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Wed, 08 Jun 11

Bitcoin Mania

In the past two months, Bitcoin rapidly cycled through the entire mainstream news cycle of discovery, buzz, hype and punditry. Fueled by a report on peddlers and feted by pirates, we only needed furor by politicians to complete the picture. With this increased attention, speculation in Bitcoins has reached new highs, with one Bitcoin trading for 21 USD, up 200% in the last week.

Bitcoin was publicly outlined three years ago by Satoshi Nakamoto as a peer-to-peer electronic cash system. Specifically a cryptographic mechanism to ensure that this cash cannot be spent twice. As in any p2p system, the mechanism was designed to not require a trusted third party.

In Bitcoin, the electronic coin is simply a chain of digital signatures, akin to a paper note that you co-sign with the next person when you spend it onward. In crypto-speak, you sign a hash of the previous transaction and the public key of the next owner and add them to the end of the coin.

However, this chain of ownership should be verifiable by the receiving party at the time of the transaction. A paper banknote is verifiable through physical ownership since counterfeiting is difficult due to security features supplemented by serial numbers. Bitcoin verification requires a radically different scheme. Not just because the coin is a string of text and therefore easily copiable, but also because the creators do not want a central mint to sign and verify the text. The approach taken is to instead track spending and safeguard against double spending in the chain of ownership as the coin passes from one person to another.

All transactions are announced publicly, widely broadcast and “known” by the network. That is, a majority of nodes on the network agree on a particular chain of ownership certifying that the previous owner did not sign any earlier transactions before giving a coin to you.

The system utilizes a distributed p2p timestamp server, based on proof-of-work. which is a hash that takes a moderate amount of CPU time (work) to generate, but is near instantaneous to verify. This makes it harder for counterfeiters in cheating or forging ownership records. Each node collects transactions for several coins (announced publicly) into a block, and tries to find the proof-of-work for that block. If it does, it broadcasts that block to all nodes, who verify that transactions and the hash are valid. If the block is accepted, its hash is chained to the next block as all nodes get busy trying to find proof-of-work for it.

The genius of the system is that the node that gave the proof-of-work, gets to insert for itself a reward of (currently 50) Bitcoins as the first transaction in its block. This is what is called mining. The supply of bitcoins thus generated is to be capped at approximately 21 million.

Obviously the creators of Bitcoin are well familiar with the functions of money as both a medium of exchange and a store of value. You could consider that the worth of a bitcoin is the amount of CPU, memory, network and electricity costs expended into generating it. Of course, since the bitcoins generated are a reward for helping people track the spending of bitcoins, this is highly circular, literally bringing forth the bitcoin economy by a combination of an act of faith and the straps of one’s own boots (or bits).

It is worth noting some specific facts about Bitcoins:

  1. It is definitely a fiat currency, however much touted otherwise. The difficulty of the proof-of-work and the reward for finding it are mandated by the Bitcoin software and network protocol, similar to how central bank committes control money supply.
  2. It is not strictly anonymous. All transactions are publicly announced, and require public key of the recipient. At some point, bitcoin users will use their email addresses, or not change keys for every transaction. Data analysis systems less powerful than those used by ad servers on the web can be used to correlate transactions and identify patterns, and possibly tie spending with online identities.
  3. A Bitcoin collection has to be stored in digital wallets and transacted through software interfaces provided by bitcoin clients. Your holdings are therefore susceptible to worms, viruses, computer failures and even user errors. Just like cash, if you lose it, its gone.

The Bitcoin system can be attacked for gain or to induce loss.

  1. The system relies on CPU power to maintain chains of ownerships, essentially one-CPU-one-vote. Those who can bring large scale, high compute GPU nodes to the party get to mine more bitcoins.
  2. All chains of ownerships are based on agreement by a majority of nodes. A dishonest entity or cartel can gain majority on the network, and forge ownership chains.
  3. An entity that controls the majority of the client distribution may fork the client software to tweak the protocol for their own benefit.

Regardless, speculators have latched onto Bitcoin as an investment vehicle. If you consider this a capped commodity or a limited edition (only 21M will be “minted”), you might want to get yours today. Or if you see how this appeals to libertarian-anarchists, anti-government types, you may be able to profit from it. So far there has been no downside for the early miners and even the early buyers. Some of them have not been shy in promoting and blogging about it.

Tulip bulb

Bubbles take on a life of their own, until they pop. At the height of the Tulip Mania in Amsterdam, a single tulip bulb would sell for more than 10 times the annual income of a skilled craftsman. When do people decide that holding a commodity of limited convertibility and no intrinsic value is not aligned with their investment portfolio? When do tulip bulbs go back to being simply a gardener’s delight?

Ultimately, Bitcoin is a reminder that even though money is simply a medium of exchange for productive services, it becomes a force of its own and exerts a powerful effect on everything we do.

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