The Avatars of Mammon: Bitcoins

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A note on usage: Bitcoin, with a capital ‘B’, is the name of the digital currency and the technology built around it. Individual units of the currency are called ‘bitcoins’, with a lower-case ‘b’. Bitcoin is the world’s pre-eminent digital currency but not the only one of its kind. Others (including Litecoin, Peercoin, and Dogecoin) operate on similar bases, with minor differences.

A note on hashes: A hash is a value generated when a computer converts a string of any number of characters into a code with a fixed number of characters, using a set of rules known as the hash function. Hashes find favour in cryptography since converting an input to its hash or verifying an input’s hash is a fairly easy task, while forging a hash is prohibitively difficult.

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Bitcoin is not issued by a government, a single person, or an organisation. Instead, bitcoins can be generated by any computer in the world with a copy of the Bitcoin client installed. The client is available for mobile devices as well as traditional computers.

The Bitcoin system was first described in a 2008 paper by a ‘Satoshi Nakamoto’ and subsequently launched in 2009. ‘Nakamoto’ is the pseudonym of a person claiming to be Japanese and in his early forties, although it has been speculated that Nakamoto is a team of finance professionals, lives in the western hemisphere (based on the timings of his online activity), or is from the Commonwealth (based on his spelling).

I entertain the notion that Satoshi Nakamoto is likely a woman, since switching genders remains a reliable method for maintaining pseudonymity, despite George Sand, Andre Norton, and James Tiptree, Jr. Earlier this month, a Japanese-Californian physicist also named Satoshi Nakamoto was outed by Newsweek as the man who invented Bitcoin, but he has so far denied being the same person. One hundred-millionth of a bitcoin is called a satoshi.

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The creation of bitcoins is called ‘mining’.

Imagine a lottery in which you are asked to guess a number between one and one thousand, and if you guess a number equal to or lower than the target number I have written down on a piece of paper, you win. If the target is quite low (say, 2), chances are that your guess will be higher than it. On the other hand, if my number is a somewhat larger (say, 652), it increases your chances of guessing a ‘winning’ number.

Bitcoin uses a similar system to award bitcoins among competing computers worldwide. A target number is relayed to all the Bitcoin clients in the world. The target number is a 256-bit number and can have one of a large but finite set of values (0 to 2^256). Each computer attempting to create or ‘mine’ bitcoins generates a ‘block’ – a record of the most recent transactions on the bitcoin network since the last block was generated, and prepends it with the hash of a randomly chosen number out of that set of values. The first computer to generate the hash of a number lower or equal to that of the target wins (as of early 2014) 25 bitcoins. Again, the lower the target number, the more unlikely it is that a randomly generated hash will qualify. Every two weeks, the number of actual blocks generated is compared to a target rate of generation and the target number difficulty is adjusted accordingly.

The number of bitcoins that are awarded for solving a block is halved for every 210,000 bitcoins generated. You can probably see where this going. The program is constructed so that the world’s supply of bitcoins is capped at around 21 million. That’s it. For all time. There are about 12.5 million bitcoins in existence right now.

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A bitcoin transaction isn’t mediated by a bank or a government, but the system itself is built to prevent counterfeit. The blocks mentioned earlier append to each other to form the block chain – an ever-lengthening record of every bitcoin transaction that has ever occured. Every Bitcoin client in the world has access to this. The only way to counterfeit bitcoins would require a forger to insert a fake transaction in the latest block being generated *and* ensure that their block won. The first is trivial; the second is nigh-impossible. Consider this: Bitcoin clients are programmed to accept as authoritative the version of the block chain that appears to have taken the most effort to produce. Inserting a fake transaction would mean outdoing the combined computing power of the rest of the Bitcoin network to produce a longer block chain with more successfully solved consecutive hashes more rapidly than the everybody else. Tianhe-2, the fastest computer in the world, can do 34 quadrillion operations a second. The Bitcoin network, meanwhile, can chew through 350,000 quadrillion operations in the same time. Admittedly, the system would be vulnerable if one mining interest ever gained access to more than fifty percent of all bitcoins, which would be self-defeating.

The block chain introduces a useful analogy in the discussion about Bitcoin. The block chain can be thought of as an eternal ledger of transactions. A bank does not physically transfer any pieces of metal or paper when you use your credit card to make a payment. It simply subtracts that number from your account record and adds it to the seller’s. Similarly, the ‘ownership’ of bitcoins can be thought of having your Bitcoin client’s address as the latest address to which a bitcoin was sent. The use of addresses anonymises Bitcoin to a large degree, although some institutions insist on names and credentials before setting up an account.

The anonymity has also made Bitcoin the preferred currency of grey market enterprises such as Silk Road, the website that dealt in pedestrian merchandise alongside banned substances, assassinations, and child pornography. It was shut down last October and its owner, Ross Ulbricht, who went by the pseudonym ‘the Dread Pirate Roberts’, was arrested. Silk Road was subsequently re-launched with new safeguards by a new Dread Pirate Roberts. (Readers of The Princess Bride will not be surprised by this inheritance of the pseudonym; I implore the rest to read the unabridged version of this article.)

Bitcoin’s relative anonymity and decentralised nature have made it attractive to crime financing and a perfect candidate for laundering money, attracting regulations across the globe. China’s central bank has forbidden the country’s banks from handling bitcoins transactions. Japan and Singapore both classify bitcoins as goods rather than currency, although the former is considering taxing it and the latter already does. Russia has declared Bitcoin transactions illegal, full stop.

Bitcoin’s other bugbear is its volatility. A private cryptocurrency is very much a novelty and would have been impracticable mere decades ago. Compare this to the centuries of experience the financial sector has in handling stocks, bonds, or foreign exchange, and it is clear why opinions on Bitcoin are confused and divergent. Bitcoin exchanges have had their own challenges. Mt. Gox, a Tokyo-based exchange, was shut down last month (February, 2014) after it revealed BTC 850,000 (about $500 million) were missing from its accounts. Gox’s meltdown led to a minor Bitcoin scare, its price falling precipitously on that exchange. Other exchanges moved in rapidly to close the gap, and Bitcoin’s price stabilised. Bitcoin is still more vulnerable to market sentiment than most fiat currencies.

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Here begins the idle speculation. Bitcoin has unique attributes that fiat currencies do not. Bitcoin does not pay interest. This may seem like a minor complaint (Canadian banks pay little more in interest than a kindly pat on the head) but it means that storing large quantities of one’s savings in bitcoins is only sensible if one can invest them, or thinks of the bitcoins themselves as an investment.

One set of investors would like to see an income from their investments. While cash savings pay vanishingly little interest (pat, pat), we always have the option of investing it elsewhere: stocks, bonds, real estate, garage start-ups, laundromats. That’s not the case with bitcoins, so this set is likely to use bitcoins only as a medium of transaction until opportunities arise for investing bitcoins to generate more bitcoins.

Investing via Bitcoin would require an ecosystem of Bitcoin users. A business cannot accept investments made in bitcoins unless it knows they will be accepted by its creditors in turn, and so forth. If it needs to change bitcoins to dollars at every stage, and then convert dollars back to bitcoins to pay dividends to its investors, then it is not clear why it would bother at all. True, businesses do seek out listings in major stock markets with foreign currencies, but that’s to raise volumes of money and credibility beyond what their local markets can provide. The business case for wishing to transact in bitcoins is not apparent, and this shuts off the bitcoin-owner’s access to revenue-generating assets, ergo, ersatz interest.

Bitcoin as a medium provides an anonymising ‘black box’ for payments. Once Bitcoin’s notoriously choppy volatility eases, this is what I believe will keep it going. If I want to slip you a quiet ten thousand dollars (say, for a motorised stunt tribble used in original Star Trek episode ‘The Trouble with Tribbles’), I could convert it to bitcoins and you could convert it back on your end, with no record with our names on it. It’s not the exchange rate but the stability of the rate that matters here. Neither of us care very much whether our money is worth one or one-millionth of a bitcoin en route, as long as it doesn’t change in value drastically between the sending and the receiving. Bitcoin may prove worse news for money transfer and security agencies than central banks.

The other response is the use of bitcoin as an asset class in its own. This has some precedence in the pre-digital world. As discussed in the previous article in this series, finite commodities like gold have been used as a basis for monetary systems before. The challenge for Bitcoin is that the idea of gold as a store of value has unmatched pedigree. A metal dug out of the earth and sold by weight is an easier concept for most than a sequence of digits arrived at by solving a cryptographic hash function. Even if a sufficiently large community considered bitcoins valuable enough as assets in their own right, it would need to compete for that role with precious metals which are universally understood and valued.

Bitcoin is the sort of audacious invention that comes but rarely. That we aren’t entirely quite sure what it is for, or where it will lead, already puts it in the company of such inventions as electricity and the web. This is not even its final form. Watch this space.