Difference between revisions of "Bitcoin"

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Satoshi Nakamoto has developed '''a new open source P2P e-cash system''' called Bitcoin.
'''a new open source P2P e-cash system''', originally developed by Satoshi Nakamoto
URL = http://en.wikipedia.org/wiki/Bitcoin
URL = http://en.wikipedia.org/wiki/Bitcoin
Download Bitcoin v0.1 at http://www.bitcoin.org ; Design paper at http://www.bitcoin.org/bitcoin.pdf
Download Bitcoin v0.1 at http://www.bitcoin.org ; Design paper at http://www.bitcoin.org/bitcoin.pdf
Clearing up Bitcoin misconceptions, Let's clear up some common Bitcoin misconceptions.
Line 114: Line 116:
=Bitcoin Business and Economics=
* a list of online and real world businesses that currently accept Bitcoin, https://en.bitcoin.it/wiki/Trade

Revision as of 12:25, 9 March 2012

a new open source P2P e-cash system, originally developed by Satoshi Nakamoto

URL = http://en.wikipedia.org/wiki/Bitcoin

Download Bitcoin v0.1 at http://www.bitcoin.org ; Design paper at http://www.bitcoin.org/bitcoin.pdf

Clearing up Bitcoin misconceptions, Let's clear up some common Bitcoin misconceptions.


1. Bitcoin is a leader in distributed P2P Currency. Each participant can be part of a network as wide as they can reach, or as small as they choose to make it. The only drawback of Bitcoin is the necessity to use the Bitcoin currency. This is offset for many by the fact that, because the currency is 'in force' and widely used, a number of exchanges have popped up, allowing users to trade coins for other currencies. Bitcoin may be useful for a P2P Network as an immediate replacement for cash with low infrastructure requirements for implementation.

2. From the Wikipedia:

"Bitcoin is an open source peer-to-peer electronic cash system developed by Satoshi Nakamoto. The system is decentralized with no central server or trusted parties. Bitcoin relies on cryptographic principles to create unique, unreproducible, and divisible tokens of value. Users hold the cryptographic keys to their own money and transact directly with each other, with the help of the network to check for double-spending." (http://en.wikipedia.org/wiki/Bitcoin)

3. Springwise

"Bitcoin bills itself as “the first digital currency that is completely distributed.” In essence, that means that it’s managed collectively by a global network of users, so no bank or payment processor is required between buyers and sellers in any transaction. Users begin with Bitcoin by downloading its client program for Linux, Mac or Windows, thereby creating a digital wallet and associated Bitcoin address for themselves. Next, very small quantities of Bitcoins are available for free from the Bitcoin faucet, but to get larger ones, users can visit various currency exchanges and sites. They can also accept Bitcoins as payments for goods and services. Either way, once they have Bitcoins — abbreviated “BTC” — users can spend them at various participating online merchants for a wide variety of goods and services. It’s free for merchants to accept Bitcoins, and there are no chargebacks or fees. Currently, there is no charge for processing Bitcoin transactions, but eventually a small fee of about one bitcent will be charged every transaction to one of many competing Bitcoin “miners,” who create Bitcoins in a controlled way by running a dedicated program." (http://www.springwise.com/financial_services/bitcoin/)


1. Satoshi writes:

"It’s completely decentralized, with no central server or trusted parties, because everything is based on crypto proof instead of trust.

The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible.

A generation ago, multi-user time-sharing computer systems had a similar problem. Before strong encryption, users had to rely on password protection to secure their files, placing trust in the system administrator to keep their information private. Privacy could always be overridden by the admin based on his judgment call weighing the principle of privacy against other concerns, or at the behest of his superiors. Then strong encryption became available to the masses, and trust was no longer required. Data could be secured in a way that was physically impossible for others to access, no matter for what reason, no matter how good the excuse, no matter what.

It’s time we had the same thing for money. With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.

One of the fundamental building blocks for such a system is digital signatures. A digital coin contains the public key of its owner. To transfer it, the owner signs the coin together with the public key of the next owner. Anyone can check the signatures to verify the chain of ownership. It works well to secure ownership, but leaves one big problem unsolved: double-spending. Any owner could try to re-spend an already spent coin by signing it again to another owner. The usual solution is for a trusted company with a central database to check for double-spending, but that just gets back to the trust model. In its central position, the company can override the users, and the fees needed to support the company make micropayments impractical.

Bitcoin’s solution is to use a peer-to-peer network to check for double-spending. In a nutshell, the network works like a distributed timestamp server, stamping the first transaction to spend a coin. It takes advantage of the nature of information being easy to spread but hard to stifle. For details on how it works, see the design paper here at http://www.bitcoin.org/bitcoin.pdf.

The result is a distributed system with no single point of failure. Users hold the crypto keys to their own money and transact directly with each other, with the help of the P2P network to check for double-spending."

2. Aran explains:

Bitcoin is an open source peer-to-peer (a.k.a "p2p") electronic cash system that's completely decentralised, with no central server, trusted authorities or middle men. The availability of bitcoins can't be manipulated by governments or financial institutions. Bitcoin already has a number of exchanges for converting to and from other currencies; BitcoinFX, New Liberty Standard, Bitcoin Exchange and Bitcoin Market.

Bitcoin may last for years and become a popular global currency, or it could be just a flash in the pan, but either way I think this is an important sign of the times to come. This is one of the first truly decentralised currencies and has paved the way for hundreds more to compete together in the new arena of Cipherspace over the coming years. This is one of the key factors in the transition of global society into the post-nation-state economy talked about in The Sovereign Individual.

In a p2p computer network there are no servers, the entire network is composed of users running instances of the application on their computers. Each running instance offers a small amount of processing and storage resource to the network so that it can deliver the services it was designed for such as redundant storage, anonymity or voice-over-IP applications.

In the case of a p2p currency system, some of the services the network is designed to offer are privacy, verification, authentication, currency creation and transfer of ownership. To ensure a reliable and tamper-proof system requires a lot of resource, and that amount is proportional to the amount of coins in the network. The network is able to pay the users for the resource they offer by making the coin-creation process part of the network protocol itself instead of being handled by a central trusted authority. This creates a natural and incorruptible link between the supply of currency in the network and the demand for it.

Even aside from the ability to exchange bitcoins for other currencies, it still makes a very useful tool for independent organisations and groups because it allows them to trade and settle accounts amongst themselves independently and privately. It effectively gives them a "bank" that has a trustworthy system of accounts that can't be tampered with and requires no corruptible central authority to operate. See the Bitcoin Whitepaper for more detail about how it works.

To try Bitcoin, download the Bitcoin software, then once it's running, click 'Generate Coins' which will pay you bitcoins in exchange for your computer working to validate bitcoin transactions. Check the exchange rate to calculate how many bitcoins need to be sent. The payer can purchase additional bitcoins if needed. The payer's previously generated bitcoins allow for a lower out of pocket payment. The payer then sends the bitcoins to the receiver using the Bitcoin software. The receiver can then sell their bitcoins for dollars. The receiver's previously generated bitcoins allow a higher dollar payout." (source?)


Rainey Reitman (EFF):

"To understand digital currency, one must first note that money in the digital age has moved from a largely anonymous system to one increasingly laden with tracking, control and regulatory overhead. Our cold hard cash is now shepherded through a series of regulated financial institutions like banks, credit unions and lenders. Bitcoin, created in 2009 by Satoshi Nakamoto, is a peer-to-peer digital currency system that endeavors to re-establish both privacy and autonomy by avoiding the banking and government middlemen. The goal is to allow individuals and merchants to generate and exchange modern money directly. Once the Bitcoin software has been downloaded, a user can store Bitcoins and exchange them directly with other users or merchants — without the currency being verified by a third party such as a bank or government. It uses a unique system to prevent multiple-spending of each coin, which makes it an interesting development in the movement toward digital cash systems.

The model proposed by Bitcoin is in many ways a response to some of the privacy and autonomy concerns surrounding our current financial system. Current money systems now increasingly come with monitoring of financial transactions and blocking of financial anonymity. A peer-to-peer currency could theoretically offer an alternative to the bank practices that increasingly include sharing information on their customers who don't actively opt-out, and who may even then be able to share data with affiliates and joint marketers. Bitcoin is particularly interesting in the wake of recent events that demonstrated how financial institutions can make political decisions in whom they service, showcased by the decisions of PayPal, Visa, Mastercard and Bank of America to cut off services to Wikileaks. Bitcoin, if it were to live up to the dreams of its creators, might offer the kind of anonymity and freedom in the digital environment we associate with cash used in the offline world.

But Bitcoin's current implementation won't resolve all of the issues surrounding autonomy and privacy. Notably, the anonymity on Bitcoin is not entirely secure at this time, which makes its merits as a more private form of currency tenuous at best. There are also other weaknesses to the system, some significant, which should be understood before using Bitcoin. And as of this writing, Bitcoin can't be used to donate to Wikileaks. But even more important than these concerns is the fact that governments around the world may raise legal issues with any digital cash scheme — ranging from money laundering to tax evasion to a range of other regulatory concerns. Nonetheless, Bitcoin is an intriguing project and worth watching to see how it develops in the coming years." (https://www.eff.org/deeplinks/2011/01/bitcoin-step-toward-censorship-resistant)


Excerpted from a more detailed interview:

"Klint Finley: Could you give us a brief overview of what Bitcoin is for the unfamiliar?

Gavin Andresen: Sure. Bitcoin is the first peer-to-peer currency - it is money created by people instead of by a central bank or government.

And how does it work?

Everybody trying to create bitcoins and everybody trading bitcoins is connected by a peer-to-peer network. And the code everybody is running makes sure nobody else is cheating - nobody else is creating more bitcoins than are allowed, nobody is trying to spend their bitcoins more than once, and that bitcoins are only being spent by their rightful owners.

The really novel idea is a mechanism for preventing bitcoins from being spent more than once WITHOUT relying on a central authority.

The other mostly new idea is limiting the supply of bitcoins without relying on a central authority.

How do you accomplish these things without a central authority? And how do Bitcoin clients and servers find each other?

Let me tackle the easy one first - how do Bitcoin clients find each other:

All p2p networks have "the bootstrapping problem" - without central servers, nodes (machines) on the network need to be able to find each other. Bitcoin solves it using three mechanisms:

1. By default, Bitcoin clients join an IRC chat channel and watch for the IP addresses and ports of other clients joining that channel. The name of that channel (and the name of the IRC chat server) is hardcoded into the Bitcoin software.

2. There is a list of "well known" Bitcoin nodes compiled into the software in case the IRC chat server is unreachable for some reason.

3. You can manually add (via configuration file or command-line option) IP addresses of other machines running Bitcoin to connect.

Once you're connected to the Bitcoin p2p network, other machines send you messages containing IP addresses (and ports) of other machines they know about, so after bootstrapping you find other Bitcoin nodes via the Bitcoin network itself.

There is a lot of discussion about alternative bootstrapping mechanisms, so I wouldn't be surprised if alternative Bitcoin implementations that use something else pop up in the next year or so.

I'm guessing you can also change the IRC server and channel manually as well?

No, actually, you can't - you'd have to recompile Bitcoin to do that." (http://www.readwriteweb.com/hack/2010/12/interview-bitcoin.php)

Bitcoin Business and Economics


Summary of a p2p-based critique by Michel Bauwens

The great achievement of Bitcoin is that we have the very first "socially sovereign" digital currency, independent of government and corporation, that is workable, technically "peer to peer", and that it creates the enthusiasm of the hacker community, which almost certainly means it will be adapted and used later by more people. So, in this way, this is a tipping point. However, the Bitcoin design also has serious flaws. First of all, the way it is mined privileges the technical community itself as it can have access to networks of botnets to generate coins, in a way most people can't. Secondly it is a 'scarcity' based currency, subject to hoarding and wealth accumulation (only 21m bitcoins will be created, insuring a constant growth in value), that does not really change what is 'wrong' with the current currency system. As many so-called 'peer to peer' technologies (such as crowdfunding, crowdsourcing, etc..) it may increase wider participation and 'distribution' but without necessarily changing the dysfunctional neoliberal functioning of the market. There are also environmental concerns regarding the way Bitcoints are created through sometimes very long 'processing time'. Finally, it seems the current team behind Bitcoin is very libertarian in outlook and is supremely interested in evading taxation by the state, which depending on your own views, may be seen as politically and socially problematical. Nevertheless, what it really shows is that socially sovereign currencies are viable, and could be created as a tool of the countereconomy, though this would require a different ruleset for its functioning. so that true 'social' peer to peer values can be integrated in the design of future 'post-Bitcoin' currencies.

A comprehensive critique of the weaknesses of bitcoin

Sebastiano Scròfina:

"Bitcoin has many advantages over the traditional currency system but it is undermined by two major security weaknesses that make it technically unreliable on the long run, and by at least three major economic weak points that will prevent it from ever becoming a real currency.

At Kakigarden we're developing a solution that is immune from those issues, and in our opinion some important things to improve are:

1) Majority attacks

As I outlined in 2010 answering How can Bitcoin be hacked?, Bitcoin can indeed be hacked. It's a beautiful concept but it's not secure. It can be exploited, which means it will. It's just a matter of time.

2) Social attacks

The scarcity of Bitcoin is not a real, hardcore scarcity such as the scarcity of gold or platinum. It's just defined in some lines of code. Those lines can be changed, Bitcoin can indeed be inflated and loose all of its appeal. There is a variety of ways in which this can happen in practice. More scarily, there is hardcore economic evidence that doing so would actually benefit Bitcoin as a currency (see below). Again, if it can, it will. It's just a matter of time.

3) Still centralized, not really P2P

Bitcoin is not really P2P. The amount of currency is decided by a central authority (the community), while the truth is defined by what 50%+1 of the nodes believe to be the truthful block chain. As always with centralization, these two weak points are also the easiest single points of failures to exploit.

4) Deflation and liquidity trap

In economics, a liquidity trap happens when people are unwilling to invest and keen to keep their assets "under the pillow". That's exactly the trap Bitcoin is falling in and will fall in. It was actually designed for it. Bitcoin is a deflationary currency, which means it's worth more and more as time goes by. Sounds good ? It did to the developers, but it actually isn't. In Gresham's terms Bitcoin is good money, while inflated central banks' money is a bad one. What would you spend first ? The bad money, because you want to get rid of it, and keep the good one for yourself. The only exception to this are illegal businesses who don't have any alternative to Bitcoin, or people where central banks have failed or are failing (as Somaliland or Zimbabwe). This means that, with the aforementioned exceptions, Bitcoin is not actually a currency as it appears to be, but rather a digital store of value that can be used as a currency.

5) Government intervention

As soon as the US government will rule against Bitcoin, which could happen sooner than we think, all US businesses will be forced not to accept Bitcoin. Maybe even running the client could be deemed illegal. This will trigger drops in BTC value because the expectations for Bitcoin as a currency will drop. As other governments will follow, as it already happened with Napster and file sharing, the use of Bitcoin will be more and more restricted to criminals and illegal activities, and people where central banks have failed or are failing (as Somaliland or Zimbabwe).

6) No lock-in

As soon as a better p2p currency comes along, people can sell their BTCs and jump on the other system. This means that as soon as a better alternative comes along, there will be an incentive to be the first to abandon Bitcoin, while the last ones will be heavily penalized: they'll have to sell their Bitcoins for a fraction of the price they bought them at. Think of bank runs: what happens usually is that the bank closes until panic has stopped. Here there's no bank, so what's gonna happen when the run starts ? If you own Bitcoins, keep your eyes open.

7) Lack of intrinsic value

The current value of BTCs is artificial. Bitcoin is in a bubble because more than 90% of people who buy BTCs with USD or other currencies are speculators. They don't buy Bitcoins because they need them, but because they expect somebody will need them in future. And you know what ? This is very risky, because Bitcoin has no intrinsic value. This means that as soon as it is hacked, or government intervenes, or a better alternative comes along, the value of Bitcoins can drop to zero. Yes, that's right: zero. That's the intrinsic value of a digital signature. Gold has an intrinsic value: it's needed for a lot of real uses, which guarantees you that however bad the gold market goes, you'll never loose everything. Bitcoin doesn't.

8) Friction

You can't buy Bitcoins with Paypal. You can't convert Bitcoins to Paypal. The value of Bitcoin fluctuates enormously every day. All this means there is friction for the average person and the average business to use Bitcoins as a currency instead of the dollar. Again, only who's got no alternatives is really driven to use Bitcoin (see above).

9) Speculation

Remember how George Soros broke the British Pound ? Currencies don't belong only to the domain of economics, but also to that one of politics. And that's why central banks have policies. If a speculator like Soros comes along with their massive buying power, they can start to use their power to do politics on the Bitcoin community, and there's no Bitcoin authority that can react. For example, a speculator can enter slowly in a massive quantity, and then sell enough and fast enough to trigger panic in the community and push Bitcoin owners to panic sell (something similar already happened in Bitcoin's "black friday" on June 10th). Such attack could be politically motivated, or financially (to buy after the price drop). Who knows ? Who cares ? Bitcoin has no protection against those types of attacks. And remember: this can happen with any commodity or precious metal, but they do have intrinsic value at least. Bitcoin doesn't have the safety net of real goods, nor the one of fiat currencies.

10) Anonymity

Bitcoin is not anonymous. As one of the lead developers already pointed out, it's fairly easy to track people down unless they don't take extreme precautions.

11) Speed

Transactions take minutes, or even hours, to be confirmed. Given it's electronic and not physical, this slowness is a bit of a paradox.

12) Fractional reserve

Bitcoin doesn't stop middlemen from practicing fractional reserve banking, thus inflating the currency at their own benefit. In fact, this is probably what will happen and what could partly relieve its deflationary nature.

This is the tip of the iceberg. There is much more to the future p2p currencies (objective value vs subjective value, scarcity vs abundance, etc), but I feel this is a concise enough answer to the question, specifically focused on Bitcoin's immediate weaknesses rather than what the mid-term future of currency might look like.

In conclusion:

As I said, think of Bitcoin as the Napster of central banking and banking as we've known them. Bitcoin represents probably just 1% of the coming currency revolution. The future p2p currencies will have to solve Bitcoin's technical and economical flaws, and totally redefine economics. Contrary to what most economists (from Mill to Schumpeter) believe, currency is not a neutral veil, but indeed the very matrix of how we interact, trade and live as a species. As every language influences the way one thinks, currency influences the way one behaves. Mainstream currency is the most powerful and spoken language on our planet, and in the next decade it's going to be totally redefined by the Internet. The next generation will have a hard time trying to understand what economics was to us." (http://www.quora.com/Bitcoin/If-one-were-to-make-a-competitor-to-Bitcoin-what-features-would-be-desirable/answer/Sebastiano-Scròfina?)

A summary of BitCoin criticisms

Adam Cohen posted on Quora:

Bitcoin, described most generously, is a system that makes digital transactions more like cash transactions. That's...fine. The problem is it does this not by offering dollar-denominated digital cash-transfers, but by bootstrapping an entirely new currency. The question to ask is why this would be at all desirable. Maybe you hate the US government, or all governments. Maybe you want to avoid bank interchange fees, or perhaps avoid tracking altogether because your payment is for something illegal, or because you're a particular private person. Or perhaps you just think that the world currency regime is going to collapse and you see Bitcoin as a technological salvation.

No matter what your reasoning, Bitcoin is a ridiculous idea that will not accomplish what you want.

Severe Problem Number 1: Seeding Initial Wealth

When the federal reserve "prints money", it doesn't just mail million-dollar checks to random Americans. It does one of two things. It either (a) purchases some other asset [generally us treasury bonds] on the free market, thereby injecting more cash into the system than there had been before, or (b), loans money to a bank, who will then loan it to other people who will then spend it.

Importantly, the people on the other end of those transactions did not just get free money. They either sold an asset for cash, or they borrowed cash that they will eventually repay (with interest).

Bitcoin does not have a central bank capable of printing and lending Bitcoin; it has an "algorithm" which through some convoluted mechanism allows Bitcoins to be "mined". Essentially it randomly allocates Bitcoin to early adopters. This is a very good system for early adopters (free money!) It is a nonsensical system for a real currency, not to mention being obviously unscalable (what happens when everyone tries to mine Bitcoin all day long?). To solve this second problem, the supply of Bitcoin is algorithmically limited, which is again good for early adopters. But that brings us to...

Severe Problem Number 2: Built in Deflation.

Econ lesson time! Deflation is the phenomenon where cash grows in value relative to everything around it (i.e. prices go down). More specifically, deflation occurs when people expect the value of cash to grow in relative value to everything around it, and prices trend down consistently.

Question: if your money is getting predictably more valuable, why would you want to spend it? Answer: marginally speaking, you wouldn't.

The supply of Bitcoin is programmed to grow at a known but decreasing rate over time, topping out relatively quickly at about 21M. The graph looks like this:

(graphic 1)

Known rate -- ok, I'm with you, predictable inflation, not necessarily desirable from an economic standpoint, but I'll go with it -- but decreasing rate? If you were designing a currency that was going to topple the world order, wouldn't you want it to look like this?

(graphic 2)

Or at least have constant in rate of growth? Yes, of course you would, because that's the only way to actually accommodate more people using it.

But Bitcoin is not designed to be a functioning currency, it's designed to enrich early adopters. Again, that is why it is a scam. Period.

As a quick thought experiment, let's say demand for Bitcoin grew as more people found out about them. Well, you'd expect the price of Bitcoin in dollars to grow rapidly. Now assume I own one Bitcoin. I also have a dollar bill. I would like to purchase a Pepsi. Which one of those will I spend? Obviously the devaluing dollar gets spent before the skyrocketing Bitcoin.

In the best case scenario [the one where it becomes popular] the limited supply of Bitcoin will cause crippling deflation, drying up most Bitcoin-denominated commerce save whatever speculative buying and selling happens on exchanges. Some new world order. All that transparency and all those low interchange fees aren't going to do you much good if you don't ever want to spend these things and no one wants to give them to you anyway.

Severe Problem Number 3: Lack of Convertibility

There is a common misconception among people that there is such a thing as an inherent value of money. There is no such thing. Paper assets are literally only valuable to the extent they can be exchanged for other paper assets. A dollar is worth a certain number of euro cents. A euro is worth a certain number of Yen. A Yen is worth a certain number of dollars. A dollar can be put in a bank for a certificate of deposit, which can then be exchanged for a dollar. It can be turned into a cashier's check or a personal check, and then converted back to cash or deposited. It can be converted to traveler's checks which can then be converted to Yen on your vacation. Even if you spend your money and buy a sandwich, the sandwich stop only took that money because it was convertible to something else, such as his payroll check and then his bank account. Paper <--> Paper <--> Paper. All the same, all different. It's a beautiful circular equilibrium. Envision a tee-pee. Paper assets are the poles; they fall over by themselves, but leaning against each other they form an edifice.

The critical point here is that exchange rates might change, but they never go away completely. The term in economics is "convertibility". For Bitcoin to work as a currency, it would have to act as a predictable store of value, which means it needs to be easily convertible to all other stores of value depending on an individual's needs or wants. It needs to be a part of that tee-pee. It isn't.

The problem here is that because Bitcoin is completely decentralized, no one is completely invested in the long-term success of the system. No one is literally making the market, saying "no matter what happens, I'll buy Bitcoins from you at some price". I understand that there are "exchanges" floating around. Their commitment to this market is (in my opinion) not credible. Anyone and everyone can just pick up their ball and leave.

As a result, my ability to turn a Bitcoin into a dollar or a euro or a yen is no greater than my ability to sell my laptop on Ebay. I can probably do it, but that doesn't mean I'm going to start measuring my bank account in macbook pros, because one day I might not be able to find a buyer, and then what?

Because of this, Bitcoin is not really a currency, it's an asset [and a particularly useless one at that]. It is being marketed as a currency to appeal to people who are crazy, idealistic, or afraid, and it is a scam.

Severe Problem Number 4: When Something Goes Wrong, It Will Die

In the early days of the great depression, some Americans started to worry that if their bank closed, they would lose all of their money. They then tried to take money out of banks all at the same time, which actually caused some banks to fail. That made even more people nervous, which caused even more banks to fail. That's called a bank run, and for obvious reasons we want to avoid them.

After that happened, the US government started explicitly guaranteeing savings deposits (as well as implicitly guaranteeing other forms of financing, see Bush, Obama et all, "Bailouts", 2008). Despite everyone's frustration with this state of affairs, it turns out to be vastly preferable to a complete collapse of our banking system, so it continues on.

Now, fast forward five years. The Bitcoin economy is roaring! Everybody owns these things. Life is great. But then...something goes wrong. Maybe it's a slight hardware glitch. Maybe there's a rogue node somewhere in the system that causes transaction delays. Maybe some people were storing their Bitcoin on AWS and they lost it when it crashed again. It doesn't really matter what: something will eventually go wrong, and Bitcoin will be tested.

Will it pass this test? People will get nervous. Some will panic. Few will run for the exits. The exchange rates will dip. Others will get nervous. Some will realize they never really had faith in the system to begin with. That will make them really nervous. Who is going to step in to backstop this system?

More importantly, is there anyone that even CAN do that? When a bank collapses, the federal reserve can honor deposits by quite literally printing money and giving people their cash back if need be. That slight increase in expected inflation (maybe) is a small price to pay for avoiding a financial meltdown. In the bitcoin economy, that's literally impossible. It's decentralized; it's a published algorithm. No one can change it, and even if they could, it's no one's job to do so. Anyone with a large stake in Bitcoin will be too busy trying to get their own money out to worry about systemic risk.

Bitcoin (and really, any e-currency) is inherently unstable. And with currency, stability is everything.

In Conclusion

So, do I think Bitcoin is a good idea? The cryptography system seems to have technical merit although I'm not a cryptologist. If it were thoughtfully integrated into a legitimate banking product it might be a good idea. But this is not a good idea, this is a scam. Someone out there is trying to become very rich off of this system, and anyone who participates will be playing hot-potato until the inevitable collapse.

More discussion

Scarcity Aspects of Bitcoin

Thomas Greco writes:

"They seem to be trying to simulate gold mining and using Bitcoin as "virtual gold." If they think that scarcity is the requisite feature for a workable currency, then they're way out of bounds." (email, March 2011)

Here's a post from the Open Collective Skype chat about Bitcoin.

[05:43:48 PM] permaworld: Does anyone have information or experiences with BitCoin http://bitcoin.org ..... a new peer2peer open source digital currency? If so, what do you think of it? [05:55:27 PM] Arthur Brock: Bitcoin has gotten a lot of things right about decentralization and intrinsic integrity built into the structure of the data itself. [05:56:04 PM] Arthur Brock: However, they've confused issuance of currency with creation of value and are still building for artificial scarcity. [05:58:06 PM] Arthur Brock: It currently takes about 113 days of 100% CPU use to "mine" a bitcoin. You pay for $25 of electricity to generate a coin worth about $18. If the world switches to using bitcoin as a primary currency we can deplete our oil supplies just generating the electricity required issue them.

(via Thomas Greco)

Mining Privileges associated with Bitcoin


"Another problem that I have with Bitcoin is that mining for coins becomes more difficult as time goes by and the market grows. The algorithms that produce new coins increase the amount of processing power necessary to create each new block, so producing new money is more difficult as time goes by, and this difficulty is built into the system to try to keep the total amount of Bitcoins at a maximum of 21 million. So, the first block “mined” by BTC creator Satoshi Nakamoto (probably a pseudonym) was done at difficulty 1, at the time of writing there were 131301 blocks, making a total BTC of 6.56 million, and a difficulty of 877,227. That means, making a new block will be more than 800 thousand times more difficult than it was for the initial block. This difficulty will only go up, so an individual cannot hope to have the processing power to develop new coins, and this can only be done currently through pool mining CPU resources. This model is trying to replicate scarcity in the market, but it acts as a punishing disadvantage for late adopters, and means that early adopters have too much power if they hoarded coins early. More than anything else, this would lead me to be very sceptical of Bitcoin, the whole scheme screams Ponzi, but I am willing to be proven wrong.

Another practical concern is that while I found it easy to install the client, once it is open it is not very clear what to do with it. Bitcoin has reached a point where it is very difficult to create new coins, so their value has gone up considerably. I found the mining instructions difficult to follow, but was able to get a miner registered and working, although this was not easy to achieve. I would like to think of myself as a person with above-average technical skills, so I do not see the scheme catching on, particularly to a wider audience. It is possible to buy BTCs with real money in exchanges, but this didn’t strike me as straightforward either, and I did not feel inclined to invest in this currency (maybe I will regret it in the future, who knows?) The fact that the mining business seems to be a very closed niche would mean that newcomers would have to part with their hard-earned cash to acquire a virtual currency. At the time of writing, the exchange rate of $19 USD per 1 BTC seems ludicrously inflated." (http://www.technollama.co.uk/is-bitcoin-legal)

The Difference between Bitcoin and Open Coin


"Bitcoin and Opencoin are "sons" of David Chaum's Digicash both. Chaum is one of the most important cryptographers and freedom fighters in the world and invented in the eighties the first digital cash, that was refused, attacked and destroyed by credit card companies societies, that instead wanted to propagate a model not based on anonimity. The big difference between them is that Bitcoin is a complete currency system instead Opencoin is the system to make a currency (a digital mint). Bitcoin you need to use as-it-is, with Opencoin instead you can create your own currency system." (p2p-foundation list January 2011)

Is Bitcoin a deflationary currency?


"The relative value of a currency depends on two factors: The number of currency units available for exchange operations, and the combined value of items to be exchanged using the currency, which is really the size of the market the currency serves.

A currency's relative value will go up as the number of currency units or their availability decreases, or as the size of the market the currency serves grows without a corresponding growth in the available currency units. Technically, this is called "deflation".

A currency's relative value will go down as the number of currency units or their availability increases, or as the size of the market the currency serves decreases without a corresponding decrease in the available currency units. The technical term for this is "inflation".

In the Bitcoin ecology, there is no provision for keeping the currency aligned with the size of the market it serves at any given time. Bitcoin has a phase of growth which at first is fast and then slows progressively, to come to a standstill at 21,000,000 Bitcoins. So the availability of the number of currency units is set to grow, ever more slowly because of increasing difficulty to calculate blocks, and to eventually come to a complete standstill at an arbitrary figure set by the currency's initiators.

It is safe to assume that the market that is being served by Bitcoin will grow in a way dissimilar to the programmed increase of availability of the currency units. It will grow slowly at first and then - as the idea catches on - it will grow at an increasing pace. This disparity of growth between the number of coins and the size of the market will have some undesirable consequences for the stability of the value of Bitcoin. Coins will become more and more scarce, as creation of new coins gets ever slower, but market growth gets ever faster. The consequence is going to be severe deflation of the currency, meaning each existing coin will grow in value.

Prices expressed in Bitcoins will be subject to a continual decrease, while fortunes of Bitcoins obtained by the initiators and early adopters will grow in value. The price decrease will be a continual nuisance as prices need to be adjusted, and the growth of fortunes expressed in Bitcoins will be a reward to early adopters that is not commensurate with any work done. It will also act as an incentive to "sit on" Bitcoins, waiting for them to get more valuable, which takes coins out of circulation, making the natural deflationary tendency of the currency even more severe.

One way to overcome this problem would be to make the target of 21,000,000 Bitcoins mobile, by creating a mechanism that links the target to the real market size. As market size goes up, the final target amount of Bitcoin creation should move up as well, promoting stability of the relative value of Bitcoins.

In order to avoid manipulation of the currency - a concern that has been expressed by its creators - the target amount of creation of bitcoins should be adjusted in accordance with changes in the number of active nodes running the Bitcoin software. This number would give a good independent indication of the growth of market size. It also is not subject to manipulation.

Bitcoin wastes energy


"With the EFF’s announcement that they would being accepting BitCoin donations, the alternative money community began to take a larger interest. I certainly did, and found that there are good and bad things about this form of money. In the end, BitCoins create a perverse incentive to consume energy to “create money.” Here is why.

What is a bitcoin and how do you create one? — A BitCoin is created whenever a user’s computer churns though a SHA-256 hash repeatedly from a hash until it results in a number less than a given number. Statistically, hash functions are supposed to have very unpredictable content–that is what makes them secure. Whenever a BitCoin client churns through a hash starting from a given number issued to the network, it burns CPU time (and thus energy). The probability of getting a hash to be “less than” a given 256-bit number is quite low. Successfully determining how many SHA-256 rounds it takes for a particular nonce to hash to a number lower than some value is called the “proof of work.” If while your computer receives a new “block” from the network (meaning another computer successfully won some BitCoins), your computer must start over with a new nonce.

How much energy does it require to mine the average BitCoin? — With my “older computer,” the hash rate averages around 2000 khps on a microprocessor going full-bore consuming about 65W. The current difficulty shows that a new BitCoin can be mined by a computer at this speed on average every 113 days. So, 113 days × 24 hours = 2712 hours. 2712 hours × 65W = 176280 Wh or 176.28 KWh. The average cost of a KWh in the United States is 10.45 cents. So we’re looking at spending $18.42 to create 50 BTC (at the moment). So the electrical cost is about $0.36/BTC. BitCoins are trading now already at values below this, so I can only assume that they’re being sold at a loss or others may be externalizing the costs of electricity and not taking this into account. If you were to pay your electric bill in BTC, you would have a positive feedback loop (always a bad thing) that consumes more energy to earn money to pay back the power company. It doesn’t matter how efficient your processors are—you’re spending more money to make money." (http://xifin.wordpress.com/2010/11/18/bitcoin-a-rube-goldberg-machine-for-buying-electricity/)

Is Bitcoin Legal?


"is Bitcoin legal? There are generally two types of currency from a legal perspective, there is legal tender and legal currency. Legal tender is simply currency that cannot be refused in the fulfilment of a debt. Legal currency is currency that is recognised by the government as a legitimate manner to pay for goods and services. In most countries legal currency and legal tender are one and the same, but there are some exceptions. For example, in the most of the UK the Bank of England notes are legal tender, but in Scotland only coins are legal tender, there are notes issued by several banks, which act as legal currency. The same applies for Northern Ireland. It is also common to see economies with a weak local currency to accept international money as legal currency.

In the United States, where most of the BTC action seems to be taking place at the moment, only the US Dollar is legal tender (31 U.S.C. § 5103). Similarly, only the Mint and the Federal Reserve can produce coins and currency, which are the only means of legal tender. Title 31 of the US Code does not seem to make the distinction between legal currency and legal tender, so to me both are one and the same (please comment if this is not the case). This is corroborated by several official documents that indicate clearly that only the USD is allowed as the official currency of the United States. According to the FBI “it is a violation of federal law for individuals, [...] or organizations,[...] to create private coin or currency systems to compete with the official coinage and currency of the United States.” I am no securities expert, but it would seem that Bitcoin would not fall under definitions of securities and commodities either(see here for a discussion on these). So in my humble opinion Bitcoin is not legal currency in the United States.

The picture is clearer in the European Union. Unlike the United States, the EU has implemented a legal framework for the regulation of electronic money.

The Electronic Money Institutions Directive 2009/110/EC defines electronic money thus (paraphrased for clarity):

1. electronically, including magnetically, stored monetary value;

2. as represented by a claim on the issuer which is issued on receipt of funds for the purpose of making payment transactions;

3. the transaction is an act, initiated by the payer or by the payee, of placing, transferring or withdrawing funds, irrespective of any underlying obligations between the payer and the payee;

4. which is accepted by a natural or legal person other than the electronic money issuer.

If a payment system fullfils these requirements, then it is considered electronic money, and only electronic money institutions can issue electronic value. There is a high threshold for an electronic money institution, as the EMI would have to fulfil quite a lot of requirements. The idea behind this stringent regulation is evident, as what is taking place is the issuing of value into the economy. In my opinion, Bitcoin would definitely meet the legal definition, which would mean that in order to work in Europe it would need to be declared an electronic money institution, otherwise it is operating outside of the regulatory framework.

It seems like it is only a matter of time before regulators come knocking on the doors of Bitcoin. However, part of the appeal of the system is that it is completely decentralised. Just as it happens with P2P file-sharing, you could shut down the entire Bitcoin operation tomorrow and the network would still run because it does not depend on a central system. So, while Bitcoin may very well be illegal, it may also be almost impossible to shut down in any efficient manner, that is the beauty of distributed networks.

However, this point may be moot. Regulators only need to be involved if Bitcoin becomes a large source of value in a national economy. At the moment, there are 6.5 million BTCs in circulation, with a value of almost $130 million USD at today’s prices. This is no small change, and would seem to prompt some form of involvement from governments. However, I think that the value of Bitcoins may be a bubble as a result of hoarding from early adopters. Once newcomers realise that it is very expensive to enter the market, prices may drop. However, investors only invest if they see room for growth, it is perfectly possible that speculation will continue to drive prices up, therefore prompting regulation by the government. Catch 22 in my opinion, Bitcoin is better off remaining small." (http://www.technollama.co.uk/is-bitcoin-legal)

More Information

Explanatory paper at http://www.bitcoin.org/sites/default/files/bitcoin.pdf

  • Bitcoin for beginners
  1. http://mybitcoin.com ; website version, no download required, start making or receiving donations.

@the best available info for beginners is http://bitcoinme.com.

Critiques of Bitcoin

  1. http://www.pds.ewi.tudelft.nl/~victor/bitcoin.html

Video documentation

  1. TWIST Bitcoin episode, Full show: http://thisweekin.com/thisweekin-startups/bitcoin-discussion-with-gavin-andresen-and-amir-taaki-on-this-week-in-startups-140/
  2. Gavin explains the fundamentals of Bitcoin, http://www.youtube.com/watch?v=Ta73DofiT7o
  3. Who is Satoshi, the mysterious bitcoin founder? http://www.youtube.com/watch?v=RDRwgbWkxFw
  4. The million-dollar bitcoin question: Can the system be hacked? http://www.youtube.com/watch?v=G2837h-85O4
  5. Jason sets his software to generate bitcoins and Gavin explains why that's a bad idea, http://www.youtube.com/watch?v=jix4MG5V0-E

Other Digital Currencies

"While Bitcoin is relatively young, digital currencies have been around a long time. Digicash, released in 1994, is considered a pioneer of electronic cash using cryptography to maintain anonymity. The Ripple currency project relies on interpersonal relationships to allow communities to create their own money systems (which is similar to the Local Exchange Trading System). There is also the anonymous digital cash system eCache, which can only be accessed via the anonymous onion routing network Tor. There are also numerous other digital money projects that have been proposed over the years; Bitcoin is just the newest chapter in the ongoing effort to create wholly digital currency." (https://www.eff.org/deeplinks/2011/01/bitcoin-step-toward-censorship-resistant)

  1. eCache: an anonymous bank operating over the Tor network.
  2. Pecunix: an (optionally?) anonymous digital gold currency.