Imperialistic Democracy of Bitcoin: Power of Money in the Hands of a Few

Introduction. This article is essentially the second chapter in the series “In the Hands of a Few.” It is recommended, but not mandatory, to have first read the chapter on “Big Data Brother” to appreciate the terminology and examples. I also share some terminology with the previous blog post by 8RD+ (@ http://versustakes.co) although my topic is much different from it. And to remind you, this article is not an introduction to the technical protocol “Bitcoin” nor the actual currency “bitcoin,” and I do not always make a distinction between the two either. This article is about the (presumed) democratic aspects of Bitcoin often used in promotion. I desire to stay truthful to the scientific origins of thought: any missing literature references are available upon request.

[1.] An impressive list of distinguished Bitcoin evangelists and investors were present at the two-day Bitcoin conference in Las Vegas. I, on the other hand, got more seriously interested in Bitcoin only within the last year or so. My interest was not triggered by any specific event; not for example the Cyprus Crisis of 2013 which many cite as their breaking point related to weak government ruled fiat currencies. I had no such breaking point. I had just read a book by two columnists of The Wall Street Journal, P. Vigna and M. Casey, and needed to see some real beef. So, on that sunny Thursday, 30th of October, 2015, I lost my Bitcoin conference virginity at the bit cheesy D Hotel in downtown Las Vegas, close to Fremont Street, infamous for rough gambling, mobbing, hooking, and pimping. A fitting venue for a speculator-arbitrageur.

[2.] Just two days before that “D-day,” in highly anticipatory Halloween spirits in the midst of colorful October rust, the Nasdaq Exchange had made a new milestone announcement: a product they had been developing in near secrecy, and that would apply Bitcoin type block chain technology to manage the shares of small privately hold companies, such as startups. That was a nod to Bitcoin. It sent tremors through the industry. Nasdaq is, after all, a heavy-weight player in the North American trading scene, although considered to be more welcoming of modern technology than the remnants of the New York Stock Exchange. The Nasdaq release was announced, fittingly, at the mainstream Money20/20 conference at the Venetian Hotel, some miles south of the D on Las Vegas Boulevard – better known as the Strip.

[3.] The block chain is intimately linked to Bitcoin (the protocol) and similar cryptocurrencies. The Nasdaq block chain application would not use exactly the same technology as Bitcoin, but its principle would be the same. Stripped down, block chain technology purports to keep track of all electronic transactions confirmed in a decentralized style. The block chain is the naked backbone of Bitcoin and its presumed democracy. And As I said, this article is about the democracy aspect. I do that mainly from the perspective of an economist, which is my formal academic training. Although the writing format here is less cryptographic than in chapter one of the series (although it still respects prime numbers), I mention several connections to Big Data Brother and especially to high-frequency trading.

[4.] As a mandatory word of warning, I will concentrate on Bitcoin to keep matters simple – although majority of the text below can be generalized to other similar cryptocurrencies. My choice should be obvious: Bitcoin has, due to its innovative design and other “cool” supportive factors, become nearly synonymous with (electronic) cryptocurrencies. That does not, of course, imply that other cryptocurrencies with enhanced features could not exist or be developed. They can. In fact, one of my main motivations here is to create discussion of Bitcoin’s democracy. The negative aspects of it appear to be quietly, and perhaps conveniently, disregarded by many Bitcoin evangelists. At the “D-conference,” some of the critical parts were not revealed either. That strip disappointment just fueled my interest.

[5.] At the D, you could not avoid hearing mentions of the positive aspects of the Bitcoin democracy, but they were cried out uncritically: Bitcoin allows people everywhere to trade, save, and invest (nearly) anonymously and with lower transaction costs than in the current centralized bank system. No longer is a central government able to choose the amount of money in circulation and thus control its purchasing power. That power would be handed over to sophisticated computers and logic that could be executed by practically anyone following the preset rules of Satoshi Nakamoto – who still (?) remains an unidentified individual or a group behind Bitcoin. The cool mystery hanging over Nakamato may in fact be one of the softer reasons for the rapid and quite wide adoption of the Bitcoin technology.

[6.] How Bitcoin bookkeeping and safety is achieved efficiently makes a fascinating topic worthy of a book or several – technical details can be found in “Mastering Bitcoin,” among others. Very shortly: All Bitcoin transactions need to be verified by someone. This is done by computer nodes called “miners.” Their accepted transaction blocks are included in the official book of transactions: the block chain. At the micro user level, security is guarded by clever cryptography solutions that prevent private keys (here, money) to become publicly owned. More explicitly, elliptic curve theory is applied to guarantee that users’ confidential information only flows in a desired 1-way fashion. Security appears to be rock solid. But there is an Achilles heel: forging the chain of transactions is possible.

[7.] Before venturing into the exciting but illegal things part, the Las Vegas trademark, the high-tech flavor of Bitcoin may ring a bell to people critical of HFT. There is a link, but the HFT critics may not stand the fight. Namely, from a social cost point of view, HFT is criticized for introducing a negative externality. An extra cost is put on Institutional Investors (II), in particular, who have to adapt to the modern era of HFT-algorithms: the poor II’rs need to develop their own trading algorithms, smart order routers, or buy such solutions. That is because if their trades would be executed as they were in the past as large block trades, they would be hurt by higher transaction costs. But the total social cost to the society is far from clear: new business, firm diversity and competition thrive overall.

[8.] It is true that HFT technology is expensive. Similarly to Bitcoin miners, powerful computers are necessary to play the game. In HFT, it is about faster reaction to the exchanges’ and other data providers’ events. In the Bitcoin world, the game is about brute-force computing power to solve the Nakamoto puzzles required for the verification of the Bitcoin transactions. This begs the question: Is bitcoin (currency) mining socially costly? Without powerful computers and incentives to upgrade, bitcoin could not compete with other alternative currencies. In this sense it is necessary. And as in HFT, there also exist profit-makers: manufacturers, innovators, and energy companies. The social cost depends on how bitcoin is valued as money. Does bitcoin provide extra value over fiat currencies?

[9.] The Bitcoin conference at the D had a star appearance: an anonymous guest, the last speaker of day 1. That does not happen often, I heard. The guy who stood up without any showmanship is rarely seen speaking. Obviously, he enjoys a special status in the Bitcoin community; the audience sat like nailed to their seats and remained eerily silent through the uncomplicated and no frills style talk. The speaker was the developer of an early 1990’s cryptocurrency “Bit gold.” Intriguingly enough, it has recently been proposed by some that he would actually be the mysterious Nakamoto; he denies it, of course. But according to both, and most of the audience at the D, Bitcoin does deliver extra value. But as one of my former economics professors in Helsinki used to motivate his lectures: “HOW?”

[10.] Gold is one of the longest thriving forms of money in the history of modern man. But gold has not been “democratically” chosen for that job. Gold was highly valued by the trading centralized Western societies which essentially forced its usefulness (value) on other less developed societies – similarly to forcing a religion on them. Later, over several decades, many government operated fiat currencies have been tied to the price of gold by the gold standard. Gold based economies were formed. In contrast, Bitcoin is argued to be independent of gold and governments. These are hailed as the revolutionary features by Bitcoin evangelists. Essentially, Bitcoin should give the “Power of Money” to people. If so, the expensive stack of computers behind the Bitcoin democracy can be argued to be justified.

[11.] The crucial question is: Is bitcoin fairer than fiat currencies or gold? That largely depends from whose point of view fairness is considered. The Bitcoin democracy asserts that people in poor (underdeveloped) countries – that is, by Western standards – would be better off using bitcoin rather than using their own presumably weaker fiat currencies. Their weakness is reflected in the observation that the value of their fiat currency is highly volatile and inflationary. That is the standard claim of Bitcoin evangelists. Bitcoin provides a greatly needed service by allowing the poorer people to trade with each other efficiently – and, of course, with people and firms in the developed countries (“West”). This assumes implicitly that bitcoin’s price is more stable than of the weak fiat currencies – which is not yet established.

[12.] The obvious counterclaim is: Suppose for a moment that Bitcoin would gain a dominating status in a poor country where most of the people have no assets other than cash (or its fiat equivalent), only a simple house, and perhaps a bit of land. Should there suddenly be a significant swing in the value of bitcoin, its effect would be quickly felt in a country where hard assets are in limited supply and wealth is currency-dependent. Similarly to HFT, where new powerful, but untried (or tried in a limited sense) technologies have lead to near-bankruptcies – just recall Knight Capital whose trading algorithms lost $440M in about half an hour – Bitcoin and its block chain technology could prove fragile, too. KC suffered the consequences of their own blunder. What about Bitcoin?

[13.] How likely is it that bitcoin’s value changes by 20% or more in a day? If its price history is of any indication of its future, quite likely. Percentage changes of more than 10% in value are still frequent. Currency speculators could drive the price of bitcoin down or up and with the current liquidity this would not necessitate much capital. In fact, empirical studies already indicate that the value of bitcoin is very speculative: not only through risk sharing practices, as after the Cyprus Crisis when people flocked to invest in Bitcoin, but more inherently as a vehicle for taking additional risk. This is suggested by a more complicated correlation with the Fear Index, VIX, as might be assumed. Also, because the number of bitcoins (the currency) is fixed by a hard ceiling means that its value should rise in the long-term.

[14.] The core of the Bitcoin democracy problem concerns the miners. The miners do the quintessential bookkeeping off the Strip. The miners are thought to be decentralized and honest nodes. Their incentive is believed to stay honest in the future. But the theoretical results of the article “Majority is Not Enough” imply disturbingly that miners would be better off pooling with the dishonest miners earning more. The game is like with biased slot machines systematically winning against the honest players. Unless the honest players get perks and satisfaction for their efforts, they will not stay honest. If they do not, we will revert to central control. Even if “forking” the block chain by a large pool would not be executed, its possibility would undermine bitcoin’s value and retain its high volatility.

[15.] What can be said about the stability of bitcoin’s price in the future? It may well happen that bitcoin’s price – or of other major cryptocurrency’s price – will stabilize to a “normal” level that has nearly the same volatility as the main fiat currencies USD, EUR, and JPY, show now. But it is also likely that flash crashes are expected: normal low volatility periods will be interspersed with dramatic movements both up and down, with the downwards movements being more harmful for the ordinary bitcoin users. It is also likely that pure speculation in bitcoin price will thrive. The control of bitcoin’s value will attract more interest from governments and big organizations around the world, including terrorist groups. The highly automatized and nearly anonymous nature of Bitcoin will attract hackers.

[16.] Economically, a controversial aspect of the Bitcoin democracy is that while Bitcoin (block chain) ingeniously gives the “Power of Money” to people instead of simply surrendering that power to a central (bank) government, Bitcoin coincidentally centralizes the “Power of Influence.” By this I mean that it will be easier, in my view, to disturb the value of a dominating cryptocurrency than of many weaker fiat currencies. The fiat currencies act as buffers: a crisis contagion from one region to another is less likely than in the Bitcoin world where changes in value are felt widely and instantly, in particular if a dominant cryptocurrency would exist over the respective fiat currencies. The economic long-term risks in the adoption of Bitcoin, and its democracy, may be higher than acknowledged.

[17.] Let me give an example of a problematic dominating fiat currency to make the claim a bit more reasonable. I do not have to look very far either. Euro has faced trouble during the last past few years and its problems are not expected to fade away soon since they arise from inherent differences between the nations included in the euro zone. Although the price of euro may serve the larger economies at least reasonably, it has been shown to cause trouble to smaller economies which no longer have the capacity to have their own monetary policy. If there would exist small fiat currencies along with bitcoin then that could help to stabilize the economies. Such a solution might work for developed (“Western”) countries, but not for all, and unless the economies are “equal states,” we should expect problems.

[18.] The Bitcoin conference organized at the D was aimed to current and potential investors (speculators) and people interested in its applicability in everyday life. That was not trash talk either. The D allows bitcoins to be used at their premises. One could in fact double-speculate: (1) by using bitcoins one has to accept there is a lot of speculation on its value, and (2) one of course faces the usual casino odds. Which one is actually the better bet? We know that the casino has a slight edge over the player so the more interesting question is are the odds of the value of bitcoin stacked against you, too? In all likelihood, with the current information, the answer is no; the odds are still in favor of the early adopter. Should the value of bitcoin continue to increase, the D is favorable, if one just avoids the Gambler’s Ruin.

[19.] Why should one be concerned about the Bitcoin democracy after all? The technology of Bitcoin is largely developed in countries with a Western mindset – places such as Silicon Valley that will first serve the interests of their respective investors. In fierce competition, the products may have to sold with high promises that may fail to be fulfilled in the long-term. This reminds me of old imperialistic thinking: What works well for one part of the world (“West”) may not work so well for others – not in the long-term, at least. In this of reasoning, the risk of Bitcoin application and its democracy may be severely underestimated. This underestimation may hold the seed for the next wave of financial disruptions. After the shocks in 2001, 2008, and the Euro Crisis, the next shock may be cryptocurrency related.

[20.] Do not get my message wrong – there is much to love about Bitcoin. The benefits were extensively and carefully listed at the D. Compared to cash and gold, Bitcoin is easier to handle and carry. Bitcoin may become more secure over time. Bitcoin is quick and has lower transaction costs compared to the current credit cards fees. There is more anonymity with the Bitcoin transactions. Anybody can become a miner and earn Bitcoins in return, although the incentive to do so diminishes. Nobody, as of yet, presumably controls Bitcoin. Its technology is open similarly to an earlier open-source success Linux, founded by Finnish (unanonymous) Linus Torvalds. Nowadays Linux plays a major role on Wall Street and in HFT. With improvements, Bitcoin and certainly block chain will become as big (or bigger).

[21.] Bitcoin and its block chain should be useful for paying for “Things.” Decentralization of Things, built partly on the infrastructure of Internet of Things by companies such as Nokia, may form a new business framework. Decentralization has created innovations by Airbnb, Uber, among others, that give the “Power of Business” to people through incentives at micro level. Decentralization produces efficiency gains compared to the old centralized economy – of which communism, as explained in my previous Big Data Brother article, sits at the (now forgotten) extreme. Financial markets also are expected to operate in a more decentralized style; their fragmentation now is the tip of the iceberg. There is an incentive for it: decentralized solutions can produce a more robust trading environment.

[22.] It is controversial that stability is both a plus and a minus of a decentralized system. A fragmented market may first appear to be weak, but in fact the more decentralized the system is, the better chances it will have to survive malfunctions – unless they are severe and collective. For example, a technological malfunction on one stock exchange should not prevent price discovery more generally; in July 2015, the New York Stock Exchange experienced a computer malfunction for 3.5 hours, but it did not truly disturb the markets. However, the resiliency of Bitcoin, or in other words, its anti-fragility is questionable. Although “Power of Money” is supposed to be decentralized, the incentives for collusion can lead to system wide breakdowns. Stability is largely about who has the control.

[23.] So fragility of the system is linked to its control. Most people live in a relatively tightly controlled society, although that control would not be as extreme as in communism – roughly estimated by my “Social Entropy Index” (SEI). Although Bitcoin is decentralized, it has already had problems in its short history related to central control: in 2014, a major bitcoin exchange (now defunct) Mt. Gox reportedly lost $620M because its user accounts were hacked, or claimed to be. Centralized control is fragile. In modern physics, it is possible although highly improbable, that an object at rest moves without outside force acting on it; in SEI terms, independent and equally distributed units (noise) imply stability. That is, unpredictable and uncontrollable noise has the maximum social entropy.

[24.] Let me reiterate an argument that demonstrates the undemocratic incentives of Bitcoin. How many computer nodes would have to collude to electronically counterfeit the books, that is, to fork the block chain? A common guess is “more than 50%.” However, mathematically the threshold does not need to be that high. The aforementioned article “Majority is Not Enough” shows that Bitcoin is more vulnerable to an attack than that. The true threshold is lower at 33% of the number of nodes. The winning pooling strategy uses an observation that it is worth a shot to keep a private (pool) owned record of transactions and essentially let the other honest miners to believe that your record is honest as well. The implication is that the Bitcoin control ends “In the Hands of a Few.”

[25.] About 12M of the total 21M bitcoins have been mined already. The rest will be mined by the year 2040. According to Forbes, of those already mined, 29% are owned by the (now-influential) 47. 50% are owned by 930. Should not that sound disturbing, not at least a bit? Then what about this: Ibid, over 90% of all the bitcoins (the currency) are hoarded. To me, after reading these numbers, Bitcoin democracy sounds even more like an imperialistic mission: a fortunate tech-savvy handful from the New Wild West sailing in electronic cryptospace to faraway lands where the product is promised to make everyone happier and free from government control. With the current price of one bitcoin, 378 EUR (416 USD), the mined coins represent combined assets worth of yet only 4.5bn. Space for imperialism.

[26.] I end by an example how surprisingly interconnected things can be, and how badly underestimated the estimated systemic risks can become if conglomerates roam around freely. You do not have to look that far in the history here either. I remember it well myself. The worst meltdown took place only four days before another “D-day”: the defense of my Doctoral dissertation, “Elements of Volatility at High Frequency,” on 19th of September, 2008. The “Too Big to Fail” Lehman Brothers failed on 15th due to large losses related to the U.S. housing market and the collapse in the value of “low-risk” financial contracts, credit default swaps. The U.S. credit market turned out to have a larger systemic risk than estimated. Bitcoin’s coin value pales in comparison, but the block chain’s may not.

Remark. If none of the risk scenarios play out within the next ten years, this article has done its job well. Sound risk management has been placed to reflect the true(r) systemic risks. In that case the article will remain as unknown as the true identify of Nakamoto currently is. On the other hand, should the risks stay underestimated, we will collectively lose as a society. Then I can only say: “I told you so.” Being a (presumably) honest node of the society, I should now declare that I prefer this article to be forgotten. But as a speculator and arbitrageur at the D, whose marketing slogan is “Long on Fun & Short on Ordinary” my desire is to follow their advice and collect the money in some form at the cashier. In neither case, you will not know the true value of this article, ex ante. That is the Nature of the Game.

Postscript. It may be the biggest technology related news of 2015, or it may be just an elaborate hoax. In either case, the “D-conference” just gained more weight. The Wired Magazine announced on Tuesday, 8th of December, 2015, about one month after the “D-day,” who they believe to be the true Satoshi Nakamoto: Craig Steven Wright, apparently linked to “Tulip Trust” managing a staggering amount of 1.1M bitcoins. Personally, I can (or wish) only recollect parts of the session that had the named guy. “What happens in Vegas, stays in Vegas” is the famous slogan. Now, I may have witnessed the best Las Vegas striptease show yet, with the noticeable difference that everyone knows about it. Perhaps in the era of computers, nothing can really be kept a secret. Not even with the best cryptography. □

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[Signed: 7/.V]

 

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