Tag Archives: Bitcoin

Abracadabra, here’s Libra Calibra

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As Facebook attempts to bounce back from some of the latest setbacks, it is interesting to hear about the launch of Libra and Calibra, in what seems to be more of an offensive, rather than defensive response.

What is Libra?

In describing their mission, Libra starts by touting the banked-unbanked statistics, as have most of the would-be disruptive services for the last couple of decades or so. The question this raised for me is whether all this has really been tailored to those currently shut out of the banking system. With that segment more pre-occupied by bread-and-butter services, schooling, healthcare and local spend, it seemed to me that this product, aimed at global money transfer and payments transactions may turn out to be more attractive to a different tribe. Facebook seems to have received similar feedback already, so perhaps there is more to this than currently meets the eye.

The service is underpinned by the Libra Blockchain, and a currency unit termed, not unexpectedly, Libra (LBR). Adoption has generally been the main sticking point in most of the services that failed to make it over the last decade. Knowing this, their proposed founding members list reads like a “Who’s Who” of the Payments ecosystem. We have though, seen such a line-up in many previous products that are no longer around today. Perhaps this time it will be different. It is still early days. With so much of industry learning available, succeeding this time should hopefully be simpler.

What is Calibra?

Calibra is the digital wallet service from Facebook, meant to be the wallet for Libra. It may be used as a standalone app or through the Facebook Messenger and WhatsApp platforms. A subsidiary of Facebook, it seems to be the main go-between into Libra, which Facebook seems to be keeping more at arm’s length, judging from the “Libra, 2 weeks in” blog from David Marcus.

The Libra Association has been set up as an independent organization in crypto-currency friendly Geneva, Switzerland. Arguably, as just one of the 28 initial Founding Members, Facebook is not the sole influencer. However with a charter yet to be put in place, the trust the market places in Facebook will still be a central issue for the success of this service.

How does all this connect into the Bitcoin ecosystem?

Libra appears to position itself as a peer of Bitcoin. It is built on Blockchain, as is Bitcoin. While Libra claims not to be as open as Bitcoin, it is designed to be open, as it is not restricted purely to members. Where exactly the “openness line” is drawn will probably be clearer in the coming days.

Unsurprisingly this has raised similar concerns for regulators and Central Banks as have crypto-currencies launched before, though given the reach of Facebook and recent events, concerns seem to be stronger. Chris Skinner who spent time looking at what’s been happening at the United Nations shares his views in “The Regulator’s View of Facebook’s Libra Currency”.

Future Outlook

India’s base of tech-savvy consumers became a leading adopter that decided the fate of WhatsApp as a communications platform. An earlier P2P payments service from Facebook termed the WhatsApp payments service recently completed a pilot in India, offered to a million users. It now aims to rollout across the country, and is also being introduced in London. It will be interesting to see how that service pans out, and what the connection is to the new services planned. What is the future direction Facebook has in payments, how will all their acquired products fit in, and whether they will at last make the break through they have sought for so long – these are just some of the many questions that remain unanswered. 

If any company is well aware of the network effect and how to use it, Facebook is. With experienced David Marcus involved there is undoubtedly a high degree of preparedness to be expected. So, they would well know how the closely-knit Indian community around the world could contribute to the success of these new products. At present though, Facebook claims to have ruled out plans for Calibra in India. The chosen markets and corridors will no doubt have an enormous impact on the success of these services.

For more on this, there is an infographic from MrBTC.org that aims to describe the crypto-currency in 5 minutes.

Ethereum- A summary

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Part 3

In this third and final post on the topic of Ethereum, Dr. Neeraj Oak sums up his thoughts on this potentially ground-breaking decentralised contracting system and considers the issues and benefits he thinks should be highlighted before Ethereum is launched.

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To summarize my view in the previous two posts, Ethereum is a good idea but one that is far more complicated than even Bitcoin was at its inception. This is an admirable thing, but it is important to provide credible solutions to the rather fundamental legal and technical issues that Ethereum faces before it is officially launched. Without these, Ethereum seems a risky proposition for any investor.

 

One vital part of creating a sound market proposition for Ethereum is in crafting a cohesive argument for why their service is better than a centralised, non-pseudonymous alternative. If the argument centres on the idea of a safe means of transferring data or value, then eliminating pseudonimity is a good way of achieving this. On the other hand, if the goal is to eliminate the need to trust a single central authority then this could be achieved in easier ways. For instance, making several independent organisations responsible for maintaining copies of the ledger would preserve a part of the checks-and-balances of full decentralisation without exposing ordinary users to the hassle and potential threats that could come from holding a copy of the ledger themselves. Without explicit reasons for including the design features of pseudonimity and decentralisation, Ethereum risks looking like a purely ideologically motivated experiment rather than a practical alternative for mainstream users.

 

It is also worth considering the merits and drawbacks of making the Ethereum project fully open source during development. While this certainly increases the confidence and engagement of the cryptocurrency community, it also makes it hard to keep competitors and clone services out of the market. Ethereum will live or die by its ability to get third party developers to utilise its smart contracts and scripting language. If Ethereum’s code can be easily reproduced, then it faces a real risk of being outcompeted by a cloned or forked service with a better marketing department. In response to this issue, supporters of Ethereum have made the argument in the past that the best guarantee of a quality service is the participation of its creators. I’m afraid I don’t subscribe to that view; the very fact that Ethereum is being developed a mere 6 years after the launch of Bitcoin suggests that open source projects are very susceptible to competition from new innovators from outside the immediate circle of their creators. More to the point, the effort of fighting off forks and clones will be a distraction to the Ethereum team, win or lose.

 

I’ll finish with this thought: the reasons why Bitcoin is the dominant cryptocurrency today is not only that it was first. It is also because it launched at a time when hardly anyone had heard of the concepts it espoused, and fewer still believed in them. Through its early years, it was obscure and barely capitalised. I believe that it was this period of insignificance that gave the Bitcoin community the time to find answers to its early critics in a relatively technical, low-stakes environment. In contrast, Ethereum will be launched with its coffers filled and in the full glare of the media spotlight. Its creators should prepare for a rocky few months after its launch.

Neeraj Oak

Chief Analyst, Digital Money

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Author of Virtual Currencies – From Secrecy  to Safety, co-author The Digital Money Game

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Join us to explore ideas at The Digital Money Group on LinkedIn

Ethereum- Opportunities and challenges

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Part 2

In the second post on the topic of Ethereum, Dr. Neeraj Oak examines some of the outstanding technical and legal challenges that Ethereum faces.

In this post I’m going to give a brief outline of the kinds of challenges and obstacles that Ethereum will have to overcome before it launches. But before I do that, I want to consider some of the advantages that Ethereum could bring to the virtual currency community.

Bitcoin was designed to be a value transfer mechanism, but in its original form it only supports the transfer of one commodity: Bitcoins. In recent years, the idea that other commodities could be traded on the Bitcoin blockchain has grown in popularity. So-called coloured coins have been proposed that can be used to represent other items on the blockchain, using the benefits of decentralisation to record ownership without the need for a trusted third-party registry.

If Ethereum achieves what it has set out to do, it would represent a far more flexible implementation of the coloured coin concept, not only allowing other commodities to be traded but also enabling the creation of complex trading instruments like derivatives and options. It would also open up the possibility of decentralised versions of existing services such as Dropbox.

If it succeeds, Ethereum holds a great deal of promise in terms of the opportunities it would open up for entrepreneurs in the blockchain technology space. But for this to happen, Ethereum must tackle a few serious concerns about its technical operation and the legal ramifications users may face by using Ethereum contracts.

Technical issues

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Bitcoin’s creators are believed to have purposely left Turing-completeness out of their service because of the unnecessary hassles it creates. For instance, when code is executed in a pseudonymous decentralised system, the processor of that code is unaware of its origin. This is dangerous, since the code could be malicious, both in its operation on the funds it is given and its interaction with the computer on which it is being processed.

As an example, imagine an Ethereum user who decided to upload a virus to the blockchain. This virus would be contained within a smart contract and would eventually reach a processor for execution. If the processor attempts to execute the code without any safeguards, they could risk infecting their own computer. However, if they were to somehow screen the code before processing, they may have to perform considerably more computations (in verifying the code is secure) than they are being paid for. Further, even the most sophisticated screening process cannot guarantee that any piece of code is safe to execute, so processors would still run a risk of infection even after they take due precautions.

Ethereum partially addresses this problem by forcing a finite execution time on all contracts by charging the contract ether for the computational time it takes up. This makes infinite loops impossible, because they would require infinite money to perform. Unfortunately, this does not tackle the security challenge of finitely long malicious code.

Legal issues

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An immediate problem with the idea of smart contracts is that in practice it is hard to hold anybody to account for their actions. Because the contracts execute autonomously from their creators once deployed, their activities are hard to stop should they become destructive or malicious. Moreover, one cannot track down the creators of the code easily because Ethereum upholds the principle of pseudonimity, the representation of users with account numbers or public keys. Even if the creator of a piece of malicious code were located, it would be difficult to punish him/ her for the potentially unintended or unforeseen actions of their autonomous code.

It may also be the case that a smart contract created between two people was the result of deception or coercion. Ordinarily, a physical contract drawn up by two parties is witnessed by independent signatories to minimize the risk of coercion. However, in the digital world there is no way of knowing if one of the parties signing the contract is doing so against their wishes. Moreover, neither party has any recourse to a court of law should the contract have been misrepresented, since it is unclear which nation’s jurisdiction applies. After all, the contract signatories may be in different countries, as may be the processor who executed the contract code. As a further complication, the execution of the contract cannot be stopped once it has been deployed, so in practice the only law that counts in the world of Ethereum is the computer code that resides within each contract. This leaves users of such contracts dangerously exposed, something that they should be made aware of before they put their digital signatures to any smart contract.

Ethereum is an innovative idea, but one of the problems with innovations is that they stretch the institutions that already exist in our societies. This would not be a problem if the idea was to remain experimental, but as things stand at least $15 million worth of investment has been put into Ethereum and several million more may follow once the service is brought to market. If credible solutions to the legal issues that Ethereum could face were not made public by then, the creators of Ethereum should probably prepare to face some stern criticism.

Join me for my next post, in which I sum my views on Ethereum and the possible risks and rewards it offers to investors.

Neeraj Oak

Chief Analyst, Digital Money

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Author of Virtual Currencies – From Secrecy  to Safety, co-author The Digital Money Game

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Join us to explore ideas at The Digital Money Group on LinkedIn

Ethereum- Bitcoin 2.0?

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A great deal of publicity has surrounded the development of Ethereum, the decentralised contracting platform. Over the next few posts, Dr. Neeraj Oak considers what Ethereum offers, and the benefits and obstacles it might face as it is brought to market.

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I’ve had a lot of people asking me about Ethereum lately. It has been a hot topic among virtual currency enthusiasts, partly due to Ethereum already claiming to have raised around $15 million worth of Bitcoins from its initial sale of Ether, the value unit of the Ethereum system.

In this post, I’d like to cover the basics of what Ethereum claims to be and what differentiates it from existing virtual currencies such as Bitcoin. But before I begin, it’s worth stressing that Ethereum has not yet launched so we can’t know for sure if its final feature set will live up to the ambitions of its developers. Consequently, we can only base our knowledge of its features on the project yellowpaper and public code.

What is Ethereum?

Bitcoin, the first and largest of the cryptocurrencies, works on the principle of a decentralised blockchain in which transactions are registered. When a user requests a transaction, the system bundles it up with a set of other transactions into a mathematical puzzle called a block. This block is solved by transaction processors (or miners) who expend computational effort on the problem in return for a monetary reward. This system makes the history of Bitcoin transactions tamper-resistant, an important feature when dealing with people’s money.

Ethereum will also be a decentralised exchange system, but with one big distinction. While Bitcoin allows transactions, Ethereum aims to offer a system by which arbitrary messages can be passed to the blockchain. More to the point, these messages can contain code, written in a Turing-complete scripting language native to Ethereum. In simple terms, Ethereum claims to allow users to write entire programs and have the blockchain execute them on the creator’s behalf. Crucially, Turing-completeness means that in theory any program that could be made to run on a computer should run in Ethereum.

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As a more concrete use-case, Ethereum could be utilised to create smart contracts, pieces of code that once deployed become autonomous agents in their own right, executing pre-programmed instructions. An example could be escrow services, which automatically release funds to a seller once a buyer verifies that they have received the agreed products.

Because the execution of code costs time and computational capacity, the people who process Ethereum contracts (analogous to Bitcoin’s miners) must be compensated. As such, Ethereum contracts are issued along with a finite amount of ether, the value token of Ethereum. When the code is processed, the processor receives a predefined amount of ether from the contract for the work they put in. By making code costly, the designers of Ethereum also hope to limit the size of their blockchain, since it could quickly balloon to a size that dwarfs Bitcoin’s if safeguards were not put in place. In the short term, it also creates an income for the creators of Ethereum: the money they have raised so far has come from the pre-sale of ether.

Ethereum contracts are designed to be ‘fuelled’ by ether, so the designers of the system have chosen to inject 18 million ether units into circulation through mining each year in perpetuity. This is unlike the Bitcoin model of mining, which has diminishing returns that result in a long term limit in the quantity of value tokens in circulation.

Join me for my next post, in which I look at some of the outstanding technical and legal challenges that Ethereum must overcome before it reaches the market.

Neeraj Oak

Chief Analyst, Digital Money

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Author of Virtual Currencies – From Secrecy  to Safety, co-author The Digital Money Game

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Join us to explore ideas at The Digital Money Group on LinkedIn

3 reasons why a falling Bitcoin price is good news for virtual currencies

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In the context of the dramatic price changes faced by Bitcoin in recent weeks, Dr. Neeraj Oak explains why it isn’t all bad news for the supporters of virtual currencies.

With the price of Bitcoin continuing to fall from the dizzying peak of over $1100 in December 2013 to a current value of around $300, it is easy to assume that this is a very bad thing for the virtual currency community. In reality, it might actually be a blessing in disguise. Here are three reasons why:

 

Reason #1: High prices dissuade new users

The operating model of any virtual currency is to grow its user base to become as widely accepted as possible. However, if the price of the currency is too high, this can become a psychological barrier to new adopters, who may feel that they do not get a good deal when they exchange fiat money for Bitcoin. This is especially true when one considers that the price of Bitcoin in September 2014 was around 100 times greater than its price in January 2012. New users may find it unsatisfying to pay such a high price for a commodity that was so recently considerably cheaper.

A lower price for Bitcoin is helpful in this respect, but what is even more important is that the price becomes stable. This does not mean a stagnant price, but rather one that has a relatively predictable trend. Volatility and uncertainty are not attractive features for new adopters.

 

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Figure 1: Bitcoin prices (USD) since December 2012

 

Reason #2: Reducing the dominance of Bitcoin encourages the growth of newer virtual currencies

The price of Bitcoin towers above all the major alternative virtual currencies in the market today. A high price often brings the added advantage of greater visibility and prestige for the currency, making potential investors and adopters sit up and take notice. One of the problems of the dominance of Bitcoin is that many of the newer, smaller virtual currencies have struggled to find the limelight. With the price of Bitcoin falling, opportunities may appear for these currencies to garner more attention. Ultimately, this is beneficial for the virtual currency community; these alternative virtual currencies tend to be at the forefront of innovation in the field, and increasing their profile will help to spread ideas that could improve the prospects of all virtual currencies.

 

Reason #3: Deflation encourages speculation

Throughout the meteoric rise of Bitcoin stories have spread of the enormous fortunes made by early adopters. So long as the price of Bitcoin continued to increase, the idea that such price rises were somehow systemic became almost credible. When investors believe that the price of a commodity is bound to rise, they will often pay over the odds to acquire it, raising the price further. On the other hand, people using Bitcoin as a transaction method would be at a disadvantage, since the prices of goods and services that can be bought using Bitcoin often lag behind the headline Bitcoin price.

The result of sustained increases in Bitcoin prices is that it becomes a speculative vehicle rather than a transaction vehicle. This crowds out the true value makers in the currency: the consumers and merchants. Without these two groups of Bitcoin users, it is hard to conceive of a sustainable business model for Bitcoin- it would merely be a speculative bubble.

The recent fall in Bitcoin prices will do a lot to dispel the myth that short-term investments in Bitcoin are bound to pay off because it is a deflationary currency. With luck, this will help to drive away the types of speculators who drive the notorious volatility of Bitcoin prices.

To summarise, the recent fall in Bitcoin prices may have been painful for many of its users, but may help to create a healthier, more sustainable virtual currency. The Altcoin community too should take note; this could be their chance to assume the leadership position in the rapidly changing virtual currency domain.

 

Dr. Neeraj Oak, Chief Analyst, Shift Thought 

Author of Virtual Currencies – From Secrecy  to Safety, co-author The Digital Money Game

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Security is not safety

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Dr Neeraj Oak explains the first of the three themes of the new book: “Virtual Currencies- From Secrecy to Safety”. In this post, he covers the ideas of secrecy and safety, and considers why they may not be able to coexist.

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It’s often said by proponents of cryptocurrencies that the design of such systems makes them safe to use. Is this really true?

It’s easy to confuse the idea of a secure system with that of a safe one. In reality, these terms mean very different things. A secure system is one that is locally resilient to errors or malicious attack. A safe system is a much more all-encompassing idea, describing an environment in which users can make payments with confidence, knowing that their money and personal information cannot be stolen, leaked or lost.

To illustrate the difference between security and safety, I like to use the example of putting a padlock on a live bomb. A padlock is a security device; it stops people from tampering with whatever object it is attached to, protecting it from potential attackers. But does it make the bomb any safer? Perhaps a little, since someone trying to set off the bomb may have a little more trouble doing so. However, the bomb still remains as dangerous as it was before; if it were to go off, it would cause no less damage.

How does this analogy fit with the cryptocurrencies on today’s markets? I’d agree that the security features are impressive, indeed many of the methods they use are ahead of their time. But safety has still eluded many cryptocurrencies, as several incidents ([1],[2],[3]) in the past years have shown. The problem is that while the security provided by cryptography and the blockchain is strong, attackers find it easy to bypass these by targeting individual users.

Attacks on users include phishing, communications exploits, keylogging and mining clipboards and computer data. These types of attack predate cryptocurrencies and are often used against services like online banking. The difference is that centralised organisations banks will often take responsibility for flaws in their security systems and go to a great deal of effort to ensure customers are kept safe. This could include providing memorable information, tying online banking to email or telephone banking to force attackers to break two levels of security or using physical devices such as card readers to verify transactions. In a decentralised system like Bitcoin, there is currently no provision of such features, nor is there likely to be one in the near future.

Beyond the means of attacking users, the consequences of attacks are also reduced in cryptocurrencies. Anonymity means that attackers find it easier to hide their true identity, giving them safe havens to store stolen funds. Further, transactions cannot be reversed without the explicit consent of both parties, so once a user has lost money to a thief or scammer, there really is no way of getting it back. In the case of online banking, there may be some means of halting transactions or compensating users. This is not the case in many of today’s generation of decentralised virtual currencies.

While there is certainly a vulnerability in the safety aspect of virtual currencies at the moment, this need not always be the case. Allowing anonymity or secrecy is a choice that many of these virtual currencies make, and is not intrinsic to their operation. Anonymity has been one of the most attractive features to the early adopters of cryptocurrencies such as Bitcoin, but it is not the only reason to use such technologies. Decentralised cryptocurrencies could potentially be faster, cheaper, more accessible and more convenient than centralised payment services. Abandoning anonymity could be a drastic step in the eyes of many current users of cryptocurrencies, but if it has a positive effect on the safety of the system, then it is a step that both current and future cryptocurrencies should consider.

Join me for the next post, in which I look at the consequences of trading secrecy for safety and the importance of attracting mainstream users to cryptocurrencies, which are still considered by many to be a fringe movement.

Why we wrote “Virtual Currencies- from Secrecy to Safety”

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Virtual currencies have been grabbing headlines since the release of Bitcoin in 2008/9, and not always for the right reasons. Like any new technology, virtual currencies offer an equal share of promise and danger, creating opportunities for those locked out of today’s financial services and threatening to bypass incumbents.

In my role as Chief Analyst at UK-based consultancy Shift Thought, I have often been faced with questions from our clients about virtual currencies, such as: “How do they work?”, “What do they mean for my business?” and “How will they change the economy of my country?”, “Should I be worried”, “Where are virtual currencies headed” and “What are the regulatory implications”.

As a mathematician, scientist and engineer, I have come to depend on the availability of reliable books as a means of quickly getting a grasp of a new field. However, in the field of virtual currencies, I struggled to find reliable resources and this led to our efforts into building such a resource ourselves. There is a lot of raw information out there, but it is often hidden away in white papers and government studies. Some of the information also seems biased. Virtual currencies seem to have a way of encouraging fanatical loyalty or extreme loathing. Considering the disruptive potential of virtual currencies, it is critical to have some form of unbiased, comprehensive guide in order to rapidly understand the opportunities and challenges they represent.

At Shift Thought we research how people pay in each part of the world, and how this is changing. Utilising the architectures and proprietary technologies created by our founder Dr. Raju Oak, we have been able to create a constantly updated picture to inform the Digital Money Game described in the first book in the Digital Money Series.

In this second book, we wanted to create a guide for readers who are interested in understanding the multiple facets of virtual currencies, and a vision of where the virtual currency market is going, and how best to profit from its trajectory. If you work in financial services, telecoms or retail, this book will help to inform strategy with respect to virtual currencies. If you are a merchant or consumer, we hope that you will discover any potential advantages virtual currencies now offer. More importantly you should be able to understand the How and Why and also see potential risks from dealing with them.

We address questions from a wide cross-section of interest groups and perspectives. Dealing with the opportunities and challenges that virtual currencies represent will be crucial to the world economy. Providing a clear picture to those outside the virtual currencies community is vital in informing balanced decisions in the years to come. We wanted to create an easily accessible resource for young entrepreneurs and innovators around the world to explore this exciting space.

Our book Virtual Currencies - From Secrecy to Safety is available at Amazon sites across the world. You do not need to buy a kindle device as Amazon provides a free Kindle app for the PC as well as tablets and mobile devices. Do register at our Shift Thought portal to get access to more content and join us in The Digital Money Group on LinkedIn.

Join me for the next three posts, where I plan to cover some of the major themes of our book: The move from secrecy to safety, the importance of the mainstream user and the implications of decentralisation.

The Swiss say yes to Bitcoin

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Following on from our webinar about Bitcoin in Switzerland, there’s been some movement in the Swiss Bitcoin space. The Swiss regulatory authority, FINMA, has chosen to authorize SBEX, the Swiss Bitcoin Exchange. SBEX, founded in February 2014, operates an offline brokerage service for buying and selling Bitcoins, but has ambitions to expand its service to include an online brokerage and an extensive network of Bitcoin ATMs.

As a result of FINMA’s ruling, Bitcoin transactions can now be considered to be a payment, and deposits of Bitcoin can be considered as bank deposits. It is, in a sense, fitting that Switzerland should be an early mover in regulating Bitcoin; its reputation as a safe but confidential banker to the world will add credence to Swiss Bitcoin brokers and may spur other governments to make similar moves.

However, Switzerland must be careful not to allow exchanges such as SBEX to self-regulate too freely. Should such services be found to have enabled illegal or undesirable transactions, the fallout could cause problems for Swiss foreign relations, especially in the wake of recent tensions over tax evasion.

On a related note, the European Banking Authority (EBA) have issued an official opinion document on virtual currencies (VCs). In terms of regulatory advice, the EBA takes a cautious line, encouraging long term legislation and a short term avoidance strategy. The EBA wishes to shield currently regulated financial services from VCs until legislation and governance experience can catch up with the strides made by the new technology.

In the meantime, the obligation for legal requirements such as the EU Anti-Money Laundering Directive should, in the opinion of the EBA, be put on the operators at the interface of conventional and virtual currencies. In other words, brokers such as SBEX. It’s clear that European and Swiss regulators are trying their best to balance the risk of virtual currency with the potential reward it could hold. This is especially true for the Swiss, who could potentially find their vital financial services sector bypassed by these new technologies.

The opinion document by the EBA takes a classic ‘wait-and-see’ approach, mirrored by the earlier report of the Swiss Federal Council, which decided not to propose new statutory provisions. The reasons given were that ‘virtual currencies like Bitcoin are of only marginal economic significance and are not in a legal vacuum’. We certainly agree with the former for the moment, but the latter reason is a bit more nuanced. The Federal council also assert that ‘virtual currencies carry substantial risks of loss and abuse for users’.

What we’d be interested to know about is the specific legislation they might consider in future. But this might yet take a great deal of time and debate to emerge.

Cryptocurrencies and Bitcoin: size in context

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Blog 8

Dr. Neeraj Oak considers the size of Bitcoin and its scope for the future compared with other players and industries.

In this post, I will provide a context in which the size of Bitcoin, both present and future, can be judged. The true size of Bitcoin is often skewed in the media through qualitative descriptions; I will look at it quantitatively, and compare it with other relevant organisations and markets.

Let’s start with the cryptocurrency industry. I will show values as squares, with the area of the square proportional to its value.

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Using market capitalisation as a proxy for size, we can see that Bitcoin forms very nearly the entirety of the cryptocurrency industry. Perhaps this isn’t surprising, given the earlier start and greater publicity Bitcoin enjoys over the other 670 alternative coins in more than 50 exchanges. Moreover, many of the other cryptocurrencies use Bitcoin as a basis of operation or an intermediary; thus the growth of these currencies will actually spur growth in Bitcoin.

Let’s take a wider view. I’ve been asked about how cryptocurrencies could affect energy markets, as more computing time and energy goes into mining coins. The intrinsic link between the electricity used to mine a coin and its value was originally used to set the price of the first Bitcoin. It seems fitting to start by considering how Bitcoin compares to the world energy industry.

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According to one estimate, the world energy market is worth around $5 trillion a year. Comparing this to cryptocurrencies by their market capitalisation isn’t a perfect analogy as they measure different things, but it’s enough to see that cryptocurrencies would have a very long way to go before they form a sufficiently large energy drain to cause any significant effects on the energy industry.

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Beyond the energy industry, another great benchmark for size is the total size of the world economy. At this scale, the cryptocurrency squares are effectively invisible. But what’s that grey square on the left?

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It turns out that the value of non-cash transactions made each year dwarfs even the global economy. This is the space which cryptocurrencies would wish to someday occupy- and it seems they have a fair way to go yet.

While we’re at it, let’s look at the number of users of Bitcoin in comparison to some of the other e-commerce services in the world.

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From this perspective, Bitcoin isn’t quite as miniscule, but is still far smaller than any of the big established players. It’s interesting to note that the transaction volume of Bitcoin per user is actually much higher than that of established services such as Paypal; it’s possible that this is a sign of trust from users, but to my mind it’s more likely that it is just an artefact of speculative trading and the decentralised structure of a peer-to-peer market. Over the past 30 days, Bitcoin has averaged a transaction volume of around $65m per day, whilst Paypal averages $315m.

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Bitcoin also fares favourably against international money transfers (IMT) in terms of transaction volume. This is another prime area in which cryptocurrencies could be used to bypass existing institutions, especially in developing economies.

So what do all these comparisons tell us? It’s clear that Bitcoin is still in its infancy compared to some of the alternative payment methods, but this also means that there is a lot more room to grow. For now, Bitcoin is unlikely to cause any price effects in the energy industry, but that isn’t to say it could never happen; if Bitcoin were to process even 1% of world non-cash transactions, the energy drain from miners would be worth taking into consideration for energy policy planners. But that would require Bitcoin to grow approximately 100-fold.

Join me for my next post, in which I look at the spread of Cryptocurrencies in Europe and North America.

The mechanics of Bitcoin- Mining

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Blog 7

Dr. Neeraj Oak continues his examination of why Bitcoin is designed the way it is. In this post, he looks at how miners are compensated for their work, and the implications this has on how Bitcoin operates. He concludes with a look at whether a transaction-fee or Bitcoin mining business model is a better bet for the future.

So who are the ‘miners’ and why do they expend computer time (and hence money) on keeping Bitcoin ticking?

Miners benefit the Bitcoin community by using CPU resources to process transactions, so the designers thought they should receive some recompense for their services. In a traditional financial-institution (FI) based payments service, the FI provides the transaction validation service in return for a transaction fee. But it is exactly these kinds of fees that the users of Bitcoin feel are unjustified, or at least far too high. So miners need to be given some other form of incentive to continue providing a validation service and to invest in expanding their service as more users adopt Bitcoin. Miners could also use a transaction fee based system, but this would be unpopular initially and might stop people from adopting the currency. So Bitcoin developed an innovative new solution- to ‘discover’ more Bitcoins.

The term mining is meant to draw a parallel between the process of validating transactions and the creation of wealth through costly labour. When a block is successfully processed, the person who found the solution receives a reward in Bitcoins. This both provides a cash incentive for the miner, but also ties them ever closer to the Bitcoin community, as the continuing success of Bitcoin is the only guarantee of the value of the reward. As such, no miner can ever afford for Bitcoin to collapse, as the value of their earnings from mining would collapse with it. This forces them to either immediately cash their earnings into some other currency or reinvest a portion in expanding their computing capacity to continue to mine successfully in future.

There’s a problem with mining though- inflation. Let’s take an example from history. When the Spanish discovered the huge gold and silver deposits of South America in the 16th century, they were quick to extract as much as possible, mint it into coins and ship in home to Spain. But once that money arrived and started being spent, the Spanish suddenly found that everything started to go up in price. Why did that happen? Well, the total amount of goods and services in Spain hadn’t gone up much, whereas there was suddenly a whole lot of extra money in the economy. What happens in this situation is that people simply outbid each other for the goods they need or want, and this slowly but surely pushes prices up. The result was that went from one of the richest and largest empires in history to an economic basket-case by the 18th century, as the influx of American gold ate away at the domestic Spanish economy.

So inflation can be a bad thing. How did the designers of Bitcoin get around this problem?

The first step was to establish a rule that makes the difficulty of solving blocks become progressively harder after a certain number of blocks are solved. The second step was to limit the total number of new bitcoins that can ever be mined.

Raising difficulty forces up the cost of mining bitcoins, as problems take more computer time to solve. This reduces the number of people willing to mine purely for the Bitcoin reward as time goes on, as the profit margins from doing so reduces.

Limiting the total number of Bitcoins ensures that there is a hard cap on inflation, and that the currency retains user confidence in the long run as nobody can simply ‘print more money’, as is the case with fiat currencies.

There is a problem with the way these rules interact- as mining grows more difficult, and the number of remaining minable Bitcoins grows smaller, the currency might actually become a deflationary one. Add to this the effect of lost or frozen Bitcoins and the deflationary pressure could be quite substantial. The risks posed by deflation are high, but I will cover this in more detail in a later blog.

Returning to miners, has the incentive structure offered by Bitcoin’s designers been effective? At the moment, about 13 million out of a maximum of 21 million Bitcoins have been mined. I mentioned earlier that miners are incentivised to keep mining because it helps the Bitcoins they earn to hold their value; unfortunately, while this effect may well be true, it is completely masked by the effects of speculation.

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The green shaded area in the graph above shows the total number of Bitcoins in the world over time, and the blue line shows their price. If the main incentive for miners was to stabilise the price of Bitcoin, then there should be at least some correlation between the two datasets. But there doesn’t seem to be any. My view is that this is almost entirely down to the effect of speculators. And so far, it seems to be working in the miners’ favour.

Let’s look at the true worth of all those Bitcoins: their market capitalisation.

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The market capitalisation of Bitcoin, shown as the orange shaded area above, is calculated by multiplying the number of available bitcoins by the price of bitcoins at any given moment.

For a commodity that is completely free of speculation and does not get destroyed by usage but is produced at a steady rate, the price of the commodity should slowly decline. At the same time, more of the commodity is always available, and each new unit should grant at least some profit for the producer, otherwise it would not be worth creating. As such, the market capitalisation should slowly increase until it is no longer worth creating more of the commodity, or it is not possible to create any more. This is a rather sober and rational market in which to operate, and it is my belief that this is the business model that the creators of Bitcoin would have envisaged for miners.

Instead, miners face a far less stable business model in which the value of the coins they create rises and plunges wildly. In a sense, they must become speculators themselves in order to get the most value from their mined Bitcoins. Yet by participating in the speculation, they make it even worse, perpetuating what might become a destructive cycle.

My final point on the way Bitcoin mining is designed is to emphasise that mining should be thought of as a stopgap, not an integral part of Bitcoin. It is a mechanism by which the first adopters of the cryptocurrency could operate effectively and earn enough money to keep investing in the growth of the Bitcoin concept. Transaction fees are the real long-term mechanism for revenues, and this is where mainstream organisations should look to invest, not in mining.

I’ll leave you with an analogy that illustrates this point. Bitcoin mining is, in many ways, like the California gold rush of the late 1840s. It’s a chance for people to get rich quick, but it’s also tough, risky and best suited to people with nothing to lose. Big companies did not invest in the gold rush of the 1840s, but they did put their money into developing California by building railroads and cities. In total, the California gold rush dug up around $20-30 billion in today’s money. Compare this to the GDP of California- around $1.8 trillion. That’s around a thousand times more than the value of the gold rush each year. Perhaps investors in Bitcoin should start to look at the more boring but predictable transaction model rather than the lottery that is Bitcoin mining. Because if the gold rush analogy holds, that’s where the real money is.