Techno-hype part 2

Don't, don't, don't, don't believe the hype!

Public Enemy

Enough about the hype around self-driving cars, now on to the hype around cryptocurrencies.

Sysadmins like David Gerard tend to have a realistic view of new technologies; after all, they get called at midnight when the technology goes belly-up. Sensible companies pay a lot of attention to their sysadmins' input when it comes to deploying new technologies.

Gerard's Attack of the 50 Foot Blockchain: Bitcoin, Blockchain, Ethereum & Smart Contracts is a must-read, massively sourced corrective to the hype surrounding cryptocurrencies and blockchain technology. Below the fold, some tidbits and commentary. Quotes not preceded by links are from the book, and I have replaced some links to endnotes with direct links.

Gerard's overall thesis is that the hype is driven by ideology, which has resulted in cult-like behavior that ignores facts, such as:

Bitcoin ideology assumes that inflation is a purely monetary phenomenon that can only be caused by printing more money, and that Bitcoin is immune due to its strictly limited supply. This was demonstrated trivially false when the price of a bitcoin dropped from $1000 in late 2013 to $200 in early 2015 - 400% inflation - while supply only went up 10%.

There's recent evidence for this in the collapse of the SegWit2x proposal to improve Bitcoin's ability to scale. As Timothy B Lee writes:

There's a certain amount of poetic justice in the fact that leading Bitcoin companies trying to upgrade the Bitcoin network were foiled by a populist backlash. Bitcoin is as much a political movement as it is a technology project, and the core idea of the movement is a skepticism about decisions being made behind closed doors.

Gerard quotes Satoshi Nakamoto's release note for Bitcoin 0.1:

The root problem with conventional currency is all the trust that's required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible.

And points out that:

Bitcoin failed at every one of Nakamoto's aspirations here. The price is ridiculously volatile and has had multiple bubbles; the unregulated exchanges (with no central bank backing) front-run their customers, paint the tape to manipulate the price, and are hacked or just steal their user's funds; and transaction fees and the unreliability of transactions make micropayments completely unfeasible.

Instead, Bitcoin is a scheme to transfer money from later to earlier adopters:

Bitcoin was substantially mined early on - early adopters have most of the coins. The design was such that early users would get vastly better rewards than later users for the same effort.

Cashing in these early coins involves pumping up the price, then selling to later adopters, particularly in the bubbles. Thus Bitcoin was not a Ponzi or pyramid scheme, but a pump-and-dump. Anyone who bought in after the earliest days is functionally the sucker in the relationship.

Satoshi Nakamoto mined (but has never used) nearly 5% of all the Bitcoin there will ever be, a stash now notionally worth $7.5B. The distribution of notional Bitcoin wealth is highly skewed:

a Citigroup analysis from early 2014 notes: "47 individuals hold about 30 percent, another 900 hold a further 20%, the next 10,000 about 25% and another million about 20%".

Not that the early adopters' stashes are circulating:

Dorit Ron and Adi Shamir found in a 2012 study that only 22% of then-existing bitcoins were in circulation at all, there were a total of 75 active users or businesses with any kind of volume, one (unidentified) user owned a quarter of all bitcoins in existence, and one large owner was tying to hide their pile by moving it around in thousands of smaller transactions.

In the Citigroup analysis, Steven Englander wrote:

The uneven distribution of Bitcoin wealth may be the price to be paid for getting a rapid dissemination of the Bitcoin payments and store of value technology. If you build a better mousetrap, everyone expects you to profit from your invention, but users benefit as well, so there are social benefits even if the innovator grabs a big share.

Well, yes, but in this case the 1% of the population who innovated appear to have grabbed about 80% of the wealth, which is a bit excessive.

Since there are very few legal things you can buy with Bitcoin (see Gerard's Chapter 7) this notional wealth is only real if you can convert it into a fiat currency such as USD with which you can buy legal things. There are two problems doing so.

First, Nakamoto's million-Bitcoin hoard is not actually worth $7.5B. It is worth however many dollars other people would pay for it, which would be a whole lot less than $7.5B:

large holders trying to sell their bitcoins risk causing a flash crash; the price is not realisable for any substantial quantity. The market remains thin enough that single traders can send the price up or down $30, and an April 2017 crash from $1180 to 6 cents (due to configuration errors on Coinbase's GDAX exchange) was courtesy of 100 BTC of trades.

Second, Jonathan Thornburg was prophetic but not the way he thought:

A week after Bitcoin 0.1 was released, Jonathan Thornburg wrote on the Cryptography and Cryptography Policy mailing list: "To me, this means that no major government is likely to allow Bitcoin in its present form to operate on a large scale."

Governments have no problem with people using electricity to compute hashes. As Dread Pirate Roberts found out, they have ways of making their unhappiness clear when this leads to large-scale purchases of illicit substances. But they get really serious when this leads to large-scale evasion of taxes and currency controls.

Governments and the banks they charter like to control their money. The exchanges on which, in practice, almost all cryptocurrency transactions take place are, in effect, financial institutions but are not banks. To move fiat money to and from users the exchanges need to use actual banks. This is where governments exercise control, with regulations such as the US Know Your Customer/Anti Money Laundering regulations. These make it very difficult to convert Bitcoin into fiat currency without revealing real identities and thus paying taxes or conforming to currency controls.

Gerard stresses that Bitcoin is in practice a Chinese phenomenon, both on the mining side:

From 2014 onward, the mining network was based almost entirely in China, running ASICs on very cheap subsidised local electricity (There has long been speculation that much of this is to evade currency controls - buy electricity in yuan, sell bitcoins for dollars)

And on the trading side:

Approximately 95% of on-chain transactions are day traders on Chinese exchanges; Western Bitcoin advocates are functionally a sideshow, apart from the actual coders who work on the Bitcoin core software.

Gerard agrees with my analysis in Economies of Scale in Peer-to-Peer Networks that economics made decentralization impossible to sustain:

Everything about mining is more efficient in bulk. By the end of 2016, 75% of the bitcoin hashrate was being generated in one building, using 140 megawatts - or over half the estimated power used by all of Google's data centres worldwide.

This is the one case where I failed to verify Gerard's citation. The post he links to at NewsBTC says (my emphasis):

According to available information, the Bitmain Cloud Computing Center in Xinjiang, Mainland China will be a 45 room facility with three internal filters maintaining a clean environment. The 140,000 kW facility will also include independent substations and office space.

The post suggests that the facility wasn't to be completed until the following month, and quotes a tweet from Peter Todd (my emphasis):

So that's potentially as much as 75% of the current Bitcoin hashing power in one place

Gerard appears to have been somewhat ahead of the game.

The most interesting part of the book is Gerard's discussion of Bitfinex, and his explanation for the current bubble in Bitcoin. You need to read the whole thing, but briefly:

• Bitfinex was based on the code from Bitcoinica, written by a 16-year old. The code was a mess.
• As a result, in August 2016 nearly 120K BTC (then quoted at around $68M) was stolen from Bitfinex customer accounts.
• Bitfinex avoided bankruptcy by imposing a 36% haircut across all its users' accounts.
• Bitfinex offered the users "tokens", which they eventually, last April, redeemed for USD at roughly half what the stolen Bitcoins were then worth.
• But by then Bitfinex's Taiwanese banks could no longer send USD wires, because Wells Fargo cut them off.
• So the "USD" were trapped at Bitfinex, and could only be used to buy Bitcoin or other cryptocurrencies on Bitfinex. This caused the Bitcoin price on Bitfinex to go up.
• Arbitrage between Bitfinex and the other exchanges (which also have trouble getting USD out) caused the price on other exchanges to rise.

Gerard points out that this mechanism drives the current Initial Coin Offering mania:

The trapped "USD" also gets used to buy other cryptocurrencies - the price of altcoins tends to rise and fall with the price of bitcoins - and this has fueled new ICOs ... as people desperately look for somewhere to put their unspendable "dollars". This got Ethereum and ICOs into the bubble as well.

In a November 3 post to his blog, Gerard reports that:

You haven’t been able to get actual money out of Bitfinex since mid-March, but now there are increasing user reports of problems withdrawing cryptos as well (archive).

Don't worry, the Bitcoin trapped like the USD at Bitfinex can always be used in the next ICO! Who cares about the SEC:

Celebrities and others have recently promoted investments in Initial Coin Offerings (ICOs).  In the SEC’s Report of Investigation concerning The DAO, the Commission warned that virtual tokens or coins sold in ICOs may be securities, and those who offer and sell securities in the United States must comply with the federal securities laws.

Or the Chinese authorities:

The People's Bank of China said on its website Monday that it had completed investigations into ICOs, and will strictly punish offerings in the future while penalizing legal violations in ones already completed. The regulator said that those who have already raised money must provide refunds, though it didn't specify how the money would be paid back to investors.

This post can only give a taste of an entertaining and instructive book, well worth giving to the Bitcoin enthusiasts in your life. Or you can point them to Izabella Kaminska's interview of David Gerard - it's a wonderfully skeptical take on blockchain technologies and markets.