Tuesday, July 29, 2014

Beyond New York: What Lies Ahead for Bitcoin

By Jon Matonis
Thursday, July 24, 2014


According to the proposed 17th July bitcoin regulation from New York State, the public now has 45 days to comment and then a 45-day grace period prior to full adoption. But what's after 17th October? More importantly, what's after New York?

The poor regulators are in a quandary. It's hard not to be sympathetic sometimes. They are practically in a no-win situation, because regulators must use their tools to regulate, but the more they do, the more they inadvertently encourage market-based responses.

With the New York framework for bitcoin businesses, financial regulators need to demonstrate that they have not ceded control of the payments mechanism and the wholesale money transfer business, while simultaneously trying not to be accused of squashing technological innovation.

If improved financial privacy is considered a bitcoin innovation, then, yes, government choke points do stifle innovation.

Sitting on a razor's edge, their actions can either propel bitcoin more into an off-the-books counter-currency or retard US monetary progress for decades as more nimble jurisdictions exploit the economic benefits of cryptographic money. However, in the regulator's mind, they have no good options and permitting unimpeded bitcoin growth is unacceptable  so act they must.

Regulators and their red herrings

It is this general desire for enforcement action that so fatally misses the mark, because it blindly ignores the societal consequences of the great cryptocurrency wealth transfer and the temporary turmoil for the wave of people caught ill-prepared.

If anything, governments should encourage greater bitcoin savings and user-friendly open-source software. Seismic shifts that will transform existing financial and political institutions are now occurring directly underneath our feet.

And, while all of that happens, what do New York regulators choose to focus on?

Among many red herrings, they focus on perceived problems, like identifying physical addresses of bitcoin transactional parties and prohibiting bitcoin-related companies from maintaining profits in bitcoin.

Contrary to what the alarmist Perianne Boring states, bitcoin's fate will not be decided by lawmakers and regulators in the next 18 months. The only fate that will be decided is that of New York and any other regions that would adopt such a harsh line of regulatory thinking. In other words, the New York Department of Financial Services (NYDFS) doesn't harm bitcoin, it harms only the citizens of that jurisdiction who suddenly become disadvantaged relative to citizens in the rest of the world.

Here's what happens on 17th October: bitcoin continues to be a juggernaut, rolling over the promiscuous money printers and corrupt kingpins of the centrally planned banking system, albeit with some market-based adjustments. Markets perceive regulation as 'damage' and route around it. This is true with Internet-related damage and it is equally true with bitcoin-related damage.

Ultimately, the market will provide solutions to cases of bitcoin privacy 'damage', so I provided two handy reference guides: 'Why Bitcoin Fungibility is Essential and 'A Taxonomy of Bitcoin Mixing Services for Policymakers.

Bitcoin, Tor and Financial Privacy

For starters, don't be discouraged by the New York regulatory proposal, because while exchanges and banking interfaces are useful for price discovery, they are optional for everyday bitcoin usage.

Government attempts to exploit systemic choke points is all part of the natural transition process.

Similar to the Electronic Frontier Foundation's Tor Challenge to circumvent government censorship, the bitcoin community needs a challenge to support and encourage true financial privacy, compared to the sanctioned privacy permitted under the guise of consumer protection. Privacy is claimed  it is not sanctioned.

Without privacy by default in the original Satoshi bitcoin client software, additions and workarounds for various wallet implementations have been the norm.

Writing in Forbes, Andy Greenberg explains that an upcoming version of bitcoinj the software that powers many of the most popular bitcoin apps like Multibit and Bitcoin Wallet  will route all connections to the bitcoin network over Tor’s anonymity network before reaching another bitcoin node.

Bitcoinj creator Mike Hearn said:
"The fact I use bitcoin isn’t a secret, but I don’t want all my transactions in an NSA database. When I use bitcoin in a bar, I don’t want someone on the local network to learn my balance. The way bitcoin is used today, both those things are possible."
Thanks to IP tracking, it’s "possible that the NSA and GCHQ have de-anonymized most of the block chain by now," he added.

Also, various implementations of the CoinJoin method have emerged recently, including Shared Coin from Blockchain and the Dark Wallet alpha release from developers Cody Wilson and Amir Taaki.

Relying only on bitcoin for operations and avoiding the regulatory glare implicit via banking relationships, Blockchain's modern uniqueness is in tune with bitcoin's principles, including user-defined privacy.

Despite some prior user claims to the contrary, Blockchain does not block Tor exit nodes  although individual account owners can block Tor IP access. Denial-of-service defenses may also cause some Tor exit nodes to be blocked temporarily.

In an enormously important three-minute interview, political theorist and global resilience guru Vinay Gupta recognizes that "[bitcoin] cannot be divorced from pre-existing political theory."
Gupta goes into explicit detail on the meaning of power and the significance of property rights:
"The vast majority of the people using bitcoin are politically shallow. The problem is that bitcoin has succeeded technically and is midway through the process of failing politically."
Gupta explains that the fundamental underlying issue for bitcoin and its future success is how to do strong property rights within the system and no property rights to operate the system as whole. The answer lies in what we already know about political theory and similar economic arrangements.

Foreshadowing the coming slew of ambitious regulatory restrictions, he surmises that "until the bitcoin community admits that it's got political problems rather than technical problems, they're trapped".

Tuesday, July 22, 2014

The Bitcoin Mining Arms Race: GHash.io and the 51% Issue

By Jon Matonis
Thursday, July 17, 2014


Tensions over bitcoin's long-term security have eased following a hastily-arranged roundtable of mining participants on 9th July in London.

With representatives from all areas of bitcoin mining and ASIC hardware manufacturing in attendance, the most significant thing about the meeting was that it even occurred at all.

A forum for discussing these issues is critical to maintaining the integrity of the bitcoin network, as its overall health depends on smooth mining operations with a minimum amount of orphaned blocks, hard forks and dominant players capable of executing a 51% attack.

Last month, Jeffrey Smith (CIO of bitcoin's biggest mining pool, GHash.io) announced a new focus on openness, reiterating the company's willingness to "address the decentralization of mining as an industry". Thus, it was natural for Smith and GHash to convene the first forum on bitcoin mining.

According to Ittay Eyal and Emin Gün Sirer from Hacking, Distributed:
"[GHash] got brazen at 55% from 2014-06-12 11:53:05 until 2014-06-13 09:45:24 GMT, for almost 24 hours. And prior to that, it seems to have tested the waters over a period of 10 days or so, perhaps gauging the public's reaction."
With GHash, the pool operators are known and they willingly initiated this important step. Conversely, stealth mining operators such as Discus Fish do not take steps to make themselves known, although it is claimed that they operate as China-based f2pool.

Then they got brazen at 55% from 2014-06-12 11:53:05 until 2014-06-13 09:45:24 GMT, for almost 24 hours. - See more at: http://hackingdistributed.com/2014/06/18/how-to-disincentivize-large-bitcoin-mining-pools/#id1
The consolidated hash rate from GHash has backed off significantly, with its network statistics from 13th July displaying approximately 34.6% of bitcoin's total.

As the foundation's representative present at the meeting, I agree with BitGos Will O'Brien, who said "we cannot and should not rely on one or more trade organizations to set the rules. Bitcoin is decentralized, and we must build solutions that support that original framework of decision-making."
The technical solution, if there is to be one, will ultimately come from the open-source developer community ratified by the miners and users.

In the meantime, we have temporary ways to mitigate the risk of a 51% attack, such as GHash's agreement to "do all it can to limit its share of the total bitcoin network to 39.99%."

Generally, participants understood this pledge to be a very unenforceable solution fraught with potential pitfalls, namely GHash's concern that they are being punished for their own success and how meaningful the pledge will be when other mining operators approach the same self-imposed threshold.

Potential solutions

In the last month or so, there have been a wealth of proposed technical solutions to minimize the likelihood of a successful 51% attack.

Gavin Andresen first made a recommendation for utilizing P2Pool, a decentralized bitcoin mining pool that works by creating a peer-to-peer network of miner nodes.

Mike Hearn expanded on that thinking with a detailed description of 'freemining' – regaining miners' ability to select their own block content.

These are immediate solutions available today. Hearn states:
"Freeminers mine in such a way that they both reduce their payout variance but also create their own blocks, a process that always requires running a fully validating p2p node like Bitcoin Core. If you aren’t running one, you aren’t decentralising the mining process."
Newer technical solutions are most likely nine to 12 months away, given the development and testing cycles.

One of those solutions includes the Two Phase Proof of Work (2P-PoW) to disincentivize large mining pools yet enables existing miners to continue using there current mining hardware, as outlined by Cornell's Ittay Eyal and Emin Gün Sirer in "How to Disincentivize Large Mining Pools." This proposal is based on the research work of Andrew Miller and others at University of Maryland, College Park.
Would an attack be disruptive? Sure. Would it be fatal? No.
Another solution, proposed by mathematician Meni Rosenfeld, involves the creation of Multi-PPS, a platform that allows miners to mine in multiple pools simultaneously.

Since a small pool could find either 10 blocks in a day or 0 in a week, many miners elect to use larger pools that offer a more consistent payout. Once the payout instability of small mining pools is reduced, it makes them a viable alternative.

According to Rosenfeld, the basic premise of Multi-PPS is "that miners should mine in multiple pools simultaneously, in proportion to each pool’s strength, which has two important features," these are:

(1) The miner enjoys performance that is equivalent to that of a pool with a combined size of all pools he uses together

(2) The stable equilibrium is not consolidation in one pool, but rather, maintaining a distribution between many pools according to the merits of each.

Crypto arms race

called Two Phase Proof of Work (2P-PoW), to disincentivize large mining pools. We - See more at: http://hackingdistributed.com/2014/06/18/how-to-disincentivize-large-bitcoin-mining-pools/#sthash.i9Eo2RQV.dpuf called Two Phase Proof of Work (2P-PoW), to disincentivize large mining pools.
The reality of bitcoin mining today is that we are in a crypto arms race and this ASIC-driven computational power massively strengthens the network from outside attack by malicious actors or disgruntled states.

Would an attack be disruptive? Sure. Would it be fatal? No.

In many ways, it is the price we pay for a distributed, resilient cryptocurrency, for if we wanted to abolish all uncertainty on mining, we would simply centralize the block chain and anoint a trusted party like the Fed.

The 9th July roundtable meeting was a great start. It is my sincere hope that the participants of the bitcoin mining community continue to hold a regular forum to maintain an open dialogue on the decentralization of mining.

Sunday, July 6, 2014

Why the OECD Needs to do its Homework on Bitcoin

By Jon Matonis
Tuesday, July 1, 2014


The Organisation for Economic Co-operation and Development (OECD) recently published a working paper on bitcoin and the implications of financial trust without intermediaries, authored by economist and Special Advisor to the Secretary-General on Financial Markets at the OECD, Adrian Blundell-Wignall.

Entitled ‘The Bitcoin Question: Currency Versus Trust-less Transfer Technology’, the paper represents one of the first official analyses on bitcoin in the context of contract law, legal tender, and plenary powers.

Besides grossly misunderstanding the economic nature of bitcoin, the general prescription for public policy would be disastrous, accelerating a 'parallel' monetary system faster than normal and simultaneously depriving millions of people of seamless participation.

The author fundamentally views bitcoin as something that must replace legal tender in order to be successful, so he is dismissive of bitcoin the monetary unit. Moreover, the author fears bitcoin more as a competitive alternative within a  freedom-of-choice scenario and thus outlines policy behavior that attempts to extinguish any interface with established institutions.

However, monetary freedom has already arrived, demonstrating that the state's compulsory monopoly over money is unearned and unjustified. Government powers now need to be directed at removing hindrances for participation in alternative monetary units, because excluding large swathes of society from engagement with bitcoin exacerbates the problem of inevitable integration.

This article gives a critique of the general public policy prescriptions contained in the OECD working paper:

1. A general ban on cryptocurrencies in the interbank clearing system

Bans and prohibition are totally ineffective. A ban on bitcoin would increase global awareness for bitcoin, inspiring alternative and parallel clearing systems. This result would end up harming the existing clearing system even more and it would probably take the form of denying bitcoin a currency code such as XBT. Gold currently has code XAU within the ISO 4217 standards body.

2. Recognition that bitcoin the network is separable from bitcoin the unit

A bitcoin network separable from the bitcoin unit would be neither decentralised nor secure. The technology underpinning the bitcoin network is distributed and massively decentralised for a reason – it had to be immune to plenary power shutdown and strong enough to sustain an attack from outside computational power. The bitcoin unit provides the incentive for maintaining the security and integrity of the block chain, which makes it inseparable.

3. Best practice registration to verify the owner's identity

I am assuming that this recommendation is made only for the exchange endpoints that interface with national currencies (not merchants), thereby treating bitcoin exchanges like financial institutions. Physical cash transfers do not typically demand owner identity verification, but of course when an exchange business is involved, the operating jurisdiction defines the required conditions around getting in and out of national fiat currency. In some jurisdictions, this best practices registration may be conducted on an opt-in basis.

4. Balance sheet and income statement reporting for all networks

Again, I am assuming exchange networks because the bitcoin block chain is already a publicly accessible transparent ledger of transactions. Market competition will demand exchange solvency and reporting of financial status.

5. Mandatory capital should be held by exchanges (in the form of legal tender)

Jim Harper, Global Policy Counsel at the Bitcoin Foundation, suggests that consumer protection may differ in the future bitcoin era as the assumption of government regulation providing sophisticated commercial oversight becomes challenged.

Cryptographic proof of reserves can deliver responsible public audits of exchange assets as bitcoin's cryptography-based public ledger allows an organization to prove control of bitcoin assets without revealing private information about customers or account holders.

Harper continues, "multisignature transactions are a second innovation that may remake consumer protection. 'Multisig' allows any combination of consumer and business entities to exercise control over a bitcoin-based asset."

"These innovations, and others to come, will tend to make consumer oversight of bitcoin businesses easier – and government oversight a less important part of the mix. Consumers will be better positioned to do their own monitoring and, in the best case, to enjoy cryptographic proof that they are being properly served."

6. Implement some form of backing for cryptocurrencies, such as gold

Requesting gold backing for bitcoin is one of the rookie mistakes made by new analysts, because the transportation costs, audit issues, and potential confiscation are all issues that bitcoin seeks to bypass. A gold-backed bitcoin would lead to centralisation in the way of specie reserves and would irreparably damage the incentive structure for securing the distributed block chain, which includes the process of new bitcoin issuance.

Despite the fact that our working paper author appears to support gold, he is mostly an apologist for ‘The State Theory of Money’ myth that the sovereign’s power to collect taxes and declare legal tender imbues a currency with ultimate value. Bitcoin is the primary value unit and requires backing from neither state sanction nor gold. I recently attempted to explain that logic to legal-tender poster boy Paul Krugman, in 'The Fiat Emperor has no Clothes'.

7. Use of government plenary powers to restrict contracts in bitcoin

Given today's cryptographic protocols and smart contracts with time-release amounts and multisignature transactions, it is simply infeasible to restrict private party contracts that would not require the judicial system. Potentially, contracts could be banned by statute within aggressive jurisdictions, but that would probably only drive them underground.

Blundell-Wignall references the 1935 gold clause cases where the Supreme Court decided in a 5:4 majority in all of these cases that "the power to regulate money is a plenary power". The author concludes that "the abrogation of all gold clauses was considered to be within the powers of Congress when such clauses presented a threat to Congress’ control of the monetary system." He then posits that "if bitcoins begin to undermine the financial and tax systems they will be shut down and all contracts between traders would be unenforceable."

According to law professor Henry Mark Holzer, the abrogation of gold contracts and gold clauses during the Roosevelt administration in the US marks one of the saddest periods in worldwide monetary history, because it restricted freedom to transact.

Market-based legitimacy

Ironically, the items that the author highlights with respect to legal tender and monetary contracts are precisely what the bitcoin protocol alters with its 'trustless transfer technology.' Governments will no longer maintain a monopoly position over money because an alternative exists and that alternative does not rely on legal tender status for its legitimacy – it relies on global acceptance of the mathematics behind the protocol for its market-based legitimacy.

The implications of bitcoin are quite simply "Money Without Government." We don't need kings to coin our money. Trust has become decentralised.

The die has been cast. All that remains is the jurisdictional competition to determine if any nation-state has the political will to harness and benefit from nonpolitical money.

Tuesday, July 1, 2014

Government Sale of Bitcoin Establishes Fungibility Precedent

By Jon Matonis
Thursday, June 26, 2014


The US Marshals Service (USMS) will auction off the bitcoin seized from Silk Road to the highest bidder tomorrow. It amounts to 29,656.51 BTC contained in wallet files residing on Silk Road servers.

In total, there will be nine blocks of 3,000 bitcoin and one block of around 2,656 bitcoin offered in the auction, representing the amount stated in the forfeiture order by the court on 15th January, 2014.

Although the authorities hold more coins, the auction does not include the approximate 140,000 BTC contained in wallet files that resided on computer hardware belonging to Ross William Ulbricht that were seized on 24th October, 2013 and are known as "DPR SEIZED COINS".

Establishing equivalent value

Regardless of the morality of pre-trial asset forfeiture, the sale via auction of approximately $17 million worth of bitcoin by the USMS will establish the first governmental precedent for bitcoin fungibility, which could become significant for future bitcoin-related cases involving 'blacklisting', or 'tainted bitcoin'.

Fungibility refers to the concept that every unit or sub-unit remains equivalent and identical to any other unit or sub-unit. It is the property of a good or commodity in which individual units are capable of mutual substitution.

Blacklisting and the notion of tainted bitcoins refers to the concept that certain bitcoins may be treated different due to their origin and/or usage, thereby resulting in a valuation differential.

Each bitcoin sold in the government's auction is made without representation and also without any disclaimer or restrictions on their subsequent usage and transfer within the bitcoin block chain.
In additional clarifying statements, the auction notice says:
"The USMS will not answer any questions regarding (a) the associated criminal or civil cases that resulted in the seizure of the bitcoins being auctioned, (b) Bitcoin characteristics, uses or value, or (c) specifics of the auction process other than information provided in these documents;
The USMS will not sell to any person who is acting on behalf of or in concert with the Silk Road and/or Ross William Ulbricht, and bidders will be required to so certify;
The USMS will not transfer bitcoins to an obscene public address, a public address apparently in a country restricted by the Office of Foreign Assets Control (OFAC), a public address apparently associated with terrorism, other criminal activities, or otherwise hostile to the United States;
The winning bidder will receive a signed Bill of Sale from the United States Marshals Service prior to the transfer of the bitcoins."

A bitcoin is a bitcoin

None of these statements carry any indication that the USMS or the Department of Justice view these coins to be 'legally different' or 'subject to special treatment' by exchanges and market participants. Conversely, the USMS is attempting to maximize its return of the sale of these bitcoin assets by specifically not disrupting their implied fungibility.

No special discounts apply to the sale and if they are bulk discounted by virtue of the wholesale bidding process, it would neither be due to the source of the bitcoin assets nor their alleged use on the Silk Road for various transactions.
For now, a legally-orchestrated sale of bitcoin assets demonstrates that a bitcoin is a bitcoin is a bitcoin.
Furthermore, there is no intent to blacklist or whitelist the coins for subsequent circulation, because this would negatively impact the valuation at auction. All bitcoins obtained from the auction sale process are able to be freely transferred and circulated around the world.

An interesting Scottish monetary case from the 1700s suggests that blacklisting or mandatory coin validation is a misguided premise. Fortunately, in that particular case, the judges upheld the principle of unrestricted fungibility.

The auctioned bitcoin are theoretically being sold at par to other circulating bitcoin. In the future, governments or free markets may determine that certain bitcoin addresses carry a taint or don't trade at par for some reason, but, for now, a legally-orchestrated sale of bitcoin assets demonstrates that a bitcoin is a bitcoin is a bitcoin.

Market role

As covered on Bloomberg TV, SecondMarket's Barry Silbert even organized a bidding syndicate to allow smaller investors the opportunity to obtain bitcoin at favorable bulk pricing, where 10% of any auction fees received by SecondMarket will be donated to the Electronic Frontier Foundation.

While the government's actions and announcements regarding bitcoin fungibility play a critical role in setting expectations for the market, the globally distributed bitcoin network spans many jurisdictions and true fungibility is ultimately determined by what the market will bear. Not all market participants have to adhere to fungibility determinations in the same way.

The list of possible Silk Road bitcoin bidders can be seen here and the introductory form to participate in the syndicate organized by SecondMarket and the Bitcoin Investment Trust can be found here.