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A Computer Scientist and “Gold Bug” Analyzes BitCoin

by Aaron Krowne
founder, ML-Implode.com

In the last year an alternative electronic-only currency known as “BitCoin” has exploded onto the scene. The “value” (or more specifically, prevailing price in “standard” currencies) of BitCoins tripled over this period. And on June 13th, 2011, the largest BitCoin exchange and repository, “Mt. Gox”, was hacked, with many of the BitCoins stored therein stolen (and possibly all of them put at risk of being compromised).

So with all this hullabaloo and excitement, what is really going on? Is BitCoin for real or just a fad? Is it sustainable? Is it trustworthy? Can it muscle in on the role of today’s prevailing government-endorsed backed-by-nothing currencies? What does it portend for sound money advocates like myself who support some notion of gold and/or silver as money?

I hope to begin to answer all of these questions in this brief review of BitCoin.

I actually have some relevant credentials: my master’s is in computer science (from Virginia Tech) and I worked professionally doing software research from ’01-’07 (and to some extent today, though its now a side occupation for me). While I never worked in cryptography, I also have a Bachelor’s in math (and am the co-creator of PlanetMath.org) and have used cryptography on a day-to-day basis in server administration and other computing tasks.

Day-to-day, I publish in economics and monetary science on ML-Implode.com and sister sites, which grew to a full-time occupation from many years of studying finance and economics on my own. I’m a big fan of sound money and largely base my economic framework on the “Austrian” economics of von Mises.

(For the record, I only use the term “gold bug” jokingly, as the term has been turned by the establishment into an insult of its critics.  In my view it is perfectly natural to want to be able to hold on to one’s hard-earned savings by utilizing money.   One cannot do that with the fiat currencies governments of today proffer, which can hardly be called “money” due to the fact that these same governments intentionally inflate their value away to nothing.  Rather I ask: why does everyone else seem to be a “paper money bug” when this paper money is nothing more than an “IOU nothing”?)

The Essentials On BitCoin

I’ll let Wikipedia do the honors:

Bitcoin is a digital currency created in 2009 by Satoshi Nakamoto. The name refers both to the open source software he designed to make use of the currency and to the peer-to-peer network formed by running that software.

Bitcoin eschews central authorities and issuers, using a distributed database spread across nodes of a peer-to-peer network to track transactions. Bitcoin uses digital signatures and proof-of-work to provide basic security functions, such as ensuring that bitcoins can be spent only once per owner and only by the person who owns them.

This is pretty cool, after we’ve seen peer-to-peer services like Napster, Gnutella and BitTorrent take off and attract massive uptake.  But unlike some of these services, BitCoin was very well designed and actually seems to work very well in practice (in terms of scalability and practicality).    It also seems to be extremely resistant to government control, borrowing ideas from services like Tor (anonymous internet routing).

The key fact about BitCoin other than its peer-to-peer nature is that the quantity of bitcoins are limited.  Mathematically speaking, they can only be “discovered” at a fixed rate, and this rate is designed to taper off over time, with a maximum total number of bitcoins at somewhere around 21 million.

It is also important to note that BitCoin doesn’t require major exchange or “coin storage” sites to function.   At the basic level, you store your own BitCoins in your own personal “wallet” on your computer.   And an exchange with any other user for anything in return that is mutually agreed-upon can take place over any venue.

Incidentally, the founder “Satoshi Nakamoto” is (as far as anyone can tell) is an anonymous programmer and monetary activitist who simply goes by that name as pseudonym. “He” obviously has a very anarchist bent which he has put into practice, so the anonymity is probably pretty wise for anyone who has unleashed something on the world so disruptive to governments (just look what they did to Bernard von Nothaus for daring to mint his own gold and silver coins which the US Treasury even admitted could not be confused with US currency.)

Is BitCoin Any Good As A “Real” Money?

Initially my take was pretty steep skepticism, as someone who highly values the soundness of anything to be utilized as “money”.

But recently I decided to seriously look into BitCoin rather than simply dismissing it offhand, and I have to say I am impressed.   Mind you my analysis is focused on concepts and does not go down to the nitty-gritty mathematical level — I defer to others more expert on all that, but have not heard of any major flaws in the design of the system as put forth in the published research, so I am proceeding assuming it does what the proponents claim.

It is not just the “illusion” of scarcity that sustains BitCoin: the system actually is cryptographically scarce. This seems to be as certain as just about any mathematical/cryptographic truth we’ve discovered, which are used day-to-day in billions of internet transactions.  I would go so far as to say that if you don’t believe BitCoin is cryptographically-secure in its scarcity (as claimed), then don’t bother with any data encryption at all, because you’re essentially saying you don’t believe in it.

Now, that’s still not perfect certainty, but it is a hell of a lot more certain than today’s government money managers have provided with their “restraint”, “full faith and credit”, etc (ad nauseum).

This is obviously a big “win” for BitCoin over traditional fiat money: the limited supply is guaranteed.    I mean, why would you ever hold a dollar in an electronic account for online transactions (or in any bank account, all of which are now digital, for that matter), when you can hold BitCoins and know you have a hard guarantee against inflation?

BitCoin vs. True Sound Money

All that said, I’m still a big fan of gold, and that’s where I’d still put the vast majority of my personal-savings chips.

Here’s why:

  1. When you “pull the plug,” bitcoin is gone. Obviously. It’s computer and network technology, and if you disable even just one of those elements, you’re SOL.Even more disturbing, as we’ve seen from governments around the world in the last couple years, they don’t hesitate to disrupt computer networks to assert their power, sometimes to the extent of unplugging an entire country. Even the US, which has asserted domain “blacklists”, has bullied commerce websites into unplugging Wikileaks, none of which inspires confidence.
  2. Bitcoin can in principle be attacked, and I wouldn’t put it beyond governments to try. They could in theory achieve disruption (though probably not total disabling) of BitCoin in a sense similar to “denial of service”, or DoS attacks. Technically, in terms of “trust networks” like Bitcoin, these are called “sybil” attacks and involve creating lots of dummy entities/bitcoins and “polluting” the network.Bitcoin is extremely secure, but only statistically so. It relies on the entire BitCoin network to essentially “self-cleanse” of abusive data (the basic attack involves repeatedly spending already-extant bitcoins, creating inflation through copying them). It isn’t clear that any amount of attacks could defeat a sufficiently widespread BitCoin network, but it isn’t certain that BitCoin is redundant enough to function durably either.I won’t get too much into the details, but this network redundancy is achieved in a counter-intuitive manner: every BitCoin participant has the entire history of every bitcoin that has ever been transacted! They’ve rather ingeniously taken care of privacy and scalability concerns, again, using clever network-based algorithms.  But while durable and scalable to the nth-degree in normal use, it isn’t clear that an entity with as much resources as a government (or many world governments) couldn’t cause serious problems to the framework.
  3. While BitCoin is anonymous, government could in principle start to “data mine” usage by combining open internet information (the US taps all internet traffic) with the anonymous usage data inherent in BitCoin. They could also simply get access to a user’s physical computers or accounts where bitcoin “wallets” might be stored, and clearly associated with them. Conceivably a user could be identified by this “information fusion”, and all of their transactions would then become inherently de-anonymized. This could then “implicate” those that have transacted with them. Now, such methods would be extremely difficult to execute, and probably could only be used against high-value targets suspected of doing extremely illegal and unsavory things (i.e. terrorism money laundering, child pornography, etc.), but I don’t relish the prospect anyways.

Finally, the hacking of Mt. Gox highlights another sort of vulnerability of the system, althought not entirely unexpected even by BitCoin proponents: major third-party repositorities of bitcoins introduce an inherent vulnerability to those that store their bitcoins there.   This is actually very much akin to the a bank robbery, except in this case (obviously) there is no FDIC or other insurance to protect depositors.  This is why I noted above that users can store their own bitcoins locally on computers or storage devices they control (indeed, it is probably wise to make this the main manner of storing one’s bitcoins, should one participate in the system).

When Mt. Gox was hacked, the hacker soon dumped large numbers of the BitCoins on the market to “cash in” on them as rapidly as possible.   This actually had a more limited effect than you might think, since it caused bitcoin prices to crash in an abnormal manner (which we are now pretty familiar with thanks to the stock market’s recent history of “flash crashes”).    The brute-force manner in which this was done leads me to believe this was either an amateur hack, or a government-sponsored psy-op to try to discredit the notion of BitCoins.  I believe it will probably pass in time.

Still, it certainly gives pause.

Staying Power and BitCoin vs. Gold

All that said, I’m still intrigued by the possibility of utilizing BitCoin to replace today’s intrinsically insecure online commerce. It’s vastly more secure than the status quo (remember that banking and other dollar-based online commerce sites are hacked every day), and were the network to be sabotaged and “break down” or become inaccessible (the biggest risk, I think), people could simply revert to the standard methods of commerce widely in use today.

Hopefully the Mt. Gox incident will turn out to be a beneficial event as BitCoin users will learn they need to store the majority of their “hoard” locally, and bitcoin repository operators will not employ such shoddy security (in the case of Mt. Gox, it appears more secure encryption of user accounts, to currently-prevailing standards, would have prevented the bitcoin-theft aspect of this debacle).

Ok, so how about the gold question?   I actually don’t really see BitCoin as competing with gold.   The two forms of money/commerce are in fact compatible, just as dollars and gold are.  Just because I hold gold and might choose to freely transact it with those willing to receive gold, it does not prevent you from doing similar with dollars (legal tender laws are another thing entirely).  In that spirit, bitcoin-gold exchanges could be set up and make it easy for people to spend bitcoins, while holding the bulk of their (digital) monetary savings in gold.  Both halves of this equation already exist (bitcoin commerce, digital online gold saving/spending, e.g. GoldMoney.com or BullionVault.com). They simply need to be “bridged”.

Thus, those that don’t care about the risk of the network disappearing or being sabotaged could keep their “savings” in bitcoins, and those that retain a healthy paranoia for that prospect could hold their savings in gold and merely spend bitcoins for transactions where it is convenient.

Of course, you can do this on your own now, informally: if you’re a fan of precious metals, you can hold them (even in your own custody) and simply sell of whatever amounts you need to buy enough bitcoins for immediate commerce.   It’s just a bit more of a pain because you have to go from gold/silver -> dollars -> bitcoins, involving a step of dealing with those pesky antiquated, insecure government fiat currencies.

“BitGold”

One of the most intriguing possibilities coming out of this line of inquiry is having something like “BitGold” that fuses the secure online characteristics of BitCoin with the physically-guaranteed scarcity and accessibility of gold.   A BitGold would be superficially almost identical to BitCoin, except each “gold bit” would be guaranteed to correspond to a unit of gold in physical existence.

To my (possibly naive) thinking on this matter, this system could be almost perfectly grafted onto the BitCoin  network methodology, with the key difference being that a robust network of trusted “warehouse agents” must exist to certify gold bits into existence by guaranteeing that the physical gold is there.

While this might sound like a difficult problem, note that people already accept that it has been “solved” whenever they buy units in services BullionVault or GoldMoney (people who participate in schemes such as non-physically-redeemable precious metals pool accounts are even more trusting).

Users wouldn’t need to care about where that physical unit of gold is located; that would be an issue handled by the gold bit warehouse storage agents.  They would simply act as guarantors who would provide for extraction of gold based on their pool of held gold, and known goldbit-gold location mappings.   They would also act as a network to collectively “resolve” gold “cash-outs” (extraction)  from the network (i.e. if the gold for BitGold I hold is at warehouse A, but I extract from warehouse B, warehouse B would perform a “virtual swap” with warehouse A so that it can disburse the gold).

Intrinsically this would require a “trusted network” of warehouse agents, but again, that is something a combination of the BitCoin network verification algorithm, and brick-and-mortar free market trust should be able to solve without too much difficulty.

Conclusion

Despite its imperfections, I believe BitCoin really adds some important value to the world’s competing field of monies and is here to stay.  In fact some of its innovations I would argue are sorely needed in economically empowering the world’s people, who have been extensively abused through the government’s mismanaged and adversely-managed fiat currencies for most of the past century.

Now if we can only get the real-world advantages of gold combined with the digital innovations of BitCoin (in some of the ways outlined above or otherwise), we will really be on our way to an unstoppable force of monetary good for the world’s people against government and financial elites that endlessly try to abuse us through the faux-monies they’ve foisted on us.

There Are 7 Responses So Far. »

  1. Great article. You’ve clearly done your research and provided a fair analysis.

    I’d just like to point out that a user’s wallet does not actually contain any Bitcoins. The coins themselves are stored and distributed throughout all the computers (nodes) running the Bitcoin program. The wallet is simply a “key”, if you will, that allows a user to claim his coins from the network when he runs the program.

  2. Good point, Matt, I should have made that clear! I guess I got a little caught up in the metaphor. However, I don’t think it changes the overall analysis (let me know if it does).

  3. Good overview for the sane.

  4. Great article. Thanks.

    I would think that mtgox attacks are even more irrelevant than you suggest. If anything it generated another round of high profile publicity and confirmed that bitcoins are indeed valuable. Otherwise thieves would not even bother, would they?

  5. You seem to be suggesting that the hackers (thieves), were immediately able to turn some of their ill gotten gains into actual spendable dollars…

    Did the buyers, who also lost out when the value crashed, not have some suspicions, or require some kind of ID before they handed over their hard(ish) currency?

    Maybe I am sruggling to understand how it works…

  6. Dingbat:

    Yes, apparently they were able to turn some of their ill-gotten gains into “regular” currency.

    I don’t believe suspicion can play into such transactions; assuming they take place on large-scale bitcoin-dollar exchanges, they are highly anonymous venues. To the extent the sales took place through other venues, I think there WERE suspicions. But bitcoin itself is anonymous; the ID is the wallet itself (and the cryptographic signing).

    My understanding is that the questionable transactions have (for the most part, if not completely) been rolled-back. This is part of what is built into bitcoin: every transaction is conditional on verification from the network.

    It isn’t clear to me either how “permanent” any transaction actually is, but I do know that normally transactions aren’t permanent until they are confirmed repeatedly by the network.

  7. the hack was to the database of mtgox and almost literally having nothing to do with bitcoins. the hacker simply altered the database to ‘give’ themselves ‘money'(not actual bitcoins) that don’t exist and then ‘sold’ it on the exchange, crashing the prices on just that one bitcoin exchange for a brief time before the exchange was shutdown and the database had the extra funds removed. the only thing that has any lasting effect is that they got away with 2000 btc(daily limit), but the address that holds it is publicly known. and mtgox took the financial hit. to say they got off easy is a understatement and to say their security was poor would likely also be a understatement. the bitcoin market as a whole is new and still developing many things, software included. and in a case such as this the entire community learned just how important security is and will be all that much safer for it. the 2000 btc is likely lost forever, but no specific user was effected in this. rolling back any transactions in the ‘block chain’ is /impossible/ at this point without undoing every transaction that came after it and would require everyone agreeing on it. for the most part transactions cant be undone, their are a few cases where you would have to wait for 3 confirmations to be sure, 10 is considered statistically safe. to undo a transaction(and that is all they could do) would require being able to generate enough new blocks to pass the current ‘block chain’ and with the networks combined processing power, its darn near impossible.

    note: 21 mill is the total number of bitcoins, but the current implementation has 8 decimal places and can easily be altered for more if its ever needed.

    hope that helped a tiny bit 🙂 glad to see you took a good look at bitcoin though, most seem to just assume it doesn’t work or go by what they hear. it can be rather complicated stuff!

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