This is a republication of the notes, slides, and video of my Dec 7, 2013 presentation at LabitConf Buenos Aires.

Originally Presented Dec. 7, 2013 at laBITconf Buenos Aires

Over the last two years, I spent eight months living in Argentina and Chile, and actually, it was here in Buenos Aires that my friends taught me about Bitcoin. They called it ‘La Moneda del Futuro’, and it was their great passion that infected me with the ‘Bitcoin virus.’

Actually, the true meaning of this Bitcoin-revolution only recently started dawning on me, and that is that Bitcoin marks the end of monetary apartheid. Let me repeat that: Bitcoin marks the end of monetary apartheid. It is the end of financial discrimination and segregation based on nationality and political privilege.

In the economy of Satoshi Nakamoto, there are no artificial barriers to entry, you are not asked for any papers, there are no unnatural restrictions preventing mutually beneficial transactions. Basically, if you’ve got value to offer, you’re in business!

This process of value creation has been happening for nearly 5 years now- and how far have we come in such a short period of time!

Since I started recommending Bitcoin as an investment, in late 2011, there was one single question people kept asking me again and again: “why the hell should I invest in Bitcoin?”

However, with the tremendous growth we’ve seen and ever more opinion leaders expressing their admiration for this technology, the mentality is clearly changing, and the main question that I get now, is “Please tell me, how in the world can I invest in Bitcoin?” And that’s exactly the question that I’ve been asking myself for all this time.

So in this presentation I’ve boiled down some of the insights that I think are useful into a couple of lessons. Please don’t take them as the ten commandments, but rather a humble starting point for discussion. That said, I think they have merit and it’s these ideas that inform my own investment strategy.

1. First, and most importantly: Do Your Homework

If you consider investing in Bitcoin, do your very best to deeply understand what you are dealing with.

To invest in Bitcoin without understanding it, is like being in the middle of the ocean on a boat and not understanding your position and what the currents are. — Bitcoin is not just a vehicle for speculation, — it’s not just a currency, — it’s not just a commodity, — it’s not just a better version of paypal or western union, — it’s not just a cheaper way of transacting financially, either … Bitcoin is all of the above, and more The best way to describe Satoshi Nakamoto’s value proposition is probably to say that we are dealing with a:

…globally distributed… …digital protocol… …for trustless and easily verifiable… …information synchronisation and… …property allocation.

Let’s go over this definition word by word:

• “global” means that anyone in the world can use it;
• “digital” means that it’s super fast and nearly free;
• “protocol” means that it is carefully constructed and approved by many;
• “trustless” means that it’s extremely reliable & not dependent on third parties;
• “information synchronisation” means that it can host and secure any type of contract imaginable;
• and “property allocation” means that you can use it to determine your ownership of money or economic goods, and that you can use the network to transport property to anyone you want at any time.

So this is Satoshi’s gift to the world, an amazing network and community for the storage and exchange of value. And the only way to transact on that network, is by making use of digital currency units called “bitcoins”, of which there will only ever be 21 million in circulation. That is what makes these bitcoins so very special as an investment.

And this is why, when you become familiar with the Bitcoin culture, you’ll bump into phrases like “one never sells all of his bitcoins”, or: “To the moon!” — pointing out the enormous long term potential of this technology.

Indeed, people who have a profound understanding of Bitcoin, realize that their decision to start acquiring some coins might very well be the most important investment they will ever make.

2. Don’t make things too complicated: first and foremost, focus on acquiring some coins

As I said, the real value of Bitcoin lies in the size and quality of its network. Sure there are many other decentralized digital currencies around nowadays, but the one with the largest and most sophisticated community surrounding it, by a clear mile, is Bitcoin itself.

So if you think the technology developed by Satoshi is something worth investing in, go out there and simply buy some bitcoins, or some millibitcoins, as they are called these days. Apart from the coins itself, it is also possible to invest in the ecosystem that is developing around Bitcoin: exchanges, merchant services, mining companies, escrow services, and more. It is definitely true that there are many brilliant entrepreneurs active in this ecosystem by now, and some of them created businesses that are growing very fast. However if you plan to invest, keep in mind that the Bitcoin network is designed to be a super lightweight, very open environment allowing people to transact directly with one another. That’s the essence of a peer to peer currency: it cuts out the middle man, reducing overhead to almost zero. So in other words, if you go out and invest in too many Bitcoin middle men, you might end up empty handed, or at least with less than if you had just invested in coins. It is very hard to outperform an average growth of +1000% per year, so by all means consider these periphery investments, just don’t go crazy on them.

3. Security, security, security

I’m going to keep this one very brief. If you invest in an asset with low third party risk, the implication of that is that nobody is taking care of you. You are responsible for the safe storage of your coins, and nobody else. So do your research and take some time to set up a secure way to store your investment for the long run.

4. Don’t overestimate the impact of politics

In every practical sense of the word, Bitcoin is a global and nongeographical phenomenon. From the perspective of governments, it is like water: try to grasp it in your hands, and it flows to another place out of your reach. That’s why in general, political events will be overestimated in their eventual impact.

We’ve seen the seizure of the Silk Road for example, which caused BTC to drop from $125 to $85 overnight. Well, 3 days later the price was back up — the heist turned out to be a non-event. Given that many people (especially in the West) are very fearful of government and tend to overestimate its actual reach, I think that negative political shocks affecting Bitcoin are actually buying opportunities.

5. Mass Psychology : understand and ride the wave

To keep with our sailing analogy, there are fundamental currents that drive the Bitcoin ship, but there are also waves and wind, which have a strong short term impact.

When Bitcoin experiences a series of positive shocks (maybe a celebrity endorsement, like the one of Richard Branson recently, or a major retailer deciding to accept it), that leads to a lot of media exposure and usually a big rally in the price.

The rapid growth in price however, eventually puts stress on the bitcoin ecosystem, and inevitably a sort of crisis develops. The new investors panic, and the cycle enters the ‘bust’ phase. (This is the phase where Bitcoin ignoramuses triumphantly shout from all the rooftops: ‘The Bubble has popped!’.)

In order to survive the volatility in Bitcoin, it’s very important to be aware of this dynamic of mass psychology. Map out a strategy for yourself and try to stick with it, in order to avoid being swept away by the emotion of the moment.

6. Understand the interaction of all things Crypto

Recently there was a lot of news about the huge rally in Litecoin and the other alternative cryptocurrencies. And then when Bitcoin went down a bit, the altcoins dropped much more in percentage terms. Someone on reddit said “when Bitcoin sneezes, the altcoins catch a cold”.

Well I think there is a logic to the madness, and it looks a little like this:

This diagram is a model of how liquidity flows through the Bitcoin ecosystem. On the left there is a huge tank of Fiat money. When the sentiment around Bitcoin is positive, money flows from the Fiat-tank into the Bitcoin ecosystem.

First, people spend fiat money to buy bitcoins and the value goes up. If it looks like that they can make more money by buying mining equipment, they will also spend dollars buying Bitcoin mining rigs. As the rally continues, the new adopters are bummed out that they have to buy bitcoins at such a ‘high price’ and they start buying litecoin, peercoin, terracoin and the other alternatives to Bitcoin.

In that sense, we could say that the altcoin markets serve as a pressure valve for Bitcoin.

The same happens with the mining market: when bitcoin prices rise, the cost of mining equipment expressed in bitcoin drops, and bitcoin savers buy more mining rigs. When that happens, mining hardware manufacturers are given the signal to speed up production.

At some point however, the sentiment around Bitcoin begins to turn again, and the value of Bitcoin stagnates or declines. Because the markets for the altcoins hardly have any US dollar-liquidity, people exchange their altcoins for bitcoin, leading to a very quick decline in value in the altcoin markets. And in the bitcoin mining sector, at some point investors will figure that the massive investments in extra capacity have put a lot of pressure on the profitability of individual machines. Enthusiasm drops, and the stream of investments dries up — to stay with our diagram: the bucket starts overflowing and no longer seems to reward new investments.

However this perception can be misleading, because, like what happened in september and october this year, the market did not take into account that Bitcoin might actually rally again, bringing the yield of mining machines back into positive territory.

So what is the investor to make of this dynamic?

A possible trading strategy based on this model is to basically be a contrarian:

• When do you invest in Bitcoin mining? When nobody thinks it is profitable anymore.
• When do you diversify into altcoins? When Bitcoin is entering a new hype phase in the media and the price starts rising.
• When do you sell your altcoins for Bitcoin? Well, when these are hyped as well, and are breaking records valuations compared to Bitcoin.

Personally I recommend trading with very conservative amounts, because you are exposing yourself to a lot of risk by moving in and out of these currency exchanges.

7. Invest what you feel comfortable with

Despite the attention that Bitcoin is getting in the media, it is clear that we are still in early phases of Bitcoin adoption. Merrill Lynch estimates that today not even 3 million people are to some extent savers in Bitcoin. That’s about one in every 1000 internet users, and one for every 1500 mobile phone users. And the market cap of Bitcoin is now around $10 billion. That’s a small fraction of every market that it could potentially disrupt.

To give an idea: the size of the remittance market is $500 billion; the e-commerce market is $1000 billion large; the US financial services industry alone is $1300 billion in size, the money supply in high inflation countries (+6%) is over $4000 billion, the value of all paper money banknotes is about $4500 billion; the size of the physical gold market is some $7000 billion; foreign currency reserves (which Bitcoin could replace) are also $7000 billion; … you get the picture.

These are all market places that Bitcoin technology has the power to completely disrupt, and each time this happens it will put rocket fuel under the price of the Bitcoin currency.

What does this mean for the investor?

Well, that we shouldn’t be afraid of estimating the future potential value of one bitcoin in the range of $100,000 to $1 million. In other words, the risk/reward ratio of Bitcoin is still extremely positive.

Yes, there are scenario’s thinkable in which Bitcoin as a currency would fail — but the potential upside if it keeps growing like it does today is simply spectacular.

That’s why I recommend investing with a conservative amount of one’s portfolio: say 1–10%, depending on your risk profile and on how much volatility you can stomach.

In conclusion: no need to bet the farm on Bitcoin, feel free to invest with what you personally feel comfortable with.

Closing remarks

— That’s it, these are my seven lessons on how to invest in Bitcoin.

In closing here, I just want to express why I’m so very optimistic about Bitcoin in Latin America.

Everywhere I go in Europe or the US I feel many young people suffer from a phenomenon called ‘pronoia’ — they believe in a conspiracy of people, especially politicians, aimed at helping them. Young people tell me: “I’m not too worried, the state will surely find a solution for the debt problem.” They tell me: “Politicians will secure our deposits, they will find a way to contain inflation and keep the banks open. And the government will also find a way to keep paying for our pensions, our health care, my children’s education, etcetera.”

I find that the young people of Latin America suffer a lot less from this pronoia disease. They instinctively know that the answer to the question of their economic well being lies not in the decision of some government official, but in their own entrepreneurship, in their own imagination, in their own effort and initiatives.

Talking about this country in specific: right now things may look pretty bleak, but I think Argentina has amazing potential for economic prosperity. Yes, the old days can come back, when Buenos Aires was on equal footing with Paris and New York, and in many ways actually, life can become much better than it was then.

There is a tremendous amount of value in this country, that’s just obvious, and I think Bitcoin, which is the first truly global language of finance, Bitcoin will play an important role in helping to unlock that value.

Thank you.

Post Scriptum: Here’s a short interview I did for ElBitcoin during the conference, who then published it on their website.

Many investors and advisors are on record stating that $5,700 was the bottom in Bitcoin for this year, and that higher prices lie ahead. While we are very bullish on Bitcoin’s long term prospects, we do heed caution for more short term price optimism.

To find the starting point of the historic parabolic rally in Bitcoin that ended at $20,000 we have to go as far back as August 2015, when Bitcoin traded at below $200. This past rally was a stupendous, historic move. Even in secular bull markets, the collective of economic actors need time to absorb the information embedded in its characteristic high volume rallies.

Peter Brandt on Twitter

In my 43 years as a trader there has never been a move like $BTC. The only other market that achieved a superior parabolic advance was German interest rates in 1920s. Even taking a starting point of $1, BTC redoubled 16 times.

As I’ve indicated in my 2018 outlook, I think chances are high for this year to be remembered as a shakeout year: a lemon market in altcoins, regulators catching up, and infrastructure growing pains.

Let’s look at some data.

Since January, the Bitcoin mining hashrate (aggregate computations per second made to secure the network ) has tripled, which means that a huge amount of new or more efficient mining rigs have come online. In combination with declining prices, this means that miners who weren’t able to upgrade their machines or find cheaper electricity have been faced with a steep decline in profitability, a 90% drop in 7 months (altcoins have faced similar or steeper declines). With profit margins under heavy pressure, it’s not unlikely that miners are and will stay responsible for a significant amount of selling in the market.

Next, trading volumes are not dead, but still below those seen during last winter and spring. It’s unclear how much of the recent pick-up in volumes are the result of a short squeeze and how much are coming from new long term buyers coming in.

After last year’s FOMO, retail interest in Bitcoin has now become very sluggish:

• A Gallup poll conducted three months ago suggested that less than 0.5% of US investors “will probably buy Bitcoin in the near future”.
• Despite transaction fees and volatility having dropped strongly, merchants are seeing +50% lower Bitcoin revenues compared to last fall.
• Google searches are not suggestive of a quick retail fueled recovery either:

Next, here’s some comments we’ve gathered from Bitcoin analysts, market makers, and Wall Street insiders:

The first Bitcoin ETF will likely not be approved before 2019. So any anticipation of approval by September will likely be met by disappointment.

While institutional investors are certainly getting involved in Bitcoin, the vast majority of the firms are trading firms who are looking to make markets regardless of price: they’re just as happy to take on short positions as they are to go long. Institutions who are known to be long biased, such as mutual funds and pension funds are not ready to invest because they’re not yet comfortable with the available custody solutions.

There’s also the NVM Ratio, which is designed to reflect early stage adoption, now suggesting that there’s now too little on-chain activity to justify Bitcoin’s current market cap:

The assumption here is that Bitcoin’s market value is mostly derived from it being a network that connects users around the world: the more people and entities use the Bitcoin blockchain to settle transactions, the more it acquires the liquidity and utility that we’d expect from digital gold. The NVM ratio approximates that by measuring daily active addresses on the blockchain.* Similar valuation models have been made for growth companies such as Facebook and Linkedin, where the number of monthly active users reasonably correlates with enterprise value.

The related NVT ratio, which tries to measure if the daily dollar value of all Bitcoin transaction is relatively high or low versus the market cap, also suggests overvaluation.

Finally, in the past few months we’ve also seen a number of macro events that would appear to be bullish for Bitcoin as a safe haven: the North Korea debacle, a spike in volatility, Chinese stocks breaking down, etc. However, these shocks didn’t move the meter for Bitcoin.

฿Alt$ on Twitter

Anyone else waiting for #altseason to finally dump underwater bags while promising themselves they'll do it better this time or is it just me? $btc #SecondChance #crypto #lessonlearned

All this being said, lower Bitcoin prices ahead are not a foregone conclusion:

• Bitcoin price has already come down by 62% since December.
• Since March, the Chinese Yuan has dropped by 8% against the dollar. If this slide continues, Chinese capital could flee into Bitcoin.
• Bitcoin dominance is gaining ground, which we think indicates the market’s slow realization that there’s a large moat around the Bitcoin ecosystem now which will make it hard to dislodge.
• The 2015–’17 rally was historic but not entirely unique for this ecosystem: between late 2011 and April 2013, the Bitcoin price multiplied by 100x, and, after a 6 month correction, it multiplied again by 10x.
• Value investors are already anticipating the May 2020 block reward halving, which will cut down Bitcoin’s annual supply inflation from 3.7% to only 1.79%.
• A Bitcoin ETF approval, even if it’s delayed, would be a huge deal because it makes the asset extremely accessible for the retail investor. After the first gold ETF went live in 2004, the gold price rallied by 350% (and it’s still 200% higher today). The 2017 rally has also set in motion a flurry of corporate activity on the Bitcoin infrastructure side, and the promise of established banks, brokers, payment processors, and security providers offering their own solution suites is catching the attention of value investors.

Conclusion

We think the market likely needs more time to absorb the recent 30 month rally, which could produce lower prices. We don’t foresee new all time highs in Bitcoin for 2018, and unless data starts suggesting differently, we are expecting mostly sideways or lower price action.

*There are several objections one could raise against the NVM Ratio: it doesn’t take into account transaction amounts nor the difference between old an new addresses, it doesn’t discount spam attacks, it doesn’t acknowledge limitations to the block size, and neither does it consider institutions coming into the market who build derivatives on Bitcoin that rely on a small amount of high value cold storage addresses. More work is needed to refine valuation models. That said, even though Bitcoin’s core value proposition is store of value, we do think we’re still in the early adoption phase, and hence using a valuation metric that reflects this adoption makes sense to us. In that context, we think the NVM’s on-chain activity based valuation method has merit.

Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.

Before we go into how much we hope to raise and for what damages, let’s go over a few ways in which Luke has contributed to this community:

• Created one of the very first mining pools in 2011, and in 2014 released BFG miner, open source freeware to help others operate their Bitcoin miners. Both initiatives contributed significantly to helping Bitcoin stay decentralized.
• On March 11, 2013, Luke was the first to warn others that the Bitcoin blockchain was splitting and to call for emergency measures.
• Despite his interest in mining, Luke has always supported individual Bitcoin users, as was illustrated by his work on User Activated Soft Forks to help support SegWit activation.
• With 321 commits to Bitcoin core, he’s currently ranked by github as 7th most prolific core dev.
• Even though he’s most known for extensive code review and testing, Luke has contributed significant improvements to Bitcoin, such as figuring out how to deploy SegWit as a soft fork and BIPs 22 & 23.

In short, over the past 6 years, Luke has donated many thousands of volunteer hours to improve Bitcoin and has made important contributions that helped it become the +$40 billion platform it is today.

And now with this fundraiser, we’d like to give something back. In the hurricane, Luke’s house suffered the following damage:

• a broken bedroom window
• unstable electricity situation: his generator failed repeatedly and so he has no backup for inevitable future power outages
• His internet is unstable due to storm damage to the neighborhood
• broken water line
• large fallen down trees in the yard
• roof damage to side building
• propane piping & tanks damaged
• damage to the front door

https://twitter.com/LukeDashjr/status/907204325755236352

Luke does have home owners insurance, but it’s unsure how many of the claims will be approved and there’s a deductible of nearly $5,000.

In the past week, Luke has offered housing and support to an extra family with five children whose Sarasota property was badly damaged. He reported last weekend that those people have found a home now.

Our goal is to raise five bitcoins to help him with repairs and recovery. All donations, large or small, are equally welcome. If you’d like join us to support Luke and his family, here is a Bitcoin address for donations: 1Cyc4X8ES9Qvsqc8FBupLdTLKnbxo6wmUj (verification)

Thank you,

Tuur Demeester and Eric Lombrozo

—

Addendum

Since our goal of 5BTC was quickly achieved (thank you!!), we’d like to add a stretch goal: Luke would like to get cable service in his street, allowing him to have faster and especially more reliable internet. Right now the internet becomes unreliable when there’s an electricity black out. Where he lives, cable requires a wire to be pulled through the entire street, which the cable company charges around $12,000 for . So our stretch goal, with your help, is to raise another 3.5 bitcoins.

1. “Cost of attack should exceed cost of defense” is illogical

This is a core building block for the argument that proof-of-stake (PoS) is ‘more efficient’ than proof-of-work (PoW), so important to review carefully.

Vitalik starts this argument by claiming that cryptography allows users to defend their data in a much more effective way than a castle or island owner can self-defend in the physical world. While it is true that cryptography changes the game of wealth and information protection, often enabling a level playing field, this is comparing apples to oranges. Yes, it’s true that a medieval knight cannot crack a bitcoin wallet, but neither can a computer hacker effectively defend a castle. Cryptography is used in the real world, where private keys worth millions can be stolen with a $5 wrench attack.

Moreover, ‘cost of attack’ and ‘cost of defense’ are not abstract and fixed, but rather relative and dynamic phenomena: they depend on the subjective value of the thing that one is attacking or defending, and on the conviction of the actors involved. Cost is a relative phenomenon, it only becomes meaningful once compared to forgone utility, to the opportunities the actor is willing to miss out on in order to pursue a particular goal. In the case of an attacker-defender scenario, cost is also dynamic: if I’m facing an attacker with high commitment and huge resources, my potential cost of defense will be very high, and vice versa.

When discussing proof-of-work, Buterin claims that it goes against the ‘cypherpunk spirit’ because in this system, the “cost of attack and cost of defense are at a 1:1 ratio”. This statement is misleading, because he is really only talking about what a 51% attacker could do to the very last blocks in the blockchain.

Attacks on Bitcoin where one tries to reverse historical transactions which are more than a few days old are expensive in the extreme. Let’s imagine that the person who paid 10,000 BTC for a pizza in May 2010 is now an evil villain (‘Pizza Man’) and he wants to reverse that regrettable transaction. To succeed, he would need to somehow infiltrate and control a full 100% of all Bitcoin mining rigs and mine for a period of over 200 days (or a smaller +51% percentage for much longer) in order to roll back the chain far enough with valid proof-of-work. After the multi-billion mining equipment acquisition costs, the cost of running the Bitcoin network for 200 days would be over $700 million (7.5 TWh at 10 cents/KWh). Now, the cost of defense against anything less than the Pizza Man attack is hard to compute, because it suffices for competing Bitcoin miners to simply follow their economic self-interest and mine Bitcoins for their own account—the protection of the network against a myriad of possible attacks is a side-effect.

Given that knowledge, subjective value, and resources are spread unevenly in society (just like in nature), there will always be a tug of war between attackers and defenders—no matter which security mechanism one uses. To speak of a cost/defense ratio of 1:1 is quite meaningless in my opinion.

To return to cryptocurrencies: one can try to design transaction clearing algorithms that are different from proof-of-work, but all you end up doing is obfuscating the work that attackers must do to exploit the system, and making it harder to define how much and which kind of work defenders need to do to keep the ledger honest and complete. Like Paul Sztorc has stated (also echoed by Adam Back): “all proposed PoW alternatives should be labeled ‘obscured proof-of-work’”.

2. No, humans are not “quite good at consensus”

Vitalik asserts that a 51% attacker who reverted the transaction ledger in his favor would have a very hard time convincing the community that his chain is legitimate. The crowd would unmask him and quickly reach consensus to restore justice. He continues: “these social considerations are what ultimately protect any blockchain in the long term”, and cites the stone money on the island of Yap as an example.

First of all, I don’t think the stone money from Yap is a good example of the effectiveness of social consensus. We have virtually no information about the amount of fraud committed or prevented under the stone money system. Further, it is well known that mores, customs, rituals, and social pressure play a much larger role in tribal communities like on the tiny island of Yap, so it’s not fair to assume that one can successfully operate a similar system of monetary coordination in society at large. And finally, the Yap ‘social consensus ledger’ became victim of at least two successful attacks. The first was when in 1874 the Irish-American captain David O’Keefe managed to use large amounts of cheaply produced stones as currency to gain power and wealth. The second documented attack on the Yap financial system happened when German traders confiscated the yap stones and instituted harsh capital controls.

So let’s focus on Buterin’s assertion that social consensus is a protection against resource driven attacks. In my opinion that is plain wrong. An actor with the assets to conduct a such an operation can target his attack on very few individuals, and can make it expensive for the community to undo the theft and restore justice. Or the attacker can strategically target a huge amount of users, making sure to only inflict a small amount of financial damage per user — so that the cost per individual to rally against the attacker is higher than the loss incurred by the attack.

Even in the rare case where people largely agree that a certain event is disruptive and undesirable, they often entirely disagree on how it should be dealt with. Markets are good at letting people pursue their personal goals in a voluntary way, but that’s about it. If a subset of people (or an individual) doesn’t like something, they can always exit. In the universe of cryptocurrency, that means they can hard-fork and create their own new currency, or soft-fork to impose more stringent rules upon themselves.

All too often the word ‘consensus’ is used as rhetorical tool to silence dissent. For example, again in ‘A Proof of Stake Design Philosophy’, Buterin makes the claim that if a collusion of validators take over a proof-of-stake chain, “the community can simply coordinate a hard fork and delete the offending validators’ deposits”. Given that TheDAO bailout passed by supposed ‘community consensus’ even though less than 6% of Ether in circulation voted on the matter in a process of under 2 weeks, it seems risky to ‘offend’ the wrong people in the ETH community.

In sum, when faced with resource driven attacks, real response consensus is nigh impossible to achieve. Long or short term, political systems are not sufficiently reliable to prevent fraud and theft. In the pursuit of social scalability we can encourage individual liberty and responsibility by using the tools of cryptography, engineering, and economic self-interest as sources of robustness — but what we can not count on is the idealistic concept of social consensus.

3. Unsubstantiated claim that PoS is more resilient than PoW

Buterin states the following: “if desired, the cost of a single 51% attack on proof of stake can certainly be set to be as high as the cost of a permanent [sic] 51% attack on proof of work, and the sheer cost and ineffectiveness of an attack should ensure that it is almost never attempted in practice.”

In other words, he implies that from a security point of view, Proof-of-Stake is much more robust than Proof-of-Work.

In comparing PoW with PoS, consider the following:

• Cryptocurrency mining designs are solutions to the problem of trust in systems with imperfect knowledge and unknown adversaries. Proof-of-work has applications in early modern money and in nature, where the handicap principle evolutionarily evolved to let animals prove the “honesty” or reliability of their signal. To my knowledge, proof-of-stake has no equivalent applications in either human history or biology.
• A PoW 51% attacker can significantly slow down the network, but even a single attempt to revert historical transactions requires a huge and long-running expense. In other words, the production of ledger history is extremely expensive and its disruption arguably even more so.
• Contrary to a PoW-chain absent a +51% cartel, it’s mathematically proven that it is impossible to determine the “true” transaction history in a PoS blockchain without an additional source of trust. If a source of trust is always needed, a potential pandora’s box of attack and centralization scenarios is opened. This is a seed of truth behind the joke that Ethereum plans to use “proof of Vitalik”.
• In a naive PoS environment, an attacker can easily create many alternative histories of the ledger, making it cheap to try different strategies. This is known as as the “nothing at stake problem”. Ethereum plans to solve this by destroying the bonded security deposit of malicious validators. SolidX’s Bob McElrath makes the point that the strategy of ‘economic punishment’ of attackers is moot if the punishment itself can be forked away. Another criticism of bonded PoS, as recently voiced by BitTorrent creator Bram Cohen, is the question how one prevents honest stakers from being tricked into interacting with the network in a way that triggers the punishment that is supposed to protect them. (Think of it as the crypto equivalent of large scale swatting.) An alternative attack scenario, suggested by Galois Capital’s Kevin Zhou, is one where the attacker tricks enough honest people onto his network, so that it becomes these honest peoples interest to support the attacking chain as the true chain.

Conclusion

While it is commendable that Buterin works to build his cryptocurrency design proposals from first principles, I believe his write up contains several flaws. He is confused about cost-defense trade-offs and makes unsubstantiated claims about work- versus stake-based security. He fails to provide convincing logical or historical proof of the efficacy of social consensus. And he claims proof-of-stake is more resilient without providing proof or arguments, and without acknowledging the numerous objections that have been raised by people of substantial pedigree. Buterin’s article does not convince me that proof-of-stake has a sound philosophical foundation, nor that it’s a viable stand-alone mechanism for securing public blockchains.

I am grateful for the feedback of Kevin Zhou, Afsheen Bigdeli, Lawrence Nahum, Tommaso Pellizzari, and Christian Lundkvist. All errors remain my own.

Disclosure: I have a short position in ETH/BTC (short Ether, long Bitcoin).

Here’s the story of what is happening today (click to read tweetstorm):

Tuur Demeester on Twitter

1/ So the NSA developed backdoors, which have morphed into malware, now fueling a global ransomware carpet bombing (57,000 attacks today). https://t.co/Q94J7R1vce

After 2015 generated revenues of $25 million in Bitcoin for ransomware attackers, the year 2016 was the breakthrough year for the malignant technology:

Tuur Demeester on Twitter

@SonicWALL report: #Ransomware attacks have grown by a factor of 167. From 4 million attacks in 2015 to 638 million attacks last year.

Tuur Demeester on Twitter

@DoctorLex @desantis 3,700 attacks per day, 26% in the US. Last 12 months, 50% of US businesses was victim of a ransomware attack.

Tuur Demeester on Twitter

The FBI estimates ransomware revenues at $1 billion for 2016, growing every quarter. Huge game changer on many levels. https://t.co/BGxC26rVil

Tuur Demeester on Twitter

Total Ransomware Money Paid to Attackers by Businesses 2015: $24 million 2016: $850 million

Some more information about who is targeted and how often they get hurt:

Tuur Demeester on Twitter

Ransomware attacks are the most prevalent in the healthcare and financial services sectors.

Tuur Demeester on Twitter

@TuurDemeester 78% of ransomware attacks hurt people personally, 6% of the time it results in lost revenue for the company.

The attacks persisted in 2017:

Tuur Demeester on Twitter

Ransomware attack: Austrian 4★ Hotel pays €1,500 in Bitcoin to hackers. IT system frozen, 180 guests locked in/out. https://t.co/7nIxjJzYc6

Tuur Demeester on Twitter

Big data precedent? Faced with $4k ransomware demand, police dept refuses to try and recover 8 yrs of bodycam video. https://t.co/VD1SZzlm5t

Tuur Demeester on Twitter

Days before Trump's inauguration, 66% of D.C.'s CCTV capacity was down due to #ransomware attack. Police didn't pay. https://t.co/ZWs6CSQQ9N

Given the high sophistication, growing market share in the malware space, and its rising attack frequency, I think it’s apt to refer to ransomware hacking as a fast evolving, disruptive cybercrime industry:

Tuur Demeester on Twitter

Bitcoin fueled malware now 5% of total malware incidents. Locky encrypts your data and demands ransom, bitcoinminer secretly mines bitcoin.

Tuur Demeester on Twitter

Introducing: ransomware-as-a-service. (yes, imo this could push bitcoin prices up) https://t.co/UkBYg2qm1q

Here’s how I see ransomware in the big picture:

Tuur Demeester on Twitter

Bitcoin ransomware attacks are the viruses that will beef up the internet's immune system. #encryption #decentralisation

In the medium term, I only see the attacks increase in intensity, and I see the phenomenon as a driver of demand for Bitcoin:

Tuur Demeester on Twitter

Possible cause of high interest in "how to buy bitcoins": spike in #ransomware attacks. HT @massimochi

If you wake up with your system affected by a ransomware attack, pay a visit to nomoreransom.org, a website dedicated to helping victim of this crime.

Because of various network effects, I hold a cryptocurrency maximalist position, believing that one protocol will eventually win +80% of the market.

With that as a given, I currently have a binary view on the ecosystem: either Bitcoin will win, or Ethereum.

Here are my assumptions about the Ethereum (ETH) blockchain, compared to Bitcoin’s:

• “Turing vulnerable”, i.e. has a much larger attack surface
• Less backwards compatible
• On track towards a more centralized future
• Transaction finality is less certain
• Its proposed proof-of-stake mining algorithm won’t be more efficient than proof-of-work
• Will suffer more blockchain bloat than Bitcoin, leading to more risky design paths such as sharding.

Based on these assumptions, I had until recently projected a path forward where Bitcoin continues to dominate the cryptocurrency market.

However, the following observations give me pause:

• Ethereum Enterprise Alliance is making a good impression, lending the Ethereum project credibility in the highest levels of finance.

• Bitcoin faces a scaling bottleneck with no clear short term solution
• Ethereum’s current on-chain tx fees are much lower than Bitcoin’s
• Its great flexibility makes it attractive to developers
• Several projects are making the transition to the Ethereum platform, or are creating applications for it: Brave, Storj, Shapeshift.
• The NY Department of Financial Services (DFS) has given Coinbase official authorization to offer ETH to its customers.

I am still skeptical about the long term merit of the Ethereum blockchain as a store of value (and with that, of its long term staying power), but nonetheless I am seriously considering the following questions:

• What if the current lull in attacks to the network can be maintained, or if the market comes to accept hard-fork interventionism?
• What if the market majority wants a more centralized—governed—cryptocurrency?

TheRustyTwit on Twitter

@gavinandresen Quite possible that more people would be happy with a centralized but non-government currency. Maybe Worse is Better?

• What if Ethereum’s developer community is capitalizing on Bitcoin’s deadlock and is gaining enough momentum to take the upper hand?
• What if Ethereum solves its scaling conundrum with payment channels? According to Raiden’s team lead, the software is getting close to launch.
• What if ETH finds a way to make PoS work, and people buy into the good sounding narrative that PoW is more wasteful?

In short, what if Ethereum manages to become a good enough cryptocurrency and thereby wins this protocol war?

At the risk of making an all-too-simplistic comparison, Betamax had better picture quality than VHS. But VHS had a better marketing strategy (rental market), and had tapes that ran the length of a feature film, which was more in line with what the market wanted.

On the flip side, I see the following:

• Bitcoin has a consistent track record of being an immutable ledger (ideal for long term value preservation), versus ETH’s interventionist history
• Likely higher developer activity in Bitcoin vs Ethereum
• Bitcoin has 100 core contributors, ETH has ???
• Core dev Vlad Zamfir: Ethereum isn’t money, safe, or scalable
• Legal concerns about ICOs and ETH/ETC launches, SEC fallout possible
• Buterin’s & Zamfir’s approaches to scaling (Casper) seem to diverge
• Problematic scaling future, e.g. “mathematical proof that it is impossible to determine the ‘true’ transaction history in a proof-of-stake blockchain without an additional source of trust”, sharding…
• Future inflation rate unknown
• Uncertain fundamental value proposition over Bitcoin’s modular design

Bitcoin also has a few aces up its sleeve:

• Segwit can be activated via UASF, circumventing miners and allowing immediate activation of alpha status lightning payments. (If that fails, Lightning can be implemented even without segwit.)
• Rootstock could port Ethereum’s tech to Bitcoin.
• Sidechains are close to production-ready, don’t need segwit and allow for unfettered experimentation with additional features. (In this way, anyone who just wants cheap extra block space can find it on a sidechain.)

If it is true that over time one cryptocurrency will overwhelmingly dominate as the basis for an ‘internet of property’, then a lot of capital is at stake when considering the question who is winning this protocol war, Bitcoin or Ethereum?

In that regard, here are some questions I’m hoping to find answers for:

• What are the different challenges for implementing payment channels (lightning, raiden) on Bitcoin vs. on Ethereum?
• What are today’s non-speculative ETH use cases? (What do people need ETH for?) And, related, what are some revenue generating ETH smart contract based businesses?
• Are there ways to quantify the differences between Ethereum’s and Bitcoin’s security model?
• What proxies do we have to assess the aggregate quantity and average quality of Bitcoin vs. Ethereum core development?
• What are potential analogies with historical protocol wars?
• What kind of security analysis has been done on blockchain bloat and sharding?

Thanks for reading, I’m eager to hear your thoughts and discuss.

I own BTC, I don’t own ETH (for the time being).

1. Bitcoin matures as a financial asset

Remembering my chats with two CEOs, a CTO, and a fund manager at the conference, it’s clear to me that Bitcoin is coming into its own as a financial asset.

Because selling and re-buying Bitcoin can have tax consequences, entrepreneurs are now building solutions to allow use of it as collateral for dollar denominated short term loans. And in order to meet the demands of investors looking for a liquid and nuanced way to make Bitcoin price bets (and for Bitcoin intermediaries to diminish the volatility of their positions), exchanges are likely to start offering Bitcoin futures products. From the protocol side we see these initiatives complemented by public & federated sidechains, smart signatures, and hardware wallet applications.

In line with these developments, hedge funds and family offices are finally starting to look at Bitcoin with more serious eyes, considering to build up a long term position in this counter-cyclical, counter-inflationary asset.

2. The Segwit impasse: a Chinese-Western cultural deadlock?

A couple miners from China, and some people close to them, were present at the conference. It was difficult to get straight answers about why Chinese miners refuse to implement the Segwit soft-fork. One person said it was “too complex.” Another intriguing answer was that “if [Bitmain CEO] Jihan doesn’t do it, no-one will.” Someone familiar with China said that “Chinese miners just wants bigger blocks”—which gave food for discussion, because Segwit is an actual block size increase.

In the end, the theory that made most sense to me is that Chinese miners feel unappreciated and possibly even insulted by how they’ve been treated by the western Bitcoin community. Without prior consultation with China, Segwit was perceived to be presented in Hong Kong as “the solution to scaling.” Stories surfaced about a Chinese miner who arrived in the U.S. but was not picked up by his hosts there, and other instances where host-guest relationship rituals were potentially breached. Also some memories were shared about the political negotiations involved with upgrading internet protocols.

Suggested solutions to the Segwit stalemate: a name change from Segwit to something more respectful of Chinese miners, a bona fide diplomatic mission to China, and culturally sensitive strategies to introduce new, “next best” scaling solutions in China.

3. Outright trolling is less toxic than subtle misinformation

At the conference, people’s assessment of Bitcoin’s culture and dynamism varied widely. An attendee stated bluntly: “this community is toxic.” Others praised examples of productivity, courage, and diplomacy in the community.

One critical remark that stuck with me was about how harmful it is to have self-styled experts with some technical skills who don’t take responsibility for their errors or even deliberately spread misinformation in the community. Because most people with a stake in Bitcoin (including myself) use technical experts as proxies to form opinions about issues at hand, it’s particularly damaging when these sources aren’t trustworthy—potentially even more damaging than the attacks of anonymous trolls, who can be quite easily recognized and ostracized.

4. Trust is in perpetual flux

Another thing that struck me was the diversity of opinion when it came to what business and tech solutions are to be trusted. Some used intermediaries to help store their coins, others only trusted open source software and hardware wallets. Some relied heavily on exchanges because they believed in liquidity and diversification, others believed only minimalism and self reliance would help them survive and prosper. Some believed hard-forks are out of the question in a post-DAO world, others think they are inevitable or desirable. And so on.

The takeaway for me is that the Bitcoin community is generating an abundance of solutions to some extremely tough problems, and that investors and entrepreneurs are the “skin-in-the-game” actors who put their theories to the test on a daily basis—meritocracy in action.

5. Ransomware negative catalyst for Bitcoin regulation

Bitcoin, as the first successful pseudonymous e-cash, allows hackers to monetize their attacks. This has lead to an explosion in ransomware attacks that victimize virtually anyone: luxury hotels, subway systems, even Washington D.C.’s CCTV video recording systems. The FBI estimates that the revenues of these crimes amounted to $1 billion in 2016. A side effect is that security firms are now proactively building up Bitcoin holdings in order to pay clients’ ransoms (if deemed the best solution).

At the Roundtable, I talked to someone familiar with Capitol Hill lawmakers. There is concern that one day soon the wrong company, high-profile individual, or government entity will be victim of a ransomware attack which will spark heavy-handed intervention: crackdowns on Bitcoin mixers, altcoin exchanges, Bitcoin-to-cash service providers, and potentially other players in the ecosystem.

6. Bitcoin devs embrace permissionlessness, power forward

Despite the palpable disappointment that Segwit may not be activated for quite some time (or ever), Bitcoin development is thriving. Lightning, Sidechains, Mimblewimble, Smart Signatures, Joinmarket… each of these projects continues to produce breakthroughs on a regular basis. Meanwhile, applied crypto-technologies that are currently more in the altcoin sphere, such as zero-knowledge proofs, ring signatures, and proof-of-stake, are also being thoroughly explored.

One alternative proposal to Bitcoin scaling that caught my attention was to create a bigger block sidechain (either using the Segwit or the Bitcoin classic strategy) to which bitcoins could be migrated for cheaper and higher volume transactions. A suggested variation was a Mimblewimble sidechain—given that it’s likely Mimblewimble can be integrated with Lightning solutions.

Conclusion

Even with serious short-term challenges on the scalability and regulatory fronts, Bitcoin is healthier than ever and is developing at a rapid clip.

In my opinion Bitcoin is and will be both: digital gold and digital cash.

Cash and gold aren’t that different

The vision behind Bitcoin emerged from the cypherpunk movement, which over the course of two decades pursued the development of ‘digital cash’, also named ‘digital gold’. These two words are more alike than it may seem on the surface.

The definition of cash is “money in coins or notes” and “money in any form, especially that which is immediately available”. The etymological origin of the word cash is thus:

1590s, “money box;” also “money in hand, coin,” from Middle French caisse “money box” (16c.), from Provençal caissa or Italian cassa, from Latin capsa”box”

In order for cash money and its value to remain ‘immediately available’, it must have the possibility to be stored privately and securely. This is why, historically, most lasting forms of cash have gravitated towards forms that are durable, so they cannot be destroyed by time, and compact — so they can be easily stored in a secure environment like a vault.

As a consequence, anyone who pursues the notion of a durable standard of ‘digital cash’, must also put a significant value on security. Cash that cannot be stored securely is useless, and forms of cash that have better security characteristics will, ceteris paribus, win out over cash with inferior security. India is a good example, where private gold holdings are valued at $770 billion, versus at the most $210 billion for rupee notes.

Satoshi called Bitcoin ‘cash’ as well as ‘gold’

Satoshi Nakamoto called Bitcoin ‘electronic cash’ in his white paper, and later referred to it as “an implementation of Wei Dai’s B-Money proposal [an ‘anonymous, distributed electronic cash system’] and Nick Szabo’s BitGold proposal”. In his emails and forum posts, he explained Bitcoin using the analogy of gold and gold mining on six different occasions (1,2,3,4,5,6).

The most clear way in which Satoshi explained Bitcoin as digital gold was in a 2010 forum post:

As a thought experiment, imagine there was a base metal as scarce as gold but with the following properties:
- boring grey in colour
- not a good conductor of electricity
- not particularly strong, but not ductile or easily malleable either
- not useful for any practical or ornamental purpose

and one special, magical property:
- can be transported over a communications channel

If it somehow acquired any value at all for whatever reason, then anyone wanting to transfer wealth over a long distance could buy some, transmit it, and have the recipient sell it.

The bridge from gold to cash

Satoshi was right in my opinion: Bitcoin can be both a secure store of value, as well as a liquid medium of exchange used for small size payments. The solution is to accept and embrace an ecosystem with division of labor, where each sector prioritizes a different part of the solution.

In the case of Bitcoin, you can let one part of the ecosystem prioritize security, while the other focuses on convenience and speed. I’ll let Hal Finney, the first ever person to receive a Bitcoin transaction, explain:

“Actually there is a very good reason for Bitcoin-backed banks to exist, issuing their own digital cash currency, redeemable for bitcoins. Bitcoin itself cannot scale to have every single financial transaction in the world be broadcast to everyone and included in the block chain. There needs to be a secondary level of payment systems which is lighter weight and more efficient. Likewise, the time needed for Bitcoin transactions to finalize will be impractical for medium to large value purchases.

(…) Most Bitcoin transactions will occur between banks, to settle net transfers. Bitcoin transactions by private individuals will be as rare as… well, as Bitcoin based purchases are today.”

Finney wrote this in 2010. In my discussions with developers in 2012–’13, this was the prevailing idea of long term scaling: specialized custodians would store bitcoins and issue easily tradable deposit tokens, just like what happened throughout history with gold banks issuing gold backed paper money—only this time the users of the bills would much more easily be able to audit the reserves backing them.*

And that has become our reality today. Western Bitcoin exchanges process over $80 million in Bitcoin off-chain transactions per day; Bitcoin bank Xapo processes 500,000 off-chain Bitcoin transactions daily; Bitcoin gambling site PrimeDice processes 13 million off-chain Bitcoin bets per day. And so on. Cheap, high volume Bitcoin transactions are here already — though they require trust in a third party.

Modular scaling

Little did we know a few years ago that Bitcoin core developers would produce something even better than an enterprise network on top of the blockchain; technology that truly eliminates the need for trusted parties to serve as middle men. I’m talking about second layer solutions such as the Lightning Network, Sidechains, and MimbleWimble.

Scaling software solutions in a modular way is considered good digital hygiene. Here’s how Unix guru Eric Steven Raymond explains the principle:

“The only way to write complex software that won’t fall on its face is to hold its global complexity down — to build it out of simple parts connected by well-defined interfaces, so that most problems are local and you can have some hope of upgrading a part without breaking the whole.”

Developer John Ratcliff puts it a bit more bluntly when arguing for the Bitcoin Core strategy to scaling:

You do not build a networking protocol by shoving everything and the kitchen sink all into one layer; trying to solve every single problem for every single use case world wide in one massive giant glob of all encompassing code. That doesn’t work! Instead, you create a series of layers; with each layer focused on solving just one part of the overall problem extremely well, extremely efficiently, and as simple as possible.

To further illustrate the importance of how modularity produces functionality that stands the test of time, consider its applications in product design, construction, biology and even evolutionary psychology.

Conclusion

The question whether Bitcoin ought to be digital cash or digital gold represents a false dichotomy: it can be both a secure and accessible form of money. By embracing modularity, the main Bitcoin blockchain can act as a maximally secure settlement layer, while second layer payment channels serve as pipelines for fast, high liquidity transactions.

Note added on 6/6/’17

Hal Finney’s view on Bitcoin scaling may have been informed by Nick Szabo’s concept of bitgold. Szabo comments in a recent article ‘Money, blockchains, and social scalability’: “When I designed bit gold I already knew consensus did not scale to large transaction throughputs securely, so I designed it with a two-tier architecture: (1) bit gold itself, the settlement layer, and (2) Chaumian digital cash, a peripheral payment network which would provide retail payments with high transactions-per-second performance and privacy (through Chaumian blinding), but would like Visa be a trusted third party and thus require a “human blockchain” of accountants, etc. to operate with integrity. The peripheral payment network can involve only small value transactions, thereby requiring much less of a human army to avoid the fate of Mt. Gox.”

This list is mostly based on my experiences on Twitter, so people who are more active on other platforms may be underrepresented or absent. I have no doubt that this list is non-exhaustive, as I have a lot more to learn about the platform. It’s fair to consider this a list of sources I rely on for my research.

• Alex Van De Sande
• Fabian Vogelsteller
• Taylor Gerring
• Manuel Aráoz
• Vlad Zamfir
• Tristan Winters
• Vitalik Buterin
• Jameson Lopp
• Peter Vessennes
• Jop Hartog
• Paul Sztorc
• Kevin Riggen
• Cem Paya
• Nick Tomaino
• MAbtc
• BitcoinErrorLog
• Kanzure
• Daniel Krawisz
• Dan McArdle
• Philip Daian
• Datavetaren
• Muneeb Ali
• Joseph Lubin
• Pelle Braendgaard
• Christopher Allen
• Kyle Torpey
• Jake Brukhman
• Mason
• Aaron van Wirdum
• Peter Todd
• Chris DeRose
• Oleg Andreev
• Andrew T. DeSantis
• Ryan X. Charles
• Anthony Di Iorio
• Adam Back
• Bram Cohen

When it passed a market cap of $1.5 billion, both in March and in May, Ethereum became the highest valued non-bitcoin cryptocurrency ever.

The enigmatic project is no doubt the altcoin that has the most Bitcoin enthusiasts confused—or even rattled. People are wondering whether Ethereum could be Bitcoin 2.0, like Facebook versus Myspace, or VHS to Bitcoin’s Betamax.

Others have stated that Ethereum is carving out its own space entirely, calling it the oil to Bitcoin’s gold.

Andreas on Twitter

Ethereum is a competitor of Bitcoin, like a shark is a competitor of a lion. You can have two apex species in different niches not competing

I don’t share either opinion. In my view, Ethereum is in direct competition with Bitcoin, and going forward it’ll most likely lose market share against it.

On March 18 I took a first ETH/BTC short position. I got stopped out, after which I suspected a double top and I initiated a new short position:

Tuur Demeester on Twitter

Just sold short $ETH/$BTC, with stop losses at abt BTC 0.028. Feel like #Ethereum disarray isn't properly priced in.

In this article I explain why I have a bearish outlook on Ethereum’s token $ETH, certainly when expressed in Bitcoin terms. I don’t claim omniscience and I of course could be wrong. Still, I think the following list gives voice to substantially under-appreciated concerns about the Ethereum cryptocurrency and ecosystem.

If after reading this article you feel inclined to also short ETH/BTC, I suggest keeping in mind the following:

• Professional traders risk less than 1% of their capital in a trade, 2% in a maximum commitment. This is also my personal rule of thumb.
• Trading positions can only be held by an exchange, which means you will be subject to (significant) risk of loss of funds in case of a hack.
• A number of smart people are ETH-bullish—I suggest studying their arguments, maybe even their direct criticism of this article.
• Even if my analysis is correct, I could still lose money on my trade: markets can stay irrational longer than we can stay solvent.

Alright, let us dive in — first with an overview of the appeal of Ethereum, then with a criticism of its main selling point: flexibility.

Ethereum’s ambition

The idea behind Ethereum is to move way past digital cash that simply registers transactions in an immutable ledger, such as is the case with Bitcoin. Ethereum’s vision is to build a Virtual Machine, a cloud based decentralized computer. Interfacing with that machine, people can then create strings of code called “smart contracts” or “decentralized applications” and publish these on the Ethereum network. In exchange for a fee, the network will then execute the code for anyone calling on it.

After Gavin Wood published his Ethereum Yellow Paper, lot of enthusiasm ensued, and programmers started discussing and developing ideas such as a decentralized airbnb, decentralized prediction markets, a decentralized gold exchange, a decentralized hedge fund, and so on. Ethereum’s programming language is simple to learn and young developers jumped on the opportunity to create decentralized applications (‘dapps’). So far there are 298 such dapps listed.

Sounds great, right? An all-in-one decentralized financial system with its own native currency, greater functionality than Bitcoin, and much easier to code applications for. Truly a ‘Bitcoin 2.0’.

However, I think there’s a catch. Having followed the project since inception, I’m concerned that a number of risks and fundamental issues are being overlooked in bootstrapping this ambitious project. I think the project at least needs to undergo a big overhaul, and at worst needs to be abandoned entirely, to prevent more intellectual and financial capital to be wasted in the pursuit of impossible goals.

(Here is probably a good place to acknowledge that I’m not a computer scientist nor even a coder. I hope to compensate for that by linking back to sufficiently technically credible sources.)

Computer network trade-offs

Imagine a network of computers, from bottom to top: the hardware, the energy needed to run the processors, the operating system, and the protocols that coordinate the data exchange. No matter which configuration you choose, there will be a trade off between cost, security, speed, and flexibility.

Bitcoin’s core protocol does everything to maximize security so that it can be used as ‘digital gold’, a decentralized store of value. Therefore it operates at a fairly high cost, while generating low speed, low flexibility transactions. Indeed, it doesn’t acquire new functionality quickly—as illustrated by the many failed colored coin projects. Now, that doesn’t mean that lower cost, higher speed, and high flexibility are impossible, but just that those things have to be built on other protocol layers on top of the Bitcoin module: layers such as the lightning network and sidechains.

Ethereum has a different approach. It prioritizes flexibility and, I argue, compromises on security, speed, and even cost .

Let’s go over each of these computer network categories one by one.

Flexibility

The Bitcoin ‘digital cash’ core protocol is a stern and barren environment. Its primary client is called Bitcoin Core, which runs on the C++ programming language. C++ is known for its precision in allocating memory and high speed, and for its steep learning curve. For constructing new transaction-commands, Bitcoin uses a scripting system: there’s a list of less than 70 precise commands that can be executed at the core protocol level. Bitcoin smart contracts have been part of the roadmap since Satoshi, and a lot of thinking has gone into the limitations required to maintain consistency with the security confines of the Nakamoto framework.

Ethereum is founded with different ambitions in mind. The Ethereum Homestead Guide, written mostly by Ethereum Foundation hired developers, states, “…unlike the Bitcoin protocol, Ethereum was designed to be adaptable and flexible.”

The way Ethereum creates this adaptability and flexibility is in four ways: radical openness, multiple implementations, multiple contract specification languages, and institutionally endorsed hard-forks.

First, the founders chose the opposite approach from Bitcoin’s scripting system by pursuing Turing Completeness; in other words, by setting absolutely no restrictions on which type of code can be published and executed on the blockchain. In the words of Vitalik Buterin, “Instead of having a protocol with lots of features, what you have is a protocol with a built in programming language, and then you can write whatever features you want on top.”

The challenge here is that flexibility comes with a large attack surface. Ethereum code published on the blockchain can contain unintentional loopholes and other vulnerabilities. If any code can be embedded in Ethereum, so can code that is intentionally designed to crash the Ethereum software. We saw this exact scenario play out on September 18, when a specific smart contract on the Ethereum blockchain caused most geth and parity client nodes to crash at once, after which the hash rate dropped by 12%. Another such attack happened a few days later, on September 22nd, followed by more recent attacks which thwarted even the “come at me bro” hotfix.

The extreme openness of the Ethereum blockchain has been disapproved by several computer scientists and developers — criticism that seems to have been validated by the recent client crashes:

Muneeb Ali on Twitter

Putting more logic in the blockchain makes it easier to trigger bugs on *all* nodes on the network.

Secondly, the Ethereum developers created multiple interfaces to program and publish code on the blockchain, with the following motivation:

Maintaining diversity in clients connecting to and running the Ethereum network forces the development and documentation of a cleaner protocol and enables increased robustness of the overall system: an issue with a single implementation will likely not take down the network assuming other implementations are unaffected.

Ethereum Foundation director of technology Taylor Gerring adds:

When a discrepancy occurs due to either human or computer languages, a roundtable of client developers can compare results and discuss the ramifications of a particular interpretation so as to determine a specific course of action.

Today Ethereum features clients in different programming languages. While 90% of the nodes run on Geth, the Ethereum foundation also supports a python-based client and a C++ based client as official reference clients. There are currently also six active third party implementations.

This strategy of supporting multiple implementations, rather than being a diversifying boon for the network, has been criticized as fundamentally undermining its goal of decentralized consensus:

Peter Todd on Twitter

Multiple consensus implementations aren't: they're multiple slightly different protocols. Better to safely shutdown than unsafely "work".

Even Satoshi Nakamoto was critical of multiple consensus implementations:

I don’t believe a second, compatible implementation of Bitcoin will ever be a good idea. So much of the design depends on all nodes getting exactly identical results in lockstep that a second implementation would be a menace to the network.

For an in depth look into this issue, see the write up by Aaron van Wirdum: “The Long History and Disputed Desirability of Alternative Bitcoin Implementations.” In it, Peter Todd argues that the September 18th Ethereum attack could have effectively resulted in an accidental split into two independently operating chains.

Furthermore, in a recent article, Todd argues that Ethereum’s multiple implementations do not make its network more reliable, because there exists no comprehensive protocol specification for those implementations to be based on. If we assume that geth, which recently had a 90% market share, is the de facto reference client, one could still argue that the other implementations form a serious distraction, and geth does not attract enough intellectual capital to make it an implementation that can compete with Bitcoin in terms of reliability. Gregory Maxwell points out that:

…In the last six months Bitcoin Core had 800 non-merge commits from 91 authors across 469 merges, while go-ethereum [geth] had 247 from 22 authors across 105 merges.

Based on these numbers, one could say that Bitcoin displays four times as much activity and diversification compared to Ethereum.

Furthermore, despite continuous cheers for the boons of diversification, the concerns about multiple implementations are not just theoretical musings. Ethereum’s predecessor Mastercoin also had multiple implementations, causing numerous problems and leading them eventually to revert to a single reference implementation.

It’s my view that the multiplicity of implementations, in absence of a unambiguous specification, will lead to more problems down the road.

Christopher Allen on Twitter

The problem isn't just bugs, it is also poor understanding of markets, incentives, human behavior and bad actors. https://t.co/ixX3PgS7VF

A third way in which the Ethereum project has worked to adopt a flexible approach, is by supporting the creation of multiple contract specification languages (JS-esque Solidity, go-esque Mutan, python-esque Serpent, …).

This ‘shotgun approach’ to protocol languages has not been universally lauded. One of the more popular Ethereum languages, for example, is Solidity. It was used to construct the now infamous TheDAO smart contract, a contract from which $50 million worth of ether was stolen (4.5% of the total supply at the time). Philipp Daian, Cornell graduate student under prof. Emin Gün Sirer, had the following to say in his post mortem analysis of TheDAO hack:

I would lay at least 50% of the blame for this exploit squarely at the feet of the design of the Solidity language. …[T]he contract, even if coded using best practices and following the language documentation exactly, would have remained vulnerable to attack.

Perhaps over time more and more bugs in Solidity and the other smart contract languages of Ethereum will be fixed.

Emin Gün Sirer on Twitter

Writing secure smart contracts is closer to writing nuclear reactor code than loose web code. Solidity/EVM target the latter.

In comparison with the reinforced concrete of languages and implementations suitable for security, Ethereum’s implementations and languages are weaker and more malleable — one could compare it to straw. And of course, if you recommend entrepreneurs build houses with straw, you increase the risk of fire.

Christopher Allen on Twitter

Solidity as a #SmartContracts language is too easy for a bad programmer to horribly obfuscate what he's doing-accidentally or purposefully.

It’s important to mention that efforts are on the way to improve Ethereum smart contracts by working on better contract standards by means of formal verification. Though whether it’s possible to formally verify the Casper protocol is still unclear.

Finally, a fourth way in which Ethereum promotes adaptability and flexibility is by hard-forking the chain for security or scalability purposes.

Simply put, a hard-fork is a change to the protocol that makes upgraded nodes incompatible with nodes running the older version of the software, and vice versa.

In stark contrast to Bitcoin Core, which has never implemented such a drastic change to the code, most Ethereum developers see hard-forks as both an instrument for fixing undesirable features and acute problems with the network, as well as a legitimate tool with which to execute parts of the scalability roadmap.

alex van de sande on Twitter

Watching the successful hard fork. Congratulations to the team for another smooth transition!

Core dev Vlad Zamfir said, “I initially became a fan of protocol hard forks a long time ago, when I realized that they are a necessary part of the blockchain technology upgrade path.”

Of all its perceived sins against Satoshi’s canon, Ethereum’s pro hard-fork stance has probably garnered the most controversy — I think for good reason. Here’s a list of the criticisms against institutionally endorsed hard-forks that I agree with:

• Hard forks can result in two active, independent chains (which happened with Ethereum post TheDAO hard-fork). This introduces new security risks, political division, and consumer confusion.
• Institutional hard-forks destroy fungibility and annul settlement finality, which undermines Ethereum’s status as a blockchain-based cryptocurrency as well as the autonomy of its users. The project’s credibility has suffered too, as several key principles were violated.

• Exchanges hate dealing with the risky repercussions of hard-forks.
• Institutional hard-forks open a political can of worms, leading to (in my opinion) an unstable and inevitably unfair system of lobbying and favoritism. Take for example the ‘Buterin effect’: when following the attack on TheDAO, Vitalik Buterin did not take a clear stance against a hard fork. People began to read between the lines of his statements (much like central banker tea leaf reading) and, probably correctly, assumed that he and the Ethereum Foundation were actually in favor. Supposedly the hard-fork was a decision by ‘community consensus’, even though voting on the issue only occurred during a 12 day window, during which owners of less than 6% of the Ether in circulation actually cast a vote.
• Institutionally endorsed hard-forks introduce legal risks for the core developers, which could endanger and discourage future development efforts. By supporting the hard-fork, core devs potentially ‘prove’ that they have the power to claw back funds, or fix other (perceived) unfairness on the network. As a result, they may be held liable in court by anyone who thinks they are a victim of some injustice (victims of theft, hackers, users of the old chain, FinCEN). One legal conflict-of-interest dance may have already begun, as Buterin, who was a trustee for The DAO, bought TheDAO tokens before the hard fork and then endorsed the new post hard-fork chain which re-allocated a large amount of DAO tokens, claiming community consensus. More legal issues could ensue based on the fiduciary obligations assumed by core devs Buterin and Zamfir over the funds transferred from The DAO into a trustee-like structure, or from the white hat attack group (consisting of several prominent Ethereum Foundation members) that tried to expropriate DAO tokens from the original attacker.

Preston J. Byrne on Twitter

Someone is going to really regret having voluntarily/unnecessarily accepted fiduciary obligations in respect of DAO Ether. Watch. https://t.co/Zk9B2GlonQ

• Institutionally endorsed hard-forks are an unsustainable strategy to scale in the long term. Protocols are foundational layers on top of which infrastructure is built, and as an ecosystem grows, the vested infrastructure interests favor stability over predicted security or performance gains. Buterin agrees: “…hard forks will become technologically riskier and riskier over time and at some point assuming sufficient institutional adoption they just won’t be available as an option anymore.”

In conclusion, if Ethereum is to become the transaction ledger “to securely execute a wide variety of services […] at the global level,” then its contracts and programming language need to be sufficiently robust. The question remains whether the flexibility of the network is undermining this much needed robustness. I’m afraid that it is.

In closing part 1

In the forthcoming part 2 of this article, I plan to discuss three aspects of the Ethereum network: speed, cost, and security. I’ll take a deeper look into the planned transition to a proof-of-stake protocol that uses sharding as strategy towards on-chain scalability. Meanwhile, I welcome comments and thoughts.

I’d like to thank Bryan Bishop, Christopher Allen, Pelle Braendgaard, MAbtc, and Jameson Lopp for reviewing a draft of this article. Of course, all errors remain my own.

Disclaimer: Nothing contained in this article constitutes investment, accounting, tax or legal advice or a recommendation to buy, or sell any security or other investment, management product or service or pursue any investment strategy.

Edits/corrections:

• Changed voting period on the hard-fork issue from 12 hours (source) to 12 days following comments from Vitalik Buterin.
• Removed “So can code that accidentally causes infinite loops”. It’s correct that in Ethereum infinite loops are extremely unlikely or even impossible due to the fact that writing to the blockchain costs gas.
• After consulting with a few people and studying the comments below (see also here) I decided to remove this passage: “However, that could have sweeping repercussions for existing code. As remarked during a recent meeting of Bitcoin core devs, ‘if you change something in Solidity, existing smart contracts might stop working.’ ”

Note (19 April 2017): I closed out the last tranche of this ETH/BTC short in December 2016 at around 0.008 BTC, turned out to be a profitable trade. So far I haven’t written part 2, mainly because I’ve been struggling to gather clear information about how Ethereum is going to scale. I did publish a new Ethereum article earlier this month: “I’m not worried about Bitcoin scaling, but I am losing sleep over Ethereum”.