Dr. Ernie Teo

Research FellowSim Kee Boon Institute for Financial Economics

Singapore Management University

Mainstream Acceptance in Recent

News

Many More on a Daily Basis

Introduction

• Motivations of this Conference

• To engage industry and professional organizations to further understand and contribute to the pool of knowledge

• To understand the impact and identify areas of financial technology that improves welfare of Singapore and beyond

• To examine the incentives that will encourage the development of an ecosystem for financial technology and financial cryptography

• Disseminate research by SKBI and the speakers today,

• to be published in a HANDBOOK OF DIGITAL CURRENCY

Introduction

• The aims of this introduction

• Give you enough non-technical information to be able to:

• Understand the topics to be discussed in the coming panel sessions

• Be able to ask critical questions during the Q&As sessions

• Outline the main issues with cryptocurrencies which the panel sessions will try to address later

Even before Bitcoin…

“I think 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.”

Milton Friedman, winner of Nobel prize in economics, 1999

The Future of Money

“There are 3 eras of currency: commodity based, politically based, and now, math

based.”

Chris Dixon, Technology Investor

“Bitcoin will do to banks what email did to the postal industry.”

Rick Falkvinge, IT entrepreneur

Bitcoin

• To understand cryptocurrencies today, we need to start Bitcoin

• Cryptocurrency history can be traced back to DigiCash started David Chaum in 1990’s

• Bitcoin was started in 2009 by Satoshi Nakamoto who created the Bitcoin protocol and reference software

• bitcoins are created and held electronically

• Encryption (cryptology) is used• to create currency

• to verify transactions

Bitcoin

“With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.”

Satoshi NakamotoBitcoin developer

Bitcoin: not so easy

“The first five times you think you understand it, you don’t.” Dan Kaminsky, American Security Researcher

Bitcoin Made Simple

• Watch video here:

• https://www.youtube.com/watch?v=Mq9TEFRaunU

taken from: www.theguardian.com

Is i t the same as Money?

3 Functions of Money (found in most economics textbooks)

•Medium of exchange

• Can you give a seller bitcoins for goods/services?

•Unit of account (or measure of value)

• Will you post prices or record debts in bitcoins?

•Store of Value

• Will bitcoins hold their value into the future?

Is i t the same as Money?

Warning: just l ike money, you can lose it!

•If you do not back up your mobile wallet, you lose your bitcoins when you lose your phone

•If you store your encrypted bitcoins on your PC and a hackers gets onto your computer (just like a burglar breaks into your home), your bitcoins can be stolen

Is i t the same as Money?

Warning: just l ike money, you can lose it!

•Due to this issue, some users have turn to “Cold Storage”

• Storing your coins offline• On a piece of paper in a secured safe deposit box

• On a USB/disk drive disconnected from the internet

• If you lose the piece of paper you have written your bitcoin keys on, you lose your bitcoins as well

•If you intend to own a lot of bitcoins, get the technical expertise on how to store it securely

Is i t the same as Money?

“Bitcoin is exciting because it shows how cheap it can be.

Bitcoin is better than currency in that you don’t have to be physically in the same place and, of course, for large transactions, currency can get pretty inconvenient.”

Bil l Gates, Microsoft co-founder

Why would you use it?

• Lower transactions costs

• Faster transactions across borders

• Traditional international transfers take as long as 3 days and costs as much as 8% (it usually costs 0.001 BTC for a transaction)

• Cashless way to travel

Why would you use it?

• Hedge against hyper-inflation

• Crowd-funding

• Donate to charities

• Support startups

• Decentralized: No central government or institution controlling it

Cryptocurrency?

• Cryptography is used to • secure transactions• control the creation of new units

• You use public addresses to send and receive money (similar to your account number)

• Transactions have to be signed with a private key (similar to your password or pin)

• Cryptocurrency is one form of virtual currency

• Bitcoin is one form of Cryptocurrency

Where are my bitcoins?

• There are no actual bitcoins

• What you store are the secure digital (private) keys used to access your public bitcoin addresses and sign transactions

Hash

QR Code

The Blockchain

• Bitcoin is a distributed network

• Data is stored by all individuals on the network

• Every node on the network has a copy of the ledger of transactions called the Blockchain

• It is a chain of block of information that holds the record of all the transactions with the public address, the quantity, where the bitcoins came from and other information

The Blockchain

• Block chain is a sequence of blocks, which holds the complete record of transactions like a public ledger.

• No one is in charge but everyone has a copy

• Those who update the Bitcoin blockchain, called miners, are enticed by a reward via a cryptography contest periodically (e.g. every ten minutes)

Isn’t i t for criminals?

• Silk Road (website) allowed users to make anonymous drug purchases using Bitcoin

• Shutdown in 2013

• Bitcoin has also been used for online gambling

• Can be used for money laundering…

• Most drugs are still paid for with cash!

• More legitimate companies are accepting bitcoins

Regulator is Part of the Ecosystem

“…a challenge to our great innovators: extend your focus to devising creative solutions for preventing the abuse of virtual currencies by criminals, such as those who would exploit children. We all stand to benefit from such innovation, and the related transparency and integrity to our financial system.”

Jennifer Shasky Calvery,DirectorFinCEN, Jun 2013

Bitcoin is only pseudo-anonymous

• Argument:

• Easier to use anonymously compared to other financial networks

• All transactions that have taken place can be seen by anyone on the network

• Users are identified by pseudonyms

• Satoshi recommends to change pseudonyms every time you transact to be anonymous

• However, it is still possible to link transactions if there were multi-input transactions

Bitcoin is only pseudo-anonymous

• Evaluating User Privacy in Bitcoin

• By Androulaki, Karame, Roeschlin,Scherer and Capkun from ETH Zurich NEC Laboratories

• Shows that almost 40 percent of Bitcoin user identities  could be recovered, even if they were using the recommended privacy protections. 

• Identities can be recovered by law enforcement officials if required through similar investigations methods used to track internet users

Changing the Technology

• “The customers we’re talking about aren’t trying to be anonymous. They’re willing to be known, so Bitcoin technology is key and you can add to it or you could build a similar technology where there’s enough attribution where people feel comfortable that this is nothing to do with terrorism or any type of money laundering.”

• Bill Gates, Microsoft co-founder

“I’m a big fan of Bitcoin … Regulation of money supply needs to be depoliticized.”

Al GoreFormer US Vice PresidentWinner of Nobel Peace Prize

Decentralized Network

Decentralized Network?

• New bitcoins are created through a process called mining where a cryptographic puzzle is solved

• This also verifies a set of transactions and places them on the ledger or blockchain

• This process requires computational power and the difficulty is adjusted such that each “block” takes approximately 10 minutes

• As the competition for mining goes up, difficulty becomes harder

Decentralized Network?

• Bitcoin was designed to be a distributed decentralized system with no central authority

• In the sense that no one has a major influence over the way mining functions

• If no one wins consistently, then the ledger is updated by different miner each critical cycle (6 blocks), ascertaining the accuracy and completeness of the transactions

• However, as the systems evolves this may not necessarily to be the case

Decentralized Network?

• As difficulty increases, it becomes inefficient for an individual to mine on his own

• Over time, individuals start combine their computational power on a platforms known as a mining pools

• Reference: “Emergence, growth and sustainability of Bitcoin: the network economics perspective”, by Ernie Teo (2014)

Decentralized Network?

• SKBI’s agent-based computer simulations shows:

Number

Time

Non-Miners

Mining Pool

Individual Miners

Decentralized Network?

• The majority of computing power now falls on a few large entities such as owners of mining pools and IT developers

• There are no clear regulations on decision making or changes to the Bitcoin protocol unlike a government or financial institution

Announced in Aug 2014

“I can today announce that the Government will start a major programme of work exploring the potential of virtual currencies and digital money.

These alternative payment systems are popular because they are quick, cheap, and convenient – and I want to see whether we can make more use of them for the benefit of the UK economy and British consumers. I also want to be alert to the risks that accompany any new technology.”

George OsbornChancellor of the ExchequerSecond Lord of the Treasury

“I really like Bitcoin. I own Bitcoins. It’s a store of value, a distributed ledger. It’s a great place to put assets, especially in places like Argentina with 40 percent inflation, where $1 today is worth 60 cents in a year, and a government’s currency does not hold value. It’s also a good investment vehicle if you have an appetite for risk. But it won’t be a currency until volatility slows down.”

David MarcusCEO of Paypal

Bitcoin’s Volati l i ty

Bitcoin’s Volati l i ty

• In 2013, We saw the price of bitcoins go up more than 80 times in January ($14 USD) to $1242 USD per bitcoin in November

• 2014, we see it fall down to a low of about $294 USD in October

Bitcoin’s Volati l i ty

• As with any disruptive asset class, bitcoin prices are highly volatile

• As a payment system, this is manageable

• Most prices are tagged in conventional currencies and are converted to bitcoins at the time of purchase

• It is a risky investment for now

• Regulatory risk is high in some countries

Some Issues

• Highly volatile

• Susceptible to pump and dump

• Hoarding of coins may cause volatility

• Need more real transactions for price to stabilize

• Mining has become highly expensive

• Uses energy

• Transactions are irreversible, no consumer protection like credit cards

Some Issues

• Sustainability (large Blockchain)

• As all nodes are required to store the ledger on their system/devices, this may not be sustainable in the long run

• Attacks

• 51% attack

• Goldfinger attack

• Selfish Mining

• Double spending may still be a risk for instant transactions

State of Bitcoin Q3 2014

From www.coindesk.com

Venture Capital

Block Chain Technology

Uses of the Block Chain Technology

• Smart contracts

• Issue shares – replace exchanges

• Currency exchanges - Ripple

• Can be integrated by banks

• Property, virtual property,

• Smart Accounting

Some popular cryptocurrencies

• Namecoin – a decentralized domain name system (with .bit domain)

• Litecoin – each block takes 4 times faster than Bitcoin

• Dogecoin – created as a joke, used as an internet tipping system on social media

• Mastercoin – successful crowd-funding effort• some 500 people invested in the project, sending a total

of about 5000 bitcoins worth about US$500,000 at the time

• aims to enable complex financial functions such as a decentralized exchange

Some popular cryptocurrencies

• Peercoin – uses “proof of stake” protocol, sustantially different from bitcoin

• Darkcoin - uses a system called Darksend to add privacy to transactions, with a different hashing algorithm

Ripple – a payment network for transfer of coins

Historical map of cryptocurrencies

551 currencies(as of July 2014)

(Taken from http://mapofcoins.com/)

Future Coins & Business Models

• New cryptocurrencies or altcoins can be developed to address the shortcomings of current coins or to cater to different needs

• National coins

• Bitcoin 2.0

Bitcoin 2.0

• New protocols which innovatively build upon the Bitcoin platform

• A layer lying on top of the blockchain

• Using the blockchain for applications other than just for the purpose of payment transactions

• Bitcoin 2.0 technologies include • GEMS – A social network currency• STORJ – Cloud Storage based on blockchain technology

• The Internet of the Sharing Economy• To distribute the reward in proportion to those who contribute and it

pays to be part of the distributed “NETWORK”, e.g. FB versus GEMS, Dropbox versus STORJ, etc

• Reference: Bitcoin IPO, ETF and Crowdfunding, by Bhaskar, Lam and D. Lee (2014)

Ending Quotes

“Bitcoin is a remarkable cryptographic achievement and the ability to create something that is not duplicable in the digital world has enormous value”

Eric SchmidtCEO of Google

Ending Quotes

“Given that most of the welfare improvement wil l come from the bottom of the wealth pyramid, emerging markets have the upper hand in harnessing the low hanging fruits of Cryptocurrency via a decentralised, but not necessary distributed system.

It is about reduction of business cost. Welfare improvement wil l occur as a consequence, and new financial technology wil l lead to enhanced efficiency in a sharing economy and the growth of profitable social businesses.”

David Lee, Director, Sim Kee Boon Institute for Financial Economics

The EndThanks!