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Bitcoin Meets Gresham’s Law

May 24, 2012 6 comments

If you’re a bitcoin user, you’re probably aware of the frailties the system has shown since the big bitcoin bubble of last year. There have been several huge bitcoin heists, a couple of exchanges have gone down, malware has stolen unencrypted wallets, and so on. Most of these issues have been fixed, or are being fixed. While the bitcoin bubble did, in fact burst—as all bubbles must—bitcoin’s trumpeted demise by so called economic experts not only seems to have been wrong, but in the after math of its publicity, the digital currency is actually gaining real traction.

Unfortunately, that real traction has exposed a very real problem with the digital currency that could end up killing it. Not quickly, mind you, but slowly, by a thousand cuts. Or maybe I should have said, a thousand fees.

Let us suppose I receive lots of small, ฿1 payments, and then wish to make a larger purchase. For example, let’s say I receive one hundred payments of ฿1 each, and then want to purchase something that costs seventy bitcoins. I could end up being forced to pay nearly ฿6 in processing fees—that’s an 8% surcharge!—for the transaction to go through. Failure to pay the fee cancels the transaction. This is exactly what happened to one bitcoin user last year. Just yesterday I wanted to test a new savings wallet on my system and was told I would have to pay a ฿0.0005 transaction fee, that’s 2.5%, to move ฿0.02 from my online wallet to my savings wallet. Why? Fragmentation. The bitcoin fragments in my wallet that make up the 2 bitcents are (apparently) very, very small indeed, which means that lots of transactions have to be processed by the miners—the volunteer computers who clear all bitcoin transactions. Apparently, the new bitcoin clients force users to pay fees when a transaction is comprised of a large number of small coins: a 70 bitcoin transaction comprised entirely of single coins, or a very small transaction, like my ฿0.02 transaction made up of even smaller bits of bitcoin.

Why is this problem appearing now? Well, I’m no bitcoin expert, but I suspect it’s because bitcoin has now been around for awhile and, given the very serious economic problems around the world, it’s growing in popularity. With greater use comes increased fragmentation, and there doesn’t seem to be a way to reassemble the fragments back into easily processable transactions. Let’s remember: bitcoin started as an experiment. I seriously doubt anyone believed it truly could become a global currency. Hence the relatively small cap on the number of bitcoins that will ever be created. Hence the complete lack of any mechanism to deal with attrition as wallets are lost (and so the bitcoins within them). Hence the complete lack of security in the original releases of the bitcoin client and the wallet.

The security issues are being fixed. Today, if you lose your bitcoins due to theft, it’s due to a lack of care on your part. Popularity has forced exchanges to ramp up their security to that of a bank. All of these measures are to the good.

But the fragmentation issue is another problem entirely. In the first place, bitcoin is supposed to be “cash.” Hard money that, like dollars or euros, can be handed to anybody else free of charge. While tipping the miners has always been considered the polite thing to do, it was never supposed to be compulsory. Nor was the amount to be “tipped” supposed to be a set fee. Yet slowly, the “tips” are becoming transaction fees that there’s no easy way for the average user to escape. John Doe may be paid his ฿5 in a single block, or his ฿5 may be made up of hundreds of coin fragments. He has no way to know until he tries to buy something with them and is hit with an 8% surcharge for using his money. Worse, unlike being handed 500 pennies, he can’t simply run down to the bank or local grocery and exchange his pennies for a $5 bill, free of charge. He’s literally stuck with five hundred pennies and the best he can hope for is that he might be able to make his purchase free if he breaks his ฿5 down into several smaller transactions.

Which leads us to the second issue, and the one that could end up killing bitcoin. If inflation heats up, sending the world economies into a second recession as many experts believe is likely, bitcoin will once again rise in value. That is only going to increase the rate of fragmentation which, in turn, could end up subjecting a greater percentage of bitcoin transactions to mandatory processing fees. This will set off a twenty first century version of Gresham’s Law. “Clean” bitcoins—those that are freshly minted and so not yet fragmented—will be horded because they’re not debased: There will be no transaction fees attached to using them. Whereas the “old” bitcoins that have been fragmented will be shunned because they’re no longer worth their “face value.” They’re worth their face value less the price of the mandatory transaction fee associated with their use.

And that could kill bitcoin!

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The World’s First Global Currency

June 9, 2011 2 comments

bitcoin logo

It actually started back in 2008 when a hacker named Satoshi Nakamoto (which is believed to be a pseudonym) got a crazy idea. Given the success and complete inability of the world’s governments to make a dent in bit torrent file sharing, why not have a bit coin: A digital currency that, like bit torrent, is traded peer to peer, buyer to seller, exactly like you trade paper money today. It became known as Bitcoin, an anonymous digital currency that is securely exchanged using encrypted keys. No third parties are involved: No banks or credit card companies taking their cut and recording your deposits and withdrawals, no “Fed” manipulating the money supply; just the “currency” that two parties agree to use as compensation for the exchange of goods and services.

The number of Bitcoins in circulation is always known, and following the Austrian School of economic thought, and the work of famed economist Milton Friedman, will slowly increase to some 21 million, where it will be capped. A fact that, as Bitcoin has increased in popularity, has led to its rise against all the major currencies.

Until recently, the only form of the e-currency was virtual. Your Bitcoins were kept in your “ewallet” on your computer, or in a third party ewallet, or both. But there was nothing physical to hold on to. No handbills were available that you could walk into a store with. But in mid 2011 a new site launched offering BitBills. “With Bitbills,” the site claims, “you can transfer bitcoins in person, just like cash!” As of this writing, the site was taking preorders for the bills.

So, just how important is Bitcoin? What difference does/can it make in our increasingly well policed and regulated world? Up until this week most people would have probably said very little. As MIT’s Technology Today put it back in May:

“It might have a niche as a way to pay for certain technical services,” says Roberts, adding that even limited success could allow Bitcoin to change the fate of more established currencies. “Competition is good, even between currencies—perhaps the example of Bitcoin could influence the behavior of the Federal Reserve.”  —Technology Today, May 25, 2011

Others have larger visions of what the digital currency is capable of:

The governments of the world are on the brink of losing the ability to look into the economy of their citizens. They stand to lose the ability to seize assets, they stand to lose the ability to collect debts. No application of force in the world is going to help: everything is encrypted, and destroying a computer with any amount of police firepower will accomplish zilch.

All the world’s weapons in all the world’s police hands are useless against the public’s ability to keep their cryptographic economy to themselves. Won’t make a scratch.

If you thought the wars over knowledge and culture were intense, I believe we’ll see much more interesting events unfold in the coming decade. The decentralized, uncontrollable economy where one lifetime employment is no longer central to every human being is something I’ve called the swarm economy, and I predict it will redefine society to an immensely larger extent than the ability to get rap music for free.  Pirate Party founder Rick Falkvinge calls e-currency “the Napster of Banking” (May 11, 2011)

Tech guru Jason Calacanis at LAUNCH recently claimed:

  1. Bitcoin is a technologically sound project.
  2. Bitcoin is unstoppable without end-user prosecution.
  3. Bitcoin is the most dangerous open-source project ever created.
  4. Bitcoin may be the most dangerous technological project since the internet itself.
  5. Bitcoin is a political statement by technotarians (technological libertarians).
  6. Bitcoins will change the world unless governments ban them with harsh penalties.

He goes on to point out the benefits. Benefits governments fear:

  • Your coins can’t be frozen (like a Paypal account can be)
  • Your coins can’t be tracked
  • Your coins can’t be taxed
  • Transaction costs are extremely low (sorry credit card companies)

Others disagree, and claim Bitcoin is nothing more than an empty box (rather like all Fed driven currencies?):

A BitCoin is a highly trustworthy certificate—or at least it would be, if there were any commodity to certify. A BitCoin is a little like a very well sealed, very well documented box with nothing inside. Now, if there were a way to put something in the box, BitCoins could become a very good currency, but the current incarnation of the technology does not allow for this to occur. A good analogy for a marketplace using BitCoins would be to imagine a group that plays “catch” with an imaginary “ball” (a game I remember playing a few times back in elementary school), except that instead of playacting, the group actually believes they are playing catch.  — Grant Babcock, OpenMarket.Org, June 3, 2011

Detractors not withstanding, the e-currency is starting to move in some pretty high circles. “The thing to note is that Bitcoin has real, and actual, value. Currently a Bitcoin (BTC) is trading at around $15,” Wall Street Journal blogger Ben Rooney recently wrote. “One other way you can tell that it is getting traction,” he goes on to say. ”is when politicians start to take note and then inevitably try to ban it.” Indeed, The Chicago Tribune reported this morning that “Two senators are pressing federal authorities to crack down on an online black market and ‘untraceable’ digital currency known as Bitcoins after reports that they are used to buy illegal drugs anonymously.” And the DEA, according to the same article, “is ‘absolutely” concerned about Bitcoins and other anonymous digital currencies, agency spokeswoman Dawn Dearden said when asked for a response to the senators’ concerns.” So, though at the moment it’s only a small contingent in the U.S. Government that is exorcised about “anonymous digital currencies,” it would appear that Falkvinge’s prophecies may, at least in part, come true. And, as Rooney rightly observes, there probably is something to anything a government fears.

Because even our right to buy and sell anonymously with cash has been restricted by the government. Deposit more than a few thousand dollars in cash into your bank account and it triggers red flags at the bank, who then reports the transaction, electronically, to federal authorities which, in turn, triggers an audit of all your accounts for “suspicious activity”. Proudly take those savings of yours down to the car dealer to buy a car in cash (a once proud American tradition) and the dealership, like the bank, must report you. Legal tender is, in our post 9/11 police state, only mostly legal.

So it should come as a surprise to no one that Big Brother takes a dim view of anything that might allow the masses to conduct their own lives in their own way without constant surveillance and supervision—all in the name of our “protection,” of course. True, all such unsupervised activity means, by definition, that there will be illegal activity. But it is worth noting that even after trashing our Constitution, spying on our own people, searching their cars, homes, and cell phones without warrants, and putting more people in jail than any other country on earth, little has been accomplished other than an exponential increase in government power and a massive shift in wealth to a very few, very powerful people. It has made no difference in the amount of crime.

Bitcoin may or may not be the end all and be all global currency of the future. But it is certainly easy to understand why it is finally gaining traction amongst those who believe that their right to run their own lives as they see fit, without Big Brother watching their every move.