Gaining currency

Bitcoin can buy you goods, fund assassinations and is a good investment. Yet it does not exist in a physical form. The author demystifies the alternative currency

Last February, I mentioned the virtual currency called bitcoin to an official of the Reserve Bank of India, or RBI. He was unaware of its existence. After I explained how it worked, he laughed it off saying, "It's just funny money from a computer game."

This gentleman called me in November, for more details. By then, the bitcoin was trading at above $1,100. The market capitalisation of the 12-million-odd bitcoins around is $11.9 billion. Impressive, since the bitcoin is no more than a unique combination of symbols generated by a computer network and controlled by nobody.

Global monetary authorities don't seem to know what to do about it. The central bank of China and the European Central Bank have issued advisories against speculative activity in the bitcoin. The US Federal Reserve has frozen money transfers to MtGox, a large exchange where bitcoins can be exchanged for real currencies. RBI has put the currency under observation.

A Bank of America analyst said recently that we may be underestimating the impact of bitcoin. He projected that it could end up powering 10 per cent of the global e-commerce and becoming one of the three most popular means of money transfer. Close to 100,000 diverse businesses already accept bitcoins. Bitcoin owners can buy goods and services as diverse as cars, groceries, haircuts and gym memberships. Specialised ATMs and currency exchanges allow the bitcoin to be exchanged into real currency.

The Federal Bureau of Investigation, or FBI, claims that over $1.2 billion of drug deals, and even contract killings, were bitcoin-denominated in the underground online market, Silk Road.

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There have been many virtual currencies before the bitcoin. But others were issued by companies which took decisions about money supply, exchange rates, and so on. Each could only be used for a relatively narrow range of specific tasks. The bitcoin has no issuing authority. The money supply is decided by mathematical laws. It runs off an open source peer-to-peer network, which anybody can join. The bitcoin P2P network is big enough now to run 256 times as many calculations as the world's fastest 500 supercomputers combined. Even so, trading has picked up so fast that this massive P2P network can take days to verify transactions.

The encryption is robust and elegant. Every bitcoin is identified uniquely and every transaction is verified, while concealing trader identities. The encryption and digital signature system allows A and B to conduct a transaction where the bitcoin is placed in an escrow account controlled by an intermediary C, without A,B,C knowing each other's identity. This efficient anonymity is one reason why Silk Road worked so well.

A year ago, the bitcoin was considered a geeky toy, attracting the interest of fringe groups of libertarians and techies. Trading exploded after the Cyprus crisis in April 2013. Since bitcoin supply is unaffected by shenanigans in real currencies, speculators thought it would "hold value" in a currency crisis much as gold does.

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The bitcoin system has advantages and disadvantages. It cannot be easily regulated or taxed, which is a two-edged sword of course. It is easily transferred since it is purely digital. On the other hand, the rigid money supply and the elimination of "double usage" in transactions makes normal fractional banking loans impossible or cumbersome, even if currency pairs are used.

Venture capitalists have started building businesses around the bitcoin as the value has soared and acceptability grown. Offline businesses in tech hotspots like Silicon Valley accept bitcoins, as does Chinese search engine Baidu. Several Korean and Taiwanese businesses also used bitcoins. It is popular among game developers, porn studios and chip-makers who build chips specially designed for the bitcoin network. A Lamborghini dealership in Florida has sold cars for bitcoins. Richard Branson's Virgin Galactic space tourism company sells tickets in bitcoins. Even some Silicon Valley tax consultants accept the bitcoin.

"Mining" is the original source of bitcoins. But it is possible to buy bitcoins online, using any currency, including rupees. Quite a few Indians are speculating in the bitcoin, and some Indian venture capitalists are looking to build exchanges and get local vendors onboard as well. As a technical analyst, I've received requests to analyse liquidity on different bitcoin exchanges from speculators. Liquidity and volumes are good. Each coin can be fractionated down to one part in a hundred million (1/100000000), which makes it easier to denominate trades and prices.

Obviously the lack of an issuing authority worries central banks, and law-and-order/tax authorities. If the bitcoin becomes really popular, it could impact the ability of central banks to set monetary policy via manipulation of the money supply and interest rates of real fiat currencies. Anonymity also enables crime and helps bypass tax laws. One way perhaps for central banks to gain control would be to study the bitcoin's concepts, and issue a similar virtual currency backed by a consortium of central banks.

In a strange way, the bitcoin's adoption harks back to the old days. When all currencies were tied to metals, they were easily exchanged and, in effect, the world had one currency. The money supply and value was linked to the mining and production of precious metals, often leading to phases of mad inflation and deflation. Bankers had to develop contorted methods of deficit financing and fractional reserve banking.

The success of the bitcoin shows that such a world currency could be artificially developed. Only, instead of paper backed by metal, it would have computer codes backed by nothing. There may be advantages to studying the technology since such a currency could have its uses in easing trade barriers.

HOW THE BITCOIN WORKS

• In 2008, somebody using the pen-name Satoshi Nakamoto wrote a paper and put it in the public domain outlining how a virtual currency without any central issuing authority could work.
• The bitcoin system is run by a vast distributed peer-to-peer network. Money supply is through “mining” where solving cryptographic problems over a peer-to-peer network results in release of new bitcoins
• The number of reward bitcoins gets smaller as the number of coins “mined” increases. The computation problems also get harder. The supply of bitcoins is thus limited by mathematical rules, and will be capped at about 21 million coins by around 2150.
• Each coin has a unique encrypted ID and is stored in an electronic wallet, which also has a unique ID. The wallet and the coin are not linked to ownership. The system verifies the wallet and coin as genuine via digital signatures. If the wallet data is lost or stolen, the coins are also gone.
• How does bitcoin verify that the same coin is not being used simultaneously for many transactions, given a lack of trustworthy authorities like banks to reconcile ledgers and tie coins to owners?  The bitcoin P2P network reconciles all the transactions in a public ledger called a blockchain, where every bitcoin transaction ever made is stored. Any new transaction is verified by simultaneously synchronising all wallets containing bitcoins to check a given coin transfer is valid and not a double usage.
• Blockchain checking is very resource-intensive and it gets progressively harder. Synchronising and verifying every new transaction involves checking all prior transactions to eliminate possible duplicates. Defrauding the blockchain requires compromising over half the computers in the P2P network simultaneously.
• Bitcoins are traded by various financial exchanges, for other virtual currencies and for real fiat currencies. Each of those transfers is also verified by the P2P network. This leads to every single transaction taking a long time to verify. Currency exchanges can take up to 48 hours before allowing transfer of bitcoin.
• Specialised chips designed specifically for bitcoin mining and clever blockchain ledger management systems can reduce the time. But the number of transactions is also growing much faster than the number of P2P nodes, so time per transaction may always be a constraint.

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Security for the bitcoin is similar to a bank's: Prithwis Mukerjee

Prithwis Mukerjee first dabbled in virtual currencies when he set up an account as Calcutta Cyclone on the virtual reality site, Second Life, in 2006 where, among other things, he runs a virtual Kali temple. The IIT graduate is the programme director at the Praxis Business School, Kolkata. Mukerjee, one of the select few Indian bitcoin owners, explains how secure the bitcoin ecosystem is

How likely is it that the bitcoin mining algorithm will be cracked?

It is computationally very hard; the duration of the cracking process may simply be longer than useful. It's akin to a bank safe that takes over 48 hours to break into - even if the robber started on a weekend, the effort would be pointless since the bank would reopen before the safe is cracked.

Could one crack the network to pull off a bitcoin fraud or fool the blockchain ledger into allowing a fraudulent transaction?
As I understand it, over 50 per cent of the servers in the bitcoin network must be compromised before someone can fool the blockchain into accepting a transaction that is fraudulent or otherwise unacceptable.

How secure are the exchanges where bitcoins are traded for other currencies, including real currencies?

The current security that I have accepted at MtGox is a basic user id/password security. It is similar to what I have in my netbanking account at StanChart and SBI. However, MtGox offers higher levels of security in the form of a Yubikey and a One Time Password Card. This is similar to the security I have in my HSBC Internet banking account.

What sort of security and data backup would you want for the hard drive where your wallet details are stored? Isn't the wallet uniquely numbered but not linked to the ID of the wallet holder?

My wallet is held with a company called blockchain.info. My user id is pretty long and complex. There is a "two-factor security" feature available, but I have not used it because I am afraid of forgetting it and locking myself out permanently.

There is no connection between the wallet id and the user id/identification of the wallet-user. This is useful since it provides anonymity, but it carries risks. However, any reliable exchange like MtGox will demand KYC documentation similar to any real-world bank or service provider.

In terms of data backup, blockchain.info allows me to create a backup of my wallet. It can be stored on Google Drive or on my hard disk. Should I lose access to my wallet, I'd be able to create a new wallet and import my "balance" into a new wallet. I can use any compatible electronic wallet software and import data from this backup file and recreate my balance in a new wallet and migrate to a different service provider.

You exchanged Linden$ earned in Second Life for bitcoins. Would you care to compare the bitcoin with the Linden $?

Linden$ is a toy currency (like Monopoly money). It is issued by a single company for a specific purpose and cannot be used outside of the site or the game. Bitcoin is sophisticated, open and universal. A company called Virtual World Exchange (Virwox) facilitates exchange of various game currencies with each other and with real currencies. They offered a facility to exchange Linden$ for bitcoins. I had a large stash of Lindens that I exchanged.