This is the final essay for lecture two (the Byzantine Generals Problem) of the University of Nicosia MOOC, Intro to Digital Currencies.  This prompt asked students to describe a centralized asset or transaction ledger and describe advantages or disadvantages of decentralizing the ledger.  I must admit, I might have stretched a bit in my example selection.  Nonetheless, I’m proud of this one and I think the analogy is interesting and useful, if unlikely or a bit silly.  This and all the essays are all tagged: Digital Currency Course Essay Series.

 

Prompt: Describe a centralized asset or transaction ledger and describe what advantages or disadvantages might exist if it were to be implemented in a decentralized form.

 

This might be a little out there, but I have to admit I peeked at the everyone else’s responses to avoid picking a popular example of a centralized ledger.  The example of a centralized asset ledger I’ve selected is YouTube.com’s database of available videos.  Currently, to add an asset to the ledger, a YouTube user must first create or sign in to an existing account with Google.  The user uploads the video to YouTube’s servers, and software updates the database with information about the video, such as what account submitted the video, a timestamp, whether the video is marked public (searchable and all may view), private (only viewable by accounts specified by the uploader), or unlisted (not searchable but anyone with the link may view), among other data.  Assets may be removed from the ledger by several methods: YouTube staff will delete videos that violate its terms of service or as a result of a successful Copyright Infringement Notification, and the user who submitted a video may also mark it for deletion.  Once the deletion is effected, the video may no longer be viewed nor the deletion reversed; however, the YouTube Terms of Service, section 6C, state, “you understand and agree, however, that YouTube may retain, but not display, distribute, or perform, server copies of your videos that have been removed or deleted”, so the content may still exist on the YouTube servers.

 

In a decentralized model of the database of YouTube videos, users might post content to a self- or decentrally-owned site and submit a link to a blockchain-like ledger of submitted videos.  The blockchain software might visit the link to validate that a video exists and trace prior confirmed submissions to ensure the same link is not already included in the ledger.  The uploading user may also be required to prove that she has the ability to manage the linked content.

 

There are several advantages and disadvantages that might arise by converting YouTube’s database of video submissions to the decentralized model described above.  Firstly, with a decentralized ledger, it would be impossible to remove the initial link submission, as the ledger must be public and prior additions unalterable in order to function and foster trust in the system.  A user could remove or change the content from the linked site; however, the entry of the link in the ledger would still persist in the history of asset additions.  This feature has advantages, for example, it would be the individual users’ responsibility to comply with copyright law as opposed to leaving this right in the hands of the central managing authority (i.e. Google).  One could also imagine scenarios where the inability to truly remove record of the link could be disadvantageous, such as if the content is viral and politically unpopular.  Taking the maintenance of the ledger out of a single entity’s hands does have clear advantages in that searching for content could be vastly improved, and there is no risk that the central manager fraudulently alters data relating to the video, such as timestamp or the submitting user.  Furthermore, data about uploaded videos would be visible to all instead of trusted to a single entity, and with multiple nodes maintaining full copies of the ledger, a denial of service attack on the database would be exponentially more difficult.

 

Although unorthodox, a decentralized asset ledger of uploaded video content might prove advantageous over the centralized model employed by Google’s YouTube.com.

 

References:

1. YouTube.com, Video Privacy Settings

https://support.google.com/youtube/answer/157177?hl=en

2. YouTube.com, Terms of Service

https://www.youtube.com/t/terms

This next essay in the Digital Currency Course Series is the first one I wrote for the second lecture taught in the University of Nicosia’s Bitcoin MOOC.  This chapter is about the Byzantine Generals Problem and the theoretical underpinnings of Bitcoin.

 

Prompt: Describe in your own words, why ‘proof of work’ is important to a decentralized blockchain-based system like Bitcoin.

 

For any ledger to be trusted, the users must be assured that the transactions comprising the ledger are valid, authorized, and represent actual transactions that have occurred.  In the case of a centralized ledger, all the transactions are entered by a single, trusted authority, such as a bank or a company’s accounting department.  In many cases, this trusted authority will also hire a disinterested third party, such as an auditor or public accountant, to review the ledger and the transactions that comprise it and attest to the veracity of the data.

 

In the decentralized ledger model, the trusted authority is done away with, and instead, many disbursed entities may submit transactions to be recorded to the ledger.  Therefore, in order to assure participants that the ledger can be trusted, a decentralized system must have rules which govern the posting of items to the ledger.  Bitcoin and other alternative cryptocurrencies have chosen ‘proof of work’ as the governing rules for posting transactions to the blockchain ledger (as an aside, some people have proposed other systems, such as proof of stake, as an alternative set of rules to govern transaction posting).  Proof of work requires a user’s computer to expend effort and resources as the price for posting transactions to the blockchain.  The bitcoin protocol demands that a computer discover a nonce, a string of garbage data, which when combined with the transaction details and run through a cryptographic hash function, produces an output value which meets certain difficulty criteria.  The bitcoin software adjusts these criteria accordingly as the pool of computing power dedicated to searching for a solution waxes or wanes.  Users are allowed to post transactions to the blockchain only after exerting the time, effort, and resources to find a correct solution, and because the effort level required is kept consistently high, the probability of discovering a solution is fairly low relative to the resources that must be invested.  Consequently, any person wanting to examine the blockchain can be assured that transactions are not frivolously posted and that there is some degree of network security.  Combined with rules governing what constitutes a valid transaction, the proof of work system gives bitcoin a level of security and reliability on which trust can be built and users can be assured about the accuracy of the blockchain.

 

References

1. Bitcoin Wiki, Protocol rules

https://en.bitcoin.it/wiki/Protocol_rules

Here is the third and final essay for the University of Nicosia MOOC on cryptocurrency’s first lesson, Introduction to Digital Currencies. My other responses can be found here.

 

The prompt: Post 2-3 paragraphs comparing any two types of currencies along the dimensions of the functions of currency and rate their pluses and minuses in this regard.

 

Currency is useful in an economy by performing three primary functions, as a medium of exchange, a store of value, and a unit of account.  The functions are independent but mutually reinforcing, and different types of currencies perform each function better or worse than other currencies.  The advantages and disadvantages between primitive, commodity currency and paper fiat money strongly illustrate this concept.

 

As a medium of exchange, a currency is a common intermediary which allows for a standard comparison of value between diverse types of assets for trade.  Without media of exchange, sellers are forced to accept as pay for their wares only items their suppliers might accept in trade, a type of transaction cost known as a double coincidence of wants.  As a medium of exchange paper currency is superior to commodities across many dimensions.  Paper money is highly fungible and divisible since each note is consistent with the next and multiple notes of varying denomination are typically issued.  Contrarily, the fungibility and divisibility of different commodities might be greater (one kilogram of salt) or lesser (one cow).  Furthermore, paper money is generally easier to transport than most commodities, further enhancing its value as a medium of exchange.

 

A good store of value permits individuals to retain wealth over a period of time with a measure of predictability about the asset’s future worth.  The supply and demand, as well as expectation about future supply and demand, all affect the value of a currency, whether commodity or paper.  Many commodities used as a currency have some inherent utility and therefore floor on demand; whereas, the demand for paper money is generated solely by its use as a currency.  The supply of commodities may experience a sudden shock if a new reserve is found or a big cache is destroyed.  On the other hand, the supply of paper money is generally determined by a central bank or other sovereign authority.  The predictability of future value varies widely among paper and commodity currencies, so neither is inherently more advantageous as a store of value.

 

A unit of account allows for a standard measure of the worth of disparate assets, liabilities, and economic activities.  Deflating money leaves its holders better off just as Inflation in a currency may benefit holders of debt denominated in the currency; however, up and down movement in the value of paper money or commodities complicates the comparison of the currency across time.  The utility of a currency as a unit of account depends less on whether it is paper money or commodity than it does on the form of paper money or the particular type of commodity.

I have the first three essays already finished, so I’ll go ahead and publish them all now.  In the future, I’ll post the essays as I write them so they will appear here a bit more sporadically, though that’s probably a feature, not a bug.  Anyway, onward we press, to essay number two.

 

Prompt 2: post research and mention your opinions on why a decentralized currency may have benefits over a centrally issued one for private issuers.

 

There are a couple as yet unmentioned advantages that a decentralized private currency might have over a centralized one:

First, and perhaps most importantly, since privately issued currencies compete to some extent with money sanctioned by sovereign states with court systems and law enforcement agents, decentralized private monies are more resilient to legal attacks and other forms of pressure than are centrally-issued currencies.  Case in point is E-Gold, an early internet payment service provider, operated by Gold & Silver Reserve, Inc (G&SR) and initially backed by gold reserves in safe deposit boxes.  After changes to money laundering standards promulgated in the USA PATRIOT Act, E-Gold and G&SR faced various allegations and legal attacks, including unlicensed transmission of money.  The owners plead guilty, sentences were issued, and millions of dollars in assets were seized.  Further, Paypal has notoriously been subjected to pressure from the U.S. government, such as State Department lobbying to freeze donations to Wikileaks.  In the world of Bitcoin, exchanges have been a single point of failure and have been subject to hacks, legal action, and other attacks.  Distributing issuance makes the currency less vulnerable to attacks on one node; instead, most or all of the network must be compromised to shut the currency down.

Second, by its nature a currency whose issuance is disbursed rather than concentrated must have rules and procedures for the issuance of additional units of the money.  If anyone could issue the currency at any time, inflation would run rampant and the currency’s value would plummet.  Bitcoin solves this problem with mining, a proof of work system, monetary policy built into the protocol, and the open source and transparent nature of currency issuance, among other innovations.  These rules and systems make the issuance of new Bitcoin highly predictable, which is generally good for markets and efficient operation of businesses.  Centralized private currencies, however, need not follow published, predictable rules for currency issuance.  The “central bank” of the currency may be staffed by extremely intelligent, wise, and trustworthy individuals, or it may not.  The babysitting co-op case study presented in the additional reading to the course articulates how first a recession, then a depression in the market for babysitting scrips was created by the monetary policy of the co-op board, not due to malfeasance, just ignorance and a poorly designed economy.  According to Wikipedia, the wisdom of the crowd theory states that a “large group’s aggregated answers to questions involving quantity estimation, general world knowledge, and spatial reasoning has generally been found to be as good as, and often better than, the answer given by any of the individuals within the group.”  If this holds true to the issuance of private currency, then the decisions made by consensus in a decentralized environment should tend to outperform ones made by a central authority.

References

1) Wikipedia.org, E-Gold

http://en.wikipedia.org/wiki/E-gold

2) Digital Currency Business E-Gold Pleads Guilty to Money Laundering and Illegal Money Transmitting Charges

http://www.justice.gov/opa/pr/2008/July/08-crm-635.html

3) Operation Payback cripples MasterCard site in revenge for WikiLeaks ban

http://www.theguardian.com/media/2010/dec/08/operation-payback-mastercard-website-wikileaks

4) The Bitcoin drama continues: another exchange shuts down, while Overstock reports over $1 million in Bitcoin sales

http://www.engadget.com/2014/03/04/another-bitcoin-exchange-shuts-down/

5) Bitcoin.org, Frequently Asked Questions, How are bitcoins created?

https://bitcoin.org/en/faq#how-are-bitcoins-created

6) Monetary Theory and the Great Capitol Hill Baby Sitting Co-op Crisis: Comment

http://cda.morris.umn.edu/~kildegac/Courses/M&B/Sweeney%20&%20Sweeney.pdf

7) Wikipedia.org, Wisdom of the crowd

http://en.wikipedia.org/wiki/Wisdom_of_the_crowd

As previously mentioned, I’m enrolled in the University of Nicosia free MOOC on digital currencies.  One of the assignments for each lecture in the course is to write a brief essay for each of a couple topics related to the material covered in that lecture.  To encourage myself to put more effort in my responses and gather feedback from readers not necessarily enrolled in the course with me, I’ve decided to publish each of my responses as a separate post on this site.  I’d love your feedback, whether you like what I wrote or not.  Without further ado, here’s the first of my responses.

 

The prompt is: post a short paragraph, describing your local currency and how potential changes in its supply or demand you are aware of, have affected its exchange rate over a timeline you choose.

 

My local currency is the United States Dollar, a sovereign form of fiat money, centrally issued by the U.S. Federal Reserve and used more often in international transactions than any other currency.  In late 2008, the Fed began a monetary policy called quantitative easing, injecting dozens of billions of additional dollars into the circulating money supply each month.  This chart shows the total value of dollars put into circulation through quantitative easing from 2008 through the present, with a projection of future activity through 2015:

 

The next chart shows, after accounting for the effects of quantitative easing, the total base money supply (M0) of U.S. Dollars in circulation from January 2009 through the present (in millions of dollars):

 

The currency I have chosen to compare against the Dollar is Bitcoin.  First mined in early January 2009, Bitcoin is a private, decentralized, digital cryptocurrency which, unlike the U.S. Dollar, has a fixed total supply (21 million Bitcoins to be mined by circa 2140), which is fabricated according to an open source Bitcoin generation algorithm.  Accordingly, the total money supply of Bitcoins in circulation has smoothly increased from zero on January 1, 2009 to approximately 13 million today:

 

If we compare the quantity of Dollars and Bitcoins in circulation across the selected time horizon, we see that the supply of Dollars in January 2009 was approximately 1.70 x 1016 whereas the supply of Bitcoin was near 1.  Presently the supply of Dollars has climbed to nearly 3.93 x 1016 and Bitcoin has risen to 1.28 x 107.  Over the past four years, the supply of Bitcoin has increased exponentially; whereas, Dollars have merely doubled.  Therefore, all else being equal, we should expect the price of Bitcoin relative to Dollars to have plummeted in the past four years.  Of course that expectation is not reflected in reality:

 

The preceding graph shows the price of Bitcoin in Dollars over the past five years.  From the data, the price looks fairly stable until a first, small blip and downswing around May 2011, a larger jump and softening of price May 2013, and a last dramatic spike cycle this past December.  So given what we know about the supply of these two currencies, why is a Bitcoin now trading near $450 dollars when January 2009 it was worth mere pennies?

As a new currency Bitcoin has certainly been very volatile since its inception, a quality that will hopefully subside as Bitcoin grows older. However, volatility could account for erratic price movement but would not explain the upward trend, especially given the disparity in rates of inflation of Bitcoin relative to Dollars.  I believe that the upward price trend is best explained by changes in relative demand, as well as current expectations of future demand.

In the past five years, the number of individuals and businesses willing to accept Bitcoin as tender has grown considerably.  Furthermore, the expectation about the future of Bitcoin has grown immeasurably more positive since 2009.  Therefore, I believe, relative to the U.S. Dollar, the burgeoning demand for Bitcoin since 2009 has offset the rising supply and this growing demand accounts for the increasing price of Bitcoin.

Sources:

1) A Complete History Of Quantitative Easing In One Chart

http://www.businessinsider.com/quantitative-easing-chart-2014-1

2) United States Money Supply M0 [2009 – 2014]

http://www.tradingeconomics.com/united-states/money-supply-m0

3) DFIN-511 Introduction to Digital Currencies, Session 1: A brief history of money

http://mooc.universityofnicosia-online.com/pluginfile.php/283/mod_resource/content/2/1.%20A%20brief%20history%20of%20money.pdf

4) Total Bitcoins in Circulation [All Time]

http://blockchain.info/charts/total-bitcoins?timespan=all&showDataPoints=false&daysAverageString=1&show_header=true&scale=0&address=

5) Market Price (USD) [All Time]

http://blockchain.info/charts/market-price?timespan=all&showDataPoints=false&daysAverageString=1&show_header=true&scale=0&address=