Bitcoin As Cryptocurrency

The nature of cryptocurrency

Cryptocurrency in its purest form is a peer-to-peer version of electronic cash. It allows online payments to be sent directly from one party to another without going through a financial institution. The network time-stamps transactions using cryptographic proof of work. The proof-of-work Bitcoin protocol is basically a contest for decoding and an incentive to reward those who participate.

For Bitcoin, first participant to crack the code will be rewarded with the newly created coins. This contest will form a record of the transactions that cannot be changed without redoing the proof of work. Cryptocurrency is a subset of digital currency. 

Examples of the many digital currencies are air miles issued by airlines, game tokens for computer games and online casinos, Brixton Pound to be spent only in the Brixton local community in the Greater London area, and many other forms that can be exchanged for virtual and physical objects in a closed system and, in the case of an open system, exchanged for fiat currency.

The beginning: eCash

Commercially, it all began with DigiCash, Inc.'s eCash system in 1990, based on two papers by its founder (Chaum, 1983; Chaum et al., 1992). Payments were transferred online and offline using cryptographic protocols to prevent double-spending. The cryptographic protocols also used blind signatures to protect the privacy of its users.

As the first cryptocurrency, the eCash system was available via various banks and smart cards in various countries like the United States and Finland. It slowly evolved into the current form of cryptocurrencies with many refinements by various software developers over the last 20 years. eCash was a centralized system owned by DigiCash, Inc. and later eCash Technologies. However, after it was acquired by InfoSpace in 1999, eCash and cryptocurrency faded into the background.

Pioneering Internet payments with digital gold

Digital gold currency came into the limelight between 1999 and the early 2000s. Most of these new forms of electronic money based on ounces of gold are stored at the bullion and storage fees are charged. We have seen the growth of e-dinar, Pecunix, iGolder, Liberty Reserve, gBullion, e-gold, and eCache. With a couple of exceptions, most have ended up in the graveyard due to either compliance issues or regulatory breaches. e-Gold was a pioneer for Internet payments. As the first successful online micropayment system, it pioneered many new techniques and methods for e-commerce, which later became widely used in other online aspects. 

These techniques and methods include making payments over a Secure Sockets Layer-encrypted connection and offering an application programming interface to enable other websites to build services using e-gold's transaction system. However, its Achilles heel was its failure to fulfill knowyour-customer (KYC) and suspicious transaction reporting requirements. 

With the introduction of the US Patriot Act, compliance has been a major issue for money transmitters. Furthermore, it has to contend with hackers and Internet fraud. 

Before the motion to seize and liquidate the entire gold reserve of e-gold under asset forfeiture law in 2008, e-gold was processing more than USD2 billion worth of precious metal transactions per year. There are clear lessons to be learned by the cryptocurrency community.

Revival of cryptocurrency

At the onset of the global financial crisis in 2008, interest on cryptocurrency was revived. Cryptocurrency had the potential to counter a few problems associated with the fiat currency system, argued Szabo (2008) in a blog post just at the beginning of the global financial crisis. Given that it is cumbersome to transact using commodities, the concept of bit gold was mooted. As the name suggests, there is gold to be mined and bit recorded on a digital register. 

The digital record would resolve the issues of a trusted third party, and in his own words, 
Thus, it would be very nice if there were a protocol whereby unforgeably costly bits could be created online with minimal dependence on trusted third parties, and then securely stored, transferred, and assayed with similar minimal trust. Bit gold.

My proposal for bit gold is based on computing a string of bits from a string of challenge bits, using functions called variously "client puzzle function," "proof of work function," or "secure benchmark function." The resulting string of bits is the proof of work. Where a one-way function is prohibitively difficult to compute backwards, a secure benchmark function ideally comes with a specific cost, measured in compute cycles, to compute backwards."

Despite sounding technical, what Szabo described was a simple protocol that requires participants to spend resources to mine the digital gold or bit gold, be rewarded, and in the process validate the public digital register. What differentiated his approach from failed digital currencies of the past were the timing of the financial crisis and the distributed nature of the protocol. The reward to the miners was one innovation and the free access to digital record for the users was another. 

One of the reasons is that the nature of the Internet makes collecting mandatory fees much harder, while voluntary subsidy is much easier. Therefore, there must be no barrier to access content or digital record, and there must be ease of use and voluntary payments. Ideas were discussed in the literature, and technology was developed over time by a group of cryptographers, old and new, such as Chaum (1983) on DigiCash, Back (1997) on Hashcash, Dai (1998) on b-money, Szabo (1999, 2002, 2008) on the concept of money, and Shirky (2000) on micropayments.

Cypherpunk is an activist group since the early 1980s that advocates the widespread use of strong cryptography as a route to social and political changes. Finney (2004), who ran two anonymous remailers as a cypherpunk member, created the first reusable proof of work (RPOW), which is an economic measure to deter denial-of-service attacks and other service abuses such as spam on a network by requiring some work from the service requester. 

It means that whoever requests for the information has to incur more processing time on a computer than the provider. Hashcash, used by Bitcoin, is a proof-of-work system designed to limit e-mail spam and denial-of-service attacks (Back, 2002). At the same time, sociopolitical interest in cryptocurrency grew. Since we abandoned the gold standard in 1971 and adopted the fiat currency system, central banks have used their discretion to print as much as they desired during a crisis. 

This has created an asset inflation environment and worsened income equality. The supply of cryptocurrency or coins may or may not be limited but the new coins are usually created by a predetermined rule. The loss of trust in the fiat currency system, caused mainly by quantitative easing and huge government debts, has brought attention to cryptocurrency for those who wanted to hedge their positions with a currency that has a finite supply. 

Cryptocurrency was thought to possess the characteristics of a currency that can impose fiscal discipline on the government and it is perceived to be a debt-free currency with a constant growth rate with finite supply. For asset managers who were constantly seeking for negative correlation with their core portfolio, cryptocurrency provided a glimpse of hope for a high-risk and complex asset class that enhances the returns of a portfolio with bitcoins acting as a negatively correlated alternative asset class. 

But the origins of Bitcoin have their roots in cryptoanarchy that started as a movement in 1992:

Just as the technology of printing altered and reduced the power of medieval guilds and the social power structure, so too will cryptologic methods fundamentally alter the nature of corporations and of government interference in economic transactions. Combined with emerging information markets, crypto anarchy will create a liquid market for any and all material which can be put into words and pictures. 

And just as a seemingly minor invention like barbed wire made possible the fencing-off of vast ranches and farms, thus altering forever the concepts of land and property rights in the frontier West, so too will the seemingly minor discovery out of an arcane branch of mathematics come to be the wire clippers which dismantle the barbed wire around intellectual property.

The use of cryptocurrency as a safe haven and an alternative asset class was demonstrated in the 2013 Cypriot property-related banking crisis where a 6.75% levy was imposed on bank deposits up to EUR100k and 9.9% for larger deposits. With confidence in traditional banking shaken, investors were betting heavily on the most well-known cryptocurrency, bitcoins, to offer a more stable alternative. Many investors converted their fiat money into cryptocurrency, sending the price and volume to spike. The price of bitcoins spiked 57% within a week to USD74. Like gold and other commodities, Bitcoin's price spikes in moments of uncertainty. 

Both assets are increasingly favored by a small group of managers in alternative investment and critics of contemporary monetary policy. The most common arguments against Bitcoin are 
(i) the lack of a central issuing authority like that of a central bank, 
(ii) its fixed supply and deflationary nature by design, 
(iii) doubts that the price is stable enough to function as a currency, and 
(iv) the risk associated with it.

The rise of Bitcoin

An example of a cryptocurrency is bitcoins. Satoshi Nakamoto published a paper on the Web in 2008 for a peer-to-peer electronic cash system. Despite many efforts, the identity of Satoshi remains unknown to the public and it is not known whether Satoshi is a group or a person.1 The cryptocurrency invented by Satoshi Nakamoto, called bitcoins, is run using open-source software. 

It can be downloaded by anyone, and the system runs on a decentralized peer-to-peer network. It is not only decentralized but also supposedly fully 

Satoshi in Japanese means "wise" and someone has suggested that the name might be a portmanteau of four technology companies: SAmsung, TOSHIba, NAKAmichi, and MOTOrola. Others have noted that it could be a team from the National Security Agency (NSA) or an e-commerce firm (Wallace, 2011). Other suggestions are David Chaum, the late Hal Finney, Nick Szabo, Wei Dai, Gavin Andresen, and the Japanese living in the neighborhood of Finney by the same surname Dorian Nakamoto. 

There are other suggestions such as Vili Lehdonvirta, Michael Clear, Neal King, Vladimir Oksman, Charles Bry, Shinichi Mochizuki, Jed McCaleb, and Dustin Trammell, but most have publicly denied that they are Satoshi.

distributed. That means that every node or computer terminal is connected to each other. Every node can leave and rejoin the network at will and will later accept the longest proof of work known as the blockchain as the authoritative record. This longest blockchain is proof of what has happened while these nodes were gone. 

Cryptocurrency is mysterious and misunderstood for a few reasons. First, no one knows who is really behind some of these cryptocurrency systems. It was designed so that third-party trust is not needed and sometimes there is no legal entity behind it but open-source software. Second, many have jokingly remarked that Bitcoin sounded more like "big con" especially after the collapse of Mt. Gox. 

But it is important to note that Mt. Gox was merely a financial intermediary, being just one of many unregulated exchanges that trade in Bitcoins. Mt. Gox was not part the Bitcoin system itself. It is a complex currency system to the men in the street and therein lies the confusion. Third, cryptocurrency involves mining or proof of work. There are rewards for mining and the reward is given to the first who can solve a cryptography problem. The degree of difficulty of the problem will ensure that the timing to solve the problem is approximately 10 min for Bitcoin. 

Cryptocurrency cleverly solves the doublespending problem so that every cryptocurrency can be spent only once. It is a financial technology and it involves financial regulation but 
therein lies the difficulty in execution and understanding even for the professionals. That is why it is an area of great interest to researchers, regulators, investors, and merchants and it is hitting the headlines regularly.

The general arguments for a successful distributed cryptocurrency are as follows: 
1. Open-source software: A core and trusted group of developers is essential to verify the code and possible changes for adoption by the network. 
2. Decentralized: Even if it is not fully distributed, it is essential that it is not controlled by a single group of person or entity. 
3. Peer-to-peer: While the idea is not to have intermediaries, there is a possibility of pools of subnetworks forming. 
4. Global: The currency is global and this is a very positive point and workable for financial integration with or without smart contracts among the parties. 
5. Fast: The speed of transaction can be faster and confirmation time can be shortened. 
6. Reliability: The advantage is that there is no settlement risk and it is nonrepudiable. The savings in cost of a large settlement team for financial activities can be potentially huge. 
7. Secure: Privacy architecture can be better designed incorporating proof of identity with encryption. If that is done, the issues surrounding Know Your Customer/Client (KYC) and anti-money laundering and terrorist financing (AML/TF) will be resolved. 
8. Sophisticated and flexible: The system will be able to cater to and support all types of assets, financial instruments, and markets.
9. Automated: Algorithm execution for payments and contracts can be easily incorporated.
10. Scalable: The system can be used by millions of users. 
11. Platform for integration: It can be designed to integrate digital finance and digital law with an ecosystem to support smart contracts with financial transactions. Customized agreements can be between multiple parties, containing user-defined scripted clauses, hooks, and variables. 

The possible applications will be wide-ranging and include global payment and remittance systems, decentralized exchanges, merchant solutions, online gaming, and digital contracting systems. 

Each cryptocurrency is a great and an interesting experiment. No one knows where these cryptocurrency experiments are heading but the experiments are interesting because of the technology that is developed along with them. The technology disrupts the payment system as we know it because it costs almost nothing to transfer payments. Cryptocurrency technology will allow us to reach out to the unbanked and underbanked. It presents the opportunity to function as a conduit for payments and funds. 

It will transform the way business is being done by diminishing the role of the middleman, whether it is smart accounting or smart contract. It will also change the way financial world operates especially in fund raising and lending. Basically, it is possible to do an Initial Crowd Offering or crowd lending, all in the peer-to-peer framework, eliminating the middleman. 

However, there are downsides or potential risks for cryptocurrency too. Cryptocurrency like Bitcoin depends on mining, and once the incentives for mining disappear, no one knows if the cryptocurrency in question will continue to have consensus on the digital register. They are over 400 cryptocurrencies and the number is increasing on a daily basis. But many of them are in the graveyard. 

So, as they say, "let the buyer beware," because what you own may just be worthless once there are doubts about the blockchain. It seems that if the cryptocurrency exhausts most of their coin supply too fast and too early, the probability of the coins dying is higher. For some coins, it is difficult to know who is behind them and whether there could be a backdoor that allows someone to control the system. Cryptocurrency with unknown developers has a higher probability of being buried in the graveyard. The blockchain may come under attack as well. 

The blockchain serves as a proof of the sequence of events as well as proof that it came from the largest pool of computing power. As soon as the computing power is controlled by nodes that are cooperating to attack the network, they may produce the longest chain of their choice creating doubts about the validity of the blockchain. This can easily happen once the interest on a particular currency wanes and the number of miners shrinks, which opens up the possibility of having a few blockchains in concurrent existence. 

Once there is any doubt of the accuracy of the blockchain, even if it was subsequently corrected, the coin will be heading for the graveyard. When there are no new coins to reward the miners, the system is unlikely to continue. Once no new coins are issued as the mining reward, then the miners are expected to be rewarded purely by transaction fees. This can be a problem. 

On the other hand, if the fees are increased too quickly or to an unreasonable level, interest on the coins will wane as well. With higher mining cost due to expensive equipment, mining pools will be formed. This is because miners prefer higher probability of success in cracking the code. However, this will lead to an undesirable outcome of mining pools exceeding 30% or even 50% of the network, thus exposing the cryptocurrency to attack. This was indeed the case for Bitcoin when the mining pool accounted for over 50% in the middle of 2014. 

This is one serious problem that needs to be solved sooner rather than later and consensus ledger or digital register without mining may be one solution.

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