What is BitCoin and How Does It Work? (Save 7% On All Bitcoin Purchases)
In fact, a new study released by the Mercatus Center, “Bitcoin: A Primer for Policymakers,” details some of the innovative applications in the Bitcoin economy that the public debate may not fully appreciate. Before regulators rush to mitigate anticipated harm, they should first understand how this technology works and how it can improve lives.
First, Bitcoin is a promising way to lower transaction costs. Credit card companies charge merchant fees that are often prohibitively expensive for small businesses. Small-business owners face the hard trade-off of either refusing to accept credit card payments and losing business or accepting card payments and losing money by eating the costs. Transaction fees with Bitcoin are negligible and can save money for cost-conscious businesses.
Consumers, too, could benefit from these lower transaction costs in the form of lower prices. This is the business model of the Bitcoin Store, an online electronics retailer that only accepts Bitcoin transactions. Bitcoin allows sellers to charge only $436 for a Samsung Galaxy Note at the Bitcoin Store that currently sells for $517 on Amazon.
Similarly, these lower transaction costs will greatly benefit people who send global remittances to their relatives in developing countries. Traditional wiring services, like Western Union and MoneyGram, may charge steep fees of up to 10 percent of the amount transferred and take days to process. With instantaneous transfers and fees of less than 1 percent, Bitcoin could significantly lower the cost of sending remittances—which amount to more than $400 billion annually.
Second, Bitcoin may provide affordable access to financial services for the world’s unbanked population. With Bitcoin, accessing the financial world is as easy as downloading an application on your phone. The popular mobile payment system, M-Pesa, recently added Bitcoin payment options for customers in Kenya. The world’s less affluent may stand to gain the most from the ease and affordability of making Bitcoin payments.
Countries with poor monetary management will also benefit from Bitcoin. Strict capital controls and high rates of inflation led to a surge of Bitcoin downloads in Argentina. Some even suggest that the Eurozone crisis drove the use of Bitcoin in distressed countries. Bitcoin increases the number of monetary options available to people in dire situations.
Finally, Bitcoin could be a democratic tool to ensure a basic level of freedom of speech around the globe. Dissident activists in authoritarian countries now no longer need to fear that their government will block payments for blogging services. Bitcoin places power back in the hands of the people.
These are just a few of the innovations to materialize so far. Built within the Bitcoin protocol are capabilities to develop other financial innovations, like notary services, encrypted communications, and “smart” collateral contracts. Developers and businesspeople are still learning the myriad applications for this innovative technology.
Just as the public debate understates some of the benefits of Bitcoin, it also overstates some of the concerns. The hypothetical crimes that Bitcoin may enable are traditionally committed with cash, but policymakers would never dream of criminalizing cash. Instead, they regulate the use of cash. Regulations targeting Bitcoin could adopt this time-tested approach.
What’s more, Bitcoin may not be an ideal vehicle to commit these crimes. Bitcoin is not actually anonymous, but pseudonymous. Each Bitcoin transaction is verified and recorded in a public ledger by all computers running the Bitcoin network. Criminals using Bitcoin will leave a perpetual smoking gun in the public ledger that could tie their identities to the illegal transactions. For this reason, criminals may opt to continue using their favorite currency of choice, the U.S. dollar, instead of using Bitcoin.
Policymakers understandably worry about the risks stemming from a new technology, but effective policy will also consider the substantial benefits that Bitcoin may provide. The risk of lost benefits from overregulating this promising technology appears greater than the risk of its criminal use, and that is an outcome that no policymaker should want.
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Bitcoin, the world's "first decentralised digital currency", was devised in 2009 by programmer Satoshi Nakomoto (thought not to be his—or her—real name). Unlike other virtual monies—like Second Life's Linden dollars, for instance—it does not have a central clearing house run by a single company or organisation. Nor is it pegged to any real-world currency, which it resembles in that it can be used to purchase real-world goods and services, not just virtual ones. However, rather than rely on a central monetary authority to monitor, verify and approve transactions, and manage the money supply, Bitcoin is underwritten by a peer-to-peer network akin to file-sharing services like BitTorrent.
The easiest way to store Bitcoins is to sign up to an online wallet service through which all transactions are carried out. This, of course, means trusting the provider of that service not to cheat, or go out of business, taking clients' savings with it. Security-concerned users can install a personal digital wallet on their own computers. They must then, however, keep it safe from viruses or physical damage. If a laptop went up in smoke, so would the virtual coins stored on its hard drive. (Keeping back-up copies would do the trick.)
All transactions are secured using public-key encryption, a technique which underpins many online dealings. It works by generating two mathematically related keys in such a way that the encrypting key cannot be used to decrypt a message and vice versa. One of these, the private key, is retained by a single individual. The other key is made public. In the case of Bitcoin transactions, the intended recipient's public key is used to encode payments, which can then only be retrieved with the help of the associated private key. The payer, meanwhile, uses his own private key to approve any transfers to a recipient's account.
This provides a degree of security against theft. But it does not prevent an owner of Bitcoins from spending his Bitcoins twice—the virtual analogue of counterfeiting. In a centralised system, this is done by clearing all transactions through a single database. A transaction in which the same user tries to spend the same money a second time (without having first got it back through another transaction) can then be rejected as invalid.
The whole premise of Bitcoin is to do away with a centralised system. But tracking transactions in a sprawling, dispersed network is tricky. Indeed, many software developers long thought it was impossible. It is the problem that plagued earlier attempts to establish virtual currencies; the only way to prevent double spending was to create a central authority. And if that is needed, people might as well stick with the government devil they know.
To get around this problem, Bitcoins do not resemble banknotes with unique serial numbers. There are no virtual banknote files with an immutable digital identity flitting around the system. Instead, there is a list of all transactions approved to date. These transactions come in two varieties. In some, currency is created; in others, nominal amounts of currency are transferred between parties.
In the very first transaction the creator's computer forged 50 units of the currency. The next transaction would have involved subtracting some amount from the creator's account and crediting it to a recipient's. These actions, and any subsequent ones, were automatically broadcast to the entire network. At first, when the network was small and transactions few and far between, verifying them was been straightforward. The first person to confirm the new transactions would offer his updated log as the one against which any future transactions ought to be judged. Once everyone else agreed that this candidate register was indeed accurate, it would be adopted and the new transactions included in it confirmed. If anyone tried to game the system by erasing an old transaction (so he could re-use the same money again) or adding an unwarranted new one (transferring the same money as before, say), he would be promptly found out, his proposed log discarded, and the transactions rejected as invalid.
However, as the network expands from dozens of users to thousands, and transaction volume grows, so does the number of logs vying for the official crown. Getting everybody to scrutinise the first proposal aired across the network for inconsistencies soon becomes impractical; the whole system grinds to a halt. Some way is therefore needed to ensure that the official register can be updated and agreed on in real time (or nearly), while preventing individuals from tampering with it. Mr (or Ms) Nakomoto's ingenious solution involves two related cryptographic techniques: hashing and forced work.
A hashing algorithm converts a message into a number called a hash value, or a digest. If this number is big enough, it provides a unique representation of the original (since the same algorithm could not conceivably yield identical hash values for different messages). Moreover, it is impossible to reconstruct the original on the basis of the digest alone. Nor is it possible to predict what the digest would be for even a slightly tweaked version of the original message; fiddling with a single letter will produce a completely different digest. In that regard, digests appear to be generated at random. As a result, hashing is what computer scientists call an irreversible process.
Consider a hashing algorithm which converts anything fed into it to a whole number between one and 1,000. For random sets of data, the algorithm would spit out a value below 11, say, once in every 100 tries, on average. Now suppose some data are given in advance. How does one find a number that needs to be appended to these given data to produce a hash value below 11? Because hashing is irreversible, and digests are essentially random, the only way to do this is through trial and error: by splicing different numbers onto the old data and hashing the whole lot until the desired result pops out. On average, this will require 100 tries. However, once the answer is found, everyone else can verify whether the problem has indeed been solved by running the hashing algorithm just once, with the proposed solution. This type of puzzle can only be cracked using brute force, which is why it is dubbed forced work.
With Bitcoin, all new transactions are automatically broadcast across the entire network and analysed in portions, called blocks. Besides any new as-yet-unconfirmed transactions, each block contains the digest for the last block to have got the nod from the network. That last block will always come from tip of the longest chain of blocks currently on the network. This chain is, in effect, the official log—confirmation that all the previous blocks tot up.
For a new block to be deemed valid, some computer on the network must create a transaction log for it that dovetails with the previous blocks. To prevent acceptance of bogus logs, giving it a seal of approval has to be prohibitively costly to any individual user, but relatively cheap for the network as a whole. This is done by making it into a forced-work task, which involves using the valid blocks and the new transactions to generate a digest consisting of 256 bits (ie, any number between 0 and 2256). The task is complete when the system's algorithm spits out a hash value below a preset target (like 11 in the example above). The target is set so that the puzzle is solved by someone on the network, and a new block approved, every 10 minutes. To keep this rate constant as the network's ranks swell and its combined computing power grows, the target is lowered in order to make generating a value below it harder. (Conversely, if the network were to shrink, it would get easier again.)
Creating the doctored block and having it validated and attached to the official log would thus require outpacing the network's combined computing power. This can only happen if a fraudster controls more than half of the network's total number-crunching capacity, which is possible, but extremely expensive for any one person.
The system can thus rely on users to police it. As a reward for giving up some computing power to that end, the first user to crack the forced-work task gets 50 coins for the effort. This is done by always making the first new transaction in each block the conjuring up of 50 coins out of nothing. When other participants agree to append the new block to the official chain, they also validate the creation of the new money (they would, of course, reject it if someone tried to game the system by minting more than 50 coins).
This is also how Bitcoin niftily gets around the problem of increasing the money supply without a central mint. Since blocks are created at a constant average rate, and there is a set number of coins minted per block, the total money supply, too, increases at a steady clip. For now, this is 300 coins every hour on average. Every four years, though, the minting rate is set to fall by a half. It will drop to 25 coins per block in 2013, to 12.5 coins in 2017, and so on, until the total supply plateaus at 21m or so around 2030.
The idea is to mimic the extraction of minerals (the transaction-validating software is called the Bitcoin miner). As the most readily accessible resources are exhausted, the supply dwindles. Unlike real resources, however, there is no as-yet-undiscovered, hidden lode a fortunate prospector can strike to disrupt the money supply. Should a powerful new computer be introduced to the network, the difficulty of the forced-work challenge would soar, keeping the rate at which blocks are approved—and new money created—unchanged.
In theory, then, the system ought to keep a lid on inflation—making it attractive to critics of interventionist monetary policy of the sort practised since 2008 by America's Federal Reserve under the label quantitative easing. (The mineral analogy, in particular, appeals to proponents of a return to a gold standard.) It offers other apparent benefits, too. The currency can be used by anyone (unlike credit cards, for instance), anywhere. Transaction costs are also likely to be lower than those for traditional payment systems, though these are not in fact zero. Some are reflected in the hardware and energy used to police the system. Some surely creep in whenever those who have no wish to mine Bitcoins themselves purchase them for dollars, euros and several other currencies at specialised sites like Mt. Gox.
Legally, Bitcoin exchanges are subject to the same regulations as ones trading commodities. For example, an exchange must report any transaction above $15,000, a policy meant to stem money laundering. For the purposes of taxation, meanwhile, reimbursing somebody for a product or service in BitCoins is treated as barter. The tax code makes provisions for such practices, though, admittedly, they can be tough to enforce.
This has not stopped some American politicians from expressing grave concern about the virtual currency. Charles Schumer, a prominent Democratic senator, has weighed against it, claiming it is just what drug dealers have been waiting for. All the clever cryptography means Bitcoin dealings are difficult to trace. But not impossible. According to Bitcoin's defenders, its users may be more difficult for a government agency to pinpoint than someone paying with a credit card. But they are easier to catch than those using cash. Moreover, any drug trade involves sending physical products to recipients. Authorities already track many packages sent by groups under investigation. When it comes to physical delivery, the method of payment is irrelevant. Another worry, for the authorities at least, is that, in theory, a Bitcoin account cannot be frozen. But, like cash, Bitcoins can be nabbed by seizing the computer on which they are stored.
Ordinary folk, meanwhile, have different concerns. They fear being bilked by a cabal of clever boffins, who can insidiously fiddle with the system's software to take advantage of less geeky types. This queasiness, though understandable, may be misplaced. As an open-source project, the computer code which undergirds Bitcoin can be viewed, and modified, by anyone. As with all such ventures, however, if a change is introduced that most participants do not accept, they will simply refuse to download that version of the software. Since the self-professed geeks who make up the web's open-source communities often delight in (and excel at) scrutinising seemingly impenetrable lines of computer language, it is highly unlikely that someone could get away with surreptitiously inserting a command to create excess Bitcoins and siphon them off to his account, for instance. For the same reason, the open-source nature of the project is also a bulwark against hackers or malware. Indeed, as cybercrime goes, Bitcoin may be safer than traditional financial institutions, which are often on the receiving end of such attacks.
And then there are the currency's economics (discussed in more detail in this week's print edition). These have engendered a surprisingly lively debate. One particular bone of contention is whether it makes sense to decrease the rate of money creation with time. Some people think this will entail disastrous deflation if the demand for Bitcoins grows at a faster rate than new coins are minted. As recent wild swings in their dollar price amply demonstrated, they are not the most predictable of vehicles. The volatility is largely due to the fact that the currency remains illiquid—only 6.5m currency units (divisible to eight decimal places) are currently in circulation among some 10,000 users (including several hundred merchants who accept payment in Bitcoins). This seems unlikely to change in the foreseeable future, as even Bitcoin's most ardent supporters admit. That is not because people are queasy about intangibles. After all, much of modern pecuniary activity already involves bits and consumers have embraced credit cards, electronic transfers and the like.
The difference is that established fiat currencies—ones where the bills and coins, or their digital versions, get their value by dint of regulation or law—are underwritten by the state which is, in principle at least, answerable to its citizens. Bitcoin, on the other hand, is a community currency. It requires self-policing on the part of its users. To some, this is a feature, not a bug. But, in the grand scheme of things, the necessary open-source engagement remains a niche pursuit. Most people would rather devolve this sort of responsibility to the authorities. Unless of course, this mindset changes.
Venture Capitalists Take Note
Bitcoin’s record highs and the ensuring surge in hacking attempts and thefts may be grabbing headlines. However, beneath the chaos, Silicon Valley’s best-known venture firms are finally starting to make real bets around the crypto-currency.
“It’s far from certain that Bitcoin is going to be a big deal,” said Lightspeed Venture Partners’ Jeremy Liew, who has made two investments in the space. ”But the potential for disruption is enormous. If Bitcoin realizes its full potential, you’re talking about disrupting Visa, First Data, MasterCard, a lot of the banks, Western Union. These are huge multibillion dollars companies. It’s far from certain. But if it happens, a lot of value will be destroyed and a lot of value will be created. That’s when venture capitalists should be looking.”
While there have been attacks on independently-run Bitcoin wallets and exchanges, the core 31,000 lines of Bitcoin haven’t been compromised despite being available to the world’s best hackers and cryptographers for the last four years. On top of that, the currency is starting to become a speculative asset for well-heeled investors that want a gold-like hedge against U.S. dollar inflation or instability in the European Union.
“My feeling is that Bitcoin has moved away from nerdy tech types and is now attracting more of the finance and Wall Street types,” said Jered Kenna, who just re-launched TradeHill, a Bitcoin exchange targeted at accredited investors and high-net worth individuals. After launching a few weeks ago, he says he’s had investors open accounts and individually send in more than $1 million to buy Bitcoin. Even the Winklevii, the twins who famously sued Mark Zuckerberg over the creation of Facebook, have accumulated one of the world’s largest stakes in the crypto-currency. They say they own 1 percent of all Bitcoins in circulation.
With that growing acceptance, VCs are betting that Bitcoin will need a more reliable ecosystem of payments processors, exchanges, wallets and financial instruments.
The funding rounds are still small and exploratory, ranging from a few hundred thousand dollars in seed money to a few million. But they do underscore real VC interest in the space.
“Basically, payment is just a form of information and every other type of information — music, media and so on — is accessible across borders. But payments is one of these weird things that’s not,” said Kleiner Perkins’ Chi-Hua Chien, who has yet to make a bet but has spent the last two weeks immersed in everything Bitcoin.
It’s easy and frictionless, for example, to send a music track to a friend in Egypt, but sending money is much more complicated and there are transaction fees skimmed along the way.
Bitcoin was designed to be a pure peer-to-peer currency that wouldn’t need to rely on trusted third parties like banks for transactions. It is the work of a mysterious, pseudonymous hacker called Satoshi Nakamoto who was clearly frustrated with the fallout of the 2008 financial crisis when central banks cut interest rates to zero or near zero and the U.S. started expanding the money supply through quantitative easing.
In contrast, Bitcoin was designed to have a mathematically predictable, fixed supply that increases until sometime around the year 2140. In that sense, its behavior is somewhere in between that of a commodity and currency.
It is even “mined” like a precious metal; to generate new Bitcoin, a great deal of computational power has to be expended to add to the currency’s public record of transactions with some Bitcoin as the reward. Bitcoin’s fixed supply has made economists like Paul Krugman criticize its design for encouraging hoarding. With its recent surge, Bitcoin has behaved like a store of value, but its volatility and proneness to deflation undermine it as a medium of exchange.
Yet a fervent, core following has helped Bitcoin gain gradual, broader acceptance. “I’m a huge fan of taking monetary policy out of the government and putting it back into the hands of the people,” said 24-year-old Charlie Shrem, who co-founded BitInstant, a platform for instant Bitcoin transfers.
AN UNUSUAL WORLD
Few of the Bitcoin entrepreneurs fit the typical psychological profile of a Valley founder.
While building the version of his Bitcoin payments processor, Shrem absconded to a remote town in Southern Norway for months while crashing with a hacker friend named Polynomial he had never met in real-life.
“I wanted to be secluded,” he said. “He told me I could stay with him. I just took that risk, flew out of meet him and he was the nicest guy in the whole world.”
He’s never even had a face-to-face meeting with his co-founder, a reclusive Welsh hacker named Gareth Nelson.
“It’s nerve-wracking. I’m nervous to meet him,” said Shrem, who runs a team of 15 from New York’s Flatiron district. “We’ve built this relationship and this multi-million dollar business around the fact that I don’t see him. I guess I’ll go in a few months.”
TradeHill’s Kenna is an ex-Marine who built the first version of the exchange while living in Vina Del Mar on the Chilean coast. In his spare time, he converted a 41-room building in San Francisco’s Mission District into a “hacker hotel” where he collects rent in Bitcoin. “I collect dollars too,” he added.
“I have to be careful not to sound like a kid who wants to blow stuff up, but I’ve never been content with a normal life,” said Kenna, who backpacked through most of the “Stan” countries of the former Soviet Union after leaving the military. “I went from having no professional experience in finance to being in the industry leader in a new field and being one of the most knowledgeable people in the world on one of the oddest, most obscure assets.”
Some Bitcoin founders are driven less by ideological passion and more by personal experience — especially if they grew up in countries with unstable currencies. They are keenly aware of how fragile faith in a government’s ability to repay its debts can be. (We in the U.S., Europe and Japan are lucky to grow up in countries with the world’s major reserve currencies.)
Lemon’s Wences Casares
Wences Casares, a Bitcoin enthusiast and miner who runs mobile wallet startup Lemon, is the son of Patagonian sheep ranchers who lost their life savings in the 1990s to hyper-inflation during the Carlos Menem years in Argentina.
“I remember my parents losing everything. I was 14,” said Casares, who founded the Argentina’s first Internet service provider before moving to the U.S. He got into Bitcoin two years ago and is looking for ways to bring it to smartphone platforms. “I remember the feeling I had when I saw the web for the first time in 1992. That’s how I feel about Bitcoin. It feels like the Internet before the browser.”
His company has attracted well-known firms like Lightspeed and Chamath Palihapitiya’s Social+Capital Partnership.
“The interesting part of diligencing Bitcoin deals won’t be the technical part. What’s unique about the Bitcoin world is that it’s spread all over the world,” Chien said. “It’s not based in Silicon Valley and that’s partially because of the very distributed nature of the system.”
Even the best-known Bitcoin exchange in the world, Mt. Gox, processes $121 million in transactions a month from Tokyo’s central Shibuya district.
Because of the global nature of Bitcoin, it will be interesting to see how Silicon Valley fares as the currency matures. While the Valley has been at the center of the last waves of innovation in social networking and in new smartphone platforms like Android and iOS, it is just one geographic node out of many in the Bitcoin universe.
Kenna chose to relocate from South America to Silicon Valley to be close to investors. TradeHill, which shut down two years ago amid a conflict with Dwolla over chargebacks, has been reborn as a new entity and just closed $300,000 in funding. He said he came to the Valley to do TradeHill the right way in recruiting a technical co-founder from Google named Miron Cuperman who had worked on PCI compliance and privacy.
“When I looked at reforming TradeHill, I wanted three things: operating capital to do it right, regulatory certainty and a good team,” he said. “It’s hard to run a tech company from Chile when investors want to meet with you on-demand.”
But others are staying where they are. Atlanta-based BitPay just processed $5.2 million in Bitcoin transactions last month and just closed a little over a half-million dollars in funding from angels like Path and Spotify’s Shakil Khan and SecondMarket’s Barry Silbert. They’re now hiring aggressively.
One of the most interesting startups to watch will be OpenCoin, which has one of the most pedigreed teams. CEO Chris Larsen was a founder of E-LOAN and peer-to-peer lending platform Prosper and co-founder Jed McCaleb, was behind eDonkey and Mt. Gox. They just closed an angel round of undisclosed size from Andreessen Horowitz, FF Angel, Lightspeed Venture Parnters, Vast Ventures and Bitcoin Opporunity Fund.
OpenCoin, run by Chris Larsen, has created an alternate math-based currency called the Ripple.
If the startup develops enough support and infrastructure for the currency that people starting putting trust in it, the currency will strengthen. That in turn will also make OpenCoin’s valuation rise as the value of its currency holdings appreciates. It feels analogous to the business models of other open-source companies.
“The Ripple network is like Bitcoin in certain ways. The currency exists as a public good,” Larsen said. “But we thought it was good to have a company to help nurture the development of the code.”
Ripple is designed to address a few of Bitcoin’s issues. For one, it doesn’t require mining and two, it is invulnerable to what’s known as the “51% attack.” Bitcoin is secure as long as at least half of the computing power in its network is controlled by nodes that are “honest” or are not attacking the network. Nakamoto designed it this way.
At this point though, the network supporting Bitcoin is so large that it would not only cost tens of millions dollars to bring Bitcoin down, the supply of hardware necessary to do Bitcoin mining is so limited and expensive that it would be logistically difficult to pull off. Even Casares had to plunk down $30,000 six months ago to buy specialized mining equipment, which now pays for itself.
“The challenge would be how to get your hands on enough computing equipment. There are only so many Bitcoin mining chips in the world,” said BitPay CEO Tony Gallippi. “The bottleneck is really just the supply of hardware. Even if you wanted to throw hundreds of millions of dollars at taking Bitcoin down, you’d have to create your own semi-conductor fab line.”
REGULATORY AND SECURITY RISKS:
For investors who are still trying to figure out how to wrap their heads around Bitcoin, there are plenty of concerns: 1) regulatory risk if governments act against Bitcoin 2) security risks with so many third-party services being attacked and hacked constantly and 3) adoption risk, or whether the broader public will warm up to math-based currencies.
Regulatory risk was cleared up a bit last month when the U.S. Treasury’s Financial Crimes Enforcement Network issued a statement about virtual currencies. While the document itself is still a bit vague, it did make it clearer that individual Bitcoin users or miners wouldn’t be regulated. Exchanges, on the other hand, look like they will need to get a money transmitter license.
Security is a constant concern. Bitcoin transactions are irreversible and anonymous, which makes the currency an ideal target for hackers. Once Bitcoin is stolen, reclaiming it is pretty much impossible. There have been several wallets that have shut down after attacks over the past few years. In some cases, it’s not even clear whether those attacks were real like with MyBitcoin, an early wallet that controversially shut down in 2011. Claiming a hacking attack could have been an easy excuse for an unethical wallet provider to walk off with people’s Bitcoin savings.
Liew estimates that somewhere around 10 percent of all Bitcoins have been lost or stolen at some point. Even the biggest exchange, Mt. Gox, suffered lags last week as the company coped with a massive distributed denial of service attack. Today it said it was doing a 12-hour halt or “cooldown” to deal with increased trading volumes after the U.S. dollar value of Bitcoins fell by half.
“You can’t trust anyone,” Shrem said. “If you’re able to stay alive by this point, hopefully you’re making some money. Everyone else that’s failed has gotten hacked, become insolvent or had bad management.”
When Kenna launched the first version of TradeHill, he said he was constantly getting hit by hacking attempts out of Russia. One of the reasons he says he’s been able to relaunch and keep TradeHill’s brand name is because he returned whatever he could to the company’s customers back in 2011. TradeHill’s first incarnation shut down after their payments network Dwolla started doing chargebacks on their transactions. A suit between the two companies is still ongoing.
“Shutting down was painful but I knew it was the right thing to do,” Kenna said. “When we gave people their money back, it assured people that there were legitimate people with integrity in Bitcoin.”
But as I said above, the core Bitcoin protocol hasn’t been compromised, which is one reason why VCs are still interested in it.
“All of modern cryptography is based on certain assumptions that could go away tomorrow,” said Chris Dixon, a general partner at Andreessen Horowitz who has experience in security after selling SiteAdivsor to McAfee in 2006. “But Bitcoin’s been out there and has been battle-tested. Maybe there’s some core flaw in all of our security systems, but if that were the case, we’d have much bigger problems.”
While researching Bitcoin, Lemon’s Casares hired two separate teams of hackers to examine the Bitcoin source code for vulnerabilities for about a half-year.
“They are arguably the best in the world. I spent a lot of time and money on the best hackers I could find and came back from that convinced that Bitcoin’s security is robust,” he said. “What they found was very, very compelling for me.”
The last investor risk is around whether people will increasingly have faith in Bitcoin itself. For now, the currency spikes with every bit of media attention and companies like WordPress are starting to accept it. Bitcoin’s estimated daily trading volume of $31.1 million is infinitesimally small in the pool of $5 trillion in currency trades that happen every day. It isn’t even a drop in the bucket, but it continues to grow.
The irony is that if an ecosystem of trusted third-party Bitcoin wallets, banks and exchanges succeeds, it goes against the original peer-to-peer design of Bitcoin that Nakamoto envisioned. The point of Bitcoin was not to have to rely on a third-party financial institution.
But who knows what Nakamoto’s ultimate intent was? He mysteriously disappeared two years ago, saying that he had moved onto other projects. Nobody ever figured out who Nakamoto was.
“I wouldn’t say Satoshi was full of himself. But he was sure of himself,” said Shrem, who says he corresponded with Nakamoto a few times on IRC. “He seemed to know what Bitcoin was going to do every step of the way.”
A Side Note....
Security Guru Confesses, ‘I Couldn’t Hack Bitcoin’
Bitcoin may have been through some hard times lately, what with DDoS attacks, exchanges closing down and massive price fluctuations. But one renowned security expert is defending its basic resilience.
Dan Kaminsky Thinks It’s OK.
Writing in Business Insider, Kaminsky says he tried to hack bitcoin two years ago, and failed. This is a big admission coming from Kaminsky, who has serious credentials: in 2008, he discovered a fundamental flaw in the internet domain naming system (DNS). (That’s the part of the internet that tells your web browser where to go to fetch a webpage, and it is vital to the functioning of the world wide web.)
The odds — before he tried his hack — were stacked against bitcoin, Kaminsky writes. The digital currency uses an enormous cloud of machines that are always on and listening to the internet. It uses a proprietary protocol, and is written in C++, which is a language that, when used badly, is easily subverted with security exploits. Moreover, the financial gain for those hacking the system is huge.
“The core technology actually works, and has continued to work, to a degree not everyone predicted,” he now concedes. “Time to enjoy being wrong.”
Kaminsky argues that bitcoin’s high financial stakes actually change the game, leading to better programming and eliminating the security bugs he would normally look for.
The size of the system, which includes a huge “accounts ledger” for every account in the form of the blockchain, makes it difficult to subvert, he adds. There are enough nodes in the bitcoin system to always keep a copy of that blockchain, making it hard to spend bitcoins that have been stolen without being spotted.
Although bitcoins have been stolen in several high profile incidents, all of the pilfered coins can be monitored in the future, Kaminsky argues.
“As far as I’ve seen none of the stolen bitcoin(s) have actually been spent in any way,” he writes.
Bitcoin’s Potential Threat to the Federal Reserve
The Congressional Research Service, aka “Congress’ Think Tank,” recently made public their report on Bitcoin, Bitcoin: Questions, Answers, and Analysis of Legal Issues. The fascinating report details in sparkling prose the history, uses, threats and regulatory implications of the world’s best-known cryptocurrency.
The report’s most interesting part deals with the impact Bitcoin might have on the Federal Reserve. According to these experts, widespread adoption of Bitcoin could severely curtail the effectiveness of the Fed’s monetary policy.
The report describes the Federal Reserve’s mission as aimed at achieving “stable prices, maximum employment, and financial market stability.” It’s impossible to know the counterfactual. But many are entirely unsatisfied with both the nation’s employment rate and the continuing financial crises which led to its most recent rise.
For some of these people, Bitcoin is a personal escape hatch from wealth-destroying inflation. As the report dryly notes, “Some may find the removal of government from a monetary system attractive…Unlike the dollar, a Bitcoin is not legal tender nor is it backed by any government or any other legal entity, nor is its supply determined by a central bank. The supply of Bitcoins does not depend on the monetary policy of a virtual central bank.”
However, as more people choose to escape inflationary monetary policy to cryptocurrency, the Fed becomes less and less able to easily artificially inflate the money supply.
At Bitcoin’s current scale of use, it is likely too small to significantly affect the Fed’s ability to conduct monetary policy. However, if the scale of use were to grow substantially larger, there could be reason for some concern.
The main threats posed to the Fed by widespread Bitcoin use are Bitcoin substantially affecting how much money is in circulation and/or substantially reducing demand for dollars.
Basically, if everyone is exchanging Bitcoins instead of dollars, dollars are just hanging out. The Fed would then need to tighten monetary policy to be able to have any impact on their value.
Also, a substantial decrease in the use of dollars would also tend to reduce the size of the Fed’s balance sheet and introduce another factor into its consideration of how to affect short-term interest rates (the instrument for implementing monetary policy). However, the Fed’s ability to conduct monetary policy rests on its ability to increase or decrease the reserves of the banking system through open market operations. So long as there is a sizable demand by banks for liquid dollar-denominated reserves, the Fed would likely continue to be able to influence interest rates and conduct monetary policy.
There are many impediments to wide-enough adoption of Bitcoin to threaten US monetary policy. The two biggest ones, according to the report, are the fact that it’s not yet widely adopted, and its potential for deflation.
But, if Bitcoin does get big enough to potentially threaten US monetary policy, or the Federal Reserve gets worried enough that it might, we may see a surge in regulation and selective law enforcement for Bitcoin businesses. New regulations and prosecutions will likely continue to be justified under the guise of preventing other crimes and protecting consumers.
Hopefully, however, instead of the federal government checking Bitcoin, the very real possibility that people will leave the dollar en masse for Bitcoin will be an effective check on the federal government. We’ll see.
Also, the Feds. "engineered" periods of financial crisis (recession/depression periods) where-by they literally take back all of the hard-earned real assets of the people would also be a thing of the past with Bitcoin.
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