Blog

Bitcoin, Cryptography and Trustless Exchange

By Stuart C.

As a disclaimer: I do not use Bitcoin because, as of yet, I do not feel like I understand the financial risks and security flaws enough to mitigate the risks associated with this emerging technology. This post will be more about what change crypto-currencies like Bitcoin (along with cryptography) will bring about in the world, rather than more specific technical specs about the protocols and digital structures behind the blockchain. I will use the term “Bitcoin” as it is the most popular crypto currency, but please note that it may not be the end-all-be-all of digital currencies. If you would like to learn more about the technical side of Bitcoin specifically, Bitcoin.it is a good place to start.

Many wonder what makes Bitcoin so special. How is it different from paying with Paypal, a credit card number or other digital means of exchange? Why do governments want so badly to bring it under regulatory control? What makes it more than just a currency?

To the casual observer, Bitcoin is just another (albeit, currently a more difficult) way to facilitate digital exchange, much like Paypal. But the structure behind it makes it so much more that just a way to trade goods over digital mediums. Bitcoin is not just digital representation of already existing currency, but rather it is a “distributed crypto-currency” in and of itself. Instead of relying on a potentially corruptible centralized authority to issue and insure value of a currency, it relies on decentralized verification system to confirm that users have the value they claim to have, and to reward users for their participation in the verification process. The anonymity of exchange is possible due to powerful and widespread encryption. Encryption that at one point was classified as a cyber weapon by the US government. For more detail about cryptography such as PGP, check out Phil Zimmerman, the Cypherpunks, or just google cryptography. But I digress, a detailed history and explanation of cryptography is not what I am here to provide.

What I am here to discuss is what Bitcoin and cryptography enable: Bitcoin enables trustless two-party exchange, and cryptography keeps that exchange away from prying eyes. This is important because it fundamentally changes the nature of trade.

Traditionally, exchange happens two different ways.

Option 1: Two individuals who have a longstanding relationship, who trust each other to follow through on their promises, make a contract (verbal, written or otherwise), and exchange goods and services. If one person reneges, there are no systemic repercussions or restitution, other than the loss of trust or potential violent retrieval of loses from the other party, and perhaps a loss of reputation in the community. For centuries before organized governments, this was the only option. Transaction and information costs were extremely high, and many people were hesitant to trade with those whom they did not know.

Option 2: Two individuals who have no prior relationship, and perhaps no intention for a further relationship, trade through a trusted 3rd party that insures both parties follow through on the contract. Often this third party is government, but it may also be another independent intermediary (for example, in black markets, it may be a mutual contact that vouches for both parties). In day to day exchanges this becomes somewhat difficult to see, but it happens in every exchange that you make when using government issued currency. The government, through central control of currency, guarantees these exchanges; that your fiat money will be worth something when you want to exchange it in the marketplace for tangible goods or useful services. In the event of a disagreement, judicial systems and courts are used to hash out a solution according to (somewhat) predetermined rules. When compared to option 1, this system drives down both information costs, as you no longer had to do research on who you are trading with to assure yourself that they will provide you what they promise, and transaction costs, by introducing uniform currency as opposed to barter systems that are common in trusted two-party systems.

What Bitcoin does it introduces a new option: exchange that relies on neither trusting the other party, nor a centralized third party. It, like the trusted 3rd party system before it, further decreases transaction costs and information costs. Through transparent exchange verification, digital and contractual escrow capabilities, and other decentralized financial instruments, Bitcoin allows for the positive aspects of a trusted 3rd party, without the drawbacks.

By reducing the need for trusted third parties, trustless two-party exchange decreases the utility of government, and by encrypting this exchange, the ability of government to interfere with the market decreases as well. This is why governments are trying so hard to regulate and control Bitcoin.

But they will not be successful, the key reason being that Bitcoin is decentralized and encrypted. This breaks the government’s monopoly control of capital and allows for previously disenfranchised groups to empower themselves. Governments, with their monopoly on violence, are very good at stamping out organized competitors, otherwise they would not be governments. But, because of encryption, governments will have extreme difficulty in identifying digital signatures of Bitcoin users. And, if they do manage the decryption of any single user (which takes massive amount of time and computing power), they still have no location on which they can focus their regulatory regime, no corporations they can fine, no leaders they can arrest; they have no power to stop the unending tide. As more people choose to use cryptography (PGP is the default option many websites), crypto-currencies, and systems of trustless exchange, the threat to governments will become greater as their ability to counter it diminishes. Eventually peaceful, voluntary and trustless exchange will become the norm, all the while lowering information and transaction costs, and humanity will find new solutions for sustaining prosperity.

Hopefully this post has piqued your interest, if so, here are some videos to watch and sites to explore:

Bitcoin: Bitcoin.it, https://www.youtube.com/watch?v=Lx9zgZCMqXE (great explanation of Bitcoin, 22 mins), https://darkwallet.unsystem.net/, blockchain.info

Cryptography: https://www.youtube.com/watch?v=6NcDVERzMGw (PGP explained simply in 8 mins), http://www.garykessler.net/library/crypto.html (very dense reading)

Keep an eye out for future posts about how this technology can be used not only for currency, but also for voting systems or fact checking.

3 Comments

  1. john

    If someone breaks into my home or hacks into my bank account and steals my money, I can go to the government (through the police) to help me get my money back. Since Bitcoin is completely decentralized I worry that there won’t be a similar entity to protect its users. As it stands, anytime Bitcoins are stolen, they are lost to the original owner. Finding solid protections for storage and transactions will be a deciding factor in whether or not cryptocurrencies become more mainstream in the coming years.

    1. stuartcuw

      I totally agree with you, and this is one of the huge reasons why I have yet to use bitcoin myself. That said, once one understands these security factors, it becomes a much more secure means of exchange and wealth storage compared to government-issued/bank secured money, as you are in 100% control. And if the demand for crypto-currencies continues on its current trajectory, open-source and user friendly technologies (like Dark Wallet) will be developed to make security much more accessible to the average person.

  2. oogenhand

    Reblogged this on oogenhand.

Leave a Comment

Your email address will not be published. Required fields are marked *