Turning megabytes into megabucks
After three years of crashes, controversy and fluctuations can e-currency Bitcoin establish itself as a viable alternative to cold, hard cash?
"The root problem with conventional currency is all the trust that's required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve."
Many people will agree with this statement from Satoshi Nakamoto in light of the Euro crisis. However, in 2011, in a wave of media coverage, his virtual currency Bitcoin rose to over $30 and crashed in four months. Technology, it seemed, was not an antidote to unreliable banks and human fallibility. A few months earlier, Nakamoto (probably a pseudonym) disappeared. Some speculated he might be virtual himself despite the existence of real co-developers such as Gavin Anderson, Nils Schneider, Jeff Garzik, and Wladimir J van der Laan who have solid engineering pedigrees with firms such as Red Hat, Silicon Graphics, and ASML.
Bitcoin insiders have a different take on last year's events: the currency as a whole did not crash, just its value on one popular exchange in Tokyo called Mt Gox. "Mt Gox restricted daily account withdrawals to $1,000 worth of Bitcoins but a hacker got round this by simulating a sell-off in order to drive the exchange rate to zero," explains Donald Norman who, with programmer Amir Taaki, set up the UK Intersango.com Bitcoin exchange.
"By pushing the price down, the hacker was able to cash out a large number of Bitcoins. While the value of Bitcoin went down to cents on Mt Gox, on all the other exchanges it stabilised to around $13. Mt'Gox was not up to professional security specifications. "They were repeatedly warned about this and clearly did not fix the problem," says Norman with some frustration.
When a bank or a company collapses, we don't say it is a problem with the dollar but a problem with the bank or the company, he adds. "Bitcoin has never been cracked or compromised."
Like the file-sharing application Bittorrent and the free phone-call software Skype, Bitcoin is a way of sharing computation, data, and bandwidth – known as peer-to-peer (P2P) computing – among a community of Internet users. In the case of Bitcoin, participants hold the cryptographic keys to a currency made of secure mathematical tokens and transact directly with each other.
P2P applications generally provide a lower cost alternative to a paid-for service. Bitcoin lets its users send a form of digital cash around the world in minutes without incurring the large fees charged by financial organisations. The Bitcoin community would go further and describe Bitcoin as the first completely decentralised and fully democratic currency. "It is giving the power back to the people," says Amir Taaki.
What is real?
For those not heavily engaged in the virtual world, a virtual currency might seem baffling. How can you have money that is not contractually backed by physical assets or legal tender laws?
A currency is a kind of collective belief, like a religion, says Ursula Huws, professor of labour and globalisation at the University of Hertfordshire. An extreme example would be the huge stones that were used on the island of Yap in the South Pacific as a currency. People agreed on the stones' value and remembered who owned them. "Modern currencies are not fundamentally very different," says Huws. "In essence, as soon as people stop believing in the Euro or the Yen or whatever, it collapses."
But at some point, she says, we have to come back to the idea of a real economy, created by real workers, putting in real effort, inventing real things, sold in real markets. Huws is particularly interested in how this relates to virtual products. "The basic form of transaction in a money economy is people exchanging their time for money. Because of the different values of different people's time, it can become profitable to outsource from one person to another. So you can create a market in someone playing your video games or using your computer to do cryptography and so on."
Virtual monsters pay the bills
Playing multiplayer online games to acquire virtual in-game currency has become a source of real full-time employment for up to one million people, mostly in China. Estimates about the size of the 'gold farming' trade range from US$1bn to more than $10bn, suggesting there is plenty of potential to build large global 'sub' economies on virtual currencies.
Gold farming brings real-world scarcities and inequalities of time and money to bear on virtual scarcities of currency and resources, explains Richard Heeks of the University of Manchester in his paper 'Understanding "Gold Farming" and Real-Money Trading as the Intersection of Real and Virtual Economies'. The Internet, he says, has allowed those in the world with more money than time (player-buyers) to trade a scarce resource (gold, or items, or high-level characters) with those with more time than money (gold-farmers).
Heeks traces gold-farming's origins to 1997, a year that brought us Ultima Online, the first true massively multiplayer online game; the launch of eBay (providing a low-cost marketplace for virtual items); and the Asian currency crisis in which Asian governments invested heavily in broadband infrastructure. A games culture took root in east Asia. Some of the unemployed set up PC kiosks in which games could be played. Others turned to gaming to fill their empty hours. Chinese 'playborers' earn can around US$150 or so per month with food and accommodation thrown in working a 10-12 hour daily shift 'in-game' mining ore, picking herbs, killing monsters and so on.
Who's in charge?
Within an online game, a company controls the virtual currency like a central bank in a conventional currency. Bitcoin has the global reach of a game currency but no central control. It is also cryptographically secure – the only way to crack it is to have more 'attacking' nodes on the P2P network than benign ones.
Such characteristics, say Bitcoin's detractors, make the currency easily subverted for illicit purposes. This is a legitimate worry. And yet fiat currencies with full regulation do not stop tax avoidance or money laundering or worse. Natalia Morar's investigations into the murder of Andrey Kozlov, deputy chairman of the Central Bank of the Russian Federation, for example, brought to light the kind of corruption, money laundering and thuggery one would expect from a Scorsese movie, says Donald Norman.
Realistically speaking, it is hard to stop any currency being used for illicit purposes. But there is wealth and social value that can be made by having a more economical system in place. A so-called 'frictionless' global means of exchange could stimulate a new era of trade, says David Birch, director of the British IT consultancy Consult Hyperion, which worked on the mobile phone-based money transfer system M-PESA used in Kenya.
"We are moving into an era of blogs and e-books but it is complicated getting paid for them," says Birch. "If there was a red button on your keyboard that said give this person 50p, you can imagine new businesses springing up. Because M-PESA provides a simple low-cost way of paying people, there are businesses in Kenya that could not have existed before. Firms can now sell a day's insurance, for instance, to farmers who need to move their animals from one place to another," he says.
Whether Bitcoin is the way forward, or a variation on the P2P approach, or another technology, will depend on many factors.
Birch thinks Bitcoin is technically appealing but he has reservations. "Distributing the processing over a P2P network is a good idea for efficiency but if I'm going to buy a TV from someone in Kazakhstan, say, I want a central registry too so if the TV does not turn up, I can complain."
Edwin Jacobs, a partner at time.lex, a Brussels-based law firm specialising in business law for the information society, has been looking into the legal complexities of electronic cash. Having been involved in checking compliance across Europe for international clients who were rolling out an electronic wallet, Jacobs wondered if a decentralised P2P currency might fit into one of the 'exceptions' in the revised European Electronic Money Directive 2009/110 EC.
The new variation came into force on 20 April 2011 and removed some barriers to offering e-money services. Money stored on specific pre-paid instruments such as London Transport Oyster cards, designed for precise payment needs or with limited scope, is excluded from the more onerous compliance requirements. Another exception is where a mobile phone or other digital network customer pays the network operator directly for digital goods or services, such as buying ringtones.
"Bitcoin could possibly claim it was under an exception but it needs to be transparent about why. Much can be regulated and explained in a contract, for instance, but at the moment, the Bitcoin software only comes with a basic disclaimer saying the authors accept no liability."
The data protection position also needs clarification. "Because Bitcoin is decentralised and operates over a P2P network, there are in essence many mini databases which collect data. Do they collect personal data by which you can identify someone? If so, what do they collect and who has access to it?"
If many people start using and trusting Bitcoin, then it will gain traction, says Jacobs. "New technology is what gives us progress. But from a consumer perspective, to be more widely accepted it needs to comply with basic regulatory requirements or there should be a clear explanation why it does not need to. 'Comply or explain' is a philosophy also used in the financial sector."
Donald Norman and Amir Taaki have no illusions about what is needed to get the technology widely accepted. "Right now, Bitcoin is not as user-friendly as it could be. It is like the Internet without the Web browser," says Taaki. He is working on improving the software by developing a library of functions for developers to make it easier to build applications.
As part of their Intersango activities, they have had positive feedback from the FSA, says Norman. "While there is not yet any declaration by any government body as to how Bitcoins will be classified under law, the FSA has been very fair and supportive in confirming that Bitcoin resellers will not be regulated by many of the more restrictive regulations seen with other similar methods of payment."
Meanwhile, those who find the subversive aspect of Bitcoin appealing might be disappointed to learn that (apparently) co-developer Gavin Anderson has been asked to talk to the CIA's technology investment arm, In-Q-Tel.
Maybe those Mexican drug cartels will have to stick to their usual methods...
How it works: The generation of bitcoins
To ensure Bitcoins are not generated at will or counterfeited, encryption is used to sign them over from one entity to another. In essence, Bitcoins are a chain of digital signatures. Central to Bitcoin is a transaction ledger – the blockchain – distributed over the P2P network.
The blockchain describes all the money flows since the system's inception in 2009 and stops the same coins being spent twice. New blocks are created by solving a mathematical riddle chosen by computers in the network according to an algorithm. When nodes solve this riddle, they make a new block. Each block contains as many transactions as will fit in 1MB (about 1,000 transactions).
Computer nodes involved in solving the riddle are called miners, whose role is to validate the transactions. The first miner to solve each riddle is awarded 50 newly generated bitcoins. The difficulty of each puzzle automatically increases with the number of miners so a predictable rate of Bitcoins enters the economy. The size of each block 'subsidy' halves every four years with a limit of 21 million Bitcoins produced by 2040. Bitcoins are divisible to eight decimal places meaning 2,100'trillion of the smallest divisible denomination will eventually exist.
Social currency: How to get good KARMA
Social networks such as Facebook depend on their participants posting information and interacting. Their interests, affiliations, likes and dislikes are the 'oil' of the digital economy, to quote Trebor Scholz, author of the upcoming book 'The Internet as Playground and Factory'. Other companies profit from this interaction by collecting and selling the data.
To encourage participation in social and other networks there is growing interest in offering incentives. With this in mind, Jon Allen at the department of computer science at Baylor University, Texas, has developed MultiKarma, a working version of a theoretical peer-to-peer (P2P) resource exchange framework called KARMA.
Vivek Vishnumurthy and colleagues at Cornell University invented KARMA nearly a decade ago. They described a single value called karma that represents a user's standing within a P2P network. A user starts off with a seed amount of karma, which is adjusted up and down according to the amount of resources (files, messages, or the result of a computation) a peer has contributed or consumed. Groups of peer nodes, called bank-sets, keep track of each user's karma 'balance'.
Allen's MultiKarma system is a practical version for creating and controlling multiple currencies and purchasing/selling resources on any participant-based technology. A company like Disney, explains Allen, could create a currency and reward participation for locally caching content on a user's computer for use by nearby consumers. A participant can use 'Disney Dollars' to purchase Disney content or exchange the dollars for another currency on the network.
In practice: My Bitcoin Diary
Jason Goodyer takes a tour through the Bitcoin process.
Anyone wanting to take their first steps to becoming a Bitcoin millionaire obviously needs a way of trading and storing spoils. With this in mind I start off by heading to bitcoin.org and downloading the open-source Bitcoin client. Upon opening the software I am faced with an inconspicuous grey window declaring itself to be my Bitcoin wallet. Now I'm up and running.
Slightly uncertain of what to do next I resort to the service's intimidatingly extensive wiki. The easiest way to get your hands on some coins seems to be by buying them with traditional currency from one of several exchange websites. But before I am able to reach for my credit card my attention is drawn to the following unpromising but refreshingly honest admonition: "anyone who puts money into Bitcoin runs the severe risk of losing all of it". Okay, perhaps it's not the greatest idea to transfer my meagre life-savings into Bitcoins.
With investment out of the equation I wonder if I could earn my way to becoming a Bitcoin millionaire. After all, several Bitcoin-related websites state that the best way to earn coins is to supply services to other users. And indeed there are a number of web designers and tech-oriented artists who accept payment for their work. Call me reactionary but if I'm going to go to the trouble of setting up a part-time business I think I'd rather stick with old-fashioned Sterling.
Next I stumble across something referred to as 'mining'. This is a process in which computing power is used to solve numerical codes with unique digital signatures and thus generate new coins. But after one glance at the photos of the miners' impressive computing set-ups posted on the forum it's pretty clear my lowly netbook will not be capable of generating much income, even if I leave it running for a year.
My fortunes start to look up when I chance upon Bit Faucet, a website created by one of the currency's early adopters and enthusiasts Gavin Andresen that gifts 0.005BTC to everyone who visits. The lowest denomination of a coin is eight decimal places and is named after Satoshi Nakamoto – the currency's mysterious creator. So, I am now the holder of 500,000 Satoshis. Put like that it doesn't seem like too bad a start.
Next up I attempt to put my 500,000 Satoshis to work via that mainstay of the Internet economy – gambling. I'm not much of a card player so opt for Bitcoin Darts, a simple web-based game that is, alas, as unglamorous as its real-world version. However, there's a hitch. It requires 0.01BTC per play. A look through several other dice and card game sites and it's the same story.
Every gambler should know when to cash in his chips and I know when I've been beaten. So, that leaves only one last thing to investigate: what exactly can one buy for 0.005BTC? The quick answer is not a lot. Perhaps a more pertinent question would be: what exactly can one buy with Bitcoins, full-stop? Several lengthy Internet searches later reveals few merchants willing to accept the currency as payment.
Btcbuy.info claims to offer a service to transfer coins into Amazon or Sears gift-cards but this isn't available in the UK. Elsewhere, there are several slightly suspicious looking websites offering to exchange coins for precious metals but again they only seem to operate in the US. Of the handful of products on offer the most appealing are Bitjerky, a company which ships 100g of its beef jerky worldwide for a tidy 4.68BTC, and some pretty cosy looking alpaca wool socks offered by Grasshill Alpacas for 5.5BTC. Sadly both are way out of my price range.
While it is undoubtedly an interesting concept, Bitcoin clearly has some way to go before bringing the global banking system to its knees. It is, for the foreseeable future at least, the preserve of a cadre of enthusiasts. A band of techies who take pleasure in assembling their own computers and get a kick out of the feeling they are part of an off-the-grid economy, something bigger than themselves, and something that sends the slight whiff of revolution wafting around their bedrooms or offices, no matter how faint. Then again, it could just be that they've been wearing their alpaca wool socks too long.
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