Bitcoin: More than Money

On August 6, Judge Magistrate Amos Maazant of U.S. District Court for the Eastern District of Texas made many a headline when he became the first known United States government official to declare that Bitcoin-the non-government and non-bank currency, payments network, and anarchic digital phenomenon-is indeed money. In a ruling rejecting a defense argument that a certain Ponzi scheme was not in fact a Ponzi scheme because its shares were sold in Bitcoins, instead of “real” money, Maazant made this declaration: “Bitcoin is a currency or form of money, and investors wishing to invest in [the scheme] provided an investment of money.”

The following week, the German Ministry of Finance also formally recognized Bitcoins as a private money. Germans can now use Bitcoins to buy bratwurst, sell lederhosen, or invest in Volkswagen. The government is developing rules to ensure Bitcoin transactions are taxed, just like those in euros.

So governments are slowly acknowledging the obvious: Bitcoins are money. But bureaucrats, like many observers since the digital currency burst on the scene in January 2009, are likely missing the larger implications. Bitcoin is much, much more than just money.

At its core, Bitcoin is a completely decentralized ledger system. It can be thought of as a massive online version of an accountant’s book in which transactions are recorded by deducting from one account and adding to another. An accountant’s ledger can be used to keep track not just of dollars, but also cows or bushels of corn or anything else, and Bitcoin is just as flexible. That means it can serve as the backbone for any online transaction that relies on a ledger, such as property registration, futures swapping, and bonded contracts. Because Bitcoin is decentralized, these applications can exist largely outside regulators’ reach. And because Bitcoin is growing in popularity, financial regulators are beginning to make plans for dealing with it, much to the chagrin of those who see the private currency as a revolutionary force inherently unmanageable by statist forces.

The Mysterious Rise of Bitcoin

The Bitcoin concept was introduced in a remarkable academic paper published online in late 2008 by someone calling himself Satoshi Nakamoto. (So far, Nakamoto’s true identity remains a mystery despite the attempts of several investigative reporters to uncover it.) The paper described a cryptographic breakthrough that for the first time made possible “a purely peer-to-peer version of electronic cash [allowing] online payments to be sent directly from one party to another without going through a financial institution.”

In early 2009, Nakamoto released open-source software implementing the concept and launching the Bitcoin peer-to-peer network. After the launch, volunteer programmers from around the world began to work with Nakamoto to further develop the underlying software protocol, collaborating via email, forums, and chats. Nakamoto remained an active participant through mid-2010, when he turned over control of the project to a contributor named Gavin Andresen. In April 2011, when asked by a developer to explain his declining involvement, Nakamoto said that he had “moved on to other things.” He hasn’t been heard from since.

The mystery of Bitcoin’s designer is fascinating, but the fact that we don’t really know where Bitcoin came from does not undermine its security or stability. The Bitcoin protocol and software are completely open-source, open to inspection by anyone. Hundreds of programmers and cryptographers have pored over the code’s thousands of lines, and volunteers are continuously adding innovations. By now most Bitcoin code has been written by people other than Nakamoto.

At first, Bitcoin attracted interest mostly from a small group of cryptographers and technology enthusiasts who casually traded the currency back and forth and even gave some away to attract new users. The currency’s early value was commonly in the pennies. The first known Bitcoin purchase took place in May 2010, when one user paid another 10,000 Bitcoins for two pizzas. That sum would be worth around $1.2 million at today’s exchange rate.

Merchants ranging from bars and restaurants to online specialty retailers began to accept Bitcoin for payment in 2010. Now businesses as big as WordPress, Reddit, and OKCupid accept the stuff. The most popular use of Bitcoin today is in online gambling at sites such as SatoshiDice.com.

As demand grew and the marketplace expanded, so did the exchange rate. Before settling at a relatively stable price of about $120 per Bitcoin over the last few months, Bitcoin experienced several bubbles and crashes. It reached an all-time high of $266 in April 2013-an increase of more than 1,000 percent over the previous three months-and then dropped to $105 before turning back up. Each bubble has largely been driven by media attention, which attracts new users and thus new demand. At some point in these cycles of publicity, a critical mass of speculators cashes out, sending the currency tumbling.

Such volatility is not surprising. The total value of all outstanding Bitcoins is still relatively low-about $1.5 billion. This means even a small increase in interest in Bitcoin can send prices soaring. Additionally, a large portion of existing Bitcoins are for the moment being held as a long-term investment, so the market is not very liquid. As more and more people begin to use them for everyday purchases, the exchange rate will likely increase.

The How of Bitcoin

Until the invention of Bitcoin, online digital payments had to rely on trusted third parties, such as PayPal or Visa, to keep a ledger of account-holder balances, or a record of who owns what. For example, if I send you $100 via PayPal, PayPal will deduct the amount from my account and add it to yours.

Without such ledgers, digital money could be spent twice. Imagine that digital cash is simply a computer file, just as digital documents such as spreadsheets or photos are computer files. I could send you $100 by attaching a “money file” to a message. But just as with email, sending you an attachment does not delete that file from my computer. I could send the same $100 file to a second person, essentially spending the same money twice. In computer science, this is known as the “double spending” problem. Until Bitcoin it could only be solved by employing a trusted, ledger-keeping third party.

What makes Bitcoin revolutionary is that for the first time the double-spending problem can be solved without a third party. Bitcoin accomplishes this by distributing the necessary ledger among all users of the system via a peer-to-peer network. Every transaction in the Bitcoin economy is registered in a public ledger called “the blockchain.” Complete copies of the blockchain reside on the computers of everyone who uses Bitcoin. New transactions are checked against the blockchain to ensure that the same Bitcoins haven’t been previously allocated, thus eliminating the double-spending problem.

Transactions are checked by users called “miners,” who lend their computers’ processing power for that purpose. Miners essentially solve the difficult cryptographic math problems that verify transactions, and they are awarded newly created Bitcoins for their trouble. This is how new Bitcoins are injected into the money supply. As more users become miners and the processing power that is dedicated to mining increases, the Bitcoin protocol also increases the difficulty of the cryptographic problem miners must solve to verify transactions, thus ensuring that new Bitcoins are always mined at a predictable and limited rate.

This mining process will not continue forever. Bitcoin was designed to mimic the extraction of gold or other precious metals from the earth-only a limited, known number of the coins can ever be dug up. The arbitrary number chosen to be the cap is 21 million Bitcoins. This certainty and predictability appeals to many because it makes artificial currency inflation impossible. In most countries, a central bank controls the money supply, and sometimes (such as during the recent economic crisis) it may decide to inject more money into an economy. A central bank does this essentially by printing more money. More cash in the system, however, means that the cash you already hold will be worth less. By contrast, because Bitcoin has no central authority, no one can decide to increase the money supply. The rate of new Bitcoins introduced to the system is based on a public algorithm and is therefore perfectly predictable.

Yet as interesting as Bitcoin’s deflationary nature is, it is the decentralized design that makes the innovation truly revolutionary. It means you and I can transact online without PayPal or any other central authority between us, much in the same way we might exchange cash for goods on the street. This design has two important ramifications: First, because the ledger is decentralized, the Bitcoin protocol leaves governments with no intermediary to regulate or shut down. Second, the technology is potentially useful for many other types of transactions.

Censorship and Resistance

In late 2010, after WikiLeaks began releasing its trove of State Department cables, many individuals sought to show solidarity with the group by donating money. They found that many payment processors, including Visa, MasterCard, and PayPal, would not remit money to Julian Assange’s organization, thanks to U.S. government pressure. PayPal even froze the group’s account so that it could not access funds it had already collected.

“Hey, Visa, Mastercard, Paypal: It’s MY money,” media critic Jeff Jarvis tweeted at the time. “How DARE you tell me where I can and can’t spend it?”

As long as you rely on intermediaries to transact, they can indeed tell you how you can and can’t spend your money. This is why governments seeking to control online activity tend to regulate not end users but the facilitators in-between. For example, the rightfully defeated Stop Online Piracy Act would have worked not by going after digital pirates, but by requiring payment processors to block the transactions of people merely suspected of piracy.

Because it is a decentralized peer-to-peer network, Bitcoin is inherently resistant to censorship or control. There is no Bitcoin company to subpoena, no headquarters to raid, not even a server to shut down. Add to that its pseudonymous nature and Bitcoin becomes a real challenge to the state’s ability to restrain or keep track of financial transactions.

Unlike cash, Bitcoin is not anonymous, since a public record is made of every transaction. But it is more private than traditional electronic payments, such as credit card transactions, because users’ identities need not be tied to the exchanges. Security researchers have begun to develop techniques to unmask the identities of the persons behind transactions by analyzing the patterns of activity in the blockchain, and there is no doubt that law enforcement will soon adopt such schemes. While the state may be able to uncover the identity and punish the parties to a Bitcoin transaction, however, it will no longer be able to prevent those transactions from happening in the first place by regulating middlemen. That genie is out of the bottle.

With a little bit of effort, usually involving meeting a stranger in person, you can purchase Bitcoins anonymously with physical cash. From that moment, a whole universe of government-disfavored activities opens up. You could buy illegal drugs on the notorious “Silk Road,” an encrypted website that has operated with impunity for the past two years, facilitating annual sales estimated at over $20 million (until federal agents shut it down and arrested its alleged operator as this story went to press). You could gamble at various casinos or prediction markets, buy contraband Cuban cigars, or-yes-give money to WikiLeaks. Dissidents in Iran or China can use Bitcoins to buy premium blogging services from WordPress. And perhaps more importantly, Bitcoin can potentially replace not just the intermediary payment processors, but the intermediary markets as well.

More than Money

Mike Hearn, an engineer at Google who serves as one of Bitcoin’s core developers, likes to compare the currency’s potential to the early Web. “The Web started out as scientists simply showing documents to each other,” he says. “You could link documents and embed images, but the true potential of the Web really came when these pages became interactive and started gaining more and more features allowing people to build things like Facebook or online shops. Those things are not documents, and now probably half the time people use the Web they aren’t really interacting with documents; they are actually using applications.”

Bitcoin, Hearn says, is now only being employed for its most obvious use-money transmission. But its design supports any number of other applications, just like the Web.

“Ultimately Bitcoins are data, and you can use a data transit protocol to transit information other than just ‘I’m sending you Bitcoins.’ It could be ‘I’m sending you a stock,’ or it could be ‘I’m sending you a bet,’ ” says Jeff Garzik, another core Bitcoin developer. Each of these applications would by definition be beyond government control.

One of the most interesting potential applications of the protocol is decentralized electronic markets. These could be for futures contracts, sports bets, or political predictions. J.R. Willett, author of a white paper proposing such a system, explains with a thought experiment. Suppose two parties, A and B, want to bet on the future price of Google stock; and suppose there is a third party, C, that publishes the price on the network every few minutes. A thinks the price of Google will go up, and publishes a message saying so, establishing how much he’s willing to wager. B thinks it will go down and publishes a message accepting the bet.

Once that happens, both parties are committed to the transaction. The only question is who takes the pot. Others on the distributed network don’t know the real-life identities of the bettors, but they can see that A said it would go up and that B said it would go down, and they can see C publish the price of Google shares. “If the price goes up, then the whole protocol recognizes that A won that bet; the whole protocol recognizes that A now owns B’s coins,” says Willett.

Bitcoin, then, may soon enable a world of decentralized electronic betting markets largely impervious to government sanction. The predictions market Intrade, a darling of academic economists and political scientists, closed down last year after the Commodities Futures Trading Commission (CFTC) sued it for violating a ban on certain options trading. (See Katherine Mangu-Ward, “The Death of Intrade,” page 44.) According to the CFTC, Intrade “unlawfully solicited and permitted U.S. customers to buy and sell options predicting whether specific future events would occur, including whether certain U.S. economic numbers or the prices of gold and currencies would reach a certain level by a certain future date, and whether specific acts of war would occur by a certain future date.”

A predictions market built as a peer-to-peer network on top of Bitcoin could not be shut down so easily. And no operator could abscond with users’ funds, as has also been rumored of Intrade in the wake of the CFTC action.

Eliminate the Middleman

When users don’t rely on intermediaries to transact, governments have a much harder time restricting with whom users can engage and for what purpose. (It also makes it harder for tax collectors to grab a cut of the transaction.) Governments seeking to control online activity so far have tended to crack down on the intermediaries first. For example, online gambling and sports betting is perfectly legal in countries such as the U.K., Ireland, and Australia, and residents of the United States can easily access those websites. Placing a bet is another matter, however, because the Unlawful Internet Gambling Enforcement Act of 2006 requires payments processors, such as PayPal and Visa, to block transactions to online gambling sites. (See Jacob Sullum, “How Poker Became a Crime,” page 62.)

Not only does Bitcoin remove the need to rely on third-party payments processors, it has the potential to remove the need to rely on third-party betting platforms altogether. Suddenly, the government can’t regulate gambling either.

“A year or more ago there was very much an ‘Occupy’ type feel to Bitcoin, where this is the anti-establishment currency, and now the establishment is getting interested in Bitcoin,” says Bitcoin developer Garzik. “There is a tension, and you definitely see the libertarian crypto-anarchist roots bang heads with the venture capital that’s coming in right now.”

Many entrepreneurs are inviting regulation as a way to legitimize virtual currencies. They are looking to get rich through what they rightly see as a disruptive technology, and ideology plays little part in that quest. If playing ball with regulators is what it takes, they figure, then so be it.

Cameron and Tyler Winklevoss, the Facebook-cofounding twins who own about 1 percent of all Bitcoins, filed papers in September with the Securities and Exchange Commission seeking permission to launch a fund that would allow investors to easily speculate on the price of Bitcoins. They have been making a full-court press for regulation.

“I don’t think anyone wants a fight-I think everyone here wants to build Bitcoin, to work with regulators,” Cameron Winklevoss told the crowd at a Bitcoin conference in San Jose this May. “Cooperation is really the way forward.” In June Winklevoss turned it up another notch, telling the NExT entrepreneurship and technology conference in Brooklyn that “in the Bitcoin world, we love regulation.” He said regulation would confer legitimacy on Bitcoin, helping to stamp out illicit uses.

Ultimately, both camps-those who would like to see Bitcoin regulated, and those who see Bitcoin as a perfect escape from state control-will have to face facts. Regulators and law enforcement will have to come to terms with the fact that the Bitcoin protocol is beyond their reach, and while they may be able to spy on the vast majority of consumer transactions by regulating third-party Bitcoin businesses, they will not be able to stop individuals from transacting with each other directly on the network. Meanwhile, those who would rather have nothing to do with the state will have to face the fact that laws that ban money laundering and license money transmission exist, and that the choice before the Bitcoin community is not whether it should want regulation but what to do about it.

Given this inevitability, what matters is how onerous the ultimate regulatory structure around Bitcoin will be. Why should this matter to those who seek to opt out of the legacy financial system altogether? Because Bitcoin is a network and networks depend on network effects.

The more people use Bitcoin, the stronger it will grow; the stronger it grows, the more difficult it will be to regulate in the long run. Does Bitcoin need millions of average American consumers (or Chinese consumers, for that matter) to succeed? No, but that would surely help. Eventually, hopefully, more and more value will remain inside the Bitcoin economy, not requiring easily regulatable conversion to government currencies. But that process will take time. The more people transact with Bitcoins and are comfortable doing so, even under a regulated regime, the quicker the currency’s full potential can be realized.

While governments can’t kill Bitcoin, it would be naive to think that they could not substantially slow down its development and raise the cost of using it. “The choice is not whether to have digital currencies,” Jim Harper wrote recently in Cato Unbound. “The choice is between adopting digital currencies the hard way or the easy way.” Right now U.S. regulators seem to be choosing a middle path.

At the moment Washington is not interested in outlawing Bitcoin, especially since the currency’s $1.5 billion economy is comparatively trivial. The government is interested, however, in forcing Bitcoin to fit within its existing bureaucratic buckets.

If regulators can avoid big-ticket prohibitions or mistakes early on, they may counterintuitively enable the growth of something they’ll never be able to control. The stronger the network effects grow, the harder it will be for states to take more aggressive actions in the future. Before you know it, Bitcoin will never look trivial again.