Streetwise Professor

February 24, 2018

Are Trustless Transactions a Good Thing? I Don’t Know Until You Tell Me How Much They Cost

Filed under: Commodities,Cryptocurrency,Economics — The Profesor 2 @ 11:04 am

One of the most annoying crypto-tropes is the unconditional statement that Bitcoin and its competitors are great because they eliminate the need for trust in transactions. It is annoying because it is repeated ad nauseum despite the fact that it is seriously analytically incomplete. There is no free lunch: the banishment of trust comes at a cost, and a proper comparative analysis of cryptocurrency vis a vis alternatives (e.g., traditional bank-based payment mechanisms, fiat currency) requires a comparison of the costs of each. Which mechanism performs particular types of transactions more efficiently? Which mechanism performs particular economic functions more cheaply?

In Bitcoin, the economic function performed is the elimination of fraud (e.g., double spending, spending what you don’t have) in an anonymous setting. This is achieved via proof of work, which involves the use of real resources–notably, large quantities of electricity and computing power. That is, trustlessness comes at a cost.

The relevant question is whether this cost is higher or lower than the cost of performing the same economic functions (elimination of double spending, spending what you don’t have) using alternative mechanisms, such as traditional bank payment systems that rely on trust.

Trust is not free either. In essence, economic actors can be incentivized to act in a trustworthy way if they earn a stream of rents that would be lost if they betray trust.  But creating a stream of rents requires an increase in the price of an output and a reduction in the prices of the inputs of the trusted entity.  These price adjustments reduce output below the level that would be attained if transactions could be executed costlessly. (Proof-of-stake mechanisms use a variant of this to address double spend problems.)

The answer to this question is likely to differ, depending on the type of transaction at issue. For example, Bitcoin et al are likely to be cheaper for transactions for which anonymity or concealment of the identities of the parties from third parties  is highly desired by one or both of the transactors (which is a condition that may characterize many illicit transactions).*

It has yet to be shown, and there is room for serious doubt, that cryptocurrencies scale as efficiently as traditional trusted payment systems. Unless it scales, crypto will not be a viable replacement for large scale transactions, especially commercial transactions which represent the vast bulk of payments.

Another potential difference in cost involves security.  It is costly for trusted institutions to prevent theft and loss, but as has been seen of late, theft and loss are serious issues for crypto too. It is not clear which  mechanism mitigates theft and loss most cheaply.

Economics is all about the analysis of the costs and benefits of alternative means of achieving particular objectives. An analysis that hypes a feature of one such alternative (no trust required!) without comparing its costs with that for other ways of achieving the same objective (fraud-free transactions) is fundamentally flawed. Yet that is the default mode of discourse in cryptocurrency.

*The use of cryptocurrency in illicit transactions is close to the top of many elite/official criticisms of cryptocurrency–as it is in elite/official criticisms of fiat currency (“the war on cash”). I am at best ambivalent about this critique because the government decides what is illicit, and tends to overcriminalize transactions between consenting adults, and to overtax. As a Swiss friend told me when we were discussing the war on cash: “I would fight any attempt to eliminate cash. Cash is freedom!”

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  1. The idea that bitcoin provides “anonymity” is in general misguided as the vast majority of users haven’t acquired their holding through mining but have purchased it through an exchange or had it transfered to them by another individual. The ledger is fully public and it provides a permanent public record of every transfer. All that’s missing is the link between bitcoin addresses with real people but the fact that the this information isn’t fully publicly available only provides temporary protection. Many bitcoin addresses are already known – including those of the most popular drug dealers that used to operate on silkroad and all it takes is a few FBI warrants to exchanges – or more likely a hack – to fill in many of the gaps. I’ve seen stupid suggestions that you should transfer your holding to a new address periodically for “protection” but that does absolutely nothing to launder it – all your addresses will be publicly linked via the block chain.

    It’d be like if for every dollar bill – there was a public record listing every holder of that dollar bill in it’s history, albeit whether the holders were identified by a code. This it would an intelligence agency’s wet dream. Knowning the codes of all the retailers would allow anyone to build a detailed profile for any individual which would quickly lead to a real world identity.

    Comment by derriz — February 24, 2018 @ 3:28 pm

  2. Well, marginally, if you shift the balance from stationary towards roving bandit, the value of the trustlessness feature should go up. So I suppose the price trajectory of BTC depends strongly on whether the US can rediscover some principles and reverse its convergence to Russia.

    Comment by Ivan — February 25, 2018 @ 2:35 am

  3. @derriz: That’s a really interesting comment. I wonder if this is why bitcoin “ATMs” caused such opposition: Somebody could show up wearing dark glasses and a hat, buy some bitcoin with cash and then disappear..?

    @Anybody: Could we imagine a blockchain without proof of work? (i.e. the incentive is that the other blockchain participants simply won’t allow you to cheat). But in asking that, I’m assuming that the difficulty of bitcoin mining is just busy-work, which I suspect is untrue: I know that one of the functions of mining is to tidy-up the blockchain, so maybe the proof-of-work is unavoidable…

    Comment by HibernoFrog — February 26, 2018 @ 5:19 am

  4. @HibernoFrog: ATMs would be potentially be even worse – if they get a link between your credit or bank card used to fund the purchase. If they were to allow cash, it would likely be with very strict or monitored limits – token amounts. By design it’s impossible to do anything with bitcoin with out leaving a public trace and all the exchanges are dodgy. Mark my words there will be people busted for buying bags of week online in their teens even 10 or 15 years after the fact as intelligence agencies and law enforcement fill in more and more of the gaps in identifying bitcoin addresses. There’s no rush for them either – with the public blockchain, the map is there, it just requires coloring in the sections. And it’s a puzzle that gets easier as you solve more of it. It tells you something that even the inventor of bitcoin hasn’t been able to keep his holdings private.

    By the way, the other great bitcoin fallacy is it’s supposed independence from governments. That may have been true when most of the mining was done by curious geeks on their rigs at home. Those days are long gone and now enough of the mining is taking place in China that, were the government of China to use their massively effective internet censorship infrastructure to block bitcoin traffic at any time, they would break the bitcoin network. If they were to coordinate the miners, they could write any transactions they wanted into the block chain – for example transferring a portion or all of everyone’s holidng to themselves and then switch the network back on and nobody could do a thing about it. So investing in bitcoin involves a great deal of trust in the Chinese government.

    Comment by derriz — February 26, 2018 @ 4:38 pm

  5. To answer some of the questions posed:

    It is possible to do a blockchain without proof-of-work. Proof-of-stake (or the even more abstract “coin age”) is a more energy-efficient scheme, albeit with some concessions on the assumptions underpinning the security. It is also possible for an alt-coin to free-ride off the resources used to secure a more-established blockchain, and this is the principle behind ERC-20 tokens, whose security comes for free by riding on the Ethereum blockchain.

    It is clear that ordinary blockchains cannot scale to anything near what, for example, Visa does. Most proposed solutions to this involve off-chain transactions, where coin holders extend credit to each other (the “lightning network”), hash-locked contracts (“sidechains”), or turning the blockchain inside-out and having account holders prove their ownership of coins (“directed acyclic graph”). I cannot say which of these technologies (or some new one yet to be invented) will win out, but the allure of peer-to-peer currency is so compelling that mother necessity is almost certain to bring forth the inventions needed to scale.

    Regarding privacy on the blockchain, this is possible with cryptographically obfuscated blockchains. Monero and Zcash are the most prominent. Traditional blockchains can be made private by either purchasing with cash (for a long time the only way to get Bitcoin anyhow) or buying (e.g.) Monero and then using that to buy Bitcoin.

    Bitcoin’s allure come less from any alleged anonymity than than from its indifference to human identity. When code is law, corrupt governments can’t play favorites. Those of modest means now have a shelter against fiat currency hyperinflation and can escape the tyranny of capital controls.

    Comment by M. Rad. — March 3, 2018 @ 12:22 am

  6. I would also add that @derriz notion that investing in Bitcoin requires trust in the Chinese government fundamentally misunderstands how blockchains work. Massive censorship can stop miners from operating within China, and (in principle…very difficult in practice) prevent Chinese users from making Bitcoin spends, but ownership of the coins is established by the self-verifying (via the proofs of work) data in the blockchain. If Chinese officials successfully shut down all mining within their borders, the hashpower of the network would simply migrate elsewhere and, after a period of slow transactions as the protocol adjusts to a sudden loss of hashpower, the network will return to normal again. So long as copies of the blockchain exist somewhere, integrity of ownership is assured.

    And that assumes perfectly co-ordinated and technically competent bureaucratic behavior. Attempts to control Bitcoin so far have resembled attempts in the Bretton Woods Era to fix exchange rates by diktat. The inherent cross-border fluidity of cryptocurrency brings swift punishment by arbitrageurs. We *still* see Washington regulators, so accustomed to a KYC/AML regime that deputizes financial institutions into doing all their investigative work for them, looking for a central control point to coerce crypto into compliance with their idea of regulated markets.

    Comment by M. Rad. — March 3, 2018 @ 8:33 am

  7. @M.Rad–Thanks. Informative.

    I mentioned proof of stake in the post. It is essentially a bonding mechanism. Bonds are costly, but likely cheaper than proof of work. So again it comes down to the relative costs of alternative means of achieving a particular objective.

    As for the means to achieve scaling. I would surmise that at the end of the process, any such system will look similar to the existing system.

    Comment by The Professor — March 3, 2018 @ 12:47 pm

  8. Well yeah, proof of stake is, in essence, an investment that represents forgoing some alternate consumption, in an abstract sense at least. More perniciously though, is that the “Schelling game” you-win-if-you-conform-to-the-majority that POS represents is known to have multiple Nash equilibria. If enough stake commits to a false state of the books, then the rest of the stake has an incentive to play along with the lie. (This is a classic technique of the modern totalitarian state, where, if given enough propaganda power, the people have an incentive to play along with the lies without even believing them.) POW has the external incentive in that a correct state of the books makes mining rewards worth more, so I think we are stuck with POW, though perhaps mixed 1-in-10 with POS to reduce costs by 90%.

    The tendency for scaling solutions to centralize and fall under the aegis of forced trust in governments and cartels is the great Gordian knot confronting cryptocurrency developers these days. Bitcoin itself rapidly centralized very early with the MtGOX exchange, whose sordid collapse left an indelible impression on the community. In fact, the assumed tendency for the proposed Lighting Network to centralize to a small number of clearinghouses is its principal (and by my estimation, likely fatal) critique; the law of large numbers favors the big when extending liquidity, even if hash-locked contracts eliminate barriers to entry. Even a centralized Lightning Network is an improvement over custodial banking though, since attempts at favoritism or rent-seeking will tend to be routed around, and user privacy (errr, indifference to human identity) is built into the design.

    There is a Pre-Cambrian Explosion of thinking out there on scaling cryptocurrencies. Some projects have already demonstrated Visa-scale transaction volumes on their testnets with near-zero fees. Whether these schemes can stay secure from malicious attack when the money becomes real remains to be seen. I have my doubts about the implementations I have seen so far, and suspect that client software complexity will take longer to sort out than anyone would like to admit, but, post Bitcoin, the long hard road to true e-cash for everyone, un-banking the world, appears to be one of steady incremental evolution. In my view, this parallels the green revolution, a concerted effort against a whole array of technical problems that succeeded largely because the goal of eliminating famine was too compelling to give up on.

    Comment by M. Rad. — March 4, 2018 @ 11:48 am

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