Bitcoin As Anarchist Financial Engineering

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Because of my M.Sc. in financial engineering and professional experience in finance, people often ask me about certain trends they notice happen in markets. I have been somewhat critical of Bitcoin, despite being a big fan of competing currencies in general.

I want to make it clear that, overall, I am a huge fan of Bitcoin (BTC), but I do want people to understand why I have been outspoken with regard to not buying them at times (especially when all the Pollyannas were trying to get people to buy while BTC was at its highest prices). It really all has to do with risk. In my opinion, most of the people in the last year or so that have been rushing to buy Bitcoin are the same type of people who bought tech stock at the top of the dot-com bust, bought real estate at the top of the housing bubble and most recently bought gold at the top of the recent surge.

Sometimes, the simplest investment advice is the best: buy low, sell high. Remember, oftentimes, if you are buying as the price increases, you are going to have to find a sucker that will buy what you did at an even higher price if you want to profit. Everyone wants to make a quick buck, but unless you are connected to some inside information, if there is a quick buck to be had, you are probably on the losing side of that quick buck. So I eagerly look forward to Bitcoin markets, but I won’t really be taking it too seriously until we are at Bitcoin 2.0 (and probably 3.0). Here’s why:

Current Risks

Political Risk: China has already thrown its weight behind creating volatility for Bitcoin with very little effort. Additionally, as I was explaining to a friend last night over espresso, Bitcoin is backed by nothing more than an algorithm and media mentions, whereas its competition, the U.S. dollar is not constrained by a computer algorithm but, even more importantly, it is still backed by the largest military on the planet.

To put things in perspective, the Federal government spends about $10.5 billion every single day. With a Bitcoin market cap just around $5 billion (as of 9/27/2014), it would take the U.S. government about 12 hours of diverting the budget to buy all the Bitcoin on the planet. The federal government spends the equivalent of all the Bitcoin on the planet in a half day span. Now imagine what the U.S. can spend via its off-balance sheet transactions? But why even bother with black budgets when, due to their incarceration of Ross Ulbricht, the U.S. government already owns the largest Bitcoin wallet in the world? This makes this next risk even weightier.

Concentrations of Power: Well, it is interesting to note the positive correlation between the price of Bitcoin and the number of Bitcoin cheerleaders making media mentions. Please remember that just because you can’t afford a profitable astroturfing campaign doesn’t mean that the very wealthy 927 people that possess 50% of all the Bitcoins on the planet can’t.

Let me elaborate a point that I first raised awareness about in my 2010 book TEA-O-CONNED. In that book, I showed the deliberate détournement of the nascent modern 21st century Tea Party movement away from the pacifist ideas of liberty and toward nasty jingoist neoconservatism. I am not the only one to note a certain M.O. that has proven to effectively manipulate marginal libertarians away from pro-liberty values; that modus operandi is known as astroturfing. I don’t think it is too paranoid to suggest that astroturfing may possibly be at play here as part of a potential pump and dump strategy to transfer financial capital back toward the establishment elite and away from the people, especially given the correlation between Bitcoin media cheerleaders and valuations.

When you combine the political risk with the concentration of power, you run into some very real problems. Cryptographers Dorit Ron and Adi Shamir have recently published a paper called “Quantitative Analysis of The Full Bitcoin Transaction Graph” which reveals the concentration risk, which revealed a very unfortunate “kill switch.” As Stanislav Datskovskiy writes:

The total number of bitcoins in actual circulation is much smaller than previously believed. If the early adopters were to cash out and place their hoards on the market, the exchange rates (as denominated in anything) would dive through the floor, never to recover. The hoarders, in effect, possess an off switch for Bitcoin.

And it isn’t just the “kill switch” that the Bitcoin big fish could throw, there is more. Researchers Ittay Eyal and Emin Gun Sirer at Cornell, in their paper “Majority is not Enough: Bitcoin Mining is Vulnerable,” have shown now how “selfish mining” is another sizable risk to any aspirations Bitcoin has toward a sustainable decentralization. Without getting too deep into the weeds, the “selfish mining” strategy allows Bitcoin miners to game the system by secretly withholding blocks in the blockchain. Honest miners (as opposed to “selfish miners”) continue solving the original block, while the selfish miners try to mine new blocks from the secret block, creating a profitable long chain. Since this is profitable, more miners are naturally incentivized to join this “Selfish Pool.” As the Cornell researchers reveal:

The selfish pool would therefore increase in size, unopposed by any mechanism, until it becomes a majority. Once a miner pool, selfish or otherwise, reaches a majority, it controls the blockchain. The Selfish-Mine strategy then becomes unnecessary, since the others are no longer faster than the pool. Instead, a majority pool can collect all the system’s revenue by following the prescribed Bitcoin protocol, and ignore blocks generated outside the pool; it also has no motivation to accept new members. At this point, the currency is not a decentralized currency as originally envisioned.

The authors suggest randomizing which block you choose when presented with chains of equal length, as this will throw a wrench into the “selfish mining” strategy, but these glitches hopefully illustrate why I am more cautious than excited about Bitcoin.

In addition to the political and concentration risk, there is the risk that your digital currency will be stolen because someone less scrupulous and more tech savvy than you may know how to hack your digital currency.

Hijacking Liberty Redux: Is BTC the New “Tea Party”?

I am sure some Bitcoin cheerleaders are just clueless—albeit opportunistic—Pollyannas, but I am beginning to become suspicious that maybe others are wearing such Pollyannaism as a mask to cover their a less wholesome agenda of détournement (for some reason I seem to be tuned into these hijackings of the liberty movement as evidenced by my book TEA-O-CONNED, the thesis of which has now been confirmed). Either way, such naivete is unbecoming, in my opinion.

So if I may be so bold, I would like to suggest that perhaps it may be more accurate to use quotation marks when referring to BitCoin as a “crypto”-currency from now, especially since it seems that Bitcoin’s security depends upon algorithm SHA-256, which was designed by the NSA and published by the National Institute for Standards and Technology (NIST). In a nutshell, there is a very serious conflict of interest between the NSA and NIST.

If you assume that the NSA did something to SHA-256, which no outside researcher has detected, what you get is the ability, with credible and detectable action, they would be able to forge transactions. The really scary thing is somebody finds a way to find collisions in SHA-256 really fast without brute-forcing it or using lots of hardware and then they take control of the network. —Cryptography researcher Matthew D. Green of Johns Hopkins University

Perhaps, this is why the CEO of a major BitCoin exchange has been “arrested at JFK airport and charged with money laundering” and how the FBI got Ulbricht. The anonymity concern only goes to reaffirm my concerns about political risk, there are probably easier ways to topple the aspirations of Bitcoiners than breaking the SHA-2 encryption, but Green’s concerns only seem to add to the growing stack of problems for the nascent “crypto”-currency…

It seems Bitcoin has become a bit of a Rorschach Test lately—for some, it is a joke; for others, it is a love affair; and for yet others, they aren’t all that excited either way. Despite all my concerns, I am still a huge fan of crypto-currencies long-term because they integrate two subjects that I’ve spent a lot of effort studying since the mid-90s—financial engineering and libertarianism. I earned my M.Sc. in Financial Engineering in 2002, and I’ve been explicitly libertarian for over 2 decades now. For those, who may never have heard of financial engineering, a definition is in order. Financial engineering is defined by Investopedia.com thus:

The use of mathematical techniques to solve financial problems. Financial engineering uses tools and knowledge from the fields of computer science, statistics, economics and applied mathematics to address current financial issues as well as to devise new and innovative financial products.

So, as a long-time libertarian financial engineer, I see many financial problems that are created by the state. The biggest problem, in my opinion—and the subject of my book ENDonomics—is the threat that it presents to everyday citizens of the United States—and the world.

Crypto-currencies like Bitcoin offer a mathematical approach to solving the problems created by that bane of libertarians almost everywhere—centralized banking. This is why I contend that crypto-currencies are libertarian financial engineering, and at its best. I don’t think this claim is all that controversial, as both friends and foes of crypto-currencies alike have noticed the decidedly libertarian bent to Bitcoin. Additionally, Bitcoin-like solutions to the problems created by central banking have been presented by libertarians before. Peter Theil‘s Paypal tried to accomplish something very similar years ago. I am not alone in speculating that Bitcoin’s future may look a bit like Paypal’s past. This is why while I am not sold entirely on Bitcoin 1.0, I am very excited for 2.0, 3.0, etc.

As Bitcoin shakes off the problems from the last few months, it is becoming clear that the real threat to Bitcoin now is from rival cyber-currencies. This is as it should be. It is fun to watch libertarian culture express itself in new alt-currencies, like PotCoin and SexCoin. These crypto-currencies are solving problems created by competing legal systems, too, not just problems created by central banking. For example, as you may have seen in the news, the state laws decriminalizing marijuana use are creating Federal problems for banks. Alt-currencies have the potential to circumvent the need for legislation all together.

So, while I have been somewhat critical of Bitcoin, I have looked at the recent fiascos as blessings in disguise. It is possible now to brush aside the neophyte Pollyannaism and get to the real anarchist financial engineering aimed at solving the problem created by central banks. Unfortunately, there certainly are a few problems that should be daunting to even the most talented financial engineers.

The NSA has been studying crypto-currencies in-depth since before I started my graduate studies in financial engineering in 1997. This gives me a lot of humility when I compare what I can know versus what they know (for example, in addition to time, they’ve likely devoted more resources toward studying and potentially destabilizing crypto-currencies than anyone). We must always be wary of the power of black chambers to be one step ahead.

The political risks to alt-coins are palpable, well beyond those presented by the NSA. Many inside the alt-currency market are eager to seek out regulation. This sort of Stockholm Syndrome approach undermines the very spirit of libertarian financial engineering in favor of rent-seeking corporatism. The sales pitch is a common one—security trumps liberty. Hopefully, by now, in the wake of all the 911 “security” measures, we understand that when you trade liberty for security, you get neither.

Also, now the IRS has gotten involved. Shocker, I know. This is not a good thing for Bitcoin —when is it ever a good thing when the IRS gets involved? The IRS has defined Bitcoin as property, not currency. In so doing, they have turned using Bitcoins into a complicated nightmare. This means capital gains are taxable, which means the IRS can chase after you if you neglect to “keep a strict record of every purchase made all year long” all the while performing “difficult calculations to account for the changing value of a Bitcoin.” Granted, a bright programmer could develop an app to help mitigate this specific problem, but this is really about subjecting all Bitcoin enthusiasts to the “reasonable suspicion” of the IRS.

The bottom line? I am cautiously optimistic. Perhaps, the best things I’ve read about libertarian financial engineering was written by Erik Voorhees in the wake of the MtGox debacle:

We are building a new financial order, and those of us building it, investing in it, and growing it, will pay the price of bringing it to the world. This is the harsh truth. We are building the channels, the bridges, and the towers of tomorrow’s finance, and we put ourselves at risk in doing so.

We are at risk from accidents. We are at risk from fraud, from corruption, and from evil. We are at risk from journalists seeking headlines and from politicians seeking power and glory. We are at risk from the very market we are trying to build – a market which cares not about our portfolio, our ambitions, or our delicate sympathies.

For all these risks, devastation will befall us repeatedly. Some of us will be discouraged. Some will be ridiculed and insulted. Some will be tricked, or swindled. Some of us will be crushed or caged. We will be set upon by all manner of antagonists, repeatedly, for a long time.

So why do we do it? Why do we build these towers that fall down upon us? Why do we toil and strain and risk our precious time, which is the only real wealth we possess?

Because the world needs what we’re building. It needs it desperately. If that matters to you, as it does to me, then hold to that thought. You will see through the smoke, and your wounds will heal.

(This article originally appeared in my newest book, Strange Attractor.)

About Author

Jake Shannon

Jake Shannon (1973 - ) was born in Colorado and has worked in a hodgepodge of professions including "Quant" (i.e., financial mathematician), serial entrepreneur, Discordian Pope, radio talk show host, Chairman of the Libertarian Party of Utah, Luchador (i.e., mexican wrestler), and Comedy Hypnotist before settling upon pursuing an unwitting vow of poverty as an independent writer, practical magician (Chaos Magick) and more importantly, as a stay-at-home dad (his greatest accomplishment by far). He currently lives in Salt Lake City, Utah (which still surprises him) with his lovely wife, three bright children and three loyal dogs.