Wednesday, July 27, 2011

Shave and a haircut: two bitcoins

Someone the other day was mentioning Bitcoin, which calls itself the first decentralized digital currency.  Regular readers of this blog, a select group to be sure, will probably not be surprised that this sent my not-so-disruptive-technology sensors into high gear.  So what's a decentralized digital currency?

Virtual worlds often have virtual currencies, which citizens can earn by doing various things in the virtual world and which they can exchange within the world.  In at least some cases these virtual currencies have leaked into the real world, or been tied to real money to begin with, not always with happy results.  One can view Bitcoin as abstracting that process and removing it from the confines of a closed, proprietary virtual world.

Bitcoin uses a modest ensemble of established crypto techniques to create a public audit trail certifying that a particular person has generated a Bitcoin, or that one person has exchanged some possibly fractional amount of Bitcoin with another (and by "person" I really mean "whatever has control of a given private key").  Generating bitcoins and certifying transactions requires a non-trivial amount of computation, much as generating money in a virtual world requires a non-trivial amount of whatever one does to earn money in that world.

There are various safeguards to ensure that each unit of Bitcoin has exactly one owner and everyone has a consistent view of who owns what.  That view can change over time.  In other words, Bitcoin meets some basic requirements for a currency: It is transferable, limited in supply and difficult to duplicate or forge.  So far, so good.

It occurs to me that there is actually already a very widely-used decentralized digital currency, namely money.

While it is still possible to exchange cash for goods and services, an awful lot of commerce gets done without it.  Instead, various banks and other entities simply increment and decrement balances in various accounts.  If I pay you, my balance goes down, yours goes up and one way or another our banks and various intermediaries get to take a cut.  This is certainly digital, and it's certainly currency.  It's also decentralized, in that there are many banks, particularly once we move into the international arena, and not even the various central banks have complete control of what happens.

However, it's not as radically decentralized as Bitcoin aims to be.  Bitcoin aims to take out all intermediaries.  If I pay you in Bitcoin, everyone in the system will be informed, reasonably soon, that I now own that much less Bitcoin and you own that much more.  All participants are an essentially equal footing.  There are no banks, clearinghouses or other such entities at all.

More precisely, everyone learns that whoever controls my private key has that much less and whoever controls yours has that much more.  Whether anyone knows who controls what keys is a separate matter.    Bitcoin uses pseudonymity -- known names tied to possibly unknown entities -- to recapture some of the anonymity of cash transactions.

The Bitcoin documentation is very careful to make the classic economical distinction between value in use and value in exchange.  The computational work done in producing Bitcoin and validating transactions is not inherently useful.  It basically consists of guessing numbers until one the right one comes up (technically, one that contains a given bit string and hashes to a particular value).  The value, if any, comes of people being willing to use Bitcoins in exchange, that is, as currency.  This is no different from printed pieces of paper or numbers in databases or, for that matter, materials like gold whose prices -- that is, their exchange rate with paper currencies -- are largely decoupled from their practical uses.

So this looks well thought through and doesn't seem wildly implausible.  Why was my spidey-sense tingling?

In trying to make sense of this I went back and reviewed the concept of currency.  Except there doesn't seem to be a nice, crisp, near-universally accepted concept of what makes currency work.  Scarcity is required, in the sense that the supply of currency must be bounded, albeit typically large.  Gold and other precious metals are hard to produce.  Coins are limited by fiat -- the king's mint will only put his face on so many coins, and woe betide the counterfeiter -- making it less important what the coin is made of.  Notes carry this one step further.  Clearly it doesn't matter much how much the paper and ink is worth, only that it's difficult to duplicate the note itself.

Numbers in databases are completely abstract, and they seem to work fine.  So why not Bitcoin?

At the end of the day, currency has to be exchangeable for something useful, for example, food.  This can only happen if the person accepting currency in exchange can be confident that they in turn will be able to exchange it for something useful to them.  Bitcoin works hard to ensure that it will behave essentially like physical cash and carefully-regulated changes in bank balances, but that still doesn't make it a currency.

And that's the crux of it.  Will people trust that Bitcoin will remain exchangeable?  What is the mechanism for maintaining confidence?  Typically, this confidence is based on confidence in a government, but other systems work as well.  Failed states may continue to circulate currency well after the government has collapsed.  Some countries are perfectly happy to use another country's currency.  Local communities have been known to create their own currencies which rely on the communal bond among members.  All of these and more can work, so why not Bitcoin?

Well, maybe it can.

The best measure I can think of for the viability of a new currency is how it converts to and from existing ones, and there are Bitcoin currency exchanges which do just that.  From what I can tell, the jury is still out, if only because Bitcoin hasn't been around that long yet.  Bitcoin is currently trading around $14, but it's been as high as twice that in the past couple of months and much, much lower not long before that [and on 28 November 2011, around $2.75, less than 10% of the all-time high ... given that the earth shook slightly when the Swiss Franc dropped from around $1.27 to around $1.16 and that Sterling's fall from 2.80DM to around 2.55 helped bring down a government, this sort of volatility does not look good ... my source for the price,, is now offering options and margin trading on the bitcoin, just in case anyone wants an even bigger adrenaline rush -- D.H.].  On the one hand, a non-zero value is encouraging, but on the other, that sort of volatility doesn't inspire confidence.

Personally, I don't see much reason to use Bitcoin in any significant way.  Money has worked fine so far, and if the US dollar should collapse, I'm not exactly convinced that Bitcoin would become a safe haven.

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