BitCoin & the Disruptive Potential of Cryptocurrency

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14BitCoin & the

Disruptive Potential of

Cryptocurrency April, 4th 2014

Stefano Grazioli

Objective: Assessing BitCoin’s disruptive potential What is it?

What is its business value?

There are No BitCoins

BitCoin “it’s a method of

transmitting money”

A distributed ledger that tracks fund transfers among accounts

‘Block Chain’

2009 2010 2011 2012 2013 2014

Mt. Gox bankruptNov.08

Nakamoto paper

German finance ministry recognizes BTC

as a unit of account

Silk Road shut down by the FBI

‘09 BTC trades at $0.14

Jan.09 Bitcoin (BTC) is launched

IRS recognizes

BTC as property

Use of BitCoin follows apre-existing business agreement RHONDA the merchant

Account XYZ678

“I accept BitCoin Payment12 roses = 0.1 BTCAccount: XYZ678”

“Please send 12 roses to 839 Hilton Rd., Cville, VA.I am sending a transaction (from ABC123)”

SAM the consumerAccount ABC123with secret key Secret123

Fund transfers use public key cryptography to insure non-repudiation and integritySAM the consumerAccount ABC123with secret key Secret123

RHONDA the merchant Account XYZ678

Proof of BTC ownership Sender: RST234 Transfer to: ABC123 Amount: 5 BTC

Digital Signature: 973sdskhu9dft

TransactionTransfer of funds Sender: ABC123 Transfer to: XYZ678 Amount: 0.1 BTC

Transactions are propagated through a P2P network

TransactionTransfer of funds

Proof of ownership

Digital Signature

BitCoin P2P client network

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

SAM the consumerAccount ABC123

RHONDA the merchant Account XYZ678

The peers verify the ownership of funds using the block chain

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

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Digital Signature

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Proof of ownership

Digital SignatureTransfer of funds

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Digital Signature

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Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

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Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

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Digital SignatureTransfer of funds

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Digital Signature

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Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

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Digital SignatureTransfer of funds

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Digital Signature

Unverified transactions

Verified transactions

Transfer of funds

Proof of ownership

Digital Signature

‘Locked’ into the next block

of the Block Chain

‘Block Chain’ of verified transactions

BitCoin P2P client network

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Check

Once in the block chain, the transaction is irreversible

RHONDA the merchant Account XYZ678

Transfer of funds

Proof of ownership

Digital Signature Transfer of

funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

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Digital Signature

Transfer of funds

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Digital Signature

Transfer of funds

Proof of ownership

Digital Signature Transfer of

funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

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Digital Signature

Transfer of funds

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Digital Signature

Transfer of funds

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Digital Signature

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Digital Signature

Transfer of funds

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Digital Signature Transfer of

funds

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Digital Signature

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Digital Signature

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Digital Signature

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Digital Signature

Transfer of funds

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Digital Signature

Transfer of funds

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BitcoinStrategic Analysis

Network Analysis is a better fit than Porter’s Five Forces for many Internet businesses.

Based on Iyer & Davenport HBR 2008

Google Platform

Consumers

Advertisers

Content Providers

Network Effect = when the value of a service changes for the user, based

on how many others adopt it.

We will apply Network Analysis to assess BitCoin’s business potential

Based on Iyer & Davenport HBR 2008

BitCoin Platform

Users

Merchants

Miners

Services: Wallets & Exchanges

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Users and Merchants

An awkward experience

BTC has a poor value proposition for buyers and sellers Low Transaction CostsSemi-anonymousIrreversible10-minute confirmationVolatileDifficult legal remediationTaxed as property

RHONDA the merchantSAM the consumer

The same characteristics make BTC attractive for dishonest playersLow Transaction CostsSemi-anonymousIrreversible10-minute confirmationVolatileDifficult legal remediationTaxed as property

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MinersReward Schema Introduce a Serious Flaw

Verification (‘Mining’) includes a reward to the Miner

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

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Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

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Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

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Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

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Digital Signature

Transfer of funds

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Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

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Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

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Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

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Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Unverified Transactions

Verified Transactions

Transfer of funds

Proof of ownership

Digital Signature

Newly minted BTC that is

owned by the miner

‘Block Chain’ of verified Transactions

BitCoin P2P client Network

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Check

Transfer of funds

Proof of ownership

Digital Signature

Many Miners compete to create the next block and reap the reward

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Unverified Transactions

Verified Transactions

Transfer of funds

Proof of ownership

Digital Signature

‘Locked’ into the next block

of the Block Chain

‘Block Chain’ of verified Transactions

BitCoin P2P client Network

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital SignatureTransfer of funds

Proof of ownership

Digital Signature

CheckCheckCheckCheckCheckCheck

Transfer of funds

Proof of ownership

Digital Signature

Transfer of funds

Proof of ownership

Digital Signature

Mining requires solving cryptopuzzles by brute-force methodsApplication SpecificIntegratedCircuit

1 ASIC = 70,000 Intel CPUs

Source: HashFast

Mining activity is determined by hard economics Avalon ASIC Miner 75 GigaHash/sec Network speed: 140 TeraHash 0.05% of BTC network 0.05% of 3600 BTC /day =

1.8 BTC /day $200/day

Source: Dec. 2013 data self-reported by a miner

BTC has a good value proposition for miners in the short term“Printing money”Rewards ingenuityRapid depreciation

Malicious mining pools can rig the ledger“The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes” – Satoshi Nakamoto

Hashrate distribution from BitcoinX.com, Apr. 2014

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Exchanges &Wallet Services

Weakest point in the BitCoin Ecosystem

Wallet services companies build software that makes Bitcoin easier to use 1,100,000 consumer wallets 28,000 merchants U.S. bank integration

Source: coinbase.com Apr 2014

Source: The wayback machine

Exchanges trade BTC for other currencies

Mt. Gox is no Ft. Knox Feb 7 – suspended

withdrawals Feb 28 - Bankruptcy 850K BTC missing 7% of the BTC supply No FDIC

Mark Karpeles, CEO of Tibanne Co.

The BTC platform is unsecure at its outer edges Sheep Marketplace lost $6 mil Black Market Reloaded lost 200 BTCs Silk Road 2.0 lost $2-6 mil Flexcoin forced to close after hackers stole $590,000 Inputs.io (storage) was compromised and hackers stole

4,100 bitcoins ($1.2 million) in two separate attacks. MyBitcoin and Instawallet, have both shut down due

to thefts

BTC has a fair value proposition for Wallet Services and Exchanges Low transaction costsSemi-anonymousIrreversibleSecurityVolatileDifficult legal remediationTaxed as property

ExchangesWallet Services

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Conclusion“Stay Away!” - Warren Buffett

For the general public BitCoin has low usefulness and ease of use

Services: Wallets & Exchanges

BitCoin Platform

Users

Merchants

Miners

BitCoin has strong network effects

Services: Wallets & Exchanges

BitCoin Platform

Users

Merchants

Miners

Users are the engine for BitCoin’s growth, but do not have sufficient reasons to adopt it

Services: Wallets & Exchanges

BitCoin Platform

Users

Merchants

Miners

As a currency, BTC scoreswell below the DollarJevons’ Functions of Money USD BTC Ideal

crypto currency

Medium of exchange- recognized / accepted

Store of value- constant intrinsic value, or linked to a basket of goods- safe

Unit of account- standard unit of measurement for the value of goods, services, or assets (e.g., Euro 1999-2002, UF in Chile)

Standard of payment- enforceable legal tender

“It is a bubble, there is no question about it.”

“The central problem with Bitcoin … is that it doesn’t really solve any sensible economic problem.”

Robert J. Shiller, Professor of

Economics at Yale

Exhaustion of the pool of Bitcoins will lead to transaction fees

Source: Wikipedia

Total Coins In Millions

2033

: 21

Mil.

2014: 12 Mil.

Satoshi Nakamoto Is The Alleged Inventor of BitCoin

“I did not create, invent or otherwise work on Bitcoin” -Dorian Satoshi Nakamoto

An Experiment by Wired Confirmed The Claims By Miners Butterfly Labs Bitcoin Miner, $274 5.5 GH/s on average Eclipse Mining

Consortium 2 BTC in 10 days.

Source: Wired May 2013 report

2009 2010 2011 2012 2013 2014

“Our best definition would be that it is currently a speculative financial asset that can be used as a medium of exchange”

Dominic Wilson, Chief

markets economist at

Goldman Sachs

BTC is a bubble High volatility Market inefficiencies manifested as

persistent forex arbitrage opportunities

Forex Arbitrage Opportunities Exchange A: BTC = $1,000 Exchange B: BTC = $1,100

1. Purchase 10 BTCs in Exchange A for $10,000

2. Immediately sell 10 BTCs in Exchange B for $11,000

BitCoin is “Evil”

Trust“Any transaction issued with Bitcoin cannot be reversed, they can only be refunded by the person receiving the funds. That means you should take care to do business with people and organizations you know and trust, or who have an established reputation. ”

– BitCoin Website

BitCoin Faces a Long List of Serious Challenges Better articulation of CVP with users Fostering trust in the face of high technical

complexity Credit and interest require legal framework

(regulation) Weeding out illegal uses of currency Required 10-minutes delay in transaction

confirmation Deflationary and recessionary effects of fixed

monetary bases “Fatal flaw” of the verification schema

BitCoin is an electronic payment system based on cryptographic proof “electronic payment system based on cryptographic proof

instead of trust allowing parties to transact directly with each other without the

need for a trusted third party Transactions that are computationally impractical to reverse

protect sellers, and routine escrow mechanisms protect buyers. peer-to-peer distributed timestamp server to generate

computational proof of the chronological order of transactions. The system is secure as long as honest nodes collectively

control more CPU power than any cooperating group of attacker nodes”

A Chain of Transactions [Source] 10 BTC to Paul15

I give 10 BTC to Bob34, signed: Paul15

I give 5 BTC to Mary82, signed: Bob34

I give 5 BTC to Ellen23, signed: Mary 82

…..

The Original Paper Mediation increase transaction costs

Small transactions impractical

Mediated transactions are reversible Increases fraud Reversibility requires trust

An electronic coin is a chain of digital signatures

Source: Satoshi Nakamoto 08

The Double Spending Problem

Source: Satoshi Nakamoto 08

Distributed Timestamp Server

Source: Satoshi Nakamoto 08

Proof of work

Source: Satoshi Nakamoto 08

Network1) New transactions are broadcast to all nodes.2) Each node collects new transactions into a block.3) Each node works on finding a difficult proof-of-work for its block.4) When a node finds a proof-of-work, it broadcasts the block to all nodes.5) Nodes accept the block only if all transactions in it are valid and not already spent.6) Nodes express their acceptance of the block by working on creating the next block in the chain, using the hash of the accepted block as the previous hash.

Simplified Verification

Source: Satoshi Nakamoto 08

Silk Road Dread Pirate Roberts in jail Utopia closed after nine days in D and

NL Charlie Shrem (24) founder of

Bitinstant.com arrested for recycling BTCs

Incentive “the first transaction in a block is a

special transaction that starts a new coin owned by the creator of the block”

“analogous to gold miners” Transaction fees also possible

Mining Profitability Over time is Declining

US Government Stance US Treasury secretary Jack Lew said that he

has decided [on ] a wait-and-see strategy. “From the government’s perspective, we

have to make sure it does not become an avenue to funding illegal activity or to funding activities that have malign purposes like terrorist activities. You know, it is an anonymous form of transaction, and it offers places for people to hide.”

The days of anonymous transactions in Bitcoin and operating an exchange with no outside interference are over. In March 2013, the Financial Crimes Enforcement Network, a part of the

Treasury Department known as FinCen, issued guidance stating that anyone operating an exchange for virtual currencies would be considered to be running a money transmitting business.

That designation means exchanges must collect information about customers, as required under Bank Secrecy Act regulations, which are intended to prevent transactions through anonymous accounts. FinCen went a step further in its guidance by including any person who puts into circulation a virtual currency, which means that the so-called Bitcoin miners are also subject to the regulations. (FinCen last week issued a letter clarifying that users mining Bitcoins for their own purposes would not be considered money transmitters under the Bank Secrecy Act).

individuals and merchants who use Bitcoin like cash do not need to comply with the regulations imposed on those operating exchanges.

The Economist Report ASIC-based hardware the kit paid for itself within three days Between July and mid-November 2013 the

computational capacity of the Bitcoin network increased 25-fold, from 200 trillion to 5 quadrillion hashes per second.

Newer generation of more efficient ASICs in November

Hashing capacity has increased so rapidly in 2013 that the practice of hijacking thousands of PCs and using them for mining is no longer worth the effort

As the rate of transactions increases, squeezing all financial activity into the preset size limit for each block has started to become problematic. The protocol may need to be tweaked to allow more transactions per block, among other changes. A further problem relates to the volunteer machines, or nodes, that allow Bitcoin to function. These nodes relay transactions and transmit updates to the block chain. But, says Matthew Green, a security researcher at Johns Hopkins University, the ecosystem provides no compensation for maintaining these nodes—only for mining. The rising cost of operating nodes could jeopardize Bitcoin’s ability to scale

Bitcoin’s growing popularity is having other ripple effects. Every participant in the system must keep a copy of the block chain, which now exceeds 11 gigabytes in size and continues to grow steadily. This alone deters casual use. Bitcoin’s designer proposed a method of pruning the chain to include only unspent amounts, but it has not been implemented.

As the rate of transactions increases, squeezing all financial activity into the preset size limit for each block has started to become problematic. The protocol may need to be tweaked to allow more transactions per block, among other changes.

The original paper that sparked the creation of Bitcoin has since been supplemented by layers of agreed-upon protocol, updated regularly by the system’s participants. The protocol, like the currency, is a fiction they accept as real, because rejection by a large proportion of users—be they banks, exchanges, speculators or miners—could cause the whole system to collapse. Mr. Hearn notes that he and other programmers who work on Bitcoin’s software have no special authority in the system. Instead, proposals are floated, implemented in software, and must then be taken up by 80% of nodes before becoming permanent—at which point blocks from other nodes are rejected. “The rules of the system are not set in stone,” he says. The adoption of improvements is up to the community. Bitcoin is thus both flexible and fragile.

Explaining BTC’s Limited SuccessPsychological and Sociological reasons Alignment with libertarianism and anarchism No trust required Qualified anonymity Speculative greed Technological novelty Geek factor

Explaining BTC’s Limited SuccessEconomics & Business reasons Low transaction costs Ecosystem Network effects Fraud resistance (maybe) Irreversibility (maybe)