Econ135:  Lecture  4

• Fiat currencies (think cash) differ from country to country and are typically not directly usable outside national borders

• Fixed denominations which must be aggregated to make transactions and then re-aggregated to make change

• Difficult to transport and protect large quantities• Receiver must be able to detect counterfeit• 100% untraceable and anonymous

Money  is  Imperfect

• Book-entry money (think balances in savings accounts) has the potential to circumvent most of these deficiencies.– Banks can transfer balances electronically, cheaply – Any amount– Verification by central authority– Traceable and sometimes reversible – But not the same as teleporting cash!

Book-­entry  money

• Imagine you could teleport a $1 or $1 billion cash anywhere in the world, instantly.

• Would that be better?– To some it would be, but is it possible?– How do we solve the double-spending problem?

Virtual  Currencies

• Each division of the Byzantine army is commanded by its own general

• Generals, some of whom are traitors, communicate with each other about the time for attacking the enemy castle using messengers

• The problem is messengers will arrive at different generals at different times with possibly conflicting proposals for an attack time– The attack will only be successful if a majority of generals attack at the same

time– And traitors may purposely try to confuse things

• How do we ensure that: – All loyal generals decide upon the same plan of action– A small number of traitors cannot cause the loyal generals to adopt a bad plan

Byzantine  Generals’  Problem

• The proof-of-work chain is a solution to the Byzantine Generals' Problem.

• Ensures a sufficient number of generals know the same info (attack time) and know other’s know it, etc.

• This is the classic hard problem of distributed data processing.

Proof-­of-­Work

• Once a general receives an attack time he sets his computer to solve an extremely difficult proof-of-work problem that incorporates the attack time

• The proof-of-work is so difficult, it takes around 10 minutes before one of them finds a solution.

• Once one of the generals finds a proof-of-work, he broadcasts it to the network, and everyone changes their current proof-of-work computation to include that proof-of-work in the new problem they are working on.

• If anyone was working on a different attack time, they switch to this one, because its proof-of-work chain is now longer.

Source: Cryptography chat room description by “Satoshi Nakamoto”

How  it  works  (fast  forward  to  2012)

• After two hours, one attack time should be included in a chain of 12 proofs-of-work.

• Every general, just by verifying the difficulty of the proof-of-work chain, can estimate how much parallel CPU power per hour was expended on it and see that it must have required the majority of the computers to produce that much proof-of-work in the allotted time.

• If the CPU power exhibited by the proof-of-work chain is sufficient to defeat the castle, they can safely attack at the agreed time.

How  it  works  (fast  forward  to  2012)

• Bitcoin is a virtual currency: only exists as a digital entry in a public ledger known as the Blockchain– Blockchain = publicly available history of all bitcoin transactions

• Governed by an open-source protocol (set of rules)

• People download “Bitcoin wallets” and obtain coins by purchasing them on exchanges, by selling goods and services, or by “mining”.

• Mining is the process by which new transactions (additions to the public ledger) are verified.

Introducing  Bitcoin

• Agents called “miners” verify that there is enough bitcoinin the sender’s wallet to make payment– This is an easy task for a computer to perform.

• Miners then compete with each other to encode the transaction and add it to the block chain – This is where proof of work comes in!

• If everyone was simultaneously verifying transactions and announcing changes to the public ledger we could run into problems (Byzantine Generals’ problem)

• So the protocol requires miners to compete for the right to add a block of new transaction by solving a difficult problem

• The difficulty of this problem is automatically adjusted by the protocol so that the expected time to find a solution is 10 minutes

Bitcoin and  Proof  of  Work

• The first miner to successfully encode the transaction is awarded newly issued bitcoins by the system and this success is communicated to the other miners in the network

• Other miners subsequently confirm the transaction by building off the blockchain with the previous transaction now a part of it– Subsequent confirmations lead to greater certainty that

a transaction is “final”

Bitcoin and  Proof  of  Work

• They take the code used to describe new transactions, some information about past transactions, information about their own identity, and a “nonce” (a number that they add to the mix) and run it through the SHA-256 Hash function. This produces a 64 digit, hexadecimal number: – 22123FE3423336672D698BB19592E1FBDAA58971899C160F9

F554F0D19AAEBD1

• Goal is to try different nonces until output has correct number of leading zeros• 00000000000000000BCAF61ECAFB48D643412CFF4DDCF1

0A99ECE331A23725FD (An actual winning Hash from November 4, 2014)

• Only way to do this is by trial and error• 154,559,506,455,029,779,103 = average number of Hashes

needed to win

What  problem  do  miners  solve?

• People have designed special chips that are particularly good at performing this task. This has led to a high degree of market concentration in mining.

What  problem  do  miners  solve?

• Two miners, Alice and Bob, and two types of computer processors Slow and Fast.

• The Slow processor costs $5 and the fast processor costs $10.

• If Alice and Bob each use the same processor they will each have an equal chance of winning the $25 reward, for each new block that becomes available.

• If one person uses the fast processor and the other uses the slow processor, then the person with the fast processor will have an 75 percent chance of winning the reward and the person who uses the slow processor will have a 25 percent chance of winning the reward.

Prisoner’s  Dilemma

• The situation can be summarized by the following normal form game.

• In general, if (α-.5)R>Cf-Cs, then Fast is a dominant strategy for each player and this is a prisoner’s dilemma game.

• The NE in dominant strategies (Fast,Fast) is inefficient.

Prisoner’s  Dilemma  cont.

Bob

Slow Fast

Alice Slow .5*25-5=7.5,.5*25-5=7.5 .25*25-5=1.25,.75*25-10=8.75

Fast .75*25-10=8.75, .25*25-5=1.25 .5*25-10=2.5,.5*25-10=2.5

• One objection to this specification might have been that with faster processors the players would solve more blocks and hence receive more rewards in a given period of time.

• But the design of the Bitcoin protocol prevents this. – The Bitcoin protocol manages the rate as which new coins

are awarded by setting the difficulty level of the mining problem so that on average a new block is added every 10 minutes.

– Specifically, the program computes a historical average of how fast new blocks are being added and changes the difficulty level so that the desired frequency is maintained.

– So regardless of how fast the processors are, a new block will arrive at the same rate.

Prisoner’s  Dilemma  cont.

Roughly  speaking,  that  is…

• Can it happen? Yes, but not if you are careful (i.e., wait long enough).

• It is not possible to submit false transactions. All Bitcoin clients on the network can detect this.

• What you might do is pay someone $1 million in bitcoins for $1m cash, and then, after you leave with the money, try to reverse the transaction.

• Suppose buyer makes you wait one hour

Double-­spending

Need  to  solve  6  blocks  before  anyone  else  solves  1

Past transac-

tions

Past transac-

tions+

Bill pays Alice

$1m in bitcoin

Past transac-

tions+

Bill pays Alice $1m in bitcoin

+New

transac-tions

Past transac-

tions+

Bill pays Alice $1m in bitcoin

+New

transac-tions x 2

Past transac-

tions+

Bill pays Alice $1m in bitcoin

+New

transac-tions x 3

Past transac-

tions+

Bill pays Alice $1m in bitcoin

+New

transac-tions x 5

Past transac-

tions+

Bill pays Alice $1m in bitcoin

+New

transac-tions x 4

Past transac-

tions+

Bill pays Bill $1m in bitcoin

Past transac-

tions+

Bill pays Bill $1m in

bitcoin+

New transac-

tions

Past transac-

tions+

Bill pays Bill $1m in

bitcoin+

New transac-tions x 4

Past transac-

tions+

Bill pays Bill $1m in

bitcoin+

New transac-tions x 2

Past transac-

tions+

Bill pays Bill $1m in

bitcoin+

New transac-tions x 3

Past transac-

tions+

Bill pays Bill $1m in

bitcoin+

New transac-tions x 5

Past transac-

tions+

Bill pays Bill $1m in

bitcoin+

New transac-tions x 6

Headlines (June 16, 2014)

Bitcoin price dips as backers fear mining monopoly

Ghash.IO's share of Bitcoin computation power has alarmed backers

• Fears that a Bitcoin mining pool controlled more than half the total computational power used to create the digital currency prompted a decline in its value from $653 to $600.

51%  attack  problem

• Fear is that Ghash.IO would try to manipulate the block chain

• Only two things they could do1. refuse to validate specific transactions

• i.e., preventing people from sending Bitcoins between addresses

2. reverse transactions they send during the time they are in control (double spending)

• Either would likely lead to a huge decline in value of bitcoin, if not a complete collapse.

51%  attack  problem  cont.

• So then where would the Ghash.IO miners be? • At current prices a group that controls 51% of all

Bitcoin mining revenue would earn around $734,400 a day.

.51*25*6*24*$500=$734,400

• Think of this as an infinitely (or indefinitely) repeated game

• Is there a one-shot manipulation that will earn them more than that income stream is worth?

51%  attack  problem  cont.

• Ignore hardware/chip cost (sunk)

• Electricity cost?

Compute  mining  profit

• Current hash rate: 250 million GH/s (approximate average over most recent 24 hour period) https://blockchain.info/stats

• There are 52 different chips listed https://tradeblock.com/mining/– Average of top 20 chips is: 0.73 joules/gigahash.

• If all mining is done via a 0.73 J/GH chip, then the bitcoin network would use 182,500 kilowatts.

• So over the course of a day, the bitcoin network would use 4.3 million kwh (= 4.3 gigawatt-hours). – Kilowatt-hours=kilowatts*hours

Energy  Used

• The cost of energy varies a lot depending on where the miners are located.

• Bitcoin forums (e.g. bitcointalk.org) suggest that many miners try to re-locate to areas where the electricity is cheaper (e.g. Iceland, the Pacific Northwest, Canada!),

• OECD computes prices for two categories– Average electricity price (household): $0.158/kwh – Average electricity price (industry): $0.1109/kwh

Cost  of  Energy

• It is unclear what proportion of miners are industrial versus individual. – a lot of bitcoin start-ups that would presumably receive

industrial electricity prices • Using the simple assumption that half of all

electricity is used by industrial miners and half of all electricity is used by household miners, the total electricity cost of Bitcoin mining is $588,891 per day.

.5*($0.158/kwh+$0.1109/kwh)*$4.3m = $588,891

Cost  of  Energy

• Revenue = $734,400 a day • Electricity Cost per day = .51*$588,891 =

$300,334 • Size of one-shot manipulation = uncertain

– May be low if anonymity is preserved• Need a big manipulation and/or a large discount

rate to throw away $434,066 a day!

Another point: Ghash.IO is a mining pool– Not under complete control of single individual

Should  we  worry  about  a  51%  attack?

• Bitcoin is clearly ingenious and seems pretty resilient. But is it hear to stay?

• Not the same question as: Will bitcoin replace the $?

• The question that provoked such great blog titles as

“Bitcoin is Evil” (Paul Krugman) And

“Why I want Bitcoin to Die in a Fire” (Charlie Stross)

So…

• 3 Functions: 1. Unit of account 2.Medium of Exchange 3.Store of value– Too volatile for 3.

These  argue  Bitcoin  is  not  a  good  currency

• Bitcoin Stats (as of 8/29/2014)– Total BTC: 13,202,425 – Market Cap based on latest prices: 6,790,667,299 USD– Transactions last 24h: 66,926– Transactions avg. per hour: 2789– Bitcoins sent last 24h: 450,783.11 BTC– Bitcoins sent avg. per hour: 18,782.63 BTC– Blocks count: 318,096– Blocks last 24h: 165– Blocks avg. per hour: 6.88

Can  it  still  function  as  a  medium  of  exchange?

• Some numbers from late 2013• 2% of the Bitcoin population control 80% of the

current world supply and 50% control 99% of outstanding coins.

• The Gini coefficient is .877.– What is the Gini coefficient for $100 bills? (Charlie

Kahn)• Give some indication what Bitcoin is used for

Behind  the  Stats

• Anton Badev and Matthew Chen, economists at the Federal Reserve Board, find– The volume of transactions is still small, e.g. 1000

times smaller than that of general purpose credit cards. – About half of the transactions involve more than 100

USD – For the majority of its life Satoshi Dice accounted for

more than 40% of the overall transaction volume and almost all small-value transactions on the Bitcoin network.

• These observations suggest that the Bitcoin is still barely used for retail payments and may be used primarily for gambling, speculation and crime!

Usage  Study  (early  2014)

• Overstock.com: In first 22 hours accepted 800 orders worth $126,000– $5 million in transactions in first 2 months – expects 1% of its annual revenue.– Recently Overstock started to hold 10%

• Braintree, the mobile payment company that runs commerce systems on which companies like Airbnb, Uberand TaskRabbit are built, was bought by PayPal and eBay last year

• August 14 Wall Street Journal story says eBay is thinking about ways to integrate Bitcoin into its system.

More  and  more  retailers  starting  to  accept  bitcoin  

• Most major retailers deal in Bitcoin at arms length, i.e, through Coinbase– Coinbase, is a San Francisco based exchange that

processes Overstock’s bitcoin transactions, says it is also serving 19,000 other businesses

– How does pricing work?

Buying  with  Bitcoin

Overstock  USD  BTC  Price  Spread  Percent

Bitcoin  Price

Mean  Price  Spread

• On-us processing by Coinbase

• ChangeTip also uses an internal ledger to process tips off chain.

Micro-­payments

• ChangeTip is a Bitcoin-enabled social media tipping platform by which users can send any amount of money over 35 different social media platforms or content showcase channels (including GitHub, Reddit, Twitter, and YouTube).

Micro-­payments

 

ChangeTip  Social  Accounts  

   

• Venture capital firms have invested more money into Bitcoin startups in the first half of 2014 ($150 million) than they did in all of 2013 ($88 million).

• Bitcoin venture funding is running at $300m in 2014 – the same as the Internet circa 1995 (Yahoo!, eBay, Amazon).

The  next  big  thing…

• Global Advisors Bitcoin Investment Fund– Trade on volatility– world's first regulated bitcoin hedge fund (Isle of Jersey)

• Pantera Capital– Buys bitcoin as an asset and makes VC investments

• Bitcoins Reserve– a "cryptocurrency arbitrage fund", Bitcoins Reserve hopes to buy

low on one exchange and sell high on another, using automated trading software that it has developed itself.

• Binary Financial– range of trading strategies including arbitrage

– Coin Capital Partners and Falcon Global Capital– straightforward buy-and hold-strategy

Bitcoin  Hedge  Funds

Statistical  Trickery

Some  Perspective

Some  Perspective

Summary

• Virtual currencies are proliferating and appear to be here to stay in an ever-evolving form.

• They may offer many potential benefits– Censorship-resistant – Financial inclusion– No transaction limits– Micro payments– Remittances

• International payments using Bitcoin as “rails”• “Last mile” problem

– Need to see how increased regulatory inclusion impacts benefits• Price drop following Canadian announcement

• Healthy competition for existing payment platforms

• Mining is particularly wasteful• VCs have been used for money laundering and

other criminal activity (Silk Road)• Dark Wallet

– Stealth payments + CoinJoin mixing = Bitcoin Anonymity

• Many consumer risks– Like cash when wallet is stolen– Level of protection to consumers provided by third-party institutions may

be insufficient (Mt.Gox)• Aug 28 announcement by Coinbase (Aon as its insurance broker)

• Volatility of the value of the currency• Operational risks

– Although there is no single point of failure in peer-to-peer network, it is unclear how robust the protocol is to other types of operational failures

– Operational risks of third-party institutions is another concern

But…

• Not clear what problem VCs are solving– Technological versus market failures– Venmo, Apple Pay

• What if speculators lose patience?

And…

• Distributed ledger protocols may be useful for payment and settlement – E.g., Ripple promotes the use of its decentralized transaction

protocol for settlement in a broad range of fiat and virtual currencies

– Trust• Other uses also promising

– Patents• https://www.btproof.com/

– Title transfer– Many more

Separate  the  wheat  from  the  chaff?

• Virtual currencies are for real• They provide a distinct service that people value

– Not just about being faster or cheaper (which are debatable)

• Interaction with fiat money could go away (exchanges could disappear), but (at a minimum) I expect that usage as a self-contained medium of exchange will survive– True believers

• Distributed ledger protocols are here to stay (obviously!)

Final  Word