August 1, 2013

The Big Book of Bitcoin - August 2013

Bitcoin is an electronic pseudo-anonymous decentralized crypto-currency. There. That was a mouthful. But what does it actually mean?

Currency: At the most fundamental level, Bitcoins are just a means of exchange. Just like shells, gold, dollars, or rubles. And just like silver, euros or stones, their value hinges on an implicit agreement between the parties using them (legal or informal). Ok. So it’s just another currency. What makes them special then?

Virtual: Bitcoins are abstract. They exist as anotations on a very big ledger.

a big ledger

On page 33,560 of the book it might say:

Hal - 3 bitcoins
Philip - 9 bitcoins
Wei - 100 bitcoins

…

When Wei decides to send Hal 2 bitcoins, it gets updated to:

Hal - 5 bitcoins
Philip - 9 bitcoins
Wei - 98 bitcoins

…

I hear you: Who updates the book? Where is the book? and wouldn’t it be easy to write a fake balance? Therein lies the beauty of Bitcoin: The accountant is not a central authority like the European Central Bank, the FED or the People’s bank of China. The book keepers are all those who chose to participate. A good slogan could be:

Bitcoin, the banking system run by you.

When Moxie sends Runa a bitcoin, bookkeepers ask: Does Moxi actually own a bitcoin? Since the Big Bitcoin Book also contains the history of all transactions it can be checked: Moxie got 3 bitcoins from Jacob who in turn got it from Julian and Julian from John … all the way back to 2009 when Satoshi sent 10BTC to Hal (here’s what a book entry can look like). Ok, so it’s verified!! Moxie has the balance in his account according to the whole history of every transaction ever made. We can send Runa her bitcoin, update the ledger and add a transaction to the history.

Distributed: With about 2,100 transactions per hour and a growing history of 21 x 10⁶ transactions you can see how the bookkeeping can get complicated: Every accountant on the planet must check the history, reach a consensus on the new version of the book and keep their book up to date. This big book is actually called the “blockchain” and is about 8.7GB in size today.

The computers of the accountants are constantly calculating the transactions, comparing, and creating short unique summaries of previous book chapters called “hashes”. For their hard work, bookkeepers (also called miners) are rewarded. Keeping the system running, safe and honest has a cost (computers, electricity, knowhow) so for every chapter closed 25 bitcoins are awarded to the bookkeepers proportionally to their efforts. This however, won’t last forever. In 2016 the reward will drop to 12.5BTC and halve every few years until it reaches zero. Eventually only 21m bitcoins will ever be in circulation and bookkeepers will be compensated with small transaction fees.

Crypto (secure): The protocol is too long to explain here, but essentially doing all these calculations (history checking, consensus, update, summarize) is so difficult (i.e. needs so much processing power) that Bitcoin transactions can’t be counterfeited. For an attacker to defraud people by chargeback (making a transfer and then getting the money back) (s)he would have to buy enough computers to run a network half as strong as the accountants’. IBM charges over $100m per unit of super-computation (peak PetaFLOPS), and the bitcoin network can deliver 1000 of them!

Super Computers vs Bitcoin
source: Stackoverflow

So a wealthy person/state would need to shell out $50,000 million to trick the network with off the shelf super-computers! After spending all this money (electricity bill not included) the attacker can’t even counterfeit new money, spend what (s)he doesn’t have or reverse other people’s transactions. The attacker could chargeback and stop the confirmation of other people’s transactions, but not much else. So the only incentive would be to undermine the trust of the network and devaluate the currency. The reality is more complex and dynamic: hardware price drops, cheaper hardware could be used, custom made chips could be used, but the difficulty of cracking the blockchain also increases exponentially with time. While Bitcoin was considered a passing fad nobody thought of stoping it or attacking it. As it grows stronger and complex it becomes increasingly expensive to halt (It would take 10 full years of Paypal revenue to buy such an IBM super-computer!). Another way to look at it is that the power of the computers of all the “accountants” outperforms to world’s top 500 super computers, Combined!

The highly distributed nature of the bookkeeping and the fact that it involves a complex problem needing calculations is what makes the Bitcoin Book secure.

cartoon bitcoin crypto
source: Techcrunch

Pseudo-anonymous: In our naive example above we gave names to each entry on the book, but in reality all entries are anonymous. Just like your bank account might be GB70 1200 0300 45 3807628044 a bitcoin account will be identified by numbers and letters: The ledger will have entries like:

1MisPu4HQ68SeRhDzn4y6gEnibn45fsUUo - 5 bitcoins
14nghhzmLuqU6UwkvPDYuwnjH2TQKjpDxa - 9.032 bitcoins
1MmadcPb8KYKRgn7RgULUm17rhsExHu6vZ - 98 bitcoins

These addresses are public since all incoming and outgoing transactions are recorded on the ledger. But if you don’t associate an email address, bank account or picture with the bitcoin address, it’s anonymous. However, consider that paying with it online can leave many traces (confirmation email, physical address, cookies, IPs). So it’s anonymous in the same sense that browsing online is anonymous (Anonymous browsing can only be done with the right tools like TOR, VPN and the right precautions). Why would anyone need anonymous payments? Or conversely: Why should Visa, Mastercard, Paypal, and many Governments (not just your own) know what you’re purchasing and decide who you can’t fund (for ex. Wikileaks or Wordpress).

Think of an activist buying a forbidden book, a secure laptop or flight for an undercover journalist, medicine for that condition insurance companies shouldn’t know about. Or perhaps something which is illegal today: It could be abortion, a gay magazine, a given medicine, drugs, weapons, alcohol, gambling, services and a long etcetera depending on the country and period in history.

Bitcoin’s anonymity has its fans and detractors: When the account is used anonymously it’s essentially cash which can be sent in a second around the world. This can obviously facilitate money laundering, and illegal activities (like drug and weapon trafficking). However drugs, terrorism and corrupt politicians seem to operate fine with regular currencies. So it becomes a question of principle: Should governments be given unlimited power over the currency (with risk of hyperinflation, bailouts and corruption), allowed to spy on all transactions, and continue with rampant tax evasion? Bitcoin is obviously not the solution to these issues, nor will it be a key enabler to crime. It is just a currency with some interesting features on top: peer-to-peer, security, public transactions and potential anonymity. But will these features give birth to new financial paradigms?

The Future: Bitcoin is a social and technological experiment. Its roots are in the cypher-punk movement with some libertarian and anarchist influences. Many are comparing the potential impact of this innovation with the creation of the Internet. If successful it would question the need for a money-printing central authority and become a universal currency.

The Bitcoin economy is growing fast. You can pay at restaurants, buy food, ingredients, electronics, travel, accommodation, clothes, services, drugs, porn, blogs, all major currencies, and a growing list of things. However it still remains too technical, and niche for most. The value of the bitcoins in circulation today (August 2013) is around $1.1bn, a minuscule amount for any bank or country. This, however highlights the potential growth for the value of the currency. If 10m bitcoins end up facilitating half of paypal’s transactions (~$80bn/yr) each bitcoin would be worth ~$8,000. (It’s a very crude estimate, of course, but it gives an order of magnitude). fortunately there are not only bitcoin cents, but also mili-bitcoins, down to a satoshi: 0.00000001 bitcoins. So in that scenario, a bread baguette would simply cost 0.15mBTC (0.15 mili bitcoins or 150 micro bitcoins).

From a purely practical point of view it’s looking more attractive by the day: You can send anything from $0.10 to $10m anywhere in the world, almost instantly, for minuscule fees. Try to send 10cents to a charity of your choice, or try to wire $10m to a third world country, on a Sunday, in 5 hours. Chargebacks are not possible (which protects honest sellers from fraudulent buyers). Exchange fees with other currencies (say Bitcoins to USD) can be as low as 0.5% making currency exchange easy, convenient and cheap.

From the point of view of economics many questions remain unanswered. If the coins are limited and demand grows it will lead to deflation. When and how does it stop? Given the growing mis-trust from central banks, many savers are hoarding bitcoins. Will that be a problem? How liquid will this market be? how does a world economy based on bitcoins grow? (degrowth or steady state economy anyone?)

For a more practical introduction on how to open a wallet, buy or get bitcoins see: www.weusecoins.com

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