The Chicago Fed Explains Bitcoins

Bitcoins have been in the news a good deal lately, and they get there in ways that suggest they are poised to impact the world of alpha and its pursuers. So it’s good to have a primer: a brief accessible essay that answers the simplest questions, like “what’s a bitcoin?”

As a first approximation, says a recent paper by a senior economist in the economic research department at the Federal Reserve Bank of Chicago, abitcoin is “a string of zeros and ones” stored in a computer file known after its molecular-world analog as a “wallet.”

Ann wants to transfer the bitcoin to Bob, who also has a wallet. Each party, Ann and Bob, has an app for this, and their two apps carry out the transaction.

There exist a large network of internet nodes, called “miners,” and the transaction between Ann and Bob involves broadcasting a message to the nodes. The key is that every ten minutes the miners gather up the recent proposed transactions and try to add them to the block chain, which is, as Francois R. Velde, the Fed economist behind the primer, calls it: the “universal ledger of bitcoin transactions.”

I say the miners “try” to do this because the Ann-Bob transfer doesn’t get onto the block chain unless the coin, those 1s and 0s, solves a difficult mathematical problem. The nodes are called miners because they are compensated for their part in confirming the Ann-Bob transfer by being allowed to create new bitcoins themselves.

As Velde observes, there exist a range of mathematical problems that are both difficult to solve and easy to verify. The exploitation of such a duality links bitcoin conceptually to the old gold standard: gold is difficult to get out of the ground, on the one hand, but it is quite easy to determine whether a certain material actually is gold on the other. The verification has been routine since soon after Archimedes cried “Eureka!”

A Fixed Amount of a Digital Currency
Another consideration dear to those who see gold as an ideal money supply: there is a fixed amount of it on or in the planet. Successful metal mining operations can increase the amount in circulation, and the amount in circulation will approach but can never exceed the amount on the planet.

There is an analogy to this, too, in the bitcoin protocol. The difficulty of the computation that must be solved is adjusted over time (every two weeks) so as to keep the rate at which blocks can be added to the chain to just six an hour. The protocol further provides that the total number of bitcoins in existence will never exceed 21 million.

Velde’s math tells him that the production (or mining) of one bitcoin per day at the current level of difficulty requires a machine that costs roughly $3,000 a day’s worth of electricity, also per day. If the machine lasts five years, the cost of the creation of one bitcoin is $2.50. But that $2.50 has no connection to the value of a bitcoin. It has no value except in exchange. And its value in exchange as I write, expressed in U.S. dollars, is above $300.

So again: what is a bitcoin? Is it a viable digital currency with a big future?, a flash in the pan? or a tool for fraudsters?

Limitations and Irony
Velde, who seems of the flash-in-the-pan persuasion, sees some limitations. First, there are barriers to anonymity in the use of bitcoins, because given the way in which they are transferred possession must be linked to the unique identifier of a particular file/wallet. The owner of the wallet can employ the same sort of tricks that the owner of a check account can to obscure ownership, but the easy anonymity of simply handing over a wad of paper cash for a product is lost.

Second, the speed of transactions is slow. As noted, the block chain only grows six times an hour. This means a ten-minute wait for confirmation of a trade. For large transaction, it is customary to break the total down into units, added consecutively, so that some transactions require a wait of an hour: six blocks of those ten minutes each.

Third, there may be trust /confidence issues driven by the fact that the protocol is an open source work in progress, leaving much to the discretion of a small set of programmers who may have a natural monopoly due to a first-mover effect.

On this last point, bitcoin advocates have already taken to quoting with irony Velde’s words: “it is hard to imagine a world where the main currency is based on an extremely complex code understood by only a few and controlled by even fewer, without accountability, arbitration, or recourse.”

That sounds to some a lot like a description of the impact of central banking in the world since August 1971.