionless’ system to accommodate pseudonymous actors.  The entire cost structure and threat model are tied to this.  If actors are no longer pseudonymous, then there is no need to have this cost structure, or to use proof-of-work at all.  In fact, I would argue that if KYC/KYM (Know Your Miner) are required then a user might just as well use a database or permissioned system.  And that is okay, there are businesses that will be built around that.

This again has nothing to do with purism and everything to do with the costs of creating a reliable record of truth on a public network involving unknown, untrusted actors.  If any of those variables changes — such as adding real-world identity, then from a cost perspective it makes little sense to continue using the modified network due to the intentionally expensive proof-of-work.

On page 107 they talk about bitcoin price volatility discussing the movements of gasoline.  The problem with this analogy is that no one is trying to use gasoline as money.  In practice consumers prefer purchasing power stability and there is no mechanism within the Bitcoin network that can provide this.

For instance:

volatility 1volatility 2volatility 3The three slides above are from a recent presentation from Robert Sams.  Sams previously wrote a short paper on “Seigniorage Shares” — an endogenous way to rebase for purchasing power stability within a cryptocurrency.

Bitcoin’s money supply is perfectly inelastic therefore the only way to reflect changes in demand is through changes in price.  And anytime there are future expectations of increased or decreased utility, this is reflected in prices via volatility.

Oddly however, on page 110, they write:

A case can be made that bitcoin’s volatility is unavoidable for the time being.

Yet they do not provide any evidence — aside from feel good “Honey Badger” statements — for how bitcoin will somehow stabilize.  This is something the journalists should have drilled down on, talking to commodity traders or some experts on fuel hedging strategies (which is something airline companies spend a great deal of time and resources with).

Instead they cite Bobby Lee, CEO of BTC China and Gil Luria once again.  Lee states that “Once its prices has risen far enough and bitcoin has proven itself as a store of value, then people will start to use it as a currency.”

This is a collective action problem.  Because all participants each have different time preferences and horizons — and are decentralized — this type of activity is actually impossible to coordinate, just ask Josh Garza and the $20 Paycoin floor.  This also reminds me of one of my favorite comments on reddit: “Bitcoin will stabilize in price then go to the moon.”

The writers then note that, “Gil Luria, the Wedbush analyst, even argues that volatility is a good thing, on the grounds that it draws profit-seeking traders into the marketplace.”

But just because you have profit-seeking traders in the market place does not mean volatility disappears.

trading view

Credit: George Samman

For instance, in the chart above we can see how bitcoin trades relative to commodities over the past year:

  • Yellow is DBC
  • Red is OIL
  • Bars are DXY which is a dollar index
  • And candlesticks are BTCUSD
DBC is a commodities index and the top 10 Holdings (85.39% of Total Assets):
  • Brent Crude Futr May12 N/A 13.83
  • Gasoline Rbob Fut Dec12 N/A 13.71
  • Wti Crude Future Jul12 N/A 13.56
  • Heating Oil Futr Jun12 N/A 13.20
  • Gold 100 Oz Futr Dec 12 N/A 7.49
  • Sugar #11(World) Jul12 N/A 5.50
  • Corn Future Dec12 N/A 5.01
  • Lme Copper Future Mar13 N/A 4.55
  • Soybean Future Nov12 N/A 4.38
  • Lme Zinc Future Jul12

It bears mentioning that Ferdinando Ametrano has also described this issue in depth most recently in a presentation starting on slide 15.

Continuing on page 111, the writers note that:

Over time, the expansion of these desks, and the development of more and more sophisticated trading tools, delivered so much liquidity that exchange rates became relatively stable.  Luria is imagining a similar trajectory for bitcoin.  He says bitcoiners should be “embracing volatility,” since it will help “create the payment network infrastructure and monetary base” that bitcoin will need in the future.

There are two problems with Luria’s argument:

1) As noted above, this does not happen with any other commodity and historically nothing with a perfectly inelastic supply

2) Empirically, as described by Wences Casares above, nearly all the bitcoins held at Xapo (and likely other “hosted wallets”) are being held as investments.  This reduces liquidity which translates into volatility due to once again the inability to slowly adjust the supply relative to the shifts in demand.  This ties into a number of issues discussed in, What is the “real price” of bitcoin? that are worth revisiting.

Also on page 111, they write that “the exchange rate itself doesn’t matter.”

Actually it does.  It directly impacts two things:

1) outside perception on the health of Bitcoin and therefore investor interest (just talk to Buttercoin);

2) on a ten-minute basis it impacts the bottom line of miners.  If prices decline, so to is the incentive to generate proof-of-work.  Bankruptcy, as CoinTerra faces, is a real phenomenon and if prices decline very quickly then the security of the network can also be reduced due to less proof-of-work being generated

Continuing on page 111:

It’s expected that the mirror version of this will in time be set up for consumers to convert their dollars into bitcoins, which will then immediately be sent to the merchant.  Eventually, we could all be blind to these bitcoin conversions happening in the middle of all our transactions.

It’s unfortunate that they do not explain how this will be done without a trusted third party, or why this process is needed.  What is the advantage of going from USD-> paying a conversion fee -> BTC -> conversion fee -> back into USD?  Why not just spend USD and cut out the Bitcoin middleman?

Lastly on page 111:

Still, someone will have to absorb the exchange-rate risk, if not the payment processors, then the investors with which they trade.

The problem with this is that its generally not in the mandate or scope of most VC firms to purchase commodities or currencies directly.  In fact, they may even need some kind of license to do so depending on the jurisdiction (because it is a foreign exchange play).  Yet expecting the payment processors to shoulder the volatility is probably a losing proposition: in the event of a protracted bear market how many bitcoins at BitPay — underwater or not — will need to be liquidated to pay for operating costs?4

On page 112 they write:

‘Bitcoin has features from all of them, but none in entirety.  So, while it might seem unsatisfying, our best answer to the question of whether cryptocurrency can challenge the Visa and MasterCard duopoly is, “maybe, maybe not.”

On the face of it, it is a safe answer.  But upon deeper inspection we can probably say, maybe not.  Why?  Because for Bitcoin, once again, there is no native method for issuing credit (which is what Visa/MasterCard do with what are essentially micro-loans).

For example, in order to natively add some kind of lending facility within the Bitcoin network a new “identity” system would need to be built and integrated (to enable credit checks) — yet by including real-world “identity” it would remove the pseudonymity of Bitcoin while simultaneously maintaining the same costly proof-of-work Sybil protection.  This is again, an unnecessary cost structure entirely and positions Bitcoin as a jack-of-all-trades-but-master-of-none.  Why?  Again recall that the cost structure is built around Dynamic Membership Multi-Party Signature (DMMS); if the signing validators are static and known you might as well use a database or permissioned ledgers.

Or as Robert Sams recently explained, if censorship resistance is co-opted then the reason for proof-of-work falls to the wayside:

Now, I am sure that the advocates of putting property titles on the bitcoin blockchain will object at this point. They will say that through meta protocols and multi-key signatures, third party authentication of transaction parties can be built-in, and we can create a registered asset system on top of bitcoin. This is true. But what’s the point of doing it that way? In one fell swoop a setup like that completely nullifies the censorship resistance offered by the bitcoin protocol, which is the whole raison d’etre of proof-of-work in the first place! These designs create a centralised transaction censoring system that imports the enormous costs of a decentralised one built for censorship-resistance, the worst of both worlds.

If you are prepared to use trusted third parties for authentication of the counterparts to a transaction, I can see no compelling reason for not also requiring identity authentication of the transaction validators as well. By doing that, you can ditch the gross inefficiencies of proof-of-work and use a consensus algorithm of the one-node-one-vote variety instead that is not only thousands of times more efficient, but also places a governance structure over the validators that is far more resistant to attackers than proof-of-work can ever be.

On page 113, they write:

“the government might be able to take money out of your local bank account, but it couldn’t touch your bitcoin.  The Cyprus crisis sparked a stampede of money into bitcoin, which was now seen as a safe haven from the generalized threat of government confiscation everywhere.”

In theory this may be true, but in practice, it is likely that a significant minority — if not majority — of bitcoins are now held in custody at depository institutions such as Xapo, Coinbase and Circle.  And these are not off-limits to social engineering.  For instance, last week an international joint-task force confiscated $80,000 in bitcoins from dark web operators.  The largest known seizure in history were 144,000 bitcoins from Ross Ulbricht (Dread Pirate Roberts) laptop.

Similarly, while it probably is beyond the scope of their book, it would have been interesting to see a survey from Casey and Vigna covering the speculators during this early 2013 time frame.  Were the majority of people buying bitcoins during the “Cyprus event” actually worried about confiscation or is this just something that is assumed?  Fun fact: the largest transaction to BitPay of all time was on March 25, 2013 during the Cyprus event, amounting to 28,790 bitcoins.

On page 114, the writers for the first time (unless I missed it elsewhere), use the term “virtual currency.”  Actually, they quote FinCEN director Jennifer Calvery who says that FincCEN, “recognizes the innovation virtual currencies provide , and the benefits they might offer society.”

Again recall that most fiat currencies today are already digitized in some format — and they are legal tender.  In contrast, cryptocurrencies such as bitcoin are not legal tender and are thus more accurately classified as virtual currencies.  Perhaps that will change in the future.

On page 118 they note that, “More and more people opened wallets (more than 5 million as of this writing).”

I will get to this later.  Note that on p. 123 they say Coupa Cafe has a “digital wallet” a term used throughout the entire book.

Chapter 5

On page 124:

“Bitcoins exist only insofar as they assign value to a bitcoin address, a mini, one-off account with which people and firms send and receive the currency to and from other people’s firms’ addresses.”

This is actually a pretty concise description of best-practices.  In reality however, many individuals and organizations (such as exchanges and payment processors) reuse addresses.

Continuing on page 124:

“This is an important distinction because it means there’s no actual currency file or document that can be copied or lost.”

This is untrue.  In terms of security, the hardest and most expensive part in practice is securing the credentials — the private key that controls the UTXOs.  As Stefan Thomas, Jason Whelan (p. 139) and countless other people on /r/sorryforyourloss have discovered, this can be permanently lost.  Bearer assets are a pain to secure, hence the re-sprouting of trusted third parties in Bitcoinland.

One small nitpick in the note at the bottom of page 125, “Sometimes the structure of the bitcoin address network is such that the wallet often can’t send the right amount in one go…” — note that this ‘change‘ is intentional (and very inconvenient to the average user).

Another nitpick on page 128:

Each mining node or computer gathers this information and reduces it into an encrypted alphanumeric string of characters known as a hash.

There is actually no encryption used in Bitcoin, rather there are some cryptographic primitives that are used such as key signing but this is not technically called encryption (the two are different).

On page 130, I thought it was good that they explained where the term nonce was first used — from Lewis Carroll who created the word “frabjous” and described it as a nonce word.

On page 132, in describing proof-of-work:

While that seems like a mammoth task, these are high-powered computers; it’s not nearly as taxing as the nonce-creating game and can be done relatively quickly and easily.

They are correct in that something as simple as a Pi computer can and is used as the actual transaction validating machine.  Yet, at one point in 2009, this bifurcation did not exist: a full-node was both a miner and a hasher.  Today that is not the case and we technically have about a dozen or so actual miners on the network, the rest of the machines in “farms” just hash midstates.

On page 132, regarding payment processors accepting zero-confirmation transactions:

They do this because non-confirmations — or the double-spending actions that lead to them — are very rare.

True they are very rare today in part because there are very few incentives to actually try and double-spend.  Perhaps that will change in the future with new incentives to say, double-spend watermarked coins from NASDAQ.

And if payment processors are accepting zero confirmations, why bother using proof-of-work and confirmations at all?  Just because a UTXO is broadcast does not mean it will not be double-spent let alone confirmed and packaged into a block.  See also replace-by-fee proposal.

Small note on page 132:

“the bitcoin protocol won’t let it use those bitcoins in a payment until a total of ninety-nine additional blocks have been built on top its block.”

Sometimes it depends on the client and may be up to 120 blocks altogether, not just 100.

On page 133 they write:

“Anyone can become a miner and is free to use whatever computing equipment he or she can come up with to participate.”

This may have been the case in 2009 but not true today.  In order to reduce payout variance, the means of production as it were, have gravitated towards large pools of capital in the form of hashing farms.  See also: The Gambler’s Guide to Bitcoin Mining.

On page 135 they write:

“Some cryptocurrency designers have created nonprofit foundations and charged them with distributing the coins based on certain criteria — to eligible charities, for example. But that requires the involvement of an identifiable and trusted founder to create the foundation.”

The FinCEN enforcement action and fine on Ripple Labs could put a kibosh on this in the future.  Why?  If organizations that hand out or sell coins are deemed under the purview of the Bank Secrecy Act (BSA) it is clear that most, if not all, crowdfunding or initial coin offerings (ICO) are violating this by not implementing KYC/AML requirements on participants or filing SARs.

On page 136 they write:

“Both seigniorage and transaction fees represent a transfer of value to those running the network. Still, in the grand scheme of things, these costs are far lower than anything found in the old system.”

This is untrue and an inaccurate comparison.  We know that at the current bitcoin price of $240 it costs roughly $315 million to operate the network for the entire year.  If bitcoin-based consumer spending patterns hold up and reflect last years trends seen by BitPay, then roughly $350 million will be spent through payment processors, nearly half of which includes mining payouts.

Or in other words, for roughly every dollar spent on commerce another dollar is spent securing it.  This is massive oversecurity relative to the commerce involve.  Neither Saudi Arabia or even North Korea spend half of, let alone 100% of their GDP on military expenditures (yet).

Chapter 6

Small nitpick on page 140, Butterfly Labs is based in Leawood, Kansas not Missouri (Leawood is on the west side of the dividing line).

I think the story of Jason Whelan is illuminating and could help serve as a warning guide to anyone wanting to splurge on mining hardware.

For instance on page 141:

“And right from the start Whelan face the mathematical reality that his static hashrate was shrinking as a proportion of the ever-expanding network, whose computing power was by then almost doubling every month.”

Not only was this well-written but it does summarize the problem most new miners have when they plan out their capital expenditures.  It is impossible to know what the network difficulty will be in 3 months yet what is known is that even if you are willing to tweak the hardware and risk burning out some part of your board, your hashrate could be diluted by faster more efficient machines.  And Whelan found out the hard way that he might as well bought and held onto bitcoins than mine.  In fact, Whelan did just about everything the wrong way, including buying hashing contracts with cloud miners from “PBCMining.com” (a non-functioning url).

On page 144 the authors discussed the mining farms managed by now-defunct CoinTerra:

With three in-built high-powered fans running at top speed to cool the rig while its internal chi races through calculations, each unit consumes two kilowatts per hour, enough power to run an ordinary laptop for a month. That makes for 20 kWh per tower, about ten times the electricity used for the same space by the neighboring server of more orthodox e-commerce firms.

As noted in Chapter 2 above, this electricity has to be “wasted.”  Bitcoin was designed to be “inefficient” otherwise it would be easy to attack and censor.  And in the future, it cannot become more “efficient” — there is no free lunch when it comes to protecting it.  It also bears mentioning that CoinTerra was sued by its utility company in part for the $12,000 a day in electrical costs that were not being paid for.

On page 145 they wrote that as of June 2014:

“By that time, the network, which was then producing 88,000 trillion hashes every second, had a computing power six thousand times the combined power of the world’s top five hundred supercomputers.”

This is not a fair comparison.  ASIC miners can do one sole function, they are unable to do anything aside from reorganize a few fields (such as date and nonce) with the aim of generating a new number below a target number.  They cannot run MS Office, Mozilla Firefox and more sobering: they cannot even run a Bitcoin client (the Pi computer run by the pool runs the client).

In contrast, in order to be recognized as a Top 500 computer, only general purpose machines capable of running LINXPACK are considered eligible.  The entire comparison is apples-to-oranges.

On page 147 the authors described a study from Guy Lane who used inaccurate energy consumption data from Blockchain.info.

And then they noted that:

“So although the total consumption is significantly higher than the seven-thousand-home estimate, we’re a long way from bitcoin’s adding an entire country’s worth of power consumption to the world.”

This is not quite true.  As noted above in the notes of Chapter 2 above, based on Dave Hudson’s calculations the current Bitcoin network consumes the equivalent of about 10% of Ireland’s annual energy usage yet produces two orders of magnitude less economic activity.  If the price of bitcoin increases so to does the amount of energy miners are willing to expend to chase after the seigniorage.  See also Appendix B.

On page 148 they write that:

For one, power consumption must be measured against the value of validating transactions in a payment system, a social service that gold mining has never provided.  Second, the costs must be weighed against the high energy costs of the alternative, traditional payment system, with its bank branches, armored cars, and security systems. And finally, there’s the overriding incentive for efficiency that the profit motive delivers to innovators, which is why we’ve seen such giant reductions in power consumption for the new mining machines. If power costs make mining unprofitable, it will stop.

First of all, validation is cheap and easy, as noted above it is typically done with something like a Pi computer.  Second, they could have looked into how much real commerce is taking place on the chain relative to the costs of securing it so the “social service” argument probably falls flat at this time.

Thirdly, the above “armored cars and security systems” is not an apples-to-apples comparison.  Bitcoin does not provide any banking service beyond a lock box, it does not provide for home mortgages, small business loans or mezzanine financing.  The costs for maintaining those services in the traditional world do not equate to MC=MV as described at the end of Chapter 1 notes.

Fourthly, they ignore the Red Queen effect.  If a new hashing machine is invented and consumes half as much energy as before then the farm owner will just double the amount of machines and the net effect is the same as before.  This happens in practice, not just in theory, hence the reason why electrical consumption has gone up in aggregate and not down.

On page 149 they write:

“But the genius of the consensus-building in the bitcoin system means such forks shouldn’t be allowed to go on for long. That’s because the mining community works on the assumption that the longest chain is the one that constitutes consensus.”

That’s not quite accurate.  Each miner has different incentives.  And, as shown empirically with other altcoins, forks can reoccur frequently without incentives that align.  For now, some incentives apparently do.  But that does not mean that in the future, if say watermarked coins become more common place, that there will not be more frequent forks as certain miners attempt to double-spend or censor such metacoins.

Ironically on page 151 the authors describe the fork situation of March 2013 and describe the fix in which a few core developers convince Mark Karpeles (who ran Mt. Gox) to unilaterally adopt one specific fork.  This is not trustless.

On page 151 they write:

“That’s come to be known as a 51 percent attack.  Nakamoto’s original paper stated that the bitcoin mining network could be guaranteed to treat everyone’s transactions fairly and honestly so long as no single miner or mining group owned more than 50 percent of the hashing power.”

And continuing on page 153:

“So, the open-source development community is now looking for added protections against selfish mining and 51 percent attacks.”

While they do a good job explaining the issue, they don’t really discuss how it is resolved.  And it cannot be without gatekeepers or trusted hardware.

For instance, three weeks ago there was a good reddit thread discussing one of the problems of Andreas Antonopolous’  slippery slope view that you could just kick the attackers off the network.  First, there is no quick method for doing so; second, by blacklisting them you introduce a new problem of having the ability to censor miners which would be self-defeating for such a network as it introduces a form of trust into an expensive cost structure of trust minimization.

On page 152 they cite a Coinometrics number:

“in the summer of 2014 the cost of the mining equipment and electricity required for a 51 percent attack stood at $913 million.”

This is a measurement of maximum costs based on hashrate brute force — a Maginot Line attack.  In practice it is cheaper to do via out of band attacks (e.g., rubber hose cryptanalysis).  There are many other, cheaper ways, to attack the P2P network itself (such as Eclipse attacks).

On page 154 when discussing wealth disparity in Bitcoin they write:

“First, some perspective.  As a wealth-gap measure, this is a lousy one.  For one, addresses are not wallets.  The total number of wallets cannot be known, but they are by definition considerably fewer than the address tally, even though many people hold more than one.”

Finally.  So the past several chapters I have mentioned I will discuss wallets at some length.  Again, the authors for some reason uncritically cite the “wallet numbers” from Blockchain.info, Coinbase and others as actual digital wallets.

Yet here they explain that these metrics are bupkis.  And they are.  It costs nothing to generate a wallet and there are scripts you can run to auto generate them.  In fact, Zipzap and many others used to give every new user a Blockchain.info wallet por gratis.

And this is problematic because press releases from Xapo and Blockchain.info continually cite a number that is wholly inaccurate and distorting.

For instance Wences Casares said in a presentation a couple months ago that there were 7 million users.  Where did that number come from?  Are these on-chain privkey holders?  Why are journalists not questioning these claims?  See also: A brief history of Bitcoin “wallet” growth.

On page 154 they write:

“These elites have an outsize impact on the bitcoin economy. They have a great interest in seeing the currency succeed and are both willing and able to make payments that others might not, simply to encourage adoption.”

Perhaps this is true, but until there is a systematic study of the conspicuous consumption that takes place, it could also be the case that some of these same individuals just have an interest in seeing the price of bitcoin rise and not necessarily be widely adopted.  The two are not mutually exclusive.

On page 155 and 156 they describe the bitsat project, to launch a full node into space which is aimed “at making the mining network less concentrated.”

Unfortunately these types of full nodes are not block makers.  Thus they do not actually make the network less concentrated, but only add more propagating nodes.  The two are not the same.

On page 156 they describe some of the altcoin projects:

“They claim to take the good aspects of bitcoin’s decentralized structure but to get ride of its negative elements, such as the hashing-power arms race, the excessive use of electricity, and the concentration of industrialized mining power.”

I am well aware of the dozens various coin projects out there due to work with a digital asset exchange over the past year.  Yet fundamentally all of the proof-of-work based coins end up along the same trend line, if they become popular and reach a certain level of “market cap” (an inaccurate term) specialized chips are designed to hash it.

And the term “excessive” energy related to proof-of-work is a bit of a non-starter.  Ignoring proof-of-stake systems, if it becomes less energy intensive to hash via POW, then it also becomes cheaper to attack.  Either miners will add more equipment or the price has dropped for the asset and it is therefore cheaper to attack.

On page 157 regarding Litecoin they write that:

“Miners still have an incentive to chase coin rewards, but the arms race and the electricity usage aren’t as intense.”

That’s untrue.  Scrypt (which is used instead of Hashcash) is just as energy intensive.  Miners will deploy and utilize energy in the same patterns, directly in proportion to the token price.  The difference is memory usage (Litecoin was designed to be more memory intensive) but that is unrelated to electrical consumption.

Continuing:

“Litecoin’s main weakness is the corollary of its strength: because it’s cheaper to mine litecoins and because scrypt-based rigs can be used to mine other scrypt-based altcoins such as dogecoin, miners are less heavily invested in permanently working its blockchain.”

This is untrue.  Again, Litecoin miners will in general only mine up to the point where it costs a litecoin to make a litecoin.  Obviously there are exceptions to it, but in percentage terms the energy usage is the same.

Continuing:

“Some also worry that scrypt-based mining is more insecure, with a less rigorous proof of work, in theory allowing false transactions to get through with incorrect confirmations.”

This is not true.  The two difference in security are the difficulty rating and block intervals.  The higher the difficulty rating, the more energy is being used to bury blocks and in theory, the more secure the blocks are from reversal.

The question is then, is 2.5 minutes of proof-of-work as secure as burying blocks every 10 minutes?  Jonathan Levin, among others, has written about this before.

cthuluSmall nitpick on page 157, fairly certain that nextcoin should be referred to as NXT.

On page 158 they write:

If bitcoin is to scale up, it must be upgraded sot hat nodes, currently limited to one megabyte of data per ten-minute block, are free to process a much larger set of information.  That’s not technically difficult; but it would require miners to hash much larger blocks of transactions without big improvements in their compensation.  Developers are currently exploring a transaction-fee model that would provide fairer compensation for miners if the amount of data becomes excessive.

This is not quite right.  There is a difference between block makers (pools) and hashers (mining farms).  The costs for larger blocks would impact block makers not hashers, as they would need to upgrade their network facilities and local hard drive.  This may seem trivial and unimportant, but Jonathan Levin’s research, as well as others suggest that block sizes does in fact impact orphan rates.5

It also impacts the amount of decentralization within the network as larger blocks become more expensive to propagate you will likely have fewer nodes.  This has been the topic of immense debate over the past several weeks on social media.

Also on page 158 they write:

The laboratory used by cryptocurrency developers, by contrast, is potentially as big as the world itself, the breadth of humanity that their projects seek to encompass. No company rulebook or top-down set of managerial instructions keeps people’s choice in line with a common corporate objective. Guiding people to optimal behavior in cryptocurrencies is entirely up to how the software is designed to affect human thinking, how effectively its incentive systems encourage that desired behavior

This is wishful thinking and probably unrealistic considering that Bitcoin development permanently suffers from the tragedy of the commons.  There is no CEO which is both good and bad.

For example, directions for where development goes is largely based on two things:

  1. how many upvotes your comment has on reddit (or how many retweets it gets on Twitter)
  2. your status is largely a function of how many times Satoshi Nakamoto responded to you in email or on the Bitcointalk forum creating a permanent clique of “early adopters” whose opinions are the only valid ones (see False narratives)

This is no way to build a financial product.  Yet this type of lobbying is effectively how the community believes it will usurp well-capitalized private entities in the payments space.

Several months ago a user, BitttBurger, made a similar observation:

I’ve said it before and I will say it again. There is a reason why Developers should not be in control of product development priorities, naming, feature lists, or planning for a product. That is the job of the sales, marketing, and product development teams who actually interface with the customer. They are the ones who do the research and know what’s needed for a product. They are the ones who are supposed to decide what things are called, what features come next, and how quickly shit gets out the door.

Bitcoin has none of that. You’ve got a Financial product, being created for a financial market, by a bunch of developers with no experience in finance, and (more importantly) absolutely no way for the market to have any input or control over what gets done, or what it’s called. That is crazy to me.

Luke is a perfect example of why you don’t give developers control over anything other than the structure of the code.

They are not supposed to be making product development decisions. They are not supposed to be naming anything. And they definitely are not supposed to be deciding “what comes next” or how quickly things get done. In any other company, this process would be considered suicide.

Yet for some reason this is considered to be a feature rather than a bug (e.g., “what is your Web of Trust (WoT) number?”).

On page 159 they write:

“The vital thing to remember is that the collective brainpower applied to all the challenges facing bitcoin and other cryptocurrencies is enormous.  Under the open-source, decentralized model, these technologies are not hindered by the same constraints that bureaucracies and stodgy corporations face.”

So, what is the Terms of Service for Bitcoin?  What is the customer support line?  There isn’t one.  Caveat emptor is pretty much the marketing slogan and that is perfectly fine for some participants yet expecting global adoption without a “stodgy” “bureaucracy” that helps coordinate customer service seems a bit of a stretch.

And just because there is some avid interest from a number of skilled programmers around the world does not mean public goods problems surrounding development will be resolved.

For reference: there were over 5000 co-authors on a recent physics paper but that doesn’t mean their collective brain power will quickly resolve all the open questions and unsolved problems in physics.

Chapter 7:

Small nitpick on page 160:

“Bitcoin was born out of a crypto-anarchist vision of a decentralized government-free society, a sort of encrypted, networked utopia.”

As noted above, there is actually no encryption used in Bitcoin.

On page 162 they write:

“Before we get too carried away, understand this is still early days.”

That may be the case.  Perhaps decentralized cryptocurrencies like Bitcoin are not actually the internet in the early 1990s like many investors claim but rather the internet in the 1980s when there were almost no real use-cases and it is difficult to use.  Or 1970s.  The problem is no one can actually know the answer ahead of time.

And when you try to get put some milestone down on the ground, the most ardent of enthusiasts move the goal posts — no comparisons with existing tech companies are allowed unless it is to the benefit of Bitcoin somehow.  I saw this a lot last summer when I discussed the traction that M-Pesa and Venmo had.

A more recent example is “rebittance” (a portmanteau of “bitcoin” and “remittance”).  A couple weeks ago Yakov Kofner, founder of Save On Send, published a really good piece comparing money transmitter operators with bitcoin-related companies noting that there currently is not much meat to the hype.  The reaction on reddit was unsurprisingly fist-shaking Bitcoin rules, everyone else drools.

yakov breakfast

With Yakov Kofner (CEO Save On Send)

When I was in NYC last week I had a chance to meet with him twice.  It turns out that he is actually quite interested in Bitcoin and even scoped out a project with a VC-funded Bitcoin company last year for a consumer remittances product.

But they decided not to build and release it for a few reasons:

  1.  in practice, many consumers are not sensitive enough to a few percentage savings because of brand trust/loyalty/habit;
  2.  lacking smartphones and reliable internet infrastructure, the cash-in, cash-out aspect is still the main friction facing most remittance corridors in developing countries, bitcoin does not solve that;
  3.  it boils down to an execution race and it will be hard to compete against incumbents let alone well-funded MTO startups (like TransferWise).

That’s not to say these rebittance products are not good and will not find success in niches.

For instance, I also spoke with Marwan Forzley (below), CEO of Align Commerce last week.  Based on our conversation, in terms of volume his B2B product appears to have more traction than BitPay and it’s less than a year old.

What is one of the reasons why?  Because the cryptocurrency aspect is fully abstracted away from customers.

marwan p2p

Raja Ramachandran (R3CEV), Dan O’Prey (Hyperledger), Daniel Feichtinger (Hyperledger), Marwan Forzley (Align Commerce)

In addition, both BitX and Coins.ph — based on my conversations in Singapore two weeks ago with their teams — seem to be gaining traction in a couple corridors in part because they are focusing on solving actual problems (automating the cash-in/cash-out process) and abstracting away the tech so that the average user is oblivious of what is going on behind the scenes.

singapore ron

Markus Gnirck (StartupBootCamp), Antony Lewis (itBit) and Ron Hose (Coins.ph) at the DBS Hackathon event

On page 162 and 163 the authors write about the Bay Area including 20Mission and Digital Tangible.

There is a joke in this space that every year in cryptoland is accelerated like dog years.  While 20Mission, the communal housing venue, still exists, the co-working space shut down late last year.  Similarly, Digital Tangible has rebranded as Serica and broadened from just precious metals and into securities.  In addition, Dan Held (page 164) left Blockchain.info and is now at ChangeTip.

On page 164 they write:

“But people attending would go on to become big names in the bitcoin world: Among them were Brian Armstrong and Fred Ehrsam, the founders of Coinbase, which is second only to Blockchain as a leader in digital-wallet services and one of the biggest processors of bitcoin payments for businesses.”

10 pages before this they said how useless digital wallet metrics are.  It would have been nice to press both Armstrong and Ehrsam to find out what their actual KYC’ed active users to see if the numbers are any different than the dated presentation.

On page 165 they write:

“It’s a very specific type of brain that’s obsessed with bitcoin,” says Adam Draper, the fourth-generation venture capitalist…”

I hear this often but what does that mean?  Is investing genetic?  If so, surely there are more studies on it?

For instance, later on page 176 they write:

“The youngest Draper, who tells visitors to his personal web site that his life’s ambition is to assist int he creation of an iron-man suit, has clearly inherited his family’s entrepreneurial drive.”

Perhaps Adam Draper is indeed both a bonafide investor and entrepreneur, but it does not seem to be the case that either can be or is necessarily inheritable.

On page 167:

“The only option was to “turn into a fractional-reserve bank,” he said jokingly, referring tot he bank model that allows banks to lend out deposits while holding a fraction of those funds in reserve.  “They call it a Ponzi scheme unless you have a banking license.”

Why is this statement not challenged?  I am not defending rehypothecation or the current banking model, but fractional reserve banking as it is employed in the US is not a Ponzi scheme.

Also on page 167 they write:

“First, he had trouble with his payments processor, Dwolla which he later sued for $2 million over what Tradehill claimed were undue chargebacks.”

A snarky thing would be to say he should have used bitcoin, no chargebacks.  But the issue here, one that the authors should have pressed is that Tradehill, like Coinbase and Xapo, are effectively behaving like banks.  It’s unclear why this irony is not discussed once in the book.

For instance, several pages later on page 170 they once again talk about wallets:

The word wallet is thrown around a lot in bitcoin circles, and it’s an evocative description, but it’s just a user application that allows you to send and receive bitcoins over the bitcoin network. You can download software to create your own wallet — if you really want to be your own bank — but most people go through a wallet provider such as Coinbase or Blockchain, which melded them into user-friendly Web sites and smart phone apps.

I am not sure if it is intentional but the authors clearly understand that holding a private key is the equivalent of being a bank.  But rather than say Coinbase is a bank (because they too control private keys), they call them a wallet provider.  I have no inside track into how regulators view this but the euphemism of “wallet provider” is thin gruel.

On the other hand Blockchain.info does not hold custody of keys but instead provide a user interface — at no point do they touch a privkey (though that does not mean they could not via a man-in-the-middle-attack or scripting errors like the one last December).

On page 171 they talk about Nathan Lands:

The thirty-year-old high school dropout is the cofounder of QuickCoin, the maker of a wallet that’s aimed directly at finding the fastest easiest route to mass adoption.  The idea, which he dreamed up with fellow bitcoiner Marshall Hayner one night over a dinner at Ramen Underground, is to give nontechnical bitcoin newcomers access to an easy-to-use mobile wallet viat familiar tools of social media.

Unfortunately this is not how it happened.  More in a moment.

Continuing the authors write:

“His successes allowed Lands to raise $10 million for one company, Gamestreamer.”

Actually it was Gamify he raised money for (part of the confusion may be due to how it is phrased on his LinkedIn profile).

Next the authors state:

“He started buying coins online, where her ran into his eventual business partner, Hayner (with whom he later had a falling-out, and whose stake he bought).”

One of the biggest problems I had with this book is that the authors take claims at face value.  To be fair, I probably did a bit too much myself with GCON.

On this point, I checked with Marshall Hayner who noted that this narrative was untrue:  “Nathan never bought my stake, nor was I notified of any such exchange.”

While the co-founder dispute deserves its own article or two, the rough timeline is that in late 2013 Hayner created QuickCoin and then several months later on brought Lands on to be the CEO.  After a soft launch in May 2014 (which my wife and I attended, see below) Lands maneuvered and got the other employees to first reduce the equity that Hayner had and then fired him so they could open up the cap table to other investors.

quickcoin

QuickCoin launch party with Marshall Hayner, Jackson Palmer (Dogecoin), and my wife

With Hayner out, QuickCoin quickly faded due to the fact that the team had no ties to the local cryptocurrency community.  Hayner went on to join Stellar and is now the co-founder of Trees.  QuickCoin folded by the end of the year and Lands started Blockai.

On page 174 they discuss VCs involved in funding Bitcoin-related startups:

Jerry Yang, who created the first successful search engine, Yahoo, put money from his AME Ventures into a $30 million funding round for processor BitPay and into one of two $20 million rounds raised by depository and wallet provider Xapo, which offers insurance to depositors and call itself a “bitcoin vault.”

While they likely couldn’t have put it in this section, I think it would have been good for the authors to discuss the debate surrounding what hosted wallets actually are because regulators and courts may not agree with the marketing-speak of these startups.6

On page 177 they write about Boost VC which is run by Adam Draper:

“He’d moved first and emerged as the leader in the filed, which meant his start-ups could draw in money from the bigger guys when it came time for larger funding rounds.”

It would be interesting to see the clusters of what VCs do and do not co-invest with others.  Perhaps in a few years we can look back and see that indeed, Boost VC did lead the pack.

However while there are numerous incubated startups that went on to close seed rounds (Blockcypher, Align Commerce, Hedgy, Bitpagos) as of this writing there is only one incubated company in Boost that has closed a Series A round and that is Mirror (Coinbase, which did receive funding from Adam Draper, was not in Boost).  Maybe this is not a good measure for success, perhaps this will change in the future and maybe more have done so privately.

On page 179-180 the discussion as to what Plug and Play Tech Center does and its history was well written.

On page 184 they write:

With every facet of our economy now dependent on the kinds of software developed and funded in the Bay Area, and with the Valley’s well-heeled communities becoming a vital fishing ground for political donations and patronage, we’re witnessing a migration of the political and economic power base away from Wall Street to this region.

I have heard variations of this for the past couple of years.  Most recently I heard a VC claim that Andreessen Horrowitz (a16z) was the White House of the West Coast and that bankers in New York do not understand this tech.  Perhaps it is and perhaps bankers do not understand what a blockchain is.

Either way we should be able to see the consequences to this empirically at some point.  Where is the evidence presented by the authors?

incumbents

Source: finviz

Fast forwarding several chapters, on page 287 they write:

“Visa, MasterCard, and Western Union combined – to name just three players whose businesses could be significantly reformed — had twenty-seven thousand employees in 2013.”

Perhaps these figures will dramatically change soon, however, the above image are the market caps over the past 5 years of four incumbents: JP Morgan (the largest bank in the US), MasterCard and Visa (the largest card payment providers) and Western Union, the world’s largest money transfer operator.

Will their labor force dramatically change because of cryptocurrencies?  That is an open question.  Although it is unclear why the labor force at these companies would necessarily shrink because of the existence of Bitcoin rather than expand in the event that these companies integrated parts of the tech (e.g., a distributed ledger) thereby reducing costs and increasing new types of services.

On page 185 they write:

“Those unimaginable possibilities exist with bitcoin, Dixon says, because “extensible software platforms that allow anyone to build on top of them are incredibly powerful and have all these unexpected uses. The stuff about fixing the existing payment system is interesting, but what’s superexciting is that you have this new platform on which you can move money and property and potentially build new areas of businesses.”

Maybe this is true.  It is unclear from these statements as to what Chris Dixon views as broken about the current payment system.  Perhaps it is “broken” in that not everyone on the planet has access to secure, near-instant methods of global value transer.  However it is worth noting that cryptocurrencies are not the only competitors in the payments space.

According to AngelList as of this writing:

Chapter 8

This chapter discussed “The Unbanked” and how Bitcoin supposedly can be a solution to banking these individuals.

On page 188 they discuss a startup called 37coins:

“It uses people in the region lucky enough to afford Android smartphones as “gateways” to transmit the messages.  In return, these gateways receive a small fee, which provides the corollary benefit of giving locals the opportunity to create a little business for themselves moving traffic.”

This is a pretty neat idea, both HelloBit and Abra are doing something a little similar.  The question however is, why bitcoin?  Why do users need to go out of fiat, into bitcoin and back out to fiat?  If the end goal is to provide users in developing countries a method to transmit value, why is this extra friction part of the game plan?

Last month I heard of another supposed cryptocurrency “killer app”: smart metering prepaid via bitcoin and how it is supposed to be amazing for the unbanked.  The unbanked, they are going to pay for smart metering with money they don’t have for cars they don’t own.

There seems to be a disconnect when it comes to financial inclusion as it is sometimes superficially treated in the cryptocurrency world.  Many Bitleaders and enthusiasts seem to want to pat themselves on the back for a job that has not been accomplished.  How can the cryptocurrency community bring the potential back down to real world situations without overinflating, overhyping or over promising?

If Mercedes or Yamaha held a press conference to talk about the “under-cared” or “under-motorcycled” they would likely face a backlash on social media.  Bitcoin the bearer instrument, is treated like a luxury good and expecting under-electrified, under-plumbed, under-interneted people living in subsistence to buy and use it today without the ability to secure the privkey without a trusted third party, seems far fetched (“the under bitcoined!”).  Is there a blue print to help all individuals globally move up Maslow’s Hierarchy of Financial Wants & Needs?

On page 189 they write:

“But in the developing world, where the costs of an ineffectual financial system and the burdens of transferring funds are all too clear, cryptocurrencies have a much more compelling pitch to make.”

The problem is actually at the institutional level, institutions which do not disappear because of the Bitcoin blockchain.  Nor does Bitcoin solve the identity issue: users still need real-world identity for credit ratings so they can take out loans and obtain investment to build companies.

For instance on page 190 the authors mention the costs of transferring funds to and from Argentina, the Philippines, India and Pakistan.  One of the reasons for the high costs is due to institutional problems which is not solved by Bitcoin.

In fact, the authors write:

“Banks won’t service these people for various reasons. It’s partly because the poor don’t offer as fat profits as the rich, and it’s partly because they live in places where there isn’t the infrastructure and security needed for banks to build physical branches. But mostly it’s because of weak legal institutions and underdeveloped titling laws.”

This is true, but Bitcoin does not solve this.  If local courts or governments do not recognize the land titles that are hashed on the blockchain it does the local residents no good to use Proof of Existence or BlockSign.

They do not clarify this problem through the rest of the chapter.  In fact the opposite takes place, as they double down on the reddit narrative:

“Bitcoin, as we know, doesn’t care who you are. It doesn’t care how much money you are willing to save, send, or spend. You, your identity and your credit history are irrelevant. […] If you are living on $50 a week, the $5 you will save will matter a great deal.”

This helps nobody. The people labeled as “unbanked” want to have access to capital markets and need a credit history so they can borrow money to create a companies and build homes.  Bitcoin as it currently exists, does not solve those problems.

Furthermore, how do these people get bitcoins in the first place?  That challenge is not discussed in the chapter.  Nor is the volatility issue, one swift movement that can wipe out the savings of someone living in subsistence, broached.  Again, what part of the network does lending on-chain?

On page 192 they write:

“They lack access to banks not because they are uneducated, but because of the persistent structural and systemic obstacles confronting people of limited means there: undeveloped systems of documentation and property titling, excessive bureaucracy, cultural snobbery, and corruption. The banking system makes demands that poor people simply can’t meet.”

This is very true.  The Singapore conference I attended two weeks ago is just one of many conferences held throughout this year that talked about financial inclusion.  Yet Bitcoin does not solve any of these problems.  You do not need a proof-of-work blockchain to solve these issues.  Perhaps new database or permissioned ledgers can help, but these are social engineering challenges — wet code — that technology qua technology does not necessarily resolve.

Also on page 192 they write:

“People who have suffered waves of financial crises are used to volatility. People who have spent years trusting expensive middlemen and flipping back and forth between dollars and their home currency are probably more likely to understand bitcoin’s advantages and weather its flaws.”

This is probably wishful thinking too.  Residents of Argentina and Ukraine may be used to volatility but it does not mean it is something they want to adopt.  Why would they want to trade one volatile asset for another?  Perhaps they will but the authors do not provide any data for actual usage or adoption in these countries, or explain why the residents prefer bitcoin instead of something more global and stable such as the US dollar.

On page 193 they write that:

“In many cases, these countries virtually skip over legacy technology, going straight to high-tech fiber-optic cables.”

While there is indeed a number of legacy systems used on any given day in the US, it is not like Bitcoin itself is shiny new tech.  While the libraries and BIPS may be new, the components within the consensus critical tech almost all dates back to the 20th century.

For instance, according to Gwern Branwen, the key moving parts that Bitcoin uses:

  1. 2001: SHA-256 finalized
  2. 1999-present: Byzantine fault tolerance (PBFT etc.)
  3. 1999-present: P2P networks (excluding early networks like Usenet or FidoNet; MojoNation & BitTorrent, Napster, Gnutella, eDonkey, Freenet, etc.)
  4. 1998: Wei Dai, B-money5
  5. 19986: Nick Szabo, Bit Gold
  6. 1997: HashCash
  7. 1992-1993: Proof-of-work for spam7
  8. 1991: cryptographic timestamps
  9. 1980: public key cryptography8
  10. 1979: Hash tree

That’s not to say that Bitcoin is bad, old or that other systems are not old or bad but rather the term “legacy” is pretty relative and undefined in that passage.

On page 194 they discuss China and bitcoin:

“With bitcoin, the theory goes, people could bypass that unjust banking system and get their money out of China at low cost.”

This is bad legal advice, just look at the problems this caused Coinbase with regulators a couple months ago.  And while you could probably do it low-scale, it then competes with laundering via art sales and Macau junkets and thus expecting this to be the killer use-case for adoption in China is fairly naive.

On page 195 they write:

“Bitcoin in China is purely a speculator’s game, a way to gamble on its price, either through one of a number of mainland exchanges or by mining it. It is popular — Chinese trading volumes outstrip those seen anywhere else in the world.”

Two months ago Goldman Sachs published a widely circulated report which stated that “80% of bitcoin volume is now exchanged into and out of Chinese yuan.”

This is untrue though as it is solely based on self-reporting metrics from all of the exchanges (via Bitcoinity).  As mentioned in chapter 1 notes above, the top 3 exchanges in China run market-making bots which dramatically inflate trading volume by 50-70% each day.  While they likely still process a number of legitimate trades, it cannot be said that 80% of bitcoin volume is traded into and out of RMB.  The authors of both the report and the book should have investigated this in more depth.

On page 196 they write:

“This service, as well as e-marketplace Alibaba’s competing Alipay offering, is helping turn China into the world’s most dynamic e-commerce economy. How is bitcoin to compete with that?”

Great question and the answer is it probably won’t.  See Understanding value transfers to and from China.

Next on page 196 they write:

“But what about the potential to get around the controls the government puts on cross-border fund transfers?”

By-passing capital controls was discussed two pages before and will likely cause problems for any VC or PE-backed firm in China, the US and other jurisdictions.  I am not defending the current policies just being practical: if you are reading their book and plan to do this type of business, be sure to talk to a legal professional first.

On page 197 they discuss a scenario for bitcoin adoption in China: bank crisis.  The problem with this is that in the history of banking crisis’ thus far, savers typically flock to other assets, such as US dollars or euros.  The authors do not explain why this would change.

Now obviously it could or in the words of the authors, the Chinese “may warm to bitcoin.”  But this is just idle speculation — where are the surveys or research that clarify this position?  Why is it that many killer use-cases for bitcoin typically assumes an economy or two crashes first?

On page 198 they write:

“The West Indies even band together to form one international cricket team when they play England, Australia, and other members of the Commonwealth. What they don’t have, however, is a common currency that could improve interisland commerce.”

More idle speculation.  Bitcoin will probably not be used as a common currency because policy makers typically want to have discretion via elastic money supplies.  In addition, one of the problems that a “common currency” could have is what has plagued the eurozone: differing financial conditions in each country motivate policy makers in each country to lobby for specific monetary agendas (e.g., tightening, loosening).

Bitcoin in its current form, cannot be rebased to reflect the changes that policy makers could like to make.  While many Bitcoin enthusiasts like this, unless the authors of the book have evidence to the contrary, it is unlikely that the policy makers in the West Indies find this desirable.

On page 199 they write:

“A Caribbean dollar remains a pipe dream.”

It is unclear why having a unified global or regional currency is a goal for the authors?  Furthermore, there is continued regional integration to remove some frictions, for instance, the ECACH (Eastern Caribbean Automated Clearing House) has been launched and is now live in all 8 member countries.

On page 203 they spoke to Patrick Byrne from Overstock.com about ways Bitcoin supposedly saves merchants money.

They note that:

“A few weeks later, Byrne announced he would not only be paying bitcoin-accepting vendors one week early, but that he’d also pay his employee bonuses in bitcoin.”

Except so far this whole effort has been a flop for Overstock.com.  According to Overstock, in 2014 approximately 11,100 customers paid with bitcoin at both its US and international websites.  Altogether this represented roughly $3 million in sales which when coupled with low margin products (based on the top 10 list of things sold on Overstock) is an initiative that Stone Street Advisors labeled “distracting” (see slides 21, 32, 33, 37, 58).

This continues onto page 204:

“As a group of businesses in one region begins adopting the currency, it will become more appealing to others with whom they do business. Once such a network of intertwined businesses builds up, no one wants to be excluded from it. Or so the theory goes.”

Byrne then goes on to describe network effects and fax machines, suggesting that this is what will happen with bitcoin.

In other words, a circular flow of income.  The challenge however goes back to the fact that the time preferences of individuals is different and has not lended towards the theory of spending.  As a whole, very few people spend and suppliers typically cash out to reduce their exposure to volatility.  Perhaps this will change, but there is no evidence that it has so far.

On page 206 they talk to Rulli from Film Annex (who was introduced in the introduction):

With bitcoin, “you can clearly break down the value of every single stroke on the keyboard, he says.

And you cannot with fiat?

Continuing the authors talk about Rulli:

He wanted the exchange to be solely in bitcoin for other digital currencies, with no option to buy rupees or dollars: “The belief I have is that if you lock these people into this new economy, they will make that new economy as efficient as possible.”

What about volatility?  Why are marginalized people being expected to hold onto an asset that fluctuates in value by more than 10% each month?  Rulli has a desire to turn the Film Annex Web site “into its own self enclosed bitcoin economy.”  There is a term for this: autarky or closed economy.

Continuing Rulli states:

“If you start giving people opportunities to get out of the economy, they will just cut it down, whereas if the only way for you to enrich yourself is by trading bitcoins for litecoins and dogecoins, you are going to become an expert in that… you will become the best trader in Pakistan.”

This seems to be a questionable strategy: are these users on bitLanders supposed to be artisans or day traders?  Why are marginalized people expected to compete with world-class professional traders?

On page 210 the second time the term “virtual currency” is mentioned, this time by the Argentinian central bank.

On page 213 they write:

“With bitcoin, it is possible to sen money via a mobile phone, directly between two parties, to bypass that entire cumbersome, expensive system for international transfers.”

What an updated version to the book should include is an actual study for the roundtrip costs of doing international payments and remittances.  This is not to defend the incumbents, but rebittance companies and enthusiasts on reddit grossly overstate the savings in many corridors.7 And it still does not do away with the required cash-in / cash-out steps that people in these countries still want and need.

On page 216 they write about the research of Hernando de Soto who discusses the impediments of economic development including the need to document ownership of property.  Unfortunately Bitcoin does not currently solve this because ultimately the recognition of a hash of a document on a blockchain comes down to recognition from the same institutions that some of these developing countries lack.

Continuing on page 217 they write that:

“Well, the blockchain, if taken to the extent that a new wave of bitcoin innovators believe possible, could replace many of those institutions with a decentralized authority for proving people’s legal obligations and status. In doing so, it could dramatically widen the net of inclusion.”

How?  How is this done?  Without recognized title transfers, hashing documents onto a chain does not help these people.  This is an institutional issue, not one of technology.  Human corruption does not disappear because of the existence of Bitcoin.

Chapter 9

On page 219 they write:

“Like everything else in the cryptocurrency world, the goal is to decentralize, to take power out of the hands of the middleman.”

By recreating the same middleman, depository institutions, yet without robust financial controls.

On page 220 and 221 they mention “basic encryption process” and “standard encryption models” — I believe that it is more accurately stated as cryptographic processes and cryptographic models.

On page 222 they define “Bitcoin 2.0” / “Blockchain 2.0” and put SatoshiDice into that bucket.  Ignoring the labels for a moment, I don’t think SatoshiDice or any of the other on-chain casino games are “2.0” — they use the network without coloring any asset.

One quibble with Mike Hearn’s explanation on page 223 is when he says, “But bitcoin has no intermediaries.”  This is only true if you control and secure the privkey by yourself.  In practice, many “users” do not.

On page 225 they write:

“Yet they are run by Wall Street banks and are written and litigated by high-powered lawyers pulling down six- or seven-figure retainers.”

Is it a crime to be able to charge what the market bears for a service?  Perhaps some of this technology will eventually reduce the need for certain legal services, but it is unclear what the pay rate of attorneys in NYC has in relation with Bitcoin.

Also on page 225 a small typo: “International Derivatives and Swaps Association (ISDA)” — need to flip Derivatives and Swaps.

On page 226, 227, 229 and 244: nextcoin should be called NXT.

On page 227 they write:

“Theses are tradable for bitcoins and other cryptocurrencies on special altcoin exchanges such as Cryptsy, where their value is expected to rise and fall according to the success or failure of the protocol to which they belong.”

There is a disconnect between the utility of a chain and the speculative activity around the token.  For instance, most day traders likely do not care about the actual decentralization of a network, for if they did, it would be reflected in prices of each chain.  There are technically more miners (block makers) on dozens of alternative proof-of-work chains than there in either bitcoin or litecoin yet market prices are (currently) not higher for more decentralized chains.

On page 228 they write that:

“Under their model, the underlying bitcoin transactions are usually of small value — as low as a “Satoshi” (BTC0.00000001).  That’s because the bitcoin value is essentially irrelevant versus the more important purpose of conveying the decentralized application’s critical metadata across the network, even though some value exchange is needed to make the communication of information happen.”

Actually in practice the limit for watermarked coins typically resides around 0.0001 BTC.  If it goes beneath 546 satoshi, then it is considered dust and not included into a block.  Watermarked coins also make the network top heavy and probably insecure.8

On page 209, the third time “virtual currency” is used and comes from Daniel Larimer, but without quotes.

On page 230 they discuss an idea from Daniel Larimer to do blockchain-based voting.  While it sounds neat in theory, in practice it still would require identity which again, Bitcoin doesn’t solve.  Also, it is unclear from the example in the book as to why it is any more effective/superior than an E2E system such as Helios.

On page 238 they write:

“It gets back to the seigniorage problem we discussed in chapter 5 and which Nakamoto chose to tackle through the competition for bitcoins.”

I am not sure I would classify it as a problem per se, it is by design one method for rewarding security and distributing tokens.  There may be other ways to do it in a decentralized manner but that is beyond the scope of this review.

On page 239 they discuss MaidSafe and describe the “ecological disaster” that awaits data-center-based storage.  This seems a bit alarmist because just in terms of physics, centralized warehouses of storage space and compute will be more efficient than a decentralized topology (and faster too).  This is discussed in Chapter 3 (under “Another facsimile”).

Continuing they quote the following statement from David Irvine, founder of MaidSafe: “Data centers, he says, are an enormous waste of electricity because they store vast amounts of underutilized computing power in huge warehouse that need air-condition and expensive maintenance.”

Or in other words: #bitcoin

On page 242 they mention Realcoin whose name has since been changed to Tether.  It is worth pointing out that Tether does not reduce counterparty risk, users are still reliant on the exchange (in this case Bitfinex) from not being hacked or shut down via social engineering.

On page 244, again to illustrate how fast this space moves, Swarm has now pivoted from offering cryptocurrency-denominated investment vehicles into voting applications and Open-Transactions has hit a bit of a rough patch, its CTO, Chris Odom stepped down in March and the project has not had any public announcements since then.

Chapter 10

If you missed it, the last few weeks on social media have involved a large debate around blockchain stability with respect to increasing block sizes.

During one specific exchange, several developers debated as to “who was in charge,” with Mike Hearn insisting that Satoshi left Gavin in charge and Greg Maxwell stating that this is incorrect.

gavin mike hearn

Source: Reddit

This ties in with the beginning of page 247, the authors write about Gavin Andresen:

“A week earlier he had cleared out his office at the home he shares with his wife, Michele – a geology professor at the University of Massachusetts — and two kids. He’d decided that a man essentially if not titularly in charge of running an $8 billion economy needed something more than a home office.”

Who is in charge of Bitcoin?  Enthusiasts on reddit and at conferences claim no one is.  The Bitcoin Foundation claims five people are (those with commit access).  Occasionally mainstream media sites claim the Bitcoin CEO or CFO is fired/jailed/dead/bankrupt.

The truth of the matter is that it is the miners who decide what code to update and use and for some reason they are pretty quiet during all of this hub bub.  Beyond that, there is a public goods problem and as shown in the image above, it devolves into various parties lobbying for one particular view over another.

The authors wrote about this on page 247:

“The foundation pays him to coordinate the input of the hundreds of far-flung techies who tinker away at the open-licensed software. Right now, the bitcoin community needed answers and in the absence of a CEO, a CTO, or any central authority to turn to, Andresen was their best hope.”

It is unclear how this will evolve but is a ripe topic of study.  Perhaps the second edition will include other thoughts on how this role has changed over time.

On page 251 they write:

“Probably ten thousand of the best developers in the world are working on this project,” says Chris Dixon, a partner at venture capital firm Andreessen Horowitz.

How does he know this?  There are not 10,000 users making changes to Bitcoin core libraries on github or 10,000 subscribers to the bitcoin development mailing list or IRC rooms.  I doubt that if you added up all of the employees of every venture-backed company in the overall Bitcoin world, that the amount would equate to 2,000 let alone 10,000 developers.  Perhaps it will by the end of this year but this number seems to be a bit of an exaggeration.

Continuing Dixon states:

“You read these criticisms that ‘bitcoin has this flaw and bitcoin has that flaw,’ and we’re like ‘Well, great. Bitcoin has ten thousand people working hard on that.”

This is not true.  There is a public goods problem and coordination problem.  Each developer and clique of developers has their own priorities and potential agenda for what to build and deploy.  It cannot be said that they’re all working towards one specific area.  How many are working on the Lightning Network?  Or on transaction malleability (which is still not “fixed”)?  How many are working on these CVE?

On page 254 they discuss Paul Baran’s paper “On Distributed Communications Networks,” the image of which has been used over the years and I actually used for my paper last month.

On page 255 the fourth usage of “virtual currency” appears regarding once more, FinCEN director Jennifer Shasky.  Followed by page 256 with another use of “virtual currency.”  On page 257 Benjamin Lawsky was quoted using “virtual currency.”  Page 259 the term “virtual currency” appears when the European Banking Authority is quoted.  Page 260 and 261 sees “virtual currency” being used in relation with NYDFS and Lawsky once more.  On page 264 another use of “virtual currency” is used and this time in relation with Canadian regulations from June 2014.

On page 265 they mention “After the People’s Bank of China’s antibitcoin directives…”

I am not sure the directives were necessarily anti-bitcoin per se.  Rather they prohibited financial institutions like banks and payment processors from directly handling cryptocurrencies such as bitcoins.  The regulatory framework is still quite nebulous but again, going back to “excessive” in the introduction above, it is unclear why this is deemed “anti-bitcoin” when mining and trading activity is still allowed to take place.  Inconsistent and unhelpful, yes.  Anti?  Maybe, maybe not.

Also on page 265 they mention Temasek Holdings, a sovereign wealth fund in Singapore that allegedly has bitcoins in its portfolio.  When I was visiting there, I spoke with a managing director from Temasek two weeks ago and he said they are not invested in any Bitcoin companies and the lunchroom experiment with bitcoins has ended.

On page 268 the authors discuss “wallets” once more this time in relation with Mt.Gox:

“All the bitcoins were controlled by the exchange in its own wallets” and “Reuters reported that only Karpeles knew the passwords to the Mt. Gox wallets and that he refused a 2012 request from employees to expand access in the event that he became incapacitated.”

Chapter 11

On page 275 the authors use a good nonce, “übercentralization.”

On page 277 they write:

“While no self-respecting bitcoiner would ever describe Google or Facebook as decentralized institutions, not with their corporate-controlled servers and vast databases of customers’ personal information, these giant Internet firms of our day got there by encouraging peer-to-peer and middleman-free activities.”

In the notes on the margin I wrote “huh?”  And I am still confused because each of these companies attempts to build a moat around their property.

Google has tried like 47 different ways to create a social network even going so far as to cutting off its nose (Google Reader, RIP) to spite its face all with the goal of keeping traffic, clicks and eyeballs on platforms it owns.  And this is understandable.  Similarly Coinbase and other “universal hosted wallets” are also trying to build a walled garden of apps with the aim of stickiness — finding something that will keep users on their platform.

On page 277 they also wrote that:

“Perhaps these trends can continue to coexist if the decentralizing movements remains limited to areas of the economy that don’t bleed into the larger sectors that Big Business dominates.”

What about Big Bitcoin?   The joke is that there are 300,027 advocacy groups in Bitcoinland: 300,000 privkey holders who invested in bitcoin and 27 actual organizations that actively promote Bitcoin.  There is probably only one quasi self-regulating organization (SRO), DATA.  And the advocacy groups are well funded by VC-backed companies and investors, just look at CoinCenter’s rolodex.

On page 280 they write:

“Embracing a cryptoccurency-like view of finance, it has started an investment program that allows people invest directly in the company, buying notes backed by specific hard assets, such as individual stores, trucks, even mattress pads. No investment bank is involved, no intermediary. Investors are simply lending U-Haul money, peer-to-peer, and in return getting a promissory note with fixed interested payments, underwritten by the company’s assets.”

This sounds a lot like a security as defined by the Howey test.  Again, before participating in such an activity be sure to talk with a legal professional.9

On page 281 they use the term “virtual currencies” for the 11th time, this time in reference to MasterCard’s lobbying efforts in DC for Congress.

On page 283 a small typo, “But here’s the rub: because they are tapped” — (should be trapped).

On page 283 they write:

“By comparison, bitcoin processors such as BitPay, Coinbase, and GoCoin say they’ve been profitable more or less from day one, given their low overheads and the comparatively tiny fees charged by miners on the blockchain.”

This is probably false.  I would challenge this view, and that none of them are currently breaking even on merchant processing fees alone.

In fact, they likely have the same user acquisition costs and compliance costs as all payment processors do.

For instance, in October 2014, Brian Armstrong and Fred Ehrsam, co-founders of Coinbase, did a reddit AMA.  At the 21:12 minute mark (video):

Q: Is Coinbase profitable or not, if not, when?

A: It’s happened to be profitable at times, at the moment it’s not; we’re not burning too much cash.  I think that the basic idea here is to grow and by us growing we help the entire ecosystem grow — without dying.  So not at the moment but not far.

It’s pretty clear from BitPay’s numbers that unless they’ve been operating a high volume exchange, they are likely unprofitable.

Why?  Because, in part of the high burn rate.  What does this mean?

Last week Moe Levin, former Director of European Business Development at BitPay, was interviewed by deBitcoin, below is one detailed exchange starting at 1:57m:

Q: There was a lot of stories in the press about BitPay laying off people, can you comment on that?

A: Yea, what happened was we had a high burn rate and the company necessarily needed to scale back a little bit on how many people we hired, how many people we had on board, how much we sponsored things.  I mean things were getting a little bit out of hand with sponsorships, football games and expansion — more care needed to be put on how and where we spent the money.

Q: Can you elaborate on the burn rate?  Tim Swanson wrote a piece on BitPay in April, published this piece about the economy, the BitPay economy. Posted this piece on the burn rate and actual figures, have you read that piece?  Can you comment on that?

A: Yes, it is especially hard for a company to build traction when they start off.  Any start up is difficult to build traction.  It’s doubly hard, the hardness is amplified when a company enters a market with competitors that have near unlimited resources because the other companies can either blow you out of the water or have better marketing strategies or they can do a ton of different things to make your startup more irrelevant.  Standard in any company but it is doubly difficult when you enter a market like that.  In the payments industry, forget about Bitcoin for a second, in the payments industry and the mobile commerce, ecommerce, company-to-company payments industry there are massive players with investments and venture backed companies in the billions.  Competing at that stage is tricky and it necessarily requires a burn rate that is much higher than the average startup because of how you need to compete in this space.  What is also important is that the regulation costs a lot of money for the startups in the Bitcoin economy.  It’s the perfect storm of how a startup will be hit with a ton of expenses early on and that can hurt the growth of a company.  Even though a lot of the money that went into it was growth capital it takes a while to get the balance right between spending and growing.

On page 284 they write:

“That leads us to one important question: What happens to banks as credit providers if that age arrives? Any threat to this role could be a negotiating chip for banks in their marketing battle with the new technology.”

This is a good question and it dovetails with the “Fedcoin” discussion over the past 6 months.10

On page 285 they write:

“With paper money they can purchase arms, launch wars, raise debt to finance those conflicts, and then demand tax payments in that same currency to repay those debts.”

This is a common misconception, one involving lots of passionate Youtube videos, that before central banks were established or fiat currencies were issued, that there was no war or “less war.”

On page 309 they quote Roger Ver at a Bitcoin conference saying:

“they’ll no longer be able to fund these giant war machines that are killing people around the world. So I see bitcoin as a lever that I can use to move the world in a more peaceful direction.”

Cryptocurrencies such as Bitcoin will not end wars for the same reason that precious metals did not prevent wars: the privkey has no control over the “wet code” on the edges.  Wars have occurred since time immemorial due to conflicts between humans and will likely continue to occur into the future (I am sure this statement will be misconstrued on reddit to say that I am in support of genocide and war).

On page 286 they write:

“Gil Luria, an analyst at Wedbush Securities who has done some of the most in-depth analysis of cryptocurrency’s potential, argues that 21 percent of U.S. GDP is based in “trust” industries, those that perform middlemen tasks that blockchain can digitize and automate.”

In looking at the endnote citation (pdf) it is clear that Luria and his team is incorrect in just about all of the analysis that month as they rely on unfounded assumptions to both adoption and the price of bitcoin.  That’s not to say some type of black swan events cannot or will not occur, but probably not for the reasons laid out by the Wedbush team.  The metrics and probabilities are entirely arbitrary.

For instance, the Wedbush analysts state:

“Our conversation with bitcoin traders (and  Wall Street traders trading bitcoin lead us to believe they see opportunity in a market that has frequent disruptive news flow  and large movements that reflect that news flow.”

Who are these traders?  Are they disinterested and objective parties?

For instance, a year ago (in February 2014), Founders Grid asked 50 Bitcoin “experts” what their bitcoin price predictions were over the next year.  The end result — all but a couple were completely, very wrong (see this spreadsheet for a line-by-line itemization).

Later, in May 2014, CoinTelegraph asked (video) more than 30 Bitcoin “experts” as to what their bitcoin predictions were for the end of 2014.  Once again, all but a couple were completely, very wrong.

Or in short, no one has a very good track record of predicting either prices or adoption.  Thus it is unclear from their statements why a cryptocurrency such as Bitcoin will automatically begin performing the tasks that comprise 21% of US economic output based on “trust.”

On page 288 they write:

“So expect a backlash once banks start shutting back-office administrative centers in midtown Manhattan or London’s Canary Wharf when their merchant customers start booking more customer sales via cryptocurrency systems to avoid the 3 percent transaction fees.”

I think there is a lot of conflation here.

  1.  back-offices could be reformed with the integration of distributed ledgers, but probably not cryptocurrency systems (why would a trusted network need proof-of-work?).
  2.  the empirical data thus far suggests that it doesn’t matter how many merchants adopt cryptocurrencies as payments, what matters is consumer adoption — and thus far the former out paces the latter by several an enormous margin.
  3.  that 3% is broken down and paid to a variety of other participants not just Visa or MasterCard.
  4.  the US economy (like that of Europe and many other regions) is consumer driven — supply does not necessarily create its own demand.

There is one more point, but first the authors quote Chris Dixon from Andreessen Horowitz, “On the one hand you have the bank person who loses their job, and everyone feels bad about that person, and on the other hand, everyone else saves three percent, which economically can have a huge impact because it means small businesses widen their profit margins.”

This myth of “3%” savings is probably just a myth.  At the end of the day Coinbase, BitPay and other payment processors will likely absorb the same cost structures as existing payment processors in terms of user acquisition, customer support, insurance, compliance and so forth.  While the overhead may be lean, non-negligible operating costs still exist.

There are two reasons for why it could be temporarily cheaper to use Coinbase:

1) VC funding and exchange activity subsidizes the “loss-leader” of payment processing;

2) because Coinbase outsources the actual transaction verification to a third party (miners), they are dependent on fees to miners staying low or non-existent.  At some point the fees will have to increase and those fees will then either need to be absorbed by Coinbase or passed on to customers.

On page 290 they quote Larry Summers:

“So it seems to me that the people who confidently reject all the innovation here [in blockchain-based payment and monetary systems] are on the wrong side of history.”

Who are these people?  Even Jeffrey Robinson finds parts of the overall tech of interest.  I see this claim often on social media but it seems like a strawman.  Skepticism about extraordinary claims that lack extraordinary proof does not seem unwarranted or unjustified.

On page 292 they write:

“But, to borrow an idea from an editor of ours, such utopian projects often end up like Ultimate Frisbee competitions, which by design have no referees — only “observers” who arbitrate calls — and where disputes over rule violations often devolve into shouting matches that are won by whichever player yells the loudest, takes the most uncompromising stance, and persuades the observer.”

This is the exact description of how Bitcoin development works via reddit, Twitter, Bitcoin Talk, the Bitcoin Dev mailing list, IRC and so forth.  This is not a rational way to build a financial product.  Increasing block sizes that impact a multi-billion dollar asset class should not be determined by how many Likes you get on Facebook or how often you get to sit on panels at conferences.

Final chapter (conclusion):

On page 292 they write:

“Nobody’s fully studied how much business merchants are doing with bitcoin and cryptocurrencies, but actual and anecdotal reports tend to peg it at a low number, about 1 percent of total sales for the few that accept them.”

My one quibble is that they as journalists were in a position to ask payment processors for these numbers.

Fortunately we have a transparent, public record that serves as Plan B: reused addresses on the Bitcoin blockchain.

Evolution Market v Bitpay BtcAs described in detail a couple weeks ago, the chart above is a log scale measuring the amount of bitcoins that both BitPay (in green) and Evolution (in red) received starting January 16, 2014.

The drop off at the end in March 2015 is related to the exit scam that Evolution underwent (and the drop off for BitPay is related to a limitation in WalletExplorer’s data).

As we can see here, based on the clusters labeled by WalletExplorer, on any given day BitPay processes about 1,200 bitcoins (the actual number is probably about 10% higher).

coinbase transactions

Source: Coinbase

The chart above are self-reported transaction numbers from Coinbase.  While it is unclear what each transaction can or do represent, in aggregate it appears to be relatively flat over the past year.11 Perhaps that will change in the future.

On page 295 they write:

“Volatility in bitcoin’s price will also eventually decline as more traders enter the market and exchanges become more sophisticated.”

As Christopher Hitchens once remarked, that which can be asserted without evidence, can be dismissed without evidence.  Those making a positive claim (that volatility will decline) are the party that needs to prove this and they do not in this book.  Perhaps volatility will somehow disappear, but not for the non-technical reasons they describe.

At the bottom of page 295 they write:

“Even so, we will go out on a limb here and argue that encryption-based, decentralized digital currencies do have a future.”

Again, there is no encryption in cryptocurrencies, only cryptographic primitives.  Also, as described in the introductory notes above, virtual currencies are not synonymous with digital currencies.

Also on page 295 they write:

“Far more important, it solves some big problems that are impossible to address within the underlying payment infrastructure.”

Yes, there are indeed problems with identity and fraud but it is unclear from this book what Bitcoin actually solves.  No one “double-spends” per se on the Visa network.  At the time of this writing no one has, publicly, hacked the Visa Network (which has 42 firewalls and a moat).  The vulnerabilities and hacks that take place are almost always at the edges, in retailers such as Home Depot and Target (which is unfortunately named).

This is not to say that payment rails and access to them cannot be improved or made more accessible, but that case is not made in this book.

On page 296 they write:

“Imagine how much wider the use of cyptocurrency would be if a major retailer such as Walmart switched to a blockchain-based payment network in order to cut tens of billions of dollars in transaction costs off the $350 billion it sends annually to tens of thousands of suppliers worldwide.”

Again this is conflating several things.  Walmart does not need a proof-of-work blockchain when it sends value to trusted third parties.  All the participants are doxxed and KCY’ed.  Nor does it need to convert fiat -> into a cryptocurrency -> into fiat to pay retailers.  Instead, Walmart in theory, could use some type of distributed ledger system like SKUChain to track the provenance of items, but again, proof-of-work used by Bitcoin are unneeded for this utility because parties are known.

Also, while the authors recognize that bitcoins currently represent a small fraction of payments processed by most retailers, one of the reasons for why they may not have seen a dramatic improvement in their bottom line because people — as shown with the Wence Casares citation above (assuming the 96% figure is accurate) — do not typically purchase bitcoins in order to spend them but rather invest and permanently hold them.  Perhaps that may change in the future.

On page 297 they write:

“But now bitcoin offers an alternative, one that is significantly more useful than gold.”

That’s an unfounded claim.  The two have different sets of utility and different trade-offs We know precious metals have some use-value beyond ornamentation, what are the industrial usages of bitcoin?

In terms of security vulnerabilities there are trade-offs of owning either one.  While gold can be confiscated and stolen, to some degree the same challenge holds true with cryptocurrencies due to its bearer nature (over a million bitcoins have been lost, stolen, seized and destroyed).12 One advantage that bitcoin seems to have is cheaper transportation costs but that is largely dependent on subsidized transaction fees (through block rewards) and the lack of incentives to attack high-value transactions thus far.

On page 300 they write:

“As you’ll know from having read this book, a bitcoin-dominant world would have far more sweeping implications: for one, both banks and governments would have less power.”

That was not proven in this book.  In fact, the typical scenarios involved the success of trusted third parties like Coinbase and Xapo, which are banks by any other name.  And it is unclear why governments would have less power.  Maybe they will but that was not fleshed out.

On page 301 they write:

“In that case, cryptocurrency protocols and blockchain-based systems for confirming transactions would replace the cumbersome payment system that’s currently run by banks, credit-card companies, payment processors and foreign-exchange traders.”

The authors use the word cumbersome too liberally.  To a consumer and even a merchant, the average swipeable (nonce!) credit card and debit card transaction is abstracted away and invisible.

In place of these institutions reviled by the authors are, in practice, the very same entities: banks (Coinbase, Xapo), credit-card companies (Snapcard, Freshpay), payment processors (BitPay, GoCoin) and foreign-exchange traders (a hundred different cryptocurrency exchanges).  Perhaps this will change in the future or maybe not.

On page 305 they write about a “Digital dollar.”  Stating:

“Central banks could, for example, set negative interest rates on bank deposits, since savers would no longer be able to flee into cash and avoid the penalty.”

This is an interesting thought experiment, one raised by Miles Kimball several months ago and one that intersects with what Richard Brown and Robert Sams have discussed in relation to a Fedcoin.

On page 306 they write about currency reserves:

“We doubt officials in Paris or Beijing are conceiving of such things  right now, but if cryptocurrency technology lives up to its potential, they may have to think about it.”

This is wishful thinking at best.  As described in Chapter 13, most proponents of a “Bitcoin reserve currency” are missing some fundamental understanding of what a reserve currency is or how a currency becomes one.

Because there is an enormous amount of confusion in the Bitcoin community as to what reserve currencies are and how they are used, it is recommended that readers peruse what Patrick Chovanec wrote several years ago – perhaps the most concise explanation – as it relates to China (RMB), the United Kingdom (the pound) and the United States (the dollar):

There are four main factors that set the Pound and the Dollar apart as viable and attractive reserve currencies. Each was necessary. They were liquid. They were available. And they were perceived as safe. I’m going to run through each of these conditions in turn. I will consider how they applied to the Pound and the Dollar, and to what extent they are satisfied by China’s Renminbi.

(1) Necessity. The fundamental purpose of a reserve currency is to settle external obligations. The greater quantity and variety of obligations a particular currency can settle, the more useful it is as a reserve currency. The currency of a country that produces little of note and lacks funds to lend or invest is not nearly as useful as one whose home economy produces many goods and services desired around the world, serves as an important source of capital, and has many commercial partners who also find its currency relevant to meeting their own obligations. This idea — that the dominant reserve currency derives its status from its connection with the dominant national economy in an interconnected world – is what underlies Roubini’s reasoning that the Renminbi may be next in line to replace the Dollar.

But this conclusion misses something important. A reserve currency must not only be capable of settling obligations in connection with a heavy-weight economy. It must be required to. Because if you can settle those obligations, as sizeable and important as they may be, using your own currency — or the currency of another leading economy — there is no reason to hold that country’s currency as a reserve. That is precisely the case today with China.

It is unclear how or why some Bitcoin advocates can suggest that bitcoins will ever be used as a reserve currency when there is no demand for the currency to meet external trading obligations let alone in the magnitude that these other currencies do (RMB, USD, GBP).

On page 307 they write:

Under this imagined Bretton Woods II, perhaps the IMF would create its own cryptocurrency, with nodes for managing the blockchain situated in proportionate numbers within all the member countries, where none could ever have veto power, to avoid a state-run 51 percent attack.

Proof-of-work mining on a trusted network is entirely unnecessary yet this type of scenario is propagated by a number of people in the Bitcoin space including Adam Ludwin (CEO of Chain.com) and Antonis Polemitis (investor at Ledra Capital).

Two months ago on a panel at the Stanford Blockchain event, Ludwin predicted that in the future governments would subsidize mining.  Again, the sole purpose of mining on a proof-of-work blockchain is because the actors cannot trust one another.  Yet on a government-run network, there are no unverified actors (Polemitis has proposed a similar proof-of-work solution for Fedcoin).

Again, there is no reason for the Fed, or any bank for that matter, to use a Bitcoin-like system because all parties are known.  Proof-of-work is only useful and necessary when actors are unknown and untrusted.  The incentive and cost structure for maintaining a proof-of-work network is entirely unnecessary for financial services institutions.

Furthermore, maintaining anonymous validators while simultaneously requiring KYC/AML on end users is a bit nonsensical (which is what the Bitcoin community has done actually).  Not only do you have the cost structures of both worlds but you have none of the benefits.  If validators are known, then they can be held legally responsible for say, double spending or censoring transactions.

Robert Sams recently noted the absurdity of this hydra, why permissionless systems are a poor method for managing off-chain assets:

The financial system and its regulators go to great lengths to ensure that something called settlement finality takes place. There is a point in time in which a trade brings about the transfer of ownership–definitively. At some point settlement instructions are irrevocable and transactions are irreversible. This is a core design principle of the financial system because ambiguity about settlement finality is a systemic risk. Imagine if the line items of financial institution’s balance sheet were only probabilistic. You own … of … with 97.5% probability. That is, effectively, what a proof-of-work based distributed ledger gives you. Except that you don’t know what the probabilities are because the attack vectors are based not on provable results from computers science but economic models. Do you want to build a settlement system on that edifice?

Though as shown by the NASDAQ annoucement, this will likely not stop people from trial by fire.

Concluding remarks

Bertha Benz, wife of Karl Benz, is perhaps best known for her August 1886 jaunt through present day Baden-Württemberg in which she became the first person to travel “cross-country” in an automobile — a distance of 106 kilometers.

It is unclear what will become of Bitcoin or cryptocurrencies, but if the enthusiasm of the 19th century German countryside echoed similar excitement as reddit sock puppets do about magic internet money, they must have been very disappointed by the long adoption process for horseless carriages to overtake horses as the primary mode of transportation.

For instance, despite depictions of a widely motorized Wehrmacht, during World War II the Teutonic Heer army depended largely on horses to move its divisions across the battlefields of Europe: 80% of its entire transportation was equestrian.  Or maybe as the popular narrative states: cryptocurrencies are like social networks and one or two will be adopted quickly, by everyone.

So is this book the equivalent to a premature The Age of Automobile?  Or The New Age of Trusted Third Parties?

Its strength is in simplicity and concision.  Yet it sacrifices some technical accuracy to achieve this. While it may appear that I hated the book or that each page was riddled with errors, it bears mentioning that there were many things they did a good job with in a fast-moving fluid industry.  They probably got more right than wrong and if someone is wholly unfamiliar with the topic this book would probably serve as a decent primer.

Furthermore, a number of the incredulous comments that are discussed above relate more towards the people they interviewed than the authors themselves and you cannot really blame them if the interviewees are speaking on topics they are not experts on (such as volatility).  It is also worth pointing out that this book appears to have been completed around sometime last August and the space has evolved a bit since then and of which we have the benefit of hindsight to utilize.

You cannot please everyone 

For me, I would have preferred more data.  VC funding is not necessarily a good metric for productive working capital (see the Cleantech boom and bust).  Furthermore, VCs can and often are wrong on their bets (hence the reason not all of them outperform the market).13 Notable venture-backed flops: Fab, Clinkle, DigiCash, Pets.com and Beenz.  I think we all miss the heady days of Cracked.com.

Only two charts related to Bitcoin were used: 1) historical prices, 2) historical network hashrate.  In terms of balance, they only cited one actual “skeptic” and that was Mark Williams’ testimony — not from him personally.  For comparison, it had a different look and feel than Robinson’s “BitCon” (here’s my mini review).

Both Michael and Paul were gracious to sign my book and answer my questions at Google and I think they genuinely mean well with their investigatory endeavor.  Furthermore, the decentralized/distributed ledger tent is big enough for a wide-array of views and disagreement.

While I am unaware of any future editions, I look forward to reading their articles that tackle some of the challenges I proposed above.  Or as is often unironically stated on reddit: you just strengthened (sic) my argument.

See my other book reviews.

Endnotes:

  1. Note: I contacted Rulli who mentioned that the project has been ongoing for about 10 years — they have been distributing value since 2005 and adopted bitcoin due to what he calls a “better payment solution.”  They have 500,000 registered users and all compete for the same pot of bitcoins each month. []
  2. See also Megawatts Of Mining by Dave Hudson []
  3. Additional calculations from Dave Hudson:
    – Current Bitcoin network capacity: approximately 320 PH/s (320 x 10^15)
    – Best case power efficiency (shipping today): approximately 0.5 J/GH (0.5 x 10^-9 J/H)
    Likely power efficiency: approximately 1.0 J/GH (1 x 10^-9 J/H) = 2 x best case
    – Best case power usage (sustained): 320 x 10^15 x 0.5 x 10^-9 = 160 x 10^6 W = 160 MW
    Likely power efficiency: 160 x 2 = 320 MW
    – Best case power usage per day: 160 x 24 = 3840 MWh = 3.84 GWh
    Likely power usage per day: 320 x 24 = 7680 MWh = 7.68 GWh
    – Best case power usage per year: 3.84 x 365 = 1401.6 GWh = 1.4 TWh
    Likely power usage per year: 7.68 x 365 = 2803.2 GWh = 2.8 TWh
    The best case example would represent the entire Bitcoin network using the best possible hardware and doesn’t account for any cooling or any other computers used in the Bitcoin network. As such it represents an impossible best version of a network of this size. The likely example is probably closer as there is older hardware still in use and most data centers need cooling of some sort.
    The US Energy Information Administration estimated the US power generation capacity for 2012 at 1051 GW so the 320 MW number would represent 0.03% of the total electricity supply for the US. Assuming that we take the 320 MW figure then that would put Bitcoin at about 10% of Ireland’s electricity supply. []
  4. See: How do Bitcoin payment processors work? []
  5. See What is the blockchain hard fork “missile crisis?” []
  6. See Distributed Oversight: Custodians and Intermediaries []
  7. See also: The Rise and Rise of Lipservice: Viral Western Union Ad Debunked []
  8. See Can Bitcoin’s internal economy securely grow relative to its outputs? and Will colored coin extensibility throw a wrench into the automated information security costs of Bitcoin? []
  9. See Mitigating the Legal Risks of Issuing Securities on a Cryptoledger []
  10. See Fedcoin by JP Koning, Fedcoin: On the Desirability of a Government Cryptocurrency by David Andolfatto, A Central Bank “cryptocurrency”? An interesting idea, but maybe not for the reason we think by Richard Brown and Which Fedcoin? by Robert Sams []
  11. See Slicing Data []
  12. Tabulating publicly reported bitcoins that were lost, stolen, seized, scammed and accidentally destroyed between August 2010 and March 2014 amounts to 966,531 bitcoins. See p. 196 in The Anatomy of a Money-like Informational Commodity by Tim Swanson. See also: Bitcoin Self-Defense, Part I: Wallet Protection by Vitalik Buterin []
  13. See Venture Capitalists Get Paid Well to Lose Money from Harvard Business Review and Ouch: Ten-year venture returns still lag the broader markets from Pando Daily []
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What’s happening in the Singapore fintech arena?

About a week ago I attended two back-to-back events: the Sim Kee Boon Institute’s conference and the DBS blockchain hackathon.

SKBI, where I am a visiting research fellow, is a seven year old institute which is part of Singapore Management University, one of the youngest universities in Singapore. This was its fifth annual event to cover digital banking and its scope has expanded to impact investing and financial inclusion.

While both events took place over the entire week, the conference was a two and a half day event that included panelists, moderators and audience members from around the globe including parts of Europe, both Americas and all across Asia.

The first full day included several keynotes from industry gurus including Piyush Gupta, the CEO of DBS bank, one of the largest banks in Southeast Asia and others such as Omidyar Network, a investment fund focused on social impact investing primarily in developing countries. The second day was entirely conducted in Chinese and among others included speakers from SF Express and VCredit.

Prior to the event a private roundtable took place over a three hour period and included members from policy making and research bodies.  Both Chris Skinner and myself independently gave presentations covering the future of fintech (incidentally a few of our slides were even similar). Some of the feedback and comments discussed the sustainability, or rather the unsustainability of several P2P lending projects such as those in the UK and in China.  For example, some of the problems in this segment include a lack of credit ratings, financial controls and arbitrary quotas (e.g., incentives to approve loans in order to hit specific arbitrary numbers).

The following day, on the first day of the public conference, Professor Rui Meng from CEIBS explained how there are now 1,700 P2P lending platforms in China and that there were at least 7 reasons for why this number has rapidly increased over the past five years including financial “repression” (the dearth of financial instruments by which investors can diversify into).

rui meng

Professor Rui Meng

For some more stats related to China see: Understanding value transfers to and from China.

What was the overall takeaway of the conference?

My thoughts echo Todd McDonald’s, based on my two trips to Singapore over the past 6 months its policy makers seem to be positioning the country (via Smart Nation) as a testbed for a variety of innovations in the overall “fintech” arena. The Minister of Water Resources & Smart Nation, Vivian Balakrishnan, even gave a roughly 3 minute overview of what blockchains are to the conference dinner after the first day of the event.

Conversations on and off chain throughout the remainder of the week seemed to support the notion that key decision makers at institutions across the country were increasingly interested in potential use-cases that blockchains (or derivations thereof) could solve especially those surrounding trade finance and identity/authentication. And this makes sense.  Singapore became a wealthy developed country in part because of its ports (recall that it sits the cross roads of both regional and international maritime trade prior to even the British colonial era).

Trade finance – smart contracts

One of the conversations I had with a banking administrator was that if you took a port manager or bank manager from the late 19th century and brought them to the present day they would likely not see too many differences in how the trade finance system worked in terms of letters of credit and bill of lading. It still involves a number of frictions (manual, heavily trust-based interactions) that are over a century year old, if not longer, yet are a multi-trillion dollar segment that the revolutions in digitization and automation seem to have forgotten.

It’s a chicken-and-egg problem, a little like fax machines and airports (I am trying not to use the overused cliche phrase “network effect”).  A fax machine which cannot connect to other machines is about as useful as a paper weight and a solitary airport that has no connecting flights is effectively a parking lot.

Can distributed ledgers (or whatever we end up calling non-Nakamoto blockchains) reduce the costs and provide transparency to this seemingly anachronistic trade finance system?  Can smart contracts be used to act as custodians of collateral or property titles in the movement of goods?  Or is this all just wishful thinking? There are two startups that have a “trade piece” related to this, including Mountain View-based PurchaseChain (part of the SKUChain project). Readers: if you are working on a replicated ledger project in this area, Singapore is definitely the place to go to test its utility.

Perhaps the second most widely discussed area that came up in conversations with members of the Singapore financial industry was that of identity and authentication. Like the rest of the world, each local bank has its own KYC/AML procedures that creates frictions when transferring value and adds to the already expensive customer acquisition and on-boarding costs.  For instance, one stat that stood out was that the costs for customer on-boarding at a traditional bank branch can reach upwards of $1,500 or more (once marketing is factored in).

Customer-Acquisition-True-Costs

Credit: Amar Banwait and Optirate

Ideally, so the conversations went, something akin to SingPass or Estonia’s e-identity initiative is an idea that seems to be worth its weight in gold as it could not only lower the costs but also the potential fraud and identity theft that currently takes place (among other benefits).

While it is just my opinion, I found the two most interesting presentations to be from the Fidor bank team (Frank Schwab and Matthias Kröner)  and Daniel Epstein from the Unreasonable Group.

I moderated a panel that included Chris Skinner, Frank Schwab, David Shin (from Paywise) and Todd McDonald (from R3).  The videos are supposed to be uploaded soon.

I also enjoyed hanging out with Albert Chu, who was a moderator and also a SKBI visiting research fellow.  His diverse experience in investing, advising and mentoring.  His views are grounded and did not involve the evangelical hype of the typical Silicon Valley investor.  Anju Patwardhan from Standard Chartered also had many interesting comments and insights throughout the event involving financial inclusion, P2P lending and trade finance.  I would like to also thank professor David Lee for his time, effort and enthusiasm as well as Ernie Teo and Priscilla Cheng from the SKBI team for hosting me.  More photos on Twitter #SKBI.

Some other coverage of the conference:

skbi dinner

SKBI Conference participants

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Panel 1 on Day 1 of SKBI conference

Hackathon

Between Friday and Saturday, 18 teams comprised of 3-4 people each (hailing from a variety of countries) participated in the DBS hackathon, competing for $33,000 SGD in prize money as well as a spot at the DBS / Startupbootcamp (SBC) accelerator.

I took a number of photos with commentary that were posted on Twitter #dbshackathon.

Both CoinGecko and Bitcoin Magazine posted an overview with a few of the teams from the event including the winners and David Moskowitz has a short reddit thread on it as well.

The hackathon itself was fairly straight forward.  Held on the third floor of Block 79 called BASH (where the Startupbootcamp facility is), 18 teams initially worked in one large room and there are several adjoining rooms that were also used as meeting spaces.  Throughout the day a group of mentors (of which I was one of) spoke with and provided assistance and consultation to the teams.  Some of the mentors (and later judges) helped a few of the teams walk through the ideation phase.  The self-organized teams themselves were fairly diverse, comprised of individuals whose skillset typically involved a engineering background but also business development.

In addition to creating a three-minute presentation, there were a number of criteria the projects would be judged on including a technical code review.  While some participants arrived earlier in the week and had a chance to brainstorm, the teams themselves only had two days to bring it all together and pitch the product to six judges.  DBS was the main sponsor of the event and more than 10 individuals from the bank were on-hand throughout the event to provide feedback as to how the ideas could be used in a fintech context.  In addition to the three winners covered in the two articles above, three additional startups that participated in the event were recently accepted into SBC for their new batch.

Aside from the top 3 projects, I thought the 4th place was especially of interest.  DBB is similar to Hyperledger and Stellar but is unique in that users individually run their own ledger and validating node yet there is no global consensus or state.  One of its creators is Pavel Kravchenko who is currently chief cryptographer at Tembusu and previously worked at Stellar.

The atmosphere was friendly, informative and competitive.  Some of the teams were laser focused at winning the competition while others were more relaxed, preferring to focus on team building and becoming more proficient with the tech.  A few had not worked with a decentralized ledger before and Blockstrap was on-site to help provide support for everyone.  Overall it was probably a helpful event for both startups and banks as it led to a cross pollination of ideas and professions.

It was good catching up with the active startup scene there:  Anson Zeall from CoinPip; David Moskowitz from CoinRepublic (who led the tech auditing team for the hackathon); Yusho Liu from CoinHako (which got 3rd place), Antony Lewis (and his baby son) from itBit; TM Lee and Bobby Ong from CoinGecko, Pavel Kravchenko and Andras Kristoff from Tembusu (Pavel independently worked on a new project and got 4th place); Adam Giles and Mark Smalley from Blockstrap; Marcus Swanepoel from BitX; Taulant Ramabaja (founder of Pactum but who flew in and was part of the 1st place team); Ayoub Naciri from Artabit; Virgil Griffith (independent); Lilia Vershinina from Kraken; Markus Gnirck from StartupBootcamp; and Ron Hose from Coins.ph.

They all have, as my British friends say, heaps of passion and it appears as if Singapore is positioning itself to be an important integral role in the future of fintech innovation.

Special thanks to Mikkel Larsen and Cade Tan from DBS for organizing the event and taking the time to discuss their views on trends in this space.

IMG_20150509_191339

Blockstrap and team NuBank (which won 2nd place at the DBS hackathon)

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Antony Lewis (itBit), Taulant Ramabaja (Pactum) and a future stuntman

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Ernie Teo (SKBI), Todd McDonald (R3CEV) and Albert Chu at the Economic Society of Singapore’s annual dinner

dbs hackathon day 1

DBS Hackathon Day 1

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The Future of Fintech: Crystal balls and tasseography

Yesterday I gave a new presentation at a roundtable talk at the Sim Kee Boon Institute at Singapore Management University.

Additional notes, references and citations are in the comments of each slide.

I would like to thank Arthur Breitman, Andrew Geyl (Organ of Corti), Yakov Kofner, Raja Ramachandran and John Whelan for their feedback and comments on several slides.

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The flow of funds on the Bitcoin network in 2015

Over the past several months, there has been a number of useful, simplified flow charts that show the general demand and supply for bitcoins.

chain participants

Source: Chain

The diagram above was created this past fall by Adam Ludwin, co-founder of Chain.com.  Subsequently, there have been a variety of similar charts from others describing the flows in an easy-to-understand way.  I think these are helpful and look forward to seeing more.

However, based on blockchain data, what do the specific flows look like?

After consulting with a number of industry experts, I constructed a rough, but more granular flow of funds based on actual user behavior.  This is not to say that these trends or activities will stay the same, but rather this is a visual aid to better understanding where the supply and demand of both “coins” and fiat are within the current ecosystem.

bitcoinland april 2015

Bitcoinland flow chart

The legend

  • The term “BTC” is in reference to unspent transaction outputs (UTXO), because “coins” do not actually exist1
  • The orange buckets and arrows involve mining farms, manufacturers and pools.
  • The brown buckets involve exchanges, ATMs, financial intermediaries, custodians and payment processors which have access to fiat (“early adopters” may also be on the sell side).
  • The green buckets represent fiat, this can be in the form of bank accounts or in the case of Localtrader, Localbitcoins.com, #bitcoin-otc (an IRC room) and “human” ATMs actual physical cash.
  • The champagne arrows involve the sale of BTC and block rewards.
  • The red arrows involve the purchase and buying of BTC.
  • The purple buckets and arrows involve illicit activity including darknet markets, scams, ransomeware, gambling, laundering and mixing of BTC.
  • The black arrows involve the sending of BTC to another hop or address.
  • And the blue buckets and arrows have no real commonality but are important in terms of the flow of funds.
  • Technically wallets do not exist at all, they are just a mental analogy to abstractly describe addresses as UTXO labels (not all wallets are “burner” as that would imply an increase in anonymity and requires knowledge of intent; they all can be effectively “temporary”).
  • In terms of mixing, certain altcoins are now a popular method for mixing.  For instance, litecoin (LTC) is one of the most liquid altcoins.  This typically looks like convert BTC at exchange A to LTC.   Then send LTC to exchange B and convert back to BTC.  Darkcoin (now called Dash) is another popular coin due to its specific “anonymity” features.  See also ring signatures from Monero.

[Note: I used Creately to prototype it and am releasing it as usual under a CC Attribution license]

The good with the bad

If a bitcoin is eventually deemed legally property, does this new flow chart imply that the current Bitcoin blockchain is a public, near-real-time record of contraband?  Maybe not.  Cryptocontraband would only really apply if you indeed were able to show the provenance of the property that you are talking about.2  For many of the use cases it is actually very difficult to show the provenance of individual currency units.   Perhaps this will change in the future, no one knows.

What is observable?  In addition to roughly 1 million bitcoins moving on a daily basis (more on that later), in the last four years we have seen several dozen high profile cases of individuals and companies whose bitcoins were lost, stolen or accidentally destroyed due to improper operational security.  By one account there are more than a million bitcoins that are no longer with their legal owner.345 Consequently, in terms of venture funding, the 2nd largest vertical that has received funds over the past 18 months is hosted wallet companies (“depository institutions”) such as Xapo and Coinbase which provide cold storage (“vaults”) and some type of insurance.

What has been the motivation to do so?  Because in practice, bearer assets are very hard to secure hence the reason for the emergence of banking intermediaries 500 years ago and again today in the era of virtual assets.

And this type of mercurial bearer ownership is not relegated to just the above-board economy.  For instance, about 16 months ago Sheep Marketplace, a darknet market, was “hacked” and 96,000 bitcoins were stolen (this was worth around $40 million at the time).  The purported owner of Sheep Marketplace was arrested last month.  A month ago, another darknet market, Evolution, lost at least 43,000 bitcoins (~$10 million) after two of the administrators stole them.

At a combined valuation of $50 million, this is roughly what BitPay processed in 2014 once mining and precious metals are removed from itemization.6

What about the “ransomware” subheading, what is “ransomware”?  It is a type of software, or malware precisely, that prevents users from using their computer unless the user pays the malware creator some kind of “ransom.”  In this case, bitcoins.

malware secureworks

“SecureWorks’ chart showing the correlation between Bitcoin’s price increases and the creation of new Bitcoin-targeting malware.” Source: Forbes

As noted in Chapter 12, while this type of malware has existed for several years, CryptoLocker itself stole nearly 42,000 bitcoins in the fall of 2013, thus signaling to market participants that this successful method of attack could be copied.  And as shown by the chart above, there were as of February 2014, 146 different families of “Bitcoin-stealing malware.”   According to Dell, during a six month time frame last year, “CryptoWall infected more than 625,000 computers worldwide, including 250,000 in the United States. During that time, the gang that operated CryptoWall raked in about $1 million in ransom payments.”

Currently hackers are targeting smaller and more marginal actors.  For instance, last month the network for Swedesboro-Woolwich School District in New Jersey was held hostage for a 500 bitcoin ransom.  And earlier this month, the Tewksbury Police Department system in Massachusetts became just one of many public organizations that has paid similar ransoms in bitcoin.

The case of the unknown volume

We know from public reports above of some on-chain activity, but not all.

Current total output volume is around 1 million bitcoins per day.  That is to say that on any given day (over the past year), approximately 1 million bitcoins have moved somewhere on the blockchain.  Knowing this and taking the categorization from Slicing Data, let us make a low, conservative assumption that 80% of the remaining volume is “change” being swept into change addresses, faucet outputs (a potential candidate for “long-chains”) and mining payouts.

And as established last week, we know that about $1,000,000 a day is from payment processing and above-board merchant activity, this amounts to less than 5,000 bitcoins per day.

Where is the rest of the volume coming from?

For instance, has the volume of Counterparty transactions increased?

counterparty transaction history

Source: Blockscan

As illustrated in the chart above, transaction volume for Counterparty has stayed roughly the same over the past 9 months or so.  A typical transaction requires about 0.0001 BTC (as a watermark) and about 0.0001 fee to miners.  Thus on any given day the total amount of bitcoins used by Counterparty is a handful, maybe even just 3 or 4 bitcoins.

What about P2SH?

weekly volume p2sh

Source: P2SH.info

As of this writing, about 8.63% of all bitcoins are stored using P2SH.  And while the last several months have each seen more than 1 million bitcoins move into P2SH, this still does not tell the whole story because that is per month and not per day, which we are observing (e.g., roughly 100,000 or so bitcoins per day move into P2SH).

What else comprises this gap?

If actual transactions represent 20% of the total output volume, or 200,000 bitcoins, what else could fit the bill?  Payment processors collectively would account for 2.5%, P2SH would account for 50% (although technically P2SH is not commercial activity), Counterparty less than 1%, gift cards less than 1%.

What about crowdsales?  The largest one right occurring right now is Factom.  Over the past three weeks approximately 2,180 transactions containing 1,955 bitcoins have been sent to the fundraising address; or about 104 transactions per day.

Now lets assume the international payments and remittance market is at least the same size as the merchant economy (it may be lower, based on anecdotally having talked to about 10 different exchanges overseas the past couple of months); so that is about another 5,000 bitcoins per day or 2.5%.

That means that we are still missing around 80,000 bitcoins per day if not more.  And based on address clusters at WalletExplorer, a large portion appears to come from movement in between exchanges and hosted wallets, as well as gambling services and darknet markets.

Recall that at its height in the spring and summer of 2012, nearly half of all transaction volume on the Bitcoin network were related to SatoshiDice.7 Once it blocked US-based IP addresses, its popularity waned.

Over the past two years, since May 13, 2013, there have been 946,261 bitcoins worth of wagers at Primedice, or roughly 1,350 bitcoins per day.

prime dice betting

Source: Dicesites

The chart above visualizes the activity on Primedice since January 1, 2015 – April 18, 2015.  Based on this cluser, there is is roughly as much transactional volume passing through Primedice as BitPay does each day.

A few other notable publicly known dice sites tracked by Dicesites:

  • Pocket Rocket Casino has about 440 bitcoins / day in wagers
  • BitDice has about 240 bitcoins / day in wagers
  • Dicenow has about 70 bitcoins / day in wagers

For perspective, prior to emptying its wallet (the first time), on its then-summer 2012 height, Silk Road’s public address contained 5% of all mined bitcoins at that point.8  In early November 2014, Operation Onymous — an international law enforcement action targeting darknet markets, closed down 414 sites.  Left unaffected were several of the larger DNMs, including Agora, Evolution and Andromeda, each of which actively sell illicit wares denominated in bitcoin.  Evolution, as noted above, suffered a large theft which will be looked at below.

Evolution DNM

Last week we looked at some charts from Coinalytics in relation to BitPay.  Coinalytics specializes in building data intelligence tools to analyze activities on the blockchain.  Using labels from WalletExplorer.com (which identifies reused addresses of a number of different services), the team was able to create visual aides covering Evolution.

Two things to keep in mind:

1) as a Swiss-based bot recently discovered, not everything sold on a DNM like Evolution are necessarily illegal (though a lot probably is)

2) we cannot have 100% confidence on the data since it may be missing some address clusters.  For instance, last week, the 500,000 BitPay transactions identified by WalletExplorer were 10% less than what BitPay officially reported during the same time frame (2014).  Thus, there may be a similar margin of error for the following data.

Evolution was officially launched on January 14, 2014 and its administrators pulled an “exit scam” with a large portion of the funds on March 18, 2015, effectively shutting down its operations.

Evolution Market Number of TransactionsThe chart above visualizes the time period between January 16, 2014 – March 18, 2015.  The average number of transactions per day was 1,004 and average bitcoins per day was 562.  However, as shown in the chart above it was not until the fall of 2014 that Evolution hit its stride.

For the six months between September 18, 2014 – March 18, 2015 saw traction.  During this time frame they processed 2,025 transactions and 1,260 bitcoins per day.

Evolution Market v Bitpay BtcAnother way of looking at that same trend is the comparison above: a log scale measuring the amount of bitcoins that both BitPay (in green) and Evolution (in red) received starting January 16, 2014.  The drop off at the end in March 2015 is related to the exit scam that Evolution underwent (and the drop off for BitPay is related to a limitation in WalletExplorer’s data).

evolution market volume log scaleThe log chart above measures the value of incoming market volume between BTC and USD.

In terms of USD, the average value sent to Evolution between March 18 2014 – March 18 2015 was $190,179 per day.  As it achieved traction, between September 18 2014 – March 18, 2015 the average value sent was $353,669 per day.

For comparison recall that based on the stats released last week by BitPay, on average BitPay processed 1,544 transactions worth $435,068 per day in 2014.

USD Evolution MarketThe final chart above may be of interest to those wondering what the “exit scam” looked like in USD denominated value.  The time frame above is between January 16, 2014 – March 18, 2015.  As shown at the end, in March, the administrators “exited” with a large portion of coins valued at a range between $10-12 million USD (the full amount varies based on media outlet and is not fully captured in the chart above).

A question of ownership

Throughout this post the word “owner” has been used a few times.  Why is this important when looking at economic activity and flows of funds?

In an exchange with Amor Sexton, an Australian attorney that represents cryptocurrency companies, she noted that:

It seems like the preferred legal approach in many jurisdictions is that bitcoin is a form of digital property, and not money. This means that bitcoin would lack the negotiability of money. It is an important distinction in light of the concerns about the volume of fraud and theft.

If the statistics are correct, a significant amount of people may not have good title to the bitcoin that they hold. Of course, this is all theoretical, as it is arguably nearly impossible to prove title to bitcoin and satisfy the nemo dat principle.

However, you can’t merely ignore the issue. The law doesn’t cease to exist because you ignore it. For example, as Pamela Morgan points out, when you build a website, you get a default font without needing to specify any font. If you want to change the font, you need to write code to change it. The law has default positions that are implied into every situation. To change the default position, you have to actively create a new position that takes precedence over the default position.

The default position for property (and bitcoin if it is deemed property) is that the nemo dat rule applies. Ignoring the problem doesn’t fix it. The only thing that can fix it is by creating a new default position – either by law (declaring bitcoin to have the same negotiability as fiat currency) or by private agreement.

Nemo dat (short for nemo dat quod non habet) boils down to clean titles.  If you buy property from someone who does not have ownership right of the property, then the new purchaser does not have a legitimate title to this property (e.g., you cannot sell what is not yours).

Sexton is not the only practicing attorney with this view.

I spoke with Ryan Straus, an attorney at Riddell Williams in Seattle.  According to him:

I think there is a great deal of confusion around the property/currency distinction.  This confusion was magnified by FinCEN’s classification of Bitcoin as “virtual currency” for the purposes of the Bank Secrecy Act.  Shortly after FinCEN’s March 2013 interpretive guidance, people started to use the term “digital currency” rather than “virtual currency.”9

Bitcoin is not currency in digital or virtual form.  Rather, Bitcoin is virtually, or almost, currency.  Why is this important?  Currency can be thought of as property imbued, by the sovereign, with a special power.  Specifically, the legal tender status of currency allows it to be transferred free and clear of, rather than subject to, all claims and defenses.

In other words, currency is the only unconditional exception to nemo dat quod non habet, or the general rule that one can never transfer a better interest than one has.  There are other conditional exceptions to nemo dat that apply to certain types of property (goods, negotiable instruments and security entitlements) if certain conditions are met (property is transferred “for value” and in “good faith”).  If Bitcoin is not currency and does not fit within one of the statutory exceptions to nemo dat, nemo dat applies.  At this point in the conversation, the issue of fungibility inevitably comes up. However, fungibility isn’t a solution; it is merely an evidentiary issue.

The Financial Times, recently covered similar legal analysis by George Fogg, an attorney at Perkins Coie.  According to Fogg, “under the United States’ UCC code (uniform commercial code) as long as bitcoins are treated as general intangibles, no high value investor can be sure that an angry Tony Soprano won’t show up one day to claim that the bitcoins they thought they received in a completely unencumbered manner are actually his.”

Based on this insight the Times noted that:

Indeed, given the high volume of fraud and default in the bitcoin network, chances are most bitcoins have competing claims over them by now. Put another way, there are probably more people with legitimate claims over bitcoins than there are bitcoins. And if they can prove the trail, they can make a legal case for reclamation.

This contrasts considerably with government cash. In the eyes of the UCC code, cash doesn’t take its claim history with it upon transfer. To the contrary, anyone who acquires cash starts off with a clean slate as far as previous claims are concerned. It is assumed, basically, that previous claims on cash are untraceable throughout the system. Though, liens it must be stressed can still be exercised over bank accounts or people.

According to Fogg there is currently only one way to mitigate this sort of outstanding bitcoin claim risk in the eyes of US law. Rather than treating cryptocurrency as a general intangible, Fogg argues, investors could transform bitcoins into financial assets in line with Article 8 of the UCC. By doing this bitcoins would be absolved from their cumbersome claim history.

The catch: the only way to do that is to deposit the bitcoin in a formal (a.k.a licensed) custodial or broker-dealer agent account.

Whether or not a court will agree with this view depends on the jurisdiction that future defendants/plaintiffs are located.  US law seems pretty clear when it comes to property.

And as it is encoded today, there is no technical means for the Bitcoin network to enforce  off-chain asset rights based on terms-of-service (smart contract or otherwise); although there may be technical methods for integrating a terms-of-service into contracts transacted on the network.  However that is a topic for a different post.

Conclusions

As the Bitcoinland flow chart above showed, over the past six-and-nearly-a-half years, a visible division can now been seen between a KYC economy and non-KYC economy.  And while readers will likely find different parts of interest, to me a few of the takeaways are:

  1. In terms of activity, it is still difficult to tell what each category consumes specific amounts of transaction volume (e.g., “change” addresses, above-board merchant volume, gambling and so forth)
  2. Where the fiat leakage is occurring, where people take bitcoins out of circulation and purchase them with dollars or euros; how will this change in the coming months?
  3. The fact that value is actually being transferred: for all its warts some people still use it to transfer value often without intermediaries involved

Bitcoin and most other cryptocurrencies today, were intentionally designed not to interface with the current financial infrastructure.  Satoshi Nakamoto purposefully designed the network so that on-chain activity would route around trusted third parties and this came at a capital intensive cost (e.g., proof-of-work).  The decentralized, pseudonymous nature of these networks are a dual-edged sword: it provides advantages that can and will be used by both good and bad actors alike.  It will be interesting to look again at how this flow chart evolves over the coming years.

energy consumption bitcoin

Bitcoin network power usage from O’Dwyer and Malone

Future researchers may also be interested in breaking down the energy costs for maintaining each segment or bucket in the flows above.

For instance, last year O’Dwyer and Malone found that Bitcoin mining consumes roughly the same amount of energy as Ireland does annually.  It is likely that their estimate was too high and based on Dave Hudson’s calculations closer to 10% of Ireland’s energy consumption.1011
Furthermore, it has likely declined since their study because, as previously explored in Appendix B, this scales in proportion with the value of the token which has declined over the past year.

The previous post looked at bitcoin payments processed by BitPay and found that as an aggregate the above-board activity on the Bitcoin network was likely around $350 million a year.  Ireland’s nominal GDP is expected to reach around $252 billion this year.  Thus, once Hudson’s estimates are integrated into it, above-board commercial bitcoin activity appears to be about two orders of magnitude less than what Ireland produces for the same amount of energy.

If this is the case, is there a way to determine how much energy is being consumed to transfer and secure: the KYC activities as well as the non-KYC’ed activities?  One constraint to consider too for this research is that if it somehow becomes cheaper to secure the network, it is also cheaper to attack the network — and this can impact both currency and non-currency applications of the network.

[Thanks to Fabio Federici, Andrew Geyl (Organ of Corti), Dave Hudson, Jonathan Levin, Amor Sexton and Ryan Straus for their feedback and insights.]

  1. For one explanation why, see Bitcoin: New Plumbing for Financial Services by Jonathan Levin []
  2. The first person I am aware of that used the term “cryptocontraband” is Robert Sams. []
  3. Tabulating publicly reported bitcoins that were lost, stolen, seized, scammed and accidentally destroyed between August 2010 and March 2014 amounts to 966,531 bitcoins. See p. 196 in The Anatomy of a Money-like Informational Commodity by Tim Swanson. See also: Bitcoin Self-Defense, Part I: Wallet Protection by Vitalik Buterin []
  4. The inability to enforce a contract and retrieve losses in the event of fraud is not just a challenge for Bitcoin, but other cryptocurrency systems such as Dogecoin. For instance, Dogeparty asset “DOGEDIGGERS” was used by someone mid-November 2014 to sell shares in their “mining operation.” The individual(s) behind it managed to extract a few million dogecoin before people caught on and started asking questions, identifying it as a scam and put an end to it — the social media sites that the scammers were using to make the scam look legitimate were taken down. Restitution, if there is any, will take place off-chain where contract enforcement actually exists. See also Meet Moolah, the company that has Dogecoin by the collar from The Daily Dot []
  5. While the verdict is still out on Mt. Gox, new data analysis suggests that hundreds of thousands of bitcoins were systematically stolen from Mt. Gox over a period of two years, many of which were sold on other exchanges including Mt. Gox.  See The missing MtGox bitcoins from Wizsec []
  6. Some other examples include: Neo & Bee, Bitcoin Trader, Moolah from Alex Green/Ryan Kennedy, GAW/PayCoin from Josh Garza, BFL, MyCoin and at least 192 others, more likely hundreds more.  A number of the buckets probably deserve their own flow chart, especially since stolen bitcoins can be observed being split apart, onion style (e.g., the criminal peel off UTXOs little by little). See: Investigating the allinvain heist by GraphLab and An Analysis of Anonymity in the Bitcoin System by Fergal Reid and Martin Harrigan []
  7. On May 4, 2012 Stephen Gornick calculated that of the 42,152 total transaction on the blockchain, 21,076 transactions were wagers related to Satoshi Dice. This volume doubled within four days, as Gornick posted an update that 94,706 total transactions on the blockchain, 47,353 were wagers.  In September 2013, Rick Falkvinge made the following analogy: “Money in gambling – at least instant gambling – is not in a lockdown cycle and does not contribute to the minimum size of the money supply. This becomes important as we look at the different economies making up bitcoin today. There are about 11.7 million bitcoin in circulation today. Out of these, a staggering 2 million bitcoin are gambled every year on the SatoshiDice site alone, and another, PrimeDice, 1.5 million. To put these numbers in perspective, if translated to the global economy, it would mean that people bet the entire production of the USA at one single betting site, and the entire production of Europe on another. But as we have seen, these numbers do not contribute to the money supply pool in any meaningful way in a functioning economy.” See Bitcoin’s Vast Overvaluation Appears Partially Caused By (Usually) Illegal Price-Fixing by Rick Falkvinge []
  8. See A Fistful of Bitcoins: Characterizing Payments Among Men with No Names by Meiklejohn et al. []
  9. FinCEN Issues Guidance on Virtual Currencies and Regulatory Responsibilities from FinCEN []
  10. See also Megawatts Of Mining by Dave Hudson []
  11. Additional calculations from Dave Hudson:
    – Current Bitcoin network capacity: approximately 320 PH/s (320 x 10^15)
    – Best case power efficiency (shipping today): approximately 0.5 J/GH (0.5 x 10^-9 J/H)
    Likely power efficiency: approximately 1.0 J/GH (1 x 10^-9 J/H) = 2 x best case
    – Best case power usage (sustained): 320 x 10^15 x 0.5 x 10^-9 = 160 x 10^6 W = 160 MW
    Likely power efficiency: 160 x 2 = 320 MW
    – Best case power usage per day: 160 x 24 = 3840 MWh = 3.84 GWh
    Likely power usage per day: 320 x 24 = 7680 MWh = 7.68 GWh
    – Best case power usage per year: 3.84 x 365 = 1401.6 GWh = 1.4 TWh
    Likely power usage per year: 7.68 x 365 = 2803.2 GWh = 2.8 TWh
    The best case example would represent the entire Bitcoin network using the best possible hardware and doesn’t account for any cooling or any other computers used in the Bitcoin network. As such it represents an impossible best version of a network of this size. The likely example is probably closer as there is older hardware still in use and most data centers need cooling of some sort.
    The US Energy Information Administration estimated the US power generation capacity for 2012 at 1051 GW so the 320 MW number would represent 0.03% of the total electricity supply for the US. Assuming that we take the 320 MW figure then that would put Bitcoin at about 10% of Ireland’s electricity supply. []
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A gift card economy: breaking down BitPay’s numbers

Two days ago BitPay, the largest payment processor in the cryptocurrency space, published a new infographic filled with a number of new stats.

BitPay claims that in 2014:

  • $158,800,000 total value processed (an increase from $107 million in 2013)
  • 563,568 total number of transactions (an increase from 209,420 in 2013)
  • $281 average order value (a decline from $513 in 2013)

They also state that there is a reason for the decline in average order value:

This number is dropping as adoption increases and Bitcoin moves from an investment commodity to a payment method.

At best that is just a guess.  While it is neat that BitPay is one of a very few companies in this space willing to publicly release some numbers, we cannot determine what the actual cause for this trend with the available information.  Correlation (drop in prices or average order value) does not mean the real cause is payment adoption.

correlation

Source: XKCD

According to Jonathan Levin, head of business development at Chainalysis:

The fall in the average order value seems likely to be attributed to the increase in difficulty and the fall in the number of home miners.

Unless they publish weekly or monthly bar charts (which they used to), or what merchants are their largest by volume each week, it is unclear what could be skewing that number (e.g., large block sales from miners in 2013 and 2014?).

For instance, in December 2013, the chart below was published on the official BitPay blog (it has since been removed):

bitpay 2013The spike in transactions during November 2013 is probably related to two things:

  1. the Bitcoin Black Friday marketing event
  2. simultaneous run-up in prices during the contemporary bubble that early adopters / miners were likely able to capitalize off of by exiting positions

Are there any other numbers?

bitpay 2014Above is the last known public chart of BitPay transaction volume.  The dates on the chart corresponds with April 2013 – March 2014 and the image comes from the Cryptolina conference held in August 2014.

Although the quality is a little fuzzy, transaction volume appears to have reached around 70,000 in March 2014.  Token prices during March ranged from approximately $450 – $650 which they likely weighted and multiplied by the total amount of bitcoins received each day to come up with a figure of $1 million processed each day (note: at the end of May 2014, BitPay announced it was processing $1 million in bitcoins a day).

Yet as we shall see, in terms of fiat transaction equivalent, there is less than half as much today as there was last year.

bitpay chartThe chart above is part of the original BitPay infographic released on Wednesday.

In terms of transaction volume, bitcoin mining alone accounts for the next 4 largest segments combined.  For those who believe this will change in the future, recall that if mining somehow becomes cheaper then it is also cheaper to attack the network.  So as long as there are rents to be extracted, miners will continue to fight for and bid up the slivers of seigniorage up to where the marginal cost eventually reaches the marginal value of the token; and that translates into continuous streams of mining revenue (not necessarily economic profit) that are converted into fiat to pay for land, labor, taxes and electricity.

Furthemore, because bitcoin mining is not on the top 5 list of in terms of number of transactions this likely means that the miners that do use BitPay likely sell large blocks and are therefore large manufacturers or farms or both (and of those miners, most probably come from large entities such as BFL and KnC paying their utility bills).

The second chart to the right states that gift cards as a class represent the lion share for number of transactions processed.  This is actually kind of humorous and unhumorous.  What this means is that the majority of BitPay users (and probably bitcoin users in general) are not doing economic calculation in BTC (the unit of account) but instead some kind of fiat.  And to do so, they are going through a Rube Goldberg-like process to convert bitcoins into fiat-based utility.

This is mostly borne out through a roundabout process such as bitcoins sent to Gyft -> Gamestop -> ShellCard (the gas company).  Or Gyft->Amazon->Purse.io.

What are other motivations?  Some users, based on social media posts, claim to do this in order to reduce identification (KYC) paper trails so taxes will not have to be declared and sometimes to take part in illicit trade (e.g., sell these gift cards at a discount for actual cash for illicit wares).

Based on their chart, roughly $345,000 of merchant activity is processed on a daily basis.  Of that, $277,000 comes from precious metals and bitcoin mining.  The remaining  $68,000 is for unidentified e-commerce, IT services and travel.  Or in other words, nearly 80% of bitcoins processed by BitPay in 2014 went to paying for security (mining) and buying (or selling) gold and silver.

As I have written about previously, that for roughly every $1 spent on security (via mining), there was roughly $1 spent on actual retail commerce which translates into a quantitatively (not qualitatively) oversecured network.1 But based on this new data: more capital is probably being spent securing the network than retail commerce by a factor of at least 2x.2

Recall that bitcoin mining represents just under half of all transaction volume processed by BitPay, and BitPay itself has about 1/3 to 1/2 of the global market share for payment processing, so it is probably a good sample size of world wide non-darkmarket “activity.”

What about others?

The second largest payment processor is Coinbase.  And based on their self-reported transaction volume (below), the “off-chain” trend over the past year is similar to what BitPay processed:

coinbase chartAs described in Wallet Growth, approximately six months ago, in October 2014, Brian Armstrong and Fred Ehrsam, co-founders of Coinbase, did a reddit AMA.  At the 31:56 minute mark (video), Ehrsam discussed merchant flows:

One other thing I’ve had some people ask me IRL and I’ve seen on reddit occasionally too, is this concept of more merchants coming on board in bitcoin and that causing selling pressure, or the price to go down. [Coinbase is] one of the largest merchant processors, I really don’t think that is true.  Well one, the volumes that merchants are processing aren’t negligible but they’re not super high especially when compared to people who are kind of buying and selling bitcoin.  Like the trend is going in the right direction there but in absolute terms that’s still true.  So I think that is largely a myth.

Perhaps those volumes will change, but according to the chart above, that does not appear to be the case.

And as discussed in Slicing Data, the noticeable pattern of higher activity on weekdays versus the weekend is apparent irrespective of holidays with Coinbase too. Consequently, on most days these self-reported numbers comprise between 3-5% of the total transactions on the Bitcoin blockchain.  However, as Jonathan Levin, has pointed out, it is not clear from these numbers alone are or what they refer to: Coinbase user to user, user to merchant, and possible user wallet to user vault?

What does this mean for BitPay?

BitPay has three tiers of customer pricing.  The first plan is free, the second charges $300 for the first month and the third is for enterprise clients.  They claim that there are no transaction fees at all.

While they probably do sign up customers on their 2nd and 3rd tier, it is unclear how much.  Speculatively it may not be very much due to the low transaction volumes overall (e.g., why would Microsoft pay more in customer service than they generate in actual revenue?).  Thus their margins may be razor thin at ~1% which translates to roughly $1.5 million in annual revenue (it has to be below 2-3% otherwise merchants would not perceive an advantage for using their service).  BitPay also charges (collects) a spread through a process called the BitPay Best Bid (BBB) rate.

Based on the current head count of between 70-100 people (9 were probably laid off after the “Bitbowl“), it may be the case that the revenue generated annually covers the labor costs for just one or two months.  Perhaps this will change if prices rebound and/or if volume increases (recall that payment processors sometimes have to put coins on their books if they cannot find a counterparty to sell to in the time frame so in the likely event that BitPay holds coins on their books, they can gain or lose through forex movements).

bitpay twitterOn this point, four months ago I was involved in a mini-twitter debate with Jeff Garzik (a developer with BitPay) and Antonis Polemitis (an investor with Ledra Capital).  It partially centered around some of the findings that Jorge Stolfi (a computer science professor in Brazil) posted the previous month regarding BitPay’s transaction volume.

As discussed on Twitter, their burn rate on labor — as in almost all startups — is most certainly higher than the revenue they generate.  This should not be seen as “picking on BitPay” (because virtually every US-based VC-backed Bitcoin-related startup is in the same boat, see Buttercoin and probably ChangeTip) but they probably are not generating much additional revenue from “monthly SaaS subscriptions and payroll API customers.”

How do we know this?  Again, why would Demandware pay more for a SaaS subscription than they generate via revenue?  Altruism?  Perhaps a few do (like NewEgg or TigerDirect) but even if 1,000 customers paid $300 a month, that is still just $300,000 a month far less than the $1 million (speculatively) needed to cover labor alone.

Clustering

I contacted Fabio Federici, co-founder of Coinalytics which specializes in building data intelligence tools to analyze activities on the blockchain.  Using data from WalletExplorer.com (which identifies reused addresses of payment processors, pools, gambling services and such), his team was able to create visual aides covering BitPay.

It bears mentioning that there is a ~10% discrepancy between the WalletExplorer numbers and BitPay and this is likely a result of the clustering heuristic (by WalletExplorer) which will not give 100% coverage and is not dishonesty from BitPay (e.g., WalletExplorer data set identifies just over 600,000 transactions last year whereas BitPay cites roughly 650,000 transactions).

bitpay daily number of transactionsThe time frame for the chart above takes place between July 2, 2011 and April 13, 2015.  The chart visualizes the Daily Number of Transactions.  The green line is the important line as it represents the incoming transaction amount that BitPay receives each day.  It shows that aside from a brief outlier in the winter of 2014, volume has remained relatively flat at around 1,200 – 1,500 transactions per day for the past 15 months.Daily Volume Btc (2013-2015) [Log] xThe time frame for the log chart above is slightly shorter, between January 1, 2013 and February 28, 2015 (there is a strange drop starting in March that is likely a problem with the clustering heuristic, so it was removed).  The chart visualizes the Daily Volume of bitcoin that BitPay receives.  The green line is the important line as it represents the aggregate of how many bitcoins BitPay received each day.  While there are some days where the total reaches to 8,000 or even 9,000 bitcoins, these are outliers.  Conversely some slower days reach around 500 bitcoins per day.  On average, between January 1, 2013 and February 28, 2015, the daily amount is 1,138 bitcoins.

Other specific ranges:

  • Average February 2013 – February 2015 = 1,209 bitcoins daily
  • Average February 2014 – February 2015 = 850 bitcoins daily

One explanation for the discrepancy is that there is a large incoming transaction of 28,790 bitcoins on March 25, 2013 which skews the average in the first date range.  It the same day that the Cyprus international bailout was announced.  While this coincides with the ‘bull run’ in the spring of 2013, it is unclear from public data what this one sale may have been.  Looking at some other charts, at around that date roughly 52,694,515 bitcoin days were destroyed (BDD) and total output volume (TOV) was around 4 million (which is about 4x higher than today).  During this time frame fees to miners were also about 3x-4x higher than they are today.  And on this specific day, 159 bitcoins in fees were sent to miners, the fifth highest total ever.  While speculative it could have been an “early adopter” or even a company overseas cashing out (market price was around $73.60 per bitcoin on March 25, 2013).

Daily Number of Transactions (2013-2015) [Log] xThe log chart above visualizes the daily number of transactions for BitPay between January 1, 2013 and February 28, 2015.  The interesting phenomenon is the flip that occurred in the fall of 2014.  Whereas previously the number of outgoing transactions exceeded the internally held coins, in late September this appears to have changed.  It is unclear what the reason(s) for this is.  Perhaps more merchants decided to keep coins instead of exchanging for fiat.  Or perhaps due to the continued price decline, BitPay had to hold more coins on their balance sheet due to the inability to liquidate merchant requests fast enough (e.g., between August 1 – November 1, market prices declined from around $558 to $336 per bitcoin).

Other noticeable phenomenon on the green line above include a rapid run-up during the collapse of Mt. Gox in February 2014 and then later Bitcoin Black Friday followed by Cyber Monday in November 2014.

Why are there recognizable patterns for the green line in all of the charts?  Again, since the bulk of payments are related to mining, it is likely that miners sell blocks on a regular basis.  Denominated in USD, when paired up with bitcoin volume between February 2013 and February 2015, the plot would likely look like a left-modal bell curve.

Perspectives and conclusions

On average BitPay processed 1,544 transactions worth $435,068 per day in 2014.  Once mining and precious metals are removed, the BitPay “economy” involves $57.5 million per year.  Even if the full amount, $158 million, were classified as actual economic activity, it is less money than what Harvard Business School generates from selling case studies each year (~$200 million) or roughly the same amount that the University of Texas athletic department generates each year.

If Coinbase and the rest of the bitcoin-to-fiat merchant economy sees similar patterns of activity, that would mean that above-board economic “activity” may currently hover around $350 million a year.  This is just slightly more than venture capital was invested in the Bitcoin space last year (~$315 million) and roughly equivalent to the fund that Lux Capital raised last month for funding science-related startups.  For comparison, Guatemalan’s working abroad remitted more than $500 million back to their families in one month alone last year.

In terms of payments the competitive landscape for Bitcoinland is not just other cryptocurrencies but also incumbent payment providers and tech companies such as Google, Apple, Facebook and Microsoft (the latter has been collecting money transmitter licenses), each of which has launched or is planning to launch an integrated payments system.  Startups such as Venmo and Square, both of which were launched the same year as Bitcoin, have seen some actual traction.  For instance, in the forth quarter of 2014 Venmo payment volume came in just over $900 million, up from $700 million processed in the third quarter (Square Cash claims to have an annualized volume run rate of $1 billion).

And although it is not a completely fair comparison, Second Life from Linden Lab is still around “with 900,000 active users a month, who get payouts of $60 million in real-world money every year” (note: there is some debate over specific user numbers).

When mining payments are removed, Bitcoin, as an above-board economy, appears to generate less in return than the venture capital funds have gone into it (so far).  Perhaps this will change as more of the capital is deployed but it may be the case that Bitcoinland cannot securely grow exponentially (as the bullish narrative envisions) while maintaining a fixed amount of outputs.

In his recent conversation with International Business Times, Wouter Vonk, BitPay’s European marketing manager, described the trends from the infographic, stating:

As bitcoin becomes a more established technology, we expect to see more consumers using it. The investors are usually the first ones to hop on new technology, but as bitcoin circulates more, and as the amount of transactions increases, we should see bitcoin being used by more and more average consumers. We see bitcoin being used in emerging markets as a supplement to the current banking and monetary systems.  Bitcoin breaks down the barriers to financial tools that many people in emerging countries are facing.

Empirically, regarding “more consumer using it,” this does not seem to be true.  Nor is there evidence that bitcoin is circulating “more” — in fact, based on age of last use, more than 70% of coins have not moved in more than 6 months (slightly older figure).  And while cryptocurrencies may play a role in developing countries, so far there is little evidence this is actually occurring beyond talk at conferences.  Again, perhaps this will change as new data could reinforce Vonk’s narrative, but so far that is not the case.

For perspective I contacted Dave Hudson, proprietor of HashingIt, a leading network analysis site.  According to him:

One thing that I did notice is that their earlier “incoming” graphs all look highly correlated to the transaction volume in the Bitcoin network after long chains are removed.  This gets back to the usual Bitcoin transaction volume question of what’s really in a transaction and what’s change?  It seems their transaction volumes have really only crept up in the last 12 months, much slower than the rate of growth in transactions (or non-long-chain transactions) on the main network (increased competition?).

What does this look like?  The chart below measures Number of Transactions Excluding Chains Longer Than 10 between April 2013 – April 2015.

blockchain long chainsWhat are long chains again?  Rather than rehashing the entire paper, recall that in Slicing Data, it was observed that a significant fraction of total transaction volume on any given day was likely inflated through a variety of sources such as faucets, coin mixing and gambling.

As we can see above, while there is indeed an upward trend line over the past two years, it is clearly not growing exponentially but rather linearly, and particularly in spurts around “macro” events (e.g., bubble in late 2013 and collapse of Mt. Gox).

Based on the public data from address clustering, consumer adoption is empirically not growing near the same level as merchant adoption.  In fact, consumer adoption in terms of actual non-mining, retail-usage, has basically plateaued over the past year.  We know this is the case since merchants accepting bitcoin for payments has roughly quintupled over the same time frame (20,000 to 100,000) and includes several large marquis (such as Microsoft) yet without any surge in usage by bitcoin owners in aggregate.

Other companies that have actively promoted bitcoin for payments have likely also been impacted by sluggish sales.

For instance, in February 2015, Overstock.com (which has been using Coinbase as a payment processor for over a year) tried to obfuscate weak traction by using a strange method: measuring orders per 1 million residents.

overstock bitcoin

The top 3 were:

  • New Hampshire has a population of 1,326,813 and according to the chart above Overstock received 131 bitcoin orders per million residents.  This comes out to roughly 175 orders in 2014.
  • Utah has a population of 2,949,902 and according to the chart, Overstock received 89 bitcoin orders per million residents.  This comes out to roughly 270 orders in 2014.
  • Washington D.C. has a population of 658,893 and according tot he chart above Overstock received 85 bitcoin orders per million residents.  This comes out to roughly 56 orders in 2014 (although if the greater D.C. metro population was used, the order number would be about 9x larger).
  • Fighting for last place: Puerto Rico trounced Mississippi, which came in dead last.  Puerto Rico has a population of 3,667,084 and according to the report, Overstock received 12 bitcoin orders per million residents.  This comes out to about 44 orders in 2014.   In comparison, Mississippi, with a population of 2,994,079 had 8 order per million residents.  This comes to about 24 orders.

According to Overstock, in 2014 approximately 11,100 customers paid with bitcoin at both its US and international websites.  Altogether this represented roughly $3 million in sales which when coupled with low margin products (based on the top 10 list of things sold on Overstock) is an initiative that Stone Street Advisors labeled “distracting” (see slides 21, 32, 33, 37, 58).

In addition, since gift cards represent about 16% of all transactions processed by BitPay, they can be added to the list of non-negligible reasons for fluctuation in blockchain transaction volume.  That is to say, on any given day there are roughly 242 gift card related transactions through BitPay which should appears on the blockchain.  This is about the same amount of Counterparty transactions that may take place on a slow day.

Thus, as discussed in Slicing Data, the daily components of blockchain transactions are likely: faucet outputs (which may be “long chains”), mining rewards, some retail activity, coin mixing, gambling, watermarked assets (e.g., Counterparty, Mastercoin), P2SH, movement to ‘change’ addresses, wallet shuffling and now gift cards.

While their new infographic does not come to any direct conclusions as to macro growth of Bitcoinland it is likely that there are still only a few profitable businesses and projects in the ecosystem and most are unrelated to Bitcoin itself:

  • Fabrication plants such as TSMC and designers like Alchip
  • Utility companies (hydroelectric dams in Washington, coal power plants in Inner Mongolia)
  • Large mining farms with access to the newest ASIC batches reducing overall operating costs relative to marginal players (Bitfury in the Republic of Georgia)
  • Some mining pools (Organ sometimes has a break down of block makers)
  • Law firms (such as Perkins Coie)
  • Conference organizers such as Inside Bitcoins (but not The Bitcoin Foundation)
  • A handful of bitcoin-to-fiat exchanges (BTC-e, Bitfinex and a few others)
  • Scams (Moolah from Alex Green/Ryan Kennedy, GAW/PayCoin from Josh Garza, BFL, MyCoin and at least 42 others, more likely hundreds)
  • Botnet operators (botnet mining still exists, externalizing operating costs with “other people’s electricity”)
  • Ransomeware (CryptoLocker, KEYHolder, CryptoWall and a few dozen others)
  • Darknet Markets (Evolution “exit,” Sheep Marketplace “hack“; some low-hanging fruit exists for academics studying operators and providers that transitioned from Liberty Reserve to other DNMs, after it was shut down 2 years ago)

Perhaps all of this will change and this snapshot is “too early” as the bullish narrative claims.  Trends may change, no one has a crystal ball.

[Special thanks to CukeKing, Fabio Federici, Dave Hudson, Jonathan Levin and Pete Rizzo for their feedback and info]

  1. See Are there changes in the volume of retail transactions through Bitpay this past year?, Will colored coin extensibility throw a wrench into the automated information security costs of Bitcoin? and A brief history of Bitcoin “wallet” growth []
  2. In Chapter 14 in The Anatomy: “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 the trifecta of DeepBit, BTC Guild and GHash.io).” []
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Consensus-as-a-service: a brief report on the emergence of permissioned, distributed ledger systems

I have spent the past month compiling research that took place between August and the present day.  This was much more of a collaborative process than my previous publications as I had to talk with not just 8 geographically dispersed teams to find out what their approach was in this nascent field but also find out who is working on ideas that are closely related to these projects (as seen in Appendix A).

The culmination of this process can be found in this report: Permissioned distributed ledgers

Fortunately I had the help of not just astute practitioners in the industry who did the intellectual heavy lifting, but the resources and experience of the R3 CEV team where I am an advisor.

I think the three strongest areas are:

  • Richard Brown’s and Jo Lang’s description and visualization of smart contracts.  I loathe the term smart contracts (I prefer “banana” and Preston Byrne prefers “marmot”) and fortunately they distilled it to a level where many professionals can probably begin to understand it
  • Meher Roy’s excellent OSI-model for an “internet of money”
  • Robert Sams mental model of the core attributes of a permissioned distributed ledger

I think the weakest part is in the beginning of Section 8 regarding TCP/IP.  That is reflective of the fact that there is no perfect analogy because Bitcoin was designed to do many things that no other system does right now so there probably is no single apple’s to apple’s comparison.

While you do not need special internetcoins or fun buxx to use the internet (as it were), there is still a cost to someone to connect to the net.  So perhaps, the frictional differences between obtaining and securing an internet connection versus obtaining and securing a bitcoin at this time is probably something that should be highlighted more if the report is updated.

Wither Bitcoin?

For cryptocurrencies such as Bitcoin to do what it does best on its own terms, its competitive advantage lays with the native token and not representing real-world assets: its community needs to come to terms about what it is and is not good for.  Because of its inability to control off-chain assets its developers should stop promising that bitcoins — or metacoins and watermarked-coins that use Bitcoin as a transportation layer — as a panacea for managing off-chain assets, assets the network cannot control.  At most Bitcoin’s code base and node network operates as its own legal system for non-watermarked bitcoins.

Consequently, the advantage a cryptocurrency system has is endogenous enforcement of contractual terms — or as Taulant Ramabaja calls it: “fully blockchain endogenous state transition without any external dependencies.”  Or on-chain, dry code to dry code.

I wonder if someone in the future will call themselves a full “dry code” stack developer?

Consensus-as-a-service: a brief report on the emergence of permissioned, distributed ledger systems

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Interview with deBitcoin

Earlier today I was interviewed by Paul Buitink and Jop Hartog, co-hosts of a weekly show at deBitcoin, based in the Netherlands.  The other two guests were Roeland Creve and Andreas Wauters, co-founders of Gent Bitcoincity, based in Belgium.

All views are my own and they do not necessarily represent the views of the companies and organizations I am affiliated with.

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Panel from Blockchain University Demo Day

A couple weeks ago I moderated a panel at Blockchain University, wrapping up the inaugural cohort.

Panelists included Atif Nazir (co-founder of Block.io), Matthieu Riou (co-founder of BlockCypher) and Greg Slepak (co-founder of okTurtles Foundation).  All three were instructors for the course this past winter.

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A brief history of Bitcoin “wallet” growth

There has been a lot of investment and press coverage of the overall Bitcoin ecosystem.  So what kind of growth have some of the larger companies historically had?

Even though it is not an accurate measure of growth or adoption (see Measuring Interest and Not User Adoption), a lot of discussion on social media typically uses self-reported “wallet” numbers as a valid metric for traction.  Ignoring the fact that there is nothing in the network that can be described as a “wallet” (there are no real “payment buckets,” since addresses are essentially just UTXO labels), for simplification purposes, we will talk about what are typically referred to as wallets.1

A brief history

As mentioned in a working paper last spring, Coinbase began 2013 with ~13,000 wallets and on February 27, 2014 announced it had reached 1 million.

Similarly, Blockchain.info had roughly ~13,000 wallets in August 2012 and reached 1 million in January 2014.  On April 14, 2014, Blockchain.info reached 1.5 million wallets.

Yet it is unclear how many are active or actually have any bitcoins in them (similar uncertainties surround Coinbase wallets).  More on that later.

Fast forward to the present day, Blockchain.info recently announced that it had 3 million wallets and Coinbase now has 2.5 million (note: the about section on Coinbase also states there are 2 million “users” though that is unclear if they are active, KYC’ed users with an actual balance or just a registered empty account).

Altogether, Coinbase purportedly added 1.5 million new wallets over the past year and Blockchain.info supposedly doubled its own wallets.

Sounds like real consumer traction?

Or, maybe not.

Why?  Because there is no cost to open or create a wallet.  In fact, for “best practices” users are supposed to use only one address per transaction due to privacy and security concerns.  Thus, consequently the growth in wallet creation could be a skewed metric.

Internal usage

According to media reports, merchants accepting bitcoin for payments globally increased from ~21,000 in January 2014 to now over 100,000 as of February 2015.  Of that total, Coinbase states it has 38,000 merchants and BitPay claims 53,738 merchants accept bitcoin payments through them.

What does this “growth” actually look like?

coinbase offchain transactions

Above is a chart covering the past year from Coinbase which illustrates the daily off-chain transaction volume, the transactions that take place within the Coinbase database.

While it is unclear if all of this activity represents merchant processing, vault movements, etc., the trend over the year is actually relatively flat.  Perhaps that will change in the future.

Can we be sure that this flatness is missing actual merchant activity?

Four-and-a-half months ago, in October 2014, Brian Armstrong and Fred Ehrsam, co-founders of Coinbase, did a reddit AMA.  At the 31:56 minute mark (video), Fred discussed merchant flows:

One other thing I’ve had some people ask me IRL and I’ve seen on reddit occasionally too, is this concept of more merchants coming on board in bitcoin and that causing selling pressure, or the price to go down. [Coinbase is] one of the largest merchant processors, I really don’t think that is true.  Well one, the volumes that merchants are processing aren’t negligible but they’re not super high especially when compared to people who are kind of buying and selling bitcoin.  Like the trend is going in the right direction there but in absolute terms that’s still true.  So I think that is largely a myth.

What about Blockchain.info?

blockchain my wallet transaction volume

Above is a chart measuring the internal transaction volume over the past year of the “My Wallet” feature (the product name of the user wallet) from Blockchain.info.

Earlier this week, Blockchain.info claimed that “over $270 million in bitcoin transactions occurred via its wallets over the past seven days.”

But this is probably not accurate.  Organ of Corti pointed out that the 7 day average was indeed ~720,000 bitcoins in total output volume (thus making) the weekly volume would be about “5e06 btc for the network.”

Is it valid to multiply the total output volume by USD (or euros or yen)?  No.

Why not?  Because most of this activity is probably a combination of wallet shuffling, laundering and mixing of coins (e.g., use of SharedSend and burner wallets) or any number of superfluous activity.  It was not $270 million of economic trade.

Blockchain.info’s press release seems to be implying that economic trade is taking place, in which all transactions are (probably) transactions to new individuals when in reality it could simply be a lot of “change” address movement.  And more to the point, the actual internal volume looks roughly the same as has been the past few months (why issue a press release now?).

Is there another way to look at this?

blockchain my wallet number of transaction per day

Above is a chart from Blockchain.info that visualizes “My Wallet” transaction volume over the past year.

While Blockchain.info has seen transactions per day roughly double over the past year (from 25,000 to 50,000), without doxxing where those bitcoins go, it cannot be said that a doubling of economic activity, or that bonafide consumer traction has taken place.

Has there been any “exponential” growth, adoption or traction?  Probably not.  Again, perhaps that will change, but consumer usage could simply continue to grow at a linear fashion or maybe even less as well.

There may be a number of reasons, perhaps the average consumer is still someone who buys and holds bitcoin as a speculative investment and has no need to actually spend it with the available merchants.  But this is a topic for another post (see also Zombie activity).

ChangeTip

ChangeTip was founded on December 17, 2013.  It is not generally seen as a wallet, like the services above, in fact it currently bills itself as a micropayment service (e.g., “tipping”).  However, users need a ChangeTip wallet — which is provided for free through its platform — in order to perform their tipping services.

While their “Offsite storage wallet” (cold storage) is publicly accessible, below are three charts culled from Changetip real-time usage stats which has been broken the last couple of weeks (or the API they were collecting data from is broken; or both).  The time period is from between December 6, 2014 and February 17, 2015, covering ~73 days including Christmas and BitPay’s “Bitcoin St. Petersburg Bowl.”

changetip total number of tips sent

The chart above visualizes the total number of tips sent on the ChangeTip platform .  In just over 2 months it increased from: 119,740 tips to 187,071 tips.  During this 73 day period, approximately 67,331 tips were sent which is roughly 922 per day.

changetip total usd tipped to date

The chart above visualizes the total USD tipped to date (at current exchange rate).  During this time frame it increased from: $54,767 to $111,963.  Thus $57,196 was sent in tips during 73 days, roughly $783 per day.

changetip total numbers of users

The chart above visualizes the total number of ChangeTip users during the same time frame.  It increased from 45,851 users to 67,469 users.  According to this data, 21,618 users joined ChangeTip during 73 days, which is approximately 296 new users per day.

Altogether this comes to a grand total as of February 17, 2015 — 67,469 users have sent 187,071 tips totaling $111,963.  The average user has sent 2.7 tips altogether, with each tip worth about $0.60 (just under 60 cents to be precise).

Perhaps this trend will change — in addition to its usage on Twitter and Reddit they have added support to Slack and Youtube.

But then again, maybe tipping is not a really accurate, useful or desirable signaling mechanism (recall that micropayments is not a new idea).  And while speculative, a lack of traction could be one of the reasons why — after 3 months since Coinbase first launched their own — it recently dropped their own tipping feature (e.g., the engineering resources consumed more than the service generated).

Future research and conclusions

What about Android Bitcoin wallets?  Last October a github user put together a short comparison of the top 10 Bitcoin wallets by number of downloads.  What we saw then was a power law distribution: growth in downloads among the top 3 but a relative plateau for others.  More striking was that there was linear growth, not exponential.  Future research should also take into account the corresponding amount of deleted wallets and inactive wallets.  Note: last May at the Dutch Nationaal Bitcoin Congres, Mike Hearn described this comparison of downloaded vs deleted wallets at length, see his presentation (video) starting at 11:30m.

Bitreserve, which incidentally also launched in October 2014, provides a public transparency stats page which could serve as the beginning of a “best practices” for the industry.

Why is this important?

We have previously looked at BitPay data (which was flat).  Circle and Xapo have not publicly released much data at this time (incidentally, breadwallet is actually ranked higher at #4 in the Apple Store than both Coinbase and Xapo).  Yet from the data above it is increasingly clear that actual user numbers should not be conflated with wallet creation numbers.

Aside from movement into P2SH addresses, it is hard to really say where large, sustained organic growth is occurring.  Perhaps it is only a matter of time, maybe it is “early days” as some say.  Or maybe it is a reflection of other economic development constraints.

Update:

I received an email from Andreas Schildbach, creator of the Android Bitcoin wallet, and a portion of it is posted below (with his permission):

Install count is at 700k. Perhaps an interesting metric is that on GitHub, it’s forked 384 times (and starred 371 times). A lot of these forks made it to the Play Store.

Update 2:

I received an email from Wendell Davis, creator of the Hive Wallet.  According to him, all the Hive Wallet stats are open and accessible.  He also pointed to a similar, smaller discussion on reddit last fall.

Update 3:

BitcoinPulse has been tracking the total amount of downloads for the Satoshi bitcoind client (the reference client); over the past year there has been a linear increase in downloads.  Arianna Simpson pointed out that MultiBit, as of March 2014, had at least 1.5 million downloads.

  1. I would like to, again, thank Andrew Poelstra for crystalizing this point for me. []
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While we wait for another Bitcoin black swan event

I was interviewed and quoted a few times in the past couple weeks:

Is Bitcoin Stalling? at Technology Review:

The design of Bitcoin and the blockchain, its public transaction ledger, make it challenging to distinguish specific types of transactions. Nonetheless, researchers from the U.S. Federal Reserve determined in a recent analysis that the currency is “still barely used for payments for goods and services.” Last week, nearly 200,000 bitcoins changed hands each day, on average. But fewer than 5,000 bitcoins per day (worth roughly $1.2 million) are being used for retail transactions, according to estimates by Tim Swanson, head of business development at Melotic, a Hong Kong-based cryptocurrency technology company. After some growth in 2013, retail volume in 2014 was mostly flat, says Swanson.

After the Bitcoin Gold Rush at The New Republic:

“Some of the New York Bitcoin Center guys are pretty religious,” says Tim Swanson, who has written two e-books on cryptocurrencies in the past year, most recently The Anatomy of a Money-like Informational Commodity: A Study of Bitcoin. Before that, while living in China, he built his own graphics-chip miners. (Some of his miners have since been re-purposed as gaming systems.) Swanson has grown increasingly skeptical that Bitcoin will unsettle the existing finance megaliths. “You have centralization without the benefits of centralization,” he says. Bitcoin’s promise of frictionless finance is drowning in the ever more immense cost of mining, user-friendly infrastructure, and appeasing regulators.

“Being your own bank sounds cool in theory,” Swanson says, “but it’s a pain in reality.”

Beyond Bitcoin, episode #27: An Architecture For The Internet Of Money at Let’s Talk Bitcoin.

In this episode, Meher Roy does a fantastic job explaining what a neutral, agnostic protocol actually is and why the current allotment of cryptocurrency “protocols” are not real protocols.  Many thanks to Arthur Falls for his time, patience and great questions.  We will all miss the show.

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Videos from Cryptoeconomicon event

A few of the videos from the Cryptoeconomicon event are now online (repo). If you are interested, below are two of the panels I moderated on the first day.

“Proof of Work” with Vitalik Buterin, Matthew Wampler-Doty, Peter Todd:

“Practical and Social Applications” with Aaron Wright, Steve Waldman, Anthony D’Onofrio, Stefan Thomas:

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Thoughts on the 2.0 space

Last week CoinDesk reached out and asked several questions related to Koinify and published a few of the comments in a story, “Crypto 2.0 Roundup: The Overstock Effect, Counterparty Debates and a Crypto iTunes.

Readers may be interested in a few more of my thoughts below.  [Disclosure: I am an advisor for Hyperledger and head of business development at Melotic.]

  • As of today, Koinify is probably the only serious venture-backed startup that solely focuses on building decentralized applications and decentralized autonomous corporations (DACs).   It is also setting some ‘best-practices’ in transparency that has been largely missing in this community.  You will see that soon with Koinify’s following announcements.
  • The biggest problem in the altcoin/decentralize app space is that virtually all of them lack any original utility, are blatant scams or simply cannot fulfill the paper-based promises of their vocal promoters.  In short, virtually all digital asset projects have thus far been overpromised and underdelivered, including, arguably Bitcoin itself and we see that with a dearth of mainstream end user adoption for any of them.  What I’d like to help provide Koinify is the knowledge of the past, to avoid the pitfalls of other projects.  To accomplish this, Melotic is looking to provide liquidity to unique curated assets, potentially those incubated at Koinify.  Thus, this is a mutually beneficial partnership.
  • I have been following the growing list of distributed computing and computational consensus proposals.  Beyond the annual academic Dijkstra Prize, the nascent digital currency space has been fast in proposals but slow in actual production-level roll-outs.  To be frank, I have been fairly disappointed with both the quality of product and traction of 2.0 projects in general, especially given the community euphoria in the first quarter when I did research for Great Chain of Numbers.  However, with that said, if something like Bitcoin is allowed to be given a 5-6 year “grace period” I think it is only fair for a similar runway to be given to other proposals as well.  Furthermore, there are economic trade offs depending on the level of trust and consensus required, but shoving everything onto one ledger, some kind of jack-of-all-trades Houdini ledger, is a bit like the clown car at a circus.  It can be filled with a cornucopia of clowns and coins (and clowncoins) but the economic incentives might not align with the duct tape holding it together. Consequently, the community has evolved and created several new potential methods for untrusted nodes on a public network to arrive at consensus, to the point where consensus-as-a-service is becoming its own commoditized subindustry.  In the future, this will likely be abstracted away and developers will be able to fine tune and granularize the level of centralization and trust they want to expose their users to.  Another big development that I am increasingly paying attention to is the regulatory and compliance arena, which many people seem to want to ignore and handwave away.  It is not going to disappear and structuring your project, company and even ledger in a way that reduces your personal liabilities will be an ongoing concern from now on.  There is no point in being a martyr when there are many other areas to push the envelope on in this expanding space.
  • A few weeks ago I gave a presentation covering a number of factors as to why Bitcoin protocol development has plateaued in the past year and as a result how most of the innovation has effectively been outsourced to the altledger ecosystem.  Here a steady stream of both old and new entrepreneurs and developers are toying with variables that cannot be touched with Bitcoin itself due to its current development cycle.  A friend compared the speed at which this industry moved with dog years and this is particularly true in the altledger space.  As a result, a new ledger can be forked, tweaked and spun up that incorporates the latest ideas in this space.  Most do fail and will likely fail in the future, but that’s the nature of iteration in technology.  The biggest challenges for Koinify is on boarding high quality decentralized apps that bring the utility and value that is now expected by the community.   On the one hand creating a platform that allows access to something like cryptosecurities such as Overstock.com sounds neat, yet it is a hundred year old idea (equity) married to a different type of database (a blockchain). On the other hand, the decentralized app economy that Koinify is attempting to create is in fact has a different form, yet still pragmatic enough given existing technology.  Market participants want to experiment, poke, prod and have choices — this effervescent vitality is attractive and I am excited to try and help out.
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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:

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The Continued Existence of Altcoins, Appcoins and Commodity coins

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

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

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Does Smart Contracts == Trustless Multiparty Monetary Computation?

My friend, Zaki Manian, who is working on a very interesting project called SKUChain (discussed in chapter 16), thinks we should reframe how we perceive or rather how we should define ‘smart contracts.’

In his view:

Here is my proposal.

We stop calling the idea ” smart contracts” and we start calling the idea “Trustless Multiparty Monetary Computation”. That should also tell the lawyers that we don’t really need them here at the moment….

Programming Language researchers use the term “contracts” as a way of formally reasoning about multi-part or distributed computation. But PL researchers also understand that this is idea has deep formal connections with reasoning about the relationship between people and organizations.

Here is the relevant prior art.
https://en.wikipedia.org/wiki/Secure_multi-party_computation
The SPJ paper from 2000
http://www.lexifi.com/files/resources/MLFiPaper.pdf

Some implementation of the SPJ’s ideas
http://www.itu.dk/people/sestoft/papers/amlp.pdf
https://rucore.libraries.rutgers.edu/rutgers-lib/23837/

This was in response to the panel discussion last weekend and was brought up by Adam Krellenstein from Counterparty.

If anyone is interested in discussing this further, let me know and I’ll put you in touch with Zaki or others.

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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.

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Bitcoin’s PR challenges

brand

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.

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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.

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In what ways does Bitcoin resemble a command economy?

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

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

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

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

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