Tag Archives: Bitcoin

Bitcoin and government regulation

Governments are starting to regulate Bitcoin and other cryptocurrencies. Is this good or bad? Why? Norbert Michel and I wrote a Heritage Backgrounder piece on Bitcoin and other cryptocurrencies, Bits and Pieces: The Digital World of Bitcoin Currency. We discuss the main aspects of Bitcoin without getting into technical details. We also discuss some of the possibilities for the future and indicate ways that the government can adapt to stay out of the way.
We don’t really take a stand on whether Bitcoin itself will succeed; time will tell that.
We do point out ways that the growth of Bitcoin and other cryptocurrencies could be throttled by government regulation and laws and suggest ways to avoid that outcome.

Are Bitcoin Mining Pools a Natural Monopoly?

Bitcoin relies on competitive mining to add new blockchains, thereby finalizing transactions and creating new bitcoins.

If there is a monopoly in mining bitcoins, then Bitcoin fails to achieve a design goal of having an open process which does not rely on one trusted entity such as a private firm or a central bank. The monopolist must be trusted or else Bitcoin falls apart.

Miners solve a computational problem: finding a hash less than or equal to a target value. Miners are participating in a contest to be first and the winner takes all.

Miners face the risk every period that they will not win; if they lose, they receive zero. Miners reduce this risk by combining in pools of miners and sharing the payoff when a member of the pool finds a hash less than the target value.

By itself, if all miners are risk averse, the optimal strategy is to form a single mining pool. Furthermore, even if there is more than one pool, a risk averse miner is better off joining the biggest pool if all the pools are the same in all other respects. The bigger the pool, the less risk an individual miner faces.

distribution of mining

Distribution of mining for four prior days on July 4, 2014

There is a tendency toward a natural monopoly in mining due to this pooling of risk in mining pools. This does not imply that a monopoly is an inevitable result or even a particularly likely one. After all, there is more than one pool. The attached graph shows the distribution of payouts on July 4, 2014 for the prior four days. At times, Ghash.IO has included 40 to 50 percent of all mining activity.

Why is there more than one pool? One answer would be that mining is on its way to becoming one pool and it just has not gotten there yet. A different answer consistent with differences across pools is that pools have different payout schemes and other characteristics which appeal to different miners. If differences across pools are the explanation for there being more than one pool today, there is no necessary reason there ever will be just one pool. A third answer would be based on the behavior of pools that become more dominant. As a pool becomes more dominant in miners’ computations, its terms to miners become less attractive. Possibly this third answer is part of the explanation as well.

All of this is assertion with the underlying argument. The following discussion inevitably gets somewhat complicated to support the assertions. I have tried to make it as clear as I can and avoid technical details.

The Details

Mining is organized into pools of miners. For some time, a single miner with one computer has not been able to mine on his own without highly variable returns. While mining is organized as a contest to be first, finding a hash less than or equal to the target hash is a matter of computing hashes and searching over an extremely large space to find a hash less than or equal to the target. Directed search is useless because nearby hashes bear no relationship to each other. Skill in searching is non-existent; search might as well be random over the space.

The variance of returns from mining alone is substantial. Illustrative calculations show how high the variance is.

One bitcoin mining calculator shows that a mining rig with a hash rate of 1,650 Gigahashes per second would break even on its initial outlay of $1495 after 86 days if it receives the expected revenue each and every day. It also shows that the expected time for the miner to find a block on his own is 507 days. If this block pays off roughly $600 for each of the 25 bitcoins, this is a payoff of $15,000. The implied variability in the time to payoff is huge.

This can be seen in a way which illustrates the issue more directly. Suppose that the difficulty were constant at 16,818,461,371, the total number of mining Gigahashes per second (Ghash/s) were constant at 143,627,333 Ghash/s and the payoff of 25 bitcoins also were constant with a price of $600 per bitcoin. (Other than the prices, these are the parameters on July 4, 2104 and the price is roughly $600. Success in finding a winning hash would generate a payoff of $15,000. Nice. Suppose that a miner mines at the rate of 1,650 Ghash/s. This miner has a probability of 0.00115 percent of finding the winning hash value in any ten-minute period.

Mining alone is risky in the sense that one might do quite well, and one might do quite badly.

The probability of success in a ten-minute period is the same as the fraction of total Gigahashes performed by a miner. The probability that a miner with a hash rate of 1,650 Ghash/s would find a hash less than the target in any 10-minute period is 0.11488*10-2 percent at the current difficulty rate.

If this probability of success is constant, mining for a year has a probability of one or more successes of 45 percent. Mining for two years has a probability of one or more successes of 70 percent. Conversely, the probability of not having received a single bitcoin is 30 percent after mining for two years. Even after mining for four years, the probability of not having earned a single bitcoin would be 9 percent. This is a rather bad outcome given the outlay for the mining equipment and the electricity.

Mining in a pool reduces this variance. And the bigger the pool, the more the variance is reduced.

In the limit, if all miners belonged to one mining pool and it always took ten minutes to find a hash less than or equal to the target, every miner would receive a fraction of 25 bitcoins equal to their effort every period. There would be no variability in return. The miner above would receive 17.23 cents every ten minutes, or $24.81 a day. While not grand, after a year this is $9057.19, which is not trivial given the likely outlay. This overestimates the actual likely revenue because the difficulty increases over time and the payoff in terms of bitcoins decreases, but the numbers illustrate the point. If everyone is in one pool, the risk of losing the contest to produce a successful hash is zero.

In these simplified circumstances, pooling ones’ work with all other miners generates a 100 percent probability of earning $18,114.38 in two years. Mining alone has a probability of 30 percent of generating no return at all in two years.

Even if a pool does not include all miners, the variability of the return will be less the larger the pool.

In reality of course, belonging to a pool will not reduce the variance completely. I have abstracted from the possibility that a hash less than or equal to the target will be found in less than ten minutes or more than ten minutes. This is common risk and pooling risk across miners will not reduce it. It is just there in the environment. But pooling risk across miners can reduce the risk that an individual miner will face because they may not be first.

Mining is a contest to be first. Why is it different than other contests, such as athletic contests or contests to become CEO of a company? In those contests, there are skill differences across participants. The contest to be first reveals qualities that have value to viewers, stockholders and others.

The contest to find the winning hash is affected by the number of hashes that can be done on hardware run by individuals and will be affected by downtime which can be shortened by skill. Still, in the end, the search for a hash reveals nothing about miners themselves.

Finding a hash less than or equal to the target does serve useful functions in the bitcoin economy: 1. finalizing transactions; 2. distributing new bitcoins. Those are quite important.

It now would almost be traditional for me as an outsider to say that Bitcoin must change its operation to deal with this difficulty.

I’m not going to say that. Rather, as I indicated in the first part of the blog, I think that other factors will prevent mining from being monopolized. Indeed, for reasons I indicated in my previous blog, I think that it is important that most pools be identifiable and develop reputations. It’s the “unknown” mining pools that are more likely to cause problems than GHash.

Sorry for this being so long but I don’t see how to make it shorter.

 

Bitcoin mining and monopoly

Bitcoin mining has come under scrutiny recently because one mining pool, GHash, seemed to have more than half the mining resources used in mining Bitcoin. Bitcoin mining is important because the bitcoin protocol relies on competitive mining to authenticate transactions as well as to create and distribute new bitcoins.

The existing discussions of this issue are at best incomplete.

It has been claimed by Eyal and Sirer in their paper “Majority is not Enough: Bitcoin Mining is Vulnerable” that they “show that the Bitcoin protocol is not incentive-compatible.” As a result, they have argued for a “hard fork” because it is possible for a miner to gain more than a proportionate share of earnings – new bitcoins and transactions fees – once it has sufficient computing power under its control.

It is important to note what they actually show. They show that it is possible for a participant in mining with sufficient resources to gain more than a proportionate share of earnings by a strategy of mining privately and revealing its new blocks strategically. Revelation occurs when other miners – call them public miners – find a block. If private mining has not found a block, then the private miner moves to the new blockchain and continues. If the private block has one or more new blocks, then the private mining announces those blocks. The new private addition will contain at least one block and sometimes two or more blocks. The greater-than-proportionate earnings come from having more than one block sometimes. The more mining power, the higher is the probability of adding more than one block.

Currently, such a participant would be a mining pool. The practical example which has accumulated on the order of half of mining power is the mining pool GHash.

In “The Economics of Bitcoin Mining”, Kroll, Davey and Felten argue that Bitcoin is susceptible to attacks from determined adversaries who are willing to expend resources to disrupt Bitcoin. They argue, as a result, that Bitcoin inevitably will have a governance structure which is identifiable.

How would an economist, as compared to computer scientists, approach this issue?

First, mining bitcoins is a dynamic game. Equilibrium occurs for multiple periods. Second, miners are not anonymous in the sense that any miner, let alone a mining pool with a large fraction of total resources, is anonymous. To be clear, the identities of the people who are miners may well be anonymous but the miners, as miners, are not anonymous. It is not the case that all peers in the bitcoin universe are treated the same and are unknown. For example, the Bitcoin Wiki lists a number of fallback nodes considered reliable. It also compares the characteristics of mining pools.

In a reputational equilibrium, participants develop reputations and maintain them. The reputations are maintained because failure to do so results in outcomes that have lower value than maintaining the reputation. This is the situation which confronted GHash recently and the pool behaved as I would have expected, taking actions to continue creation of bitcoins.

Mining can be supported by a reputational equilibrium because the game is dynamic, there are a finite number of participants, and at least some participants are not anonymous,. The identities of the participants matter. Any strategy such as switching addresses to hide any particular strategy (such as superseding existing blocks as in Eyal and Shirer) will be evident quickly. For example, other participants would have an incentive to ignore blocks announced by that miner and move on.

This does not mean that the current protocol deals with known attacks, let alone all possible attacks. It does not. In fact, it is not possible to have a set of rules that provides pre-determined actions in all possible states of the world. There is not enough ink or hard-disk space in the world, and there probably still would be unknown attacks no matter how much effort were devoted to thinking of new ones.

A structure to determine the rules for Bitcoin in unforeseen eventualities is inevitable. And it does exist of course as the Bitcoin Foundation. In part, this echoes a point made by Kroll, Davey and Felten.

Bitcoin is not a completely anonymous implementation of a set of rules that can run forever with no human oversight. But then, this is true for open-source software, so it’s hard to see how it could be true for something as complicated as a digital currency.

I am not, of course, claiming that I have shown there is a reputational equilibrium for mining. I haven’t. I have outlined what it would have to look like. There would be a problem completing this analysis though.

The mining protocol creates the observed tendency toward monopoly in mining. In the next week, I will discuss why on this blog.

 

Bitcoin, Regulation and Bitcoin’s Future

Is regulation the likely downfall of Bitcoin? Last week at the conference for the Association of Private Enterprise Education, a session included speakers with differing points of view about Bitcoin’s future. One speaker pretty clearly suggested that regulation would be the downfall of Bitcoin. Is that plausible?

I interpret regulation as being the setting of rules by administrative agencies which are not courts as commonly understood. The “not courts as commonly understood” here is somewhat convoluted, but many administrative agencies in the United States have branches which resolve disputes in some ways similar to resolution by the judges.

With this definition, contract law and other rules applied by courts are not regulation, even though they are very important. Most importantly, there have been few if any court cases alleging fraud in the Bitcoin community. While not rampant, there have been serious frauds. In addition, criminal law is not regulation. For example, theft – taking something of value from a rightful owner — is a crime in most (all?) countries. While there are well known instances of theft – summarized at Wikipedia – nothing much seems to have been done about bringing the thieves to justice.

It is quite likely that fraud and thefts will be pursued more seriously than in the past. Bitcoins are worth far more than in the recent past. 400 bitcoins are worth $20 at $.05 per bitcoin and $200,000 at $500 per bitcoin.

If someone steals 400 bitcoins when they are $.05 apiece, there is not much point in doing anything about it. Of course, there’s not much monetary gain from stealing them either. On the other hand, when bitcoin are worth $500, stealing 400 bitcoins is no small thing. Similarly, someone defrauded of $20 is not likely to do much about it other than learn from the mistake. $200,000 is quite another matter.

It’s hard to imagine that bitcoins will not be subject to much more legal oversight than in the past. This is not the same as regulation.

Examples of regulation include the application of specific laws before starting an exchange for digital currencies compared to laws which apply to any other exchange, for example for collectors’ postage stamps.

Financial regulations have their own nuances. Before starting a bank in the United States, the backers must show they have the skill and assets to successfully operate a bank. They also must show that there is enough demand for banking services to support existing banks and the new bank. This is far different than opening a new grocery store. Still, this arrangement is better than the situation in many other countries, in which there is no effective way to start a new bank.

No doubt there will be attempts to regulate bitcoins along the lines of other financial enterprises. It remains to be seen how effective that regulation will be. For example, if New York state requires a license before someone starts an exchange for digital currency, the only thing affected is the probability that an exchange will start in New York state. It will be zero. If the United States government requires a license before starting an exchange, the only thing affected is the probability that an exchange will start in the United States. It will be zero, although it is not particularly high anyway.

It strikes me as implausible that regulation will stifle digital currencies in a serious way. It is too easy to get around the regulations. For example, Satoshi Dice is said to block U.S. addresses. Even if they are blocked, it is not hard to use Tor to have an address apparently outside the United States.

Bitcoins probably have the greatest immediate potential in countries such as Argentina, which has serious inflation. Inflation generates revenue from the government at the expense of money holders. Bitcoin is an attractive alternative to Argentinian pesos. While U.S. dollars are attractive also, holding them is illegal and U.S. dollars are harder to conceal than bitcoins. Argentina has dollar-sniffing dogs, but a bitcoin has no smell or other physical presence besides a sequence of numbers and letters.

In short, bitcoins are a way to get around regulations. While that may sound nefarious or evil to some, it doesn’t to me. More to the point, it strikes me as a positive for bitcoin’s continued use.

 

Mt. Gox’s suspension and software problems

On Monday, Mt. Gox announced that the suspension of payments would continue because of a software problem. This will not inspire confidence by Bitcoin newbies. The dollar price of a bitcoin at Mt. Gox fell below $600 on February 11. Long term though, such difficulties and responses are inevitable. Protocols in other contexts have these problems, including theft of information on millions of credit cards.

Smart regulation of bitcoins?

Mt. Gox has suspended payments, at least until Monday, February 10. A suspension of payments means that it is not possible to withdraw funds from Mt. Gox. This is not a problem at a small outfit. Mt. Gox was the by far largest exchange for bitcoins at least until the last few months. Mt. Gox seems to have had difficulties redeeming accounts for some time. The problems started about the same time that the Financial Crimes Enforcement Network in the United States started treating Bitcoin firms as money transmitters and reportedly seized accounts in the United States related to Mt. Gox.

It is odd to read a spokesman for the Bitcoin Foundation — Jinyoung Lee Englund — say that the United States has a “smart regulation approach” at the same time this problem occurs.

But then again, maybe creating substantial difficulties for firms dealing in bitcoins is smarter than trying to ban them? The Russian government has announced that bitoins are banned in Russia.

Trying to ban bitcoins is not particularly bright. It shows a lack of knowledge, imagination or both. Bitcoins can be transferred around the world trivially by parties who completely trust each other. Anyone who has bitcoins in Russia can transfer funds abroad if they have someone they trust outside the country. It is equally easy to make the reverse transaction, bringing bitcoins into the country. Maybe bitcoins would be brought into Russia to sell? An institution such as Mt. Gox is not necessary.

 

 

Bitcoin and other digital currencies

Bitcoin has been much in the news lately. I have written a draft of a paper on “The Economics of Private Digital Currencies”. The paper uses Bitcoin to concretely summarize how private digital currencies work.

There are two major innovations associated with recent private digital currencies such as Bitcoin. The first is the settling of transactions by a peer-to-peer network. Instead of settling transactions on the books of a single institution such as the Federal Reserve in the United States, transactions are settled on a network in which no link inherently has more standing than any other link. More concretely, transactions are settled by agreement among participants in the network, for example Bitcoin’s network. The paper goes somewhat into the details without, I hope, becoming tedious for non-programmers.

The second innovation is the creation of exchanges in which buyers and sellers of Bitcoins are “end users” – people how hold bitcoins or want to buy bitcoins instead of agents such as brokers – and the trading is computerized without human intervention. This has resulted in 24/7 trading, which is quite different than trading on organized exchanges. It is more similar to Ebay than the New York Stock Exchange.

Whether Bitcoin or any other digital currency will exist in a couple of years is an open question. A close examination of Bitcoin reveals no inherent design flaws indicating that it will ultimately fail. The question is whether it will be useful. As with many other innovations, this is hard to tell.

The paper is available at http://www.jerrydwyer.com/pdf/digitalcurrency.pdf.