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22 The Milken Institute Review

The chances are pretty good that you’ve heard about

Bitcoin by now – and almost as good that you still don’t

know what it is or how it works. Perhaps this will help.

Bitcoin is a brand new digital currency whose sup-

porters argue is the uture o money because it allows

ast, inexpensive and anonymous Internet-based nan-

cial transactions, while eliminating the need or com-

mercial intermediaries to dot the i’s and cross the t’s, or

or government agencies to manage its stability. Detrac-

tors call it a Ponzi scheme eeding the paranoia o con-

spiracy theorists, as well as a tool or terrorists, drug

trackers and child pornographers – not to mention

an economic disaster waiting to happen.

Bitcoin is a product o the Cypherpunk mailing list,

a group o cryptographers with an outsize infuence on

the digital world. The group eectively won the en-

cryption wars, allowing individuals access to technolo-

gies like Skype that rely on unbreakable encryption, a

technology that the government wanted to ban. Some

by reuben

grinberg

Today

Techies,Tomorrow

the

World?

bitcoin

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b i t c o i n

whereas gold miners compete in finding, extracting and

extraordinarily difficult puzzle every 10 minutes around


c a r l w i e n s

R ub GR b RG is a frst-year law clerk at a law

frm in ew York City. He is a recent gradate o Yale Law

School, and has oth achelor’s and master’s degrees

in compter science. Some o the analysis in this article

reects research that is orthcoming in the Hastings Scienceand Technology Law Journal .

o the alumni are notorious or using the In-

ternet to attack government authority. One

o them, Bram Cohen, invented BitTorrent,technology oten used to evade copyright

protection; another, Julian Assange, started

WikiLeaks.

In 1998, a cypherpunk named Wei Dai

proposed a digital currency called “b-money”

to acilitate commerce over the Internet that

could not be traced or regulated by govern-

ments. Ten years later, a programmer work-

ing under the pseudonym Satoshi Nakamoto

– it’s not even known whether he or she is Jap-

anese – gured out how to implement Dai’s

proposal, publishing a white paper on the

topic and releasing sotware or his “bitcoin”

system.

how it works

In many ways, a Bitcoin account is like an on-

line bank account. In both, deposits are

stored in the orm o electronic ledger entries,

and payments consist o orders to credit one

account at the expense o another.

But there are crucial dierences. Bitcoin

relies on peer-to-peer networking. That is, in-

stead o being linked through a central server,each Bitcoin program located on an individ-

ual’s PC is linked to other Bitcoin programs,

which in turn are linked to still other Bitcoin

programs. And each PC contains a copy o

the account ledger that registers transactions

in the system.

Cleared transactions are quickly and auto-

matically communicated to other Bitcoin

programs. This decentralization helps the

system evade eective attacks by hackers, be-

cause penetrating even a large number o Bit-

coin programs would have little eect on the

network as a whole. Note, moreover, that it

also allows individuals to send money directly

to one another without the help o a bank.

A peer-to-peer nancial network is stillpotentially vulnerable to thieves and vandals

who transmit bogus transactions and bogus

copies o the accounts. Nakamoto’s break-

through was to gure out a way to mimic

many o the controls o a traditional nancial

system without enlisting banks or govern-

ment regulators. It’s built around “mining” –

the process that creates and distributes new

bitcoins. Anyone is ree to try to create bit-

coins, in a way that is analogous to prospect-

8/3/2019 22-31MR53


purifying the metal, bitcoin miners compete to solve anthe clock by using brute-force number-crunching capacity.

25First Quarter 2012

ing or scarce mineral. Whereas gold miners

compete in nding, extracting and puriying

the metal, bitcoin miners compete to solve an

extraordinarily dicult puzzle every 10 min-utes around the clock by using brute-orce

number-crunching capacity. Each successul

solution contains a copy o the most recent

transactions made though Bitcoin and be-

comes part o the reshly balanced ledger ac-

count that is distributed across the network.

This exquisitely complicated process makes

orgery o bitcoins next to impossible. Mining

also creates a sense o airness in the way the

wealth embodied in new units o the currency

is initially distributed. With any “at” money

system in which the exchange value o the cur-

rency exceeds the cost o making it, the cre-

ation generates a windall. So when the U.S.

Mint prints another $100 bill at a cost o just

a ew cents, the government makes a hugeprot when it buys things with that bill. Com-

pare that to the way bitcoins are created. Suc-

cess in mining the digital currency, like suc-

cess in mining gold, is determined by a

combination o luck and investment in the

search process. Some geeks invest in the com-

puter power to mine bitcoins and manage to

make a prot at it. But nobody – certainly not

Nakamoto – gets the automatic rst-mover

windall generated by printing greenbacks.

Arguably most important, mining oers a

solution to a problem that dogs every mone-

tary system – maintaining the credibility o

the currency as a store o value by containingthe rate at which it is created. Virtually every

country struggles with this credibility prob-

lem, usually as a consequence o government

decit spending. But even a true gold-stan-

dard system, in which the quantity o money

is outside the control o governments, is at

some risk because the quantity o gold in cir-

culation can change airly rapidly. Indeed, the

food o gold brought back to Europe by the

conquistadors in the 16th century almost cer-

tainly contributed to that century’s consider-

able infation.

Bitcoin solves the sel-discipline problem

by building into the mining algorithm upper

limits on both the rate the currency can be

created and the total amount that can ever becreated. The number o bitcoins awarded or

each puzzle solution is halved every our

years. Today, there are about 7.5 million bit-

coins in existence and 50 bitcoins are awarded

every 10 minutes or so. By 2030, the number

o bitcoins will approach the absolute maxi-

mum, 21 million. No individual or manage-

ment committee has the power to change this.

Bitcoin accounts are pseudonymous, iden-

tiable only by long random strings o letters

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b i t c o i n


c a r l w i e n s

and numbers such as 1Het2qD6Yab9vaLUs-

3JrM1aYMXNSJ42Rdc. This makes bitcoins

as private as cash – assuming that users don’treveal their account labels or otherwise iden-

tiy themselves. Note, too, that it is trivially

easy to create a Bitcoin account, so individu-

als can protect their anonymity by storing as-

sets in dozens or even hundreds o accounts.

Anyone can view the transactions aecting

any particular account on a Web site, blockex-

plorer.com. This openness and transparency

may appear to undermine Bitcoin’s goal o an-

onymity and privacy. But the transactions

data cannot easily be linked to account owners.

the bitcoin ecosystem

Bitcoin was, o course, not used by anybody

when it was released in January 2009. Today,

it is sustained by a constellation o miners,

programmers, account holders and service

providers. Sotware developers, led by Gavin

Andresen, took over the management o themain Bitcoin program when Nakamoto aban-

doned the team.

Technophiles were the rst users because

they were intrigued by a high-tech project

that combined peer-to-peer network technol-

ogy and cryptography. More importantly,

they liked the idea o earning money by

building specialized mining computers,

known as “rigs.” Indeed, the rapid growth o

the mining community means that, on aver-age, a miner can expect to win less than one

competition a year.

To reduce the casino-like nature o mining,

some miners have combined their computing

power into mining pools. These pools win

mining competitions more oten and with

more regularity than miners working alone,

and pay out bitcoins to members according

to the computational power that they con-

tributed. Today, mining pools with names

like deepbit and btcguild account or approx-

imately three-quarters o the computational

power o the Bitcoin network.

All told, the network constitutes the mostpowerul supercomputer in the world. Calcu-

lating at 130 petafops (a thousand trillion

foating-point operations per second), it is or-

ders o magnitude aster than the world’s ast-

est supercomputer, the K Computer in Kobe,

Japan (eight petafops), as well as other com-

putational networks including SETI@Home

(which searches radio telescope data or sig-

nals rom aliens at hal a petafop), and Fold-

ing@Home (which simulates protein-olding

or medical research at our petafops).

Along with attracting technophiles, Bitcoin

has caught the imagination o assorted “gold

bugs” who share Ron Paul’s loathing o theFederal Reserve and are attracted by the ano-

nymity o bitcoin transactions. Since mining

is costly, time-consuming and technical, gold

bugs needed a way to buy bitcoins rather than

create them. By the same token, miners

needed a market or selling their bitcoins. Ex-

changes popped up to satiate these needs, a-

cilitating transactions in a dozen currencies.

For most people, buying bitcoins on an ex-

change is the only realistic way o obtaining

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while the encryption

system protects the integrity

of the Bitcoin network, it

doesn’t prevent the theft of

the information used to verifythe identity of account owners

from their own hard drives.


them. Mt. Gox, the oldest and most heavily

used exchange, is run out o Japan and acili-

tates transers averaging about 50,000 bit-

coins per day. But there are many others; theirtransaction volumes and other statistics are

updated daily at Bitcoinwatch.com.

As the demand or bitcoins began to out-

strip supply, bitcoin prices (that is, their mar-

ket exchange value with traditional curren-

cies) rose dramatically. And this boom

attracted ideological ollowers as well as day

traders and speculators simply out to make a

buck. For example, last May, Rick Falkvinge,

the ounder o the Swedish Pirate Party, a po-

litical party aimed at liberalizing copyright

and patent laws, announced that he would be

putting all o his savings into bitcoins because

(among other reasons) they have “increasedin value one-thousandold against the U.S.

dollar in 14 months.”

Another signicant part o the bitcoin eco-

system consists o the online businesses that

oer goods and services ranging rom Web

development to graphic design to groceries.

But none o the online stores is really ready

or prime time and their prices (translated

into dollars) are much higher than those on

non-bitcoin merchant sites.

Several brick-and-mortar retailers, includ-

ing the Meze Grill, a Mediterranean restau-

rant in New York City, accept bitcoins in pay-

ment. So ar, the customer base is too smalland the risks o accepting a volatile currency

too great to motivate many merchants to ac-

commodate them. This could change, though:

a ew groups have been developing point-o-

sale systems to allow purchases in bitcoins,

using smartphones.

From the beginning, it’s been widely under-

stood that storing bitcoins on a PC is danger-

ous. For while the encryption system protects

the integrity o the Bitcoin network, it doesn’t

prevent the thet o the inormation used to

veriy the identity o account owners rom

their own hard drives. Sure enough, last June

criminals allegedly made o with hal a mil-lion dollars worth o bitcoins rom an individ-

ual with the handle allinvain.

Several sites oer to store individuals’ bit-

coins in an “e-wallet” or protection against

hackers. But the lack o eective regulation

means there is no assurance that the people

running these sites are trustworthy or compe-

tent. Last July, Bitomat.pl, a Polish exchange

that also provided e-wallet services, lost the le

that held all o its customers’ bitcoins. Soon

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b i t c o i n


ater the loss, Mt. Gox purchased Bitomat.pl

and made its customers whole (paying out

17,000 bitcoins, then worth about a quarter o a million dollars).

The bitcoin ecosystem also has a seedy un-

derbelly attracted by the bitcoin’s pseudonym-

ity and ease o transer. For example, Silk Road,

an illegal drug marketplace, allows individuals

to buy marijuana and psilocybin mushrooms

in bitcoins (the contraband is shipped by

mail). Many online gambling sites allow de-

posits in bitcoins, circumventing the ederal

Unlawul Internet Gambling Enorcement Act

o 2006. LulzSec, an online “hacktivist” group

that has participated in a number o high-

prole hacks (including the attack against

Sony’s PlayStation Network that led to an out-

age lasting three weeks), collects donations in

bitcoins to supports its exploits. And though I

don’t know that they have actually done so,

money launderers, terrorists and child por-

nographers could make use o bitcoin.Bitcoin also supports suppressed ethically

gray activities. For example, ater mainstream

intermediaries, including PayPal, Visa, Mas-

terCard and Bank o America cut o avenues

o donations to WikiLeaks, the organization

began to accept donations in bitcoins. Fur-

thermore, individuals in countries with au-

thoritarian regimes, like China and Iran, can

use bitcoins to purchase VPN services. This

means that the provider o the service can’t beorced to hand over the name o its client be-

cause the transaction is entirely anonymous.

financial fraud or the future of

money?

The arguments against Bitcoin all into a

number o categories:

bitcoin is a pyramid scheme

Critics say, in the words o Gertrude Stein,

there is no there there. Individuals invest

money and computer resources in an enter-

prise that creates no value. Early investors are

paid o with money put in by later investors.Eventually, they predict, it will become im-

possible to nd another set o gullible inves-

tors, and the whole thing will end in tears.

It’s true that those who became interested

in Bitcoin early on were able to obtain them

cheaply (or pennies each), since there were

ew competing miners and more willing sell-

ers than buyers. But as tech blogger Brock

Tice points out, early investors in every busi-

ness stand to make a lot o money i the busi-

ness is successul. The reason these investors

invest in the rst place is because they expect

to be rewarded or taking great risk. Thus, the

act that early adopters did so well hardly

means that Bitcoin is a pyramid scheme.

But do bitcoins have any real value? A at

currency is valuable to the degree it can be ex-

changed or goods and services. And that, in

turn, depends in part on whether the quantity in circulation is both limited and transparent.

By these criteria, Bitcoin is no pyramid

scheme. Indeed, the mechanism limiting the

quantity is arguably more secure than the

word o most governments.

bitcoin is vulnerale to speculation

Naysayers argue that the undamentals sug-

gest a bitcoin is worth ar less than the $30 it

peaked at last summer and maybe less thanthe $2 to $3 asking price our months later.

The bitcoin has been proven vulnerable to

market bubbles – no recommendation or an

asset whose value turns in part on the pre-

dictability o what it will be worth next year,

as well as next week.

But this volatility, I suspect, is largely a

consequence o the bitcoin’s novelty – what

might be called its “cool” actor, as shown by

the overlay o search popularity and price –

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$30

25

20

15

10

5

0

Sep 2010

Dec 2010

Mar2011

Jun2011

Sep2011

note: Prices are from Mt. Gox, the most popular Bitcoin exchange

source: Bitcoincharts.com

Price of a Bitcoin in U.S. DoLLarS


as well as more tangible reasons like the lack

o liquidity (small transactions relative to

the size o the bitcoin market can have large

eects on the bitcoin’s price). The mostspectacular asset bubbles in history have

been driven by such market hysteria. In 1637,

a single tulip bulb allegedly changed hands

in Holland or 3,000 forins, roughly 10

times the annual income o a skilled crats-

man. And though the standard accounts o

Tulipmania have been questioned in recent

years, the combination o illiquidity and

novelty – tulips had just been introduced to

Western Europe – surely makes asset prices

more volatile.

O course, i bitcoin survives and is ad-

opted as a medium o exchange by growing

numbers o people, the concept will lose its

novelty and the market will presumably be-

come more liquid.

bitcoin isn’t really ulletproof

While the growth o bitcoins in circulation issupposed to be limited to 21 million, it turns

out that it will be possible to subvert this

limit i a majority o those providing mining

computational power acquiesce to the

change. I think that’s very unlikely. The alter-

ation could not be done in secret, and would

violate the political belies o the gold bugs –

who constitute one o Bitcoin’s biggest user

groups. But to a point, the critics are right:

bitcoin scarcity is not absolutely, positively guaranteed. By the same token, while the Bit-

coin protocol is cryptographically hardened,

it isn’t quite bulletproo. In the end, the sys-

tem’s security depends on the incredible

amount o computational power needed to

prevent a orgery. And i the rewards were

sucient, a government entity, a corpora-

tion or even an individual with very deep

pockets could buy sucient power to attack

the network.

More important, while the Bitcoin algo-

rithm is heavily armored, the ecosystem o

programs and services surrounding it depend

on their own security measures. Indeed, it’s

unclear i there is any straightorward way or

owners to store bitcoins securely. Storing bit-

coins on one’s PC can certainly be dangerous,

as allinvain showed us.

The Bitcoin program developers have re-

cently made the task o guarding ownershipeasier by having the program encrypt the

wallet le – a locked le is useless to thieves.

However, as the developers point out on bit-

coin.org, encryption is not a panacea because

key-logger spy sotware could be used to steal

the password that can unlock the encrypted

les. And, as discussed earlier, paying an on-

line e-wallet provider to manage security is

no guarantee o success, either.

While Bitcoin is supposed to be completely

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b i t c o i n

Bringing down Bitcoin

doesn’t require the

power of supercomputers

— only the means to

compromise a heavily

trafficked exchange.


c a r l w i e n s

decentralized, in practice it has vulnerable

chokepoints at the most popular exchanges

and mining pools. In June, a hacker siphonedabout $500,000 worth o bitcoins into a Mt.

Gox account, sold all o them, and tried to

withdraw the proceeds. According to a Mt.

Gox press release, the hacker somehow ob-

tained administrator privileges on the system

and simply assigned himsel or hersel the

bitcoins. Meanwhile, Mt. Gox’s inexpertly en-

crypted database o usernames and pass-

words was stolen, raising the possibility that

some o the coins were not merely assigned

but stolen rom others’ accounts.

Whereas the bitcoins stolen rom allinvain

and lost by Bitomat.pl merely caused jitters in

the market, the glut o bitcoins or sale cre-

ated by the Mt. Gox hack led the price to

plummet rom $17.50 to a penny within hal

an hour, causing panic and havoc throughout

the Bitcoin world. Mt. Gox rolled back the

trades, restored account balances and prom-ised to harden its security. When trading re-

sumed the market was apparently satised,

because prices rebounded to pre-hack levels.

Nevertheless, the incident showed that bring-

ing down Bitcoin doesn’t require the power

o supercomputers – only the means to com-

promise a heavily tracked exchange.

The mining pools constitute another cen-

tralized target. Malicious individuals have ha-

rassed many pools with what are called “dis-tributed denial o service” attacks, making it

impossible or miners’ computers to connect

to the pools to retrieve the work orders

needed to do their part in the collective.

Then there’s the separate issue o main-

taining anonymity. In theory, it is impossible

to link account holders to their account labels.

But in practice, people leave clues about their

identities when negotiating transactions,

posting messages and transerring bitcoins in

e-wallets. Je Garzik, one o Bitcoin’s devel-

opers, noted that “transaction fow is easily

visible to well-known network analysis tech-

niques” already used by the FBI, the CIA andother government agencies to detect suspi-

cious money fows and chatter. “Attempting

major illicit transactions with Bitcoin, given

existing statistical analysis techniques de-

ployed in the eld by law enorcement, is

pretty damned dumb,” Garzik argues.

Last but not least, Bitcoin aces legal risk.

Elsewhere (http://papers.ssrn.com/sol3/papers

.cm?abstract_id=1817857), I’ve analyzed

some potential issues in the United States –

among them, securities regulation and the

ederal government’s legal monopoly on cre-

ating money. Applying existing laws to Bit-

coin is like trying to stick a square peg in a

round hole. Refecting the resulting uncer-

tainty, the Electronic Frontier Foundation

stopped taking donations in bitcoins, statingthat “we don’t ully understand the complex

legal issues involved with creating a new cur-

rency system.”

bitcoin is deflationary

Paul Krugman, the columnist and Nobel-

prize winning economist, argued in his New

York Times blog that “what we want rom a

monetary system isn’t to make people hold-

ing money rich; we want it to acilitate trans-

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actions and make the economy as a whole

rich. And that’s not at all what is happening

in Bitcoin.” He argued that the fipside o the

bitcoin’s rising dollar value (the post waswritten during the bitcoin bubble) was alling

value or goods priced in bitcoins. In other

words, “the Bitcoin economy has in eect ex-

perienced massive defation.”

Two actors indicate that defation in bit-

coin may not be all bad. First, who is to say

that the “right” use or Bitcoin is as a ully liq-

uid currency used to buy and sell services?

What i the “right” use is as an asset or as some

orm o currency-hedging mechanism? Sec-

ond, and more important, it’s unclear whether

Krugman’s argument makes sense or a cur-

rency that lives side-by-side with traditional

infationary currencies. No matter what the

crackpots say, the bitcoin is not going to re-

place the dollar, euro or yen anytime soon.

where to?

I’m cautiously optimistic about Bitcoin’s u-

ture. Everyone in the Bitcoin community, in-

cluding the exchanges and main Bitcoin pro-

gram developers, is taking security more

seriously. And the variety o goods and ser-

vices that can be purchased with bitcoins is

increasing every day. On the other hand, it

shouldn’t be orgotten that the advantages o

bitcoins – anonymity, decentralization, secu-

rity rom government regulation – are greater

or illicit transactions than licit ones.

As an investment asset or those who are

bearish on government-at money vulnera-ble to infation, bitcoins are inerior to gold

and other precious metals that are liquid,

widely available and pose no exotic security

issues. And as a means o exchange, the bit-

coin is ar inerior to cash, PayPal and plastic.

Why go through the laborious process o buy-

ing bitcoins in order to buy goods? Why main-

tain liquid asset balances in bitcoins that

might lose 99 percent o their value overnight?

Bitcoin is like the Web beore the advent o

all the technologies that made it so useul or

non-techies. Back then, it was nearly impos-

sible to nd anything o value on the Internet

– pioneer surers will remember clicking

through pages and pages o irrelevant Alta-

Vista results. Businesses that had Web pages

did so more to seem edgy than to make sales.O course, the Internet eventually became

a critical part o our society and economy,

with technology making it easier to nd

things, and a combination o scope and scale

increasing the value o what there was to nd.

The potential o Bitcoin – more generally, o

a decentralized, sel-regulating currency – is

similarly imponderable and similarly eared.

My hunch is that it will prove revolutionary.

I’m just not sure how or when. m

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