Let's talk money, digital money!

Alrighty then, I'm going to assume that everybody has some basic understanding of the concept of money. Next, I assume you all have some idea of how to spend money online using things like paypal, credit cards, debit cards and so forth. Also, the reason nobody that people shouldn't be able to steal your details and thus your money, if it's all done right, depends heavily on crypto. Best way to explain what I do, is to ask "Have you ever bought anything online?" When they answer in the affirmative, then I say "You're welcome."

All levity aside, let's talk about money. Money is official looking paper and bits of metal that carry some value. This value is backed by some central authority. This would normally be the central bank of the country, but could be larger such as the Eurozone. There's a whole lot of economics behind how and why this works, inflation, deflation, devaluation, exchange rates etc that I don't even pretend to understand. We all accept this at face value and move with our lives.

In the online world, it's basically the same thing. The authorities may have changed to credit card issuers, certification authorities and others, but the principle remains the same. Now, this idea doesn't sit too well with the über-privacy people. They are now afraid of all the digital "paper trail", if you will, that is created by all of this. They say that if we can use crypto to secure our transactions, then why not use it to preserve our privacy and create anonymity.

Well, there is quite a lot of cryptographic research in the field of what we like to call e-cash. All this research is completely agnostic of the economic aspects and focuses on the crypto stuff. Until a few days ago, I thought there was no real implementation of any sort of e-cash. Then I heard about Bitcoin. Just as a brief side-note, cryptographers love coins. It's some what of a convention that all randomness is generated using coins and that all e-cash schemes are described in terms of coins. There is good reasoning behind it, but I shan't go into details.

So, back to Bitcoin, which is "the first decentralised digital currency" according to the introductory video. They then go on to explain how it all works and what the advantages are. I'll just recap it for you, for completeness. Bitcoins works using identifiers called addresses, which are essentially random strings. Each user gets 1 when they download the client software. They can then create more so as to have different types of payments come and/or go to/from different addresses. All of these are tied to the same wallet. So if person has addresses a and b then sending money to either address would be the same. This is how anonymity is preserved.

When Bitcoins are sent from person to person, the transaction is hashed and signed. The hash value and digital signature are then verified by the the other users in the system. Once a transaction is verified, the Bitcoins are added to and subtracted from the relevant accounts. This is the decentralised aspect. In normal e-commerce transactions, the verification would be done by a centralised authority such as a bank or clearing house. With Bitcoins this is done in a peer-to-peer (P2P) manner. Another interesting thing is that Bitcoins are super divisible. You can go down to 0.00000001BTC. Which is the advantage of having a digital currency.

So I thought I'll give this a try. So, I downloaded the client software and started reading through the literature and all the wikis and got a feeling for how this all works. There is a whole sub-culture built based around bitcoins and it is quite fascinating. There are entire forums and IRC channels dedicated to the provision of trade in and using Bitcoins. However, as I dug deeper I discovered two very interesting points.

Firstly, Bitcoins are more of a commodity than a currency IMHO. I would like to think of Bitcoins as digital gold. This analogy is fairly apt given the way the currency works, especially with respect to generation. The generation of Bitcoins is called "mining" and involves essentially finding a pre-image for a hash function. Now this requires huge amounts of computations, but once done, a "block" is created. The creation of this block gives the creator some Bitcoins, at time of writing this stands at 50BTC. For those of us that do not have a super computer, there are still options.

The basic technique is called "pooled mining." Here what you do is you combine your computational power and split up the profits according to how much work you did. One way of doing this, if you have a reasonable large amount of computational power, is to join a mining pool. There are several ways this can be done and there are a few technical details that need to considered. Mostly these depend on a central server, which is ironically what Bitcoin was trying to avoid. For those of us with less computational power, there are alternatives, such as this (BTW if you are feeling really nice, you could try and generate a few coins for me here or you could  just send some to 1KbnDDaS3UTAMZkqHSJwGuWgdApQr3wAqp).

However, there are other ways. Carrying on the gold analogy, there are people who own gold but have never even been near a mine. How? They buy it! The same goes for Bitcoins. There are some marketplaces where you can buy and sell Bitcoins for real money. It's fairly easy to compare to say a fresh fish market, let's say. Basically, the fishermen catch the fish (in this case they mine Bitcoins) and then go to a fixed place to sell it. The public knows this place and come there to buy some fish (or in our case Bitcoins). The reason I use the fish market analogy is that there is some haggling and negotiations involved, which is not unlike the Bitcoin marketplaces. In this places you can buy and/or sell Bitcoins for USD, GBP, EUR, or even SLL, the currency of Second Life. Not kidding on the last one.

Which sort of brings me to the second point. Even though Bitcoin is supposed to be decentralised, it seems to be doing it's best to achieve the exact opposite. The whole idea is to not trust this one monolithic central institution, but instead distribute the trust amongst all participants in the system, that is using P2P. There is always some sort of large trust placed in central entities, of varying size, but the point still remains. Transaction verification is still very much P2P, but not much else is. And therein lie the problems.

"With great power comes great responsibility" said Uncle Ben, rightly so. In the mining context, there are ways that servers and miners can cheat. The details of this are fairly technical and thus I will skip them. The essence is that if you control a large enough share of the mining pool, you can control the outcome of the pool, in that who receives how much money. Some people would argue that such attacks are infeasible, but I think they are possible. Further more, with all the multiple currency exchanges, it's not unlikely that somebody could be making, or trying to make, money speculating of price rises and drops. The problem here is that because it's so decentralised, there is the risk of somebody "making a run on the currency." I'm not entirely sure I know how that works, but I believe them.

The most recent problem that has surfaced is that of theft. All the "money" is stored locally on your hard drive in a single file called "wallet.dat". After reading a few of the forums, it became painfully obvious that everybody knows exactly what this file is and what it does. I thought to myself "That's quite a nice target for an attack". Hey presto, somebody did it. The thing with attacks of this kind is that they are pretty much untraceable. Remember, Bitcoin operates on anonymous identities, so even if you get the address that the money was sent to, you don't really learn anything.

So, there are some really cool things about Bitcoin and some not so cool things. I really have no strong opinions about it either way at this point in time. I am just going to let things develop and see what happens. There is a lot of talk about how these may be used to buy and sell drugs, which could lead to the whole thing being shut down, but we shall have to wait and see.