Friday , August 17, 2018

Security Notes: Taming Bitcoin’s Wild Side

Gideon Samid •

Man’s best friend, the dog, is, after all, a tamed wolf. Our ancestors had the wisdom, good sense, and foresight to domesticate the beast. Is there a lesson here for us, as this wild new currency. Bitcoin, invades our monetary systems?

What is so wild about Bitcoin?

For one, it’s inherently speculative. It rises when the number of people who expect it to rise is greater than the number of people who expect it to drop. It depreciates when the number of people who expect it to lose value is greater than the number of people who expect it to appreciate.

These expectations in either direction are not a result of any rational analysis. One can rationally project the movement of the dollar-Euro exchange rate by analyzing the two economies. But Bitcoin is generated by agreement of the traders to reward a fellow trader for solving a mathematical puzzle for which the solution is of no societal benefit. How many dollars should such a useless mathematical solution be worth? Any exchange rate is as reasonable as another. There is no justification for a Bitcoin to be worth 1 cent or $1 million. So the expectations that govern the daily price are free to roam from zero to any value. Complexity theory suggests a bubble, a period of constant appreciation followed by a rapid collapse.

What else needs taming?

As it is defined now, Bitcoin is the perfect cover for criminals, terrorists, and other no-gooders, allowing them to trade illegally, accumulate wealth anonymously, and avoid taxation undetectably. Of course, we all prize our privacy, but we don’t want terrorists and drug cartels to harm us. The anonymity in Bitcoin is robust because there is no trusted party that can betray the traders, who remain anonymous even to each other.

There are other issues with Bitcoin, of course, but they are comparable to those of other currencies. What if the underlying cryptography fails, for example, or what if a hacker defeats the bank security wall? By contrast, inherent instability and unyielding anonymity are unique to Bitcoin and its many variants. They need to be tamed before Bitcoin can hope to become a viable alternative currency.

The way to tame the instability problem is to replace the “zero” bound with a positive bound, say, 1 Bitcoin equals $1,000. Today, when the price of Bitcoin may dwindle to zero, the only people who buy Bitcoin are high-risk gamblers and those ignorant of the risk.

Here’s one way this could work: Suppose that, alongside Bitcoin as we know it, there were an option to buy something called Bitcoin-2, which would operate with the same or a similar protocol but with a bank’s guarantee that one unit will always be redeemable for $1,000. Naturally given that choice, traders will flock to Bitcoin-2. Moreover, no one will pay more than $1,000 for Bitcoin-2 because the amount above $1,000 is not “insured.” Bitcoin-2 will therefore trade for a stable value of $1,000.

The bank that insures the price of this Bitcoin will also be the key to resolve the anonymity issue. A Bitcoin is a digital string that identifies the history of the coin: to whom it was awarded initially, to whom that first owner passed it, and so on to the current owner. This history is eventually known to the redeeming bank. Should an anonymous trader become suspicious, and can get a judge to agree, the redeeming bank could be ordered not to redeem any coin where the suspect trader is listed as a previous or current owner (counting from the day of the court order). The no-redemption decree would be voided if the trader revealed its identity to law enforcement.

This solution is akin to the search-and-seizure principle: the police cannot barge into our home just because they want to, but we cannot claim privacy if a search warrant were issued.

Expect the Bitcoin wolf to become a domesticated Bitcoin-2 dog: a stable currency, with built-in privacy and anonymity except for cases where there is well-founded suspicion of wrongdoing. If you are among the many who believe that the ills of Bitcoin spell its doom, think again. Bitcoin-2, -3, and so on will force all of us to rethink money, payment, banking, and wealth.

BitMint, for one, has just announced a tamed Bitcoin. Others have their version. Let natural selection run its course. The public is the winner in any case.

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