First published: 2015
Authors: Paul Vigna, Michael Casey
A broad-based, introductory book about Bitcoin and its potential benefits and effects on the economy and the world. Since it was written some time back, some parts of it are outdated.
Trust is at the core of any system of money. For it to work, people must feel confident that a currency will be held in the right esteem by others.
We learn from their (countries with hyperinflation) experience that the core problem is not irresponsible policy decisions by money-printing central banks, though this is the mechanism through which hyperinflation is created. Rather, the problem stems from a deep-seated breakdown of trust between the people who use a currency and the monetary authority that issues it. Since those monetary authorities are ordinarily national governments, this breakdown reflects a society’s flawed relationship with its government.
If citizens don’t trust a government to represent their interests, they won’t trust its currency—or better put, they won’t trust the monetary system around which their economy is organised. So when given a chance, they will sell that currency and flee it for something they regard as more trustworthy, whether that is the US dollar, gold, or some other safe haven. When this dysfunction is entrenched, such beliefs are self-fulfilling. The loss of value in its currency depletes the government’s financial resources, which leaves money-printing as the only means to pay its debts and ensure political survival. Pretty soon, the excess money in circulation further undermines trust, which can give way to a vicious cycle of spiralling inflation and plummeting exchange rates.
The centuries-long debate over the nature of money can be reduced to two sides.
- This “metallism” viewpoint, as it is known, encourages the notion that a currency should itself be, or at least be backed by, some tangible material.
- The other side of the argument belongs to the “chartalist” school, a group that looks past the thing of currency and focuses instead on the credit and trust relationships between the individual and society at large that currency embodies. This view recognises the presence of an implicit, society-wide agreement that allows monetary exchange to perpetuate and debt and credit to be issued and cleared. This negotiated solution, a project that’s inherently political, is money. It’s not the currency. The currency is merely the token or symbol around which this complex system is arranged.
Debt, in other words, came first. The anthropologist David Graeber hypothesizes that specific debt agreements likely evolved out of gift exchanges, which generated the sense of owing a favour. After that, codified value systems may have emerged from the penalties that tribes meted out for various wrongdoings: twenty goats, for killing someone’s brother. From there human beings started to think about money as a system for resolving, offsetting, and clearing those debts across society.
To the metallists, governments simply played an endorsement role, authenticating the quality and quantity of metal in each coin. But to the chartalists, the state evolved to become the ultimate clearing house for debts and credits through its monopoly power over taxes, which could only be paid in the coin of the realm.
The sovereign’s capacity to issue money afforded one specific benefit: the creation of seigniorage, the ability to profit directly from the issuance of currency. These days, seigniorage arises because of the interest-free loan that a government obtains by printing money on comparatively worthless pieces of paper.
It all came down to different views on how best to protect trust in the monetary system.
On one side sat the believers in gold. Based on the ideas of liberal thinkers such as the great English philosopher John Locke, the gold standard was promulgated in the late-seventeenth century. People felt it was necessary to tie money to this tangible thing to prevent governments and their new partners in a profiteering banking sector from destroying the public’s money. The model succeeded in keeping inflation down, which helped protect the savings of the wealthy. However, the monetary constraints and the elevated value of gold typically also led people to hoard money in crises, which shut down credit growth, generated bankruptcies, and led to unemployment. At such times, the biggest victims were the poor.
Spearheaded by Walter Bagehot, the nineteenth-century editor of The Economist, this thinking led to the development of modern central banking. Backed by sovereigns that could never go bankrupt, central banks such as the Bank of England were to be the “lender of last resort” to overcome crises of confidence. They would agree to freely lend to solvent banks if their access to liquidity dried up in periods of financial stress. Although Bagehot’s rule was that such loans would carry a penalty interest rate and were to be secured with good collateral, the commitment turned central banks into a critical backstop to help overcome financial panics. The gold standard still existed, but this expansive new role for central banks alarmed its advocates, who had an aversion to unfettered banking power and freewheeling debt.
Now let’s take a closer look at what happens when the cashier swipes your card. With that action, the personal information contained in its magnetic stripe—your account number, the expiration date, the billing address’s zip code, and the CVV code—is sent to something called a front-end processor.
That firm, one of hundreds now in operation worldwide, specialises in handling payment information on behalf of its merchant client—in this case Starbucks—and for the bank into which coffee vendor’s sales receipts are deposited, an institution that’s referred to within the transaction chain as the acquiring bank.
For now, both Starbucks and its bank simply need to know whether the credit-card account attached to your card has enough funds in it to cover the payment.
The front-end processor’s job is to check that out, and quickly. So it forwards along the information contained on the card to the network of the relevant card association—MasterCard, Visa, American Express, etc.—which figures out which issuing bank your card came from.
Having left imprints of itself on multiple databases already, it’s now time for your personal information to move along to a separate payment processor representing the issuing bank, the one whose name is on your card and manages your account. Once your bank has verified the validity of the information and checked for sufficient credit, the signal goes back the other way.
The bank tells its processor to give the all-clear to the association, which conveys it back to the front-end processor so that Starbucks and the acquiring bank can be satisfied for now. The cashier is notified of the approval via an “authorised” message that appears on the card-reader display. This long series of electronic communications has all occurred within seconds.
The cafe still hasn’t been paid for delivering the coffee. For that, it must send a follow-up request to its acquiring bank, usually in a batch of receipts at day’s end. The acquiring bank will pay the merchant for those receipts, but it will need to place a request for reimbursement from the issuing bank, using an automatic clearinghouse (ACH) network managed by either the regional Federal Reserve banks or the Electronic Payments Network of the Clearing House Payments Co., a company owned by 18 of the world’s biggest commercial banks.
Still, your bank won’t release the funds if it’s not convinced that it was really you who bought the latte. So before it even gets the request for payment, its antifraud team has been hard at work analysing the initial transaction, looking for red flags and patterns of behaviour outside your ordinary activity. If the team is not sure about who was swiping the card, it will call your cell and home phone numbers, text you, and e-mail you, trying to get you to confirm it really was you in New York.
Once your bank is satisfied that all is aboveboard, it will release the ACH settlement payment and register a debit on your credit-card account. The money then flows to Starbucks’ acquiring bank, which credits Starbucks’ account. This process typically takes up to 3 business days to complete.
Each entity involved demands a cut for its part of the operation, adding up to total transaction fees of between 1% – 3% of every sale, depending on whether a debit or credit card is used. The biggest piece of the pie goes to the banks, which have in recent years turned payment processing into one of their most important sources of profits.
Still, it’s an illusion to think you are not paying for any of this. The costs are folded into various bank charges: card issuance fees, ATM fees, checking fees, and the interest charged on the millions of customers who don’t pay their balances in full each month.
Let’s imagine you’re buying that latte in Paris or Cancun. In that case, a host of other intermediaries are roped in to facilitate the exchange of dollars for euros or pesos: foreign-exchange trading banks and brokers, foreign-currency settlement and clearinghouse operators, and currency messaging services such as SWIFT. This time, direct costs are imposed on you through foreign-transaction fees, and you’ll incur hidden costs via the unfavourable foreign-exchange “spread” between the price at which you are charged for acquiring dollars and the price it costs your bank to obtain them.
We need these middlemen because the world economy still depends on a system in which it is impossible to digitally send money from one person to another without turning to an independent third party to verify the identity of the customer and confirm his or her right to call on the funds in the account. They help create the institutional trust on which our exchanges of value depend.
Banks are required by their regulators—the Fed in the US, the European Central Bank in the euro zone, the Prudential Regulation Authority in the UK—to carry a minimum ratio of cash reserves to deposits in case depositors demand their funds back in paper form.
In sum, our high-tech “electronic” payment system depends on the presence of a minimum amount of paper, which must be secured in vaults with alarm systems, security guards, armoured cars, and so on. Securing and distributing all this cash costs countries between 0.5%—1.5% of their GDP, says Ajay Banga, CEO of MasterCard Inc., offering an estimate that runs as high as $1.4 trillion when applied to the entire world.
Gil Lura, the Wedbush analyst, even argues that volatility is a good thing, on the grounds that it draws profit-seeking traders into the marketplace. Their presence encourages the development of sophisticated exchanges and more reliable mechanisms for swapping bitcoins into fiat currencies, he says, noting that bigger, more high-tech, and better-regulated trading exchanges were already coming online in 2014 to service a growing Wall Street-based clientele.
The argument is that this build-out will in turn lead to stability—eventually. To understand this argument we must recognise the role played in markets by traders, that special breed of investors who buy and sell assets in a short period to profit from price moves in either direction. In placing these short-term bets, traders provide much-needed “liquidity” to markets—defined as the degree to which investors can easily find buyers of an asset they want to sell or sellers of one they want to buy.
As more traders enter the market, creating more prospective buyers and sellers, liquidity increases and price stabilises. Ironically, though, it’s the volatility, not price gains, that first draws traders in, since that’s what creates profits. If prices are swinging around, traders can make more money being on either side of the trade.
We saw this in the 1970s, when the collapse of the Bretton Woods system sent exchange rates haywire and banks rushed to set up highly profitable foreign-exchange trading desks. Over time, the expansion of these desks, and the development of more and more sophisticated trading tools, delivered so much liquidity that exchange rates became relatively stable.
Lura is imagining a similar trajectory for bitcoin. He says bitcoiners should be “embracing volatility” since it will help “create the payment network infrastructure and monetary base” that bitcoin will need in the future.
Bitcoin’s blockchain ledger is a long chain of blocks, or groupings, of transactions occurring around the same time. The chain will continue to grow indefinitely so long as the system keeps operating. This chronological structure is crucial because it confers legitimacy on the oldest transactions, the idea being that later-dated attempts by a user to re-spend the same bitcoin balance is treated as illegitimate. By creating a time-stamped sequence of expenditures and receipts among every participant in the bitcoin economy, the system keeps track of where everybody’s balances are at any given moment, as well as the identifying information attached to every bitcoin—and fraction of bitcoin—ever created, spent, or received.
Every transaction that’s added to the ever-extending blockchain ledger is checked against the existing ledger before being given a stamp of legitimacy. Based on a consensus view among the miners as to which transactions are legitimate and which are not, the ledger provides irrefutable proof of who owns what and what has been spent and received.
The blockchain is managed by bitcoin’s core software protocol. Every user of the bitcoin network from Nakamoto to the present has in one form or another downloaded a set of programming instructions that tell their computer or smartphone how to interact, talk to, and work with others on that network. The blockchain doesn’t live on a single computer or server, but is shared around that community of computer owners, or nodes. Those nodes include machines that run bitcoin wallets, a form of software that gives consumers and businesses special passwords with which to propose changes to bitcoin balances (i.e. initiate payments) in those limited parts of the blockchain that are assigned to them. The nodes also include the individual PCs—or, more likely these days, specialised mining rigs—that are used by bitcoin miners to build the blockchain and earn bitcoin rewards. Working together according to the preordained system, these nodes collectively ensure the ledger’s contents are legitimate and protected from abuse by rogue elements.
Bitcoins don’t exist per se, not in the sense that you can peer into some electronic vessel and isolate a set of self-contained coins. Bitcoins exist only insofar as they assign value to a bitcoin address, a mini, one-off account with which people and firms send and receive the currency to and from other people’s and firm’s addresses. Bitcoins do not constitute documents or other digital files. The balance you see in your wallet is simply a net value of spending power based on an accounting of the incoming and outgoing transactions. This model is extended across the blockchain, encapsulating all the debits, credits, and balances associated with each unique bitcoin address. This is an important distinction because it means there’s no actual currency file or document that can be copied or lost. Your right to bitcoin is defined as the balance that the ledger recognises as yours. You can lose your ability to exploit those balances and shift them to someone else—that is, if you lose the password needed to release them—but you can’t literally lose bitcoins since they don’t actually exist.
Also critical: the ever-lengthening blockchain of confirmed transactions is public. That distinguishes bitcoin from closed electronic-currency systems such as PayPal’s, where the ledger is a tightly kept secret. Using specially designed software—most commonly, the free tool provided by Blockchain—you can see the details of every bitcoin transaction ever conducted. You can only change, or request to change, those parts of it that are accessible via your special passwords, but at all times you have full view of every other transaction and bitcoin address.
When looking at these addresses on the blockchain, we see nothing to identify their owners. Instead, they appear as strings of letters and numbers of between 26 and 34 characters. Each of these addresses, brought into being when a past transaction occurred, represents what cryptographers call a public key. As the owner of such an address, you are free to share it with outsiders and invite them to make a deposit there. But only you have the power to make a withdrawal, which you can do with the aid of a wallet.
Once James has instructed his wallet to send bitcoins to Coupa Cafe, it broadcasts that pending transaction to the network, along with a host of important pieces of information: the two parties’ assigned wallet addresses; the date and time stamp; various other details such as a unique transaction code; and whatever other information—a greeting, perhaps—that the sender might attach.
Each mining node or computer gathers this information and reduces it into an encrypted alphanumeric string of characters known as a hash. Just as with document files that can be “zipped”, this process allows relatively large amounts of information to be summarised and reduced to a much smaller store of data.
Depending on which hash algorithm is being used, the process produces a hash of a fixed length. In bitcoin’s case the algorithm is called SHA-256, which delivers a hash of 64 characters in length taken from the full range of numbers (0-9) and letters (a-z).
The tiniest change in the underlying information—a single decimal point or a space—will change the hash completely. This power to pack a lot of information into the same hash structure but with completely different results each time makes its encryption function powerful. Much information can be reduced and encoded. And while it’s virtually impossible to decrypt that code and find out what it contains, it’s relatively trivial if a computer has access to the underlying source data to verify that the hash accurately encapsulates that data.
Hash algorithms also allow you to build a kind of hash hierarchy, which is useful because it creates a structure within which the miners can group concurrently timed transactions together.
Here’s how that works: The miner’s software client takes the hash of the first transaction—with the pool of underlying data contained within it—and combines it with the raw data of the next, unhashed transaction to form a new hash. A full record of both transactions has now been hashed. A similar action then occurs with the next transaction that the mining client picks up.
It merges the second hash, the one containing two transactions worth of data, with the next transaction’s information to form a third hash. This process goes on as new transactions get picked up, with the computers constantly packing all the incoming data into a single hash, a code whose underlying information can easily be verified at a later time by working back through the unbroken chain. This is how transactions are packaged into the blockchain’s crucial building blocks—called blocks.
While all this is going on, the computers are also participating in a kind of competition/lottery to try to be the first to “seal off” one of these blocks—that is, prepare it for insertion in the blockchain ledger and take home the prize of the next issuance of bitcoins. Until that happens, the network can’t begin to confirm the validity of the latest round of transactions. Each miner has been individually hashing and rehashing the underlying data in the manner described, but their details aren’t yet ready to be checked by the network.
The machines enter the competition by simultaneously and rapidly coming up with new potential block hashes to encode and capture all the data in the new, fully packaged block and link it to the block hash of the previous block. The winning block hash must match one that bitcoin’s core algorithm has decided will be the current block’s winning number. The match is extremely difficult to make, so the computers keep coming up with new hashes until they get it right, tweaking the process each time to change the readout—over and over and over. Each of the countless new hashes produced by the computer is created by adding a unique, randomly generated number called a nonce to the other data contained in the block hash, which includes the hashed underlying transaction information and the block hash of the previous block. Adding a new nonce each time completely alters the output hash.
At the end of this laborious trial-and-error work, one mining node will eventually come up with the block hash that the bitcoin algorithm was looking for, a number that must have just the right amount of zeros in it and various other conditions. Getting there requires brute computational force, which is why a mining rig with the fastest hashing power is going to have a better chance than a slower one of winning each block. That said, the hashing process is totally random, which means that while the most powerful rigs will win the competition more frequently than lesser rigs, they won’t win every time.
Miners are set the task of solving the puzzle for two reasons. One, it imposes a cost on mining, since the computing power it demands is expensive, in terms of both the machinery and the electricity it uses. That helps to regulate mining and create a reciprocal relationship between what otherwise would be free bitcoins and the work required to obtain them. And two, it creates a competition with a payout at the end, which incentivises the miners to do the work needed to confirm the transactions.
Once the puzzle is solved, the bitcoin software client that’s running on the winning node’s machine “seals off” a new block of transactions with the block hash and assigns to it a block number that sequentially follows the last block number on the ever-extending blockchain.
Because of that hypersensitive quality of hashes, where the slightest data change will completely alter its output, this structure means that, in theory, no one can mess with any of the data contained in the blockchain’s history. Doing so would turn the whole thing into gobbledygook. This makes it tamperproof.
Once a newly sealed block of transactions has been created and added to the chain, important work remains to be done: other miners must now confirm the legitimacy of the underlying transactions contained within it. Without their affirmation, no shared consensus exists on the truth of what lies in the blockchain. There would be no way to say for sure that a rogue miner had incorporated bogus transactions into a block. It could send bitcoins that it doesn’t have the right to spend—that is, counterfeit them—and the system would simply accept that fraud as if it were a legitimate transaction. The other miners thus verify what’s known as the winning miner’s proof of work, comparing data from the underlying transactions to the hashed data within it so as to verify its legitimacy and check it against the history in the blockchain.
While the block-completion and confirmation process implies at least a 10-minute wait until a transaction is fully cleared, merchants that use the services of a bitcoin payment processor such as Bitpay, Coinbase will typically accept a customer’s payment immediately. For all but the very largest transactions, the processor usually bears the risk of non-confirmation. They do this because non-confirmations—or the double-spending actions that lead to them—are very rare.
Notwithstanding these expediting tricks, the bitcoin algorithm establishes certain rules to build confidence in the ledger over time and to ensure that miners are properly incentivised to confirm only legitimate transactions. Although a miner is allocated a new batch of bitcoins once it seals off a block and ties it to the blockchain, the bitcoin protocol won’t let it use those bitcoins in a payment until a total of 99 additional blocks have been built on top of its block. That makes sure that over time, the network consensus on the legitimacy of the transactions contained in that original block becomes rock solid. It also motivates every miner to make sure that everyone else is doing the right thing.
Occasionally, two blocks are found virtually simultaneously, which ultimately means that one block becomes “orphaned” as the network can pick only one on which to build the longest chain. The bitcoins awarded to the orphaned block will be left as worthless, and whatever transactions that were contained within it but excluded from the legitimised block that’s now inserted into the chain will have to be processed later as new blocks are created. This capacity to orphan an illegitimate block is important because it means the entire network can be satisfied that the unbroken chronological chain, simply by virtue of continuing, represents the true record as recognised by consensus. But it also means that some transactions have longer wait times before they are fully confirmed and installed in the blockchain.
Weak and corrupt institutions are the root cause of poor people’s exclusion from the banking system because they deny people the chance to prove their integrity and net worth to bankers. Well, the blockchain, if taken to the extent that a new wave of bitcoin innovators believe possible, could replace many of those institutions with a decentralised authority for proving people’s legal obligations and status. In doing so, it could dramatically widen the net of inclusion.
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