Currency, Commodity and Bitcoins

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A brief introduction to the concept of the bitcoin and similar cryptocurrency. Presentation made at CII CIO conference at Mumbai in December 2013

A brief introduction to the concept of the bitcoin and similar cryptocurrency. Presentation made at CII CIO conference at Mumbai in December 2013

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  • 1. Currency Commodity & BitCoins Prithwis Mukerjee, PhD Praxis Business School, Calcutta Prithwis Mukerjee, PhD
  • 2. The barter market 1. Ram has excess salt, Shyam excess sugar a. b. Ram exchanges excess salt for Shyam’s excess sugar What if Ram does not need sugar at the moment ? but needs rice instead ? 2. Ram has excess salt, Shyam excess sugar, Jadu has excess rice a. b. Ram exchanges salt for Shyam’s sugar, then exchanges this sugar for Jadu’s rice And it is obvious that this process can become very tricky and unworkable if number of participants and products in the market becomes very large Prithwis Mukerjee, PhD
  • 3. Enter commodity 1. Ram has excess salt, Shyam excess sugar and Jadu has excess rice a. Every body has “cowrie” shells as well 2. Ram sells excess salt to Shyam and gets cowrie shells 3. Rams uses some cowrie shells to buy rice from Jadu, keeps rest for future use 4. Cowrie shells, otherwise useless, acquires a value in terms of a salt and rice a. and then in terms of products like sugar, oil, cloth, candle and services like farming, body massage ... Prithwis Mukerjee, PhD
  • 4. Cowrie shells become “money” Three functions ● Means of exchange ● Stores value ● Unit of account Four properties ● Durability ● Fungibility ● Divisibility ? ● Verifiability ? Prithwis Mukerjee, PhD
  • 5. Cowrie Shells >>> Gold Coins Durability Fungibility Divisibility ● a fraction of a gold coin has a proportional fractional value Verifiability Verifiability ● A central authority, the “king” or the government, certifies and authenticates the genuineness of the gold coin Prithwis Mukerjee, PhD
  • 6. Gold Coins >>> Currency Notes Verifiability >> Trust ● Monetary authority issues “representative” currency or paper that is backed by an equivalent quantity of gold Only Trust, no verification ● Monetary authority acknowledges that there is no gold behind the currency ● The credibility of the monetary authority sustains value Prithwis Mukerjee, PhD
  • 7. Currency Notes >> Ledger Entries Currency notes can be deposited in a bank and “dematerialised” ● converted into a ledger entry ● sent, received or otherwise exchanged through debit or credit operations caused by instructions ○ physical - cheques ○ digital - EFT Banks work as trusted middlemen to facilitate the transfer of money Prithwis Mukerjee, PhD
  • 8. Currency can be issued by anyone who is trusted by others Traditional national currency ● Indian Rupee ● US Dollar Private national currency ● HK Dollar issued by ○ HSBC ○ Standard Chartered ○ Bank of China Game currency ● Linden Dollars in Second Life ● “Gold”, “Silver”, “Copper” in World of Warcraft Coupons that we use in daily life ● Sodexho coupons Prithwis Mukerjee, PhD
  • 9. Trust can be Abused & Betrayed ! 1980 : 1 ZWD = 1.5 USD 2009 : 1 ZWD had effectively Zero value or buying power and was discontinued from circulation Prithwis Mukerjee, PhD
  • 10. Bitcoins ● No physical artifact, a digital currency ● No central monetary authority to issue currency ○ Managed by a network of computers operating a peer-to-peer software ● Protected by the laws of mathematics and cryptography ○ Just as the laws of mechanics ensures that planets revolve round the sun without the intervention of any central air traffic control mechanism Prithwis Mukerjee, PhD
  • 11. StupidCoin -an innocently simplistic currency Let us assume … ● A monetary authority creates 1000 jpeg image files (SCdollars) ● Gives 10 SC$ to 100 people ( “the market”) and asks them to use it for purchases. Problems ● Each person can make any number of copies of the files and increase his wealth ● Anyone, including the central authority, can create any number of new coins Prithwis Mukerjee, PhD
  • 12. Bitcoins : Two Mathematical Tricks There are mathematical algorithms that regulate ● the generation of bitcoins ● the transfer of bitcoins and the regulation process is monitored and have to be agreed to by ALL computers in the bitcoin network rules can be broken if and only if more than 50% computers collude with a violation Prithwis Mukerjee, PhD
  • 13. Two Mathematical Processes To generate a Bitcoin you must prove that you ● have consumed a certain amount of CPU cycles and ● solved a mathematical “puzzle” before anyone else has To transfer a Bitcoin you must prove that you ● have received an equivalent or higher amount of bitcoins from somewhere and ● have not spent it anywhere else Prithwis Mukerjee, PhD
  • 14. Technology behind Bitcoins Prithwis Mukerjee, PhD
  • 15. Spend or Double Spend ? Bank Ledger RAM SHYAM 60 MADHU RAM pays 30 to SHYAM 50 70 BANK allows transfer updates ledger Bank Ledger RAM 20 SHYAM 90 MADHU 70 Prithwis Mukerjee, PhD
  • 16. Spend or Double Spend ? Bank Ledger RAM SHYAM 90 MADHU RAM pays 30 to MADHU 20 70 BANK BLOCKS transfer Transaction fails Bank Ledger RAM 20 SHYAM 90 MADHU 70 Prithwis Mukerjee, PhD
  • 17. Bitcoins The shared, synchronised ledger Each person has a “wallet” and every “wallet is syncrhonised with all other “wallets in the Bitcoin ecosystem WalletID X4 WalletID Y9 WalletID 3T WalletID 8R X4 60 X4 60 X4 60 X4 60 Y9 50 Y9 50 Y9 50 Y9 50 3T 60 3T 60 3T 60 3T 60 8R 70 8R 70 8R 70 8R 70 Anonymous : Wallet ID is not linked to identity of owner Prithwis Mukerjee, PhD
  • 18. Every payment needs to be confirmed by a majority of network Wallet X4 transfers 20 to Wallet 3T Transfer needs at least 10 or 15 confirmations WalletID X4 WalletID Y9 WalletID 3T WalletID 8R X4 40 X4 40 X4 40 X4 40 Y9 50 Y9 50 Y9 50 Y9 50 3T 80 3T 80 3T 80 3T 80 8R 70 8R 70 8R 70 8R 70 TXN CONFIRM TXN CONFIRM TXN CONFIRM Prithwis Mukerjee, PhD
  • 19. Genuine payments are confirmed within a short time Wallet X4 transfers 20 to Wallet Y9 Transfer needs at least 10 or 15 confirmations WalletID X4 WalletID Y9 WalletID 3T WalletID 8R X4 20 X4 20 X4 20 X4 20 Y9 70 Y9 70 Y9 70 Y9 70 3T 80 3T 80 3T 80 3T 80 8R 70 8R 70 8R 70 8R 70 TXN CONFIRM TXN CONFIRM TXN CONFIRM Prithwis Mukerjee, PhD
  • 20. Double payments are denied by network Wallet X4 transfers 30 to Wallet 8R Transfer needs at least 10 or 15 confirmations WalletID X4 WalletID Y9 WalletID 3T WalletID 8R X4 20 X4 20 X4 20 X4 20 Y9 70 Y9 70 Y9 70 Y9 70 3T 80 3T 80 3T 80 3T 80 8R 70 8R 70 8R 70 8R 70 TXN REJECT TXN REJECT TXN REJECT Prithwis Mukerjee, PhD
  • 21. My personal wallet : hosted on web Prithwis Mukerjee, PhD
  • 22. Wallet : After logging in Prithwis Mukerjee, PhD
  • 23. In reality, the situation is slightly different The wallet does not contain the balance in each wallet It carries a series of debit and credit transactions pertaining to every transaction that is happening 0:00 X4 +60 0:01 Y9 +50 0:02 3T +60 0:03 8R +70 Prithwis Mukerjee, PhD
  • 24. Transaction # 1 : Successful X4 pays 20 to 3T ● one input transaction is marked used ● change is sent back to itself ● one input transaction is marked used 0:00 X4 +60 0:01 Y9 +50 0:02 3T +60 0:03 8R +70 1:00 X4 -60 1:01 X4 +40 1:02 3T used +20 Prithwis Mukerjee, PhD
  • 25. Transaction # 2 - successful X4 pays 20 to Y9 ● one input transaction is marked used ● change is sent back to itself ● one input transaction is marked used 0:00 X4 +60 0:01 Y9 +50 0:02 3T +60 0:03 8R +70 1:00 X4 -60 1:01 X4 +40 1:02 3T +20 2:00 X4 -40 2:01 X4 +20 2:02 Y9 used +20 used Prithwis Mukerjee, PhD
  • 26. Transaction # 3 : rejected X4 pays 30 to 8R ● there are no unused input transactions to cover this output transaction ● transaction cannot be confirmed 0:00 X4 +60 0:01 Y9 +50 0:02 3T +60 0:03 8R +70 1:00 X4 -60 1:01 X4 +40 1:02 3T +20 2:00 X4 -40 2:01 X4 +20 2:02 Y9 +20 3:00 X4 used -30 used Prithwis Mukerjee, PhD
  • 27. Public-private key encryption is used to ensure authenticity Wallet consists of the set of all previous transactions plus a set of public and private keys and the ability to send and receive encoded transaction information 0:00 X4 +60 0:01 Y9 +50 0:02 3T +60 0:03 8R +70 1:00 Encrypted by X4 private key for transmission to Y9 -60 1:01 X4 +40 1:02 3T +20 2:00 Encrypted by X4 private key for transmission to 3T X4 X4 X4 +20 2:02 Y9 +20 3:00 X4 -30 Opened by 3T by X4 public key and loaded into 3T’s wallet with 3T’s private key -40 2:01 used used Opened by Y9 by X4 public key and loaded into Y9’s wallet with Y9’s private key Prithwis Mukerjee, PhD
  • 28. Confirmations are Crucial & Expensive operation Confirming a transactions means looking through an immense pile of earlier unused transactions and determining whether a new transactions is valid or invalid This needs a lot of computing power ● why would anyone do it ? ● what is the incentive ? The reward is that you get NEW BITCOINs Prithwis Mukerjee, PhD
  • 29. “Miner” adds a BLOCK to the CHAIN The BLOCK CHAIN consists of blocks of already confirmed transactions. Lying outside this chain is a pool of unconfirmed transactions. Miner must collect a set of unconfirmed transactions from the pool, confirm them and consolidate them into a new block that is added to the block chain. Prithwis Mukerjee, PhD
  • 30. Whose block gets added ? Yours ? or Mine ? Solve a puzzle ! Input : ● Address of last block of current chain ● Set of confirmed transactions ● Guess a number Output is a mathematical hash function If the output meets a certain criteria then your block is accepted into the chain Every else has to start afresh because address of last block has changed ! Prithwis Mukerjee, PhD
  • 31. Mining Bitcoins -Difficulty and Rewards Why difficult ? ● Because the hash function must contain a number of leading zeroes and be below a certain threshold value What is the reward ? ● Today, the reward is 25 coins / block ● This reward is halved as the number of bitcoins increases ● Total cap would be 21 million around year 2150 Prithwis Mukerjee, PhD
  • 32. Bitcoin Technology What has been covered so far ? Other technical issues ● How do we ensure the authenticity of a bitcoin ● How are Bitcoins created transaction ? or generated in a ● What happens if a rival controlled manner group starts another branch ● How are Bitcoins of the BLOCK chain transferred without the danger of double Mathematically correct spending answers exist Prithwis Mukerjee, PhD
  • 33. Comparison : Gold and Bitcoin ● A finite amount of gold is available in the world. Quantity not known. ● There will be a finite amount of bitcoins. Quantity is 21 million ● Digging gold out of the ground is complex and expensive exercise. ● Creating new bitcoins is expensive in terms of computing power, electricity consumption ● Instead of mining gold you can also buy gold from a bullion dealer at a commodity exchange ● Instead of “mining” bitcoins you can always buy bitcoins at a bitcoin exchange Prithwis Mukerjee, PhD
  • 34. The Economics of Bitcoins Prithwis Mukerjee, PhD
  • 35. Bitcoins can be used as Currency ● to make payments by sending coins from one wallet to another Commodity ● that can be bought as investments and subsequently sold at profit ( or loss !) Prithwis Mukerjee, PhD
  • 36. Who will accept Bitcoins ? Prithwis Mukerjee, PhD
  • 37. New Vendors are appearing ... Prithwis Mukerjee, PhD
  • 38. Exchange : From Virtual to Real Prithwis Mukerjee, PhD
  • 39. Bitcoin : A tradeable commodity Prithwis Mukerjee, PhD
  • 40. Add and Withdraw Real Money Prithwis Mukerjee, PhD
  • 41. Are Bitcoins Legal ? ● Bitcoins are as legal as any other commodity like gold. ● Taxable when converted into recognised currency ● Bitcoins, like cash, can be exchanged anonymously ○ Can be used for payment of illegitimate activity ● Reputable exchanges ask for KYC documents ○ passport ○ phone bill Prithwis Mukerjee, PhD
  • 42. Thank You Prithwis Mukerjee http://blog.yantrajaal.com twitter: @prithwis this presentation available at http: //bit.ly/pmbitcoin1 Prithwis Mukerjee, PhD