Many years ago, when I was the new controller of a struggling medical device manufacturer, I reviewed the company’s balance sheet looking for ways to boost our cash position. There, in long-term assets, was an item one of my predecessors named ‘barter exchange’. After some digging, I discovered this asset was exactly as described, an account at an exchange that had a purported $25,000 worth of barter units. The account value really wasn’t measurable from an active market point of view, and the range of goods or services offered on the exchange seemed limited to things I didn’t need. The only exchange item that looked even a little promising was printing services. Even then, the ‘price’ appeared to be at 30 percent premium over the local market. I wasn’t able to use the barter exchange during my short time as controller, and how a company selling aesthetic surgical equipment to doctors and clinics ended up with barter units in the first place, will likely forever remain a mystery to me. Alas, this was all long before the internet became a true economic force, and the barter exchange concept was jmaybe ahead of its time. Reading about the emergence of Bitcoin and other crypto-currencies brings that memory back to me now.
If you are not familiar with Bitcoin, it is probably the best known of the digital currencies. The term bitcoin has become nearly synonymous for these new digital or crypto-currencies. A report published in November 2015 by the Committee on Payments and Market Infrastructures at the Bank for International Settlement contains a great discussion on digital currencies and is a recommended read for those curious about this emerging market.[1]
I’ll borrow from the Committee’s report to discuss the three key features of digital currency, or cryptocurrency as it is often called. First, digital currencies typically have some monetary-like characteristics. They are used as a means of payment, but they are not issued in or connected to a sovereign currency, are not a liability of any entity, and, importantly, are not backed by any authority. These currencies have zero intrinsic value. As a result, they derive value only from the belief that they can exchanged for goods or services, or sovereign currency, in the future. Second, digital currencies are transferred electronically over the internet, typically via a built-in distributed ledger system organized by an exchange. The distributed ledger aspect can be viewed as the genuinely innovative element of digital currency schemes. This distributed ledger is thought to carry lower transaction costs. It is also thought to be relatively immutable, owing in part to the decentralized nature of the grid, and in part to the unique algorithms that provide the source of authentication. The third element is that control of the exchange market is accomplished by a variety of third-party organizations, almost exclusively non-banks, which have been active in developing and operating digital currency and the distributed ledger mechanisms. These third-party exchange organizers are loosely regulated, or simply unregulated.
As with any currency, cryptocurrency trades on an ‘exchange’ allowing participants to reach the market value of one currency or ‘coin’ in relation to another. Again, this is simply a belief of value and is not linked to any single standard. So we needn’t discuss the gold standard or that silver certificate my grandfather gave me that’s sitting in the back of the safe. This new digital coin represents a stored value that is truly fiat. Market participants need only to agree that the exchange of the item fulfills the contract and that the item presented for exchange is genuine. The problems, as with any trade, are measurement and authenticity.
Bitcoin bubble or should we buy tulips? Everyone else is.
Most news articles discussing the ‘value’ of a digital coin will use U.S. dollars as the reference. In December 2017, a single Bitcoin had a quoted exchange [2] rate of one coin to $16,249 dollars, a meteoric rise from $738 dollars per coin just a year earlier. Recently, Bitcoin topped $19,000. What explains this staggering increase? Has the U.S. dollar really lost value against an unregulated, un-sovereign, digital coin? Or is Bitcoin in an unsustainable bubble?
Is the need for digital currencies so great that the limited supply is causing some sort of market squeeze? The Committee Report addresses the scarcity aspect, noting that the exchange operator can create scarcity based on the predetermined and technical aspects of issuing new coin. If it is difficult to create and authenticate a new ‘coin’, but relatively easy to maintain and transfer that coin later on, then scarcity can develop in an active market and continue to exist for at least a short time. The current Bitcoin algorithm is limited to 21 million coins. However, the supply of complex algorithms is really not limited, is it? I suspect not. Currently, the cost to maintain the coin may be less than traditional systems. But, as the computing power required to solve the hashing algorithm and thus sustain the system grows, costs will rise.
At first we think that cryptocurrencies such as Bitcoin should be almost immune from hyperbolic speculation – the ultimate free market exchange mechanism, the singular form that all other currencies can exchange in and out of, sitting on top of the market, not in it. The things we can trade that currency for—a gallon of gas, liter of milk, or a sofa— move in relative terms to our local currency and would move in relation to a coin as well. But, in the theory of relatively for global bitcoin, the coin unit wouldn’t move. All would move relation to it.
This brings us back to our question: has some global meltdown of the U.S. dollar taken place? Recognized in the ethereal free market, but not in the regulated market? While great fodder for conspiracy theory lovers, one reason for Bitcoin’s rise seems rooted, at least in small part, to scarcity. And the market has responded to this scarcity with new coin formation. We now have Litecoin, Namecoin, Novacoin, Peercoin, Ethereum, Dash and about a dozen others. Of these, Ethereum seems to be gaining some favor. But Bitcoin reigns supreme for the present time.
The Chinese government recently cracked down on dealings in Bitcoin and other digital currencies, in part to curb what it sees as rampant speculation, in part to put a stop to black market activity making use of this exchange mechanism. Jamie Dimon, CEO for JPMorgan Chase, called Bitcoin a fraud in September 2017, but later backed down from this position.[3] While his subsequent remarks about Bitcoin on CNBC seem a bit more considered, it is obvious he is not a fan of these unregulated exchange mechanisms. Still, JP Morgan apparently wants in on the game, and recently announced it is looking for a way to give its customers access to trading in cryptocurrencies. So, despite the Chinese stance and Mr. Dimon’s reservations, the emerging market for digital currency appears real, for now.
My Certificate of Authenticity has a Typo in It (picture one of those New Yorker magazine cartoons here)
The sudden interest in digital coins has also led to outright fraud. In September 2017, Swiss regulators were successful in shutting down E-coin, digital currency market with no real cryptocurrency involved. The backers took in over $4.2 million U.S. equivalent before the scheme unraveled. This points to the central problem with cryptocurrency: it is not regulated and, without oversight, quickly subsumed by the criminal element.
Will cryptocurrencies ultimately come under some regulation? Will the regulation be enough to stem the illicit aspects of the market? Or, will the lack of regulation eventually limit the digital currency marketplace, regulating it to the back alley dealings of the dark web? Since the anonymity associated with the exchange of these currencies is part of the draw – tax evasion and illicit commerce naturally follow. At some point, I expect to see a news article reporting that there are more Bitcoins being traded than could exist under the theoretical 21 million coin limit imposed by the current hashing algorithm.
Mr. Dimon believes regulators will eventually move to shut down these markets. A recent press release by the U.S. Treasury’s Financial Crimes Enforcement Network highlights the extent that organized crime is making use of these payment schemes.[4] The press release is a good read, highlighting the digital currency’s role in facilitating crime.
A recent ransom-ware attack locked computers across Europe before it was stopped almost by accident, and the hackers demanded payment in Bitcoin to unlock the infected files.[5] Shortly after the news broke, I was on Dell’s website looking at server prices and thought how ironic, Dell accepts Bitcoin[6]. Then the thought occurred: hackers need computers to ply their trade and need a place to buy these machines. Convenient for them that Dell will accept this form of payment. Brings up another thought, do companies like Dell want to be associated with a medium of exchange tainted by this level of criminality? Will Dell be forced to start tracking and reporting the ship-to address of computers purchased with Bitcoin? I can see the benefit of such a rule. I can foresee legislation requiring the reporting of transactions in digital currencies under rules similar to those of the Patriot Act or other banking regulation.
Digital Currency and the Digital Divide
At the most fundamental level, an electronic coin is a digital record that is unique and that is controlled by a key, actually two keys, one public that lives on distributed network and one private. The private key is the electronic file you store in your digital wallet, maintained at the exchange of your choice. If a hacker gains access to your wallet, then your bitcoin can be easily stolen. A recent report claims a fellow in Europe sat down in a public café and used the unsecured wireless access to check his Bitcoin account. The account was later hacked and over $150,000 worth of coin stolen.[7] I’m not sure how we verify his story, but this is certain: lose your key, or lose control of your key, and your coin is gone. At present, there seems to be no mechanism of redress for any such circumstances. Most of the exchanges are located in countries were banking regulations, even if they apply, won’t help the consumer track the path of the stolen funds or recover that which was lost.
Blockchain, blockchain, my kingdom for a blockchain
The presumed strength of digital currency is the reliance on blockchain technology to ensure that the digital record has not been altered, hence prove the coin is authentic. Blockchain accomplishes this by relying a distributed ledger of numerous individual computers, each validating or solving, called hashing, the algorithm underlying the chain. I can’t pretend to write with authority on the functioning of the Bitcoin blockchain algorithm, but I learned long ago not to accept hand waiving as sufficient evidence. I find that I must understand, and understanding takes a lot of work.
First, we must understand that Bitcoin and blockchain are not synonymous. Blockchain is the shared or distributed ledger – part of the technological foundation on which Bitcoin rests. This single, shared ledger is maintained by multiple participants, and data is shared peer-to-peer across the network. As transactions take place within the network, each peer supplies a ‘processing node’ which houses the ‘blocks’ of information. Nodes send and receive information to other nodes, synchronizing the network and maintaining the integrity of the ledger. A transaction is validated by consensus – participants agree or the transaction is rejected. This shared-ledger concept is supposedly more efficient because different participants no longer need to work to maintain separate accounting systems or to verify that their system is in agreement with other network participants. Vetting is built in. This shared network also eliminates the need for, and more importantly, the associated cost of intermediaries. In banking for example, no payer need rely on a central bank and correspondent banks to authorize and clear a payment transaction, so transactions can settle faster and without additional systemic burden.
You had me at math
To secure the shared ledger, we start with the algorithm. An algorithm is a procedure for solving a mathematical problem involving a finite number of steps that frequently involves significant repetition of an operation. Since a computer can repeat a task a very large number of times, very quickly, a complex algorithm can be solved or ‘hashed’ at a relatively low cost. I have old memories from my auditing days of using a 10-key to compute hash totals for tests of completeness. An algorithmic hash is certainly much more complex than a summing of record numbers.
Security of the shared ledger is based on the solving the cryptographic hash using a secure hash algorithm or SHA. The hash target is extended to the distributed system in the form of a hash tree or a Merkle tree. In a Merkle tree, every leaf node is labelled with a data block and every non-leaf node is labelled with the cryptographic hash of the labels of its child nodes.[8] Hash trees ensure that data blocks received from other peers in the peer-to-peer network are received undamaged and unaltered. A successful hash at the highest level of the tree, can then flow the validated block to the child nodes. Thus, hash trees allow efficient and secure verification of the contents of large data structures. I’m not certain if a the sophistication of the algorithm, the number of times hashed, or other mathematical limits will eventually come into play. But if they do, it would suggest that underlying information blocks will eventually become more costly to process each time. I suspect that in a rising cost environment, we will develop a means to scrape out the meaningful bits of information, like the details of a banking payment record, and simply restart the hash.
For Bitcoin, the “blocks” or records representing the coin are encrypted using the SHA-256 algorithm controlled by the exchange. To validate each Bitcoin block, the exchange requires it to be “hashed” periodically. The exchange therefore requires that nodes in the distributed ledger continue to compute the hash to maintain system integrity. The operators of the nodes, or ‘miners’, are paid by the exchange to perform this hash. The exchange system pays the miners in small fractions of the coin created by the exchange.[9] This then begs the question of who actually controls the exchange and thus the coin creation process. Can these anonymous exchange organizers be trusted?
I shall not be moved, resting securely, uncorrupt Psalm 62:6
With hand waiving glee we are to accept that this distributed system is somehow immutable – protected in large part by the enormous cost that would need to be incurred to somehow overcome the hash. For a small-scale attack, the system is supposed to quickly recognize and reject a false submission. Not sure what happens to the operator of the now false node which submitted the false data, or the exact correction mechanisms within the shared system. But I can envision an exchange being overrun by false node submissions, or the entire ledger becoming somehow unstable and potentially corrupt. Once a block is corrupt, what happens to the associated coin? How does an exchange participant know that their coin is secure? Are these distributed networks really secure from hacking? Will quantum computing allow an attacker to quickly overcome the hash.
There have been numerous exchange breaches since the introduction of Bitcoin in 2008. The most recent (December 2017) made away with nearly $70 million[10]. The idea that my critical data may be stored on a computer in aunt Hattie’s basement or on numerous foreign server farms is unsettling and seems somehow fundamentally not secure. The number of times the chain is replicated, whether attached to some secure algorithm or not, seems of little comfort given the premise that once breached, the network could be eventually overwhelmed and all records compromised. It just takes resources.
The economics of the system may eventually lead to problems as well. When the exchange runs out of currency to mint and ‘miners’ can only be paid through sharing of transaction fees, then the processing power and associated energy costs required to maintain the chain will erode the value proposition. This is likely to be less of an issue with private blockchains. However, in an anonymous digital currency system, there is little incentive to prop up a deteriorating environment, since no single party bears the responsibility or incentive to do so.
Strangely enough, the market seems to simply brush these concerns aside and investors continue to pile real sovereign-backed money into purely digital and largely unregulated systems to purchase their very own encrypted digital blockchain record. The ‘fear of missing out’ psychology, and the almost irresistible pull it creates for investors, will surely keep the promise alive for a while. But for how long is anyone’s guess.
When I started trying to understand blockchain and its implications for accounting systems and auditing those systems, Bitcoin was worth around $1,000. I didn’t have much money to play with at the time, so I didn’t buy a ‘coin’ for fun or, as I normally justify such things, to participate personally and perhaps gain an insider’s understanding of this emerging phenomenon. Of course hindsight is always clearer.
I wonder if the medical device company still has the $25,000 in barter units. If so, maybe they could exchange their units for a Bitcoin.
[1] https://www.bis.org/cpmi/publ/d137.htm
[2] https://www.coinbase.com/charts?locale=en-US
[3] https://www.cnbc.com/2017/10/13/jamie-dimon-says-people-who-buy-bitcoin-are-stupid.html
[4] https://www.fincen.gov/news/news-releases/fincen-fines-btc-e-virtual-currency-exchange-110-million-facilitating-ransomware
[5] https://www.theguardian.com/technology/2017/may/13/accidental-hero-finds-kill-switch-to-stop-spread-of-ransomware-cyber-attack
[6] https://blog.dell.com/en-us/we-re-now-accepting-bitcoin-on-dell-com/
[7] http://www.news.com.au/technology/online/hacking/restaurantgoer-has-bitcoins-stolen-over-unsecured-public-wireless-network/news-story/a82d75eb85763ee3d38678b430df3bf0
[8] We really must thank Wikipedia – it is a great source of drill down on each concept. While often scoffed at for academic research, for the rest of us, it is the default encyclopedia.
[9] I also must give credit to the Committee Report for teaching me a new word – seigniorage. That portion of the bullion brought to the mint for coining claimed as a right of the crown. Where does the digital exchange get its money? It simply creates it. Why didn’t I think of that?
[10] https://www.wsj.com/articles/millions-may-be-missing-in-bitcoin-heist-1512625176