Tuesday, November 19, 2013

More Than Money, But Don't Get Too Caught Up

A couple of view points about Bitcoins. First, an excerpt from a Reason.com article, which makes some valid points. Second, a more sanguine take from Santolli. My take, Bitcoin have potential but the illiquidity of the market, lack of ubiquitous acceptance, and the uncertainty of what that potential leave me an observer.

Via Reason

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.

Another possible application of the protocol is to power decentralized crowdfunding without third-party intermediaries such as Kickstarter or Indiegogo. Bitcoin transactions can be structured in such a way that they are not finalized until the recipient has received a certain predetermined amount. If an entrepreneur promises to work on a project or produce a good if he raises a certain amount, contributors can pledge their support in any amount safe in the knowledge that Bitcoins will not leave their wallets unless and until the entrepreneur receives sufficient pledges to meet his goal.

This would make crowdfunding cheaper than it is now. Kickstarter, for example, takes 5 percent of the funds raised through its service. It would also make crowdfunding more resistant to censorship. Last year, Indiegogo suspended Defense Distributed's campaign to raise $20,000 to develop schematics for a 3D-printed plastic firearm. Using the Bitcoin protocol, there is no central authority or middleman that would have the power to suspend unpopular crowdfunding campaigns. (For more on 3D-printed guns, see Brian Doherty, "The Unstoppable Plastic Gun," page 24.)

Bitcoin's potential is not limited to transactions. One non-transactional use of the technology is as a decentralized notary service, allowing anyone to verify that a particular document existed at a certain point in time. Say you've written a movie screenplay, and before you shop it around Hollywood you want to record that you had it first. To accomplish this, you can add the document's cryptographic signature to the blockchain, the Bitcoin public ledger. If someone ever were to claim the screenplay as his own, you could point to the blockchain to prove you had it first. The website ProofOfExistence.com is a first attempt at creating this kind of service.

Another non-transactional application of Bitcoin is being developed by Joe Cascio, a semi-retired software engineer living in Connecticut. Cascio calls his innovation "collateralized identity," which he initially developed to address the problem of sockpuppetry on online forums. Because creating new accounts on online services is often free and easy, one individual can conjure up many different identities and use them to harass, spam, or otherwise annoy other users. Suspending sockpuppet accounts does little to address the problem because a malicious user will simply create new ones in their place.

Online forums have tried to defeat sockpuppetry by requiring account holders to use their real identities or by allowing pseudonymous usernames but charging a membership fee to deter one person from creating more than one account. But Cascio has developed a system allowing users to log into websites pseudonymously using Bitcoin addresses. What this means is that a website owner can restrict who can create an account based on the user's current Bitcoin balance, or even her balance history.

For example, a site might require that new users must have at least 30 days of a continuous balance of the Bitcoin equivalent of $100 associated with the address he is using for his ID. That $100 is not a membership fee you have to pay, only an average balance one has to carry for each account. That makes multiple accounts a very expensive proposition for malicious users, while remaining inexpensive for average users. Only because Bitcoin's ledger is public can the site verify that a user does indeed meet its collateral requirements.

"The fact that you can observe the history of a Bitcoin address is important because it means that you can't play Three Card Monte with IDs," says Cascio. Otherwise, a malicious user might simply move money around to different Bitcoin addresses before creating new accounts.

While Cascio only intended to address the sockpuppet issue, he has since discovered that his invention essentially leverages Bitcoin to create pseudonymous identities tied to something akin to publicly verifiable "credit histories"-something that has potential implications far beyond blocking Internet jerks.

The bottom line is that the Bitcoin protocol has the potential to be much more than just digital money. It is a platform for financial and informational innovation open to anyone and everyone, with no requirement to obtain a permit.

Bitcoin vs. the State
The potential benefits Bitcoin can bring to liberty and the broader economy are profound. But such a system obviously threatens the authority of the government. Just the few examples mentioned in this article touch on the regulatory jurisdictions of the Treasury Department, the Securities and Exchange Commission, the CFTC, the Consumer Financial Protection Bureau, various state regulators, and the Internal Revenue Service, for starters. Such entities are beginning to mobilize in response.

The state's main concern at the moment is that Bitcoin could be used for money laundering, for financing terrorism, and for trading in illicit goods. Traditional payments networks, such as PayPal or Western Union, are subject to the Bank Secrecy Act, which requires that companies verify customers' identities, keep records of financial transactions, and report suspicious transactions. This data facilitates investigation and prosecution of money laundering and other crimes. Because Bitcoin is a decentralized network, the government worries that no one is responsible for identifying users and reporting transactions.

While it's virtually impossible to regulate the Bitcoin network itself, many new businesses are now emerging to facilitate consumer adoption of the currency. Those companies will certainly be subject to regulation. For example, if you would like to convert dollars to Bitcoins, you could find a stranger on Craigslist willing to trade and meet him at a coffee shop to make the exchange. Such a transaction is virtually impossible to regulate, but it's also not very consumer-friendly.

As a result, there is a slew of venture-capital-backed startups setting up easy-to-use online exchanges, as well as so-called "wallet services" that help one easily store and spend Bitcoins, and processors that help merchants accept payment. These new middlemen of the Bitcoin ecosystem are just as susceptible to regulation as existing banks and other third-party payment networks.

In March, the Treasury Department's Financial Crimes Enforcement Network (FinCEN) issued a regulatory guidance determining that the businesses now developing Bitcoin's consumer infrastructure are to be classified as money transmitters who must register with the agency and comply with existing recordkeeping and reporting requirements. More onerous regulation will likely come from states that require money transmission businesses to be locally licensed before they can operate.

Today, a company that wants to launch a new Bitcoin exchange would have to spend at least $1 million dollars and labor for more than a year acquiring 48 different licenses before it could open for business (according to various entrepreneurs and compliance officers associated with the industry), since 48 states have their own money-transmitter license requirements. In August, New York State's Superintendent of Financial Services Benjamin Lawsky subpoenaed two dozen Bitcoin-related businesses to gather more information about their operations, and he is now conducting an inquiry to determine how to regulate virtual currency businesses.

What has struck some of Bitcoin's more ideological backers-who cherish the currency as a system apart from, and perhaps even against, the state-is how eager and willing these Bitcoin-ecosystem companies are to comply with regulators.

"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.

Contrast that with the comments, at least from an investment/speculative perspective from Santolli.

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