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Economics

Just a little bit more Bitcoin trouble

Originally published on June 17, 2014

There has been so much tumult in bitcoin and cryptocurrency over the past few days! Interest and concern extends beyond online communities. Motives vary.

Anonymous and decentralized

There are two conceptual pillars of trust that uphold bitcoin as being superior to fiat currency. (The fiat currency of reference is primarily the US dollar. Why? Because the US dollar is the world’s reserve currency, for now.)

The first is anonymity. US dollars held as cash are bearer instruments. Ownership and use is anonymous, but only until one wants to use them for commercial transactions of significant size as defined by anti-money laundering rules. Bitcoin does have some anonymity shortcomings, as transactions on the blockchain are actually pseudonymous, but there may be tractable remedies. Further details have been widely covered elsewhere.

The second conceptual pillar of bitcoin is decentralization. The US dollar is highly centralized. As ideological (but not market) confidence in the dollar diminishes, the appeal of an apolitical, alternative currency increases, especially one that is a fungible store of value.

All markets are game theoretic. Bitcoin is too.  I really wish we could ask Professor John Nash what he thinks of bitcoin! Nash wrote a pleasant, accessible article that described bitcoin-like currency, titled “Ideal Money” a few years ago.

Did Mathematician John Nash Help Invent Bitcoin? http://t.co/AVNLfSW5bZ

— Egan J Chernoff (@MatthewMaddux) June 13, 2015

I mention game theory because monopolists and cartels can assert control over bitcoin production. This is playing out right now.

Centralization of bitcoin

Currently, Bitcoin’s most acute concern is loss of decentralization. This is due to the documented, persistent existence of a 51% majority mining pool controlled by gHash.io. gHash is owned and operated by private entity cex.io. gHash’s market dominant behavior was noted in March 2014, however the situation was transient. That has since changed.

Princeton computer science professor Ed Felton confirmed that Bitcoin mining is now dominated by one pool. A monopoly mining pool can pursue various bitcoin attack strategies as a function of hash power.

Bitcoin mining and transaction costs

In theory, bitcoin is a perfectly smooth, zero transaction cost medium of exchange. In reality, this is possible but involves more than a modicum of effort.

Many novice bitcoin users, especially those who are not miners, keep their holdings in custody of a clearinghouse such as Mt. Gox, Silk Road, or Coinbase. This generates transaction costs, for holding user e-wallets. In return, users benefit from greater convenience in making purchases.

Trust is just as important as middle-man expenses though. Mt. Gox “lost” many customers’ Bitcoins, then declared bankruptcy. No depositor funds have been recovered.

Clearinghouses sometimes have appeal to miners, as they offer the option of participating in a shared mining pool. Doing so offers cost savings to miners.

UPDATE: As of 2018, both Mt. Gox and Silk Road have been shut by governmental authorities. Coinbase remains in operation, as well as some others with whom I am unfamiliar.

Special-purpose mining hardware

Mining Bitcoin requires processing power and electricity. Bitcoin was designed to reward early adopters: As more bitcoins are mined, more computational effort is required.

In 2010, a PC with an NVIDIA or ATI GPU (graphics processing unit) would have been adequate, but no longer. A new cryptocurrency-specific manufacturing industry has evolved for bitcoin mining equipment, using FPGAs which are more energy-efficient than GPUs. This was further improved upon by application-specific integrated circuits,

An ASIC is a chip designed from the ground up for the specific purpose of mining bitcoins. ASIC also represents the theoretical limit on the hardware capabilities of mining equipment.

ASIC mining rigs cost tens of thousands of dollars, and create a high barrier to entry for many miners. A partial remedy had been to use mining pools in the cloud e.g. Amazon AWS, or clearinghouse hardware.

Electricity cost and externalities

Mining bitcoin is costly due to mining equipment prices and high power usage, which result in large amounts spent on electricity.

Perverse incentives motivate uneconomic choices. The most egregious and harmful behavior directly associated with bitcoin mining that I’ve seen to-date was unauthorized use of a National Science Foundation supported supercomputer to mine bitcoin. $150,000 in computing resources, e.g. electricity, was spent in order to mine the equivalent of $8000 in bitcoin.

Another incident occurred at Harvard University in March 2014. The researcher used Harvard’s high-powered network of thousands of CPU cores to mine an unspecified number of dogecoins.

Bitcoin mythos—Silly

For an intuitive understanding of bitcoin cultural approaches to attack vulnerability remediation, see Novel method for backup of wallet seeds or private keys (not serious).

Next, go play and have fun with the Bitcoin Bullshit Generator, freshly forked from the Web 2.0 Economy Bullshit Generator. It amused me.

Bitcoin mythos—Serious

For a detailed understanding of bitcoin vulnerability, see Dispelling some myths about Bitcoin, from a Bitcoin fan:

Myth #2: The proof-of-work system is great because it incentivizes miners to upgrade their equipment, thus a lot of computing power is powering Bitcoin.
Fact: These upgrades do nothing to increase the transaction processing capacity of the Bitcoin network.
Emphatically, this computational power is *not* used to validate transactions, an operation which only takes a modest amount of computing power. More hashing power does not mean that the Bitcoin network can process more transactions per second or process them faster.

Myth #3: Bitcoin is a math-based currency / is backed by math.
Fact: Bitcoin is based on a clever set of incentives.
Part of Bitcoin is indeed math based: its cryptography. Cryptography makes computational guarantees based on widely believed (but not yet proven) mathematical conjectures… However, the cryptography in Bitcoin is the easy part… The assumption made is that miners are incentivized to behave honestly with pecuniary rewards. This makes it costly to attack the system… This really is the heart of the block chain, and it relies on *game-theory* not mathematics. Yes, game theory is a branch of mathematics [but Bitcoin offers] no mathematical or even computational guarantees, only a set of incentives. This isn’t to say that the design of incentives in Bitcoin isn’t clever or even artful, but to call the currency math-based, or worse math-backed, is either dishonest or ignorant.

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