Decentralized, virtual, and anonymous—cryptocurrencies continue to grow in use and in popularity. Bitcoin, the first of its kind to achieve notoriety, was created in 2009 by an unknown person with the alias Satoshi Nakamoto. Transactions occur instantaneously through mobile apps or computers, thereby avoiding banks, credit card companies, and miscellaneous fees. Bitcoin boasts a market cap of about $8,000,000,000—considering the 13 million bitcoins in circulation, the value works out to over $500 each. In the past year, the number of bitcoin transactions per day has ranged from 40,000 to 100,000. Due to the anonymity and scope of the bitcoin economy, policymakers and corporations are beginning to take notice.
How does Bitcoin work?
Bitcoin is an open-source currency, in which bitcoins are mined on peer-to-peer networks. For the layman, the bitcoin process works like this, in ten easy steps:
- Step 1: Bitcoins are created electronically about every 10 minutes in batches of 25 coins.
- Step 2: Bitcoins are ‘mined’ when users run a mining script, which will record an entry to a gigantic public ledger containing every bitcoin transaction in history.
- Step 3: Jane wants to send a bitcoin to John for a product or service over the internet.
- Step 4: ‘Miners’—bitcoin users running the mining script on their computers—check to validate that Jane is transferring money that is hers to spend.
- Step 5: If the script validates Jane’s ability to pay, the transaction is recorded to the public ledger by the miners.
- Step 6: To ensure that the public ledger is not hacked, miners seal the transaction data with layers upon layers of computational work that is pretty much impossible to complete.
- Step 7: Jane’s bitcoin is transferred to John. John can access his bitcoins by accessing the unique digital key stored in his bitcoin wallet.
- Step 8: Some miners are rewarded for their ‘computational work,’ which is done by their computers. The script run by the computer solves a cryptographic problem that can only be solved by guessing and checking billions of times until an answer is found.
- Step 9: The miner that outcompetes the others is awarded the new batch of 25 bitcoins, which was earned for his computational work.
- Step 10: Additional bitcoins are generated and awarded as miners continue to verify the thousands of exchanges each day; the process continues.
The bitcoin network is an elaborate solution to a tough problem called ‘double spending,’ which plagues every currency. Double spending occurs when someone spends money more than once; traditional currencies avoid the problem by minting physical cash, which is difficult to counterfeit. However, bitcoins are digital and do not recognize a trusted third-party to process transactions and update account balances. Bitcoin’s innovative solution involves the public ledger, known as the block chain, where every transaction is recorded. A new block is created approximately every ten minutes. Since each bitcoin can be traced back to its creation—via public-record transaction data—miners can verify whether Jane is entitled to the bitcoins she is transferring to John.
If Jane wanted to change the record for her transaction in order to double spend, she would have to build an alternative block chain moving forward to catch up with the latest transaction. This involves solving those cryptographic problems with billions of possible answers faster than the rest of the miners. In other words, Jane would have to have more computing power than all other bitcoin miners combined—otherwise, Jane’s false record could never catch up to the collective public record. The competitive nature of bitcoin mining prevents this from happening, even if some groups decide to pool resources.
Bitcoin’s Dark Side
Bitcoin’s innovations provide many benefits to the average consumer, including privacy of transactions and cutting out middlemen. However, bitcoin plays the host to a darker side of commerce, having become the currency of choice for terrorists, drug dealers, and human traffickers. Due to the anonymity that cryptocurrencies provide, compounded with anonymity-hiding tools such as Tor, regulators find it difficult to discover money laundering and other illicit activities. Additionally, 83 other cryptocurrencies based on the bitcoin model have sprung into being since 2009.
According to Jeremy Allaire, the CEO of Circle Internet Financial, “terrorists will seek to employ digital currency if it remains unregulated.” Cryptocurrency networks are similar in principle to hawala networks, which have been employed by terrorist groups to launder money to the United States and other target countries. Websites like Silk Road, the Sheep Marketplace, and Black Market Reloaded are online marketplaces where users can buy and sell illegal drugs and weapons using cryptocurrencies. Law enforcement has found it difficult to combat these illicit transactions; after being shut down by the FBI in 2013, Silk Road reopened a few months later. The evidence of cryptocurrency abetting human traffickers is more anecdotal; however, law enforcement officials believe that cryptocurrencies enable the anonymous trade of child pornography.
U.S. regulators have struggled to cope with the explosion of cryptocurrency networks, due mostly to the legal and functional differences between traditional currencies and cryptocurrencies like bitcoin. The main problem is that current financial law cannot be applied clearly to cryptocurrency exchanges; the U.S. Treasury Department claims authority over these exchanges via the Financial Crimes Enforcement Network (FinCEN). However, FinCEN’s regulations are unclear about the information it requires from money service businesses that handle cryptocurrencies. The anonymity of cryptocurrency transactions further confounds regulation of any kind, even at the federal level. According to Sen. Tom Carper (D-DE), the chairman of the Homeland Security and Governmental Affairs Committee, “virtual currencies, perhaps most notably bitcoin, have captured the imagination of some, struck fear among others, and confused the heck out of many of us.”
The Future of Cryptocurrency
The future of bitcoin and its cryptocurrency counterparts remains uncertain. The Senate continues to consider regulatory action in committee, while states like New York have already taken action. On July 17th, Benjamin Lawsky, superintendent for New York’s Department of Financial Services, proposed new regulations for virtual currency businesses. Its flagship regulation, the ‘BitLicense’ plan, will require all companies that handle cryptocurrency to purchase a license from New York. The 40-page plan is subject to a ‘public comment period’ of 45 days beginning July 23rd; then, the department will revise the proposal and release it for another review period.
Critics of the proposed New York legislation argue that regulations will drive bitcoin startups out-of-state. Additionally, the regulations appear to cover a class of businesses that are not subject to federal regulations. In a response posted on Reddit, Lawsky cited the February 2014 bankruptcy of the Tokyo-based Mt. Gox exchange as a reason for regulation. The $460 million theft remains unsettled; Mt. Gox likely was the victim of hackers—850,000 bitcoins were declared missing due to a security breach. Before filing for bankruptcy, the exchange shut down withdrawals and blocked users from removing their bitcoins from the market.
The same arguments resurface as the U.S. Senate considers regulation. Advocates of regulation emphasize the anonymity that enables terrorist financing, black market trade, and child pornography. The bitcoin community emphasizes the benefits of cryptocurrencies, including privacy and accessibility. According to Jerry Brito, a senior research fellow at George Mason University’s Mercatus Center, cryptocurrencies are more accessible to young entrepreneurs and the world’s poorest. Countries like New Zealand and Indonesia have declined to establish regulations on cryptocurrencies, while countries like Russia and Bolivia have banned and criminalized bitcoin. Other options for the United States include expanding existing regulation to account for cryptocurrencies (like Germany), or creating new domestic regulations (like Brazil).
As bitcoin and other cryptocurrencies grow in market cap and in notoriety, corporations are beginning to take notice. German bitcoin ATM manufacturer BitXatm has announced its plan to build 1,000 machines in the United States. Once installed, these ATMs will comprise the world’s largest bitcoin ATM network. In other news, Dell—the third largest PC seller in the world—has announced that the company will accept bitcoin as a payment option. Following the trend established by Dish Network, Expedia, and Overstock, Dell’s announcement solidifies bitcoin’s mainstream acceptance. At the time of the June 18th announcement, Dell is the largest company in the world to accept bitcoin as legitimate payment. As more and more companies jump on the ‘bitcoin bandwagon,’ cryptocurrencies seem poised to change the landscape of modern commerce.
Thanks to my colleague Samuel Dunham for his research on bitcoin. His policy brief on cryptocurrencies (and his analysis of potential regulations) can be accessed here.
Photo: Francis Storr (cc).
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Future Funds: The Latest on Bitcoin and Cryptocurrency
September 4, 2014
Decentralized, virtual, and anonymous—cryptocurrencies continue to grow in use and in popularity. Bitcoin, the first of its kind to achieve notoriety, was created in 2009 by an unknown person with the alias Satoshi Nakamoto. Transactions occur instantaneously through mobile apps or computers, thereby avoiding banks, credit card companies, and miscellaneous fees. Bitcoin boasts a market cap of about $8,000,000,000—considering the 13 million bitcoins in circulation, the value works out to over $500 each. In the past year, the number of bitcoin transactions per day has ranged from 40,000 to 100,000. Due to the anonymity and scope of the bitcoin economy, policymakers and corporations are beginning to take notice.
How does Bitcoin work?
Bitcoin is an open-source currency, in which bitcoins are mined on peer-to-peer networks. For the layman, the bitcoin process works like this, in ten easy steps:
- Step 1: Bitcoins are created electronically about every 10 minutes in batches of 25 coins.
- Step 2: Bitcoins are ‘mined’ when users run a mining script, which will record an entry to a gigantic public ledger containing every bitcoin transaction in history.
- Step 3: Jane wants to send a bitcoin to John for a product or service over the internet.
- Step 4: ‘Miners’—bitcoin users running the mining script on their computers—check to validate that Jane is transferring money that is hers to spend.
- Step 5: If the script validates Jane’s ability to pay, the transaction is recorded to the public ledger by the miners.
- Step 6: To ensure that the public ledger is not hacked, miners seal the transaction data with layers upon layers of computational work that is pretty much impossible to complete.
- Step 7: Jane’s bitcoin is transferred to John. John can access his bitcoins by accessing the unique digital key stored in his bitcoin wallet.
- Step 8: Some miners are rewarded for their ‘computational work,’ which is done by their computers. The script run by the computer solves a cryptographic problem that can only be solved by guessing and checking billions of times until an answer is found.
- Step 9: The miner that outcompetes the others is awarded the new batch of 25 bitcoins, which was earned for his computational work.
- Step 10: Additional bitcoins are generated and awarded as miners continue to verify the thousands of exchanges each day; the process continues.
The bitcoin network is an elaborate solution to a tough problem called ‘double spending,’ which plagues every currency. Double spending occurs when someone spends money more than once; traditional currencies avoid the problem by minting physical cash, which is difficult to counterfeit. However, bitcoins are digital and do not recognize a trusted third-party to process transactions and update account balances. Bitcoin’s innovative solution involves the public ledger, known as the block chain, where every transaction is recorded. A new block is created approximately every ten minutes. Since each bitcoin can be traced back to its creation—via public-record transaction data—miners can verify whether Jane is entitled to the bitcoins she is transferring to John.
If Jane wanted to change the record for her transaction in order to double spend, she would have to build an alternative block chain moving forward to catch up with the latest transaction. This involves solving those cryptographic problems with billions of possible answers faster than the rest of the miners. In other words, Jane would have to have more computing power than all other bitcoin miners combined—otherwise, Jane’s false record could never catch up to the collective public record. The competitive nature of bitcoin mining prevents this from happening, even if some groups decide to pool resources.
Bitcoin’s Dark Side
Bitcoin’s innovations provide many benefits to the average consumer, including privacy of transactions and cutting out middlemen. However, bitcoin plays the host to a darker side of commerce, having become the currency of choice for terrorists, drug dealers, and human traffickers. Due to the anonymity that cryptocurrencies provide, compounded with anonymity-hiding tools such as Tor, regulators find it difficult to discover money laundering and other illicit activities. Additionally, 83 other cryptocurrencies based on the bitcoin model have sprung into being since 2009.
According to Jeremy Allaire, the CEO of Circle Internet Financial, “terrorists will seek to employ digital currency if it remains unregulated.” Cryptocurrency networks are similar in principle to hawala networks, which have been employed by terrorist groups to launder money to the United States and other target countries. Websites like Silk Road, the Sheep Marketplace, and Black Market Reloaded are online marketplaces where users can buy and sell illegal drugs and weapons using cryptocurrencies. Law enforcement has found it difficult to combat these illicit transactions; after being shut down by the FBI in 2013, Silk Road reopened a few months later. The evidence of cryptocurrency abetting human traffickers is more anecdotal; however, law enforcement officials believe that cryptocurrencies enable the anonymous trade of child pornography.
U.S. regulators have struggled to cope with the explosion of cryptocurrency networks, due mostly to the legal and functional differences between traditional currencies and cryptocurrencies like bitcoin. The main problem is that current financial law cannot be applied clearly to cryptocurrency exchanges; the U.S. Treasury Department claims authority over these exchanges via the Financial Crimes Enforcement Network (FinCEN). However, FinCEN’s regulations are unclear about the information it requires from money service businesses that handle cryptocurrencies. The anonymity of cryptocurrency transactions further confounds regulation of any kind, even at the federal level. According to Sen. Tom Carper (D-DE), the chairman of the Homeland Security and Governmental Affairs Committee, “virtual currencies, perhaps most notably bitcoin, have captured the imagination of some, struck fear among others, and confused the heck out of many of us.”
The Future of Cryptocurrency
The future of bitcoin and its cryptocurrency counterparts remains uncertain. The Senate continues to consider regulatory action in committee, while states like New York have already taken action. On July 17th, Benjamin Lawsky, superintendent for New York’s Department of Financial Services, proposed new regulations for virtual currency businesses. Its flagship regulation, the ‘BitLicense’ plan, will require all companies that handle cryptocurrency to purchase a license from New York. The 40-page plan is subject to a ‘public comment period’ of 45 days beginning July 23rd; then, the department will revise the proposal and release it for another review period.
Critics of the proposed New York legislation argue that regulations will drive bitcoin startups out-of-state. Additionally, the regulations appear to cover a class of businesses that are not subject to federal regulations. In a response posted on Reddit, Lawsky cited the February 2014 bankruptcy of the Tokyo-based Mt. Gox exchange as a reason for regulation. The $460 million theft remains unsettled; Mt. Gox likely was the victim of hackers—850,000 bitcoins were declared missing due to a security breach. Before filing for bankruptcy, the exchange shut down withdrawals and blocked users from removing their bitcoins from the market.
The same arguments resurface as the U.S. Senate considers regulation. Advocates of regulation emphasize the anonymity that enables terrorist financing, black market trade, and child pornography. The bitcoin community emphasizes the benefits of cryptocurrencies, including privacy and accessibility. According to Jerry Brito, a senior research fellow at George Mason University’s Mercatus Center, cryptocurrencies are more accessible to young entrepreneurs and the world’s poorest. Countries like New Zealand and Indonesia have declined to establish regulations on cryptocurrencies, while countries like Russia and Bolivia have banned and criminalized bitcoin. Other options for the United States include expanding existing regulation to account for cryptocurrencies (like Germany), or creating new domestic regulations (like Brazil).
As bitcoin and other cryptocurrencies grow in market cap and in notoriety, corporations are beginning to take notice. German bitcoin ATM manufacturer BitXatm has announced its plan to build 1,000 machines in the United States. Once installed, these ATMs will comprise the world’s largest bitcoin ATM network. In other news, Dell—the third largest PC seller in the world—has announced that the company will accept bitcoin as a payment option. Following the trend established by Dish Network, Expedia, and Overstock, Dell’s announcement solidifies bitcoin’s mainstream acceptance. At the time of the June 18th announcement, Dell is the largest company in the world to accept bitcoin as legitimate payment. As more and more companies jump on the ‘bitcoin bandwagon,’ cryptocurrencies seem poised to change the landscape of modern commerce.
Thanks to my colleague Samuel Dunham for his research on bitcoin. His policy brief on cryptocurrencies (and his analysis of potential regulations) can be accessed here.
Photo: Francis Storr (cc).
