Saturday, March 15, 2014

Bitcoin Explained!


On  the face of it, I’m not the ideal person to explain Bitcoin to you.  As far as you know, I don’t work in the financial industry.   Why shouldn’t you just look at, say, Wikipedia to finally understand what Bitcoin is? 

The answer is, you’re too impatient.  Who wouldn’t be?  This is the kind of topic it’s hard to dabble in.  Ten words of the techie mumbo-jumbo and your eyes start to roll and your brain browns out.  So, you should read my explanation because I feel your pain.  I am writing from a perspective comprising equal parts curiosity and impatience.  Plus, I’ll work hard to understand a related question, which is “What’s so funny about  Bitcoin?”

Basic explanation

Wikipedia says that Bitcoin is “a cryptocurrency, so-called because it uses cryptography to control the creation and transfer of money,” and that “Bitcoins are created by a process called mining, in which computer network participants, i.e. users who provide their computing power, verify and record payments into a public ledger in exchange for transaction fees and newly minted bitcoins.”  Got that?  You “mine” them by doing something with a computer that rewards you with “newly minted bitcoins.”  Who minted them?  Well, that’s where it gets confusing.  So I’ll use an analogy to help clarify.

Suppose you’re playing with your children, making play money out of construction paper.  Of course this paper will never give you actual buying power, because no government stands behind it guaranteeing that it isn’t counterfeit.  For it to be legitimate, the currency must be produced by the government mint.  But, if you take the letters that spell out “TEN DOLLARS” and rearrange them to spell “DLTN ELOSRA,” and write this on the paper and have your child bring it to her mother, there’s a pretty good chance her mother will let her “buy” lemonade with it.  The act of encryption generates the lemonade-buying wealth pretty much out of thin air.  (This isn’t a perfect analogy, because anagrams are not really encryption, but you get the idea.)

Why does this work?  Well, in the olden days, people made coins out of pure gold, and the rarity of that metal gave the gold value.  Then they started using coins and paper markers that only represented gold, but for every bit of currency minted, there was a corresponding amount of gold, most of it (or at least most of ours) stored in Fort Knox.  If anybody got nervous about the actual value of his currency he could exchange it for gold, no questions asked.  (In practice nobody did this because gold is so heavy.)  Eventually, there wasn’t enough gold to back the currency, and many feared the whole system would collapse.  But governments kept right on minting currency, with no gold behind it, and nothing bad happened.  Money went on working simply because people continued to believe in it.

So why don’t governments just print more and more money, and give it as handouts?  Well, smart governments, like ours, know that would be killing the goose that lays the golden eggs.  As with diamonds, the money supply must be artificially suppressed so the value doesn’t diminish.  (Some of the more stupid governments get this wrong somehow, and their currency tanks.)

But there’s no government behind Bitcoin!  No obvious mechanism to keep it from being produced ad infinitum, willy-nilly!  So how does it work?  This is the wrong question.  The right question is, does Bitcoin work?

Does Bitcoin work?

The answer is, Bitcoin sort of works, kind of in the way that Ross Perot’s campaign sort of worked.  Yes, some people believe in Bitcoin, so it’s possible to buy stuff with it, and it’s even possible to steal it.

Steal it?  You mean, the way you can steal credit card numbers?  Well, not exactly.  Stealing credit card numbers is stealing information of a very useful nature.  That information represents an established form of payment that everybody believes in.  By putting that information to work—i.e., stealing the access it gives to somebody’s real credit account—you can buy stuff.  But a Bitcoin isn’t really information.  It’s a notion, and an encrypted one at that.

Still confused?  Let’s go with another analogy.  Remember the story “Stone Soup?”  A penniless traveler picks up a stone on the way into a town, where he asks people for food and is turned down.  So he gets somebody to loan him a cauldron, builds a fire, and starts boiling the stone in water, saying it’s soup.  In return for throwing vegetables and stuff in there, people get to share the soup with him.  By the end he’s had a full meal based solely on the stone he’s contributed, which of course he then pitches.  In like fashion, Bitcoin is the idea of money, and so long as people pony up actual money for bitcoins, or accept bitcoins as payment, they’re as real as that stone.

So all that Bitcoin is missing is that ubiquitous acceptance.  The problem is, anytime your average joe comes across a matter involving arcane abstractions like public/private key exchanges, digital cryptography, and the sliding scale of the value of a currency, he’s going to rightly feel out of his depth, and will generally look to somebody else, somebody in a position of authority, to validate the thing for him so he can know whether to accept it or not.  (This isn’t a bad explanation of some people’s approach to religion, actually, but I digress.)  Where Bitcoin is concerned, the question is:  in the absence of a government and a grandfathered-in acceptance of a currency once backed by gold, who will step up and vouch for it?

Who will validate Bitcoin?

Alas, many governments are unfriendly to Bitcoin and warn their people that it lacks consumer protections.  Economists, unsurprisingly, cannot agree on whether Bitcoin is legit.  (I say “unsurprisingly” because no two economists ever agreed on anything, except for one pair of mental lightweights I’ve already excoriated in these pages).  It doesn’t help that the most prominent Bitcoin exchange, Mt. Gox, collapsed recently and filed for bankruptcy. It also doesn’t help that “Mt. Gox” sounds like something straight out of Dr. Seuss.

However, it does help that some merchants have started accepting bitcoins as payment for actual goods.  Some prominent examples:  the Sacramento Kings, Clearly Canadian, University of Nicosia, Zynga, and most recently the faux-British department store Lord & Taylor.

There are some caveats with these.  The Sacramento Kings is a pro sports team, which means you’re paying to see a bunch of doped-up cheaters—so the game is a sham anyway.  Meanwhile, Clearly Canadian is basically flavored water sold at the price of something legitimately nutritive.  Zynga is a video game, which—unlike productivity software—can be given away widely without costing the supplier anything, nor providing users with anything of value.  The University of Nicosia is in Greece, whose economy is so bad you could probably get anything you want there just by asking nicely.  And the last two retailers, and Lord & Taylor, while perfectly valid retailers, accept bitcoins with a very large asterisk.

The asterisk is that these retailers convert the bitcoins to something legit at the last second, so they’re not really accepting bitcoins at all.  According to Digital Transactions magazine, “Overstock tempers its currency risk by having Coinbase convert its Bitcoins instantly into dollars” and “Lord & Taylor will not accept Bitcoin directly from customers.  Instead, customers will use the Pounce app, from Israeli technology company BuyCode Inc.”

So, the validation Bitcoin gets from being accepted by two major brand-name retailers must be tempered by the fact that they’re actually transferring all the risk to more companies you’ve never heard of.  It’s tempting to call this “lipstick on a pig,” but it’s actually called “reintermediation.”  Whether or not this fancy label restores your faith in Bitcoin is your business, but I for one am not impressed. 

Now, you may accuse me of cherry-picking examples of unimpressive merchant acceptance of Bitcoin, so I guess should fess up:  I left out TigerDirect.  They’re a pretty sizeable retailer, who have been mired in various controversies such as being investigated and ruled against by the Fair Trade Commission; being sued by Dell; being sued by the State of Florida; and being investigated by the SEC.

Restoring faith

After the Mt. Gox disaster, Bitcoin is on shaky ground and badly needs to be propped up.  And, to renew faith in the population at large, the Bitcoin folks need to restore our nation’s faith in electronic commerce in general, thanks to the Target breach, which by some measures has directly affected one in three Americans.  And going back a bit further, I think we’re all a little more wary these days of the financial genius types that broke all the rules around subprime mortgages and various overly complicated financial instruments and caused the great economic meltdown of 2008.

Well, guess what:  we have the answer!  All we have to do, apparently, is lock up our bitcoins in big vaults.  According to a “Wall Street Journal” article, “a Silicon Valley startup called Xapo is among a handful of young companies trying to become the Fort Knox of bitcoin, building secret bank vaults deep in the earth that would safely store millions of dollars worth of bitcoin on computer drives.”  Xapo has raised $20 million in venture capital for this effort.  (Needless to say, “Xapo”—one of those names you can’t even pronounce—is, from a psychological perspective, the polar opposite of “Lloyd’s of London.”)

Now, I know I’m just a simple caveman and everything, but aren’t we missing something here—namely, the fact that the Mt. Gox theft was not of the hands-on, grab-and-dash type?   Nobody held up Mt. Gox at gunpoint or burgled it in the dead of night.  The Mt. Gox bitcoin theft was termed a “malleability-related theft.”  For my money, Bitcoin needs to fix its malleability problem.  How does Xapo intend to do this with vaults, video surveillance, and armed guards?  To think of it another way, how did Target incur $61 million in losses through its data breach:  by having its stores and headquarters overrun with Ninjas or bandits?  No!  The thieves were all the way over in Russia.  They almost literally “phoned in” the theft.

Perhaps the $20 million in venture capital is itself supposed to buoy up Bitcoin:  the idea that if this venture capital firm, run by geniuses, has that much faith in Xapo and Bitcoin, that we should, too.  The problem is, these venture capitalists have flamed out before:  we all watched the dot-com bubble burst.  (I myself saw $20,000 of my on-paper profits—that is, my pretend Internet money—evaporate almost overnight.)

Why should we care?

Okay, I guess it’s pretty obvious by now that I think you’d have to be crazy to mess around with Bitcoin.  But aren’t there all kinds of investment schemes to avoid, like swampland in Florida and Internet-sourced Nigerian inheritances?  Why bother writing about this one?  Well, the reason I care about Bitcoin is that I’m afraid if it gets popular, and then goes supernova, it’ll take the rest of the financial world with it, throwing the world into utter anarchy.  Because frankly, I’m already nervous about the traditional notion of money.

Why?  Well, let’s do a thought exercise.  I derive a lot of comfort from the protections available with conventional finance.  For example, when I discovered that a clothing company in China, from whom I made a legitimate purchase in January, had mysteriously dinged my credit card again in March, I didn’t freak out.  I know I can call my bank and say, “This charge is bogus, make it go away” and they’ll say, “Right away, sir!”  But what would happen if you logged into your online banking account and found it almost completely depleted but for no clear reason?  Whom would you call then?  Imagine your reaction if you complained to your bank and they retorted, “I don’t know what you’re talking about.  You never had that much money.  Go away, kid, ya bother me.” 

Sure, you’d probably have some recourse, but it wouldn’t be easy.  We take it for granted that our money, which exists electronically as a data point in some unseen database, won’t just go away.  Our entire system is already founded on trust, and on the universal agreement that this unseen money—not hard currency or gold, but numbers represented electronically by zeroes and ones—is real.  With this much riding on blind faith, the last thing we need is a Bitcoin bubble.

But you shouldn’t take my word for it—I’m no expert.  You’re probably better off listening to the financial gurus who live and breathe this stuff.  Take the 40-year-old CEO of Xapo:  the son of Patagonian sheep ranchers in Argentina, he got educated and “developed Patagon, one of Argentina’s first online financial-services firms … [and] also founded Banco Lemon, a Brazilian bank for the underbanked.”

What’s that?  You’ve never heard of the underbanked?  Well, I must confess, I hadn’t either.  And, after spending all this time thinking about Bitcoin, Mt. Gox, Xapo, and financial malleability, I’m starting to feel a bit overbanked.  In fact, I’m strongly considering turning some of my liquid assets into expensive bicycle wheels that can’t just vanish like a puff of smoke.

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