Trust: Tragedy of the Victim

Mike Hayes copyright April 6, 2014 !

Trust Tragedy of the Victim

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This paper addresses a primary problem existing today in the Bitcoin economy. It is the

carry over of the habit and use of trust from the world of old money.

People do not change ingrained habits easily or quickly. Many invested in Bitcoin, but then

left their coins on exchanges. Why should they not? Who in recent years has pulled their money

out of a bank or investment house? People were used to trusting banks with their money. They

trusted stockbrokers and many other intermediaries, most whom operated as fiduciary agents.

They knew the world as a place where intricate layers of government regulation created or

appeared to create safe havens for investment capital. Many went to exchanges, bought Bitcoin,

watched the price rise, and sat back to watch what would happen.

They might have proudly said “I, too… own bitcoins!”

But did they?

Did they actually own bitcoins?

!Owning bitcoins?

If they did not own the secret of the private key, then at best they had a contract with

someone regarding the funds and assets. One of those assets was the private key. By typical

business and legal standards, they did not own bitcoins, They owned only a “Promise to pay”

from a vendor. It may seldom be in the business interest of the “Trusted Intermediary” such as

an exchange to engage in full disclosure, or to explain such distinctions to a customer.

Indeed, if one explained Satoshi Nakamoto’s trust less model to an average consumer he

might opt for the trusted intermediary. The “workhorse of traditional finance”.

!1HAYES - TRUST - TRAGEDY OF THE VICTIM

Finally, the Bitcoin user community should, but has not and did not, help new entrants to

the Bitcoin economy in this understanding. Buyer and seller, unwittingly for the larger part, took

the technology of Satoshi Nakamoto of trustless transactions, perverted it into requiring trusted

intermediaries, and then in many cases, suffered losses from unregulated trusted intermediary

relationships. This should never have happened according to the Satoshi trustless model of

transactions.

Ownership of Bitcoins means taking possession of them. This must be explicitly defined

and understood. We are talking about “taking possession” of what is basically just long

numbers. As a way of explaining this, let’s look at a conversation between two people. We’ll call

them Jane, and her friend, named Hack.

Jane asks Hack if she could “own” the number 2345. Hack tells her, she could own the

secret of which five digit number the number was. He continues “you’d own it for a millisecond

before my computer cracked it.” Hack then says “But if you made the number a lot longer and

added letters as well as numbers, you could create a number that could not be cracked in a very

long time. You could own that secret for sure.”

Jane confronts Hack “Really? Well how about my social security number and my driver’s

license number? Bet you can’t crack those.”

Hack replies “Mmm, trying ten million combinations of digits for the Social Security

number would just take a fraction of a second. Same for the driver’s license number. Forget

those being secrets.” Then Hack states the obvious: “Jane, neither the Social Security number or

the driver’s license number were ever a secret. They were given to you by a government, and the

data was stored and recorded in thousands of places. They were routinely scraped by various

bad actors on the Internet.”

Hack explains to Jane that no such number could even get close to the true meaning and

the importance of “secret” in the cryptographic sense. He proceeds to explain that a secret was

believed to be a secret until multiple eyes had seen it, or until it was recorded digitally in multiple

places, where access - past, present or future was possible.

In fact the many, many layers of law, rules and regulation supposedly protecting privacy

have only covered up vast increases in the collection of private information, it’s incorporation

into legitimate and illegitimate databases. Today vast industries exist including Internet social

media, are based on the the sale, legitimate and illegitimate, of that information. Government


and corporate entities rely on such data, and seek to include themselves in the list of those

permitted access, while excluding the individual. In the cryptographic sense, artificial walls

around datasets, secret to those whose data is held in them, yet available for sale, publicly and

privately, do not comprise secrecy. Thus the more you hear about privacy, the less of it there is.

Looking at the trends, little personal information is or is going to be “secret” in the 21st century.

In opposition to these expanding invasions of privacy and their intricate coverups and mis

or dis information on the subject, enters the Bitcoin economy. It requires actual complete secrecy

of the private key, since anyone knowing or having access to that key could spend its money.

With Bitcoin, the very fact that it is called a “cryptographic currency” means that it is based

on secrecy of the private keys. “Private keys” are very long numbers that a skilled adversary

cannot discover. As the Hack explained to Jane, the entire system of the cryptographic currency

only works if these keys are held secret. What one “owns” is the secret of what the number is.

The important meaning of “cryptographic” to take away here, is that if and when and for

what time Jane keeps the key secret, no one can deduce, infer or compute the value of the secret

number. Jane’s funds are totally, completely safe.

Suppose that Jane possessed a private bitcoin key. She could generate some public keys of

her own, then transfer values from a third party’s bitcoins into hers. She could then check the

block chain, the public transaction registry, to verify that the transaction did happen. At this

point, Jane does in fact “own bitcoins”. As long as she holds his private key secret, she will own

them.

Now, suppose that Hack runs a bitcoin exchange. People start an account on his exchange,

then convert their US dollars to bitcoin. They may transfer the bitcoin to an outside account,

either that of someone they are doing business with or to some private key which they own. But

what if they leave their bitcoins with the exchange, in their “Wallet”?

!The customers of Hack cannot check transactions or verify their ownership of coins on the

block chain. At the point the principles of the Satoshi model cease to exist. The naive end user,

perhaps not understanding the subtle distinction, has substituted trust in a third party for the

capability of trustless transactions. He has accepted a “promise to pay” instead of ownership of

bitcoins. If an individual does not own the private keys, he cannot be said to own bitcoins.

Trust is a strong habit.


Some wallets don’t display the private keys or particularly help the user find them.

BitcoinQT is one such. There is no menu item to “show private keys”. The menu and help

options do not describe private keys. It is there, but it is fairly well hidden. BitcoinQT forces the

user to go to command line options to get the private keys. This is a very high level of security,

since the user himself does not know the private keys until he requests knowledge of them from

the program.

There is no question that if one moves funds from a web wallet to a version of BitcoinQT

on a private computer, that person has ownership of those bitcoins. To take them away requires

hacking into or taking the private computer. When the coins were at the web wallet service, first

they may have been pooled in common inventory and were used with ad hoc designated private

keys and public key pairs. Private keys may have been handed out to customers only upon

request, either being generated on the instant the customer request was made or having been in

existence from when the customer started his account. This is more akin to trade accounts

receivable than any form of true ownership.

Now that we have defined ownership, let us note that web wallets have many uses and

distinct advantages. Many active bitcoin users have both. They have cold storage on a private

computer or offline entirely in paper wallets, and they have an online “hot wallet” which contains

funds only in the amounts required for expected transactions. Basically, the online “Hot wallet”

has a sum of money that the user can afford to lose. But that describes a competent and perhaps

a sophisticated bitcoin user.

So what of the newbie, one who comes into the world of bitcoin knowing little, buys some

coin on an exchange, and who many not even know how it functions. He may engage in a few

transactions, but his primary interest is investment. The user comes into the virtual currency

market preferring or knowing only of trusted third party intermediaries. A sophisticated and

seasoned investor in the stock markets or other forms of investments may make this error without

even thinking. The very concept of trust being an error would shock him.

Hypothetically, an exchange or web wallet company could attempt to give each customer

private keys, and could operate in a fashion where each customer’s money and coins was

separated and not in a common pool. It would even be possible using M of N transaction

systems to have a web wallet company system in which customer funds could not be meddled

with, hacked or stolen. However it would be incumbent upon the company implementing these


features to explain the issues clearly and simply enough that new incoming users understood the

advantages and gravitate towards them.

!The Proper Role of the Exchange and the Web Wallet

A bitcoin exchange exists to facilitate conversion between fiat currency and virtual. But

many have a second function - facilitating on line transactions and use of the virtual currency.

Many seem to have acquired a third function - the repository of customers’ virtual or fiat

currency.

What happens when customers leave their bitcoins or their cash on the exchange? To

understand let’s take two hypothetical exchanges, and look at their business structure and it’s

effects on the balance sheet, profit, and operational risk. Assume they operate by taking a 1%

commission on conversions from and to fiat and virtual.

For $100,000,000 face value of transactions in one month, the commission would be

$1,000,000. If average stay time for a transaction was a week, the exchange might on the

average hold something like $25,000,000 of customer funds. This would be divided between fiat

and virtual currencies. If 50% of the customers left their coins or money with the exchange, in a

year the exchange would be holding a pool of $600,000,000. Out of this it could handle

promises to pay as and when they arose. Risk exists, obviously. The risk can be computed

mathematically based on the fraction of holdings in bitcoin versus currency, and a range of

possible values for bitcoin.

For this paper we leave those risks aside. The point is when…. and why, if ever, would the

exchange encourage the customer to take possession of his coins?

A hypothetical exchange that refused to hold customer funds, which for example did the fiat

to bitcoin conversion and then immediately sent the coins to the customer provided address,

would have a running balance of about $25,000,000. But an exchange which sent the coins to

customers immediately 50% of the time, and 50% of the time kept them for long term storage,

perhaps assuring the customer that they were “in safe and offsite storage” would see something

quite different. Within a year, such a company might easily be sitting on hundreds of million

dollars in customer assets. That’s without the fiduciary safeguards of the banking and investment

industries. Many businessmen, either for reasons of greed, ego, unethical inclinations, or simply


to satisfy stated and desired customer demand, would opt for the latter business structure. Any

error in the ratio of value between the two inventoried items - currency and bitcoin - would be

reflected in that exchange’s ability to pay it’s customers if they demanded what they were owed.

Exchanges all uniformly require their customers to deposit funds in fashions that prevent

chargeback risk to the exchange. Before the customer is allowed to trade fiat for bitcoin, the fiat

transaction must be one hundred percent settled and non reversible. Delivery of bitcoins is non

reversible, and if the exchange did not adequately protect itself from the possibility of a

fraudulent reversal, it could have serious problems.

But after purchasing the bitcoins, the customer is exposed to all these identical risks and

more, without the safeguards the exchange provided for itself.

!The Silence of the Bitcoin Exchanges

Finally I come to the third issue, the attitude and response of the user community to these

factors. The bitcoin community has a small core of very knowledgable people. It has a vast, and

growing majority of users who are fairly ignorant about the details of Bitcoin. And many are

quick to suggest the latest exchange with good features, fast response and reasonable fees. But

seldom has the very concept of ownership versus a “Promise to Pay” been described. Even if

Laisse Faire, clear and simple statements regarding ownership and trust relations cannot help but

improve the growth and operation of the bitcoin economy. Because the Satoshi model is a

mathematical model, any proposed deal, including those as simple as a sale of bitcoins from

Hack to Jane, can be measured in quality against the model of trust less transactions by

Nakamoto.

The Nakamoto model does not allow or require banks or governments to say “Trust us”

and the user to nod his head and do so, but neither does it allow or require exchanges or third

party intermediaries to be trusted. The only plausible way to judge the quality of a business

proposal involving bitcoins is against the Satoshi Nakamoto model.

!Summary

In conclusion I propose clarity in definition of ownership versus of “Promise to Pay” based

on the strict Satoshi model. The suggestion is made that the relationships be measured by the


Satoshi model. This is often in opposition to the prior habits of customers and the business

interests of exchanges. Silence on the issue of what comprises “owning bitcoin” on the part of a

bitcoin exchange is a purposeful effort to increase holdings by that company, possibly in a very

deceptive manner.

!Contact me if you like at mike AT makersofthemoon DOT com.


Trust: Tragedy of the Victim

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