When you can fall for chains of silver you can fall for chains of gold
You can fall for pretty strangers and the promises they hold
Dire Straits Romeo and Juliet

Regret has strong jaws and sharp teeth. It’s quick to take hold; it’s slow to release. Regret is the reason James Howell found himself at the Docksway landfill site near Newport, Wales in November, 2013. He was trying to pry himself loose.

A few months prior, while cleaning his desk, Howell had thrown out an old laptop hard drive. What he had forgotten, was that the drive held his digital wallet for Bitcoin, the world’s first decentralised, digital currency. He had essentially thrown out 7,500 bitcoins. The bitcoins had been virtually worthless in 2009, when Howell first acquired them, but by 2013, the value of his wallet had risen to some £4.6m (~$7.9m AUD). The problem was that his drive was now more than a metre deep in landfill, in an area the size of a football field. Howell did not find his hard drive. In the years that have elapsed since, his drive has sunk further into the landfill strata, while bitcoin has only continued its rise.

I. The Disappearing Nakamoto

In its early days, the Internet was seen descending Olympus with Information in its hands. Just as Prometheus brought fire to elevate mankind, the Internet would bring knowledge, ushering in a new age of enlightenment. Of course this was wishful thinking. While the Internet radically expanded the way we communicate, shifting more power to the people, it also strengthened the grasp of governments and corporate interests. It could be controlled and censored; it could come at the high price of our privacy. Information, as it transpired, was not as free as we had hoped. Neither was fire for that matter. As a direct result of his audacious theft, Prometheus wound up with a chronic liver problem. His was very much a cautionary tale.

There are still those who believe that information should be free. That it yearns to be free. And that even our monetary systems can be freed from the shackles of governments and financial institutions. Congregating on electronic mailing lists in the 1990s, it was the cypherpunks who first championed this cause. They who advocated for privacy, encryption and personal liberty on the Internet, also saw its potential to reshape commerce. A number of cypherpunks tried their hand at creating a new, global, digital currency, proposing the likes of ecash, hashcash, b-money and bit gold. Each of these brought new ideas to the table. None of them succeeded.

The key problem with a digital currency is known as the double spend issue. If data is considered to have real financial value, how do you stop people from copying and reusing it? That is to say, how do you prevent someone from re-spending a digital currency? The generally accepted solution at the time was to maintain a ledger: a file keeping account of all transactions (the book in ‘bookkeeping’). But this means trusting the ledger. Worse, this means trusting whoever controls the ledger. And cypherpunks, as you might imagine, are a notoriously distrustful lot.

Enter Satoshi Nakamoto. In November 2008, Nakamoto published a nine page white-paper entitled Bitcoin: A Peer-to-Peer Electronic Cash System, and it began making the rounds on cypherpunk mailing lists. Bitcoin was a financial system with no central authority – a new digital currency which used a network of computers to process its transactions. Instead of trusting a third party, the entire network would maintain a global ledger, recording every single transaction. Nakamoto’s system built on the innovations of earlier developers, while completely doing away with the need for trust. And for this reason the cypherpunks took notice. The cryptographers and developers responsible for ecash, hashcash, b-money and bit gold – they became some of the earliest adopters of Bitcoin in January 2009, when Nakamoto released a working system.

Of course this would not be a cypherpunk story if its central figure was not also its greatest enigma. Despite open-sourcing Bitcoin, allowing and even encouraging other developers to help improve the codebase. Despite writing hundreds of forum posts about Bitcoin over the course of two years. Despite claiming to be man in his 30s residing in Japan; almost nothing is known about Satoshi Nakamoto. His diction and schedule seemed to counter all his claims. His name was a pseudonym. His email and website left no trace of their owner. Nakamoto was, in all respects, a model cypherpunk. All we know is that he, or she, or they, were proficient in programming, economics, and academic writing (to minimise confusion and in deference to the pseudonym, we’ll use ‘he’ here). As computer security researcher Dan Kaminsky put it, “Either there’s a team of people who worked on this or this guy is a genius.” In April 2011, roughly two years after creating a working Bitcoin system and just as his idea was beginning to gain real traction, Nakamoto announced that he had “moved on to other things.” He handed the project over to another developer. Then he vanished.

II. The Block and the Chain

Nearly every piece of consumer technology follows the same path in public perception: the shift from ‘What is this?’ to ‘What can I do with this?’. One would hope, for example, that you are more interested in this page’s contents than you are in the layers of network technology required to deliver it. Eventually it will be the same for digital currencies – we’ll spend them without thinking about the mechanisms that allow us to do so. For now, while the technology is still novel and its implications are still unrealised, indulge me if you will, and let’s take a look at how Bitcoin actually works.

Bitcoin is a cryptocurrency. It’s a purely digital asset, meaning that there are no physical bitcoins we can withdraw or deposit. But unlike digital photos or digital music, there are no bitcoin files that we can save or copy. Bitcoins only exist in the form of a long list of verified transactions. This list, or ledger, is known as the blockchain, and copies of it are stored on computers all around the world. The blockchain is not managed by any group or government, rather, it is maintained by the Bitcoin network and protected by cryptographic protocols. Bitcoin is just one potential use of blockchain technology. Ultimately, the blockchain represents a reliable means of tracking and verifying not just currency, but any form of data.

Each transaction in the Bitcoin blockchain is simply a record of the transfer of bitcoins to an address. A single user can have many addresses, each associated with different bitcoin amounts. In this sense, Bitcoin addresses are more like Post Office boxes than bank accounts: one-way destinations for receiving mail or bitcoins. Addresses allow Bitcoin users to operate pseudonymously, providing a measure of privacy and security. In fact, users are typically encouraged to create a new address for every transaction. Here, for educational purposes, is an address that I prepared earlier:

Of course this alphanumeric soup is intended to be neither memorable nor intelligible, so addresses are often distributed in the form QR codes that can be scanned by camera and machine-read.

Bitcoin QR Code

To allow each transaction to be authenticated, Bitcoin addresses are created using a system known as public key cryptography. Each address has two underlying components: a private key and public key. The private key is a long string of random letters and numbers that is created and stored in a user’s digital wallet. Unsurprisingly, it is best kept secret. Public keys, on the other hand, are mathematically generated by applying a one-way function to a private key. Bitcoin addresses are created in a similar fashion, by applying a one-way function to a public key. Thus, we have:

As one might expect, the one-way functions are not easy to reverse. If you took my Bitcoin address (1GmM18dZwbuqBjvABYZoPe4Ps2yn778L4j, in case you had forgotten), it would be obscenely difficult to determine my public key. It would be even harder to then work out my private key. And this is extremely important, because anyone with access to a private key is able to spend its associated bitcoins.

Say that Lucy wishes to send bitcoins to Ivan. Lucy’s Bitcoin software uses her private key to digitally sign a transaction request. This request is then broadcast to the entire Bitcoin network along with Lucy’s public key. Computers on the network can use Lucy’s public key and her digital signature to verify that the transaction request came from her. It’s important to remember that bitcoins only really exist as transaction records, so when Lucy makes her transfer to Ivan, the entire amount associated with her private key is sent as a transaction. Any leftover change is transferred to a new address for Lucy. While anyone can see the value of the bitcoins transferred to Ivan’s address, only someone with his private key can spend them.

III. Power in the Money

Currencies are typically supplied and managed by a central authority like a Central or Reserve Bank. Bitcoin is different. Since Bitcoin is completely decentralised, the network itself creates and issues the currency. The computers on the network responsible for verifying transactions are known as Bitcoin miners. In order to validate and track transactions, Bitcoin miners are required to solve an intentionally difficult problem. But mining is also a competition: the first miner to prove that they have done the work is rewarded with newly minted bitcoins.

Bitcoin miners verify transaction requests like Lucy’s, bundling a number of them together to form a transaction block. Each such block is attached to the long chain of blocks that preceded it – hence the term blockchain. The calculation for attaching a block to the blockchain and discovering the next block is essentially a guess-and-check problem. A very difficult guess-and-check problem. The network has strict requirements, and while it’s difficult to produce a valid solution to the problem, it’s relatively easy to verify the answer. Just like the layers of landfill make it ever harder for James Howell to reach his sinking hard drive, so too does every added block make it harder to modify the blockchain. Because reversing a transaction, or indeed falsifying one, means redoing all the computations for the blocks that come after it. The network trusts the longest chain because it took the most work to build.

Bitcoin mining is designed to resemble its real-world namesake. Like a gold miner expending physical effort in the hopes of finding gold, a bitcoin miner applies computational effort to try and acquire bitcoins. And as with gold, bitcoins are an increasingly scarce resource. Over time, less and less bitcoins are supplied to the victorious miner, and eventually, once some 21 million bitcoins have been issued, there will be no more left to mine.

It’s technically possible to mine for bitcoin on any modern computer, but it’s virtually impossible to be competitive. Over the years, more and more miners have sprung up to compete over fewer and fewer bitcoins, and significant hardware upgrades have been necessary to maintain an edge. But the network adjusts for these improvements, and every two weeks or so, the guess-and-check problem adjusts to ensure that coins are issued roughly every ten minutes. No slower, and certainly no faster.

In the upper strata of this new industry, mining occurs in aggregate. Mining magnates and conglomerates run farms of computers, all of them guessing and checking, their power and heat managed with the efficiency that only scale affords. It is estimated that anywhere between 50% and 85% of the Bitcoin network’s processing power can be found in China (Coin Desk, Jan 17), where miners take advantage of cheaper electricity to run enormous computer farms.

IV. Bang for the Buck

So a pseudonymous phantom invented and then orphaned a digital currency that relies on a network of computers doing what amounts to make-work, all so we can avoid trusting a central institution.

Great.

At present we have all manner of currencies and financial instruments. The convenience of debits, credits, bank transfers and online payment systems, are all at our fingertips. What then, is the use of a cryptocurrency? To answer this we have to consider the role of money in society, which, from the coins of ancient Rome and China, to the paper and polymer notes of modern day, has remained surprisingly consistent. Namely, money is:

1. A medium of exchange
2. A unit of account
3. A store of value

In other words, money is a convenient means of trading for goods and services [1]. It’s also a standard measure by which we can compare the value of different goods [2] – a loaf of bread, for instance, may cost a few dollars, while a house might be worth hundreds of thousands of dollars. Finally, money provides relatively stable value [3], allowing us to store it with the expectation that it will be just as useful upon retrieval.

Bitcoin is an excellent medium of exchange. Transactions are generally processed within a few hours, rather than a few days like bank transfers, and the transaction fees are considerably lower than those for credit cards and payment services like PayPal. And this is because regular financial services have to factor in the costs of dealing with fraudulent transactions and payment disputes. Bitcoin transactions are irreversible. This protects sellers from being defrauded, but it also means that buyers must rely on external legal protection (if available) or escrow services. When we pay in cash, we’re relying on well established forms of consumer protection to assist us in the event of a dispute. For Bitcoin use to become truly widespread, mediation systems need to be managed just as well.

Bitcoin has one other major advantage as a medium of exchange: there is no need to trust a third party to process transactions. Anyone accepting online payments is at the mercy of their payment provider and the country in which it is based. Laws can change, terms of service can change, and political favour can also change. In 2010, WikiLeaks, an international non-profit that specialises in the disclosure of suppressed information, released a few hundred thousand U.S. diplomatic cables. Unsurprisingly, the U.S. government did not take kindly to this. Faced with mounting political pressure, Visa, Mastercard and Paypal all stopped processing donations, doing so on the pretext of purported illegal activity. A few years later, an Icelandic Supreme Court case forced both Visa and Mastercard to recommence payment processing (Reuters, Jul 13). Given that donations are now possible through a variety of means, it’s difficult not to view the whole affair as an example of extrajudicial censorship.

As a medium of exchange, Bitcoin is fast, cheap, relatively private, and global. Independent of trust, Bitcoin can even circumvent most forms of censorship, and yes, all these things make it particularly enticing for illicit businesses. But even though it’s value has generally trended upward, it has done so with a great deal of volatility.

Money has value purely because we agree it has value. The dollars, euros or rupees that you use on a day-to-day basis are known as fiat money, that is, currency declared legal tender by governmental decree. Fiat money has no inherent value – it’s just paper, polymer or metal. But the banknotes and coins are issued and backed by the government, and this means that if you need to deal with local businesses, or pay your taxes, it benefits you to have local currency. This makes the currency useful, and thus, also valuable (an oversimplification, perhaps, but useful for our purposes, and therefore valuable). If the government’s monetary policy is sound, fiat money can be quite a stable store of value.

Bitcoin, with its controlled supply and decentralised structure, can’t be managed at all. Instead, its value comes from market confidence. It soars when countries legalise it, and it plummets after reports of a heist, or of its role in a criminal enterprise. But aside from these media-driven movements, Bitcoin’s short-term value is still subject to wild fluctuations, making it a somewhat troublesome unit of account. Even Bitcoin-based retailers tend to highlight their prices in a fiat currency like U.S. dollars, because it’s easier for consumers to reconcile. So even when people trade in bitcoins, they still tend to think in fiat currencies.

While Bitcoin cannot yet compete with the reliability of major fiat currencies, it already represents an improvement on a number of national currencies. In countries with high rates of inflation, corruption or poor fiscal management, Bitcoin’s volatility is somewhat less concerning, and the cryptocurrency is already proving a better store of value than its traditional counterparts. That said, there is still some distance to cover before Bitcoin can be globally recognised as a stable point of financial reference.

V. A Fork in the Road

Bitcoin is on a long voyage toward public acceptance. Which raises the question: Who’s steering? There is no simple answer to this, but there are plenty of loud voices and strong opinions about Bitcoin’s best course of action. With its creator in absentia, and no governing authority to dictate its progress, Bitcoin’s short history has been witness to no shortage of arcane debate.

In the last few years, the most pressing concern for the Bitcoin community has been scalability. Bitcoin has a restriction on the size of each block in the blockchain, which translates to a limit on the number of transactions that can be included in a block. The network can only process around seven transactions per second, and clearly this is untenable as the cryptocurrency grows more popular. The obvious solution is to simply increase the blocksize and thus process more transactions. This was in fact proposed, and a bitter, protracted debate began.

To the Bitcoin community, whose members feel strongly about such things, the argument was not merely about technical concerns, but about ideologies. Some saw the increased blocksize as a raised barrier of entry and a violation of the network’s egalitarian ideals. Accusations flew wild, fierce arguments about security flared up, ultimatums were thrown down, and a few months ago, a compromise was reached. Then August arrived, and the same dispute that had divided the Bitcoin community figuratively, ended up dividing it literally.

An entirely new currency was formed: Bitcoin Cash (Ars Technica, Aug 17). It had bigger blocks. Since the Bitcoin software is open source, anyone can copy, remix and republish it, provided that new version is similarly licensed (Bitcoin Source). When Bitcoin split in early August, it became two separate currencies on two separate networks. In software development, this is known as a fork, and what’s interesting about this particular fork, is that Bitcoin Cash copied the existing blockchain. So anyone who previously had bitcoins, now also had bitcoin cash. Surprisingly, the value of bitcoin did not decrease as part of this, and while it has yet to prove its staying power, bitcoin cash is already fluctuating around a value of $500 USD.

While Bitcoin Cash is notable for having copied an existing blockchain, it is by no means unique. Since Nakamoto created Bitcoin, plenty of rival cryptocurrencies have sprung up. And each of these so-called alt-coins has their own blockchain running on their own network. Some, like Litecoin, have forked the Bitcoin code and implemented technical improvements to improve transaction times. Others, like the meme based Dogecoin, are considered ‘joke currencies’. But the blockchain has potential for far more than just digital currency, and one of the most interesting new players in the nascent space, is Ethereum. Developed in 2013, Ethereum is a blockchain with a host of new features including automated, trustless contracts, decentralised software and digital identity systems.

We began all this by speaking about regret, and to regret we must return. Because so much regret is expressed over not investing in Bitcoin or Litecoin or Ethereum in their infancy. There has been much wailing and gnashing of teeth at the potential millions people have failed to make. This sort of thinking gets one nowhere. The truth is, if asked, I would not recommend investing in any of these cryptocurrencies. If you had the interest or inclination to speculate on their potential, you would not need my input, and would likely have already bought bitcoins or litecoins or ether.

These cryptocurrencies could become as ubiquitous as their fiat counterparts or remain niche in their use and purpose. They could build into stable, reputable brands or they could remain fractious, forking themselves into increasing irrelevance. At the very least it’s still a gamble, and given the number of new alt-coins springing up, it’s quite possibly a bubble. But to look at Bitcoin and its peers purely in terms of financial value, is to see a fraction of the whole picture.

If the Internet was the Promethean hero who brought Information to the masses, then the Blockchain may well reshape the way we control it.