Bitcoin

And the Future of Money

Jose Pagliery

• Publisher: Triumph Books
• Year: 2014
• ISBN:
  9781623689193
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Bitcoin first appeared in 2009, and it's already challenging everything we've come to accept about money, financial institutions, and even government. The digital currency can be nearly anonymous. And it can be traded internationally—without the fees, government regulation, and bank oversight of paper money. But Bitcoin is still risky. Its value fluctuates wildly. More than $400 million of it disappeared overnight with the fall of a single trading exchange. How is that possible? And why is it so popular? CNNMoney reporter Jose Pagliery explains it all. He details the digital currency's mysterious origins. He explores the dark side of Bitcoin: a world of drugs and assassins for hire. And he examines the economic impact of this revolutionary concept through interviews with pensive economists, wary bank regulators, and free market proponents such as Ron Paul. Bitcoin: And the Future of Money explains how it works and why it matters. The book is essential reading for anyone looking to understand a financial innovation that will forever change how we think about money.

CHAPTER 1

Baby Steps

IT WAS an otherwise quiet news day in February when word got out that the niche online trading site Mt.Gox (mtgox.com) went offline. The difficulty for me then, as a technology and business reporter at CNNMoney, was to explain to the average reader how a website that few had ever heard of suddenly wiped out the savings of people around the globe. The loss totaled nearly $400 million at the time. And it was all in a currency no one understood, no less.

That was, for many people, the first time they’d heard of Bitcoin. The circumstances were less than ideal. But the occasion was an appropriate wake-up call.

The world was finally paying attention to the term digital currency. Put simply, it’s electronic money—nothing more than bits in a computer, be it your laptop, smartphone, or some far-off computer server in a chilly, climate-controlled data center.

Make no mistake. It’s real money. But it’s unlike anything we’ve ever seen. Although it has similar properties to the paper bills we all carry in our wallets, a digital currency like Bitcoin is not printed by a recognized authority like a government that determines how many are put into public circulation. Nor is it valued in a traditional sense like gold, whose limited supply is slowly extracted from the earth at great labor and expense.

You can’t feel or touch bitcoins. And it’s precisely that aspect of a digital currency that polarizes people. Bitcoin’s most idealistic supporters celebrate it as something akin to a monetary messiah, a means of exchange that will let you buy anything, anytime without nasty roadblocks, like banks or law enforcement. On the other end of the spectrum are the conservative cynics who think Bitcoin is bogus, nothing more than a moneymaking house of cards that’s bound to fall as soon as the world wises up to the fact that zeros and ones on a computer are quite worthless.

They’re both wrong. Bitcoin won’t upend the world’s superpowers—not entirely, anyway. But it’s already leaving a lasting impact, because it represents a whole new way of thinking about money. Therein lies Bitcoin’s promise. It has the potential to transform something that’s a pivotal element of human history—shaking us to our very core.

To understand the significance of something like Bitcoin, it’s worth doing a quick review of history. While economists and anthropologists disagree about the origin of money,¹ this much is certain: It’s as old as human civilization. Money had already appeared by the time humans started jotting down the earliest surviving accounts of their actions in ancient Mesopotamia around 3100 BCE. At the time, it wasn’t a medium of exchange in the form of gold coins or paper bills, though. It was merely a ledger of accounts, a running tally of who owes whom. But for all intents and purposes, the system of debt and credit served as a way to trade.

Some thinkers are inclined to say that money predates even government.² That’s the argument put forward by free-market proponents like Adam Smith, widely accepted as the father of capitalism, and Austrian economist Carl Menger. Before the appearance of money, perhaps we bartered for goods. But bartering—or the credit system of ancient Mesopotamia—is a terribly inefficient way to trade.

The turning point came around 2000 BCE, when money appeared in a fashion more similar to what we know today. People in Egypt and Mesopotamia used receipts that showed how much grain they kept stored in temples. More than a thousand years later, metal coins gained ground in nearby areas. It eventually became too much of a hassle to lug around heavy sacks of misshapen bronze coins, so people everywhere opted instead for paper currency that represented value stored elsewhere, such as a bank. In China, they first appeared with merchants during the Tang Dynasty around 900 CE.³ At about the same time in the medieval Islamic world, checks and promissory notes gained in popularity. Europe was the late bloomer, with paper currency making its first appearance in Sweden in 1661.

But that’s just about where the story of monetary innovation ends. Surprising and disappointing, isn’t it? Since then, governments have strengthened their control over the money-printing process, and countries continue to struggle with the fact that paper notes have no intrinsic value. This makes them susceptible to inflation, as occurs when a government prints extra bills to pay off its debts. That devalues its currency relative to others and impoverishes its people.

Meanwhile, banking has evolved many times over. The concept of a bank as we know it began in Italy during the Renaissance as a simple provider of bills of exchange, financing trade. Over time, banking has morphed to include loans, quick transfers of wealth across great distances, as well as a means of investing and consulting on those very investments. Over the centuries, banking has squeezed itself into the world of money, in the United States becoming the first and only entity to receive newly printed government dollars. Banks have placed themselves squarely between the people who earn money and the governments that issue it. They have made themselves necessary middlemen.

Indeed, in the modern era, banks have become synonymous with money and necessary for a prosperous life. Have you ever tried to conduct an expensive transaction without a bank? In most cases you’ll get rejected or worse—a nasty glare from someone assuming you’re up to no good. Or have you ever tried to receive steady pay for work in cash? Professionals will most likely receive a paycheck that needs to be cashed out at a financial institution, and some employers even make direct bank deposits mandatory. But think about what that does to society at large. It puts banks at the top of the social pyramid. Even though money is a necessary part of human interaction, something as ingrained in our consciousness as the rule of law, there exists an entity that retains firm control of it.

They are the gatekeepers. But that need not be the case.

Enter Bitcoin. For the first time in centuries, we’re faced with a new kind of money. Because it runs on the Internet, this money can be sent across the globe in the blink of an eye with near anonymity. Anyone can receive it—and spend it—even if they live hundreds of miles away from their nearest ATM. And because it functions directly between one wallet holder and another, there are no banks that slow down the transaction process. No fees. No restrictions.

It sounds too good to be true. Or maybe we just forgot how liberating money is supposed to be.

CHAPTER 2

The Birth of Bitcoin

IT ALL started on an obscure online discussion forum dedicated to cryptography. The subject matter—the art of secure and secret communication—dictated that the regulars were mostly technical experts in mathematics and engineering. The “low-noise moderated mailing list” on metzdowd.com served as a de facto academic community, just the right place to introduce an experimental proposal that was equal parts economics and computer science.

It was Friday, October 31, 2008—Halloween, a day when millions don masks and hide their true identity. That’s when the mysterious Satoshi Nakamoto first appeared with a message titled, “Bitcoin P2P e-cash paper” posted at 2:10 PM (ET):

I’ve been working on a new electronic cash system that’s fully peer-to-peer, with no trusted third party.

The paper is available at: http://www.bitcoin.org/bitcoin.pdf

The nine-page, academic-style document described the fundamental details for a new currency and the unique, theoretical network to deliver payments. It detailed the complex way transactions would work, the heightened privacy offered to account holders and how the software would keep people from double-spending their digital coins.

The essay, “Bitcoin: A Peer-to-Peer Electronic Cash System” (see Appendix, p. 227), isn’t a walk in the park to digest. But the introduction lays out a vision that’s easy to grasp: Technological improvements have outpaced the development of financial networks, and we’ve outgrown the need for banks in the process. The main gripe for Nakamoto* was that banks have become a third wheel. They used to speed up transactions, but now they slow them down. As middlemen, banks settle payment disputes between buyers and sellers. To do that, they must charge fees. With those costs, it’s not profitable for a bank to process tiny transactions, so we’re limited in the kind of purchases we can make. Making matters worse, merchants fear customers might try to reverse a purchase, so they raise their rates too.

“What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party,” Nakamoto writes.

Nakamoto proposed a digital currency that would live on a network of computers, a well-meaning community willing to lend their machines’ processing power to keep it alive. Together they would partake in a system that verifies transactions and “mines” for new bitcoins, producing electronic tokens at a steady rate. Bitcoin with a capital “B” would be the name of the new system; bitcoin with a lowercase “b” would mean the units of currency.

The key to the entire system was something called a block chain. This was an innovative approach that simultaneously verified transactions, kept a log of them, and created new money. Users would mine for bitcoins by solving puzzles in segments called blocks. Those blocks would house publicly viewable information about recent transactions. A solved block would produce a unique code, or hash, that formed the foundation for the next block.

He was immediately peppered with highly technical questions and concerns from others on the mailing list. Could this system handle many simultaneous transactions? What would keep people from spending the same coin twice? After all, they’re not physical. Such a blunder would topple the whole system. And what about nefarious hacker types who hijack whole server farms and turn them into spam-spewing zombies? Surely a system that lives on a network of volunteers’ computers wouldn’t stand a chance against that kind of coordinated attack.

Nakamoto’s responses were careful, controlled, and respectful. A novel approach to verifying transactions would prevent someone from spending the same bitcoin twice, he explained. And the system, by relying on the combined computing power of lots of users, was designed to withstand any single attack of that kind.

The responses also revealed a great deal about him. He had a firm grasp of the most fundamental and often elusive characteristics of money. He was even more familiar with cryptography, having built the core functions of Bitcoin with the notion that new coins would be produced as computers solve increasingly difficult puzzles. But first and foremost, Nakamoto was a computer geek.

“I appreciate your questions,” Nakamoto wrote. “I actually did this kind of backwards. I had to write all the code before I could convince myself that I could solve every problem, then I wrote the paper.”

But there was something else. Beneath the highly technical language was a youthful idealism, a grand vision of what this opaque, unproven project could become. Nakamoto imagined that bitcoins could one day become popular enough that they would give birth to a new industry, one dedicated solely to maintaining much of the network and producing new bitcoins. By then, they’d be so desirable that hackers in control of server farms would rather use those slaves to mine for electronic money than attack the network or distribute annoying spam. At some point, the network would be large enough to easily handle the same kind of bandwidth seen by payment networks like Visa, processing tens of millions of transactions each day.

Above all, though, the system would be liberating. Although all transactions between digital wallets would be recorded in a public ledger, nameless wallets would allow for enhanced privacy, a sort of pseudo-anonymity. Without financial institutions taking a cut, it would be easier for people to make small, casual payments to one another. With a predetermined, controlled growth in the supply of electronic money built into the software, Bitcoin could avoid runaway inflation. It could become a go-to currency for people living under a government eager to print money and depreciating its own currency.

Bitcoin’s rebellious nature and thinly veiled intentions didn’t get lost on one commenter, who told Nakamoto point blank: “You will not find a solution to political problems in cryptography.”

“Yes,” Nakamoto replied. “But we can win a major battle in the arms race and gain a new territory of freedom for several years.”

It was typical cypherpunk talk, derived from a school of thought that holds privacy sacred and personal liberties above everything else. In fact, understanding cypherpunk culture (not to be confused with cyberpunk, which is more of an art form) is key to appreciating Bitcoin and its enigmatic founder.

The name says it all. To use a cypher (or spelled correctly, cipher) is to convert information—say, a message to a friend—from its readable form into something incomprehensible, like a string of nonsense letters, numbers, and symbols. Using the right formula, you can take that indecipherable text and change it back into something readable.

It’s quite empowering, when you think about it. The ability to communicate privately opens the ability to truly express your thoughts, to identify political or societal problems and criticize them without fear of retribution. That’s particularly true as the Digital Age brings about the Information Age, when our means of communication via computers and phones have become practically seamless—as has the capability of governments and powerful corporations to spy on those conversations. We’re all human, and b...