Bitcoin – A Jack of All Trades is the Master of None

As cybercommerce begins it will lead inevitably to cyber-money.— James Davidson, The Sovereign Individual, 1996

The hype surrounding Bitcoin has gone off the charts in the past year.  For those of us who have been involved with digital currency systems since the 1990’s, it is interesting to see how people caught up in the hype think Bitcoin is wonderful but in many cases cannot clearly see the reason why.  Other enthusiasts think that Bitcoin is the ultimate solution for all payments.

In my opinion as an interested party in the digital currency sector, the only thing that makes Bitcoin unique is that governments cannot shut it down.  However, this is not a feature that makes Bitcoin well suited as a mainstream retail payment system.  It is a feature designed for the black market – not that I am necessarily opposed to the existence of black markets.

All the other features of Bitcoin were done first by other people or companies, and in many cases done better.

e-gold (1996) was the first peer to peer payment system on the Internet. It developed an international set of exchangers and a transaction volume exceeding $2 billion per year.  Adam Back’s Hashcash (1997) was the first system that used proof of work.  e-cash (1993) was the first RTGS payment system that used private keys to authorize and encrypt transactions.  Todd Boyle (1990s) was first to explore public ledger accounting, and he and Ian Grigg independently originated the idea of triple entry accounting.  Nick Szabo’s smart contracts (1993) were developed in the late 1990s.

MPesa, a money system on the phones in Kenya, has the most users today. It was started the same year as Bitcoin (2008) and today has over 30 million users and does $1 billion in transactions per month.  MPesa is even more impressive as a retail payment system because it is achieving a much higher transaction volume than Bitcoin with a much smaller average transaction size ($33 for MPESA compared to $1200 for Bitcoin).

So Bitcoin is a new combination of many elements that have been done before.

Dark-net or Mainstream?

The investors who are chasing Bitcoin today are likely to run into trouble if they don’t understand what it does best versus what it does the same or worse than other payment technologies.

Based on the cryptic comments of its founder and early developers, Bitcoin was a reaction to the  prosecution and seizure of e-gold and several other popular digital currency systems – symptom of the vice grip that the central banking system holds on the creation and movement of money.

Bitcoin’s strength is that it cannot be shut down without draconian control over all the computers in the world. The market price of Bitcoin is telling us that freedom from financial coercion and control is far more valuable than anyone would have guessed.

The “dark-net” refers to systems that use strong cryptography to do hidden and sometimes illegal things on the Internet.  Dark-nets are the “speakeasy” of the Internet.

Bitcoin was presumably intended to be a dark-net for money, but venture capital firms and the Bitcoin Foundation are trying to dress it up and turn it into a mainstream payment system.   In my opinion, Bitcoin, with one foot in both worlds, serves neither market very well.

Bitcoin’s technology isn’t better or faster than the others (in fact it is substantially slower than RTGS systems), but the simple fact that Bitcoin doesn’t exist at the pleasure of government and therefore doesn’t need a money transmitter license has allowed it to spread and thrive, becoming a network with a million or more users all around the world.

Freedom – free to enter or expensive to leave?

Money transmitter licenses are very expensive to obtain.  The high cost of government compliance has removed most of the competition from the payment services market and Balkanized the market, limiting financial services to certain countries.  Banks, PayPal, Visa and Western Union are all creatures of the hierarchical central banking monopoly around the world.  None of them can move money from point A to point B in real time or at low cost.  All of them charge high fees and deliver poor service.  The result is a slow, bloated, inefficient, insecure and extremely expensive banking system, one that took us to the brink of economic collapse in 2007 and still threatens us today.

Bitcoin is growing rapidly because it has low entry costs and transaction fees. Compared to the banks Bitcoin seems fast and cheap.

If you invest money in trying to make Bitcoin a mainstream payment system, you may be confusing the things Bitcoin does no better than other digital currency systems (payments, clearing, etc), while missing the secret sauce that made Bitcoin what it is – freedom from coercion, which is freedom from government licensure and regulation.

That freedom comes with a different kind of cost.  The governments shut down e-gold and similar systems by attacking the exchange agents.  Now that the governments and central banks have noticed Bitcoin, we are seeing the same sort of regulatory attacks against Bitcoin exchanges in the USA, China, India, Taiwan and many other locales.

Anyone who invests in Bitcoin-related companies needs to understand that fact up front.  You are investing in a system that only thrives because it is resistant to government control by means of low barrier to entry.  It is only inexpensive because it is not paying for banking and money transmitter licenses, and because its costs are being paid for by mining rewards, which require increases in demand to offset them.  However, this benefit comes at a cost, as governments attack the fixed nodes in the network and bring them down.

It may be that the Bitcoin market is free to enter, but very expensive to leave.  …

Do you have an appetite for the risks that come with betting against “the man”?

Bitcoin Anonymity

Bitcoin is pseudonymous, not anonymous.  You have accounts rather than coins, per se.  And account histories are preserved forever in the blockchain.

Your transaction log tells you who people have labelled themselves as – which is not necessarily who they really are.

Should a Bitcoin user be so unfortunate as to be deceived by a fraudster conducting pyramid schemes, or running a Bitcoin exchange, or leasing out mining equipment that doesn’t exist, he discovers too late that the party he was doing business with is not the person they claimed to be and now cannot be found.

You can trace the stolen Bitcoins in the blockchain in the hopes of recovering it.  However, it is much preferable not to have your money stolen or tricked out of your hands in the first place.  To do that you need a reliable identity verification and dispute resolution system.  (Incidentally, The Silk Road achieved reliability by using bonding instead of identity, showing there is more than one way to create a reliable user community.)

Bitcoin is the perfect Hell of a persistent history that is public and never goes away, yet it is not nymous enough to give you confidence that you are dealing with the person that you think you are.

The spate of IRS prosecutions that will come out of Bitcoin in five years is going to be terrible to behold.  The IRS will build their own ASICS to datamine the blockchain for tax evasion cases.  The blockchain is forever.

The FBI was able to reach two years back into the blockchain and grab Charlie Shrem’s history of what he did as a college student, and then prosecute him for it now that he is CEO of BitInstant.

Bitcoin may be invulnerable to government control, but it fails to protect its users from government control.

Bitcoin is not sufficiently anonymous to serve the needs of the dark-net, but neither does it have an identity and dispute resolution model sufficient to serve the retail mass market.  With one foot in both worlds, it is not the best solution for either.

Zerocoin Does Dark-net Better

Zerocoin was a proposed modification of the Bitcoin protocol invented by Ian Miers, Christina Garman, Matthew Green, Aviel D. Rubin of the Johns Hopkins University Department of Computer Science.

Zerocoin goes a step further than Bitcoin by truly anonymizing the transaction system. Zerocoin was submitted to the Bitcoin Foundation for consideration to be added to the Bitcoin Protocol but after one year, nothing has happened.

The rejection of Zerocoin is not surprising because the Bitcoin Foundation is furiously working to shed the black market reputation of Bitcoin.  Bitcoin Foundation wants Bitcoin to become mainstream, legitimate and well-regulated.

However that defeats the primary strength of Bitcoin – it is accessible to all because it cannot be controlled.  If you submit Bitcoin to regulation it will become less accessible and more expensive. Goldmoney.com was well regulated, but almost nobody used it for peer to peer transactions. Why? Because they did not have the capital to build a global network of exchange agents themselves, and they were not willing to open up their system to third party exchange agents.

We are already seeing the cost of regulatory compliant Bitcoin exchanges in the six week wait time for new users to get verified at licensed exchanges like Kraken and Mt. Gox.  Regulation throttles usability, causes delays and increases costs.

In light of the decision (or non-decision) not to incorporate Zerocoin into Bitcoin, Zerocoin has announced they will fork Bitcoin.  Soon Zerocoin will be the newest alt-coin, but unlike the other Bitcoin clones, Zerocoin actually brings something new to the table.

Zerocoin is the one technology on the field today that can improve on what Bitcoin does best – create a digital currency system that government cannot control.  Zerocoin goes one step further than Bitcoin and protects the user’s transaction history from the government.

I would not be surprised to see Zerocoin overtake Bitcoin as the preferred black market coin within three years.

Transaction Clearing Time

Real Time Gross Settlement (RTGS) refers to payment systems where transactions clear instantly (less than one second).  Banks and credit cards are settled once in a batch at the end of the day. RTGS systems allow high velocities of money, while banks are known for delays, delays, delays.

Bitcoin transactions cannot be verified in less than five minutes on average because the blockchain only allows one new block to be generated every ten minutes.  And to be really settled, you need to wait for six or more block verifications, which takes one hour.

This feature of Bitcoin is a byproduct of the proof of work and decentralized blockchain.  So the tradeoff for a decentralized uncontrolled currency unit is being 4000 times slower than typical RTGS digital currency systems.  (The fact that it is still faster than banks tells you how ridiculously inefficient the banking system is…)

There are three common applications that need fast transaction clearing – retail payments,  exchange trading, and mass transit payments.

At the POS in most stores the time limit is 6 seconds.  If your payment system does not enable the customer to make the payment and get final settlement in 6 seconds the management will not allow it in their store.  Bitcoin verification is 5 minutes minimum, so you can be certain that Bitcoin will never be used at the point of sale for high traffic stores.

Exchange trading for any kind of financial instrument, commodity or other good are subject to market timing attacks, as detailed in this paper about market timing attacks.  Algorithms on the NASDAQ and COMEX are competing to shave off milliseconds.  With its five minute latency, Bitcoin will never be suitable for exchange markets. Because of this you can be certain that off-blockchain trading is going to become the norm, if it isn’t already, for market exchanges related to Bitcoin.

Mass transit payments at toll booths or subway stations need to clear in less than one second – same story.

So, that’s fine, Bitcoin doesn’t have to solve all problems – it is one tool in the toolbox.  Exchange trading, retail POS and mass transit are three applications it is not designed for.  However, other digital currency systems can process transactions fast enough to serve these markets.

Bitcoin is too slow to serve retail sales in the mass market because of the cost of its dark-net features.  Once again, we find that Bitcoin’s position between the dark-net and the mass market make it less than optimal for either.

How Bitcoin Is Paid For

Bitcoin transactions cost above  $50 per transaction, which is very high, but it feels low because this cost is paid for through the creation of new bitcoins that equally dilute everyone’s bitcoins.

The person making the transaction doesn’t pay the fee, all holders of Bitcoins pay what amounts to an inflation tax out of dilution of their Bitcoin value. From the user’s perspective of sending money with Bitcoin, it feels practically free!

This situation will change once 21 million Bitcoins have been created and the blockchain reward falls to zero. Once the Bitcoin mining reward falls to zero, the entire cost of Bitcoin mining (transaction processing) will have to be borne by transaction fees.

The current transaction fee is over 4% even with an average transaction of $1200.  If Bitcoin were to become a retail payment system, the transaction fee would be over 100%.

In order to maintain the current mining reward, even if Bitcoin block size were made a lot larger, the average transaction fee would have to be about $1 per transaction.  For a retail sized transaction ($33) that is the about same cost as credit cards or paypal.  So Bitcoin is not cheap, it just feels cheap because block rewards are currently covering the cost of mining (transaction processing).

This high transaction cost is once again, due to Bitcoin’s dark-net features.  Other digital currency systems like e-gold were able to issue precious metal contracts that were never diluted by inflation.  Their transaction fee was 0.5%, capped at 50c.

What Bitcoin Doesn’t Do

People have need to trade many things, a universe of things.  Money is simply one of the things they trade that is used as the poker chip for accounting the value of other things.

Bitcoin welded the payment system (bitcoin client) to the issued value (BTC), so they are inseparable.

However, people need to trade receipts for dollars, euros, gold, cereals, graphics cards, iPads, stock shares, bonds and lots of other things where commerce happens at a distance.

We live in a world with over 100 national currencies that are not going to go away in the next twenty years.  Online and on the street, stores need to accept transactions in a variety of currencies, especially outside of North America where countries are small and close together.  Ventures are looking for ways to bring the world of altCoins together, and how to issue and trade financial instruments.

Bitcoin lacks the flexibility to describe any other instrument but its own, though newer systems have made attempts.

This is the problem that Ian Grigg solved back in 1995.  He built the first multi-instrument system that could operate without centralized control of the namespace and of the semantics of each issuance.  Starting from the contract as the defining document of any instrument, this document can be hashed (cryptographic message digest) into a single identifier that is guaranteed unique;  just like the nymous keys in Bitcoin, we can now have as many currencies as we like, and each is entirely independent of each other and of any centralized authority.  Each can also be as expressive as one likes, there are no artifical limits imposed (a failing of Ripple, which describes the currency in a block of hard-defined fields).

When investors look at digital markets, and digital payment systems that support these markets, they should ask themselves whether there is control over the issuance namespace, and whether the issuance contracts can support rich definitions of contract terms.   Bonds, for example, are very complicated little creatures.  Bitcoin simply cannot support bond issuance and trading.  Neither can Ripple.  Ricardo can and does.

If your goal is to exploit Bitcoin’s freedom from government control there might be little point in favouring a system where the issuance space is controlled.  If your goal is trading derivatives, there might be some concern if the derivatives are not easily expressed in all their richness.

On the other hand if your goal is to benefit from the media attention in the space, and to be a first mover, then control may be your goal.  But that comes at the price of flexibility and power.  Ultimately the system that supports the deepest ecosystem will win.

Whatever happens, systems with the flexibility of multiple issuance such as Ricardo are more likely to become an international standard because they are also more capable of expressing complicated local regulatory situations.  They are more flexible than Bitcoin, settle faster, and allow for the multiverse of currencies and financial instruments that people use and trade in the real world.

My Conclusion

Bitcoin should be loved for what it does best – it cannot be controlled by the government. It therefore enters best into markets where government control has raised the price too high.

However, events have shown that Bitcoin does not protects its users from the government well enough to serve the needs of the dark-net.

Fanboys who think that Bitcoin is the best at everything are not aware of the deep history of digital currencies and will end up looking silly.  Bitcoin is one tool in the toolbox.

Investors who chase Bitcoin but want it to be mainstream and accepted by government are missing the point that Bitcoin is not the biggest or the best transaction technology in town, not even close.  Bitcoin is the first transaction system outside of government control.  That alone is what makes it special.  And now that there are 80 or more equally uncontrollable Bitcoin clones the bureaucrats are starting to get concerned.

This is exactly what James Davidson predicted in The Sovereign Individualback in 1996.

This change will come about because of the effect of information technology in liberating the holders of wealth from expropriation through inflation… Inevitably this new cyber-money will be denationalized.  When Sovereign Individuals can deal across borders in a real with almost no physical reality, they will no longer need to tolerate the long-rehearsed practice of governments degrading the value of their money through inflation… Control over money will migrate from the halls of power to the global marketplace.

Bitcoin has done the world an enormous favor by creating the apolitical cyber-money that James Davidson anticipated – one that cannot be controlled, much to the chagrin of bureaucrats everywhere.  The market value of Bitcoin is telling us that a free and uncontrolled financial system is a precious thing indeed.

Bitcoin has smashed the ice of the banking monopoly.  Financial regulators will eventually realize they must compromise or else lose complete control of the financial system as more and better cryptocurrencies are fielded.  Banks like JP Morgan now want to enter the digital currency arena.  Could it be because they are jealous of an alternate financial system that they do not control?

If you are an investor who wants to make a play in the digital currency sector, you need to decide whether you want to invest in the dark-net payment systems like Bitcoin and Zerocoin, or whether you want to invest in a mass market payment system that is compatible with the regulatory systems around the world.  If you try to make a dark-net system like Bitcoin into a regulated mainstream payment system, you will kill it.

The world needs both kinds of systems.  The dark-net systems remind the bureaucrats that they cannot control everything, and will eventually force them to compromise in order to maintain any control at all.

Bitcoin’s existence and popularity make it much more likely that multi-issuer systems like Ricardo or Ripple that do have good identity models will be able to operate within the legal system because the bureaucrats prefer that over one that operates outside of it, as Bitcoin does.

The rank and file brick and mortar businesses live with the reality that they have to pay taxes, and they need mainstream payment system with auditable transaction histories that work for the paradigm they live in.

As the investors in BitInstant recently discovered, you can’t serve both the black market and the white market for very long, especially with a public blockchain to rat out your CEO.

I believe that the future of digital currency lies with multi-currency, multi-issuer systems like Ricardo.   That’s why I started a company with Ian Grigg that uses Ricardo to enable mobile payments and savings instruments to be legally traded in Africa, India and China and other developing countries.

Bitcoin has served as an excellent foil, it has expanded the envelope, and now the regulators feel pressure to adapt.  They need to look and feel like they are in control.  As never before, they must acknowledge these newer ideas of peer to peer, digital currency systems and open issuance or risk being bypassed and losing control entirely.

If you want a dark-net money system, Zerocoin will be better at protecting its users from the government.  If you want a retail payment system then a fast clearing, multi-instrument system like Ricardo is better suited to the diverse needs of the market.

Bitcoin has been a pioneer, but with one foot in the black market and one in the white market, it is not the best payment solution for either.

Though Bitcoin has breathed a second wind into the digital currency movement, this is not the end of the journey.  Bitcoin is a waypoint on the road to a digital free market.

Ken Griffith is the co-founder and Business Development Lead for Dinero Limited. Dinero provides software that enables digital currency issuances, trading and automated exchange on the Mac, PC or Android phone.

15 thoughts on “Bitcoin – A Jack of All Trades is the Master of None”

  1. > the only thing that makes Bitcoin unique is that governments cannot shut it down

    No, that is not the *only* thing that makes Bitcoin unique. It is a consequence of the fact that bitcoin is decentralized — and true decentralization is the unique thing about Bitcoin compared to all other monetary systems that don’t require physical commodities.

    Bitcoin is also a RTGS system (Real Time Gross Settlement). All other RTGS systems that have been made available for non-bank use were eventually shut down or forced to become non-gross settlement systems (i.e. not final irrevocable payment). ALL others. Without exception.

    So one of the most important properties of bitcoin is that is an RTGS that is likely to last more than a year or two. We’ve never had that before.

    1. You are mistaken. There are several RTGS systems currently running on this planet including:
      * MPESA
      * Airtel Money
      * Orange Money
      * Pecunix
      * Webmoney.ru
      * national bank systems in several countries including Kenya of all places. (though theirs has serious security problems)

      Bitcoin transactions are batched in a block every 10 minutes. Bitcoin is a batch transaction system, granted with a much higher batch frequency than banks or credit cards which are daily, but batched nonetheless.

      Because of the decentralized batch structure, it takes six or more confirmations to be sure you don’t have a double spend. So a transaction is not settled until it has been sufficiently confirmed that it is not a fork in the blockchain. The longest fork to date was 12 blocks, which is two hours.

      Sorry champ, Bitcoin is not RTGS.

      The decentralized nature of bitcoin serves one purpose – making it hard to shut down.

      Voucher-Safe is also decentralized and uses digital bearer instruments, but as far as I can tell nobody is actively using it.

      1. > There are several RTGS systems currently running on this planet

        Sorry champ, none of these are available in the US (as unlicensed and unlicensable “money transmitters”). Go ahead, try opening a business bank account in the US with the declared intention of accepting payments via one of these instruments — the bank will refuse to open (or close) your account.

        As for your nitpicking about “real time” — mean of ten minutes with a practical maximum of two hours is close enough. The “G” is the important part of RTGS, not the “R”. If you are that fixated on it, just re-read my entire post substituting “NRTGS” (near-real-time gross settlement).

        The US has banned all gross settlement systems with settlement time anywhere close to two hours… more like 10-30 days before you can be sure your payment is final.

  2. > The spate of IRS prosecutions that will come out of Bitcoin in five years is going to be terrible to behold.

    Absolutely agree. I pay taxes on my bitcoin earnings, but never ever report them as anything involving the word “bitcoin” or even remotely related therewith.

    > The IRS will build their own ASICS to datamine the blockchain for tax evasion cases. The blockchain is forever.

    Uh, custom chips are irrelevant to this. I think you’re confused. You mine bitcoin to add blocks, record transactions, and earn block rewards. “Mining” the blockchain does not give you more information about historical transactions.

    > The FBI was able to reach two years back into the blockchain and grab Charlie Shrem’s history of what he did as a college student,

    No, they didn’t.

    They reached two years back into his EMAIL ACCOUNT. Which they subpoenaed. Big difference there.

    1. Good catch! I confess that was hyperbole.

      However, ASICs are programmable. You can get ASICs for other purposes than mining. So if the IRS really wanted to they could get ASICs built just to datamine the block chain for tax evasion analysis.

      I know the IRS will not need to build ASICs because they have seven years to prosecute so urgency is not a concern of theirs. But they will data-mine the blockchain, to be sure. 🙂

      1. ASICs are not programmable. You are confusing FPGAs with ASICs.

        People wanting to data mine the blockchain is definitely a big risk. I guess you have to use a separate address for each transaction to make it harder for them.

    2. His email account would have been of little use without the actual Bitcoin transaction to prove that he actually made the trade. His email account may have tipped them off, but the blockchain had the proof that he did it. And they needed no subpoena for that.

      1. > His email account would have been of little use without the actual Bitcoin transaction to prove that he actually made the trade

        None of his emails included transaction IDs.

        Also, “business records” are exempt from hearsay rules in the US. They don’t need the blockchain; they just need to grab his company’s servers, which they had to do anyways in order to get the transaction IDs (which were on the company’s servers, not in his email).

  3. You are mistaking the expense of securing the transaction in the blockchain with the expense of solving the cryptographic puzzle that gives you the block reward.

    The cryptographic puzzle included in mining is a way to bootstrap the currency system. To gives the initial distribution of the new currency in a non-random way. Another way would be throwing bitcoins out of a helicopter…

    So miners are making expenses to earn the reward of 25btc every 10 minutes. The algorythm increases the difficulty of the puzzle to make sure no more than 25btc are given out every 10 minutes.

    Once the block reward diminishes, the difficulty can come down, up to a point where the effort goes into securing possibly tens of thousands of transactions per second with the many petahashes already available in the network. Then you can divide the cost of the computing over many more transactions and you will see that it is very low. So bitcoin really is cheap, and it will remain cheap.

    1. Blockchain.info stats are based on GPU mining. No one does that anymore. ASICs are much more efficient.

      Looking at the cost of securing bitcoin in isolation is not fair. You have to compare it with the cost of securing other types of money. When you do that you’ll see that bitcoin is cheaper.

      Mining rewards will end in 2140. Why worry about what happens then? You and I will be long dead by then.

      1. My 57 Mwatt stat came from my own calculation of the current Hash rate divided by the Hashrate per watt of commercially available 2013 ASICs.

    2. My assumptions on the blockchain reward were:
      * reward falls to zero
      * current block size has a small number of transactions per block. Current block reward is worth $25,000.
      * Currently there average 350 transactions per block: https://blockchain.info/charts/n-transactions-per-block
      * If you increase the block size to allow 25,000 transactions per block , you still need a transaction fee of $1 per transaction in order to keep the reward the same for the miners.
      * That’s a 71 fold increase in block size, but $1 transaction fee still isn’t cheap.

    3. > Another way would be throwing bitcoins out of a helicopter…

      Of course not, since then they would be utterly worthless.

      Bitcoins are backed by the computational power that had to be wasted (yes, wasted) in order to mine them. It’s the only hard proof you have that these things are linked to some scarce thing (compute cycles, silicon, and electricity) in the real world.

      Just look at the total failure of these silly “proof of stake” systems. They’re just gold stars handed out by whichever programmer wrote the client. Nobody believes that has any value.

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