Thursday, January 30, 2014

The rise of e-currencies: How bitcoins and their ilk could save — or destroy! — the world

Published in the Portland Phoenix and the Providence Phoenix

Bitcoins, and other e-currencies along similar lines, are all the rage these days — and everyone’s talking about them as if they know what bitcoins actually are, or do, or something. It won’t surprise you to learn that most people know only part of the picture, and most of those hardly understand the part they know.
In fairness, bitcoins are a challenging concept to understand. But we here at the Phoenix are always up for a challenge, so we’ll break it down for you. First, we’ll have an explanation of what bitcoins are, what they’re not, and what they make possible. Then we’ve assembled a set of arguments that explain how and why bitcoins are both the end of the world as we know it, and the next step to saving the world we love so well.
A useful point to start is to note that the word bitcoin, when used with a lowercase b, refers to the units of currency; when capitalized, Bitcoin refers to a software and the Internet-based communications methods used to track and exchange them. There are also other e-currencies, such as litecoin; all of them use the basic structure and concepts underlying the Bitcoin system, and differ only in the most arcane of technical details. They’re also not nearly as popular, nor as widely accepted — in part because bitcoins got there first.
Something from nothingDuring, and in the wake of, the 2008 financial crisis, the institutions we had relied on to ensure economic stability turned on us. Several deeply concerning and fundamental facts about the world’s currency became widely apparent:
>>Banks can’t be trusted Not only are they often working in opposition to their depositors’ best interests, but they gambled with other people’s money, lost, and then asked for government bailouts to pay off the debt.
>>Governments can’t be trusted Rather than protecting their people’s interests, governments sometimes see their citizens as just another cash source. In March 2013, faced with an impending economic collapse, the government of Cyprus confiscated 10 percent of all the money held in accounts in that country’s banks.
>>And anyway, money’s value is imaginary Governments, including the United States, can create massive amounts of new money out of thin air, and give it to whomever they want (usually the banks, as opposed to the people). This has always been true, but politicians and other financial experts no longer seem to worry that regular people object.
>>Still, money is an inescapable, integral part of our daily lives It’s a very flexible medium of exchange, which I can accept in remuneration for (to pick an example) my reporting and writing and spend in a grocery store in exchange for food.
Some people had expressed those concerns long before the 2008 meltdown; afterward, more people understood them much more clearly.
Out of these problems came a seemingly simple solution: Create another currency, not beholden to a government, and find a way to store it safely without banks.
Of course, it turns out those are two very hard things to do, while still preserving the confidence and security we expect from a monetary system. The most difficult problem is how to prevent counterfeiting — which is of course far easier with a digital item than a physical one (as the movie and music industries have learned, to their dismay).
Government currency — and even most other alternative currencies (such as time-dollars) — have a centralized authority that can verify the authenticity of money. In the United States, it’s the Federal Reserve. Replacing this system with another one that also required central authority and verification made the whole exercise moot. The real goal was to decentralize verification, while still ensuring nobody copied e-currency and, effectively, spent it twice.
In late 2008 and into 2009, a person or group going by the name of Satoshi Nakamoto proposed a system called Bitcoin, offering a solution to the double-spending problem that was ingenious for its simplicity: The central authority keeping track of transactions should be the public at large, and the ledger should be available online to all who asked.
But that created another pair of questions: How to get the hundreds, even thousands, of different computers storing their own copies of the ledger to agree on when to update it, and what changes to add when updating?
Bitcoin offered an elegant solution to this problem, too. Whenever anyone wants to spend a bitcoin, they broadcast that intent to the network of ledger-keepers via the Internet. As each request comes in, each ledger-keeper computer checks its copy of the official record, to ensure that the spender’s identity is valid, that she actually has the correct amount available, and that she hasn’t spent it elsewhere already. If it looks good, each ledger-keeper adds the transaction to its own list of approved transactions that need to be added to its ledger in the next update. The ledger-keepers communicate about their individual approved lists; if a majority of them agree, the transaction is finalized and added to the shared official ledger. These checks and updates happen in computer software and encrypted communications across the Internet, and take only a few minutes.
Adding strength to this system is the fact that anyone can install the software on their computer to make it a ledger-keeper, receive their own copy of the ledger, and contribute to validation and verification of transactions. The ledger itself is fully public, showing which accounts sent how many bitcoins to which other accounts, and when.
Of course this raises the question of privacy. One of the things people like about physical cash is that it’s not particularly traceable. Bills have serial numbers, but most people don’t pay attention to those details, and it would be terribly hard to track any substantial sum. (See for an example of trying to track dollar bills’ physical movements.)
Because it’s so central to our lives (we don’t typically want to broadcast which doctors we go to, how often, nor how much we pay them, for instance) privacy is also a cornerstone of traditional electronic payments: We trust the merchants and banks to keep our information away from wrongdoers. (The recent, and ongoing, revelations about card-system hacking at Target offer a warning against being too trusting that way.) At the very least, though, merchants and banks don’t publish their transactions online for all to see.
But that is exactly what the Bitcoin system proposed doing.
Satoshi Nakamoto had a solution for this, too: Every account would have a pseudonym in this new currency system, and everyone could create and use as many accounts (and pseudonyms) as they wanted. The ledger would store the pseudonyms of the sender and receiver (not their real identities), and the ledger-keeping software would confirm through secure encrypted communication that the people using those pseudonyms were the people who had created them, by comparing digital signatures stored when the account was created against the digital signature presented during a transaction. (For those who wish to dig deeper into how a publicly available ledger can store a signature in a way that is truly secured so only one person can sign it, look into public-key cryptography. There’s enough reading online to occupy the rest of your days.)
This seemed to solve all the problems that had faced digital currency: quick and easy transaction approvals, protection against counterfeiting and double-spending, privacy protections for buyers and sellers, and avoidance of a central authority that could steal everything on a whim.
The next trick was getting people to actually use it.
Bit-miningIn 2009, Satoshi Nakamoto released a software program, also called Bitcoin, that for the first time allowed users who installed it on their computers to begin operating as ledger-keepers on the fledgling Bitcoin network. The software was open-source, meaning anyone who wants to can read the actual programming code it uses, which lets tech-savvy types check to ensure the software does only what it says it does, and nothing else nefarious or bothersome (such as stealing your passwords or using your computer to send spam emails).
To encourage broad distribution of the software, and most importantly, large numbers of copies of its ledger, the system includes a reward for those people who offer their computers to serve as ledger-keepers. At the moment, those people receive, on occasion (based on an extremely complicated mathematical formula), some new bitcoins. This process is somewhat confusingly called “mining,” which is meant to evoke the idea that by doing some work (keeping the ledger, checking new transactions, and updating the ledger), new bitcoins are discovered, as one might mine a precious metal.
At any given moment, the number of ledger-keepers varies. People connect their computers to the internet and disconnect them; people turn off the Bitcoin software and turn it back on again. The system doesn’t care, as long as there are several connected, and there are lots.
It’s an analogy of convenience, and only works to a point; we advise not getting too caught up in mining or ledger-keeping. (If you’re a programmer with thousands of actual dollars just lying around, there’s plenty to learn and do along those lines; if not, best not to worry, but instead to know that large numbers of independent, security-minded, anti-fraud experts have checked out the system and been satisfied that it’s safe and secure, protected by the principles of mathematics that underlie computer cryptography and secure transmission of information. Also, it’s useful to know that when the rare problems have been found, they’ve been fixed quickly, easily, and without harm to innocent parties.)
Now, and increasingly into the future, those who spend the time, energy, expertise, and real-world expense (in electricity and computing power) to keep the ledger are paid not by “mined” bitcoins — the 21-millionth and final bitcoin will be mined in about the year 2140 — but by small fees added on top of ordinary everyday bitcoin transactions. There are somewhere around 12 million bitcoins in circulation right now.
Once the network was established, with several copies of the transaction ledger in place and the ledger-keeper programs communicating with each other, it became possible to actually spend bitcoins. That’s where you come in — and where the promise and problems all begin.
Money by numbersA bitcoin is, in reality, nothing more than a few pieces of electronic data. You can do silly things like print them out on pages of paper, or engrave them into metal (and people have), but their only useful form is electronic.
There are, for all practical purposes, only two ways to get bitcoins. First, you can buy them, in online exchanges that will take your dollars and give you bitcoins, the same way you might give your dollars to a bank in exchange for euros or yen before an overseas trip. (The exchange rate varies, just like those other currencies; its highest ever was in December, at over $1200 per bitcoin. The current price is around $800, though you can buy smaller increments without purchasing an entire bitcoin.)
Second, you can sell a product or service that’s desired by people, and accept bitcoins as payment. (You’ll likely have to accept other forms of payment too, just like stores that take cash, checks, and credit cards.) When you have a customer who wants to buy using bitcoins, you accept the payment. Simple as that. Among the major players already accepting bitcoins are online retail giants Tiger Direct and; so does the Sacramento Kings basketball team. EBay is considering accepting bitcoin bids and payments.
(The aforementioned “mining” is the third way to get bitcoins, and it’s extremely technical, expensive, and not particularly accessible to regular people. I’ve tried it, wouldn’t recommend it, and it’s generally accepted as appropriate only for techie types with a lot of actual dollars (and time) on their hands. Think of this system as the equivalent of the US Mint — it makes the actual physical money and enables a particular economic system, but we don’t know how and shouldn’t try it at home. There is one significant difference: Only a finite number of bitcoins can ever be made, unlike the almighty unlimited dollar.)
To truly understand how the Bitcoin system works, and where its strengths and weaknesses lie, we have to look at the mechanics of how money changes hands.
First, there’s the cash method, which is obvious. I give you a dollar bill, and you give me something I want in exchange. It’s immediate, private (nobody other than the two of us know it happened), and secure (you and I have both looked at the bill and agree it is a real dollar and not counterfeit). It also has the potential to be anonymous; even if you know the face of the person you handed a dollar to at the toll plaza, you have no idea what their name is, and they don’t know you either. If you ran into each other tomorrow, you probably wouldn’t recognize each other.
Next is the electronic method, which includes checks, credit cards, wire transfers, and pretty much everything else. In that situation, I have account data (sometimes printed on a check or magnetically encoded on a credit card) that connects me to a pile of dollars held electronically in a bank somewhere. I give you that information and the authorization to deduct one dollar from that pile, in exchange for which you give me something I want.
It seems simple, and is often instantaneous, but it’s actually very complicated  — and expensive. When I swipe a debit card at a store, for example, the merchant’s machine has to read the code and transmit it securely to a central authority, which checks its database to see which bank I’m with, and then contacts that bank to ask if I have a dollar available in my pile. The bank isn’t going to answer that question for just anyone — it should only answer it for me or people I authorize — so it needs to be sure the request is coming from a legitimate user. This can be done a few ways, one of which is to ask for my PIN code, which I have established secretly with the bank in advance. I enter my PIN, which is then transmitted and verified, and then my bank responds by saying (I hope) that I do have a dollar available. Because it has received authorization from me (in the form of my PIN), my bank also sends a message along telling the store that it will transfer the dollar to the merchant’s account.
The cost adds up. Each of those steps takes electricity; some of them require specific equipment (the card-swiper, PIN-entry device, for example); others require high-speed data networks. Of course, the banks charge for their services, and for playing the middle-man in this transaction. And since every step is recorded electronically, it’s hard to keep transactions untraceable or anonymous.
The Bitcoin system throws all of that away, leaving an interaction much more like the cash transaction, but handled electronically — making it unnecessary to carry around large amounts of cash, as well as enabling transactions across distances.
Bitcoin will destroy the worldGovernments don’t like cash; it’s hard to trace, anonymous, and secure. Digital cash (which is essentially what bitcoins are) is even worse: It can travel instantly anywhere, and lacks things like serial numbers that can allow tracking, even after the fact.
Financial writer Cameron Keng posted on the charge that “Bitcoin represents more of the same short-sighted capitalism that got us into this mess, minus the accountability.” (Of course, the accountability was laughable.)
Software engineer and writer Alex Payne has called the Bitcoin system “a marriage of dubious technology and questionable economics wrapped up in a crypto-libertarian political agenda,” which encompasses pretty much all of the criticisms of bitcoins.
He’s not talking about the time-tested technology of public-key cryptography, which the Bitcoin system uses to verify identities. Rather he’s expressing concern about the nature of the public ledger and the software by which it is maintained and updated. It is true that this arrangement is entirely new — it is, in fact, the major breakthrough of the Bitcoin system. And it’s true that it has flaws: In August 2010, someone figured out a way to spend the same coin multiple times; that counterfeiting attempt was detected, stopped, and reversed, but it does suggest there may be other vulnerabilities yet undiscovered.
The economics question is based on the concept of “money supply,” which is a tool by which centralized economies influence key aspects of their markets, such as interest rates. When the US Federal Reserve wants to lower interest rates, for example, it creates money out of thin air and then offers it cheaply to banks. If it wants to raise interest rates, it takes money out of circulation.
New York Times economics writer Paul Krugman wrote that having a currency with a limited total supply of money encourages hoarding, not spending, because scarcity makes the currency more valuable. (This is true, but it ignores the fact that bitcoins are almost infinitely indivisible into fractions far smaller than pennies, so while the total supply of money is limited at the top, it is effectively unlimited in terms of how many people can have, use, and exchange bitcoins.)
The “crypto-libertarian political agenda” Payne scorns calls attention to the perspective of some bitcoin fans: Because it’s new, because it’s independent of governments, and because it’s Internet-based, some people have expressed hope that bitcoins will help them avoid taxation, regulation, or other outside meddling. Libertarian-in-chief Ron Paul has called bitcoins potential “destroyers of the dollar,” and plenty of libertarian types are excited about the idea of a currency that is not tied to any particular government.
Regulators in the United States and elsewhere are paying attention, and issuing statements about how they will treat bitcoins. (It varies significantly by country;  the United States said it would pay attention when dollars and bitcoins started to be interchanged — which is already happening, thereby beginning to attract government scrutiny.) Of course, government regulation and taxation helps pay for things like roads and fire departments, as well as limiting crime.
And oh yes, the crime. An online site called Silk Road is perhaps the poster child for the sort of crime made easier by verifiable (but anonymous) transactions over the Internet between total strangers. A clearinghouse for all sorts of illegal drugs, it was shut down by the FBI late last year; bitcoins were its currency. There is also a site that purportedly allows people to commission assassinations and pay via bitcoin. And of course there are plenty of other examples of ways bitcoins can be used nefariously.
There are other weaknesses: Transactions in bitcoins are not reversible in the way credit-card charges can be disputed and reversed. Of course refunds are possible, but only from the person you gave the money to. If an item is not as advertised, or never arrives, there is no third party available to handle a complaint or refund a buyer’s money.
And there are the costs. Running the ledger-keeping computers takes electricity, and the more computers are part of the network, the more it will require. It’s a fair claim, but usually avoids the fact that government money systems are also expensive: Pennies, for example, cost more than two cents each to mint. Printing dollars is more cost-effective: each new $100 bill costs just over 12 cents.
Of course, all this technology means bitcoins are not quite as populist as supporters might have you believe. Sure, they’re not beholden to governments, but to even use one you have to install a program on your computer to store and track your bitcoin holdings; when you do that, you’ll encounter all kinds of notices and alerts telling you that if you lose or forget the password to your Bitcoin-holding account, the bitcoins themselves will be lost forever, These are not the sorts of messages that embolden non-tech-savvy types to continue and engage with the system.
Bitcoin will save the worldDespite all of those problems and potential downfalls, there is a lot of promise, much of it based on a key distinction, made by money-technology writer David Wolman (a college friend of mine) in Wired magazine: There are two ways to use the word bitcoin.
First is as a unit of currency and exchange, as in “This item costs 1.2 bitcoins.”
And there is significant promise in this arena. Chris Dixon, a venture-capitalist investor in Silicon Valley, notes that the payment industry is massive, with people paying $500 billion a year in fees just to move their money from one place to another. Distributing the work of handling transactions, and reducing identity fraud in the bargain, could substantially reduce those fees.
For most people, bitcoins would be an easy intermediary. They could buy bitcoins with dollars, send the bitcoins somewhere else cheaply, and the recipient would convert the bitcoins into their own local currency. Using the Bitcoin system would solve the problems of high-cost transactions that sometimes take days to process, especially in the massive sector that is remittances to developing countries from workers in developed countries who send huge chunks of their earnings home.
For people who worry about government overreaching its power a bit more, it solves the problem of having someone else control their money, with the ability to seize or freeze it. And using bitcoins could help avoid the issues that arose when major payment-processing companies were pressured by the US government to stop transferring funds to WikiLeaks, in an attempt to deprive that whistleblower organization of financial support.
As several security researchers have pointed out — and a goodly number of self-appointed investigative teams have proven — Bitcoin is not anonymous. In fact, it’s barely pseudonymous. After the feds shut down Silk Road, the site’s bitcoins were consolidated in one account. Since all the transactions are public, it didn’t take much effort to go from reading the FBI media announcements saying 26,000 bitcoins had been seized, to checking the ledger to watch as a brand-new account suddenly filled up with just that amount.
(This led to a hilariously ironic development: Because all the transactions are public in the ledger, and because there’s an option to send a message with a payment, all sorts of anti-government types started sending the feds tiny amounts of bitcoin — yes, giving the feds their money, just for the privilege of sending them a rude message.)
But beyond these financial advantages, there is another way to think about, and use, Bitcoin.
The Bitcoin system is, Wolman writes, “more than just a currency; it’s an open-source protocol.”
Marc Andreesen, co-author of the very first web-browser program and now a venture capitalist, wrote recently in the New York Times that Bitcoin is a major development, solving a longstanding problem: “how to establish trust between otherwise unrelated parties over an untrusted network like the Internet. The practical consequence of solving this problem is that Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate.”
And they are just being explored. Trumpeted by Wired as an “NSA-Proof Twitter,” a new system called Twister has emerged, combining the encryption and identity confirmation of Bitcoin with the peer-to-peer connection-management system of BitTorrent (which allows multiple computers to exchange information rapidly and efficiently over the Internet) to create a vastly distributed social network that cannot be taken down by malicious governments or corporations. This would be a great boon to people in places like Iran or San Francisco, where authorities have shut down access to Twitter in an attempt to quell public protests. Other uses are just being imagined now, and will no doubt be developed and tested soon.