Author Archives: Kartik

Multi-signature Transactions: The Future of Bitcoin

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One of the criticisms of Bitcoin is that a Bitcoin transaction is one way and irreversible. However, within the Bitcoin protocol, resides a powerful functionality called “m-of-n” or “multi-signature” transaction. A multi-signature transaction is one that is associated to more than one private key. The ‘n’ is for number of private keys and ‘m’ is the minimum number of signatures needed for that transaction to be successful. For example, in a 2-of-3 transaction, two signatures are needed to send the transaction to blockchain. This functionality has many advantages, especially in wallet security, arbitration and smart contracts.

Wallet Security

Most wallets currently available are single key. If a user looses his/her laptop, hard drive, forgets the password or gets hacked, there is no way to retrieve the coins. In a multi-signature wallet, there are typically three private keys. One key is stored on a web server, second is the user’s main key and third is a backup that can be stored on a paper wallet or USB drive. The wallet can receive funds as normal but when the user wants to withdraw any coins, signatures from atleast 2 of the 3 keys are needed to send the transaction to the blockchain. When the user initiates a withdrawal from his main key, a partially signed signature shows up on other two wallets for approval. Only when one of the other two keys has been signed, the transaction is sent to the blockchain. With a 2-of-3 type wallet, a hacker would have to steal at least 2 keys to withdraw funds. If the user forgets or looses one key, he/she can still withdraw funds using the other two keys.

Arbitration

One of the benefits of making a purchase with a credit card is that in the event of a dispute, the customer can file a chargeback with the credit card company. There are two primary issues with Mastercard and Visa arbitration systems: (1) the system is open to abuse (2) the cost of fraud is split across all consumers.

Card Not Present (CNP) affects all e-commerce transactions, as the card holder is never present at merchant’s premises. All a customer has to do is sign his/her name differently on the courier delivery note. The customer can then file a chargeback and win; the merchant will loose both the money and the product. Credit card companies not only charge merchants an admin fee for processing chargebacks but also factor in a certain percentage in their fees for dispute resolution; hence, due to network affect, everyone ends up paying for fraud. The arbitration service is costly and inefficient. On some occasions, a specialised arbitrator is needed but Mastercard and Visa can only offer a generic standardised service. For some transactions, such as sending money to charities, arbitration is not needed at all.

In a multi-signature Bitcoin transaction, there will be three players: customer, merchant and a third party arbitrator. Customer will transfer funds to the arbitrator and the merchant will ship the goods. If customer is happy with the goods, he/she will sign the transaction and merchant will receive the funds. In case of a dispute, either customer or merchant can appeal to the arbitrator, who like a credit card company, will review evidence and mediate the dispute. The arbitrator can not withdraw the funds and is paid a pre-determined market rate only if he/she is involved. Arbitration service being developed by Bitrated will work in a very similar way. Bitrated’s platform will also allow arbitrators to build reputation over time. Multi-signature makes arbitration cost effective; if there is no dispute, no fee is charged. In the long run, due to competition between merchants, these cost savings will be passed onto customers. The system is also fairer, as unlike Paypal and credit card companies, the arbitrator has no incentive to rule in the favour of the customer.

Smart Contracts

This is when things start to get really interesting. Multi-signature transactions can also be used to draw automated smart contracts. The idea of smart contracts was first discussed in 1997 by George Washington University law professor and computer scientist Nick Szabo. Szabo’s ideas were revolutionary, he argued that smart contracts must be enforced algorithmically, using cryptography and other security principals; not by law. Bitcoin and multi-signature transactions make smart contracts possible.

Consider the example of a will – one of the parties in the will would be a computer server. The computer will have its own unique key, with which it will be able to sign Bitcoin transactions. The computer will determine whether a person is alive by checking a central death certificate database periodically. If the computer finds a certificate, it will sign the transaction and transfer the funds to the beneficiary. Contracts can also be split ‘n’ ways (‘n’ grandchildren or business partners) and to authorise transfer of funds at least ‘m’ signatures would be needed. The functionality can be used to automate mortgages and leases. Automation and verification of contracts by the blockchain will reduce, if not eliminate, brokerage and banking fees. The system can be used to verify and transfer ownership of assets. Szabo described how cars could be made to read the blockchain and disable themselves if a loan payment was not made on time. Szabo explains:

consider a hypothetical digital security system for automobiles. The smart contract design strategy suggests that we successively refine security protocols to more fully embed in a property the contractual terms which deal with it. These protocols would give control of the cryptographic keys for operating the property to the person who rightfully owns that property, based on the terms of the contract. In the most straightforward implementation, the car can be rendered inoperable unless the proper challenge-response protocol is completed with its rightful owner, preventing theft.

The system could be designed to automate ownership of physical assets such as phones and houses (smart property) and non-physical assets such as shares in a company. The ability to put up assets as collateral and give away shares in a company will allow businesses to raise money over the internet. Many of these features are yet to be explored and implemented. As the Bitcoin eco-system grows, entrepreneurs and investors will flock to build new companies to explore full potential of the Bitcoin protocol.

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Bitcoin vs Gold: A Question of Intrinsic Value

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Intrinsic value is independent of the market value of an asset. Market value is based largely on perception of the market, intrinsic value on the other hand calculates the true value of an underlying asset. Most commodities derive their value from market fundamentals of demand and supply. Bitcoin and Gold are both scarce and useful in various forms; although some dispute the usefulness of Bitcoin. Alan Greenspan’s words on Bitcoin – “It has to have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it.” sparked a debate in the Bitcoin community.

Greenspan said repaying capability of a currency comes from:

a) either the intrinsic value of the currency

b) or the trust of individual/organisation issuing the currency.

Historically, gold and other commodities were used to mint coins; and paper money was backed by a set amount of that commodity. Fiat currencies are no longer backed by commodities and the US dollar has not been redeemable in gold since January 30, 1934. It now costs the US government just 9.2 cents to print a $10 note. With no asset backing, and no intrinsic value of the paper on which it is printed, the dollar derives its intrinsic value from the confidence that the US government will honor its debts. Without that confidence, the entire financial system collapses.

The intrinsic value of Gold

I believe the intrinsic value of gold is, to a large extent, based on perception. Humans have historically seen jewellery made from gold as more valuable than jewellery made from other metals; metals that are just as bright and shiny as gold. Investors have historically seen gold as a store of value, an asset that will continue to rise in value as the demand increases, and use gold to hedge fiat’s inflationary risk. If investors have little confidence in the dollar, then the price of gold rises. Additionally, as the dollar looses its value over time and gold remains scarce, gold is seen as having higher value relative to dollar.

Gold vs USD

Source: Seekingalpha.com

Demand and supply alone can not be used to explain value of gold. Silicon is intrinsically valuable as it is used to produce microchips, yet silicon trades at $0.50 / ounce, and gold trades at $1275 / ounce. Hence, intrinsic value of gold is driven by belief that humans will continue to value gold as a precious shiny metal, that gold is a good store of value and that the price of gold will continue to rise over time.

The intrinsic value of Bitcoin

Bitcoin is not issued by any government and is not backed by a commodity; therefore, when compared to the dollar and gold, Bitcoin has no intrinsic value in the ‘traditional economic sense’. However, Bitcoin is more of a technology than a commodity or a currency, therefore it is not wise to study Bitcoin in the traditional economic sense. Bitcoin is being traded like a commodity and used as a currency, and hence Bitcoin is being compared to gold and currency. But the true value of Bitcoin comes from the de-centralised protocol that powers the Bitcoin network. True potential of that protocol is still un-realised, and trying to determine the intrinsic value of that protocol today is like trying to determine the intrinsic value of the world wide web when the internet was first conceived.

We have seen that the Bitcoin protocol can be used as a payment network to send money to anyone in the world. No other technology or payment network makes it possible to send $150 million over the internet in minutes, at the cost of a few cents. While the payment network has been used to fund illicit activities, studies have shown that considerable effort would be needed to achieve complete anonymity. The blockchain is another element of the protocol that will be used to develop de-centralised products and services. Naval describes how blockchain can be used to verify and automate the ownership of assets, contracts, wills etc. If Bitcoin protocol were developed by a company, would the stock of that company not gain intrinsic value because of this technology? (atleast for a short while before that company would be shut down by regulators for facilitating money laundering). Owning part of a Bitcoin is similar to owning a part of that company, key difference is that Bitcoin runs on a peer-to-peer network, which is very difficult to shut down. Infact, something like Bitcoin can flourish only in a peer-to-peer way. The fact that Bitcoin was developed by an anonymous developer, and that the protocol is de-centralised, does not undermine the intrinsic value of the underlying protocol. Intrinsic value of gold is largely in our perception, whereas Bitcoin protocol is a real technology that has the potential to change the world. Hence, although I do not think it is fair to compare the two, if pushed, I would argue that Bitcoin protocol has more intrinsic value than gold.

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Bitcoin: Speculative Bubble or Future Currency

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The US department of justice took a soft position on virtual currencies at the senate hearings last month. Libertarians, investors, regulators and critics have different views on how Bitcoin should be handled. The European Union’s banking watchdog and many countries including France and China have called Bitcoin “highly speculative”. The two most common views on Bitcoin tend to be either a speculative bubble or a future currency.

Speculative bubble

A speculative bubble is typically defined as a phenomenon when the price of a security or an asset rises so sharply, based on over-exaggerated expectations, that the price far exceeds valuations that can be justified by fundamentals, making a sudden fall in price imminent – the point at which the so called bubble ‘bursts’. Critics dismiss Bitcoin as a ‘speculative bubble’, as the rise in Bitcoin’s price is to a large extent based on expectations of future growth, price appreciation and coin hoarding.

Bitcoin Price Fluctuations

Source: Bitcoinwisdom.com

A research paper by Princeton University states that speculative bubbles are accompanied by large trading volumes and high price volatility, based on overconfidence and optimistic beliefs. These are all characteristics that we are seeing in the Bitcoin economy today. A recent Forbes article compared Bitcoin price to Dr. Jean-Paul Rodrigue’s archetypal bubble stages chart.

stages_bubble

Bitcoin may well in a bubble but having said that, despite negative connotations of the term ‘bubble’ – the existence of a bubble does not in itself discount the value of an underlying asset. Amazon.com stock was in a bubble in the 1990’s, the price rose sharply in 1998 based on analyst predictions, exhibiting all characteristics of a bubble, and then came back down. The bubble did not undermine the underlying value of Amazon’s business. Bitcoin’s technology could prove to be an efficient payment system in the long term (Ben Bernanke agrees). Earlier this month, Bank of America analysts valued the price of a Bitcoin at $1300 and said “Bitcoin can become a major means of payment for e-commerce and may emerge as a serious competitor to traditional money transfer providers”.

Future currency

A fiat currency derives its value from the fact that it is issued by the government as a formal legal tender. But what makes one currency stronger than the other? One of the many reasons is that a lot of people believe in that currency and are willing to accept it as a form of payment. One of the reasons why Saddam Dinars did not work as intended was that people were not willing to accept them. Swiss Dinars stayed in circulation without formal government backing because people believed in the currency and used it as a medium of exchange.

I believe Bitcoin serves a different purpose from fiat currency. As a medium of exchange, Bitcoin has several advantages. Credit cards companies and Paypal charge per transaction fees that make micro payments virtually impossible. For example, a publisher can not charge 10 cents for reading an article if payment processor charges 20 cents for processing the payment. Most media websites that host content rely on advertising as their primary source of revenue, while others rely on a subscription based model. Every so often I land on Financial Times website, but I can not read the full article without an FT subscription. Apple gets around the issue by using its own payment network; however, that is not an option for small publishers who do not handle the volumes that iTunes handles. Bitcoin micro-transactions could open up new media models for publishers, allowing publishers to charge the visitor a small fee for reading an article, watching a video or downloading a file. Having said that, Bitcoin as a medium of exchange is still very small in size and limited in use. Compare Bitcoin’s 42 transactions per minute to Visa’s 165,000 per minute to get an idea of the size of the Bitcoin economy.

Bitcoin will also impact the traditional e-commerce industry. Lower transaction costs and absence of fraudulent chargebacks would encourage merchants to accept Bitcoin. Price volatility can be mitigated easily as payment processors such as Bitpay allow merchants to convert Bitcoins to fiat currency almost instantly, so merchants do not have to hold any Bitcoins if they do not want to. Merchants will incentivise consumers by offering discounts on Bitcoin transactions. It would work well for both the merchant and the consumer, as the merchant could pass off some of the savings made from lower transaction costs to the consumer, and the consumer would get the product cheaper by paying with Bitcoin. There are other incentives for consumers such as not having to share credit card details on the merchant site and anonymity.

I think Bitcoin will impact the $500 billion international money remittance the most. For example, to send money to Kenya, Western Union and other money transfer companies’ charge 8 to 10% of the amount being sent. Bill Gates wrote about a mobile service called M-Pesa that is being used in Kenya by millions of people for storing and transferring money. I believe Bitcoin opens up a huge space for disruption in money remittance, and I see Bitcoin as more of a payment system than a currency; it’s an open ledger and a platform for innovation. Bitcoin is more of a disruptive technology, a platform on which businesses will be built.

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