Section 1 : The Trusted Third Party Problem
Chapter 2: Monetary Theory
by Wendy McElroy
Satoshi’s White Paper Breaks Your Economic Chains (Chapter 2, Part 5)
I think that the Internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B without A knowing B or B knowing A. The way I can take a $20 bill hand it over to you and then there’s no record of where it came from. You may get that without knowing who I am. That kind of thing will develop on the Internet and that will make it even easier for people using the Internet. Of course, it has its negative side. It means the gangsters, the people who are engaged in illegal transactions, will also have an easier way to carry on their business.
The Nobel Prize economist predicted Bitcoin during a 1999 interview conducted by the National Taxpayers Union Foundation. Milton Friedman’s brief statement is remarkable. Within a decade, a reliable e-cash was developed. Bitcoin did and does have a profound political impact on government by shattering its monopoly on currency. Peer-to-peer transfers do not require participants to know each other, and they can be almost anonymous. Bitcoin benefits criminals, as well as peaceful individuals, in much the same manner as physical cash. The quote’s one misstep is to envision an exchange in which “there’s no record of where it came from.”
E-cash and its surrounding issues had been discussed many times before October 31, 2008 when Satoshi’s Paper, “Bitcoin: A Peer-to-Peer Electronic Cash System,” was released into the wild. Without the blockchain to enable peer-to-peer transfer, however, the emphasis was generally on how to achieve anonymity when dealing with a trusted third party. It is the blockchain that makes bitcoin remarkable because it eliminates the need for a trusted third party.
But, first, Satoshi laid the groundwork for his paper.
Context for the Concept and Coding of Bitcoin
The coding of Bitcoin began in 2007. The timing was no coincidence. The financial crisis of 2007-2008 is often viewed as the worst to occur since the Great Depression devastated the 1930s. The 2007 crisis is a cautionary tale of how dangerous it is to empower trusted third parties, and how pitbull-protective the government is of the banking system.
A collapse in the subprime mortgage industry sparked the financial crisis. Typically, a subprime mortgage is issued to a borrower with poor credit who poses a higher-than-usual default risk. To compensate the lender, the borrower pays a higher-than-usual rate of interest. Subprimes became increasingly common for several reasons. One was the use of automated underwriting software that sped up the loan process, but often bypassed the standard review of data and documents. In short, lending institutions failed in their duty to authenticate a borrower’s eligibility. Housing prices rose on a flood of artificially-loose credit. Peaking in 2006, prices then spiralled downward for years, which caused massive foreclosures in the U.S. and internationally.
The high delinquency rate, in turn, caused a devaluation of financial instruments and threatened to collapse the trusted-third-party system. On September 7, 2008, the U.S. federal government assumed the liabilities of the shaky Freddie Mac and Fannie Mae; these government-sponsored enterprises bought loans from mortgage lenders, and sold them to investors on the open market. Then, on September 15, large investment bank Lehman Brothers filed for bankruptcy. Other banks were expected to follow, including Merrill Lynch, American International Group (AIG), and the Royal Bank of Scotland. The next day, the government announced its intention to recapitalize the U.S. financial system; it would bail out the banks. AIG led the way with the government extending a loan of up to $85 billion in exchange for an 80% equity interest in AIG. On October 3, the Emergency Economic Stabilization Act of 2008 was enacted, authorizing spending of up to $700 billion to purchase distressed assets and to fund financial institutions, including foreign ones. The hierarchy of trusted third parties not only failed in its fiduciary duty but also passed-on the cost of failure to taxpayers.
Satoshi watched the bailouts unfold, as the message on the Genesis block attests: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” Solving the trusted third party problem must have assumed urgency to him.
Something else significant occurred in 2007. The U.S. federal government filed charges against e-Gold, Inc., which was then the leading digital currency company. The charges were money laundering and transmitting money without a license. E-gold’s owners were tried and convicted; the company was ruined and closed its e-doors.
Satoshi must have watched this situation, as well. No wonder he maintained absolute anonymity.
Another piece of groundwork for the White Paper was to invite feedback from cypher-experts via private email. On August 22, 2007, for example, Satoshi emailed famed cypherpunk Wei Dai. The subject line was “Citation of your b-money page.” Satoshi explained, “I’m getting ready to release a paper that expands on your ideas into a complete working system. Adam Back noticed the similarities and pointed me to your site. I need to find out the year of publication of your b-money page for the citation in my paper. It’ll look like:  W. Dai, ‘b-money’, http://www.weidai.com/bmoney.txt, (2006?).” The footnote in the final White Paper was: “1. W. Dai, “b-money,” http://www.weidai.com/bmoney.txt, 1998.” Satoshi provided Wei with the URL at which to “download a pre-release draft.” He gave permission “to forward it to anyone else” whom Dai thought “would be interested.”
The draft, “Electronic Cash Without a Trusted Third Party,” does not mention Bitcoin in its title, but the abstract differs only slightly from that of the White Paper; mostly, the latter is better written. The freelance researcher “gwern” compared both abstracts by using Mergely–a powerful online diff and merge editor that highlights changes between texts. Gwern could not compare the texts, however. He later lamented, “[t] he pre-release draft link is now broken.” His dogged efforts to find the document elsewhere came to nothing.
The next occasion upon which Satoshi emailed Dai seems to be January 10, 2009. He wrote, “I wanted to let you know, I just released the full implementation of the paper I sent you a few months ago, Bitcoin v0.1. Details, download and screenshots are at www.bitcoin.org. I think it achieves nearly all the goals you set out to solve in your b-money paper. The system is entirely decentralized, without any server or trusted parties. The network infrastructure can support a full range of escrow transactions and contracts, but for now the focus is on the basics of money and transactions.”
Satoshi’s White Paper
Satoshi defines “an electronic coin as a chain of digital signatures.” The coins travel over a distributed digital ledger, called the blockchain, in which they are recorded transparently and chronologically. Bitcoin.com’s easy-to-understand “Bitcoin Whitepaper: A Beginner’s Guide” breaks down the basic steps in a coin’s journey:
1. New transactions are broadcast to all nodes/computers in the network.
2. Each node collects new transactions into a block.
3. Each node works on finding a difficult proof-of-work for its block.
4. When a node finds a proof-of-work, it broadcasts the block to all nodes.
5. Nodes accept the block only if all transactions in it are valid and not already spent.
6. Nodes express their acceptance of the block by working on creating the next block in the chain, using the hash of the accepted block as the previous hash.
As mentioned in earlier sections, nodes always consider the longest chain to be the correct one and will work on extending it.
Technical explanations of the White Paper abound and are available online for free. The following analysis, therefore, focuses on the most important non-technical aspect of Bitcoin; Bitcoin resolves the trusted third party problem, which is the White Paper’s raison d’être. The paper opens: “Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments.” But inherent problems attend trust-based traditional financial systems, including corrupt politics and practices.
Due to the strictly technical nature of white papers, however, Satoshi does not discuss the political problems, foremost of which is the alliance of government and banking, stripping individuals of freedom and security. Instead, the White Paper points to practical difficulties. For example, “financial institutions cannot avoid mediating disputes” that arise from the reversibility of transactions or fraud. The mediation creates negative consequences, such as transaction costs and a limitation on “the minimum practical transaction size.” What is needed for online commerce is “an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly.”
The brilliance of Satoshi’s system is twofold. It allows an online transaction that resembles one person handing cash to another; it also preserves the valid services that a trusted third party is expected to perform. It preserves the benefits of an honest and competent third party while discarding the abuses. The main benefits are: verification of a transaction, ease and security of transfers, preservation of privacy, prevention of double-spending, mediation of disputes, and provision of a record. The structure of the blockchain either provides these services or obviates need for them.
Verification. A trusted third party authenticates a transaction. A bank may compare the signature on a check with one kept on file, or it may verify that money is not counterfeit. These services have value. But a staggering amount of authentication performed by banks today is a disservice to customers. The exhaustive verification of customers’ identities, for example, violates their privacy in order to satiate government’s avarice for data.
The blockchain provides verification without intrusion. A bitcoin is authenticated simply by being accepted by the blockchain. A transaction is verified by miners through a “proof of work.” And, since the blockchain is an open public ledger, everyone can trace the history of a coin and be assured of a transaction’s accuracy. Transparency and cryptographic proof replace the need to trust.
Ease of Transfer. Financial institutions have been a practical necessity for transferring wealth over distance. As global commerce gallops forward, the importance of easy transmission also increases. With a monopoly on international transfers, however, banks have set terms that greatly advantage them to the disadvantage of customers. Banks impose direct and indirect costs. One direct cost is the fee attached to every transfer. Two indirect costs are the currency conversion, if necessary, and the time required for a money wire to be completed; during this period, the institution enjoys the “float.”
By contrast, the blockchain does not recognize distance in transferring wealth or information. Two computers in the same household are as close or far away from each other as two computers on different continents. Miners charge a fee for their service but fees are competitive and no costs are hidden. Most transfers occur almost instantaneously–at least, compared to bank wires.
Security of Transfer. Financial institutions place their own self-interest ahead of their customers’, which calls their trustworthiness into question. But even honorable banks can be hacked and their transmissions compromised. And all banks share customer information with governments, who in turn use that data to tax, to confiscate, to impose fines and to arrest.
The blockchain has no self-interest, not only because it is inanimate, but also because it is not owned by one person or one company; it functions as a public resource and a public good. The blockchain is almost impossible to hack. Its information is immutable and secured by cryptography–the use of codes and protocols to create private communication. No personal information is surrendered to a government. Although the ledger is transparent to all, including government, it is relatively easy to mask an identity and to scramble transfers through mixers or tumblers. The blockchain is currently the most secure method by which to transfer funds online. The only threat to security is if government attempts to control the Internet, which would be a threat to all methods of online transmission.
Preservation of Privacy. The type of privacy once offered by Swiss banks is long gone, even in Switzerland. Instead, financial institutions are choke points at which a customer’s personal data is collected and shared with authorities. The only true ‘privacy’ is the secrecy with which banks inform on a customer without that person’s knowledge or consent.
Maintaining privacy on an open, transparent blockchain seems to be a contradiction in terms. The “Bitcoin Whitepaper: A Beginner’s Guide” explains why it is not. “With the peer-to-peer network, privacy can still be achieved even though transactions are announced. This is accomplished by keeping public keys anonymous. The network may be able to see payment amounts being sent and received, but transactions are not linked to identities.”
Nevertheless, many people post their public keys to enable donations or payments. In these cases, a commonly-used privacy strategy is pseudonymity. Peer-to-peer transfers do not require the verification of identities or the provision of information beyond the crypto-addresses of a sender and a recipient; this allows for multiple pseudonyms. The addresses are privately generated by each participant’s wallet but they become public knowledge when they join the blockchain, which makes users vulnerable to network analysis. That’s why some users generate a different address for every transaction.
Another common privacy practice is to create multiple wallets in order to isolate a transaction or a type of transaction; this prevents it from being associated with other wallets and transactions. A user can also hide his or her device’s IP address by going through an anonymizing tool such as Tor.
Moreover, mixing services are now popular, but they can be problematic if they return to the problems of a trusted third party. Those who run a service must be trusted not to lose or to steal coins, and not to keep a record of scramble requests. Even services that claim to provide absolute and innovative anonymity, such as ZeroLink, have aspects of the trusted third party problem.
Nevertheless, through an array of strategies, Bitcoin offers much greater privacy than any other online payment system to date.
Prevention of Double Spending. Double spending happens when the same unit of money is used for more than one transaction. In other words, the owner of a coin spends it twice even though it can legitimately be spent only once.
Satoshi describes how more traditional payment systems prevent double-spending, “A common solution is to introduce a trusted central authority, or mint, that checks every transaction for double spending. After each transaction, the coin must be returned to the mint to issue a new coin, and only coins issued directly from the mint are trusted not to be double-spent. The problem with this solution is that the fate of the entire money system depends on the company running the mint, with every transaction having to go through them, just like a bank.”
Bitcoin was susceptible to double spending, especially if two transactions with the same coin were transmitted in rapid succession before the first one can be mined and recorded. Satoshi’s solution was elegant in its simplicity. All transactions must be public and all participants in the network must adopt one timeline in order to assure the order in which transactions are received is the same for everyone. Then each transaction is timestamped through a proof-of-work and, if a second transaction occurs, the earliest one is counted, the later one dismissed. In short, a peer-to-peer distributed timestamp server generates mathematical proof for the chronology of transactions.
Mediation of a Dispute. An advantage of physical cash is that the exchange is non-reversible except with consent or through a lawsuit. But traditional online payment systems provide for reversing a fund transfer. Again, the need for mediation increases overall fees and limits the minimum practical size of transactions.
Blockchain transactions are irreversible; mediation is not only unnecessary but also impossible. Funds can be returned only if a recipient agrees to do so upon the request of a sender, with Bitcoin remaining uninvolved. This lowers fees, enables micropayments, and protects senders against fraud. If necessary, escrow mechanisms can protect buyers.
A Record of a Transaction. Financial institutions maintain records but the entire content of a transaction or an account may not be provided to the customer. For example, a bank interaction with the authorities, like tax collectors, about an account may be withheld from the account holder. The records can be used to harm the customer.
The blockchain is an immutable, transparent ledger of every transaction that has occurred since the Genesis block. The distributed ledger is not only open to those who transact but also to anyone who takes the time to search it. No withholding can harm the user because nothing can be withheld.
Bitcoin provides the same service as a competent and honest third party, as well as offering other advantages. It allows greater anonymity, with the individual user remaining in control; it enables micropayments and speedier transactions. Increasingly, however, users are joining exchanges that resemble traditional banks, including sharing customers’ personal data with the government. It is ironic. Bitcoin’s success as a substitute for trusted third parties seems to be leading it back into the embrace of the problem it was created to solve.