Money transmitters and other parasites.

At the risk of intruding on all the price speculation and we’re-gonna-be-rich/poor stuff, I want to focus on something more fundamental for a minute.

There are essentially two threats that make transferring value online risky (and risk is expressed in expense). The first is exploitation of a technical flaw by a cracker to redirect or obstruct the transfer. The second is malfeasance by a money transmitter (which is why money transmitters have to get licensed and monitored, etc). This is a trillion-dollar problem, in terms of it costing the world trillions of dollars per year to deal with this risk.

Blockchain-based cryptocurrency (at the moment, Bitcoin) is so far the only method of transferring value online to offer cryptographic protection from both of these threats. So, at least potentially, the world has much to gain by doing business in Bitcoin.

That said? We take our business off the blockchain often enough for both threats to be relevant to Bitcoin transactions regardless of cryptographic protections. We see prime examples of both risks in the collapse of Mt.Gox.

Gox had a fatally flawed method of handling transaction malleability, and someone (or someseveral) exploited the technical flaw to steal a half-billion dollars worth of coin from Gox over a period of nearly a full year. In fact we don’t even know whether that technical flaw was a genuine mistake or deliberately inserted by people at Gox in order to facilitate the theft. Which brings us to the second risk – malfeasance by a money transmitter. Whether or not people at Gox planned the theft, they continued operating as a “fractional reserve” system long after they became aware of it – AND FAILED TO FIX IT, exposing themselves and their clients to continued theft!! To cover the past and ongoing theft, they deliberately manipulated the market using “Willy Bot,” sending the prices on an unsupported stratospheric ride as a desperate attempt to hold off the collapse. This manipulation sucked more and more money into the black hole which was Gox for nearly eight months, multiplying both the duration/expense of theft and the collateral damage done in the collapse by at least factors of six.

Thus, even though the blockchain protocol is designed specifically to protect both against exploitation of technical flaws by crackers and against malfeasance by money transmitters, we have horrifically expensive examples of both wrapped up in a single incident. Why did this happen? It happened because we trusted Gox with our blockchain-secured money even when they were not using the blockchain protocol. Essentially people gave up sole control of the cryptographic keys that controlled their coins, leaving them to Gox and trusting Gox as holder of keys to tell them whether or not the blockchain was intact with respect to their coins. And Gox lied.

Malfeasance by money transmitters (such as Gox) has been demonstrated as a genuine risk for Bitcoin because Bitcoiners allowed Gox to do something we didn’t have to allow them to do. Because we gave up control of our coins to another party, and trusted that party to be honest. We made ourselves vulnerable to the primary risks that the Bitcoin protocol was designed to protect us from. The expense of Gox’s collapse put Bitcoin firmly into the same expense category as credit card transactions, wiping out the financial advantage of using Bitcoin. Now as Bitcoin becomes more accepted, we’re getting more money transmitters. Bitpay, etc, are, like Gox, in the business of holding the keys to other people’s money. They are money transmitters whose potential for technical failure and malfeasance continues to put Bitcoin business in the same risk category as credit cards – and, inevitably, therefore in the same expense category as credit cards.

This model (with money transmitters, online wallets, etc) does not realize the potential savings to the world of using Bitcoin. Because merchants are still exposed to the risks of technical failure and of malfeasance, they are not saving risk (and therefore not saving expense). The issue is not about whether Bitpay etc are immediately selling coins – the issue is about people trusting someone who is not themselves to hold their keys and therefore being vulnerable to the risk of that party’s failure to hold the keys securely.

So, short version of the story; had you asked me a year ago, I would have said that the emergence of money transmitters in Bitcoin was an aberration because the protocol was built specifically so that people could do all of that for themselves. I’d have said that Bitcoin would take off when people got over their reliance on third parties and therefore started realizing the potential for financial advantage. But when I look at it today and I see money transmitters becoming entrenched in the Bitcoin economy, it’s becoming more and more clear that if we don’t get away from that, then we have nothing to offer merchants better than what the credit card companies are offering them.

It’s one thing for me to explain to a CFO that they don’t need the money transmitter or the exchange and that they can manage their own wallet and be fully protected from that third-party risk; but in the first place they don’t usually believe me. Worse, there is a legit worry about first-party risk (ie, that a company insider with access to the wallet could steal the company’s Bitcoin, as may or may not have happened at Gox).

Relying on money transmitters (third party risk that’s bonded and insured) is their standard method for mitigating first-party risk (an inside job for which they’d eat the loss directly). That is why, among other things, most businesses take their cash to the bank every night instead of keeping it themselves. They expose themselves to the possibility of failure or malfeasance by the bank, but that’s better than multiplying their exposure to the possibility of theft by the manager.

So, if we think Bitcoin is advantageous to the world — if we want there to be a financial advantage to the world from using it — we have to find ways to actually deliver the savings that the protocol was designed to deliver. We have enabled users to cut out money transmitters and third parties. Now we have to make it advantageous for them to do so.

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