Bitcoin: New plumbing for financial services

Payment systems are systems of pipes and valves that allow monetary transfers between people all over the world. To most, they sit insulated from view. Even when in plain sight they evade comprehension. With large responsibility for errors and lack acknowledgement for progress, there has been little innovation and construction of new pipes. Bitcoin represents a new way to re-plumb the financial system on a decentralised architecture. However, much like the existing financial system, few people understand the consequences of the layout and design of its pipes.

The plumbing analogy fits far closer to Bitcoin than normal financial markets. Bitcoins are not coins, indeed there is no concept of identifiable currency units. Bitcoin should be considered a type of monetary fluid with a unit of account, Bitcoin. The monetary fluid, bitcoins, flows through a system of pipes (transaction outputs) and fittings (transactions).

Constructing the Bitcoin’s pipes

Transactions are constructed using previous transactions as inputs to fund transaction outputs. Each output can be thought as a pipe with some capacity of Bitcoin. Each transaction is a fitting, connecting one or more of the existing pipes. The pipe or pipes that is the result of a fitting can at most carry the same capacity of the sum of the pipes that led into the transaction.

Bitcoin is neither an account based payment system or a tokenised banking system. The protocol uses the history of all past transactions to generate a state of unspent bitcoins. When we say there are 13 million bitcoins in circulation, what we actually mean that the system recognises that there are 13 million bitcoins in unspent outputs that can be reassigned according to the rules of the payment system. The reassignment is irreversible and hence new transactions are additions to the growing complex system of pipes.

Analysing Bitcoin’s pipes

The graph of pipes or transactions is largely immutable and therefore makes it amenable to analysis. Pipes are only destroyed if there is a reorganisation on the consensus of the network. The system of pipes is append only and therefore the complexity and size of the transaction graph grows over time. Bitcoin’s history can be evaluated looking at the state of the pipes on January 1st 2014 or any block height.

One problem in any analysis is the lack of mapping from inputs to outputs. When warm water that comes out of a tap, there is no separation between the hot and the cold. In Bitcoin, if two transaction outputs are both inputs in the same transaction, the protocol makes no attempts to map inputs to outputs. Bitcoin retains the information that can reveal the capacity of the individual pipes that were feeding into the fitting. In this way, Bitcoin is not a token system but something far more fluid and complex.

In the diagram above each node is a transaction or an unspent output. The green nodes are transactions and the white node indicates unspent outputs. The number contained within the circle represents the sum of the outputs of that transaction or transaction output. Each edge is the link of output to the subsequent transaction. We cannot say in which proportion the inputs of the transaction are funding the outputs.

Imagine this transaction was the purchase of a new iphone 6 costing 1.5 BTC. Now assume that one of the funding transactions used to fund the purchase was a theft. The theft is marked as the orange transaction. Now the difficult question becomes how much of the stolen Bitcoin remains in the thief’s possession? Bitcoin the protocol does not have the answer to this. Instead we would have to rely on our legal principles to establish that all of the 0.5 BTC remaining in the possession of the thief was actually the stolen Bitcoins.

As the blockchain is a public set of transactions the analysis could be performed on an arbitrarily large scale. For example, we could ask the question: are the bitcoins that you are holding the same as the ones that I once had? The analogue is pouring water into the pipes at a source transaction and analysing how much of the same water collects at the target transaction. To perform such analysis, two types of algorithm are used — min flow and max flow. Min flow asks the question: “what is the minimum number of bitcoins that went from the source to the target?” The max flow asks the question: “what is the maximum number of bitcoins that could have gone from the source to the target”. If min flow returns a positive answer, X, then the target is at least holding X amount of bitcoins that were once held at the source. The water that flowed through the source is the same as the water that we found at the target.

However, usually the min flow quickly goes to zero because we need to combine transactions in order to pay our debts. So if I make the payment of 1.5 BTC for the iphone 6. The min flow from each of the inputs to the expenditure is 0.5 BTC. The algorithm places the maximum number of bitcoins, 0.5 BTC, in the change and leaves 0.5 BTC to pay for the good. In the max flow case, the amount would be 1 BTC in both cases since the output is larger than 1 BTC. After only a few transactions, it is likely that the min flow falls to zero.

In the instance of min flow being greater than zero, we can prove that the bitcoins went from the source to the target and we have full traceability. But where min flow is equal to zero for all potential outputs, as is often the case, we have no traceability. Even though we can show the connections between all the different transactions or pipes in Bitcoin’s history, we cannot say a lot about the flows of funds or monetary fluid. We get transparency but hardly any traceability. The parties that cause the obfuscation can also be identified by their bitcoin addresses and could be subject to adverse claims (more on this in a future post).

In light of this, perhaps it is a red herring to even think of Bitcoins as units of currency and we should be rethinking the way that we speak of “my bitcoins”. Perhaps flows of currency as I have described it should be thought of as simultaneous creation and destruction of interests that are not necessarily tied together (as is the case with some US securities). These issues must be understood in order to develop private law frameworks for Bitcoin as well as appropriate AML tools and guidelines. One thing is for sure there are no coins in Bitcoin.

In some follow up posts I will discuss more complex pipe arrangements (mixing services) and more specific legal issues around negotiability and fungibility that are prompted by this type of analysis.

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“I love blockchain just not Bitcoin”

In an age of microblogging and relentless conferencing, zeitgeist is not written in novels but in phrases shorter than 140 characters. One cannot leave a financial technology, innovation or even digital currency conference without hearing the words in the title of this blogpost. However, as with most clichés, the phrase actually goes to the core of the issue. It begs for a defence of Blockchains and the Bitcoin blockchain as the best in class.

A Blockchain is a data structure that has two distinct features:

  1. They have native tokens that form the basis of all recorded information and economic incentives for using the system. The tokens are native as they are governed by the protocol that governs the data structure and have no external dependencies like central banks or financial institutions.
  2. They contain a chain of cryptographic proofs that ensure that the data has not been tampered with, lest the chain of proofs would not be able to be reconstructed. The chain of proofs has the nice property that it reveals the amount of work it took to construct the chain. This enables the network to converge on one chain as the true chain, the one with the most work done, and discard all but one.

The title of this post poses the challenge: Do we need to have only one native token with a fixed supply in our data structure or could we have none or many? To miss the value of these native tokens would be to also miss the value of the data structures that store them. I would like to push for blockchains with native tokens rather than just blockchains (innovative, probabilistically immutable databases) which have far lower utility if any.

Universal financial coverage

There are relatively few Bitcoin business models out there that are truly harnessing the ability to provide universal financial coverage due to supply chain limitations, regulatory barriers and Bitcoin’s volatility. Isn’t then the obvious solution to do away with Bitcoin and keep the blockchain? However, without a native token and only a decentralised and open ledger we cannot acheive universal financial coverage. Financial institutions that adopt, co-opt, or fork the blockchain technology will produce no better financial coverage than they do currently. To see why this is the case look at the following examples of applications that have been built on the basis of financial coverage (note this is not an endorsement of any of the services (although I do like tipping) just their use of universal financial coverage)

  1. Tipping e.g. Changetip, Dogetipbot etc.
  2. Silk Road 1.0, 2.0…..
  3. Gambling sites e.g. Satoshi Dice, Updown etc.

The Dogetipbot and more recently the Changetip have created a frenzy on Reddit. A simple web scraper enables people around the globe to transmit value by typing a few words into a website. The tips themselves are all recorded in centralised databases so the “low cost” of cryptocurrencies is irrelevant. The important factor is that the coverage is truly universal that any user can, when they choose to, withdraw the Bitcoin or Dogecoin from the service and use it in their everyday life. In the future, this becomes the basis of integrating virtual realities with physical processes.

Drug market places needing to avoid criminal clampdowns and deliver truly global marketplaces required universal financial coverage (as well as relative anonymity). The extent of the coverage enabled these platforms to gain critical mass to win the trust of their user base. Cross-country supply chain integration was possible due to the extent of financial inclusion.

Gambling sites are some of the only sites in the cryptocurrency ecosystem that do not give dollar or fiat equivalent currency units. Sites like Satoshi dice and updown give the bettors information on the extent of the house edge. The volumes going through these sites are incredibly impressive considering that the operators often conceal their identity and they are in operating illegally in certain parts of the world. The demand for transactions are somewhat insulated from Bitcoin volatility since the house edge can be as large as 70% on a binary option. Their user growth and reputation was again only achievable due to the universal financial coverage (Bitcoin) and ability to independently audit their processes (Blockchain).

One of the most popular Bitcoin casinos, “just-dice” conducts their bets off-chain. Wagers are not recorded in the Bitcoin blockchain and are only stored on the just-dice servers. With over 1 billion bets conducted on the platform it is clear that the key advantage is universal financial coverage. While there is not the ability to independently audit their processes via a blockchain, bitcoin casinos like just-dice provide provably fair gambling. There is no reason that traditional gambling services could not do this as well but we seem content to rely on their real-world reputation and/or the certification of their services by some gambling authority.

Security and integrity

Without going into the technical details of how blockchains are secured, it is important to understand the native token as incentive mechanism for security and integrity of the blockchain (for those that want a technical overview of the security model see the dynamic-membership multi-party signatures explained in the recent Sidechains whitepaper). At the base level the blockchain technology is a data structure that contains within it a chain of proofs that must hold true. This structure allows us to verify that the history of transactions or information that is being presented has not been altered or tampered with, ensuring data integrity. The reliability of the proofs is directly dependent on the economic incentives provided to the people or organisations that supply the proofs. In Bitcoin, a miner that earns the right to publish a block on the main chain is currently paid 25 BTC (~$8500 at current prices). This provides adequate incentives to have highly specialised hardware running in datacentres across the world. If the reward halved, as it is set to do in 2016, the incentive to provide these proofs would halve and we could likely see a scenario where the proofs would now be far less reliable (partly due to the excess hardware that could be bought on the cheap). In other words without a high token value on a blockchain there is little security or integrity of the data contained within.

Model for innovation

The underlying blockchain technology relies on universal financial coverage and distributed computing to achieve its value as one of the first databases with provable integrity. Centralised services may operate on top of the Bitcoin protocol but will always face high competition due to the relatively low barriers to entry (open source software) and low switching costs (installing apps on my smart phone). We are still early in our understanding of blockchain technology. The excitement around the integrity of the ledger, its openness and its potential to unlock global financial inclusion must be embraced in a holistic framework. The blockchain’s security and utility depends on its native token. Currently the most secure and reliable blockchain is clearly our dear friend Bitcoin but this does not have to be the case forever.

Am grateful to Martin Harrigan for his useful comments on a draft of this post and ongoing conversations about the essence of blockchains