Satoshi chose a logarithmic mining rate. Should he have gone with an “S” curve instead?

Imagine that you are sitting in your room in 2008, wrapping up some code in C++, which involves peer-to-peer networking, cryptography, and some new fancy verification protocols for something that you just invented with your giant brain called “proof-of-work.”

You’ve just solved one of the oldest computer science problems of all time, moderately impressive given the nascence of computer science. You’ve tested your code extensively and you know it works. It’s time to send your child into the wilderness to see if it can survive.

You are Satoshi Nakamoto and you’ve just compiled the first version of Bitcoin. What parameters do you choose?

These parameters are the easiest parts of the code to manipulate, but perhaps the most challenging to chose. How many Bitcoins should you issue – since they are divisible, where should you put the decimal place? Should they be limited, or not? How quickly should they be disseminated – should it be over a year or a century? How often should transactions be bundled into chunks that allow for checkpoints, the virtual version of a clearinghouse?

He probably chose 2.1 quadrillion base units, or “satoshis” to permit total global dominance in 3 or more financial categories (store of value, currency, etc.) without the need to divide further: if 1 satoshi were worth 1 US cent, then 21 million bitcoins (the ultimate limit) would be worth 21 Trillion US dollars. So he’s safe there.

He probably put the decimal place after the “1” in 100,000,000 satoshis because it puts a much more palatable number in our mouths. Now we’re only dealing with 21 million bitcoins, something that anybody can chew.

He probably chose a long dissemination time to allow for regular people to get involved, and benefit from the technology. 1 week would be woefully inadequate as all bitcoins would be mined by himself and perhaps a few others. 1,000 years seems a bit… optimistic. About ~100 years should do it.

Now, what should he do about the rate? Well, if he knew much about gold, which he did, then he might find it advantageous to mimic the way in which gold has gone from easy to carve out of mountains by the tonne, to sifted in rivers by the pound, to mined by the ounce, to processed by the gram. The harder you try, the less you find. And this is exactly what he did.

Satoshi chose to begin with 50 bitcoins being “mined” roughly every 10 minutes for the first 4 years, with a subsequent halving every four years thereafter: 25, 12.5, 6.25, etc.

But did he chose rightly?

That Bitcoin is a technology is well-established. What is also well-established is that the vast majority of technologies are adopted along an S-curve. In the beginning, early users pick up the tools and begin to tinker, making the tech more useful. This draws in more users and so forth, until the market goes parabolic, and then slowly levels off as the addressable market is saturated.

My bet is that Satoshi considered an S-curve mining reward, but ditched it in favor of the logarithmic function (technically, it’s pseudo-logarithmic, as a logarithm does not have an upper bound. Really, it’s a simple series for n(2)=n(1)/2), just for the math whizzes out there), because he had to make a trade-off. The trade-off was between a) Rapid bootstrapping and securing of the network, and b) Disillusioning the medium-term adopters who might have enthusiastically embraced the technology but feel that they heard about it too late.

It’s a tough tradeoff, for sure. On the one hand, having an initially rising mining reward would have been somewhat exciting, knowing that investing in mining equipment early might position you for thicker profits in the future. Mining would have been a mid-termers game, as opposed to one for early enthusiasts. Instead, all miners know that they have very short – and frustrating – windows in which to snatch a profit before either calling it quits, or reinvesting in more equipment, thus extending their risk.

On the other hand, poorly incentivizing mining in the beginning would have risked the project, which may have fizzled before it got a foothold. Moreover, a competitor, or rather, a clone (let’s call it what it is), could have launched with a more generous mining reward function, and enticed miners to divert their resources accordingly.

The early days were clearly critical to Bitcoin’s success, and the pseudo-logarithmic mining schedule can be credited with securing Bitcoin’s place as king atop the crypto currency realm. That it has resulted in some very wealthy early adopters is a benign byproduct of this choice. Satoshi set the mining reward at full-tilt from the get go, sucking in the time, and imagination, of everybody who followed.

To close, I will reference and not break Betteridge’s law of headlines: “Any headline which ends in a question mark can be answered by the word no.”

Blockchain technology and bitcoin the currency cannot be separated, and it’s time to settle this issue.

During the last six months, many previous Bitcoin skeptics have come out in favor of crypto currency, but have tempered their excitement for “blockchain technology” by dismissing the underlying money associated with it: bitcoin.

As a Bitcoin enthusiast, the author takes special care to encourage anybody who finds a use case for Bitcoin (capitalized “B” refers to the protocol, whereas a small “b” denotes the currency). And because Bitcoin is many things, and can be many things in the future, it makes sense to invite everybody into the proverbial tent. After all, they might find something else that they like too.

In this article, we’ll explore a little bit about the fact that Bitcoin is two things – a protocol and a currency – but will also make the argument that they are inseparable. The two complement one another, and alone, each would wither.

Let’s begin with what Bitcoin is as a whole, and then move into why the currency component is more than a footnote.

At it’s core, Bitcoin is a ledger. Ledgers are easy. People have used ledgers for all of recorded history, and likely beforehand. After all, informally trading favors with friends can be seen as one of the first implementations of a ledger. I owe you, you owe me. You don’t have to write it down, but you can.

More complex relationships require a formal ledger. When groups of people trade on behalf of one another, perhaps in the form of a farm (or company), they need reliable data to track what is going in and what is going out. How much corn is in the shed? Who has the shovel? To whom did we lend our ox cart?

Keeping a ledger is easy, but keeping it honest is hard. Ledgers are subject to honest mistakes, but also to fraud (Enron, Bernie Madoff, etc). The important question is not what is on the ledger, but rather, who is in charge of it, and can we trust its contents?

The solution to this problem has been a process of institutionalizing bookkeeping practices, and for the most part, it works pretty well. Large corporations such as banks, insurance companies, and credit card companies don’t necessarily thrive because they can manage their books better than others, but rather because they have built up trust among their customers for many years. The trust that they engender is that the ledger you rely upon will be the same across the board. And this trust is something that humankind has had to place in the hands of small groups of people, until now.

Bitcoin provides the first example in history of a ledger that you know is accurate, but which you don’t have to trust any individual or group of individuals to maintain. It’s a kind of ledger in the sky that records transactions as if by magic. This is the essence of Bitcoin, from which all of its promise is derived.

So what about the currency? What about “bitcoin” with a small “b?” Well, it’s the money component. Perhaps money has a bad reputation, or maybe it is misunderstood. For whatever reason, it elicits very strong reactions. For example, witness our lexicon, ‘dirty money’ and ‘filthy rich’, these exemplify a conflicted opinion regarding the accumulation of wealth and by whom (if it’s you, it’s probably a good thing, not so for others). But whether you feel that bitcoin constitutes a viable currency long-term, one thing is for certain: bitcoin is the only way to achieve a globally trusted ledger.

The level of trust in the blockchain is directly proportional to how difficult it would be to corrupt it, or to control it unilaterally. And this level is easily observed by the amount of energy which is being expended to secure it. This energy comes from people – anybody – who devote processing power to searching for bitcoin the currency. Known as “mining,” under the hood it represents a self-interested activity that processes transactions and assures their fidelity as a byproduct. That’s right. The incentive to earn bitcoin comes first, and the network comes second.

When bitcoin was simply funny money that people traded for pizza (look up the 10,000 bitcoin pizza story for reference), the blockchain was weak. It limped along hopefully, pleading that nobody would fire up 10 laptops and mess with its sacred transactions. As time passed, the network strengthened. More and more people began to “mine” after they heard about a new, secure and limited currency that couldn’t be counterfeited, which could be transferred to anybody across the globe, instantly, and for no fees. This currency was just a ledger. But then again, money might just be a ledger too. It always had been, to some degree. Even the most traditional individual still holds the majority of their cash in bank accounts, which are just 1s and 0s on a database. Not only is this money not tied to something tangible, such as gold, it doesn’t even exist as physical cash in a vault because banks are permitted to lend much more than the reserves they hold.

In short, without the incentive to mine bitcoin, there is no security, and without security, there is no blockchain. The two are inextricable. The blockchain can be separated from bitcoin, but then what would it be? It would revert back to a simple ledger, something that anybody can keep with a cheap computer and a version of excel. The piece that new advocates are missing is that a ledger secured by a third party is par for the course – but a global, audited, real-time, ledger that you can trust must be secured by its own currency.

Could we replace bitcoin the currency, renowned for its volatility, with an existing one? At first, this may seem like a good idea. But where would this currency come from? Who would pay for it? The wonder of Bitcoin is that the issuance of its underlying currency is tied to its security, with no bounds. If bitcoin is cheap, the network is weak. If bitcoin is dear, the network is strong. The currency has to originate from within the system to support the system. Any external party who pays for the security, or who tries to implement a set of guidelines for how the currency is valued (perhaps with some algorithm that pegs it to a particular CPI or fiat currency such as dollars, euros, or yen) will reintroduce the trust of a third party, the avoidance of which was the whole point to begin with.

The Bitcoin blockchain is beautiful, and its new advocates are close to understanding it fully. MasterCard, Goldman Sachs, and the US Government already have their own blockchains. They can build on theirs, but you can’t, and that makes all the difference.

Look out! Things are not always as they seem.

One of the most arresting thoughts is that what you perceive as normal might actually not be true.

Although different in many ways, I find that astrophysics and economics have a lot in common. Specifically, both require an adequate sense of scale when examining the system appropriately. In addition, provable truths in both can seem to contradict our personal experience.

Take relativity theory, for example. One basic principle is that if an object accelerates in relation to another, that time slows down for that body. Furthermore, being subject to a gravitational field is equivalent to accelerating, oddly. Braving the hazards of illustrating general relativity in three sentences, I’ll finish with the fact that your head is older than your feet, by virtue of the fact that your feet spend more time closer to the earth’s core.

This isn’t just postulation. It’s a fact. If you take two synchronized watches, and put on in an airplane that circles the globe a few times, and then bring them back together, the intrepid timepiece will run ever so slightly behind its twin. But why is this important?

The reason that it is important is because details matter. From esoteric observations of stars in different galaxies, to calibrating satellites, we need the details to get the answer right. Every time that you let Siri guide you in your car, you rely on the GPS system keeping proper time – relative time, that is – to get you where you want to go.

Money is the same. On the surface, it’s pretty simple. At all points of observation, it appears to behave as it should. You earn it, put it in the bank, take out cash, send payments, spend it with your credit card, put it back in the bank, and so on. From a very narrow perspective, fiat currency works just fine.

But applying the concept of scale, we might become a little uncomfortable when broadening our scope. In this case, time is the most appropriate ruler. Just as we can’t perceive our heads as older than our feet, we have trouble finding fault with our money.

Fiat currency has two black marks against it. One is a terrible track record of devolving into hyperinflation, and the other is its inability to stand up to systemic analytical muster – in short, unbacked fiat currencies are impossible in the long term, completely unsustainable.

To address the first: it may be that the US dollar has operated more or less properly during the last 40 years. But time is not on its side. By historical standards, it is well past due to flutter off into the pages of failed currencies.

To address the second: I won’t belabor the details, but suffice it to say for our purposes that fiat currency is created through the issuance of debt, meaning that today’s money is debt. When we create more of it, we create more debt, and when we pay debts off, money is destroyed. But the basic equation at play is that from the moment currency is created, debt begins to outpace it. From a 30,000 ft. view, debt must grow faster than currency, and as such will consume the latter eventually.

So why is this relevant to us? In the same way that misapplying the theory of relativity would result in confused satellites which would ping geographic coordinates that drift ever so slowly across the earth, putting us farther from our destination with time – maybe imperceptibly so -, relying on fiat currencies carries its own risk and repercussions, not least of which is a pervasive and uneasy drift towards economic inequality and poverty. It happens slowly, incrementally, and no matter how hard you might stare at the $20 bill in your wallet, you won’t find the inherent flaws that are causing the problem, real as they are.

If fiat currencies are doomed in general, then what should we do? Well, if history is a teacher, those who favor real assets such as gold, stocks, and real estate tend to do better than those who hang on, but only during the last stages. Admittedly, timing this stage is incredibly difficult. But even if you don’t know when it will happen, you can still be certain that it will happen.

Bitcoin may not be a viable alternative, but in my estimation it will be. Despite its growing pains and volatility, it does provide a compelling alternative, something that isn’t created or destroyed through the credit creation process.

There may come a day in the next few years when people’s psychology switches from worrying about not being the first one into Bitcoin, to worrying about being the last one out of fiat. Although not imminent, this transition can occur incredibly fast, over the course of months.

So look out! Perhaps your fiat system is not as it seems.

“Proof of reserves,” born out of tragedy, will slowly become the global gold standard for financial auditing.

How bizarre that common criticisms of Bitcoin revolve around the issue of trust, or lack thereof. Perhaps more than any other point, Bitcoin beats most modern standards on the issue of “trust” hands down. As the world wakes up to this fact, the new concept of “proof of reserves” provides a valid contender as the vanguard for a large shift in perception by the public.

But first, let’s look at some of the trust-based concerns that get brought up time and again.

Example #1: We don’t know who made Bitcoin, so how can we trust that somebody won’t just print more of it?

Implicit to this statement is the contention that the purveyors of fiat currency can be trusted to analyze the economy and decide precisely how much money to add or subtract from the market, facilitated by the manipulation of interest rates through open market activities. Maybe they can, but that Bitcoin will maintain the 21 million hard limit is so assured as to be almost 100% certain. Whether this is a good idea may be cause for debate, but that you can trust it to be so is not.

This opinion is simply born out of ignorance for how the blockchain is maintained by powerful incentives that provide distributed security and consensus. There is no governing body to appeal to, no man behind the curtain, and even if somebody were to commit financial suicide by spending the 100’s of millions of dollars necessary to mess with transaction confirmations, they would still fail in coercing the Bitcoin community to adopt and use a currency with a more flexible supply. It’s just not going to happen.

Example #2: Bitcoin isn’t regulated, so we can’t trust that crimes committed involving Bitcoin will be subject to the rule of law.

Up until last year, this argument actually held water, but not because of anything inherent to Bitcoin. Rather, it was a failure of authorities to recognize Bitcoin as property with value (whether currency, commodity, or otherwise). Because it was new, and hard to understand, police who were notified of Bitcoin thefts initially laughed it off as kerfuffles over internet geek points.

But that has all changed. Even without strong regulatory guidance, the powers that be have already cracked down on notorious scammers (or incompetents) such as Trendon Shavers and Mark Karpeles, applying existing law to the process of investigation, prosecution, and restitution. And they didn’t miss the chance to hunt down the anonymous Silk Road kingpin either. Bitcoin has gone mainstream with respect to ownership, theft, money laundering, and acceptable uses. Whether you agree with those laws is a different matter.

Example #3: Banks have to meet certain standards and reporting requirements whereas companies that use Bitcoin can do so anonymously – we can’t tell what they are doing with the money.

Anonymous it may be, but only in the weakest sense. On the contrary, the immutable paper trail of every transaction ensures that Bitcoin is 100% traceable, and 100% transparent at the protocol level. This record is open to any member of the public, and can be viewed and analyzed to no end.

After the fall of Mt. Gox, skeptics were right to criticize the poor business, security, and accounting practices that are now apparent, but while they were still busy bashing Bitcoin, they missed one of the most revolutionary innovations in financial auditing to emerge in the last century: The “proof of reserves.”

Eager to convince their customers that they were solvent, Bitcoin exchanges and brokers worldwide offered a simple yet effective guarantee in the form of a digital signature (a secure cryptographic principle used in all industries). By pointing to an address on the blockchain and then providing proof that they were in control of those coins, they were able to immediately put everyone at ease. Sure, the coins might still get stolen at some point (let’s not claim an early victory), but at least we knew they were there.

Think about the possibilities for proof of reserves, or its cousin, proof of use. How would you feel if, instead of getting a quarterly report from the companies in which you have invested, you actually had real-time visibility into their finances? Companies might not like this idea, but I expect that their shareholders would, particularly in the case of banks or insurance companies.

Or consider the public institutions that we hold accountable with the fiscal health of our nations. Wouldn’t it be nice to see how much money is “in the vault” and where it is being spent? Governments should be in favor of such radical transparency because, after all, as they frequently remind us, if you have nothing to hide then you have nothing to fear…

The possibilities are quite limitless. Even an individual, say a homebuyer, could do away with the onerous process of vulnerably displaying their finances to the lender, who pores over their net worth and questions their transactions. One day you may be able to simply send an email with a digital signature: “My name is Satoshi, these are my coins, and I would like to buy this house now. Thanks.”

Going forward, this will undoubtedly be a consumer-driven process. If Bitcoin exchanges and brokers continue to use this honorable standard, then it won’t be long before the rest of the public wakes up to the bright and trustworthy future that we can engender from the proper application of a humble crypto currency.

Credit cards vs. Bitcoin (Part Two).

[Continued from Part One]

If Bitcoin can’t beat credit cards based on transaction costs alone, then what can it do?

At this point we’ll pull back from the microeconomics of transactional efficiency and take a 30,000 ft. macroeconomic view.

Bitcoin’s greatest strength is that it has many strengths. But this can sometimes make its message confusing. Is it a currency? It is a payment system? Is it an ownership ledger? Is it a commodity? The answer to all of these questions is “maybe.” It really depends on what happens in the future – what people make of it. Similarly, take an ordinary piece of cloth and ask if it is a blanket, a dress, a sack, or a sail. It certainly could be. It could even be all four. But what is it best at being? Nobody knows yet. People have different opinions, but only the future holds the definitive answer.

Possibility 1: Bitcoin begins acting like a currency.

If Bitcoin fulfills its promise as a means of exchange and a store of value, then it can get an adoption boost by merchants who will discount their prices even further than the transaction cost savings because they expect Bitcoin to rise in value.

The advantage of this dynamic is that it doesn’t matter whether fiat currencies are falling, or Bitcoin is rising. All that matters is the differential. As long as Bitcoin undergoes a steady and prolonged increase in value vs. the dollar, euro, yen, etc., it will be immaterial whether these currencies are falling precipitously against goods and services, staying steady, or even increasing in value.

Possibility 2: Global recession pressures slaughter the credit companies’ cash cow.

Depending on your economic world view, you may believe that the world is teetering on the brink of collapse, or in the early stages of a full blown recovery. Regardless of which scenario you find most likely, it always helps to at least acknowledge the historical precedence for sharp corrections in stock markets, bonds markets, and currency markets.

In particular, some worrisome developments are that the largest banks are about 30% bigger than they were before the 2008 recession – creating the possibility of very large systemic risks, debt to GDP ratios have increased in almost every Western nation, and global stock markets are near all time highs at the same time as underemployment figures – indicating a disconnect between valuation and production.

If the world undergoes a new recession, it may very well be a sovereign debt crisis. At the very least, the “good” credit card customer pool will certainly be diminished, perhaps dramatically so. As a result, in the same way that banks slowly eliminated the interest paid on regular bank deposits from 5%+ to almost 0% over the last 15 years, credit card companies will feel the squeeze and see their earnings become more reflective of transaction revenues than revolving debt. Essentially, the rewards programs will vanish, along with the competitive edge that credit cards have over Bitcoin as a means of payment.

Possibility 3: The only way to beat a credit card company is with another credit card company that uses Bitcoin.

Even if the above two scenarios do not pan out – i.e. Bitcoin doesn’t grow into a proper currency and the world chugs along without hyperinflation – there is still the remaining fact that credit card companies are very sensitive to cost, and that using the legacy ACH/SWIFT banking “tubes” generates a lot of unnecessary overhead.

So this brings us back to the transactional efficiency of Bitcoin. If you can’t beat them, join them. A credit card company that properly integrated the Bitcoin payment mechanism into its business could reduce many underlying costs that it currently takes for granted. As a result, it could pass these cost savings on to its customers in the form of even more generous rewards. If you thought that 1% or 2% was a good deal, how would you feel about 7% cash back?

Surprisingly, in this respect it may not be the merchants, nor the consumer who would benefit the most from Bitcoin, but rather the credit card companies that seem so obviously at odds with the world’s favorite fledgling crypto currency. And once one company executes correctly, the others will have to follow suit to keep up.

Conclusion: Whatever its going to be, it’s going to take a while.

Every day brings us closer to figuring out what Bitcoin will grow up to be. But progress takes time, code takes coding, and business takes building. Wherever Bitcoin ends up in 10 years, I’m sure it will surprise us all (hopefully in a good way).

Credit cards vs. Bitcoin (Part One).

Doing a head-to-head comparison between Bitcoin and credit cards may seem to be a reasonable exercise. At the till, given the choice between the two, what would you use?

Because Bitcoin can enable cheap transfers, merchants have an incentive to accept it over credit cards. On the front end, they are the parties who eat the 1.5-3% commission + $0.xx flat fee (for small transactions), and see it on their balance sheets. So naturally, merchants would be intrigued by a payment option which cuts these fees off at the knees: specifically, a 1% solution from Coinbase or Bitpay, or a ~0% solution using native Bitcoin, but with the associated volatility risk of bitcoin.

It hasn’t happened in earnest yet, but the next step in the puzzle is merchants recognizing that they can afford to offer a discount to Bitcoin-paying customers. But how much is needed before they can compete with credit cards? The unfortunate truth is that it may actually be impossible for Bitcoin to beat credit cards relying on its cheap transaction costs alone.

The headwinds that Bitcoin is pushing against are customer rewards programs. 1% cash back is completely standard nowadays, and depending on an individual’s card usage, or the location of their expenditures, 5% cash back is quite common too. But here we encounter an apparent paradox. For the 5% cash back on Walmart gasoline, even if the merchant is being charged a full 3%, where does the extra 2% come from? Surely the credit card companies can’t afford to take a loss in this manner.

The answer is somewhat complicated, and a bit obscured on purpose by credit card companies that don’t necessarily want to divulge their secret sauce. But the basic answer is that there are three types of customers whom credit card companies serve: good, bad, and risky.

Good customers are the bread and butter of credit card companies. These are people with steady jobs, and decent cash-flow, but who also have a tendency to carry a balance on their credit cards, or to use credit cards when cash is tight to get them through tough spots. This Goldie Locks customer is just right: not too reckless, not too responsible.

Counterintuitively, bad customers are actually those who have great credit. They take advantage of sign up bonuses, pay attention to limited-time cash-back offers, and pay their balance in full every month. In the industry, these people are known as freeloaders, because in the long run, they receive a net-positive financial benefit from the use of credit cards.

Risky customers are the ones who might actually generate substantial losses for credit card companies. These include chronic late payers, people about to undergo personal bankruptcy, and outright scammers and fraudsters. The money and time that credit card companies spend to keep these people away is well worth the money saved.

So now that we understand a bit more about a credit card company’s business model, let’s have a look at the revenue sources. Remember that transaction fees are just one source of revenue for the entire business, and it generally accounts for about 1/3rd of total revenue (depending on the company, of course). The remaining 2/3rds is generated through annual fees, late fees, balance transfer fees, over-limit fees, merchant promotions, and the mother-lode of credit profit: interest charged on balances, which averages 13-24% annually.

At this juncture, our comparison between Bitcoin and credit cards reaches an impasse because we are no longer evaluating apples with apples. If credit card companies made all of their money off of transaction fees, then Bitcoin might have a fighting chance. But in reality, all of the “good” customers are subsidizing the very generous cash-back and rewards programs which incentivize more and more people to use credit cards whenever and wherever they can.

This means that merchants accepting Bitcoin could theoretically pass on the entire amount that they would save in transaction fees as a discount to their customers, and it still wouldn’t beat the cost to consumers of credit cards. That is because the merchant isn’t picking up the whole tab. The remainder is mostly coming from consumers who maintain a revolving credit balance every month.

In part two of “Credit cards vs. Bitcoin” we’ll have a look at how Bitcoin might still be able to create an edge against credit cards in the long run.

[Continued in Part Two]