Technological Possibilities of a Virtual Currency

Faculty Fellow, RIETI

Bitcoin, a decentralized virtual currency, can be defined as a novel and ingenious embodiment of the essential properties of money. The substance of Bitcoin is an online ledger recording all of the related transactions ever executed to date (called the "blockchain") from all over the world. Participants synchronize and share the blockchain on their computers or smartphones.

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As a general rule, the crucial requirement for "payment" transactions to be executed is that the irreversibility and safety (prevention of double spending) of transactions are guaranteed by the monetary system. The irreversibility of transactions means that once payment is made, there is no denying or reversing that fact afterwards (e.g., by modifying data, playing dumb, or else). In the case of payment with cash (i.e., banknotes and coins), transactions are made irreversible by the physical delivery and receipt of cash. Physical payment is also free from concern about double spending because it is physically impossible to use the banknotes and coins handed to Person A for payment to Person B. However, in the world of the Internet where copying data is a matter of a few clicks, ensuring the irreversibility and safety of transactions is quintessential.

The core idea employed by Bitcoin toward achieving that end is to extend the blockchain by a repeated verification process called "mining." In the Bitcoin economy, all transactions executed around the world are collected and combined into a single set of records (referred to as a "block") approximately every 10 minutes, which is then added to, and extend the blockchain.

Bitcoin transactions are made public upon execution, and the content of each block to be added is shared online by all of the network participants. However, the block can be added to the blockchain only by those who have successfully solved an extremely difficult mathematical puzzle, a process that involves numerous meaningless calculations--just like rolling a dice repeatedly--but takes about 10 minutes to complete and produce a piece of data. This piece of data is called a "proof of work."

The one who completes this task first is the winner and can add the latest block to the blockchain. Furthermore, the winner is granted the right to mint a certain amount of Bitcoins and keep them as a reward. Participating in such computing competition is referred to as "mining" as an analogy to gold mining. This mechanism ensures the irreversibility and safety of transactions as a consequence of decentralized and voluntary behavior of participants in Bitcoin transactions.

Those who conspire to tamper with the transaction records would have to do so retroactively to the point when a specific transaction in question occurred, and fool all of the other participants into believing the falsified blockchain to be accurate. However, in order to create a false blockchain, they would have to redo the entire process of solving mathematical puzzles for the period from that time of the transaction to date, because the Bitcoin system is designed in such a way that any alteration to the blockchain would result in changes to mathematical puzzles. Since it takes about 10 minutes to solve one puzzle, the process of falsifying the blockchain will never be able to catch up with the process of extending the blockchain. This makes the falsification of the blockchain impossible.

As participants in Bitcoin transactions know this mechanism, they can feel assured that falsifying transaction records is impossible. Those who own high-performance computers are inclined to voluntarily participate in mining for possible rewards, because they are better off earning rewards for mining than attempting to create a false blockchain. Honest work to help protect the Bitcoin system is more profitable than dishonest work to break it. In other words, designed in such a way that the irreversibility and safety of transactions are ensured by participants' self-interested profit-seeking behavior, the Bitcoin system can and will be sustained autonomously without any government or manager.

For what I have written to this point, I referred to the following: Kaso-tsuka Kakumei [The Virtual Currency Revolution] written by Yukio Noguchi (Diamond, Inc.) and Kaso-tsuka: Gijutsu, Horitsu, Seido [Virtual Currency: Technology, law, and system] co-authored by Hitoshi Okada, Ikuo Takahashi, and Shigeichiro Yamasaki (Toyo Keizai Inc.).

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The ingenuity of the Bitcoin system can be understood as a mechanism for internalizing the "external economic effects" of money.

Not only in the Bitcoin system but also in payment systems in general, ensuring the irreversibility and safety of transactions is beneficial for all participants, but individual participants--payers in particular--do not want to bear the cost for that. Left alone, the system would become unable to maintain the irreversibility and safety of transactions as all of the participants become free riders. The irreversibility and safety of transactions are external economic benefits that cannot be traded in the market. In the case of a decentralized system, they are bound to become short in supply, causing the system to collapse. Traditionally, two methods have been used to maintain these external economic benefits.

The first is to make payments by the physical delivery of tangible money (such as paper money and gold bullion). In this case, the irreversibility and safety of transactions can be easily ensured by the physical nature of physical objects. The object used as money usually circulates at a value significantly higher than its actual value. The difference between the two values, which may be called a liquidity premium, can be interpreted as representing the cost of ensuring the irreversibility and safety of transactions.

The second is to make payments in money guaranteed by credible managers (banks) for the irreversibility and safety of transactions, i.e., bank deposits. The cost of ensuring the irreversibility and safety of transactions is paid from depositors to their banks in the form of fees.

Bitcoin is innovative in that it has presented a third money system. The system is designed in such a way that when participants in the system voluntarily engage in profit-seeking activities, the irreversibility and safety of transactions are ensured as a consequence. The cost of ensuring the irreversibility and safety of transactions is paid in the form of mining work, i.e., time and electricity consumed for doing meaningless calculations.

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While being innovative as a mechanism, Bitcoin is assumed to have characteristics similar to those of the gold standard system in macroeconomic terms, because the money (Bitcoin) supply is determined by technological conditions such as the cost of mining. Even if Bitcoin becomes widespread in the future, it may be just one additional currency to compete with the existing major currencies, gold, and silver, having no significant impact on the operation of the macroeconomy. However, a variety of new virtual currencies are now being proposed. And how the market economy operates may change in the future. For instance, this may be done by making the process of mining meaningful.

Mining for Bitcoin is performing meaningless calculations. However, if we can replace them with meaningful calculations (in the sense of contributing to public goods), for instance, relating to efforts to prevent the problem of global warming, an increase in transactions using the virtual currency will help solve it. Or if we could somehow relate such calculations to genomic analysis, greater use of the virtual currency will help contribute to advances in medical science. Calculations for data mining can be a process of supplying public goods.

If we could increase the private supply of public goods by designing a monetary system--whether that of an online virtual currency or else--in a way to provide appropriate incentives, the market economy would change dramatically. Bitcoin might have opened up such technological possibilities for us.

>> Original text in Japanese

* Translated by RIETI.

October 16, 2015 Nihon Keizai Shimbun

December 14, 2015

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