“The potential applications of this technology are being widely imagined and explored in ways that will benefit market participants, consumers and governments alike,” Giancarlo noted in his address. But in order for that to happen, he said, we have to get policy right. “It is time again to remind regulators to ‘do no harm,'” he argued, and he continued on to note that

The United States’ global leadership in technological innovation of the Internet was built hand-in-hand with its enlightened “do no harm” regulatory framework. Yet, when the Internet developed in the mid-1990s, none of us could have imagined its capabilities that we take for granted today. Fortunately, policymakers had the foresight to create a regulatory environment that served as a catalyst rather than a choke point for innovation. Thanks to their forethought and restraint, Internet-based applications have revolutionized nearly every aspect of human life, created millions of jobs and increased productivity and consumer choice. Regulators must show that same forethought and restraint now [for the blockchain].

What Giancarlo is referring to is the approach that the U.S. government adopted toward the Internet and digital networks in the mid-1990s. You can think of this vision as “permissionless innovation.” As I explain in my recent book of the same title, permissionless innovation refers to the notion that we should generally be free to experiment and learn new and better ways of doing things through ongoing trial-and-error.

How did U.S. policymakers make permissionless innovation the cornerstone of Internet policy during the mid-1990s? In my book, I highlight several key policy decisions, but the most crucial moment came with the Clinton Administration’s 1997 publication of Framework for Global Electronic Commerce in July 1997.  As I have noted here many times before, the document was a succinct and principled vision statement that made the idea of permissionless innovation the cornerstone of Internet policy for America. The five principles at the heart of this beautiful Framework were:

1. The private sector should lead. The Internet should develop as a market driven arena not a regulated industry. Even where collective action is necessary, governments should encourage industry self-regulation and private sector leadership where possible. 2. Governments should avoid undue restrictions on electronic commerce. In general, parties should be able to enter into legitimate agreements to buy and sell products and services across the Internet with minimal government involvement or intervention. Governments should refrain from imposing new and unnecessary regulations, bureaucratic procedures or new taxes and tariffs on commercial activities that take place via the Internet. 3. Where governmental involvement is needed, its aim should be to support and enforce a predictable, minimalist, consistent and simple legal environment for commerce. Where government intervention is necessary, its role should be to ensure competition, protect intellectual property and privacy, prevent fraud, foster transparency, and facilitate dispute resolution, not to regulate. 4. Governments should recognize the unique qualities of the Internet. The genius and explosive success of the Internet can be attributed in part to its decentralized nature and to its tradition of bottom-up governance. Accordingly, the regulatory frameworks established over the past 60 years for telecommunication, radio and television may not fit the Internet. Existing laws and regulations that may hinder electronic commerce should be reviewed and revised or eliminated to reflect the needs of the new electronic age. 5. Electronic commerce on the Internet should be facilitated on a global basis. The Internet is a global marketplace. The legal framework supporting commercial transactions should be consistent and predictable regardless of the jurisdiction in which a particular buyer and seller reside.

It was and remains a near-perfect vision for how emerging technologies should be governed because, as I note in my book, it “gave innovators the green light to let their minds run wild and experiment with an endless array of exciting new devices and services.”

Commissioner Giancarlo agrees, noting of the  Framework that, “This model is well-recognized as the enlightened regulatory underpinning of the Internet that brought about profound changes to human society. … During the period of this “do no harm” regulatory framework, a massive amount of investment was made in the Internet’s infrastructure. It yielded a rapid expansion in access that supported swift deployment and mass adoption of Internet-based technologies.” And countless new exciting systems, devices, and applications came about, which none of us could have anticipated until we let people experiment freely.

By extension, we should apply the “do no harm” / permissionless innovation policy paradigm more broadly, Giancarlo says.

‘Do no harm’ was unquestionably the right approach to development of the Internet. Similarly, “do no harm” is the right approach for DLT. Once again, the private sector must lead and regulators must avoid impeding innovation and investment and provide a predictable, consistent and straightforward legal environment. Protracted regulatory uncertainty or an uncoordinated regulatory approach must be avoided, as should rigid application of existing rules designed for a bygone technological era. . . . I believe that innovators and investors should not have to seek government’s permission, only its forbearance, to develop DLT so they can do the work necessary to address the increased operational complexity and capital consumption of modern financial market regulation.

And if America fails to adopt this approach for the Blockchain, it could be disastrous. “Without such a “do no harm” approach,” Giancarlo predicts, “financial service and technology firms will be left trying to navigate a complex regulatory environment, where multiple agencies have their own rule frameworks, issues and concerns.” And that led Giancarlo to touch upon an issue I have discussed here many times before: The growing reality of a world of “global innovation arbitrage.” As I noted in an essay on that topic, “Capital moves like quicksilver around the globe today as investors and entrepreneurs look for more hospitable tax and regulatory environments. The same is increasingly true for innovation. Innovators can, and increasingly will, move to those countries and continents that provide a legal and regulatory environment more hospitable to entrepreneurial activity.”

This is why it is so crucial that policymakers set the right tone for innovation for blockchain-based technologies and applications. If they don’t, innovators would seek out more hospitable legal environments in which they can innovate without prior restraint. As he ellaborates:

It is therefore critical for regulators to come together to adopt a principles-based approach to DLT regulation that is flexible enough so innovators do not fear unwitting infractions of an uncertain regulatory environment. Some regulators have already openly acknowledged the need for light-touch oversight. For instance, the UK’s Financial Conduct Authority (FCA) has committed to regulatory forbearance on DLT development for the foreseeable future in an effort to give innovators “space” to develop and improve the technology. The FCA is even going one step further and engaging in discussions with the industry to determine whether DLT could meet the FCA’s own needs. Similarly, a few weeks ago, Masamichi Kono, Vice Minister for International Affairs at the Japan Financial Services Agency, stated that regulators must take a “pragmatic and flexible approach” to regulation of new technologies so not to stifle innovation. I have no doubt that the FCA’s intention to give DLT innovators “space” to innovate will be good for DLT research and development. I also suspect that it will be good for the UK’s burgeoning FinTech industry and the jobs it creates across the Atlantic. U.S. lawmakers concerned about the rapid loss of jobs in the U.S. financial service industry, especially in the New York City area, should similarly look to provide “space” to U.S. DLT innovation and entrepreneurship and the well-paying American jobs that will surely follow.

That is exactly right. I just hope other policymakers are listening to this wisdom. The future of blockchain-based innovation depends upon it. America should follow Commissioner Giancarlo’s wise call to adopt permissionless innovation as the policy default for this exciting technology.

Additional Reading:

• Permissionless Innovation: The Continuing Case for Comprehensive Technological Freedom
• Embracing a Culture of Permissionless Innovation
• “Permissionless Innovation” & the Clash of Visions over Emerging Technologies (SLIDESHOW)
• How Attitudes about Risk & Failure Affect Innovation on Either Side of the Atlantic
• FTC’s Ohlhausen on Innovation, Prosperity, “Rational Optimism” & Wise Tech Policy
• The Innovator’s Defense Fund: What it is and why it’s needed
• A Nonpartisan Policy Vision for the Internet of Things
• Problems with Precautionary Principle-Minded Tech Regulation & a Federal Robotics Commission
• Global Innovation Arbitrage: Genetic Testing Edition
• UK Competition & Markets Authority on Online Platform Regulation

A couple weeks ago at State of the Net, I was on a panel on Bitcoin moderated by Coin Center’s Jerry Brito. The premise of the panel was that the state of Bitcoin is like the early Internet. Somehow we got policy right in the mid-1990s to allow the Internet to become the global force it is today. How can we reprise this success with Bitcoin today?

In my remarks, I recall making two basic points.

First, in my opening remarks, I argued that on a technical level, the comparison between Bitcoin and the Internet is apt.

What makes the Internet different from the telecommunications media that came before is the separation of an application layer from a transport layer. The transport layer (and the layers below it) does the work of getting bits to where they need to go. This frees anybody up to develop new applications on a permissionless basis, taking this transport capability basically for granted.

Earlier telecom systems did not function this way. The applications were jointly defined with the transport mechanism. Phone calls are defined in the guts of the network, not at the edges.

Like the Internet, Bitcoin separates out not a transport layer, but a fiduciary layer, from the application layer. The blockchain gives applications access to a fiduciary mechanism that they can take basically for granted.

No longer will fiduciary applications (payments, contracts, asset exchange, notary services, voting, etc.) and fiduciary mechanisms need to be developed jointly. Unwieldy fiduciary mechanisms (banks, legal systems, oversight) will be able to be replaced with computer code.

Second, in the panel’s back and forth, particularly with Chip Poncy, I argued that technological change may necessitate a rebalancing of our laws and regulations on financial crimes.

We have payment systems because they improve human welfare. We have laws against certain financial activities because those activities harm human welfare. Ideally, we would balance the gains against the losses to come up with the optimal, human-welfare-maximizing level of regulation.

However, when a new technology like the blockchain comes along, the gains from payment freedom increase. People in a permissionless environment will be able to accomplish more than before. This means that we have to redo our balancing calculus. Because the benefits of unimpeded payments are higher, we need to tolerate more harms from unsavory financial activities if our goal remains to maximize human welfare.

Thanks to my co-panelists for a great discussion.

As 2014 draws to a close, we take a look back at the most-read posts from the past year at The Technology Liberation Front. Thank you for reading, and enjoy.

10. New York’s financial regulator releases a draft of ‘BitLicense’ for Bitcoin businesses. Here are my initial thoughts.

In July, Jerry Brito wrote about New York’s proposed framework for regulating digital currencies like Bitcoin.

My initial reaction to the rules is that they are a step in the right direction. Whether one likes it or not, states will want to license and regulate Bitcoin-related businesses, so it’s good to see that New York engaged in a thoughtful process, and that the rules they have proposed are not out of the ordinary.

9. Google Fiber: The Uber of Broadband

In February, I noted some of the parallels between Google Fiber and ride-sharing, in that new entrants are upending the competitive and regulatory status quo to the benefit of consumers.

The taxi registration systems and the cable franchise agreements were major regulatory mistakes. Local regulators should reduce regulations for all similarly-situated competitors and resist the temptation to remedy past errors with more distortions.

8. The Debate over the Sharing Economy: Talking Points & Recommended Reading

In September, Adam Thierer appeared on Fox Business Network’s Stossel show to talk about the sharing economy. In a TLF post, he expands upon his televised commentary and highlights five main points.

7. CES 2014 Report: The Internet of Things Arrives, but Will Washington Welcome It?

After attending the 2014 Consumer Electronics Show in January, Adam wrote a prescient post about the promise of the Internet of Things and the regulatory risks ahead.

When every device has a sensor, a chip, and some sort of networking capability, amazing opportunities become available to consumers…. But those same capabilities are exactly what raise the blood pressure of many policymakers and policy activists who fear the safety, security, or privacy-related problems that might creep up in a world filled with such technologies.

6. Defining “Technology”

Earlier this year, Adam compiled examples of how technologists and experts define “technology,” with entries ranging from the Oxford Dictionary to Peter Thiel. It’s a slippery exercise, but

if you are going to make an attempt to either study or critique a particular technology or technological practice or development, then you probably should take the time to tell us how broadly or narrowly you are defining the term “technology” or “technological process.”

5. The Problem with “Pessimism Porn”

Adam highlights the tendency of tech press, academics, and activists to mislead the public about technology policy by sensationalizing technology risks.

The problem with all this, of course, is that it perpetuates societal fears and distrust. It also sometimes leads to misguided policies based on hypothetical worst-case thinking…. [I]f we spend all our time living in constant fear of worst-case scenarios—and premising public policy upon them—it means that best-case scenarios will never come about.

4. Mark T. Williams predicted Bitcoin’s price would be under $10 by now; it’s over $600

Professor Mark T. Williams predicted in December 2013 that by mid-2014, Bitcoin’s price would fall to below $10. In mid-2014, Jerry commends Prof. Williams for providing, unlike most Bitcoin watchers, a bold and falsifiable prediction about Bitcoin’s value. However, as Jerry points out, that prediction was erroneous: Bitcoin’s 2014 collapse never happened and the digital currency’s value exceeded $600.

3. What Vox Doesn’t Get About the “Battle for the Future of the Internet”

In May, Tim Lee wrote a Vox piece about net neutrality and the Netflix-Comcast interconnection fight. Eli Dourado posted a widely-read and useful corrective to some of the handwringing in the Vox piece about interconnection, ISP market power, and the future of the Internet.

I think the article doesn’t really consider how interconnection has worked in the last few years, and consequently, it makes a big deal out of something that is pretty harmless…. There is nothing unseemly about Netflix making … payments to Comcast, whether indirectly through Cogent or directly, nor is there anything about this arrangement that harms “the little guy” (like me!).

2. Muddling Through: How We Learn to Cope with Technological Change

The second most-read TLF post of 2014 is also the longest and most philosophical in this top-10 list. Adam wrote a popular and in-depth post about the social effects of technological change and notes that technology advances are largely for consumers’ benefit, yet “[m]odern thinking and scholarship on the impact of technological change on societies has been largely dominated by skeptics and critics.” The nature of human resilience, Adam explains, should encourage a cautiously optimistic view of technological change.

1. Help me answer Senate committee’s questions about Bitcoin

Two days into 2014, Jerry wrote the most-read TLF piece of the past year. Jerry had testified before the Senate Homeland Security and Governmental Affairs Committee in 2013 as an expert on Bitcoin. The Committee requested more information about Bitcoin post-hearing and Jerry solicited comment from our readers.

Thank you to our loyal readers for continuing to visit The Technology Liberation Front. It was busy year for tech and telecom policy and 2015 promises to be similarly exciting. Have a happy and safe New Years!

Today my colleague Eli Dourado and I have filed a public interest comment with the New York Department of Financial Services on their proposed “BitLicense” regulatory framework for digital currencies. You can read it here. As we say in the comment, NYDFS is on the right track, but ultimately misses the mark:

State financial regulators around the country have been working to apply their existing money transmission licensing statutes and regulations to new virtual currency businesses. In many cases, existing rules do not take into account the unique properties of recent innovations like cryptocurrencies. With this in mind, the department sought to develop rules that were “tailored specifically to the unique characteristics of virtual currencies.” As Superintendent Benjamin Lawsky has stated, the aim of this project is “to strike an appropriate balance that helps protect consumers and root out illegal activity—without stifling beneficial innovation.” This is the right goal and one we applaud. It is a very difficult balance to strike, however, and we believe that the BitLicense regulatory framework as presently proposed misses the mark, for two main reasons. First, while doing much to take into account the unique properties of virtual currencies and virtual currency businesses, the proposal nevertheless fails to accommodate some of the most important attributes of software-based innovation. To the extent that one of its chief goals is to preserve and encourage innovation, the BitLicense proposal should be modified with these considerations in mind—and this can be done without sacrificing the protections that the rules will afford consumers. Taking into account the “unique characteristics” of virtual cur-rencies is the key consideration that will foster innovation, and it is the reason why the department is creating a new BitLicense. The department should, therefore, make sure that it is indeed taking these features into account. Second, the purpose of a BitLicense should be to take the place of a money transmission license for virtual currency businesses. That is to say, but for the creation of a new BitLicense, virtual currency businesses would be subject to money transmission licensing. Therefore, to the extent that the goal behind the new BitLicense is to protect consumers while fostering innovation, the obligations faced by BitLicensees should not be any more burdensome than those faced by traditional money transmitters. Otherwise, the new regulatory framework will have the opposite effect of the one intended. If it is more costly and difficult to acquire a BitLicense than a money transmission license, we should expect less innovation. Additional regulatory burdens would put BitLicensees at a relative disadvantage, and in several instances the proposed regulatory framework is more onerous than traditional money transmitter licensing. As Superintendent Lawsky has rightly stated, New York should avoid virtual currency rules that are “so burdensome or unwieldy that the technology can’t develop.” The proposed BitLicense framework, while close, does not strike the right balance between consumer protection and innovation. For example, its approach to consumer protection through disclosures rather than prescriptive precautionary regulation is the right approach for giving entrepreneurs flexibility to innovate while ensuring that consumers have the information they need to make informed choices. Yet there is much that can be improved in the framework to reach the goal of balancing innovation and protection. Below we outline where the framework is missing the mark and recommend some modifications that will take into account the unique properties of virtual currencies and virtual currency businesses.

We hope this comment will be helpful to the department as it further develops its proposed framework, and we hope that it will publish a revised draft of the framework and solicit a second round of comments so that we can make sure we all get it right. And it’s important that we get it right.

Other jurisdictions, such as London, are looking to become the “global centre of financial innovation,” as Chancellor George Osborne put it in a recent speech about Bitcoin. If New York drops the ball, London may just pick it up. As Garrick Hileman, economic historian at the London School of Economics, told CNet last week:

The chancellor is no doubt aware that very little of the $250 million of venture capital which has been invested in Bitcoin startups to date has gone to British-based companies. Many people believe Bitcoin will be as big as the Internet. Today’s announcement from the chancellor has the potential to be a big win for the UK economy. The bottom line on today’s announcement is that Osborne thinks he’s spotted an opportunity for the City and Silicon Roundabout to siphon investment and jobs away from the US and other markets which are taking a more aggressive Bitcoin regulatory posture.

Let’s get it right.

Today the New York Department of Financial Services released a proposed framework for licensing and regulating virtual currency businesses. Their “BitLicense” proposal [PDF] is the culmination of a yearlong process that included widely publicizes hearings.

My initial reaction to the rules is that they are a step in the right direction. Whether one likes it or not, states will want to license and regulate Bitcoin-related businesses, so it’s good to see that New York engaged in a thoughtful process, and that the rules they have proposed are not out of the ordinary.

That said, I’m glad DFS will be accepting comments on the proposed framework because there are a few things that can probably be improved or clarified. For example:

1. Licensees would be required to maintain “the identity and physical addresses of the parties involved” in “all transactions involving the payment, receipt, exchange or conversion, purchase, sale, transfer, or transmission of Virtual Currency.” That seems a bit onerous and unworkable.

   Today, if you have a wallet account with Coinbase, the company collects and keeps your identity information. Under New York’s proposal, however, they would also be required to collect the identity information of anyone you send bitcoins to, and anyone that sends bitcoins to you (which might be technically impossible). That means identifying every food truck you visit, and every alpaca sock merchant you buy from online.

   The same would apply to merchant service companies like BitPay. Today they identify their merchant account holders–say a coffee shop–but under the proposed framework they would also have to identify all of their merchants’ customers–i.e. everyone who buys a cup of coffee. Not only is this potentially unworkable, but it also would undermine some of Bitcoin’s most important benefits. For example, the ability to trade across borders, especially with those in developing countries who don’t have access to electronic payment systems, is one of Bitcoin’s greatest advantages and it could be seriously hampered by such a requirement.

   The rationale for creating a new “BitLicense” specific to virtual currencies was to design something that took the special characteristics of virtual currencies into account (something existing money transmission rules didn’t do). I hope the rule can be modified so that it can come closer to that ideal.

2. The definition of who is engaged in “virtual currency business activity,” and thus subject to the licensing requirement, is quite broad. It has the potential to swallow up online wallet services, like Blockchain, who are merely providing software to their customers rather than administering custodial accounts. It might potentially also include non-financial services like Proof of Existence, which provides a notary service on top of the Bitcoin block chain. Ditto for other services, perhaps like NameCoin, that use cryptocurrency tokens to track assets like domain names.

3. The rules would also require a license of anyone “controlling, administering, or issuing a Virtual Currency.” While I take this to apply to centralized virtual currencies, some might interpret it to also mean that you must acquire a license before you can deploy a new decentralized altcoin. That should be clarified.

In order to grow and reach its full potential, the Bitcoin ecosystem needs regulatory certainty from dozens of states. New York is taking a leading role in developing that a regulatory structure and the path it chooses will likely influence other states. This is why we have to make sure that New York gets it right. They are on the right track and I look forward to engaging in the comment process to help them get all the way there.

In April I had the opportunity to testify before the House Small Business Committee on the costs and benefits of small business use of Bitcoin. It was a lively hearing, especially thanks to fellow witness Mark T. Williams, a professor of finance at Boston University. To say he was skeptical of Bitcoin would be an understatement.

Whenever people make the case that Bitcoin will inevitably collapse, I ask them to define collapse and name a date by which it will happen. I sometimes even offer to make a bet. As Alex Tabarrok has explained, bets are a tax on bullshit.

So one thing I really appreciate about Prof. Williams is that unlike any other critic, he has been willing to make a clear prediction about how soon he thought Bitcoin would implode. On December 10, he told Tim Lee in an interview that he expected Bitcoin’s price to fall to under $10 in the first half of 2014. A week later, on December 17, he clearly reiterated his prediction in an op-ed for Business Insider:

I predict that Bitcoin will trade for under $10 a share by the first half of 2014, single digit pricing reflecting its option value as a pure commodity play.

Well, you know where this is going. We’re now five months into the year. How is Bitcoin doing?

It’s in the middle of a rally, with the price crossing $600 for the first time in a couple of months. Yesterday Dish Networks announced it would begin accepting Bitcoin payments from customers, making it the largest company yet to do so.

None of this is to say that Bitcoin’s future is assured. It is a new and still experimental technology. But I think we can put to bed the idea that it will implode in the short term because it’s not like any currency or exchange system that came before, which was essentially William’s argument.

Patrick Byrne, CEO of Overstock.com, discusses how Overstock.com became one of the first online retail stores to accept Bitcoin. Byrne provides insight into how Bitcoin lowers transaction costs, making it beneficial to both retailers and consumers, and how governments are attempting to limit access to Bitcoin. Byrne also discusses his project DeepCapture.com, which raises awareness for market manipulation and naked short selling, as well as his philanthropic work and support for education reform.

Download

Related Links

• For Overstock CEO, Bitcoin Isn’t Just A Publicity Stunt, Forbes
• Meet Patrick Byrne: Bitcoin Messiah, CEO of Overstock, Scourge of Wall Street, Wired
• UBS, in Theory, a Conspiracy to Naked Short “Tens of Millions” of Shares, Deepcapture

I’m thrilled to make available today a discussion draft of a new paper I’ve written with Houman Shadab and Andrea Castillo looking at what will likely be the next wave of Bitcoin regulation, which we think will be aimed at financial instruments, including securities and derivatives, as well as prediction markets and even gambling. You can grab the draft paper from SSRN, and we very much hope you will give us your feedback and help us correct any errors. This is a complicated issue area and we welcome all the help we can get.

While there are many easily regulated intermediaries when it comes to traditional securities and derivatives, emerging bitcoin-denominated instruments rely much less on traditional intermediaries. Additionally, the block chain technology that Bitcoin introduced for the first time makes completely decentralized markets and exchanges possible, thus eliminating the need for intermediaries in complex financial transactions. In the article we survey the type of financial instruments and transactions that will most likely be of interest to regulators, including traditional securities and derivatives, new bitcoin-denominated instruments, and completely decentralized markets and exchanges.

We find that bitcoin derivatives would likely not be subject to the full scope of regulation under the Commodities and Exchange Act because such derivatives would likely involve physical delivery (as opposed to cash settlement) and would not be capable of being centrally cleared. We also find that some laws, including those aimed at online gambling, do not contemplate a payment method like Bitcoin, thus placing many transactions in a legal gray area.

Following the approach to Bitcoin taken by FinCEN, we conclude that other financial regulators should consider exempting or excluding certain financial transactions denominated in Bitcoin from the full scope of the regulations, much like private securities offerings and forward contracts are treated. We also suggest that to the extent that regulation and enforcement becomes more costly than its benefits, policymakers should consider and pursue strategies consistent with that new reality, such as efforts to encourage resilience and adaptation.

I look forward to your comments!

Later today I’ll be testifying at a hearing before the House Small Business Committee titled “Bitcoin: Examining the Benefits and Risks for Small Business.” It will be live streamed starting at 1 p.m. My testimony will be available on the Mercatus website at that time, but below is some of my work on Bitcoin in case you’re new to the issue.

Also, tonight I’ll be speaking at a great event hosted by the DC FinTech meetup on “Bitcoin & the Internet of Money.” I’ll be joined by Bitcoin core developer Jeff Garzik and we’ll be interviewed on stage by Joe Weisenthal of Business Insider. It’s open to the public, but you have to RSVP.

Finally, stay tuned because in the next couple of days my colleagues Houman Shadab, Andrea Castillo, and I will be posting a draft of our new law review article looking at Bitcoin derivatives, prediction markets, and gambling. Bitcoin is the most fascinating issue I’ve ever worked on.

Here’s Some Bitcoin Reading…

• Bitcoin: A Primer for Policymakers (with Andrea Castillo)
• Regulators Need to Take It Easy on Bitcoin Startups, WIRED, March 6, 2014.
• Bitcoin: More than Money, Reason, December 2013.
• US regulations are hampering Bitcoin’s growth, The Guardian, November 18, 2013.
• Why Regulators Should Embrace Bitcoin, American Banker, August 21, 2013.
• And here are all the posts about Bitcoin on Tech Liberation from myself, Jim Harper, and Eli Dourado

And here’s my interview with Reihan Salam discussing Bitcoin…

The volatility of Bitcoin prices is one of the strongest headwinds the currency faces. Unfortunately, until my quantitative analysis last month, most of the discussion surrounding Bitcoin volatility so far has been anecdotal. I want to make it easier for people to move beyond anecdotes, so I have created a Bitcoin volatility index at btcvol.info, which I’m hoping can become or inspire a standard metric that people can agree on.

The volatility index at btcvol.info is based on daily closing prices for Bitcoin as reported by CoinDesk. I calculate the difference in daily log prices for each day in the dataset, and then calculate the sample standard deviation of those daily returns for the preceding 30 days. The result is an estimate of how spread out daily price fluctuations are—volatility.

The site also includes a basic API, so feel free to integrate this volatility measure into your site or use it for data analysis.

I of course hope that Bitcoin volatility becomes much lower over time. I expect both the maturing of the ecosystem as well as the introduction of a Bitcoin derivatives market will cause volatility to decrease. Having one or more volatility metrics will help us determine whether these or other factors make a difference.

You can support btcvol.info by spreading the word or of course by donating via Bitcoin to the address at the bottom of the site.

Over a month ago I testified at the Senate Homeland Security and Governmental Affairs Committee hearing on Bitcoin. I’ve been asked by the committee to submit answers to additional questions, and I thought I’d try to tap into the Bitcoin community’s wisdom by posting here the questions and my draft answers and inviting you to post in the comments any suggestions you might have. I’d especially appreciate examples of innovative uses of Bitcoin or interesting potential business cases. Thanks for your help!

Post-Hearing Questions for the Record Submitted to Jerry Brito From Senator Thomas R. Carper

“Beyond Silk Road: Potential Risks, Threats, and Promises of Virtual Currencies” November 18, 2013

1. Overall, how would you assess the federal government’s activities thus far regarding virtual currencies and in what areas do you believe more work needs to be done?

The federal government’s approach to virtual currencies thus far has been understandably cautious.

On the anti-money-laundering and terrorist-financing front, FinCEN has issued guidance that adequately addresses virtual currencies, and it is heartening to see recent reports that the agency is clarifying for entrepreneur and consumers how they plan to apply that guidance. Additionally, with the tools already at their disposal, law enforcement has also successfully taken down the Silk Road online black market, as well as Liberty Reserve, a centralized digital currency favored by online criminals and responsible for laundering billions of dollars.

On the consumer protection front, state financial regulators are currently developing guidelines for the licensing of money transmitters, which are meant to ensure that such businesses are well-run and adequately capitalized. As noted in a question below, however, virtual currencies like Bitcoin are still not in use by very many consumers, and those who do use them likely understand the risks involved, giving regulators the luxury of seeing how the market develops and whether any problems arise before intervening.

One area where more guidance may be necessary is tax compliance. The IRS has indicated that it is working on guidance related to virtual currencies. Clear and simple rules for the tax treatment of virtual currency capital gains and other tax questions would be welcome.

2. Do you believe virtual currencies, including Bitcoin, fit into our current legal and regulatory framework? Do you see any gaps in our statutes and regulations regarding virtual currencies? Which agencies do you believe need to be at the forefront of the federal government’s work on virtual currencies?

To date we have seen that regulators have been able to apply existing law to virtual currencies. In the future, there may be situations in which existing law may not be able to fully account for virtual currencies. For example, to the extent we may some day see a Bitcoin futures market, the Commodities Future Trading Commission may want to exercise its authority over “foreign-exchange forwards” or “foreign-exchange swaps.” However, it would be difficult to justify that virtual currencies are “foreign” currency, which Congress did not define in Commodity Exchange Act presumably because the meaning was obvious at the time. That said, the CFTC would have no problem treating bitcoins as commodities, since “commodity” is defined very broadly by the Act. What this suggests is that rather than attempt to predict how current law may not become incompatible with virtual currency use, a better approach may be to wait for actual “cases and controversies” to arise and to intervene only if regulators cannot apply existing law. To do otherwise may invite unintended consequences or simply waste time and resources.

3. As I understand things, currently there is still a relatively very small group of people that use Bitcoin. That being the case, the full scope of the ramifications of the use of Bitcoin remains to be seen.

a. Can you share with us some examples of uses that might have a positive impact for consumers or the broader economy? What are some of the promises of this new technology, as you see them?

b. What kinds of businesses and opportunities might emerge around Bitcoin if the currency continues to grow?

I would refer you to pages 10 – 20 of Bitcoin: A Primer for Policymakers in which my colleague Andrea Castillo and I detail the ways Bitcoin may positively affect the economy, as well as the business opportunities it presents.

4. Since its introduction in 2008, Bitcoin has experienced a number of significant price swings. For example, in 2013, the price per Bitcoin fell from $266 in early April to $50 in late April, but today is hovering around $1000.

a. What factors have contributed to this volatility?

There are at least three reasons that the price of Bitcoin fluctuates so wildly. First, the total value of all outstanding bitcoins is still relatively low. This means that even a small absolute increase in interest in Bitcoin can send prices soaring.

Second, a large fraction of the existing stock of bitcoins seem, for now, to be held as a long-term investment. This means that the market is not very liquid.

Finally, when there is a change in the demand for Bitcoin, the supply of Bitcoin cannot adjust to accommodate it, so all of the adjustment has to happen in the price, rather than in the quantity. This effect may be somewhat offset for now by the fact that many bitcoins are held as investments, but it means that Bitcoin is likely to be relatively volatile even if people stop holding bitcoins as investments.

b. For those companies who are trying to build businesses around this technology, doesn’t this volatility concern you? What can be done so the price is not so volatile?

Merchants that accept payment in bitcoins and companies trying to build businesses around the protocol no doubt already take the volatility into consideration. For example, merchants that accept bitcoins often use a payment services like BitPay, which deposit dollars into merchant accounts on a daily basis, and companies like BitPay hedge against currency volatility. That said, as more and more consumers begin to use Bitcoin, the market will become more liquid and volatility should subside. Additionally, the development of a bitcoin futures market may also help stabilize the currency. Regulators can help combat volatility by allowing such a market to develop.

5. Most of the recent research and media coverage on virtual currencies has focused on Bitcoin. Are there other virtual currencies that we should be paying attention to?

It is important to keep in mind the difference between centralized and decentralized digital currencies. Centralized currencies like the defunct Liberty Reserve are of greater concern to law enforcement, as Special Agent Edward Lowery explained at the hearing. As for decentralized digital currencies, it is not surprising that Bitcoin has earned the lion’s share of attention since it is the first ever decentralized currency as well as the largest. Indeed, the economy of the next largest decentralized digital currency—Litecoin—is less than one-tenth that of Bitcoin. Competing decentralized currencies are very important, especially as they develop technical innovations, but the regulatory and law enforcement issues they raise are essentially the same as Bitcoin.

6. The point has been made to me that the way to see Bitcoin and virtual currencies today is a bit like we saw email or the internet itself 20 years ago. At the time, we thought email might replace mail but it was sort of complicated and difficult to work unless you were more technically minded. Obviously as the technology matured it became easier to use and more widely adopted and it’s changed the way we communicate in fundamental ways. With that said, if you could hazard a guess, what do you see for Bitcoin 20 years from now?

Email is a good analogy, but a better one might be the World Wide Web. As Mike Hearn, an engineer at Google who serves as one of Bitcoin’s core developers, says, “The Web started out as scientists simply showing documents to each other. You could link documents and embed images, but the true potential of the Web really came when these pages became interactive and started gaining more and more features allowing people to build things like Facebook or online shops. Those things are not documents, and now probably half the time people use the Web they aren’t really interacting with documents; they are actually using applications.”

Unlike email, the Web is a platform, which means that it can be programmed to be just about anything. Bitcoin is similarly a platform that can be programmed. As a result, it’s difficult to predict what developers and entrepreneurs allowed to freely innovate may come up with. However, some innovations that Bitcoin may make possible include micropayments, smart property, decentralized assurance contracts, and competitive arbitration services.

7. What can we as policymakers and legislators be doing to encourage innovation by good actors interested in being involved in the virtual currency space?

As I said in my testimony, policymakers’ first imperative should be to do no harm. Bitcoin and other decentralized digital currencies are an experiment, just as the wider Internet once was. The Internet has become the amazing engine of innovation and economic prosperity because it has largely been left alone by regulators. This was a deliberate policy articulated by President Clinton’s chief policy counsel Ira Magaziner, who was in charge of crafting the administration’s Framework for Global Electronic Commerce in July 1997. Its recommendations read in part:

1. The private sector should lead. The Internet should develop as a market driven arena not a regulated industry. Even where collective action is necessary, governments should encourage industry self-regulation and private sector leadership where possible.

2. Governments should avoid undue restrictions on electronic commerce. In general, parties should be able to enter into legitimate agreements to buy and sell products and services across the Internet with minimal government involvement or intervention. Governments should refrain from imposing new and unnecessary regulations, bureaucratic procedures or new taxes and tariffs on commercial activities that take place via the Internet.

3. Where governmental involvement is needed, its aim should be to support and enforce a predictable, minimalist, consistent and simple legal environment for commerce. Where government intervention is necessary, its role should be to ensure competition, protect intellectual property and privacy, prevent fraud, foster transparency, and facilitate dispute resolution, not to regulate.

4. Governments should recognize the unique qualities of the Internet. The genius and explosive success of the Internet can be attributed in part to its decentralized nature and to its tradition of bottom-up governance. Accordingly, the regulatory frameworks established over the past 60 years for telecommunication, radio and television may not fit the Internet. Existing laws and regulations that may hinder electronic commerce should be reviewed and revised or eliminated to reflect the needs of the new electronic age.

5. Electronic commerce on the Internet should be facilitated on a global basis. The Internet is a global marketplace. The legal framework supporting commercial transactions should be consistent and predictable regardless of the jurisdiction in which a particular buyer and seller reside.

The same principles should apply to Bitcoin today. If there is one thing policymakers could do today to encourage innovation by good actors in the Bitcoin space it is to signal to the traditional financial sector—especially in banking—that while Bitcoin presents some challenges, it is nothing to be feared, and they will not be penalized by regulators for servicing, working with, and even investing in Bitcoin-related businesses.

Everyone seems to be worried about Bitcoin’s carbon footprint lately. Last week, an article on Quartz claimed that Bitcoin miners are spending $17 million per day on electricity in order to reap $4.4 million worth of bitcoins. And Yesterday, Pando Daily ran a piece that ominously warned about Bitcoin’s carbon footprint.

One problem with both of these pieces is that they seem to rely on electricity consumption estimates from blockchain.info. While this site is great for getting stats about the Bitcoin network, it’s not such a great site for estimating electricity consumption. Blockchain.info clearly states that it is using an estimate of 650 Watts per gigahash [per second, I assume] in its electricity calculations. While this may have been a good estimate of the efficiency of the Bitcoin network when the page was first created, the network has become much more efficient since then. Archive.org shows that the 650W/GH/s figure was used on the earliest cached copy of the page, from December 2, 2011; yes, that is over two years ago.

Furthermore, we can use data from current-generation mining hardware to see how absurd the 650W/GH/s number is. In recent months, the Bitcoin network has mostly switched to application-specific integrated circuits, or ASICs. These devices are much more efficient at mining than previous generations of hardware. A look at this table of mining hardware shows that ASICs all seem to mine at less than 10W/GH/s. Some discontinued models seem to mine as efficiently as 2W/GH/s, and some models that are shipping next year will use less than 0.5W/GH/s. Not everyone in the Bitcoin network is using the latest-generation models of ASICs, and of course botnet mining is based on stealing electricity, so it’s not likely that the network averages 2W/GH/s or less. Nevertheless, it seems that the electricity estimates that these articles are based on may be off by a factor of close to 100.

Furthermore, we should always ask “compared to what?” Yes, the Bitcoin network uses a lot of electricity, but the computations that use this electricity are used to clear transactions, move money around the blockchain, increment the money supply, etc. In order to make a fair comparison to non-cryptocurrency payment systems, we need to ask how many resources (and how much carbon) is used to keep those systems going. And I think the answer is quite a lot. Banks, too, use computers, sometimes ancient ones, to process transactions. Furthermore, humans use a lot of carbon. Since our financial system uses a lot more human intervention than Bitcoin, much of those humans’ carbon use is due to the financial system. (Another way to put this is that if we all switched to cryptocurrency, those humans would get other jobs and produce other social benefits in exchange for the carbon used to keep them alive.) And there are of course costs of physically moving cash around, for example on armored trucks.

The relevant calculations are admittedly difficult, but it seems quite possible to me, when all is accounted for, that Bitcoin is the green alternative to Federal Reserve Notes. Cryptoanarchy and the environment don’t have to be enemies.

Is there a Bitcoin bubble? Jason Kuznicki thinks so and believes that he has conclusive proof. He blogs three graphs that show more or less that there is a lot of speculation in Bitcoin. But does speculation prove that there’s a bubble? Let’s use Bayes’s rule to think about this carefully.

Bayes’s rule is a mathematical tool for thinking about the incorporation of new evidence into subjective probabilities. Let’s suppose that there is some proposition A for which you have a prior belief. Somebody offers evidence B for or against A. How much should you change your belief in A based on evidence B?

Bayes’s rule boils the answer down to a simple mathematical form:

In English, the probability of A  given B equals the probability of B given A, times the probability of A and divided by the probability of B.

So to evaluate Jason’s argument and see how much we should change our estimate of a Bitcoin bubble based on the evidence that there’s speculation, we can simply assign the proposition and the evidence to A and B. In this case, A is the proposition that there’s a bubble, and B is the evidence that there’s speculation in Bitcoin. If we figure out our subjective probabilities for B|A and B, we can use those to determine how different P(A|B) should be from P(A).

So what is B|A? Since B is the evidence that there is speculation in Bitcoin and A is the proposition that there is a bubble, B|A simply states the proposition that  given that there is a bubble, there is speculation. It seems pretty much impossible to have a bubble without speculation, so I’ll go with a subjective probability of 1. Picking a different value here will only work against Jason’s argument.

So what is the probability of B, the fact that there is speculation in Bitcoin? The Bitcoin ecosystem isn’t built out yet. Most of the protocol’s most exciting uses haven’t even seen the light of day yet. As I blogged last week, multisignature transactions are barely in use yet, but they form the foundation for a decentralized architecture of arbitration. Ed Felten at Princeton is working on decentralized prediction markets. Jerry Brito points to microtransactions, or even nearly-continuous transactions, as another exciting future use scenario.

Given that we don’t know whether this ecosystem will ever materialize, holders of bitcoin are  necessarily speculating. If the ecosystem matures and is useful, bitcoins will be worth something. If none of these innovations come about, or if we decide they’re not that useful after all, then bitcoins will probably be worth nothing. There’s no way out of speculating, because we simply don’t know for sure if the ecosystem will come along. Almost the entire “fundamental value” of Bitcoin rests on future events.

So the probability of B, I think, is 1. When P(B|A) is 1, and P(B) is 1, what does Bayes’s rule reduce to?

B simply offers no information as to whether A is true.

A similar argument can be made when Bitcoin’s volatility is offered as evidence of a bubble. Bitcoin is a thinly-traded asset where supply does not adjust to accommodate demand. It is going to be volatile. So the fact that Bitcoin is volatile adds no new information to the question of whether it’s a bubble.

What  does provide information? I think the most reliable evidence is on the maturation (or not) of the Bitcoin ecosystem. If Bitcoin seemed static right now, I would interpret that as evidence of a bubble. But it doesn’t. Every day, people are working to build businesses that leverage some of the unique features of Bitcoin’s protocol. As long as that continues, I think it’s most reasonable to be highly agnostic about the correct price of Bitcoin.

A common question among smart Bitcoin skeptics is, “Why would one use Bitcoin when you can use dollars or euros, which are more common and more widely accepted?” It’s a fair question, and one I’ve tried to answer by pointing out that if Bitcoin were just a currency (except new and untested), then yes, there would be little reason why one should prefer it to dollars. The fact, however, is that Bitcoin is more than money, as I recently explained in Reason. Bitcoin is better thought of as a payments system, or as a distributed ledger, that (for technical reasons) happens to use a new currency called the bitcoin as the unit of account. As Tim Lee has pointed out, Bitcoin is therefore a platform for innovation, and it is this potential that makes it so valuable.

Eric Posner is one of these smart skeptics. Writing in Slate in April he rejected Bitcoin as a “fantasy” because he felt it didn’t make sense as a currency. Since then it’s been pointed out to him that Bitcoin is more than a currency, and today at the New Republic he asks the question, “Why would you use Bitcoin when you can use PayPal or Visa, which are more common and widely accepted?”

He answers his own question, in part, by acknowledging that Bitcoin is censorship-resistant. As he puts it, “If you live in a country with capital controls, you can avoid those[.]” So right there, it seems to me, is one good reason why one might want to use Bitcoin instead of PayPal or Visa. Another smart skeptic, Tyler Cowen, acknowledges this as well, even if only to suggest that the price of bitcoins will fall “if/when China fully liberalizes capital flows[.]”

Another reason why one would use Bitcoin instead of PayPal or Visa is that it’s cheaper. Posner disputes this, arguing that Bitcoin’s historic volatility makes it risky to hold Bitcoins, necessitating hedging, and therefore making it no less costly than traditional payments systems. (Cowen was one of the first to make this argument.) But this is not true.

First of all, I would argue that there’s nothing inherent in Bitcoin that makes it necessarily as volatile as it has been; its volatility to date comes largely from the fact that it’s thinly traded. If its adoption continues apace, and its infrastructure continues to be developed, there’s no reason to think it will forever be as volatile as it has been to date. But that’s conjecture. More to the point is the proof that’s in the pudding: There are tens of thousands of merchants accepting bitcoins for payment today (and growing), and the number of transactions accepted by those merchants has been exploding as well, setting a record on Black Friday. Can it be that even with the necessary hedging, Bitcoin is cheaper?

At least for some types of transactions I think the answer is unquestionably yes. Take international remittances, which is a $500 billion industry. Sending money to Kenya using Western Union MoneyGram or some other traditional money transmitter costs around five to ten percent of the amount being sent, and can take days for the deposit to take place. A new startup, BitPesa, is looking to charge only three percent, and to carry out transfers virtually instantaneously. So hedging costs would have to be more than five to ten percent to make this not worthwhile. It’s an empirical question, but it seems to me the fact that so many are jumping in helps give us a hint as to the answer. Perhaps we can look to Bitpay’s 1% fee as a market estimate of the cost of hedging.

Well then, so far I count two things that Bitcoin can do that traditional payments systems cannot: it is censorship resistant and it is cheaper. Oh, wait. I actually mentioned another one: it’s faster. Traditional wire transfers can take days or even weeks to clear, while Bitcoin takes minutes. And yet there’s more.

As Eli Dourado just pointed out in a previous post, built into Bitcoin is a facility for decentralized arbitration. Essentially, Bitcoin allows for transactions that require two out of three signatures to verify a transaction, thus allowing payer and payee to turn to an arbitrator if there is a dispute about whether the payment should go through. Paypal and credit card companies essentially provide this service today, but as Eli points out, decentralized arbitration would likely be cheaper and would certainly enjoy much more competition. That’s four things Bitcoin can do that traditional payments networks cannot, but let me quickly add a fifth. There’s no reason that the arbitrator must be a human; using Bitcoin’s scripting language the arbitrator can be a trusted automated source of information that on a regular basis broadcasts facts such as the price of gold, or price of stocks, or sports scores. Make that data stream your arbitrator and, voila, you have a decentralized predictions market. (Ed Felten at Princeton is working on executing the concept.)

One more before I sign off and go drink with the rest of the Tech Liberation gang at our 15th Alcohol Liberation Front this evening, to which you’re all invited. Bitcoin allows for microtransactions in a way that’s never before been possible. First of all, because bitcoin transactions can be cheap, you can send incredibly small amounts (say five cents or half a cent) that would be cost-prohibitive using traditional payments systems. There’s a start-up called BitWall that essentially allows publishers to easily charge tiny amounts for their content. Now, believe me, I know all the arguments for and against micropayments for content. My only point is that Bitcoin has the potential to further reduce the friction of such payments. But that’s not the exciting part. More interesting are really, really small microtransactions.

Bitcoin transactions are cheap, but you wouldn’t think they’re cheap enough that you could conduct hundreds per second. But the thing is, you can, using the micropayments channels feature of the Bitcoin protocol. It’s not yet been widely exploited, but it’s there in the spec waiting to be. I won’t go into the technical details in this post, but essentially you transmit one large transaction to the network (you can think of this like a deposit, say of $10), then you conduct as many tiny transactions between payer and payee not broadcast to the network (therefore ‘free’), and finally you broadcast how much of the initial amount remains with each party. What this means is that you can now offer metered services based on microtransactions.

One good example of how this would be useful is Wi-Fi access, which Mike Hearn explains in this video. Today we are surrounded by wi-fi hotspots, but we can’t use them because they are password protected, in part because there’s no good way to charge for their use. When you can pay to use a wi-fi hotspot, it usually entails creating an account with the provider and then purchasing a block of time, perhaps more than you need. Now imagine if you could connect to any open hotspot, without first creating any kind of account, and paying your way by the second or the kilobyte. That’s possible today with Bitcoin, it’s just going to take some time to be implemented. And think of all the other as-yet unimagined ways that this ability to meter could be put to use!

That’s six ways to answer the question, “Why would you use Bitcoin when you can use PayPal or Visa.” There are more. Hearn discusses a bunch in the video. These are all very real in the sense that they are all technically possible today, but certainly speculative in that there remain regulatory and market hurdles ahead. I can certainly understand why some would be skeptical of Bitcoin’s long-term success (I for one am not certain of it), but I really hope we can get to the point were that skepticism is based on more than misunderstandings about what Bitcoin is or what it can and cannot do.

One of the criticisms leveled at Bitcoin by those people determined to hate it is that Bitcoin transactions are irreversible. If I buy goods from an anonymous counterparty online, what’s to stop them from taking my bitcoins and simply not sending me the goods? When I buy goods online using Visa or American Express, if the goods never arrive, or if they aren’t what was advertised, I can complain to the credit card company. The company will do a cursory investigation, and if they find that I was indeed likely ripped off, they will refund me my money. Credit card transactions are reversible, Bitcoin transactions are not. For this service (among others), credit card companies charge merchants a few percentage points on the transaction.

The problem with this account is that it’s not true: Baked into the Bitcoin protocol, there is support for what are known as “m-of-n” or “multisignature” transactions, transactions that require some number  m out of some higher number n parties to sign off.

The simplest variant is a 2-of-3 transaction. Let’s say that I want to buy goods online from an anonymous counterparty. I transfer money to an address jointly controlled by me, the counterparty, and a third-party arbitrator (maybe even Amex). If I get the goods, they are acceptable, and I am honest, I sign the money away to the seller. The seller also signs, and since 2 out of 3 of us have signed, he receives his money. If there is a problem with the goods or if I am dishonest, I sign the bitcoins back to myself and appeal to the arbitrator. The arbitrator, like a credit card company, will do an investigation, make a ruling, and either agree to transfer the funds back to me or to the merchant; again, 2 of 3 parties must agree to transfer the funds.

This is  not an escrow service; at no point can the arbitrator abscond with the funds. The arbitrator is paid a market rate in advance for his services, which are offered according to terms agreed upon by all three parties. This is better than the equivalent service using credit cards, because credit cards rely on huge network effects and consequently there are only a handful of suppliers of such transaction arbitration. Using Bitcoin, anyone can be an abitrator, including the traditional credit card companies (although they might have to lower their fees). Competition in both terms and fees is likely to result in better discovery of efficient rules for dispute resolution.

While multisignature transactions are not well understood, they are right there in the Bitcoin protocol, as much a valid Bitcoin transaction as any other. So  some Bitcoin transactions are irreversible; others are reversible, exactly as reversible as credit card transactions are.

Bitrated.com is a new site (announced yesterday on Hacker News) that facilitates setting up multisignature transactions. Bitcoin client support for multisignature transactions is limited, so the site helps create addresses that conform to the m-of-n specifications. At no point does the site have access to the funds in the multisignature address.

In addition, Bitrated provides a marketplace where people can advertise their arbitration services. Users are able to set up transactions using arbitrators both from the site or from anywhere else. The entire project is open source, so if you want to set up a competing directory, go for it.

What excites me most about the decentralized arbitration afforded by multisignature transactions is that it could be the beginnings of a Common Law for the Internet. The plain, ordinary Common Law developed as the result of competing courts that issued opinions basically as advertisements of how fair and impartial they were. We could see something similar with Bitcoin arbitration. If arbitrators sign their transactions with links to and a cryptographic hash of a PDF that explains why they ruled as they did, we could see real competition in the articulation of rules. Over time, some of these articulations could come to be widely accepted and form a body of Bitcoin precedent. I look forward to reading the subsequent Restatements.

Multisignature transactions are just one of the many innovations buried deep in the Bitcoin protocol that have yet to be widely utilized. As the community matures and makes full use of the protocol, it will become more clear that Bitcoin is not just a currency but a platform for financial innovation.

Originally posted at elidourado.com.

Yesterday at Forbes, William Pentland had an interesting piece on possible disintermediation in the electricity market.

In New York and New England, the price of electricity is a function of the cost of natural gas plus the cost of the poles and wires that carry electrons from remotely-sited power plants to end users. It is not unusual for customers to spend two dollars on poles and wires for every dollar they spend on electrons. The poles and wires that once reduced the price of electricity for end users are now doing the opposite. To make matters worse, electricity supplied through the power grid is frequently less reliable than electricity generated onsite. In other words, rather than adding value in the form of enhanced reliability, the poles and wires diminish the reliability of electricity.

If two thirds of the cost of electricity is the distribution mechanism, then, as Pentland notes, there is a palpable opportunity to switch to at-home electricity generation. Some combination of solar power, batteries, and natural gas-fired backup generators could displace the grid entirely for some customers. And if I understand my electricity economics correctly, if a significant fraction of customers go off-grid, the fixed cost of maintaining the grid will be split over fewer remaining customers, making centrally-generated electricity even more expensive. The market for such electricity could quickly unravel.

While it remains to be seen whether electricity generation will indeed become decentralized, such disintermediation would be the continuation of a decades-long social trend. It all began (plausibly) in 1984. The Macintosh was released, and desktop computing became a thing. Desktop printers disintermediated printing departments, Kinkos, and the steno pool. The Internet has disintermediated telephone companies, music labels, television networks, newspapers, and much more. Online education is unbundling university courses.

What’s even more exciting is the next generation of disintermediating technologies. Bitcoin could displace some financial institutions—to varying degrees, banks, the Federal Reserve, Western Union, and credit card companies. Mesh networks could solve the last-mile problem of Internet service delivery, which tends to be monopolized or at least concentrated. 3D printers could disintermediate supply chains. 3D chemical printers could disintermediate drug companies and the FDA.

Delivery drones like Amazon Prime Air‘s arguably disrupt package delivery services, though not entirely because FedEx and UPS will still run drone-utilizing distribution networks. More importantly, delivery drones disintermediate the real estate market for small businesses. It will no longer be important, if you run a local business, to have a storefront in a prime location. Your customers can order online and items can be delivered to them in half an hour straight from the factory or artisanal workshop. It could be the Etsyfication of the economy.

If information, electricity, money, and production all get disintermediated, what is left? If these trends continue, the future will be one in which human interaction is unmediated, and to a surprising degree, unregulable. It will be difficult to stop a willing buyer and seller from transacting. Information about the proposed transaction might not be censorable. Payment via Bitcoin or other cryptocurrencies can’t be stopped. Production and delivery of the item may be difficult or impossible to detect and intercept.

Intermediaries are often used by governments as points of control. As we shed intermediaries, it may become possible to live one’s entire life without any particular authority even knowing that one exists. I doubt that we’ll ever get that far in the process, because using non-abusive intermediaries often makes economic sense. But for the next few decades, at least, I expect the trend to continue and the world to get a lot more interesting.

Originally posted at elidourado.com

“Selfie” was selected today as the word of the year by the Oxford English Dictionary’s editors, beating both “twerking” and “bitcoin.” Bitcoin’s company in that word list makes me appreciate the fact that others may be as sick of hearing about Bitcoin as I am about twerking. Nevertheless, it’s a pretty important week for Bitcoin, an I wanted to highlight some of the work I’ve been doing.

Yesterday the Senate Homeland Security and Governmental Affairs Committee held a hearing on the promises and challenges that virtual currencies hold for consumers and law enforcement respectively. I testified at that hearing and video of my testimony is below. You can also check out the written testimony, which is an updated version of the Bitcoin primer for policymakers I wrote with Andrea Castillo earlier this year. And ahead of the hearing I published an op-ed in The Guardian arguing that if the U.S. doesn’t foster a sane regulatory environment for Bitcoin, entrepreneurs will go to other jurisdictions that do.

All in all the hearing was hearteningly positive. The federal regulators and law enforcement representatives all agreed that Bitcoin is a lawful and legitimate payments system and that it holds great promise. They also agreed that plain old cash and centralized virtual currencies (contra Bitcoin’s decentralized design) are much greater magnets for money laundering, and that they needed no new laws or authority to deal with illegal uses of Bitcoin. I discuss the hearing and its implications on today’s Cato Daily Podcast with Caleb Brown.

Finally, I think there are lots of folks, especially in the wonkosphere, who think they know what Bitcoin is, but really don’t, and so the opinions they offer about its viability or significance are based on misunderstanding. For example, Neil Irwin at Wonkblog today wrote a 700-word post to suggest that what Bitcoin needs is a central bank. Now, if he’s trolling, kudos to him. But I really think he’s innocently ignorant of the fact that Bitcoin’s seminal design feature is that it is a decentralized payments system, and that the moment you add a central banker (which would in any case be impossible) you would no longer have Bitcoin, but Facebook Credits or Microsoft Points or airline miles.

So, if you think you have an inkling about what Bitcoin is, but you’re not too sure, or you don’t know why it’s so significant, please check out my cover story in the December issue of Reason, which was just made available online. Apart from explaining the basics, I go into detail about the little understood fact that Bitcoin is much more than just money. Value transmission is just the most obvious use case for Bitcoin, and thus the one that’s being built out first, but the Bitcoin platform is essentially a decentralized ledger, so it is also able to support property registrations, decentralized futures markets, and much more.

And truly finally, if you want to keep up with all the happenings in Bitcoin, including the Senate Banking Committee hearing later today, check out MostlyBitcoin.com, a site a built for myself but that I hope is useful to others that tracks Bitcoin stories in the mainstream media.

Today is a bit of a banner day for Bitcoin. It was five years ago today that Bitcoin was first described in a paper by Satoshi Nakamoto. And today the New York Times has finally run a profile of the cryptocurrency in its “paper of record” pages. In addition, TIME’s cover story this week is about the “deep web” and how Tor and Bitcoin facilitate it.

The fact is that Bitcoin is inching its way into the mainstream. Indeed, the NYT’s headline is “Bitcoin Pursues the Mainstream,” and this month’s issue of WIRED includes an article titled, “Bitcoin’s Radical Days Are Over. Here’s How to Take It Mainstream.”

The radicals, however, are not taking this sitting down. Also today, Cody Wilson and Unsystem have launched a crowdfunding campaign to build an anonymizing wallet. In their explanatory video, they criticize the Bitcoin Foundation as “helping the United States” regulate Bitcon, presumably to hasten its mainstream adoption. “Their mission is a performance to both agree with, and maintain an independence from, regulatory power,” Wilson says. “But you can’t have it both ways.”

This is an internecine battle that I’ve observed in the Bitcoin community for years. That of the cypherpunks who see Bitcoin as an escape hatch from state control versus the entrepreneurs who are more interested in the network’s disruptive (and thus profitable) potential. While it might be a fool’s errand, I’d like to make the case that not only is the work of the two groups not in conflict, they actually benefit from each other.

I’ve been following Bitcoin since early 2011, and in April of that year I penned the first (yes) mainstream article about Bitcoin. It was in TIME.com, and it’s been credited with kicking off the first bubble. Since then my work has focused on the regulatory policy around Bitcoin and other crypto currencies, especially looking to educate policymakers about the workings and potential benefits of decentralized payments systems. Why am I so interested in this? My reasons are twofold and they track both the entrepreneurial and cypherpunk ideals, and yet I don’t think I’m bipolar.

First, I’m interested in Bitcoin because it is clearly a deeply disruptive technology that could result in profound economic and social benefits for the world, especially for the least fortunate. Yet as all new technologies that challenge existing interests and institutions, it is immediately targeted for precautionary and prophylactic regulation with little thought given to the costs of such regulation. Given that my entire career has been spent trying to keep the Internet free and unregulated, Bitcoin is a perfect fit for my attention. I am interested in helping policymakers get the cost-benefit analysis right, which I think is that the costs of regulating Bitcoin far outweigh the benefits.

This gets to the question of whether those of us engaged in educating policymakers are “helping the U.S. government” regulate Bitcoin, as Wilson claims. I guess that’s one way to see it, but let me offer another.

There are no doubt those like the Winklevoss twins who are seemingly inviting as much regulation as possible. (In Cameron Winklevoss’s words, “we love regulation.”) I certainly don’t share that view, and I doubt folks at the Foundation do, either. After all, the Foundation is headed by John Matonis, a man with bylines under such articles as “Don’t Let Bitcoin Morph into Govcoin” and “Money Laundering Is Financial Thoughtcrime”. To say Matonis is a handmaiden of the state is laughable.

Just because one communicates with regulators does not mean one is encouraging regulation. There is a distinction that needs to be made between those who are engaged with regulators in order to invite regulation, and those of us who are engaged in order to, as the tagline of this website reads, “keep politicians’ hands off the ’net.”

As I’ve said before, the choice before us is not whether we should want regulation, but what to do about it. Regulatory power is something that currently exists as a fact of the world whether one likes it or not. Given that regulatory bodies exist, and given that these bodies will decide what the state’s reaction to Bitcoin will be—from an attempt to ban it on one end of the spectrum, to “light-touch” or no regulation as we see in some countries on the other end—what is wrong with advocating for the latter end?

Now, you may not think engagement will ever work, and you may want to focus your efforts on “exit” rather than “voice.” I totally respect that approach, but the beauty of Bitcoin is that if some of us focus on “voice,” it does nothing to hamper those who want to work on “exit.” Indeed, I htink it will buy those folks some time. The genius of a decentralized design is that even if I fail to talk sense into regulators, and they issue draconian licensing, and identification, and reporting rules and the rest, there is nothing they can do to stop Wilson and Unsystem from developing Dark Wallet.

And that brings me to the second, more important reason that I care about Bitcoin: its censorship resistance. Today, the small handful of regulated payment processors that you can use to transact online can prevent you from spending your money as you see fit. Bitcoin explodes this state of affairs, making it impossible for government to exercise prior restraint of financial transactions. They may be able to punish you after the fact, but they can no longer prevent transactions from taking place.

The obvious illustration of why this is important is what happened to WIkiLeaks after it released the State Department cables. PayPal, Bank of American, MasterCard, and the rest prevented American citizens from making perfectly legal contributions to the group. Though the payments processors deny it, their actions were clearly the result of political pressure. Had WikiLeaks and all of its would-be contributors been using Bitcoin at the time, all of those contributions could not have been prevented.

That, in turn, brings me to why the work of even the most amoral and ideologically disinterested entrepreneurs is so important, and why it matters that they end up with as friendly a regulatory environment as possible. What the entrepreneurs are doing is building out Bitcoin’s public infrastructure, and they are making it more widely accepted and thus more widely used. In other words, they are making it mainstream, and that should be seen as a good thing even by the most radical. Here’s why.

Bitcoin is a network, and networks thrive on strong network effects. The more people use Bitcoin, even under a regulated system, the more stable the price becomes, the more merchants will accept bitcoins, the more processing power will be dedicated to the network (thus better securing it), and perhaps most importantly, the more mindshare Bitcoin will capture and the more politically difficult it will be to restrain it. Whatever their motivations, what these entrepreneurs are poised to do is grow the Bitcoin network, and that makes the network more valuable to everyone, including the radicals, whether the regulators like it or not.

Consider WikiLeaks again. In early 2010, when its PayPal account was frozen, WikiLeaks was not accepting bitcoins. Why not? And even if they had been accepting Bitcoins, it’s unlikely very many of the lay persons who wanted to contribute could have figured out how to acquire and send them. Why? The answer to both questions are network effects. The network effects were not there yet. Indeed they may not be there now. But imagine a world where Bitcoin is commonplace and (even if regulated) exchanges and wallets are second nature and so is paying for pizza or ordering a book online. In that world, WikiLeaks would not have even considered using PayPal, and a large network of people familiar and comfortable with cryptocurrency could not be prevented from making contributions.

And again, none of this would prevent those who want to rely on “exit” from doing so. In fact, a bigger and stronger network benefits those who choose to use something like Dark Wallet, even if that bigger network is built out by entrepreneurs complying with regulation, and even if it is populated mostly by mainstream users. Indeed, tools like Dark Wallet will remain essential to maintain Bitcoin’s censorship resistance. I can imagine that in a future WikiLeaks-style scenario, the government might put pressure on regulated exchanges and wallets not to process payments to certain addresses. In that case, if Bitcoin is sufficiently mainstream, people might then have the wherewithal to transfer some coins to a Dark Wallet before making a contribution. And if it’s sufficiently mainstream, it won’t just be a handful of cypherpunks who can do that.

As long as Bitcoin remains open and decentralized, cypherpunks and entrepreneurs are not working at cross purposes, no matter how suspicious they may be of each other. The real regulatory threats to Bitcoin are the bonkers bananas proposals to centralize Bitcoin like we saw in the recent WIRED article. Luckily, that article misses the point of not just Bitcoin, but of this moment in history. Decentralization is what makes Bitcoin genius, it’s what attracts both the radicals and the entrepreneurs, and it’s not going away.

As you know doubt have heard, Silk Road has been shut down by the FBI and its alleged operator, Ross Ulbricht, has been arrested. I’ve been getting a lot of questions about this and what it means for Bitcoin. Here are some initial thoughts.

The price of Bitcoin is dropping. What does that mean? It means that speculators are speculating. That said, here’s how I’m going to read it: If the main value of Bitcoin is that it can be used to buy drugs on Silk Road (as some contend), then we should see the value drop to zero is short order. If Bitcoin has other value, we should see it weather this jolt. One year ago a Bitcoin traded for about $14. As I type this, it’s hovering at about $118 $127.

How did they catch the guy? Good question. I don’t know the answer, but that won’t stop me from speculating. I will point out two things. First is this from the criminal complaint against Ross Ulbricht:

During the course of this investigation, the FBI has located a number of computer servers, both in the United States and in multiple foreign countries, associated with the operation of Silk Road. In particular, the FBI has located in a certain foreign country the server used to host Silk Road’s website (the “Silk Road Web Server”). Pursuant to a mutual Legal Assistance Treaty request, an image of the Silk Road Web Server was made on or about July 23, 2013, and produced thereafter to the FBI.

OK. So how did the FBI “locate” the servers that hosted the Silk Road Tor hidden service? The FBI has recently admitted that they have exploited vulnerabilities in Tor to identify users. Could it be that they exploited some vulnerability in this case? I look forward to finding out.

That said, here is another possibility. Also according to the criminal complaint (emphasis added),

On or about July 10, 2013, [Customs and Border Patrol] intercepted a package from the mail inbound from Canada as part of a routine border search. The package was found to contain nine counterfeit identity documents. Each of the counterfeit identification documents was in a different name yet all contained a photograph of the same person.

That person was Ulbricht and the package was addressed to him. Maybe it was from this lead that the FBI was able to begin the process of identifying the servers, once they had a suspect. If so, and if this indeed was a “routine” search, then the authorities got completely lucky!

Finally, I’ll point out that Bitcoin was in no way involved in the identification of the suspect. In fact, in the criminal complaint the FBI argues that because the blockchain (Bitcoin’s public ledger) is pseudonymous, that it is not useful in tracing transactions. I don’t think that’s quite right, but that’s how the FBI sees it in this case. So, in this case at least, the privacy Bitcoin affords was not compromised in any way.

UPDATE: As I think about this some more, it’s clear that the FBI was able to identify Ross Ulbricht because he posted his Gmail address to the Bitcoin Talk forum using the same username that first mentioned Silk Road ever. So, what are the chances that the CPB search that turned up the package of fake IDs bound for Ulbricht was routine? If it was routine, it was routine in the sense that packages to people on a watchlist might be routinely searched. I’m still not clear how the FBI got from identifying a possible suspect to locating the server for the Silk Road Tor hidden service.

How do you seize Bitcoins? I’m surprised by how many times I’ve been asked this question. It’s amazing what it is that people seize upon in a story. I don’t know how the authorities have carried out the seizure, but it’s not to difficult to conceive how it could be done. Basically they would have to get the private keys to the suspect’s Bitcoin addresses. (Think of it essentially like getting the password to an account.) They could either get that with his cooperation or if he had stored it somewhere now accessible to the authorities. Once they have the private keys, they would be able to transfer the bitcoins and I imagine that they would transfer them to a Bitcoin address that only they control.

UPDATE: So I got ahold of the seizure order and indeed I was correct that this is how the government will try to go about seizing the bitcoins. From the court order:

The United States is further authorized to seize any and all Bitcoins contained in wallet files residing on Silk Road servers, including those servers enumerate in the caption of this Complaint, pending the outcome of this civil proceeding, by transffering the full account balance in each Silk Road wallet to a public Bitcoin address controlled by the United States.

But to be clear, to seize bitcoins you do need to get the “password” that controls them. You can’t just go to an intermediary and order that an account be frozen as you can do with traditional financial intermediaries like banks or PayPal.

I’ll be tweeting and posting more as I learn more about what happened, but those are my initial thoughts. Shoot me any questions or thoughts you have. I’m at @jerrybrito on Twitter. And by the way, you can follow all the coverage of the Silk Road arrest and seizure on my site Mostly Bitcoin.

Last week, the Mercatus Center released “Bitcoin: A Primer for Policymakers” by yours truly and Andrea Castillo. In it we describe how the digital currency works and address many of the common misconceptions about it. We also analyze current laws and regulations that may already cover digital currencies and warn against preemptively placing regulatory restrictions on Bitcoin that could stifle the new technology before it has a chance to evolve. In addition, we give several recommendations about how to treat Bitcoin in future.

As I say in the video that accompanies the paper, Bitcoin is still very experimental and it might yet fail for any number of reasons. But, one of those reasons should not be that policymakers failed to understand it. Unfortunately, signs of misunderstanding abound, and that is why we wrote the primer.

For example, New York Superintendent of Financial Services Benjamin Lawsky recently made headlines after his office subpoenaed two-dozen Bitcoin-related businesses and investors. He went on CNBC’s Closing Bell to discuss his action, and here is how he answered the host’s question, “Have you seen specific evidence, or do you sense that there is illegal activity going on using Bitcoin?”

We know it from the Liberty Reserve case, a major indictment that came down recently. Six billion dollars in transactions, clearly finding narco-terrorism. It’s something we’re deeply concerned about.

Huh? What does Liberty Reserve have to do with Bitcoin? In short, nothing. Liberty Reserve was a centralized currency almost assuredly designed to evade government control and facilitate illegal activity. Brian Krebs has had great coverage of that currency. For reasons we explain in the primer, Bitcoin makes a terrible currency for criminals relative to centralized currencies like Liberty Reserve and now WebMoney and Perfect Money. Yet journalists, members of the public, and policymakers very often lump them all together under the rubric of “virtual currencies,” and don’t appreciate the differences that have important ramifications for policy.

In short, before they consider making policy, we hope regulators will better understand Bitcoin and similar decentralized crypto-currencies. We hope our primer helps educate folks about the basics, and we know that we and many other in the Bitcoin community stand ready to answer any questions we can about this revolutionary new technology and its social and political implications.

Timothy B. Lee, founder of The Washington Post’s blog The Switch discusses his approach to reporting at the intersection of technology and policy. He covers how to make tech concepts more accessible; the difference between blogs and the news; the importance of investigative journalism in the tech space; whether paywalls are here to stay; Jeff Bezos’ recent purchase of The Washington Post; and the future of print news.

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Related Links

• Here are eight ways investing in Bitcoins could go horribly wrongn, Lee
• Blind advocates: Hollywood lobbying threatens deal for accessible books, Lee
• New Job, Lee

National Review today runs a pretty unfortunate article about Bitcoin in which the reporter, Betsy Woodruff, tries to live for a week using only bitcoins—a fun stunt already done by Kashmir Hill about two months ago. Aside from misrepresenting libertarianism, what’s unfortunate about the article is how Bitcoin is presented to NR’s readers, many of whom may be hearing about the virtual currency for the first time. Woodruff, who admits she doesn’t completely understand how Bitcoin works, nevertheless writes,

From what I can tell, the main reason Bitcoin has any practical value is the existence of Silk Road, a website that lets users buy drugs and other illegal material online. …

A lot of Bitcoin aficionados will probably take issue with my next point here, but I’m pretty sure history will eventually be on my side. My theory is that Silk Road is the Fort Knox of Bitcoin. Bitcoin, from what I can tell, isn’t valuable because of idealistic Ron Paul supporters who feel it’s in their rational self-interest to invest in a monetary future unfettered by Washington; Bitcoin is valuable because you can use it to do something that you can’t use other forms of currency to do: buy drugs online. As long as Bitcoin is the best way to buy drugs online, and as long as there is a demand for Internet-acquired drugs, there will be a demand for Bitcoin.

Woodruff is right that folks who understand Bitcoin will take issue with her because she’s demonstrably wrong. While it’s true that illicit transactions probably did help bootstrap the Bitcoin economy early on, we are way past the point where such transactions account for any sizable portion of the economy. It’s easy to put her “theory” to the test: Nicolas Cristin of Carnegie Mellon has estimated that Silk Road generates about $2 million in sales a month. The estimated total transaction volume for the whole bitcoin economy over the last 30 days is just over $770 million. So, Silk Road accounts for about 0.25% of bitcoin transactions—far from being the “Fort Knox of Bitcoin,” as Woodruff says. And to put that in perspective, the UN estimates that the illicit drug trade accounts for 0.9% of world GDP.

The fact is that Bitcoin is not only a revolutionary new payments system that potentially disrupts traditional providers and can help serve the billions of unbanked around the world, but it also has the potential to be a distributed futures or securities market, or a distributed notary service. This is why Peter Thiel’s Founders Fund and Fred Wilson’s Union Square Ventures are investing millions of dollars in Bitcoin startups. Should we really think that these investors have overlooked what Woodruff posits—that the only value of bitcoins is to buy drugs? No, and I hope NR updates its story.

Today I had the great pleasure of moderating a panel discussion at a conference on the “Virtual Economy” hosted by Thomson Reuters and the International Center for Missing and Exploited Children. On my panel were representatives from the Bitcoin Foundation, the Tor Project, and the DOJ, and we had a lively discussion about how these technologies can potentially be used by criminals and what these open source communities might be able to do to mitigate that risk.

The bottom line message that came out of the panel (and indeed every panel) is that the Tor and Bitcoin communities do not like to see the technologies they develop put to evil uses, and that they are more than willing to work with policymakers and law enforcement to the extent that they can. On the flip side, the message to regulators was that they need to be more open, inclusive, and transparent in their decision making if they expect cooperation from these communities.

I was therefore interested in the keynote remarks delivered by Jennifer Shasky Calvery, the Director of the Treasury Department’s Financial Crimes Enforcement Network. In particular, she addressed the fact that since there have been several enforcement actions against virtual currency exchangers and providers, the traditional banking sector has been wary of doing business with companies in the virtual currency space. She said:

I do want to address the issue of virtual currency administrators and exchangers maintaining access to the banking system in light of the recent action against Liberty Reserve. Again, keep in mind the combined actions by the Department of Justice and FinCEN took down a $6 billion money laundering operation, the biggest in U.S. history.

We can understand the concerns that these actions may create a broad-brush, reaction from banks. Banks need to assess their risk tolerance and the risks any particular client might pose. That’s their obligation and that’s what we expect them to do.

And this goes back to my earlier points about corporate responsibility and why it is in the best interest of virtual currency administrators and exchangers to comply with their regulatory responsibilities. Banks are more likely to associate themselves with registered, compliant, transparent businesses. And our guidance should help virtual currency administrators and providers become compliant, well-established businesses that banks will regard as desirable and profitable customers.

While it’s true that FinCEN’s March guidance provides clarity for many actors in the Bitcoin space, it is nevertheless very ambiguous about other actors. For example, is a Bitcoin miner who sells for dollars the bitcoins he mines subject to regulation? If I buy those bitcoins, hold them for a time as an investment, and then resell them for dollars, am I subject to regulation? In neither case are bitcoins acquired to purchase goods or services (the only use-case clearly not regulated according to the guidance). And even if one is clearly subject to the regulations, say as an exchanger, it takes millions of dollars and potentially years of work to comply with state licensing and other requirements. My concern is that banks will not do business with Bitcoin start-ups not because they pose any real criminal risk, but because there is too much regulatory uncertainty.

My sincere hope is that banks do not interpret Ms. Shasky Calvery’s comments as validation of their risk-aversion. Banks and other financial institutions should be careful about who they do business with, and they certainly should not do business with criminals, but it would be a shame if they felt they couldn’t do business with an innovative new kind of start-up simply because that start-up has not been (and may never be) adequately defined by a regulator. Unfortunately, I fear banks may take the comments to suggest just that, putting start-ups in limbo.

Entrepreneurs may want to comply with regulation in order to get banking services, and they may do everything they think they have to in order to comply, but the banks may nevertheless not want to take the risk given that the FinCEN guidance is so ambiguous. I asked Ms. Shasky Calvery if there was a way entrepreneurs could seek clarification on the guidance, and she said they could call FinCEN’s toll-free regulatory helpline at (800) 949–2732. That may not be very satisfying to some, but it’s a start. And I hope that any clarification that emerges from conversations with FinCEN are made public by the agency so that others can learn from it.

All in all, I think today we saw the first tentative steps toward a deeper conversation between Bitcoin entrepreneurs and users on the one hand, and regulators and law enforcement on the other. That’s a good thing. But I hope regulators understand that it’s not just the regulations they promulgate that have consequences for regulated entities, it’s also the uncertainty they can create through inaction.

Ms. Shasky Calvery also said:

Some in the press speculated that our guidance was an attempt to clamp down on virtual currency providers. I will not deny that there are some troublesome providers out there. But, that is balanced by a recognition of the innovation these virtual currencies provide, and the financial inclusion that they might offer society. A whole host of emerging technologies in the financial sector have proven their capacity to empower customers, encourage the development of innovative financial products, and expand access to financial services. And we want these advances to continue.

That is a welcome sentiment, but those advances can only continue if there are clear rules made in consultation with regulated parties and the general public. Hopefully FinCEN will revisit its guidance now that the conversation has begun, and as other regulators consider new rules, they will hopefully engage the Bitcoin community early in order to avoid ambiguity and uncertainty.

Tim Lee is right. The Electronic Frontier Foundation post announcing its decision to accept Bitcoin is strange.

“While we are accepting Bitcoin donations,” the post says, ” EFF is not endorsing Bitcoin.” (emphasis in original)

They’ve been using dollars over there without anyone inferring that they endorse dollars. They’ve been using various payment systems with no hint of endorsement. And they use all kinds of protocols without disclaiming endorsement—because they don’t need to.

Someone at EFF really doesn’t like Bitcoin. But, oh, how wealthy EFF would be as an institution if they had held on to the Bitcoin they were originally given. I argued at the time it refused Bitcoin that it was making a mistake, not because of the effect on its bottom line, but because it showed timidity in the face of threats to liberty.

Well, just in time for the Bitcoin 2013 conference in San Jose (CA) this weekend, EFF is getting on board. That’s good news, but it’s not as good as the news would have been if EFF had been a stalwart on Bitcoin the entire time. I have high expectations of EFF because it’s one of the great organizations working in the area of digital liberties.

A couple of weeks ago I wrote that bitcoin’s valuation doesn’t really matter for the currency to effectively function as a medium of exchange. Now comes word from none other than the proprietor of the notorious Silk Road encrypted black market that indeed the recent wild volatility has not affected the transactions on his site. As Andy Greenberg reports:

In a rare (and brief) public statement sent to me, the Dread Pirate Roberts (DPR) said that despite Silk Road’s reliance on Bitcoin, commerce on the site hasn’t been seriously hurt by Bitcoin’s wild rise and fall. “Bitcoin’s foundation, its algorithms and network, don’t change with the exchange rate,” the pseudonymous site administrator writes. “It is just as important to the functioning of Silk Road at $1 as it is at $1,000. A rapidly changing price does have some effect, but it’s not as big as you might think.”

Silk Road’s customers, after all, aren’t generally interested in Bitcoin’s worth as an investment vehicle, so much as in how it makes it possible to privately buy heroin, cocaine, pills or marijuana. They use Bitcoin because it’s not issued or stored by banks and doesn’t require any online registrations, and thus offers a certain amount of anonymity. …

Silk Road has built-in protections against Bitcoin’s spikes and crashes. Although purchases on Silk Road can only be made with Bitcoin, sellers on the site have the option to peg their prices to the dollar, automatically adjusting them based on Bitcoin’s current exchange rate as defined by the central Bitcoin exchange Mt. Gox. To insulate those sellers against Bitcoin fluctuations, the eBay-like drug site also offers a hedging service. Sales are held in escrow until buyers receive their orders via mail, and vendors are given the choice to turn on a setting that pegs the escrow’s value to the dollar, with Silk Road itself covering any losses or taking any gains from Bitcoin’s swings in value that occur while the drugs are in transit. So while Bitcoin’s crash last week from $237 to less than $100 means that the Dread Pirate Roberts was likely forced to pay out much of the extra gains Silk Road made from Bitcoin’s rise, most of his sellers were protected from those price changes and continued to trade their drugs for Bitcoins despite the currency’s plummeting value.

What this shows is that Silk Road is separating the “unit of account” function of money from the “medium of exchange” function. Prices are denominated in dollars (as a unit of account) but payments are made in bitcoin (as a medium of exchange). Hedging is used to smooth out volatility.

Some folks still don’t grok the distinction. Here is CBS MoneyWatch getting it wrong in a story yesterday:

Well, if you did want to buy a house using Bitcoins as your medium of exchange, it would have been best to arrange for a closing no later than Wednesday morning. Because later that day, when the value of one Bitcoin reached an all-time high of $266 to a U.S. dollar, the digital money took a swan-dive. By late Wednesday, if you were still committed to the transaction, your house would have cost you twice as much – and even more if you had waited until the following day, because Bitcoins just kept losing value.

No. If you were using bitcoin merely as a medium of exchange your house would not have cost twice as much. What the reporter means is that it would have cost twice as much if you had used bitcoin as your unit of account for the mortgage, which would be a ridiculous thing to do. As Steve Hanke, quoted in the piece, says, “One of the functions of money is a unit of account for future payments, like a mortgage payment, so if you’ve got a lot of instability it’s a big problem.”

By the way, in that same article the reporter says I “backed off from the notion that [bitcoin] can serve as a stable store of value[.]” But I don’t see how I can back off from a view I’ve never held. Yes, there is this idea that bitcoin can be a stable store of value, it is an idea that excites many bitcoin enthusiasts, and it’s an idea I explain when I talk about bitcoin, but it’s not one I’ve ever held or promoted. Quite the opposite, I’ve written about how it’s not what makes Bitcoin interesting.

Marc Hochstein, Executive Editor of American Banker,  a leading media outlet covering the banking and financial services community, discusses bitcoin.

According to Hochstein, bitcoin has made its name as a digital currency, but the truly revolutionary aspect of the technology is its dual function as a payment system competing against companies like PayPal and Western Union. While bitcoin has been in the news for its soaring exchange rate lately, Hochstein says the actual price of bitcoin is really only relevant for speculators in the short-term; in the long-term, however, the anonymous, decentralized nature of bitcoin has far-reaching implications.

Hochstein goes on to talk about  the new market in bitcoin futures and some of bitcoin’s weaknesses—including the volatility of the bitcoin market.

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Related Links

• VIDEO: Why Banks Should Care About Bitcoin, Hochstein
• Why Bitcoin Matters: It’s the Payment System, Stupid!, Hochstein
• Bitcoin vs. Big Government: How the virtual currency undermines government authority, Brito
• Online Cash Bitcoin Could Challenge Governments, Banks, Brito

The mid-to-late 90s saw the crypto wars, probably the Internet’s first major victory against government attempts to control information online. At stake was the public’s right to use strong encryption, which facilitates commerce and allows individuals to maintains their personal privacy, but which government feared would allow “drug lords, spies, terrorists and even violent gangs to communicate about their crimes and their conspiracies with impunity,” as FBI Director Louis Freeh told the Senate Judiciary Committee in 1997. In the end, popular opinion overwhelmed government efforts to include back doors in publicly available encryption, which might as well have been no encryption at all.

Leading the charge in the crypto wars were the cypherpunks, many of whom were radical libertarians who predicted that privacy and anonymity powered by strong encryption would fundamentally shift the balance of power between individuals and the state. For example, in this paper (also from 1997) Tim May, one of the cypherpunk’s founders, describes the some of the social implications of “untraceable digital cash”:

Some of these “marginal” uses are terrible to consider. Extortion, kidnapping, and even murder contracts become easier to set up. Extortion, for example, becomes almost unstoppable at the usual place: the collection of a payoff and/or the spending of the payoff money. The extortionist makes his threat from the safety of his home PC, using networks of remailers and message pools, and demands payment in untraceable digital cash… .

Similar to extortion are markets for kidnappings (riskier, due to the physical act), and even untraceable markets for murders. For murder contracts, the usual risk is in setting up the hit—asking around is almost a guaranteed way of getting the FBI involved, and advertising in traceable ways is a similar invitation. This risk is largely removed when anonymous contact and payment methods are used. To ensure the job is completed, third party escrow services—anonymous, of course, but with an established cyberspatial reputation—hold the digital cash until completion.

The thing is, untraceable digital cash has not been a reality until now. Over at Reason, I write that while much of the discussion about Bitcoin is focused on whether the virtual currency has all the attributes of money and whether it can ever be a viable alternative to state-backed fiat currency, its real revolutionary potential is as untraceable digital cash.

Time will tell whether the gold bugs or the skeptics are right, but what’s being overlooked is that it doesn’t matter whether Bitcoin makes it as a store of value or a unit of account for it to work as a medium of exchange. Even if the Bitcoin market remains volatile and never pans out as a good store of value or unit of account, one can imagine users converting their dollars or euros to bitcoins for just long enough to make a transaction; perhaps just minutes. And as long as it works as a medium of exchange, it is the true digital cash that was missing from the cypherpunks’ predictions.

With a little bit of effort, today you can purchase bitcoins anonymously with physical cash. You could then do all sorts of things the government doesn’t want you to do. You could buy illegal drugs on the notorious Silk Road, an encrypted website that has been operating with impunity for the past two years facilitating annual sales estimated at almost $15 million. You could gamble at various casinos or prediction markets, buy contraband Cuban cigars, or even give money to WikiLeaks. Dissidents in Iran or China can use Bitcoin to buy premium blogging services from WordPress, which now accepts payment in the currency. Perhaps more importantly, Bitcoin makes the cypherpunks predictions of markets for stolen secret information and even assassinations feasible.

I predict that we will soon see another round of the crypto wars. Now that Bitcoin has broken through to at least some public notice, I suspect we will see greater use of the currency and with it greater illicit use. I also suspect we will see the intelligence community, law enforcement, and child safety advocates take greater notice of Bitcoin as an anonymous payment processor. (Indeed, you can glean from this speech by the director of the Financial Crimes Enforcement Network that they see decentralized virtual currencies like Bitcoin as “emerging payment systems.”) And I suspect that traditional payment processors who might be in competition with Bitcoin to take notice as well. If these stars align, I imagine we will see public calls to “do something” about Bitcoin.

Although Bitcoin’s decentralized nature makes it difficult to regulate, its ecosystem (and even the network itself) is not impervious to attack. Those of us who see the benefits, and not just the costs of digital cash should begin preparing for this likely confrontation.

Andy Greenberg, technology writer for Forbes and author of the new book “This Machine Kills Secrets: How WikiLeakers, Cypherpunks, and Hacktivists Aim to Free the World’s Information,” discusses the rise of the cypherpunk movement, how it led to WikiLeaks, and what the future looks like for cryptography.

Greenberg describes cypherpunks as radical techie libertarians who dreamt about using encryption to shift the balance of power from the government to individuals. He shares the rich history of the movement, contrasting one of t the movement’s founders—hardcore libertarian Tim May—with the movement’s hero—Phil Zimmerman, an applied cryptographer and developer of PGP (the first tool that allowed regular people to encrypt), a non-libertarian who was weary of cypherpunks, despite advocating crypto as a tool for combating the power of government.

According to Greenberg, the cypherpunk movement did not fade away, but rather grew into a larger hacker movement, citing the Tor network, bitcoin, and WikiLeaks as example’s of its continuing influence. Julian Assange, founder of WikiLeaks, belonged to a listserv followed by early cypherpunks, though he was not very active at the time, he says.

Greenberg is excited for the future of information leaks, suggesting that the more decentralized process becomes, the faster cryptography will evolve.

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Related Links

• This Machine Kills Secrets: How WikiLeakers, Cypherpunks, and Hacktivists Aim to Free the World’s Information, Greenberg
• WikiLeaks’ ‘PLUS D’ Aims To Digitize America’s Secret Diplomatic History, Greenberg
• A Different Approach To Foiling Hackers? Let Them In, Then Lie To Them., Greenberg
• WCITLeaks, Greenberg

With Bitcoin enjoying a spike in price against government currencies, there is lots of talk about it on the Interwebs, including Jerry’s typically thoughtful post from earlier today. If you’re not familiar with it yet, here’s a good Bitcoin primer, which also counsels reading a lot more before you acquire Bitcoin, as Bitcoin may fail. If you like Bitcoin and want to buy some, don’t go all goofy. Do your homework. As if you need to be told, be careful with your money.

Much of the commentary in the popular press declares a Bitcoin bubble for one reason or another. It might be a bubble, but nobody actually knows. A way of guessing is to compare Bitcoin’s qualities as a currency and payment network to the alternatives. Like any service or good, there are many dimensions to value storage and transfer.

I may not capture them all, and they certainly don’t predict the correct price against the dollar or other currencies. That depends on the ultimate viscosity of Bitcoin. But Bitcoin certainly has value of a different kind: it may discipline fiat currencies and the states that control them.

Intrinsic Value: If you’re just starting to think about money, this is where you’ll find Bitcoin an obvious failure. These evanescent strings of code have no intrinsic value whatsoever! Anyone relying on them as a store of value is a volunteer victim. Smart people stick with U.S. dollars and other major currencies, thin sheets of cloth or plastic with special printing on them…

No major currency has intrinsic value. Indeed, there isn’t much of anything that has intrinsic value. The value of a thing depends on other people’s demand for it. This is as true of Bitcoin as it is of dollars, sandwiches, and sand. So the intrinsic value question, which seems to cut in favor of traditional currencies, is actually a wash.

Transferability: Bitcoin is good with transferability–far better than any physical currency and quite a bit better than most payment systems. Not only is it fast, with transactions “settling” fairly quickly, but it is borderless. The genius of PayPal (after it gave up on being a replacement monetary system itself) was quick transfer to most places that rich people want to send money. Bitcoin allows quick transfer anywhere the Internet goes.

Acceptance: Bitcoin bombs badly in the area of acceptance. Try buying a sandwich with Bitcoin today and you’ll go hungry because few people and businesses accept it. This is a real problem, but it’s nothing intrinsic to Bitcoin. When Hank Aaron broke Babe Ruth’s home run record, people didn’t understand that credit cards were like money. (Watch the video at the link two or three times if you need to. It’s not only a great moment in sports.) Acceptance of different form-factors for value and payments can change.

Cost: How many billions of dollars per year do we pay for storage and transfer of money? Bitcoin is free.

Inflation-Resistance: Assuming the algorithms work as advertised, the quantity of Bitcoin will rise to a pre-established level of about 21 million over the next couple of decades and will never increase after that. This compares favorably to fiat currencies, the quantity of which are amended by their managers, sometimes quite dramatically, to undercut their value. If you want to hold money, holding Bitcoin is a better deal than holding dollars. Which brings us to…

Deflation-Resistance: Without central planners around to carefully debase its value, Bitcoin might go deflationary, with people refusing to spend it while it rises against all other stores of value and goods. Arguably, that’s what’s happening in the current Bitcoin price-spike. People are buying it in anticipation of its future increase in value.

Deflation can theoretically cause an economy to seize up, with everyone refusing to buy in anticipation of their money gaining in value over the short term. There is room for discussion about whether hyper-deflation can actually occur, how long a hyper-deflation can persist, and whether the avoidance of deflation is worth the risk of having centrally managed currency. I have a hard time being concerned that excessive savings could occur. However, whatever the case with those related issues, Bitcoin is probably deflation-prone compared to dollars and other managed currencies.

Surveillance-Resistance: Where you put your money is a reflection of your values. Payment systems and governments today are definitely gawking through that window into our souls.

Bitcoin, on the other hand, allows payments to be made with very little chance of their being tracked. I say “little chance” because there is some chance of tracking payments on the network. Sophisticated efforts to mask payments will be met by sophisticated efforts to track them. Relatively speaking, though, payments through traditional payment systems like checks, credit cards, and online transfer are super-easy to track. Cash is pretty darn hard to track. So Bitcoin stacks up well against our formal payment systems, but equally or perhaps poorly to cash.

Seizure-Resistance: The digital, distributed nature of Bitcoin makes it resistant to official seizure. Are you in a country that exercises capital controls? (What a euphemism, “capital controls.” It’s seizure.) Put your money into Bitcoin and you can email it to yourself. Carve your Bitcoin code into the inner lip of your frisbee before heading out on that Black Sea vacation. Chances are they won’t catch it at the border.

Traditional currencies either exist in physical form or they’re held and transferred by institutions that are more obediant to the state than they are loyal to their customers. (If Cyprus has anything to do with the current price-spike of Bitcoin, it’s as a lesson to others. Cypriots apparently did not move into Bitcoin in significant numbers.)

Because Bitcoin transactions are relatively hard to track, many can be conducted–how to put this?– independent of one’s tax obligations. In relation to the weight of the tax burden, Bitcoin may grow underground economies. Indeed, it flourishes where transactions (in drugs, for example) are outright illegal. Bitcoin probably moves the Laffer curve to the left.

Security: The tough one for Bitcoin is security. Most people don’t know how to store computer code reliably and how to prevent others from accessing it. Individuals have lost Bitcoin because of hard-drive crashes. (This will cause small losses in the total quantity of Bitcoin over time.) Bitcoin exchanges have collapsed because hackers broke in. And there’s a genuine risk that viruses might camp on your computer, waiting for you to open your (otherwise encrypted) wallet file. They’ll send your Bitcoin to heaven-knows-where the moment you do.

When a Bitcoin transaction has happened, it is final. Like a cash expenditure or loss, there is no reversability and nobody to complain to if you don’t have access to the person on the other side of the transaction. The downside of a currency that costs nothing to transfer is the lack of a 1-800 number to call.

So Bitcoin lags traditional currencies along the security dimension. But this is not intrinsic to Bitcoin. Security will get better as people learn and technology advances. (How ’bout a mega-firewall that requires approval of all outbound Internet traffic while the wallet is open?)

There may be Bitcoin-based payment services, banks, and lenders that provide reversibility, security, that pay interest, and all the other goodies associated with dollars today. To the extent they can stay clear of the regulatory morass, they may be less expensive, more innovative, and, in the early going, more risky.

So what’s the right price for Bitcoin? Only a fool can say. (No offense, all of you declaring a Bitcoin bubble.) I think it depends on the ultimate “viscosity” of Bitcoin.

Let’s say Bitcoin’s exclusive use becomes a momentary medium of exchange: Every buyer converts currency to Bitcoin for transfer, and every seller immediately converts it to her local currency. There’s not much need to hold Bitcoin, so there’s not that much demand for Bitcoin. Its equilibrium price ends up pretty low.

On the other hand, say everybody in the world keeps a little Bitcoin on hand for quick, costless transactions once there’s a handy, reliable, and secure Bitcoin payment system downloadable to our phones. If lots of people hold Bitcoin just because, that highly viscous environment suggests a high price for Bitcoin relative to other currencies and things.

Whatever the case, people are now buying Bitcoin because they think others are going to buy it in the future. Whether they’re “speculators” trying to buy in ahead of other speculators, or if they’re buying Bitcoin as a hedge against the varied weaknesses of fiat currencies and state-controlled payment systems, it doesn’t matter.

What does matter, I think, is having this outlet. The availability of Bitcoin is a small, but growing and important security against fiat currencies and state-controlled payments. It is a competitor to state money.

Bitcoin’s existence makes central bankers slightly less free to inflate the money they control, states will have slightly less success with seizing money, and surveillance of traditional payment systems will be decreasingly useful for law enforcement, taxation, and control.

I don’t think Bitcoin delivers us to libertarian “Shangri-la” or anarcho-capitalism, but it’s a technology that fetters government some. It’s a protection for people, their hard-earned wealth, and their privacy. That’s the value of Bitcoin, in my mind, no matter its current price.

Over the past few days, interest in bitcoin has exploded as its valuation has reached stratospheric levels. Most of the media attention has been focused on that valuation and on bitcoin’s viability as money. For example, the Financial Times had the run-up in bitcoin’s price on its front page yesterday, emphasizing its volatility and its commodity-like qualities. It quoted one analyst saying, “It’s gold for computer nerds.” For many folks, this is how they will be introduced to bitcoin, and it’s a shame because it misses what’s really interesting about the crypto-currency.

It’s no secret that bitcoin excites libertarians above all others. What’s less understood is that there are two distinct reasons driving this enthusiasm. The first is that bitcoin is not issued by any authority, so there’s no central banker to monkey the money supply. This attracts what we can affectionately call the “gold bugs” or “audit the Fed” types. They are interested in bitcoin as a new, more moral form of money. And bitcoin as money is what’s been getting all the attention given it’s rising valuation.

But there is a second reason libertarians should be excited about bitcoin, and it’s the reason I am an enthusiast: bitcoin as a payments system. As the world’s first completely decentralized digital currency, there is not only no central banker, there is no intermediary of any kind needed for two parties to make a transaction. Today we rely on third parties to transact online, and when government wants to restrict how we can spend money online, it’s these intermediaries they turn to. PayPal, Visa, MasterCard and other traditional payment processors don’t let you transmit money to WikiLeaks, or to UK gambling sites, or to people in Iran, or to buy illegal goods and services on anonymous black markets. Bitcoin disrupts the ability of governments and intermediaries to control your transactions, and because there is no bitcoin company or bitcoin building anywhere, it can’t be shut down.

Tim Lee gets this when he writes that bitcoin is no competition for the dollar as a currency,

Rather, the future demand for Bitcoins will largely come from applications where conventional currencies don’t perform that well. Bitcoins have some unique properties that no other financial instrument has. They combine the irreversibility of cash transactions with the convenience of electronic transactions. And, the lack of middlemen and regulations greatly reduces the barrier to entry. You don’t need to get permission from big banks or financial regulators to create a Bitcoin-based financial service. All of this means it makes sense to think of Bitcoin less as an alternative currency than as a new platform for financial innovation.

One objection to this view comes from Felix Salmon in a very thoughtful and nuanced essay. He recognizes that bitcoin is “in many ways the best and cleanest payments mechanism the world has ever seen,” but he laments that it is “an uncomfortable combination of commodity and currency.” He goes on to ask rhetorically, “If the currency of a country ever fluctuated as much as bitcoins did, it would never be taken seriously as a medium of exchange: how are you meant to do business in a place where an item costing one unit of currency is worth $10 one day and $20 the next?”

The answer is that bitcoin doesn’t need to be a good unit of account or a good store of value to be a good medium of exchange. Indeed, the prices of products and services being sold for bitcoin online today are denominated in dollars and are converted at the market rate for bitcoin when the transaction happens. This is how WordPress, one of the most prominent companies accepting bitcoin, does it. In fact, WordPress never even handles bitcoin. They employ the services of a very interesting company called Bitpay that manages bitcoin payment processing for them.

When you check out at WordPress using bitcoin, Bitpay quotes you the total of your dollar-denominated shopping cart in bitcoin at the current exchange rate, takes your bitcoin payment, and then deposits dollars in WordPress’s account. This allows WordPress to sell to persons in Iran or Haiti or anyone of the dozens of other countries where PayPal, Visa and MasterCard are not available. It also highlights bitcoin’s true disruptive quality as a payments system—one that is unstoppable, largely anonymous, and incredibly cheap to boot.

To answer Salmon more directly: It doesn’t matter what the price of bitcoin is for it to operate as the amazing payments system that it is. It doesn’t matter if it is very volatile. Dollars go in and dollars come out and the fact that some folks are (probably unwisely) treating it as a store of value doesn’t really matter.

That all said, there are some caveats to point out. Bitcoin will work as a seamless payment system so long as you can get in and out of it quick enough to mitigate volatility. That is largely a technical consideration, but it could also depend on the market’s liquidity, which conceivably could be hurt by speculative hoarding. I haven’t given this much thought yet, but given that bitcoin can be denominated down to eight decimal places, I’m not sure it will be a big problem anytime soon.