Bitcoin: a currency outside State control


The way we pay for things changes regularly. Cheque books have been replaced by magnetic stripe and chip & pin. And these could soon be on the way out, too, as contactless payment methods become more widespread.

Bitcoin is altogether different. It is at the vanguard of new form of ‘crypto’ currencies that exist outside of national, state controlled monetary systems. It is supported by peer to peer networks, turning personal computers into mints and it has been making headlines and waves since the start of the year.

Pod Academy’s Alex Burd went to the Internet Institute, part of Oxford University, to talk to Vili Lehdonvirta, a research fellow there and an expert in all things Bitcoin. This is the first of a 2 part podcast (second part later this week).  In this part they discuss the origins and development of the new technology, its connections with the shady sides of the internet and if it can become mainstream. Vili began by explaining the fundamentals of how the system works.

Vili-LehdonvirtaVili Lehdonvirta:  Bitcoin is what some people call a distributed digital currency.

Normally in a digital currency we’ll have some kind of central ledger, a central database where all the account balances are held and all the transactions are recorded, and the transactions will normally be carried out by simply changing the account balances in the central database. This centralised model has the problem that, if the central database is compromised from outside or the authority that manages the central database wants to mess with it, they can.

The way Bitcoin works is that the database is distributed. It’s a peer-to-peer network, where everyone that uses the currency participates in the network and holds a copy of the entire transaction ledger from when the currency was first started.  So the database is distributed and with the clever use of some cryptography it’s ensured that you can only spend your own money. If you try to spend money that doesn’t belong to you or do some other unauthorised transactions – such as create new money from scratch in a way that’s not allowed – all the other clients connected to that peer-to-peer network will notice that and will not pass  your transaction along to others. That’s essentially how Bitcoin is different from other centralised digital currencies. That’s also one of its main selling points  – it is secure against hacking and also secure against a centralised authority misusing their power to manage the currency.

Alex Burd: In traditional, tangible currencies you have a central bank that’s responsible for the value of the currency and distributing the currency. But in Bitcoin everyone knows how much there is and everyone knows how much everyone has..

VL: I wouldn’t use the term tangible currency to refer to Euros or Pounds because most of them are digital records in the same way as this private digital currency. The only difference really is that the pound is a national currency, its status is upheld by law, whereas digital currencies like Bitcoin, are private currencies. That’s the terminology I would use, national currency or private currency.

AB:  So the money in my pocket is national, but Bitcoin is private. Explain how the supply of money differs between the two.

VL: In  a national currency usually you have a central bank that manages the size of the money supply by various means. The bluntest means of course is simply to issue new money or withdraw money from circulation to reduce the size of the money supply – because most of the money that is circulating in a national economy is not central bank money as such, but commercial bank money (ie money that’s created by private banks when they take deposits and lend that money on).  Central banks use things like reserve ratio requirements and lending rates to manage, to influence the size of the money supply created by private banks.  There are two main differences with Bitcoin. One is that there is no central bank that could manage the size of the money supply and the second difference is that, at least for now, there are no banks operating with Bitcoin so there is no private commercial bank money being created for lending.

AB: So without a central body managing the amount of money in the system how is new currency created and circulated in Bitcoin?

VL: It’s a really clever system. There’s an algorithm built into the system, an algorithm that’s embedded into each and every client that’s in the Bitcoin peer-to-peer network, and that algorithm basically says that you can create new money by ‘mining’, and mining essentially means expending a lot of computational power, computing resources, to try and solve a very hard mathematical problem. If you succeed in solving that problem and you send a proof of work to the network and all the other clients will check that proof of work, and if it checks out that you’ve really found the solution to this arbitrary mathematical problem, then you are allowed to claim an amount of new currency. That’s the way new currency enters the Bitcoin money supply.

The clever bit in the algorithm is that the difficulty of the problem depends on the amount of Bitcoins already in circulation, and so it’s designed in such a way that the more Bitcoins there are the harder it becomes to mine more until eventually there will be around twenty million Bitcoins in circulation. And then after that it will be too difficult to find many more. Most of these Bitcoins will have been discovered by 2030. So the number of Bitcoin in circulation depends only on time, so the algorithm is built in such a way that at a certain point in time and in a certain year you’re going to have a certain number of Bitcoin in circulation because the algorithm manages the difficulty level of mining so as to make that happen. Currently there are eleven million BItcoin in circulation.

AB:  Bitcoin started in circulation in 2009 and we’re already at half way towards the total. In order to mine more your computer has to expend computational power so the bigger and better your computer the faster you mine?

VL: That’s correct, although now because the mining has become so difficult, and there are so many coins in circulation, an ordinary desktop computer is not really viable anymore. So what happens if you try to use your ordinary desktop computer to mine bitcoins is that you’re actually going to spend more money on the electricity consumed by the computer than you earn from the Bitcoins that you mine. People are now investing in these special purpose devices, not ordinary desktop computers, but computational devices designed to do nothing else but solve the mathematical problem that the Bitcoin algorithm presents. They can do that more efficiently, expend less energy to find Bitcoin  – this is way Bitcoins are mined today.

AB: So people have purpose-built machines?

VL: Yes, exactly.

AB:Surely the cost of creating these machines will outweigh the value of the Bitcoins?

VL: Yes.  My impression is that it’s not clear at all whether people who buy these machines will ever recoup the costs because it depends on a lot of factors – it depends on what will the value of Bitcoin be over time (because if the value of Bitcoin increases significantly then these machines might be a great investment, if not then they may never pay for themselves because there’s also the cost of electricity and so on). The companies that manufacture these machines are making a killing.

AB: It came into being in 2009 but who came up with the idea – it’s obviously a very complex and well thought idea – where did it come from?

VL: Well this is the funny thing. Bitcoin has a kind of mythical beginning. It was first initiated, designed and created by a mysterious person named Satoshi Nakamoto. A paper, a scientifically presented paper, authored by Satoshi Nakamoto appeared on the internet, a code base was also established by this same person, but no one really knows who this Nakamoto is. The name would suggest that is a Japanese man but I doubt that. I’ve lived in Japan for many years and reading Nakamoto’s texts doesn’t give you the impression that he’s Japanese – it could even be a group of people.

Satoshi Nakamoto, after making the initial contributions and setting this whole community in motion that then started to maintain the codebase and peer-to-peer network, simply disappeared. He’s said that he’s moved onto other projects and no one has heard from him since. But of course it’s expected that he would be holding onto quite a big stash of Bitcoins himself because he was mining them when it first started, when the algorithm was first initiated at which point it was still very easy, comparatively speaking compared to today, it was very easy to mine Bitcoin. He is probably now a very wealthy person!

AB: Bitcoin has existed for four years already, since 2009, but has only really received much coverage in the last year, especially since the start of this year, 2013. What do you put that down to?

VL: I think it has a lot to do with media and very little to do with Bitcoin. It has been fascinating to follow.  The first media spike, media bubble, was last year. Bitcoin just started to get media attention, some bloggers wrote about it and some mainstream media outlets picked it up.  I’ve learnt a lot about media following this.  A journalist sees this fascinating story with a great mythical background and potential to change the world’s financial systems – and it also feeds into the current climate because people are disappointed with banks and disappointed with mainstream economy. Any story that offers some kind of hope that offers an alternative, a technological solution to our social problems fits a need in our current media atmosphere. And so one journalist writes about it, others see it and they start to write about it also and it escalates from there. And the funny thing that then happens is that the more people who write about it, and those people who hear about it they try it out, they buy a few Bitcoins, they give it a go. And when they do that it causes the exchange rate to rise and that generates more headlines. ‘Bitcoin is booming, the exchange rate is going up’ and that attracts  ever more people who hope to make a quick buck by buying Bitcoin since it seems to be gaining value rapidly. This happened last summer on a small scale. Then at some point  the story is saturated. The media grows tired of it, they have to move on, next topic. So it lasts two, three, four weeks usually and then what happens is those people who bought Bitcoin as a sort of investment in order to hold it and sell it on, dis-invest, once the value has grown sufficiently – they are disappointed because if the media stops writing about it then there are no more people coming in and the exchange rate is not growing anymore, it stagnates and they start dis-investing. They want to get out of it, ‘ok I’ve seen this and I want to get out.’ And then what happens is a bust because everyone starts selling and the exchange rate crashes again. This happened for the first time last summer and again at the end of March, beginning of April 2013. This year the Bitcoin story was big on any measure. I’ve been following the coverage through Google news.  In January there were zero to one, to two, stories per day about Bitcoin, and that grew to dozens of stories in March until in early April there were hundreds of stories every day. Every day hundreds of media outlets were writing about Bitcoin and as a result the exchange rate soared like never before. Well then eventually it crashed but it didn’t crash all the way down. So it reached a value of about $200 per Bitcoin at one point from starting from just a few dollars, ten dollars or twenty dollars before this boom and then it crashed, it’s currently holding at about $100 per Bitcoin.

AB: I read one of these many articles; it was something more sceptical about the Bitcoin bubble. The writer described it as an investment, a stock, rather than a currency given how it goes up and down so much,  and because there are few places you can use it as a currency. It’s people buying in as an investment rather than having any intention to use it as a currency..

VL: Well that is what I was saying before the bubble burst. In a way I think the events show that my interpretation had some merit to it.

If we go to the fundamentals, the value of a currency depends on what you can buy with it and so if you can buy a lot of things with that currency, if a lot of people want that currency then it’s a very valuable currency and if you can’t really use it for anything and no one is using it for anything then it’s not a very valuable currency. So sustainable growth in the value of currency like Bitcoin would come from people starting to use it in their everyday dealings to pay for things, to accept it as payment for services rendered. This would be a sustainable demand for a currency.

The other type of demand for a currency is where someone buys and holds it with no intention of actually using it in their daily dealings but just intending to hold it until the exchange value has grown sufficiently and then dump it to gain a profit. Given that the media stories were usually saying ‘the value of Bitcoin is soaring, it’s doubled its value in one week’, you can just imagine the type of person attracted to Bitcoin.  So what happened was that  the great majority of people who came into Bitcoin as new users, thanks to this media boom, did so with the intention of speculating with it, not with the intention of using it as a medium of exchange.  They created this unsustainable growth in value because this kind of speculation can only continue as long as there are more people, more speculators coming in and once that stops the speculators notice that the value is not growing anymore and they get disappointed, they start disinvesting and since they were only holding it for the purpose of making a profit, when that purpose disappears they offload it.

By looking at not only the exchange rate and how that was developing but also how the number of transactions was growing and the number of transactions also excluding some of the foreign exchange that was going on, there are some sources of data that try to exclude that kind of transaction from the total transaction count, you could see that the actual usage, the transactions using Bitcoin were not growing nearly as fast as the exchange rate. SO they were growing but there wasn’t any exponential growth. This observation and also what people were telling me and what you could see on social media, people talking about ‘well, I also bought some Bitcoin and I’m going to see if I can make a profit with it’, these kind of stories; lead me to believe that we are not seeing an explosion in the use of Bitcoin for commerce but in the use of Bitcoin for speculation.

A: So although many people who have bought Bitcoin recently have done so out of curiosity due to the articles or looking to make a quick profit some must be there  using it is properly. What kind of groups are using Bitcoin and what is it they’re using it for?

V: I’d like to have some hard data for this but it’s not possible to come by because people who accept payment of Bitcoin are generally not releasing numbers, they tend to be very fond of financial privacy.

However, there are some very famous uses for Bitcoin, one is the drug trade and gambling –  illegal or regulated activities where it is useful to have an untraceable currency so that authorities can’t catch you. That kind of uses are obviously well known.

AB: Places like the Silk Road? Stuff like that?

VL: Exactly, they are this kind of, not websites, but TOR sites, hidden websites where it is possible to use Bitcoin to buy drugs in your area. There isn’t much hard data on what are the relative sizes of these types of uses. Someone did a very nice study of a particular drug trading site, and I don’t remember the numbers off the top of my head but there was some quite significant volume of transactions that they were able to collect or record just by observing what was going on on the site. So they didn’t have any access to any backend or anything, they were just looking at what happened in the site to sort of sum up the traffic and the amount of transactions that were going on.

So that’s one use, and then  obviously if we’re talking about these illegitimate uses then there are things like money laundering – you can obfuscate the source of money by buying Bitcoins with your dollars and then laundering those Bitcoins in certain ways and then transferring them back into dollars. There’s tax evasion – I’m personally concerned about tax evasion. Because finally we are starting to be aware of the problem that companies, organisations, and also some individuals in the world are simply evading taxes and shirking taxes. And this is a big social problem because it means that the rest of us have to pay more taxes to maintain essential services and maintain governments and society. So now that we are starting to recognise this as a problem and hopefully take action against tax havens and Swiss bank accounts and so on. It’s kind of worrying that there are new technical means for hiding your transactions and hiding your balances from legitimate authorities.

AB: It’s kind of the ultimate Swiss Bank…

VL: Yes, it’s a digital Swiss bank account, except without the Swiss. Even the Swiss could not open that data if they wanted.

But then of course we need to talk about whether Bitcoin is really anonymous. Some people will take exception to the idea that Bitcoin is anonymous and useful for criminal activity. They would say that Bitcoin is actually less anonymous than commercial bank money because every transaction that takes place is recorded in that public ledger which every participant in the network has. They’d say that’s radical transparency. But unless you can link those transactions to actual identities then that transaction data is not useful, and when you do something like buy Bitcoin using US dollars then that links your identity if you use your credit card, so that links your credit card, in principle at least if the payment processor or the marketplace that facilitates your purchase if they want to they can record that data, they can link that credit card data with the Bitcoin ‘key’(as themaccount numbers are called), they can link them and in that way your anonymity in the Bitcoin network is compromised. But what you can then do is create multiple other Bitcoin accounts and you can move money between accounts and you can move money around with your friends.

There are even money laundering services or ‘mixers’ or ‘tumblers’ which do this process for you – you put some money in, and many other people put money into that mixer as well. The mixer mixes them, sends your money back to you to a new account number that you’ve given them. However, the money you get back is not the same Bitcoins you put in. Every Bitcoin is worth the same so it doesn’t matter which ones you get back but you don’t get the same ones back and that way the link between your identity and the Bitcoins you’ve mined and registered is broken – you get Bitcoins that were bought by someone else, somewhere else, who doesn’t know you. This way it is perfectly feasible to create a very high level of anonymity.

AB: Do you ever see Bitcoin going more mainstream? For example in terms of being a commonly used currency?  Or is it going to be something like Bitcoin that isn’t Bitcoin?

VL: Two things limit Bitcoin’s ability to become truly mainstream. One is that despite the serious abuses of a national currency system and national monetary system, national monetary systems still provide a level of convenience for the ordinary people who are not concerned about more philosophical ideals – these are important but the ordinary consumer prioritises convenience. And despite Bitcoins becoming easier to use, it’s still just more convenient really. There are people who disagree with me but in my subjective assessment of the usability of this different payment systems it’s just more convenient to use Euros, or Pounds or Dollars. If you receive your salary in that currency it goes in your bank account, we have all this infrastructure built for those currencies. They’re quite safe, if your bank account is hacked it’s the bank who will compensate you so the risk is diffused; if your Bitcoin is hacked, your key stolen, you lose everything.  There is no recourse and there is probably very little that law enforcement can do because authorities have been excluded from the system by design. So there are these very practical reasons why ordinary consumers will find it hard, well let’s say they won’t find many reasons to start using Bitcoin instead of their national currency.

The second part of this series on Bitcoin will be available later this week. In it Villi explains how Bitcoin has become the champion of political libertarians, its relationship with existing system and what it can teach existing systems.

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