Thursday, May 15, 2014

Review of "Anonymous Bitcoin"

Tax evasion is a crime in all countries, big and small, dictatorships and democracies. All nations want to keep an eye in their money, I mean in their citizens’ money, because taxation is the lifeblood of modern states, without it there will be no armies, public teachers, judges, policemen or politicians. The IRS estimates that from 2001 to 2010 the federal revenue lost $3 Trillion to tax evasion, which is amazing, specially if we take into account that tax fraud may result in huge fines and imprisonment.

In the pre-Bitcoin world it was very complicated to hide money from the scrutiny of the Government. Lying to the IRS was not a good strategy in the long run. The most effective way of hiding your money was sending it to a tax heaven, which was not easy since all banks and financial institutions are obliged to inform the authorities of all transactions made by their clients. The best way to send money anonymously was transferring physically cash, which is very complicated and only makes sense for big quantities.

Bitcoin is not only a currency, it is also a frictionless system of payment. If deals made with Bitcoins are anonymous, it would represent a serious threat to the IRS, because transactions out of the US without friction or scrutiny would be available to everyone. Therefore, all residents could easily avoid paying taxes. But are Bitcoins really anonymous?

Anonymity is a key word when it comes money. However, it is not a concept that it is easily understood. Kristov Atlas in his book “Anonymous Bitcoin” tells us that anonymity is not a binary concept. It is a probability of being identified. He gives the example of an investigator who is trying to solve a murder mystery. If he does not know anything about the murder his probability to find the murderer is one out of seven billion (the population of the world). If he knows that the murderer is a woman, his probability is one out of 3.5 billion. If she lives in Philadelphia the probability to identify her is one out of 750,000 (half of the population of Philadelphia), and so forth. Basically, the more he knows about her, the less anonymous she is. This definition challenges our imperfect intuition that anonymity is to know or not to know the authorship of an act, as if the world was black and white without an infinite array of grey and colors.

Kristov Atlas shows us that the blockchain is not safe for those who want to keep their identity private. The blockchain is a public ledger of all transactions in the Bitcoin network. In some way is as if all your bank account information was public for everybody to see. Thankfully, there are some mixing services to mix one's funds with others', with the intention of confusing the trail back to the funds' original source to anonymize the ownership. Kristov Atlas makes a case for implementing a mixing protocol within the Bitcoin protocol itself. Basically he thinks that the developers should update the protocol to make all transactions completely anonymous. I do not think that the IRS will be happy with that when it happens. Time will tell.

Anonymous Bitcoins” is a very easy to read book that contains a lot of examples so that anyone can understand all concepts. It includes an introduction to Bitcoins and a walk-through on how to use a mixing service. I strongly recommend it to anybody who wants to understand a little bit better the Bitcoin ecosystem.

Sunday, April 6, 2014

Bitcoins & The Stone Money

The billionaire Bill Gates was once asked about  his opinion of Bitcoins to which he replied that they are "a technological tour de force ." Exactly the words used by the former Google CEO, Eric Schmidt, referring to the cryptocurrency. The techies feel a fatal attraction to this coin that no one can explain how it works to a five year old. The news we get are very confusing sometimes it tell us that is a system for laundering money or that it is a bubble, but there must be something about Bitcoins that these extremely intelligent people see and are failing to communicate to us.

If we take the time to search in Google the word "Bitcoin" we get thousands of pages explaining that it is a decentralized system based on P2P networks using an efficient method of encryption, which is not very helpful if we want to understand how Bitcoins really work. Perhaps it is best to start at the beginning and ask ourselves: What is money? And to this end we will analyze the currency used in one of the islands of Micronesia.

The  Yap archipelago is located in the Pacific Ocean east of the Philippines. Four islands that were isolated from Western civilization for centuries, and have a very unique monetary system. Yap belongs to the Caroline Islands, discovered by Spanish explorers in 1528. The Spaniards sold them in 1898  to the Germans for 3.3 million dollars, a very low price for a paradise, but Spain had little bargaining power after the disastrous defeat in the Spanish-American war earlier that year.

The islands of Micronesia are the definition of heaven on earth. The climate is tropical and the food is  easy to collect from the coconuts and the generous sea. However, they have no precious metals nor limestone, that is why when they first saw it, they were mesmerized. Six hundred years ago an expedition of Yapese fishermen landed accidentally 250 miles away in one of the islands of Palau. The Yapese were fascinated when they saw the limestone in the same way that anyone who has not ever seen the sea feels spellbound by it. They decided to take a sample to Yap carved in the form of a whale. That is why they called it rai, which means whale in their native language. Later the stones ended up having a circular shape, which is more convenient. Being a rare commodity in Yap, soon became currency, following a similar process that gold had in the Mediterranean cultures of antiquity.

At first the rai stones were small, but over time the stones grew in size. Some are huge and weigh four tons. The labor needed for the extraction and carving of the stones was very significant, since they did not have iron tools, they only used shells and corals. Transportation was also an issue. Many men were needed to move the heavy stones. All rais have the center cut up to cross a trunk so that it can be lifted by several men. Another difficulty was the shipping across the sea, since the Yapese had only light canoes and rafts. Many men died in the process of manufacturing rais.

Being difficult to dig, carve and transport, the stones had a great value. The larger the rai, the more value it had, but the story behind it was more important than the size. A  rai that had cost the death of ten Yapese was more valued than a rai that had no blood stains. The stones had no functionality, nor had any spiritual or religious value. They did not even have ornamental value, however they soon began to be used as money. The intrinsic value of rais resided only in the effort it had taken to get them.

Even the possession of the stones had no meaning. The relocation of the stones was very complicated and risky because if the stone wheel  broke, it lost all its value. To make a payment, the payer communicated the  transfer of ownership of the rai publicly, without moving the stone. Usually the chief of the village served as the notary,  the only owner of any rai was the one who was publicly recognized by the village. Most interesting of all is that there is a very rich family in Yap whose rais nobody has seen in  more than a  century, but they have value nonetheless. As the story goes, there was an expedition that carved a huge rai, the value was immense. On the way home to Yap a storm shook the canoe and they lost the raft with the enormous stone attached to the canoe, which ended up sunk into the sea. The survivors of the tempest explained their adventure and the entire island decided to accept the lost  rai as payment, although it was in the bottom of the sea. The interesting thing is that no one has seen that money in 150 years and it is still used as currency and it is accepted in the public ledger of rais. This concept is essential to understanding Bitcoins: They are a public ledger, as simple as that.  But let's go back to the islands of Yap to better understand money and inflation.

The stone wheels were used as means of payment, but they used also shells and pearls for everyday exchanges of little value. The rais were reserved for transactions of great value. For example, small rais were used to buy fish, but large were used to pay dowry to the groom family, to buy land and even to pay for war reparations after losing to a neighboring village .

One of the characteristics of the population of the islands of Yap is that they love to dance. In his book "The island of stone money", archaeologist William Henry Furness III describes the customs as he lived them in 1903. As part of his study, he wanted to take some pictures of the dances, so he asked the islanders if they could show him some of their moves. Apparently he regretted having made his request, since Yapese spent a week rehearsing day and night under the moonlight and he could not sleep. They take dancing more seriously than Fred Astaire to the point that they went to the length of paying the amazing sum of four rais to another tribe just for the choreography of new dances.

In 1871 the  Irish American captain David O'Keefe was shipwrecked near Yap. Later he would become the most important copra trader, which is dried coconut meat used in the manufacture of soaps. The captain provided  the native iron tools to extract the stone more easily, as well as facilitating the transport of rais to the island on his boat in exchange for coconuts to be sold in Hong Kong. The relative ease of excavation and shipping of rai altered the economy of the islands. All of a sudden the islanders became crazy about mining and getting rich easily.  In 1882 the German explorer Otto Finsch
reported that he saw 400 Yapese in the stone quarries, basically 10% of the population of the islands at that time. If you think that this is crazy, you are right. The natives in the islands of Yap suddently felt they were rich, and spent big amounts of rais to purchase goods, and whenever you have a lot of money chasing too few goods, the prices rise. That's exactly what happened in Yap. The amount of rais greatly increased and went from very little in  to over 13,000 in the span of 80 years. There was a great inflation that led to the impoverishment of all the islands. In 1902 it was decided to limit the production of rai stones to avoid inflation and established that only older people could organize trips to the mines of Palau. The last trip was made in 1931. There have never again been a problem with inflation. This is an important concept that Bitcoins share with the stone money of Yap: Bitcoins have a cap on the production of money to avoid inflation. But let's get back to the islands to understand how bad Governments can steal money from its citizens.

When Germany took over the islands in 1898, the new rulers decided to pave the islands, because the roads were not in good condition, so they demanded that the Yapese repaired the roads, but they did not see the need, so they agreed to disagree, and left the roads undone. The authorities decided to fine the Yapese for disobedience. But what currency could they use to fine them? It did not make any sense to use the German currency. Germans marked with a black cross the largest rais in the rebels districts implying that they were confiscated. The Yapese felt poor and realized that they could lose the other  stones and fixed the roads. It's funny because the German government did not have to take ownership of the big wheels, just made sure that everyone knew that they were confiscated by marking them.

The phenomenon of rai stones teaches us that it is not necessary to hold a currency, possesion is not important. It is sufficient that there is a public ledger that gives recognition to the owner. The Bitcoin protocol is a public accounting system where every transaction is recorded on the computers of people  dedicated to keeping the system alive .

They are called miners because their work is like the Yapese quarrying in Palau to extract money. Bitcoins miners make their computers available to the system with the hope of winning a Bitcoin from time to time as a reward for the electricity spent. There are many miners of bitcoins distributed worldwide. All miner keeps a copy of all transactions of bitcoins that have been made throughout history. Ie, it is a public ledger. In itself a Bitcoin is nothing, is not even a number. This concept is genius. The computer community has been trying to create a system of digital money since the nineties, but all projects were a failure because they were not based on an accounting system, they were based on  sending numbers in a secured way, which does not work because you could send the same number twice and therefore paying twice with the same coin.

Bitcoins are like rais, the important thing is that everyone accepts them. If you want to buy a house with 100 bitcoins, all you have to do is identify yourself  with a password (private key) to the miners and tell them that I have authorized the payment of 100 BTC to the seller of the house. Miners will verify that I have at least 100 Bitcoins and will record the transaction in their accounts, the transaction will be finalized when 51% of miners have  mark the entry in their accounts.

In the history of rais stones, the German government decided to expropriate some of the most valuable wheels. That can not happen with Bitcoins. It is important that any digital payment system is protected from the evil of some governments. They can impose laws to miners who live under its protection, but miners are distributed worldwide and no government can exercise control of 51% of the miners, and therefore Bitcoins can not be expropriated by force. For the record, the German government gave back those stones to their owners after they repaired the roads.

The big advantage of Bitcoins is that there will never be a mass production of them, it is impossible to have inflation. That is great news because inflation always implies poverty. The Bitcoin protocol is a computer program that miners run in their computers, and it is designed to limit the production of Bitcoins. In fact it is already planned that in 2140 no more Bitcoins will be produced in the same manner that there are no more new rais produced in the islands of Yap.