- Do payments need to be linked to identity? Of course not. Cash proves this. But should they? This is a big question that raises legal, philosophical and ethical issues that remain subject to ongoing debate. Credit card information is frequently stolen, along with personally identifying information (name, addresses, etc) which creates a cost to society. Is it a fundamental right to be able to make payments which are shielded from the eyes of the state governments? And should people have the ability to make anonymous digital payments, as they do with physical cash? - Bitcoin has some interesting characteristics. It is the very first digital asset of value that can be transferred over the internet without any specific third party having to approve the transaction or being able to deny it. It is also an asset that is transferred from one owner to another rather than moving via a series of third party debits and credits, for example, through one or more banks. In this respect it is genuinely novel. - One argument I used to hear was, ‘When the price of BTC gets really high, the price volatility will decrease because it will take a lot more money to bully the price up and down’. The argument is flawed. A price can be high, but if a market is illiquid, small amounts of money can still push the price around. Stability is determined more by the liquidity of a market (how many people are willing to buy and sell at any price point), than the price of an asset. - <mark style="background: #FFF3A3A6;">The generally accepted academic definition of money usually says that money needs to fulfil three functions: A medium of exchange, a store of value, and a unit of account. But what does this really mean?</mark> - ‘No example of a barter economy, pure and simple, has ever been described, let alone the emergence from it of money, … All available ethnography suggests that there never has been such a thing’. Economies developed based on mutual trust, gifts and debt or social obligations—‘Have a chicken now, but please remember this for later’. Early communities were small and stable, and individuals tended to grow up with each other and know each other well. Reputation within a community was crucially important, so people didn’t tend to renege on their word. - Note: An argument that cryptocurrency proponents like to use is that the tokens should be valuable because they are scarce (‘There will only be 21 million bitcoins ever, so that is what makes them valuable!’). This is not a solid argument. Something may be scarce, but that doesn’t mean it is, or should be, valuable. There must be one or more underlying factors that make it desirable—beauty, utility, something else. And these underlying factors must create demand for the item. The two underlying factors in Bitcoin that create demand are: 1 is the most recognised instrument of value that can be transmitted across the internet without needing permission from specific intermediaries. 2 is censorship resistant. - So how and why are fiat currencies valuable? Two main reasons: 1.They are declared by law as legal tender, meaning that in that legal jurisdiction it must be accepted as valid payment for a debt. Therefore people use it. 2.Governments accept only their own fiat for tax payments. This gives fiat currencies a fundamental usefulness, as everyone needs to pay tax. The Economist newspaper has described cryptocurrencies as having fiat characteristics as it is simply declared so, but to date, cryptocurrencies have not been declared legal tender in any nation. We will discuss legal tender later in the book. - Defining Bitcoin is a popular activity for regulators and policymakers who need to determine if bitcoins fall under their purview or not. I suspect things would have worked out differently had Bitcoin been originally described as a ‘crypto commodity’ or a ‘crypto asset’. It turns out that Bitcoin is hard to shoehorn into existing categories, so perhaps it, along with other crypto-things, belongs in a new asset class. - in 1933, Executive Order 6102 had made it a criminal offense for U.S. citizens to own or trade gold anywhere in the world, with exceptions for some jewellery and collector’s coins. These prohibitions were relaxed starting in 1964—gold certificates were again allowed for private investors on April 24, 1964, although the obligation to pay the certificate holder on demand in gold specie would not be honored. By 1975 Americans could again freely own and trade gold. - ‘Yes, but Bitcoin has no intrinsic value,’ is a comment I hear a lot from people trying to understand why Bitcoin has a price. However, it is not a very good argument against Bitcoin. Fiat currencies—USD, GBP, EUR, etc—have no intrinsic value either. In fact, fiat currencies are defined by not having intrinsic value. That is worth repeating. Fiat currency has no intrinsic value. But that is ok! - Quantitative Easing (QE) often comes up in conversations about fiat currencies, and people describe it as ‘printing money,’ but it is not that simple. QE is a euphemism for an issuing authority (generally a central bank) increasing the amount of fiat money in circulation in order to stimulate a flagging economy. So people worry that this additional money ‘dilutes’ the value of existing money, and this makes people worry about the sustainability of the fiat system. ‘Printing money’ is a poor description for QE. Think about it—if the central bank really ‘printed money’ whether physically or digitally, who would it give it to, and how? - There are two worries with QE: 1. With excessive QE, the value of money will go down as there is more of it sloshing around in the private sector, which is not great for savers, and could also cause price inflation (though we haven’t seen this yet). 2. A central bank owns risky financial assets that could go down in value, damaging the central bank’s balance sheet when the value of the assets it owns falls. - This form of financial exclusion is increasing. For example, the World Bank conducted a survey in 2015. - 63 of 110 banking authorities, twenty large banks and 170 smaller local and regional banks. It found that roughly half of those surveyed experienced a decline in correspondent banking relationships, directly reducing their ability to conduct foreign currency transactions. Money Transfer Operators (MTOs, non-banks) were also surveyed and it was found that of the MTOs surveyed, 28% of MTO principals and 45% of their agents could no longer access banking services. Of those, 25% were no longer able to operate and 75% had to find alternative channels for foreign currency transactions. Large banks have been actively closing down the nostros of foreign banks, especially banks from those jurisdictions which are deemed higher risk. The large banks cite the risk of being fined or suffering reputational risk if the banks for whom they open nostros are found to be using those nostros for, or are otherwise associated with, illegal or unethical activities. This has affected the cryptocurrency industry too. In 2015, there were rumours that the big US banks would threaten to cut off smaller banks if the smaller banks continued to bank Bitcoin exchanges. This ‘de-risking,’ as it is euphemistically known, is serving to cut off the parties who need their services the most, and is creating a moat around the larger economies, disabling smaller economies from flourishing. - A cryptographic hash function is special and has some characteristics that makes it useful in cryptography and for cryptocurrencies, as we will see later. Wikipedia states that the ideal cryptographic hash function has five main properties (my comments in parentheses): 1. It is deterministic so the same message always results in the same hash 2. It is quick to compute the hash value for any given message (you can easily go ‘forwards’) 3. It is not feasible to generate a message from its hash value except by trying all possible messages (you can’t go ‘backwards’) 4. A small change to a message should change the hash value so extensively that the new hash value appears uncorrelated with the old hash value (a small change makes a big difference) 5. It is not feasible to find two different messages with the same hash value (it is hard to create a hash clash) - Using asymmetric cryptography, if you want to receive encrypted messages you create two mathematically linked keys: a public key and a private key. Together they are called a key pair. You can share your public key with the world, and anyone can use it to encrypt messages for you. You use your private key, known only to you, to decrypt those messages. Anyone who sends you encrypted messages using your public key knows that only you can decrypt them. - A digital signature is created by taking the message you want to sign and applying a mathematical formula with your private key. Anyone who knows your public key can mathematically verify that this signature was indeed created by the holder of the associated private key (but without knowing the private key itself). So, anyone can independently validate that this piece of data was signed by the private key holder of this public key. - Remember that you encrypt data with a public key, and decrypt it with a private key? With some schemes you can also do it the other way around: you can encrypt data with a private key and decrypt it with a public key. So actually the validation process is taking the digital signature and decrypting it with the well-known public key, and seeing that the decrypted signature matches the message being signed. - Also, unless a private key has been copied, it is impossible afterwards to say ‘it wasn’t me’—this property is called ‘non-repudiation’ and provides comfort for both parties to a transaction. Digital signatures are used in blockchain transactions because they prove account ownership, and the validity of a digital signature can be proven mathematically and offline, without asking any other party. Compare this to traditional banking: when you instruct your bank to make a payment, you first authenticate yourself by logging in to the bank’s website, or showing your ID to a bank teller in person. If the bank believes that you are the account holder, then the bank executes your instruction on your behalf. In a blockchain system, where there is deliberately no organisation to provide or maintain accounts for you, your digital signatures are the critical piece of evidence that entitle you to make transactions. - Bitcoins are digital assets (‘coins’) whose ownership is recorded on an electronic ledger that is updated (almost) simultaneously on about 10,000 independently operated computers around the world that connect and gossip with each other. This ledger is called Bitcoin’s blockchain. Transactions that record transfer of ownership of those coins are created and validated according to a protocol—a list of rules that define how things work and which therefore govern updates to the ledger. The protocol is implemented by software—an app—that participants run on their computers. The machines running the apps are called ‘nodes’ of the network. Each node independently validates all pending transactions wherever they arise, and updates its own record of the ledger with validated blocks of confirmed transactions. Specialist nodes, called miners, bundle together valid transactions into blocks and distribute those blocks to nodes across the network. - That first sentence says it all. It sets out the purpose of Bitcoin, and how Bitcoin derives both value and utility. For the first time in history, we have a system that can send value from A to B, without the physical movement of items or using specific third-party intermediaries. It is difficult to overstate how important a milestone this is in the evolution of payments. I get shivers down my spine every time I think of Bitcoin like this. As popularised by cryptocurrency industry commentator Tim Swanson, Bitcoin is designed as censorship resistant digital cash. - all block-creators have to play and win at a game of chance, a game that in aggregate, over the whole network, takes some specific amount of time to play (say 10 minutes on average). The game must give all block-creators an equal chance of winning. The game must not have a barrier to entry, else the gatekeeper would be a central point of control. The game must not have shortcuts, and the game needs to have a publicly displayable proof so that the winner can prove they have won. The game must not be cheatable. The prize? Being allowed to create the next block. The game of chance that Bitcoin uses is called ‘proof-of-work’. - Each block-creator takes a bunch of transactions that they know about, but which have not yet been included in any previous blocks, and builds a block out of them, in a specific format. The creator then calculates a cryptographic hash from the block’s data. Remember that a hash is just a number. The rule of Bitcoin’s proof-of-work game of chance says, if the hash of the block is smaller than a target number, then this block is considered a valid block which all bookkeepers should accept - What if the hash of the block is bigger than this number? Does the specific block-creator bow out for this turn? No. The block-creator needs to alter the data going in to the hash function and try hashing the block again. They could do this by removing a transaction from the block, or adding a new transaction, or changing the order of transactions in the block, but these are not elegant and eventually you might run out of permutations. You don’t really want to mess around with the transactions in a block. The solution in Bitcoin is that in every Bitcoin block there is a special part of the block that block-creators can populate with an arbitrary number. Its only purpose is to allow block-creators to fill it with a number, and change the number if the hash block doesn’t meet the ‘hash is smaller than a target number’ rule. So, if the first hash attempt doesn’t result in a winning hash, then they can just change the number in this part of the block. This number is called the ‘nonce’ (number once) and is completely separate from the financial transactions in the block. Its only job is to change the input data for the hash function. - mining is a tedious, repetitive job. Take some transactions with the nonce, hash it, see if the hash is smaller than a certain number, and if not, repeat with a different nonce. It is not ‘solving complex mathematical problems’ as is widely described in the media. Hashing is easy but boring! You can even do it by hand using pencil and paper if you have the patience, though you would be unlikely to win a block with only these tools to power you. - So proof-of-work works well as a solution to this kind of Sybil attack because proof-of-work is computationally expensive, and this in turn means expensive in terms of electricity and hardware (i.e., cash), which means it is expensive to try to overwhelm the network with hashing power, which in turn increases the attack costs to a bad actor. If you have all of this hashing power available, you might as well put it to work finding blocks and making money (well, bitcoins) instead of trying to subvert the network, so the theory goes. - Bitcoin’s solution is a market-based approach where people creating transactions add their own voluntary transaction fees, and the block-creators can prioritise those transactions with higher fees over those with lower fees. - The second, and currently much larger, incentive for block-creators to create blocks is the ‘block reward’. In effect, the block-creator can write a cheque to themselves once per block, for up to a certain amount. The idea is that block rewards can kick start the system, and then be phased out gradually, with transaction fees to replace them. - Instead of having each block have a ‘block number,’ each block refers to the previous block by its hash. Miners must include the previous block’s hash in the block they are creating. This means that to mine block 1,002, miners need to know the hash of block 1,001. Until 1,001 has been mined, 1,002 can’t be mined. This forces miners to focus on block 1,001, which in turn includes the hash of block 1,000, and no miner can skip ahead. - common advice for people receiving bitcoins is to wait for the transaction to be a few blocks deep (i.e., to have a few blocks mined on top of it). This gives comfort that the transaction is settled and can’t easily be unwound. At this point the amount of mining that has to be done to create a competing chain longer than the existing chain is enormous, so rational miners would prefer to dedicate their hash power towards creating legitimate blocks, receiving the block reward and transaction fees, rather than trying to subvert the network. - A physical cash transaction is definitely peer-to-peer as there are no other actors other than the payer and the recipient. But Bitcoin also has intermediaries such as miners and bookkeepers. The difference between Bitcoin payments and bank payments is that, with Bitcoin payments, the intermediaries are non-specific and can act in lieu of each other, whereas traditional banks and centralised payment services are specific intermediaries. - <mark style="background: #FFF3A3A6;">it remains highly likely that, just as in the non-crypto world, very few people probably own the vast proportion of the value. Now, there’s a surprise</mark>. - The wallet needs to access an up to date version of the blockchain in order to be aware of all the transactions going in and out of the addresses it is keeping tabs on. The wallet, software can do this by either storing the entire blockchain and keeping it up to date (this is called a full node wallet) or by connecting to a node elsewhere which does the heavy lifting (this is called a lightweight wallet). A full node wallet would contain over a hundred gigabytes of data and would need to be constantly connected over the internet to other Bitcoin nodes. So in many cases, especially on mobile phones, this is not practical so the wallet software is lightweight and connects to a server which hosts the blockchain. The wallet software on the phone asks the server ‘What’s the balance of address x?’ and ‘Please give me all the transactions related to address y’. - You can split keys or use multi-sig addresses for further security. This means if one part is found by a thief, it is useless without another part, and also means if one part is lost, the other two will still work. Remember, you are trying to simultaneously guard against two things: Loss of keys and theft of keys. - <mark style="background: #FFF3A3A6;">This is a financial market—this means that the larger amounts you want to buy or sell, the worse the prices will be. This is unlike a supermarket where you get a discount for buying in bulk. This is confusing for some people initially, but it is easily explained. When you buy something on an exchange, the exchange will naturally match you off with the person who is selling it at the cheapest price. When you’ve bought all that they have to offer, you have to find the next best price, which will be slightly higher.</mark> - Cryptocurrency exchanges perform activities that may be regulated in their operational jurisdictions. The fact that the instruments involved are cryptocurrencies does not necessarily mean that the exchanges escape local trading and tax disclosure requirements. However, depending on how the legislation is written, and owing to regulatory uncertainty, the classification of cryptocurrencies, exchanges currently operate in a legal grey area, especially crypto-only exchanges who allow trades between cryptocurrencies but not fiat. - Ethereum’s PoW maths challenge, called Ethash, works slightly differently from Bitcoin’s, and allows more common hardware to be used. It is deliberately designed to reduce the efficiency edge of specialised chips called ASICs, which are common in Bitcoin mining. Commodity hardware is allowed to compete efficiently, and this allows for a greater decentralisation of miners. In practice though, specialised hardware has been created and so most blocks in Ethereum are created by one of a small group of miners - The Ethereum Foundation then made a proposal to unwind the specific transactions related to the theft and allow DAO investors to withdraw their invested ETH. Again, this transgressed the very principles of a censorship resistant world computer. In cryptocurrencyland, it is apparently fine to cheer for censorship resistance, unless you’ve lost money. - Asset backed tokens are easy to transfer. Blockchains enable predictable and secure record keeping. The key risk is that the issuer must remain solvent. If the gold is stolen from the vault, or if the issuer becomes bankrupt, whether from fraud or otherwise, asset backed tokens can become valueless. - What’s the difference between a blockchain and a database? A common database is a system which simply stores and retrieves data. A blockchain platform is more than that. It stores and retrieves existing data just as a normal database does. It also connects to other peers and listens for new data, validates new data against pre-agreed rules, then stores and broadcasts that new data to other network participants to ensure that they all share the same updated data. And it does so constantly, without manual intervention. - The main use for cryptocurrencies is undoubtedly speculation. Their prices are volatile and people make and lose a lot of money trading these coins. The fact that there are no established methods to value a cryptocurrency means that prices are likely to remain volatile for some time. - ‘cost of creation’ argument: The price of Bitcoin should be at least the cost of mining them, so the cost of mining puts a floor under the price of Bitcoin, and as difficulty increases, it costs more to mine bitcoins, so the price should rise. Alas, this is also false. The cost incurred by a miner (or even all the miners in aggregate) bears no relation to the market price of Bitcoin. The price of Bitcoin affects the profitability of miners, but there is no rule dictating that miners need to be profitable. If a miner is unprofitable, they will eventually stop mining, but this doesn’t affect the price of bitcoins. If it costs me $5,000 to dig up 1 oz of gold, this doesn’t mean the price of gold should be at least $5,000/oz. - The fact is that ICOs who issue tokens want the price of their tokens to go up, as do their investors. Redemption is always described generically and not quantified. For example, they say, ‘Tokens will allow you access to cloud storage,’ rather than, ‘One token will give you 10 GB of cloud storage for 1 year starting in 2020’. This is a deliberate strategy. If the issuers quantified the goods or services, you could figure out an appropriate ballpark price for the token. But this would constrain the price, preventing the price of the token from massively increasing (which is really what ICO issuers and investors really want). - Two important things seem to have been created: 1.New censorship resistant financial assets, methods of value transfer, and transparent automation 2.New technologies for business-to-business data and asset transfer We can call these, respectively, a ‘crypto’ story and a ‘blockchain’ story. - Are these blockchains a bubble or fad? In my view, no. Both public and private blockchains have their roles and will continue to evolve and deliver value in ways we might not even be able to envisage today. In the public cryptocurrency industry, Innovation will continue to accelerate as tokens create financial incentives that attract developers and other staff. The speed and intensity of innovation will increase if popular cryptoassets increase in price. Many developers personally hold cryptocurrencies and tokens, and so are directly financially incentivised to make their projects successful, even more so than staff at traditional startups who often only have a tiny sliver of equity.