Getting paid in bitcoin

Here in Finland the tax authority (called Vero) keeps very close tabs on everyone's income. Banks report loan amounts and interest on savings directly to Vero. And Americans are usually shocked to find that everyone's earnings are publically available - that's right: provided you speak Finnish you can look up how much your neighbour claimed to Vero that they earned, and how much tax they paid (and subsequently you can shop them in to the authorities if they bought sports cars and foreign holidays whilst declaring a low income).

Let's forget about clandestine payments for a moment (in any case they are trickier than the media seems to think, and company accounts are in any case transparent up here).

So, if people start getting paid in bitcoins, what are the Finnish tax authorities going to do? Presumably they're going to demand that

• Bitcoin amounts earned are declared along with the euro to bitcoin rate on the date of payment
• Income taxes are paid on that amount
• When bitcoins are converted to euros, any profits are taxed at capital gains rates
• And alternately, any losses can be offset against other tax payments

But what happens if the bitcoins are never converted to euros, and are used to purchase goods instead? Someone might be paid 100 BTC today, at 100 EUR/BTC, and use them in 5 years time to buy a high performance sports car if the new rate is 10,000 EUR/BTC at that point. And Vero are going to want their share of the profits...

The only feasible solution I can see is for governments to move away from income tax and capital gains taxes, to a purely "value added tax" or "sales tax" approach, with different rates for essential goods such as staple foods (sales tax free?) and 50 foot yachts (50% 90%).

The perception of money

Back before I started looking in to Bitcoin, I'd watch television shows where gangsters or spies would be carrying around a suitcase filled with blocks of cash, and I'd think, "Wow, what a lot of money. That could get you a large house, or a sports car, or perhaps a small island off the coast of Greece."

Now when I see the same suitcase I can't help thinking, "Wow, a bunch of paper, printed by a government, valuable because people think it's valuable. And not as valuable now as it was when the program was being filmed."

Bitcoin has really damaged my suspension of disbelief. It's funny to think that for four decades I never really though about what cash actually was. Like most people, I just used it to buy groceries, and implicitly assumed it would be as valuable tomorrow as it was today.

That's why I think Bitcoin is going to be a game-changer: just like the internet, just like affordable cars, and just like the electric lightbulb. But with Bitcoin the real impact is yet to be seen.

"Pegging" Bitcoin to another measure of value

As the problem of Bitcoin's fluctuation in value over time continues to vex proponents of the cryptocurrency, I've seen several suggestions that Bitcoin should be "pegged to the dollar" or "pegged to gold".

What does it mean for a currency to be "pegged to gold"? It means that the government that backs the currency commits to exchange units of the currency for a fixed quantity of gold. This has a number of problems associated with it - the quantity of gold is relatively fixed (just like Bitcoins), but the government can always print more money. In practice the pegged currency has to be rather stable in the first place for the pegging to be successful, and the value has to be controlled carefully through printing more or buying it back with bonds.

And there we can immediately see the three problems in the "pegging" solution proposed for Bitcoin - a) you can only peg a non-volatile currency, b) you need to be able to control the production of the currency to affect its value and c) you need a backer who guarantees to exchange the currency for the item it's pegged to, and holds significant quantities of the item in store.

Bitcoin satisfies none of these.

What Bitcoin really needs to take off ...

Mt Gox gets slapped with a law suit by Coinbase, and the value of Bitcoins drops by 50%. The fact that Bitcoin's price (not value, note) is so dependent on one exchange is becoming a real problem, although there are probably some people making a fortune of the vast fluctuations. However, they're gamblers or insider traders. For the rest of us it's a dark art, and it's disturbing.

As I see it, there are two things that need to happen in the near future.

1. An established share trader like etrade.com needs to start offering a Bitcoin exchange. It should be trivial for them to set something like that - Bitcoin is still small potatoes compared to the trade volumes they handle, and their existing software and servers should be easy to convert to offering a Bitcoin exchange service.

2. A large generalised online retailer needs to start accepting them. If PayPal (and hence eBay) really takes them onboard, as was recently reported, or Amazon, or a far eastern retailer like Alibaba, then people can actually start buying stuff with them

At that point I would expect the value of one Bitcoin to steadily rise and rise and rise.

(I sold my Bitcoins at $138 a while back, watched the price rise, panicked and then bought them all back at $132. If only I'd waited one day more, I'd have 50% more. Oh well.)

Bitcoin in the eyes of the establishment...

From http://www.ft.com/intl/cms/s/0/55733b80-addf-11e2-a2c7-00144feabdc0.html

... at the New York branch of the Federal Reserve, which held a gathering this week for some of the grandees of financial regulation. When one person asked if Bitcoin could become a viable unit of international exchange, participants burst out laughing.

I actually find this rather encouraging for Bitcoin. Record executives had the same opinion about mp3s, back in the early days. Similarly, the world wide web was considered a "flash in the pan" by those who should have known better.

Bitcoin as money

The role of money is threefold:

1. a store of value
2. a medium of exchange
3. a unit of accounting

How does Bitcoin currently measure up on these three counts, and how will it progress over time?

As a store of value

With the current fluctuations in Bitcoin prices, and the general air of uncertainty and unpredictability surrounding it, the jury is still out. Bitcoin could collapse completely in a week, or in five years time they could be worth a small fortune each. Unlike gold, Bitcoin doesn't have a long history to give investors a sense of security. As such, Bitcoins are more like tech stocks at the beginning of the dotcom boom. If they end up like Amazon shares, then Bitcoin hoarders will be laughing all the way to the bank, or rather, not to the bank as you don't need a third party to hold them for you. But if they end up like all the failed dotcom enterprises then it's game over. However, unlike flooz.com or beenz.com, Bitcoin actually offers something new - a secure and cheap method for almost instantaneously transferring wealth from one person to another.

So perhaps currently Bitcoin only scores 4/10 on this count.

As a medium of exchange

Once you have your online wallet set up with a service like blockchain.info's wallet service, or with the canonical Bitcoin wallet program, transferring coins is simple - enter a destination address, an amount and click send. QR code scanners, NFC technology and possibly in the future Bitcoin ATMs and POS terminals mean that Bitcoin should be as easy, or even easier, than using a credit card. No need to type in billing addresses, expiry dates, CRC codes or a "verified by Visa" password. And merchants should be happy with the absence of chargebacks and high transaction fees. The "six verifications and the transaction is secured" means that they can be used to pay for expensive items like cars or houses, whereas a coffee or hot dog vendor would presumably not worry about the risk of a $3 double-spend.

However, the lack of price stability means that the main risk in using Bitcoins as a medium of exchange is that both buyer and seller will be worried that the value of the exchanged Bitcoins will be dramatically different the day after the exchange. Converting them back to dollars or euros immediately after the transaction is the only current defense until prices stabilize. 

So 5/10 on that count.

As a unit of accounting

This function of money is really an extension of the previous section. And again, Bitcoin perform woefully. Although you can instantaneously compare the value of different goods to each other, a television or tablet computer priced at 3 BTC one day might need to be priced at 6 BTC or 1 BTC a few hours later. 

So 1/10 for this one.

Conclusion

Bitcoin scores a rather woeful 11/30 as a form of money at the moment. So why are people still piling in and investing hundreds, thousands or even millions of dollars in them? Because at the moment Bitcoin is not a form of money, it is an investment. Almost everyone investing in Bitcoin at the moment is a speculator. If, at some point in the future Bitcoin finds a stable price and becomes a world currency, then those who got in on the ground floor will be rich. As I write, you can purchase 1 BTC for about $130, but if as many people are using them in 2023 as currently use dollars or euros that investment should be worth at least $50,000. And the potential is clearly there - it just needs the infrastructure (being worked on by various start-up companies), publicity (which only started coming about three months ago), and general acceptance by the public resulting in price stability for that to happen. If each of these three events occurs, then we can add 5 points to each back-of-an-envelope scoring for the electronic currency. Bringing the new "money score" up to at least 26/30, which is much more respectable. 

So it's a gamble, but one that could pay off extremely well in the long run. Bitcoin is an opportunity for those without any real technical knowledge or skill to put down a small amount hard cold cash and have a large(ish) piece of the biggest thing since Microsoft or Apple.

And that's why I think the price of Bitcoin continues to rise over time.

MtGox and the DDoS attacks

There must be some hackers making a fortune of the repeated "distributed denial of service" attacks on the Mt Gox exchange site. A very simple process:

• wait for the Bitcoin price to rise
• sell your Bitcoins
• attack the site with a DDoS to bring it grinding to a halt
• stop the attack and wait for the price to drop
• buy back Bitcoins, increasing your holdings
• and repeat...

Fortunately the market seems to be learning that these attacks have no long term effect - the initial ones caused the price to drop significantly, but the last one tonight only caused a 10% drop. Hopefully eventually they will have no effect at all.

Response to JC

First set of comments on this blog so far! It's only fair that I should create a new post to discuss the points he/she makes, so here goes -

JCApril 12, 2013 at 2:05 AM

Yes but... one shouldn't compare Bitcoin to Visa, since Visa already operates with many currencies it could add Bitcoin to the others. They will jump on board if enough people start using it.

Thing is, anything that Visa can do for a 3% fee, Bitcoin to do for free. Although they could branch out into Bitcoin and provide the service to their many customer for the usual fee, claiming that the value-add they provide in convenience compensates for the charge. But the thing is, I can transfer cash via Bitcoin for a very low fee, regardless of the amount I'm spending. If I use my Visa credit card in a foreign country they take 1.5% of the value of the transaction - Bitcoin takes a 0.005 BTC charge, even if I'm buying a house or a car.

In practice, if Visa took Bitcoin on board, it would be brilliant for Bitcoin and all those who hold some.

Things I would need to see before I would contemplate serious use of Bitcoin / things I like about Sterling:

(1) Prosecutability: If someone steals my paper money I call the police. They do not have a great record on IP theft, so I don't expect them to quickly develop the skills and systems to deal with Bitcoin theft.

Indeed, there's a problem with pursuing theft. But what is their success rate in returning your money in the case of fraud, or burglary? And if you decide to store your savings in gold bars you're relying on the integrity and reliability of a third party. I don't know how computer literate you are, but Bitcoin provides everything out in the open, so if you really really want to be safe you can generate your own private/public key pair and put your life's savings in there. Using a "brain wallet" so you don't even have to write down the passkey. Tricky, but not expensive (compared to building a Fort Knox).

(2) Banking: fractional reserve banking is a bugbear for many people. But a currency that can expand and contract with economic conditions (via loans and investment) results in fewer economic crises than a metal-backed one. The countries that abandoned the Gold Standard first were the first to leave the Great Depression.

Again, this is a "do you trust the powers that be to do the right thing"? We effectively pay bankers a fortune to run the economy for us (being close to the money means you're going to get more of it - why didn't I realize this and go into finance!). But do you trust them to be looking out for the average person? Obviously they don't want total collapse, but they want to skim as much of the cream off the top as they can. And governments - is Osbourne's austerity policy in Britain really the right approach? Roosevelt's New Deal is supposed to have pulled America out of the Great Depression by spending more on public works - with the current situation in Britain the opposite approach is being pursued. If the politicians and economists can't agree on what is the right thing to do, perhaps putting control in the hands of individuals is worth a try.

(3) Central banking: If you have banking, you need a lender of last resort, and ideally a guarantee for (small) depositors. Wiping out depositors when a bank goes bust tends to undermine trust.

Trust again. Do you trust your government to not 

a) spend your children's tax payments on bank bailouts?
b) force you to hand over your savings (e.g. gold) at below-market prices?
c) declare you an enemy of the state and seize all your assets

All the above have happened in the last 100 years.

How about d) arbitrarily take 10% of your savings to re-balance the books? That nearly happened to the Cypriots (although they soon realized they'd pushed things a bit too far with that one).

(4) State backing: The pound in my pocket is really a token of the trust between me, the rest of the UK population and the UK government. I know the government will accept the pound as payment of my taxes. And that provides the incentive for the rest of the UK population to continue to accept pounds as payment for goods. Why would I switch a significant chunk of my trade into Bitcoin? Because I don't want to pay tax? The government would take a pretty dim view of that...

Indeed. Governments have also taken a pretty dim view of "starving people stealing food to feed their families", "the abolishment of slavery", "the working class voting", "women voting", "homosexual relationships".

Why not remove income tax, and increase VAT? Pay tax on what you consume, and tax luxury items higher.

Ultimately, I see Bitcoin as a game changer, like MP3s were to the music industry, or VCRs to the film industry. Governments and banks hit heavier than film or record companies, but I think the genie is out of the bottle. Let's sit back and see how they handle it (at the moment they don't seem to have seen the storm front looming on the horizon. I expect  that's going to change in the near future).

Hypothetical question (about the destruction of Bitcoin)

Imagine you were a computer-literate mathematician with a software testing background, who came up with a complicated but ultimately guaranteed method for bringing about the total collapse of Bitcoin. What would you do?

* Inform the Bitcoin development team of your discovery? What if the flaw was irreparable?

* Inform the CIA/IMF/a major bank, or some other entity who might want to bring the whole system down, in order to make some money from it? But how would you broker the deal?

* Announce it in public, in order to become famous (or infamous - messengers of the bad news are often blamed for the bad news)?

* Something else?

I'm curious. Hypothetically, I hasten to add.

What does "theft of a Bitcoin" mean?

The British legal definition of theft is defined in the Theft Act of 1968 as follows: "A person is guilty of theft if he dishonestly appropriates property belonging to another with the intention of permanently depriving the other of it"

Just because Bitcoins aren't tangible, doesn't mean they aren't "real" in some sense - they are as real as a bank balance number. And stealing applies to illegally transferring money from one bank account to another, even if the transfer is data rather than actual bank notes. So the definition applies.

Obviously hacking into someone's computer, taking their private keys, and using them to transfer Bitcoins into your own account is not just theft, it involves the crime of breaking into someone's computer too.

But what happens in the very unlikely event of guessing someone's private key. Well, apparently finding and keeping something that isn't yours can also constitute theft. It's called, unsurprisingly, "Theft by finding", and is a criminal act. So if you manage to guess a password you have to go to reasonable lengths to find and inform the actual rightful owner of the Bitcoins. Or just leave them there.

Of course in practice it could be argued that if a simple web search doesn't associate the public key with an identifiable person you've done your bit. And in any case, siphoning out the Bitcoins followed by laundering them through a Bitcoin mixer service would make tracing a thief almost impossible.

There really is a market for a reliable and responsible service to secure your Bitcoins. Something like a traditional bank, perhaps?

Winklevoss twins and their investment

About a week ago the news was full of reports that the Winklevoss twins (two guys who made about $200M by winning a legal case in which they claimed that Mark Zuckerberg stole the idea of Facebook from them) have put $11M of their cash into Bitcoin. Which, ironically, they are storing on USB drives in various traditional bank vaults. All very well. But I hope that they've put another large sum into Bitcoin company development. Their investment is going nowhere if merchants don't start accepting Bitcoin, and that means that a whole slew of companies dedicated to Bitcoin services need to spring up to fill the need. That takes venture capital these days. I haven't seen any reports on the latter though.

Of Tulips and Bitcoins

Bitcoin has so far been through two crashes. One when the price suddenly rose from $1 to $32, only to collapse back to $5 a short while later. The second when it suddenly rose from $5 to $270 only to crash back down to ... let's see: about $110 a short while later.

Tulip mania, on the other hand, resulted in tulip bulbs rising from fl 1 to fl 200 over six months, only to collapse back to fl 1.

Bitcoins are still selling for over 20 times the original price. Either the bubble is still well in progress, or the spikes in price are just that - spikes, with the underlying price rising steadily.

As someone who thinks that Bitcoins are one day going to be incredibly useful (and as someone who never thought tulips were especially useful), I fail to see the comparison between Bitcoin and tulips as relevant.

Although of course only time will prove me right, or wrong.

Bitcoin miners

In the previous post I asked the question, "Why would anyone spend valuable electricity and computing power to validate a block in the blockchain." The answer is this - if you are the first person to validate a block, i.e. find a hash of the current unverified transactions floating around in the Bitcoin network together with the previous block's hash and a salt that is lower than the current "hash difficulty number" then you get to include a transaction in the block that magically assigns some Bitcoins to your own Bitcoin address. So there's a reward for being the first to create a new block.

Now to explain the difficulty: the hash that needs to be found to validate a block has to be smaller than a certain number. This number is set by looking how long it took to validate the previous 2016 blocks. If they were found too quickly then the difficulty increases, and if they took too long to find then they difficulty decreases. In practice the formula is set so a block is expected to be verified every 10 minutes.

People who are trying again and again to create the next block are called "miners", but perhaps "verifiers" would be a more accurate term. If you've followed the Bitcoin news reports you'll know that the reward used to be 50 Bitcoins for each block, but it halves every 4 years, so now it's 25, and in four more years it will be 12.5, and so on until the reward is so low it's 0. That will happen in about 2140. The upshot of this is twofold: a) the supply of Bitcoins is increasing over time, and b) the rate at which the supply increases is decreasing so there will never be more than about 21,000,000 Bitcoins in existance.

Over half of the Bitcoins that will ever exist have already been created. And they're in the hands of the early adopters that started playing around with Bitcoin before most people had heard of them. Satoshi, as the first Bitcoin miner probably has over two million of them[1].

Personally I think he deserves every single one.


1: 50 Bitcoins every 10 minutes over about two years, before other people really got involved, means 50 * 6 * 24 * 365 * 2 = about 5 million.

The blockchain

Now we can move on to the central feature of Bitcoin - the blockchain. The best way to imagine it is as a digital ledger - a book where each page contains the transactions that took place. You see, your Bitcoins don't actually reside in your Bitcoin address. It's the fact that the blockchain, a digital file which records all the transactions that have taken place, says that your Bitcoin address has a number of Bitcoins associated with it. Without the blockchain, your Bitcoin address is just a large meaningless number.

Just as a ledger has pages recording incoming money and outgoing payments, the blockchain has blocks - each block is like a page. The first page was created by Satoshi Nakamoto to kick the whole thing off. But there is a difference between a ledger and the blockchain - each block has been validated, and is linked to the previous blocks.

So how does this validation of the transactions in each block work? Well, remember the hash functions I talked about in the previous post? Each valid block consists of three things: the transaction list, the hash of the previous block, and an extra bit of data added to the transaction list called a "salt" (a kind of padding) that together when hashed give a result that is below a certain number that is smaller than "the difficulty" (we'll talk about that later) - in practice this means that the hash number starts with a lot of zeros. It takes many many hashing goes with different "salts" before a suitably small resulting hash number is obtained. This means that to rewrite history requires recalculating block after block to generate a blockchain that is valid. That's a lot of work.

Next post: why would anyone spend valuable electricity and computing power on validating blocks?

Hash functions - one of the key concepts Bitcoin relies on

Before you can truly understand the mechanics behind Bitcoin, you need to know what a hash function is. It sounds complicated, but it's not.

A hash function takes some data (like a page of text from a book) and turns it into a smaller fragment of data (like a number). If someone else takes the same page from the book, and uses the same hash function, they are guaranteed to get the same output number.

Using the same idea, here is an example of a hash function: counting "a" as 1, "b" as 2, "c" as 3, and so on, turn all the letters on the page of the book you chose into number. Then add all the numbers together. That final number is the "letters to a number hash" of your book page. Let's call this hash function LTN.

So for example, what is the LTN hash of "a cat"? 1 + 3 + 1 + 20 = 25. Simple. The number you'd get from hashing the 32nd page of Lord of the Rings would be a bit longer, but still just as simple to calculate. It would probably take you a couple of minutes, and a computer program could do it in microseconds.

Real hash functions as used by Bitcoin are quite a bit more complicated - the two used are known by the names SHA256 and RIPEMD-160.¨You could apply them to some data by hand, but it would take a long time. And the other thing is that the chance of you finding two pages of a book that each gave the same SHA256 hash output is extremely unlikely. You certainly wouldn't be able to do that by hand.

But why would we be interested in hash functions? There are a number of reasons, but the main thing is that it's easy to calculate the hash of a bit of data, but it's hard to find a bit of data that gives you a given hash. The example I've given isn't too hard - if I said "find some data that gives you a LTN hash of 26", looking back at the previous example you might suggest "a cbt". Or perhaps "z" if you're a bit smarter. But with SHA256 finding a piece of data that gives you a specific hash is really really hard. And finding two pieces of data that give you the same hash is therefore even harder.

Technical note: SHA256 takes as its input some binary data, and outputs a 256 bit number (i.e. any given piece of data, when run through SHA256, gives a number that is between 0 and about 1 followed by 77 zeroes. If you use hexadecimal notation to represent this, it's 64 characters long.)

Criminal organisations and Bitcoin

The press seems to delight in repeating the fact that Bitcoin is used to buy drugs and guns anonymously, and that criminal organisations are probably using it to transfer wealth between each other and amongst themselves. The former is not unique to Bitcoin - all cash currencies are used to buy banned goods and substances. The latter may actually be good for Bitcoin.

If, for example, drug cartels, mafias or international gangs find that transferring and storing the profits of their activities is easier and safer using Bitcoin than suitcases of cash, gold bars, or corrupt banks, then they will have a vested interest in keeping the system up and running. It could even be worth their while to track down other groups that are destabilising the Bitcoin network such as hackers and profiteers, and shutting them down.

Criminal organisations often invest their gains in legitimate businesses, partially for money laundering purposes, and partially because legal activities can also make profits. It's possible that even now they are working towards improving Bitcoin accessibility, reducing volitility, and encouraging its wider use in society.

As I see it, the biggest threat to Bitcoin is not the criminal element. It's legitimate governments, fearing a change in the current status quo.

Bitcoin tutorial

Here are some of the websites and processes I use to handle bitcoins:

https://blockchain.info/wallet/

The easiest way to handle your Bitcoins is to sign up with an on-line provider. I use blockchain.info's wallet for holding small amounts of Bitcoin and moving them about. It's a useful site because it allows you to explore your transactions (and other people's transactions too). It's fairly useble and self-explanatory.

https://intersango.com/

This is the first site I used to buy Bitcoins. I used a SEPA transfer to send cash there, and it only took a couple of days for the cash to turn up on my account. There are sometimes problems transferring Bitcoins out - if the outward transfer doesn't happen within a couple of hours, cancelling it and trying again seems to work.

The site used to have nice charts in the buy/sell section that showed how many people were "asking" for Bitcoins and how many were "selling", but now there's just a table of orders. Don't go with the rate that the "buy" recommends - scroll down to the table and see what the lowest "sell" offer is and bid at that rate. The "buy" recommendation is always higher than it needs to be. Trading fees are 0.65%, and Bitcoins you hold can be transferred out for free.

https://mtgox.com/

Mt Gox is the main trading site. I haven't transferred cash to them, so don't know how well that works. However, as the largest volume trader, they kind of set the benchmark for the "value of a Bitcoin at the moment". I've traded between dollars and Bitcoins, and paying Bitcoins into your account is easy and fairly fast (about an hour, as they want 6 confirmations of the transaction). Fees are 0.65% but drop for each transaction until you hit 0.5%.

https://www.bitaddress.org

This is a useful site for generating a "paper wallet" to store larger quantities of Bitcoin (which I unfortunately don't have). You can load the site, disconnect from the internet, generate some Bitcoin public/private key pairs and then print them out on a piece of paper. They end up looking like nice certificates, which you can store in a safe or in a filing cabinet, to be redeemed on a rainy day. You can load up the public key (your so-called Bitcoin address) with Bitcoins from your Intersango or Mt Gox purchase, and when you want to redeem them go to blockchain.info and enter your private key in your wallet to be able to spend.

Caveat Emptor: there are always risks involved in using third-party sites, which all of the above are.

Mt Gox should be reliable as they handle a lot of trading traffic, but on the other hand they are the highest profile Bitcoin target there is for hackers.

I don't know how reliable Intersango really is (there are some complaints on the Bitcoin.org forums), but I've never had any trouble with them.

Blockchain.info is well established too, but other online wallet providers have been hacked, and when they are people's Bitcoins go missing - sometimes forever. There is no Government-backed or bank backed insurance policy, so you're on  your own with Bitcoin.

I looked through the bitaddress.org javascript source code and couldn't see anything fishy (no AJAX or POST code to send your private address back to the site owner, and nothing that suggested the Bitcoin keys were being made from a limited address pool that would be vulnerable to brute-force cracking). However, as a live site it could always be changed from one minute to the next ...

Is the hoarding of Bitcoins really a problem?

A big deal is made out of the fact that more than three quarters of Bitcoins are not in circulation. Only about 28% are used in transaction. Now, ignoring the fact for a moment that perhaps a large proportion of the 28% are being moved between addresses held by the same people, and are therefore not really being used (a bit like a multi-millionare moving his or her funds between bank accounts), is this "hoarding" really a problem?

Well, this Wikipedia page claims that the top 5% of Americans hold over 50% of the wealth. Presumably they're sitting on most of it - so over half of American wealth is being hoarded. And the top 20% hold 85%, which is remarkably close to the Bitcoin hoarding figures.And yet the US economy keeps ticking over nicely.

Suddenly Bitcoin hoarding doesn't seem like so much of a problem to me.

News articles about Bitcoin

I find myself googling daily for news articles on Bitcoin, usually in the evening when there's nothing interesting on television.

The problem is that most articles tick one or more of the following annoying habits:

• Reporters who puts the something similar to the following sentences in the first paragraph: "Bitcoin is a decetralized peer-to-peer cryptocurrency" and then proceed through various clueless statements to indicate that they have no idea what Bitcoin is really about.
• Articles with the sentence, "They can be used to buy anything from socks to drugs" in them. No doubt in a year's time it will be "They can be used to buy anything from socks to drugs, to even houses and sports cars."
• Stories that focus entirely on the fact that "Bitcoin has risen spectacularly to $xxx" or "Bitcoin has suffered a crushing collapse back to $yyy." You can almost guarantee that by the time you see the story the opposite has since happened.
• Those "Ho ho ho, I have no idea what these things are, and I have no interest in finding out given that I barely managed to scrape together a degree in the Liberal Arts and they seem to involve mathematics and computers, but my editor has given me 200 bucks to try them out, so here goes..." stories.
• Articles that claim that the current boom in Bitcoin is entirely due to the threatened bank account tax in Cypress that never materialised.

No doubt more will be added to the list as time goes on.

Intrinsic value? Fundamentals? Utility? Do these terms make any sense in relation to Bitcoin?

In a recent Bitcoin article I read that one Chris Cook, a senior fellow at UCL’s Institute for Security and Resilience Studies is claimed to have stated[1]: " Since it has zero utility (use value over time), the intrinsic value of bitcoin is zero."

What does this sentence mean?

From Wikipedia: "In finance, intrinsic value refers to the actual value of a company or stock determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value."

Hmm. How about utility? Wikipedia again: "In economics, utility is a representation of preferences over some set of goods and services."

And fundamental analysis? "Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets."

But Bitcoin is not a business, aiming to increase shareholder value through gaining competitive advantages over its competitors and markets. The jargon in all these statements applies to the economics of businesses.

Try looking at it this way:

 "Since it has zero utility (use value over time), the intrinsic value of language is zero."
 "Since it has zero utility (use value over time), the intrinsic value of music is zero."
 "Since it has zero utility (use value over time), the intrinsic value of algebra is zero."

Those sentences make no sense either? But does anyone really think that words, music, or mathematics have no value? Bitcoins aren't businesses. They're like the http web protocol, or asymmetric key cryptography - a tool. They just happen to be a tool with a clear dollar price attached to them.

And now imagine that only 21 million people in the whole world were able to use words, or write down chords and notes, or were able to solve quadratic equations (actually, that last one might be true). With such scarcity, the value of language, music and algebra would be astronomically higher. Possibly as high as $5,000 or $50,000 dollars per word/note/equation even.

[1] I can only find two references on the web that he actually said this, so perhaps he didn't.

How safe is your wallet?

Something that must be giving those who hold large quantities of Bitcoin nightmares is the fear of losing them (although I wish I had enough to warrant such nightmares!). Unlike a standard bank account, if you lose your Bitcoins then they tend to be gone. Transferring them to the wrong address, losing your private key, or having your machine hacked and the coins transferred out by a thief to their own address are things that have all happened to some Bitcoin holders out there at some point. So what can you do?

1. For the least paranoid, and those with not much to lose, or without much technical knowledge - sign up to a third party wallet service such as blockinfo.com, or keep your coins in an exchange such as mtgox.com or intersango.com. If you pick a good login password, and the site remains reliable, you'll be fine. And if you forget your password the last two of these sites will send a new one to your registration address.

2. If you're slightly more paranoid, or don't want to give control to a third-party service, install the Open Source Bitcoin Client - see bitcoin.org for details. Then you're trusting the developers of the client that they're reliable and thorough. In the past they didn't encrypt the wallet.dat file with their program, so it just sat on your machine in plain sight, and as a result anyone with physical access to your computer or anyone who managed to get a trojan program onto it could steal them, and the latter did indeed happen. The developers expected people using their code to have enough technical knowledge to encrypt the key file themselves, which turned out not to be the case. Who knows what the next loophole that thieves will exploit might be?

3. Going up a notch - use a site like bitaddress.org or the vanitygen program (google it) to generate your public bitcoin address and associated private key, print it out, and store it somewhere safe. Move any coins you mine or buy to that address as a relatively secure holding place. Hope that there isn't a back door that posts your private key back to the original developers.

4. One step further - as for suggestion 3, but disconnect your computer from the internet after downloading the code. And hope that the developers of the site or program haven't done something like ensure that it generates a limited subset of private keys which can be tried out simply by a brute force attack - this leads to ...

5. As for 4, but then learn to program and review the code yourself to feel truly secure.

Of course, you could buy a laptop, never connect it to the internet, write your own key generating software, and use that to create your keys. And lock the computer in a safe when you're finished, after copying the public address out by hand and loading your coins onto it. But then you'll always have to worry that you made a mistake in your code, and the wrong public address was generated.

Oh what a problem it must be to hold thousands of Bitcoins!

Block mining delays and price drops

I noted tonight that there were two large price drops on Mt Gox - on around 18:50 to 19:00 (130 dollars down to 120 dollars), and another at 20:30 (from 125 dollars to 115 dollars). Coincidentally at the same time, there were significant delays in the verification of blocks at those times - in the first case it took 23 minutes between blocks (usually it's 9 to 10 minutes), and in the second case a whopping 28 minutes.

I wonder if the delay in verification causes the price drop? It might be worth keeping an eye on.

Update: no, it seems to be linked to a DDoS attack on Mt Gox. This is why having one exchange dominating Bitcoin trading is a bad idea.

How fast should Bitcoin be rising?

I keep coming up with a lower estimate for the value of a bitcoin of about $5,000, and upper limits of around $50,000 (see previous posts). A very simple calculation based on the assumption that Bitcoin should hit its stable value in a decade results in a minimum rise of ten dollars a week.

Suddenly the rapid rise in Bitoin prices doesn't seem so crazy...

Bitcoin comparison with Visa

Some time in the (hopefully not too) distant future, Bitcoin could well rival payment card systems such as Visa and Mastercard - especially if simpler Bitcoin payment systems are developed. This means that we can produce estimates of what Bitcoin should be worth when mining rewards are reduced and the incentive to participate in the blockchain validation process is based more on transfer fees and less on the mining reward.

A quick search online shows that Visa, for example, made $2.73 billion last year in revenue. Presumably most of this came from the 2-3% payment charge they levy on each card transaction. If we make a few "back of an envelope" calculation assumptions - the sum of the 0.1% transaction charges for Bitcoin could be as much as $150 million a year at some point. At about 50,000 block verifications a year, that comes to an average of $3000 verification rewards per block, on $3 million's worth of transactions every block.

At the moment most Bitcoins appear to be being held, or traded on exchanges. If Bitcoin is to become adopted as a form of currency rather than a speculative asset, then lets make the modes assumption that 10% of Bitoins circulate in any one year, covering the same movement of cash as Visa currently does. That's about $150 billion a year according to my calculation. (There is a flaw in the assumption that follows) So 10% of Bitcoin could be worth $150 billion, making the total market cap of Bitcoin $1.5 trillion.

That would value one Bitcoin at about $70,000.

Cyprus and Bitcoin

The news for the last few weeks has been that the latest embodiment of financial crisis in Cyprus is causing Cypriots to buy Bitcions, and this is part of the reason Bitcoin prices are rising. This seems extremely unlikely to me.

Agreed - the situation in Cyprus, where ordinary citizens woke up to find the threat of a 10% deduction on their bank accounts, subsequently causing a run on the ATMs, is draconian for recent times. It's not unprecedented though - throughout history governments and kings have arbitrarily seized people's assets . But it's been a bit of an eye opener for a lot of European citizens, previously living in a cotton-wool padded world where small bank accounts were presumed to be safe.

But why would Cypriots move from savings accounts to Bitcoin? It still takes a fair amount of technical or at least economical knowledge, and time as well, to set up a Bitcoin wallet, register with an exchange, and start buying Bitcoins. Unless people were flying in with laptops and printers to generate and hand over Bitcoin certificates to people in the market place (no reports of that), then mass-Bitcoin buying seems unlikely.

Furthermore, bank accounts were frozen. So how were they paying for the coins they were supposedly buying?

Finally, if as a Cyprus bank account holder, you managed to get your hands on your cash, why trade it in? You've got your savings. The rational response would be to hide it in a safety box somewhere, or just possibly convert it to something valuable and familiar like gold. Moving it to an experimental cryptocurrency still in its infancy seems like an unlikely choice.

And the same goes for the Bitcoin ATM story - in these uncertain times why would anyone in Cyprus insert the spare cash from their wallets into a strange machine to get Bitcoins?

Is Bitcoin a bubble?

A bubble is "a trade in products or assets with inflated values." Most people associate a bubble with rapidly rising prices of an asset or commodity without any rational underlying rhyme or reason, and the fear is that at some point the bubble will burst, usually leaving ordinary common people who got sucked into the bubble at the end with a worthless investment.

So, is Bitcoin a bubble? Three answers follow:

1. Maybe. You can never identify a bubble as a bubble until it bursts.

2. Yes. Just look at the rate at which the prices have been rising - that's unsustainable. Anything that shows its price doubling every couple of months has to be a bubble.

3. No. If Bitcoin ends up taking even just 1% of the currency market in ten years, it needs to be worth 100,000 dollars a coin at that point. For that value to be reached Bitcoin should be showing rapid value increase, especially in the early days.

Personally, I stand by answer 1. You only know what was truly worth investing in in hindsight. But if I'm honest I do lean a bit towards 3.

Is Bitcoin a Ponzi scheme?

There are frequent accusations on various blogs and bulletin boards, and in various news articles that Bitcoin is a Ponzi scheme.

A Ponzi scheme is a pyramid scheme in which the scheme operator uses money from new investors to pay old investors, and needs to keep recruiting further new investors in order to keep the money flowing. By its very nature a Ponzi scheme will eventually collapse because either the scheme will come to the attention of the authorities (who will shut it down), or the stream of new investors dries up because there's aren't any more suitable people to invest, and the money stream dries up.

Charles Ponzi, the person this kind of fraud is named after, was promising investors that he was buying food stamps in Italy at a low price, and selling them in the US at a higher price, thus making a profit. In actual fact he was doing no such thing, and the money from the increasing numbers of investors was used to pay fantastic "profits" to the older investors.

So how could Bitcoin be a Ponzi scheme?

Firstly, there is no operator. The Bitcoin system is open - the mathematical and economic ideas behind it are openly published, as is the block chain containing all the transactions, and no one controls the system.

Secondly, the Bitcoin system is not designed to take money from the newer investors and hand it over to the older investors. Bitcoins are a finite resource that are created at a steadily decreasing rate. Exchanges exist to give people who don't want to buy mining equipment or spend time setting it up the chance to buy them with cash. There's still a technical and capital threshold for setting up a profitable mining operation. It's comparable to gold - I don't want to go panning in Lapland or buying mining equipment, land and refining equipment to get hold of gold: it's easier for me to buy it (and I'm better at making money by testing software - my chosen profession). Similarly, a car mechanic or novelist or dentist who wants Bitcoins will want to buy them.

So claiming that because increasing prices mean early adopters of Bitcoin are somehow profiting from a Ponzi scheme is like claiming that gold, or even Beanie Babies are a Ponzi scheme.

That doesn't mean that at some point in the future the whole system might no crash (due to a fatal design flaw yet to be exposed, or an attack from a hostile government, or even a large meteor strike that takes out the internet). But the same risk exists if you buy Apple stock, or US dollars, or collectible stamps. If for one reason or another the public interest in any of these disappears, they collapse and people who invested at the end lose out. But that's a "bubble" - not a Ponzi scheme.

Will Bitcoin hit $100 soon?

Bitcoin has been gaining against the dollar in leaps and bounds recently. Will it hit $100 soon?

No. As we get close to the hundred mark, a lot of old-timers are going to start selling off their bitcoins for profit taking. This will cause the price to drop down (I would guess to somewhere between 60 and 80 dollars - I'd be surprised if it went down below 50 dollars). The level of trading is low, and the number of traders is low so a sudden change in trading activity such as approaching the 100 dollar milestone will have a profound effect on the price.

After a dip, people will start buying back in, so the price should bounce up back to the 90s again fairly quickly - within a few days or a week at most.

Update: this post was set to autopost on 30 March, but events got ahead of it. Looks like the 100 dollar dip happened earlier than I expected.

Why I think Bitcoin is currently like gold

I happen to think that Bitcoin is analogous to gold at the moment. Although the initial idea behind Bitcoin was that it should be a currency to buy and sell services and goods, what I've read about Bitcoin transactions shows that most Bitcoins are being held as an investment. Of the coins that are actually circulating, a few are being used to buy stuff, some are being used for gambling (mainly at Satoshi Dice), and the rest are being traded on exchange sites such as Mount Gox.

Similarly, most gold is stored in jewelry (50%), in vaults (40%) and only a little is used in industry (10%) according to Wikipedia, which as we all know is an irrefutable fount of knowledge. And although jewelry is attractive to look at (usually), most of it sits in jewelry boxes in cupboards, where no one can see how pretty it is. A gold plated necklace looks just as good as the 18 carat real deal, but people still buy the solid gold one, presumably because they get a kick out of knowing that it's valuable. As for usage - we have ten times what we need.

In uncertain times people transfer their money to safety - historically gold has been one of these safe havens. We've seen the gold price soar over the last five years with the arrival of the global financial crisis. Many pundits attribute the sudden rise in Bitcoin over the last few months to an increase in Southern European investors seeking somewhere to put their money in the light of recent threats by the Cyprus government to levy a 10% "tax" on all Cypriot bank accounts as a rather drastic measurement to overcome their deficit.

A Bitcoin private key that unlocks a hundred Bitcoins has little use if you're stuck on a desert island. But neither does a bar of gold. Both only have value in a society, and both only have value if that society thinks they are valuable. Gold has a long history as being considered precious - Bitcoin is a lot lot younger, but looks like it's heading the same way.

Then there's the obvious stuff - there is a limited supply of gold, and there's a limit supply of Bitcoin. Both are fungible - one gram of gold is like the next, one Bitcoin is like the next, and both can be subdivided (with the fractions retaining the fractional value and functionality of the whole),

So what's the real difference between gold and Bitcoin at the moment?

1. Bitcoin is a lot more volatile (but gold has been known to be volatile too)
2. Bitcoin is virtual and intangible, gold is real and tangible (more on that later though)
3. You don't have to worry that you've being sold a bar of tungsten coated in a thin layer of Bitcoin

What is value?

I've used the word "value" on several occasions in my previous posts. One of the great things about getting involved in Bitcoin is that it makes you question your understanding of concepts that previously seemed simple. The concept of "value" is one of those.

If you'd asked me a couple of years ago "is a golden ring valuable" or "is a 100 dollar bill valuable" I would have answered "yes" without a moment's hesitation. Now I'd be more likely to say, "well, it depends."

Here is how I see value now (and apologies for re-inventing centuries of philosophy):

Some things have innate value, because people need them. Clean drinking water. Food. Medicine. Housing. And in Finland - heating. Without these things our lives are dramatically shortened. And yet ironically, the more important the item with innate value, the cheaper it is in Western civilisation. There seems to be a drive in civilisations to reduce the cost of essential, innately valuable items. Without water you can survive three to five days, and yet clean drinking water costs cents per liter in Finland (and I flush most of it down the toilet or use it to wash  my clothes). And although every one is complaining that food is terribly expensive these days, for survival you just need a bag of rice or potatos (one euro per kilo), and some fruit and vegetables (cabbage, carrots or cheap apples are also a few euros per kilo), Medicine and housing are more expensive (actually, health care is an odd one, which possibly needs more discussion). But when I look at the breakdown of my own family budget I find that the quicker we'd all die without it, the less we spend on it.

Other things seem to have value because we want them. Nice cars. CDs or DVDs. Gold rings. But without them you'd still live to see another day. They're considered valuable because they reduce boredom, or because they give us some kind of satisfaction. Personally I've felt a strange desire to have the latest computer gadget, or technological toy at some gut level even though I've known at an intellectual level that it wasn't going to really give me any kind of real lasting satisfaction. It's like the desire of dragons in fantasy novels to obtain and hoard gold - they have no real need for it, but they feel compelled to have and hold it. Similarly, a Lada is just as good as a Corvette to get you from A to B (and a lot cheaper with it), but I know which one I'd like to own and drive (unfortunately I own and drive the other one).

Finally there's things that have value because they can get us things in the other two categories. Dollar bills, or Euro notes, or gold bars. Bank notes don't even make good kindling or toilet paper. Gold is just as good as the next heavy metal, but costs substantially more. However, if you have it, you can give it to people to get them to give you stuff you want, or need. You can get them to work for you. And Bitcoins are clearly in this final category. The easier it is to give them to people, and the more widely they are accepted for things you need or want, the more valuable they will become.

Is Satoshi Nakamoto a real-life Hari Seldon?

Perhaps you've read Isaac Azimov's Foundation Trilogy, in which there is a character called Hari Seldon? Seldon invents a new science, psychohistory, which allows him to predict the collapse of the galactic empire, and set up a new civilisation on a planet called Foundation, to preserve human knowledge.

When I look at how Bitcoin has progressed over the last four years, I can't help thinking there's a bit of Hari Seldon in Satoshi Nakamoto. The whole history of Bitcoin reads like a science fiction novel, and the prescience in the system is remarkable.

Firstly the anonymity - no one knows who Satoshi Nakamoto is. Various journalists and investigators have tried to profile him, and have come to the conclusion that he's probably British (even though the first post was in US English, the rest were in UK English), the time stamps on his bulletin board posts fit GMT if he was following a typical "get up in the morning, go to bed in the evening" pattern of living, And probably an academic, as his programming style isn't that of a professional coder. But perhaps there's already some misdirection going on there - pick a top layer false identity with a Japanese name, and then under that have a second false identity that makes you look like a British university professor. Who knows how many further layers there could be?

Why would the inventor of Bitcoin keep his (or perhaps her?) identity hidden? Perhaps it's modesty, or perhaps the inventor was supposed to be working on something else and was putting work time into Bitcoin. Or perhaps Satoshi was playing the long game - presumably as the first Bitcoin miner there wasn't much competition for the 50 coins every ten minutes. In the first four years of Bitcoin, coins were being generated at a rate of over 50,000 a week. Satoshi could well be sitting on a pile of at least a quarter of a million Bitcoins (if not many many more). At current prices of about 50 euros a coin, that's over 12 million euros. If you're a multimillionaire, it's better to be anonymous than a public figure; less money needs to be spent on security and bodyguards for starters.

Or perhaps Satoshi was worried about what would happen to him when Bitcoin started overtaking Government currencies. In today's political climate the inventor of something that could possibly one day wipe out the dollar could easily be labelled a "fiscal terrorist".

Then there's the interplay between the rate of Bitcoin mining reduction, mining power and the value of Bitcoins. For the first four years or so the reward for mining Bitcoins was 50 coins, and initially there were very few miners. But Bitcoins were not worth anything, so anyone putting time and computing power into it were either doing it because they were highly optimistic about the cryptocurrency's future, or because it seemed like an interesting thing to do. As the price increased from mere cents per thousand Bitcoins to dollars, and then on to tens of dollars per Bitcoin, the computing power expended on mining increased, the technology improved from CPU to GPU to FPGA and now ASICs, and then the number of Bitcoins per mining reward halved. Three variables that interact and could easily have gone terribly out of balance (and still could in the future, I suppose). But in general it all meshes together rather nicely. And the number of Bitcoins in the mining reward are scheduled to halve again and again until 2140, when the full amount will have been allotted. That's a very long term plan. For comparison, think back to what the world was like according to the history books in 1878...

So, is Satoshi relaxing on the deck of a yacht, enjoying his millions and congratulating himself on a plan well executed? Or is he a bemused elderly university lecturer in north London, packing his brief case every morning and heading off to give his daily mathematics lectures to unsuspecting undergraduates? I wonder if we'll ever know.

What is so special about August 17?

If you're going to send a Bitcoin transaction into the peer-to-peer network it needs to start with a magic number. All Bitcoin protocol transmissions start with a specific magic number. For some reason Satoshi Nakomoto picked 0xD9B4BEF9 as his magic number.

I can't help wondering why. If you choose this magic number as a Bitcoin private key, the public key you get in standard base58 format is 17AUGpBwAP5y5ptb1ksc8HWVv6XvNh5Ary. Perhaps Satoshi Nakamoto picked his Bitcoin magic number at random. Perhaps he also chose to prefix Bitcoin addresses with 1 at random. Or perhaps 17 AUG is somehow significant to him. (Also note that bitcoin.org was registered on 18 August).

Is 17 August the day of Satoshi's birthday? Is it the day on which he came up with the concept of Bitcoin?

Or am I just fueling conspiracy theories?

How much could one Bitcoin eventually be worth - a gold comparison

In a later post I'll explain why I think Bitcoin is currently like (a very volatile version of) gold, and why I think that will change in the future. But for now, make the assumption that Bitcoin will be used like gold to "store value" in the near future. How much could one Bitcoin then eventually be worth?

A quick search on Wikipedia shows that there are about 170,000 tonnes of mined gold in the world. We don't have to be more accurate than that for this "back of an envelope" estimation. And a gram of gold currently sells for about 40 euros. So the total value of gold in the world is about 7 trillion euros.

The current Bitcoin scheme determines that the maximum total number of Bitcoins is 21 million. If Bitcoin became as valuable as gold then a simple division shows that one Bitcoin could be worth about a third of million Euros.

The smallest unit of Bitcoin is the Satoshi, which is 0.00000001 Bitcoins. So in the above case, a Satoshi would be worth about a third of a Euro cent. Therefore by that point we'd probably be inventing a name for one hundred Satoshis.

Bitcoin addresses - an analogy

I've had a few tries at explaining Bitcoin addresses to various people with different levels of mathematical skill. This is the best analogy I've been able to come up with:

Imagine a huge warehouse with row upon row up row of glass fronted lockers. Each locker has a number on it - that's the public Bitcoin address of the locker. And you can walk through the warehouse and look inside any locker, but can't open a specific locker unless you have a key. However, each locker has a mailing slot in the shape of a Bitcoin, so you can drop Bitcoins into any locker you like, but you can't get them out again.

In total there are 1,461,501,637,330,902,918,203,684,832,716,283,019,655,932,542,976 lockers. That's a lot of lockers. For comparison, there are only 7,500,000,000,000,000,000 grains of sand on all the beaches on earth. So obviously such a warehouse can't exist in the real world. But it can in a virtual reality or a computer.

We can now wander about the warehouse, and if someone says on their web page that they've got a Bitcoin address you can go and have a look in their locker and see if they have any Bitcoins in it, or even if they once had some coins but don't any more (lockers show a full history of how they've been used). And if you had some Bitcoins you could drop them in any locker you liked (but you wouldn't be able to get them back!).

Now, how do you get your own locker that you can open? Each locker has a security code that needs to be used to open it. The security code is a 77 digit number, something between 1 and about 11,579,208,923,731,619,542,357,098,500,869,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000. You're never going to guess the security code for a given locker. However - there is a special calculator which, if you key in a random security code, will give you the Bitcoin address of a locker that it will open. So you pick a random number, key it in to the calculator, get an address, go to that locker, and hey presto - the random number you picked opens it. And if there were any Bitcoins in there you'd be able to take them out. But chances are there won't be - the vast majority of lockers are empty, and always will be.

And if you keep the random security code (also called a private key) secret, then no one else will be able to open your locker - just you.

And that's a visualisation of how Bitcoin uses ECDSA for storing the value of Bitcoin.