Digital Currency Deep Dive: So What Makes Bitcoin So Special?

Introduction

Remember the day when a coin was just a bothersome piece of metal that you were happy to toss in the tip jar to benefit the underpaid baristas at your local coffee shop? Well no more. Now a coin might be worth more than many people make in a week. The coin has gone virtual. You can trace its origin not to a copper mine in Peru, but to a kid with in Estonia, perhaps, who created it out of thin air by solving some difficult algorithms on the computer he uses for gaming.

Sure, there have been shenanigans with these virtual coins.  The genius behind the “big daddy” of all of them—bitcoin—remains anonymous with a stash of coins, hackers have stolen hundreds of millions of dollars of coins, the market for one of the leading coins almost got cornered, the largest exchange was liquidated, and key members of the new virtual currency have been arrested for sundry sins. And then there was the guy who hired assassins.  

Serious people, though, have been pouring tens of millions into startups that aim to capitalize on this new virtual phenomenon. A global ecosystem is emerging of virtual coins and various businesses that support them. These range from manufacturers of “mining” equipment for solving the algorithms to create the coins, to vaults for storing coins, to exchanges, to operators of wallets.

And, if that’s not enough to get you to pay attention, to paraphrase the famous advice given to Dustin Hoffman’s character in the Graduate, “I’ve got one word for you: protocol. There’s a great future in the protocol for virtual currency.”  The protocol developed by the still yet-to-be-known inventor of bitcoin, lays the basis for massive innovation in financial services according to some proponents of the new currencies.  The protocol could be more important than the Internet, they say, which was ignited in part by the TCP/IP and HTTP protocols.

Don’t worry if you haven’t the foggiest idea what I just said.  In the next several articles I’m going to provide a primer of sorts on these new digital currencies. In the course of doing that I’ll give you a sense of what’s possible, and what’s not with the virtual coins, and what questions you should be asking if you’re thinking about starting or investing in a coin-related business.

Just to be clear, I’m not covering all alt-currencies, digital currencies, virtual currencies, or whatever else you want to all them. My focus is on the many variants of the bitcoin protocol.  The bitcoinesque currencies, as I’ll call them, are the ones that have garnered the publicity and excitement. Most of what I say is based on my technical paper that is available on my SSRN page here.

So off we go with the first installment.

What’s Special about Bitcoin and Its Relatives?

There are many ways to turn currency into digits and move it electronically. Most countries have electronic systems, such as the ACH system in the US or the Giro system in Germany, for moving money between bank accounts. Some countries have mobile money platforms, such as mPesa in Kenya, that enable people and businesses to move money between each other using their mobile phones without bank accounts. There are payment card systems such as MasterCard and Visa that mainly move money electronically between people and merchants. Further, there are remittance systems such as Western Union that move money electronically in conjunction with agents that provide cash-in and cash-out services. Wallet providers such as PayPal leverage the assets of other payment networks to provide currency transfers between people and businesses in multiple countries. There have also been numerous Internet-based currencies particularly those involving games. Digital currency is therefore widespread and many decades old.

Many private currencies have appeared over time as well. US banks sponsored currencies in the 19^th Century. Merchants in various countries have issued their own currencies. One study reports that, in 1766 more than 2000 shopkeepers in Mexico City were issuing a metal token called the tlaco. Various commodities ranging from gold to airtime minutes have been used as currency. Some of these, such as airtime minutes, have been used as digital currency. These non-governmental-sponsored currencies have generally not lasted as general-purpose currencies although some solve particular problems for particular transactors in particular places for some period of time.  Private currencies have been around for hundreds of years in not millennia.

So what is new and different about bitcoin and its relatives?

The Six Components of Bitcoinesque Currencies

The November 2008 white paper by “Satoshi Nakamoto” focused on solving a very hard technical problem. One of the benefits of cash is that it doesn’t require intermediaries. If you and I agree to consummate a transaction with cash we don’t need a bank or any of third party and we therefore don’t need to pay anyone for helping with the payment.  For many purposes, cash is a great payment instrument not to mention dirt cheap.

Creating an electronic equivalent isn’t so easy though. How do unknown parties know whether they can trust each other? The creative solution proposed in the white paper involved using a decentralized labor force to verify and record transactions on a public ledger. Copies of the public ledger reside on numerous servers. The bitcoin public ledger contains a record of every transaction ever made with a coin.

This decentralized public ledger was the fundamental innovation introduced by Satoshi Nakamoto. Bitcoin, as well as many other alt currencies such as Litecoin, Dogecoin, Auroracoi, and Ripple, have adopted the decentralized public ledger as the foundation of their systems.

The public ledger is based on sophisticated computer science concepts including cryptography. It you want to know more about the deep technology, go elsewhere. What I’m going to do is to unpack the bitcoinesque currencies to show you what really makes them different from other forms of digital money and what makes them tick in the real world of financial transactions.

There are six key features.

 1.     The Network Uses the Internet

The bitcoinesque platforms rely on the Internet as the physical network for conducting financial transactions.  That’s hardly revolutionary in the 21^st century.  Most payment platforms, however, rely on private secure communication networks at least for the most sensitive details. If you tried to persuade the people who run the ACH systems to do it all over the Internet they would toss you out onto the street and wonder if you had lost your mind.

2. There’s a Decentralized Public Ledger for Verifying and Recording Value

These new platforms have a protocol for sending, receiving and recording value.  The protocol is based on a public ledger that uses cryptographic methods to secure the values that are sent and received and provides a public record of transactions. The operation of the public ledger is decentralized.  Individuals verify and record transactions. Roughly speaking, the valid public ledger is based on a consensus among the individuals doing the verification and recording. This public ledger is sometimes called the blockchain.

3. There’s a Container for Moving Value on the Public Ledger

There is container that is used to send and receive value over the peer-to-peer network and on the public ledger. It is usually called a “coin” which suggests that the platform founders intended the coin to be currency. But coin doesn’t have to be a currency at all. The container could carry a traditional currency such as a Yuan or a financial derivative or a contract to rent a Tesla. If you get this point you’ll be able to at least have a discussion with bitcoin investors and you will understand why they treat you with scorn when you say bitcoin can’t be a successful currency—they actually don’t care.

4. There’s an Incentive Scheme for Getting People to Work on the Public Ledger

Now we get to the really interesting part.  Who are all these people who are verifying and recording transactions on the public ledger?  And why are any of them willing to help me buy a second-hand bike from you with my coins?  Here’s another great invention. The unknown one developed an incentive scheme for eliciting effort and the contribution of resources from people to conduct various record-keeping and verification activities for the public ledger. People can get a reward for providing labor, computing power, and other resources for operating the public ledger. Bitcoin has been economically interesting to a lot of people and has even created a market for high-powered computers to help with the work.

5. They Are Organized as an Open-source Project

Most of the decentralized pubic ledgers were started under an open-source software model.  The software is available for free. Programmers can contribute improvements and fixes. They can also decide to take it in a direction of their own choosing.  Litecoin is the result of someone “forking” bitcoin to make changes that took if in a different direction. Ripple was started as proprietary software but the code was recently made available under an open-source license.  Another important point though. Open-source projects don’t have massive paid labor forces motivated by manna falling from heaven.  That makes the bitcoinesque platform something quite new.

6. They Have Some (Possibly Minimal) “Governance System” for Running the Platform

Who runs the public ledger?  The answer runs the same gamut that we have seen for open-source generally. There could be a for-profit company managing the project similar to Android. Perhaps a benevolent dictator—that’s the case with Linux and other large, successful open-source projects.  And there could be consensus-driven management as is the case with many smaller open-source projects.  At least so far, most of the decentralized public ledger platforms have a pretty loose governance system. Bitcoin’s founder decided not to follow in the footsteps of Linus Torvalds who keeps a tight grip on Linux. Bitcoin is run by a small board and has some core developers who are paid from donations. Most of the other platforms are similar except for Ripple, which is basically a for-profit company that has given a weak nod to open-source. The governance system for decentralized public ledger platforms is by far the least developed aspect of them—and one of the most important.

Beware of Bitcoin Acolytes Bearing Analogies, and Critics Too

There are a lot of similarities between these bitcoinesque platforms and traditional currencies, payment systems, and software platforms. Not surprisingly, supporters and critics of these platforms tend to make arguments that go along the lines, “It’s like X. And X was [fill in the “greatest thing since sliced bread” or a “total bust” depending on which camp the person belongs to].”

These analogies are almost always incredibly off. Let’s take some of the most deceptive reasoning here.

Maybe It’s a Currency, Maybe It Isn’t

Public ledger platform sponsors typically refer to the container as a coin. That name suggests that the container is a currency. Some platform sponsors have expressed ambitions to create new general-purpose and, indeed, globally used currencies. It is possible that the container could become a currency if enough people wanted to use it as a medium of exchange. It is also possible that the container could be used to carry other currencies or financial assets on the public ledger as noted above.

In the end, it is an empirical matter whether the coin becomes a general-purpose currency. Calling the container a coin, causes confusion because at the start of the platform the container is not a currency since it is not widely used and accepted. It also causes confusion because the public ledger platform could be viable even if the container did not evolve into being a general-purpose currency.  It could, as I said above, carry another currency. Or it could carry a contract, which could be even more disruptive than just being another currency.

The “is it or isn’t it a currency” problem has lead to ships passing in night debates.  Critics say the coin isn’t worth anything because it isn’t a viable currency. Sophisticated supporters say the coin is worth a lot because it could be a great contain.  In talking about the future of bitcoin critics and supporters have to be clear what role they see the “coin” as playing—is it a currency, or a container, or both.

It’s a Protocol of a Very Different Stripe

Another source of confusion concerns the “protocol” for public ledger platforms. Some commentators make the analogy between the public ledger protocols and other Internet-related such as HTTP. There are indeed similarities. Public ledger protocols and Internet-related protocols both have network effects. As more people adopt each protocol the value of the protocol increases. There are more people to transact with in the case of the public ledger platform protocols and more people to interact with in the case of Internet communication protocols.

There is, however, a critical difference between these two types of protocols. A decentralized public ledger protocol insists that a network of third parties stand between A and B to verify that person A has the money to give person B and to record this transaction in the public ledger. In fact, the public ledger protocol cannot exist as a practical matter without an incentive scheme that induces a decentralized network of laborers to provide that effort. This is a very important point: the protocol and incentive scheme are two sides of, well, the same bitcoin.  They cannot exist without each other.

By contrast, a typical communication protocol does not require any intermediary between the two parties. Parties A and B can communicate with the protocol without having to rely on any third parties.  A communication protocol does not require a network of people to facilitate the bilateral communications or an incentive scheme to induce the effort of third parties.  Establishing a decentralized public ledger protocol is more difficult than establishing an Internet protocol because it requires the participation of third parties and the adoption of an incentive scheme that induces the effort by enough third parties.

For Better or Worse This Is an Untried Method of Organizing Humans

The public ledger currency platforms may be based on an open-source license but they are fundamentally different from typical open-source projects. The pecuniary compensation of the open-source contributor is not a central design feature of open-source projects and open-source projects do not in practice typically have direct compensation schemes. Some open-source programmers work for companies that have decided to invest in an open-source project. Some entrepreneurs develop for-profit companies that provide complementary services to the open-source project. But often programmers work for non-pecuniary reasons such as a shared interest in solving a problem or to show off their coding skills.

Open-source public ledger platforms attract programming contributions just as other open-source projects do. However, the open-source public ledger platforms require another class of participants—the laborers who perform transaction processing—that require pecuniary compensation as an integral element of the protocol.

So the bitcoinesque platforms are neither fish nor fowl.  They aren’t entirely open-source given their need to have a paid decentralized labor force. They aren’t normal business organizations—either profit or for-profit—because they don’t have much hierarchy of governance structure.  This could be a wonderful new organizational form that no one ever thought of before. Or it could just be nuts.

I mention these distinctions between public ledger platforms concepts and related concepts not to suggest that these distinctions are good or bad. The point is that one must be very specific about what public ledger platforms are and avoid reasoning using improper analogies.

It’s Really about the Protocol and the Container

In the next several articles I am going to go into the economics of the bitcoinesque platforms.  To cut to the chase, though, whether any of these platforms will succeed really come down to two key questions. And, one of those questions isn’t whether the coin can become a popular currency. No one should bank on that happening and I doubt many serious investors are placing bets on that outcome. So here’s are the questions that I think most serious people are debating today:

1. Could the decentralized public ledger provide a superior way of running the financial system?
2. Could the container become a vehicle for carrying a wide range of financial assets such as currencies, stocks and bonds, derivatives, conditional contracts, and more?

With two “yesses,” we could be standing before the most profound revolution in financial services since the Venetians. With two “no’s,” we may look back on the bitcoin as the Kim Kardashian of payments innovation.