Cybersecurity: Crime and Espionage

Lawfare Buys a Bitcoin -- Introduction

By Paul Rosenzweig
Tuesday, December 9, 2014, 8:04 AM

Lawfare has decided to buy a bitcoin. We do this not as an investment but as an experiment in journalism. Buying a bitcoin will let us explore the mechanics of how the market works and also give us a fun platform to look at some of the legal and policy issues surrounding crypto-currency. This introductory article is the first in a series on the subject that will, we hope, serve as an enjoyable exploration of a novel technology. Herewith, as a way of getting started, we present a short, introductory primer on bitcoins ….

Bitcoin (often abbreviated BTC or XBT) is a digital, decentralized, partially anonymous currency/commodity/security that is not backed by any government or other legal entity. It was invented (or perhaps created is a better way of describing it) by a pseudonymous mathematician Satoshi Nakamoto, who described it in a 2008 paper as a peer-to-peer, electronic cash system. One of the fun mysteries about Bitcoin is that nobody knows who Nakamoto really is (he may even be a she or a group of individuals operating under as single name). He says he is Japanese, but his writing style suggests he learned his English in Britain rather than the United States.   Attempts to identify him by newspapers and magazines have, thus far, failed utterly.

The lack of government backing is Bitcoin’s defining characteristic. Traditional currencies are backed by a government’s authority (libertarians might say by a government’s “fiat”) and are also, sometimes, backed by a hard resource, like the gold standard that used to underlie American dollars. [Indeed, the oldest forms of currency were non-governmental units of exchange such as salt or seashells.] Other units of account (like your obligations to American Express or MasterCard) are denominated in government-backed currency units and fully convertible (at least in theory) to government-issued cash. By contrast, Bitcoin is not backed by any government or resource. It is a purely digital currency that can be accumulated and stored in electronic accounts. It can be used much like a conventional payment network, such as PayPal, but it has no backing at all – and hence its value is completely dependent on only one factor: what the users of Bitcoin will give for it in exchange.

Some Bitcoin users see this as its principal virtue. They think that government backing is (either directly or, more reasonably indirectly) a form of government control. Hence for them the development of a system that excludes government intervention is the singular achievement of Bitcoin. Other users are simply concerned that governments may debase their currencies as a quick economic fix. [As an aside on usage, I am told that proponents use “Bitcoin” when talking about the system itself and “bitcoin” when talking about an actual coin.]

To make this happen, however, Bitcoin had to provide a substitute for the other critical function of government – its backing came with a guarantee of value and uniqueness. A dollar bill (with a serial number) is certified by the US government as authentic and one-of-a-kind. When I give it to you in exchange for some goods, we are transferring value and implicitly the government is standing by to verify the authenticity of currency used in that transfer. They are also ensuring that the same dollar bill can’t be spent twice. Indeed, governments around the globe spend a lot of time and effort in that surety function --- ranging from money printing costs to anti-counterfeiting enforcement.

By contrast, transferring a digital file, such as a bitcoin, runs the risk of double spending. Since a digital file is readily copyable, a secure digital system needs a way of preventing a user from spending the same bitcoin twice. As a substitute for the government’s verification function Bitcoin relies on complex cryptographic system that involves links to a ledger system known as the “block chain.” We’ll talk about block chains in more detail in another article – for now accept this simplified description: Bitcoins are created by, in effect, adding new pages to the ledger through solving increasingly challenging cryptographic puzzles. This is colloquially known as “mining” because creating a bitcoin requires effort (in the form of the use of computing power and energy) in the same way that extracting gold from the ground requires effort.

Once created, the history of each individual bitcoin is cryptographically tracked in the block chain ledger. So when, for example, I transfer it to you in exchange for a hamburger that transfer is recorded in an indelible fashion in the block chain. Thus, the mining function combined with the block chain record assures the authenticity and uniqueness of every bitcoin transferred. Mining also has the virtue of creating new money without the need for a government to “mint” the coins.

Finally, some see Bitcoin as a cost-saving mechanism to eliminate the middleman for transactions. Another key component of Bitcoin is that it operates on a peer-to-peer basis – that is directly between a purchaser and a seller. By contrast most other new digital systems of payment, like Apple Pay, or Google Wallet or PayPal, involve reliance on a middleman to complete the transaction. Besides forfeiting anonymity, this aspect of the transaction also comes at a cost – these services don’t come for free. In essence Bitcoin is a frictionless mechanism of transfer.

Of course, to the extent bitcoins are a currency (and we will talk about their legal characterization in another article), they are exchangeable. Because they aren’t government backed, thinly traded, often held for investment and relatively unfamiliar instruments of exchange, their value has tended to fluctuate a fair bit. As of early December 2014, for example, 1 USD was worth .00268 XBT (or, conversely, 1 XBT was worth 372.69 USD). A year ago a bitcoin traded for 726.93 USD so they have dropped in value by nearly 50% over the past year. On the other hand, in July 2013, before the late 2013 “bubble,” 1 XBT was worth 108 USD – hence the last 18-months have seen an increase of more than 300% in the value of 1 XBT. As with most markets, the valuation depends a great deal on when you bought and when you sold.

Bitcoin uses are growing internationally. Today we have seen the first physical bitcoin ATMs that exchange currency for bitcoins. More than 40,000 merchants now accept bitcoin for their goods and BitPay says that more than 1 million will do so by the end of 2016. Some of the retailers sell legal products (like jewelry or cupcakes). But the partial anonymity of the exchange has also allowed Bitcoin to be used for illegal activity. There is even (I am shocked to say – and it is not easy to shock me) a site that allows bitcoins to be used to hire an assassin, where someone has bid for the assassination of President Obama. [There is some doubt about the authenticity of this site – my friends who use Bitcoin think it is a troll.] Crypto-libertarian groups like WikiLeaks, now accept bitcoin donations. In short, bitcoins are moving from the fringes to the mainstream, with as yet unknown consequences.

With that introduction, here’s an outline of the future topics we intend to cover (if any reader has additional topic we should include, please email me at psrosenzweig@lawfareblog.com). We will examine:

  • How to buy a bitcoin and use it
  • As a legal matter, is bitcoin currency, security, or commodity?
  • The math behind bitcoin and the block chain
  • Bitcoins and the Dark Web
  • Securing a bit coin (or how it can be lost/seized/stolen)
  • Bitcoin and money laundering
  • Bitcoin and remittances and financial inclusion
  • Bitcoin and free expression
  • Selling a bit coin (or keeping it if we don’t want to sell it)

We’ll probably do this bi-weekly (with a break for the holidays, of course). Enjoy.