Byzantine Generals’ Problem: So what’s bitcoin?

I’ve had a great response to my first few posts and one of the questions/feedback I received most has been “Can you talk about what exactly bitcoin is?” So let’s take a step back and explore some of the philosophical and mathematical under pinnings that led to the bitcoin network.

The bitcoin network is widely credited to have solved the Byzantine Generals’ Problem, at least in practice, with certain assumptions.

That was a loaded phrase, so let’ explore in detail.

The Byzantine General’s Problem was first defined in 1982 by a group researchers out of SRI International. The research was in part funded by NASA and is a reflection of the impact the government has had in starting the internet revolution.

The scenario is defined as a group of Byzantine Generals with their troops camped around an enemy city. Communicating only by messenger, they must agree upon a battle plan. However, one or more of them might be traitors and might try to confuse others.

The Byzantine Generals’ Problem succinctly summarizes the issue with decentralized networks and why a centralized body (commercial banks/central banks/governments) has played a critical guarantor role in facilitating electronic transactions.

In our Byzantine Generals’ problem, the only way to ensure the messages are relayed accurately is for a centralized messenger dispatch system that ensures accurate messages are dispatched to all the generals.

To analogize this to an electronic financial system – the generals are merchants and individuals looking to make transactions, relaying messages is the finite money supply and the amount of money people possess (and thus can use for transactions) and the traitors are fraudsters that would take advantage by disseminating incorrect information. The incorrect information would be a fraudster looking to spend the same amount of money in multiple places (double spending).

Let’s say we develop an electronic financial system where a certain set of characters is generated for each unit of currency. Without a centralized authority certifying whether the unit of currency has been spent or not, a fraudster could send the same unit of currency to multiple individuals and hence spending the same “unit currency” in multiple places.

This is an important issue to consider since the existence of a centralized authority (banks) is what ultimately causes transaction costs to balloon (middle man taking cuts) and is why (to this day) international money transfers can take up to 5 days.

The bitcoin network solves this problem by storing each transaction on a public ledger known as the “block chain”. Every transaction that is made on the bitcoin network is recorded on to the block chain. If all the transactions are recorded on a block chain, what prevents somebody from tampering with it or spending the same bitcoin multiple times? The answer is in the decentralized manner in which bitcoin authenticates transactions.

Each time a block chain is created, a distributed network of nodes goes through a mathematical process to verify each of the transactions on the block chain. Each transaction on the block chain is related to the previous transaction. Whenever a node solves the mathematical problem to verify the transactions, it is rewarded with a certain amount of bitcoins. This reward is issued to encourage individuals to solve the mathematical problems to verify the transactions.

The nodes are setup by individuals looking to “mine” bitcoins by solving the mathematical problems. As long as the number of honest nodes is greater than fraudelent nodes, the authenticity of the system is maintained.

In essence, Bitcoin is an electronic currency that allows it to be used as a store of value without need of a centralized authority. The implications of this are significant especially as it relates to transaction costs and speed of transaction. It’s these technological properties that give it fascinating implications for use as a money supply and many other applications outside of currency yet to be explored.

For the more technically minded, here’s a link to the original research paper on the Byzantine Generals’ Problem. And here’s a White Paper from the founder of Bitcoin, Satoshi Nakamoto, whose identity is still unknown.

P.S.  I didn’t have any charts for this blog post but I thought it was interesting to find out I live 13 minutes from SRI International, where the research paper for the Byzantines Generals’ Problem was written.

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In Data we trust: not just a clever tag line

The term “In God We Trust” was first printed on paper currency in 1956 and first appeared on US coins in 1864. Although the phrase is widely accepted to be the official motto of the United States, a variation of the phrase (In Data we trust) can quite aptly describe the implications of the bitcoin network.

Before I delve deeper, let’s have a quick 101 on money supply. The total money supply in the economy has direct implications on inflationary and deflationary pressures in the economy. This is why the US Treasury can’t simply “print more money” to pay off its debts – a drastic increase in money supply would cause hyperinflation and has ruined a number of economies in history.

Interestingly, it’s not just irresponsible policy that can lead to hyperinflation. By the end of 1780, Continental Currency (the precursor to the US Dollar) lost a majority of its face value due to rampant counterfeiting by the British who used it as a tactic to weaken the revolutionaries of the “Thirteen Colonies”. This lead to the Coinage Act of 1792 which mandated a certain amount of gold and sliver in coins to prevent counterfeiting.

The total money supply in an economy is often referred to as M1. M1 refers to both money created by the central bank (the monetary base) and money created by commercial banks. The money created by commercial banks (fractional reserve banking) is the money created through lending and is a function of the monetary base and liquidity reserve requirements.

For example, the government might print $10,000 and circulates it to banks. Total M1 is now $10,000. At the same time, the government has a 1% mandatory liquidity reserve ratio for all banks. Which basically means for every $100 that a bank lends out, it only has to have $1 in reserves. So for each dollar created by the government, the banks can lend out $100. This is referred to as the Money Multiplier. So in our example, each $1 in the $10,000 can be lent out 100 times making the total M1 ($10,000 * $100) = $1,000,000.

Now, back to data. By design, the total amount of bitcoin created is strictly regulated and predictable through it’s algorithm. Below shows a chart of growth in bitcoin’s monetary base.

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Source: http://www.dgcmagazine.com/bitcoin-money-supply-and-money-creation/

The monetary base of bitcoin is the money created through “mining” (mining is the process through which money is created in the bitcoin system – a process worthy of a seperate blog post).

In our original M1 equation, we had two relative unknowns i.e. we didn’t know how much money the central bank will create and we didn’t know how much money banks will lend out.

Bitcoin at least solves the first part of the equation – we know exactly how much bitcoin is going to be created in the next 100 years.

Why is this important? Risk & uncertainty are kryptonite for commerce. In growing and developing economies the risk of the central bank exercising irresponsible monetary policy and printing money is high which significantly increases a merchant’s risk of conducting business in the local market.

If a global merchant conducts business in a developing economy through bitcoin, the exchange rate and currency risk are completely mitigated. Additionally, most traditional banks charge higher fees for foreign transactions to act as an “insurance policy” against the risks outlined above. Bitcoin doesn’t need to charge these exorbitant transaction fees.

There are also implications for developed economies. The Fed holds 8 regularly scheduled meetings each year where each word is analyzed by the Bloombergs and CNBCs of the world looking for hints for changes in monetary policy. The decisions which the Fed makes has far reaching implications on borrowing rates, financial models and inflation. If some of the decisions the Fed makes were known in advance, some uncertainty would be moved out of the system. As an example, the monetary base is one of the factors which are affected by the Fed.

So, what does this mean? Is the Fed going to go away? No. Even if the whole world transitioned to bitcoin we would still need a regulatory authority to manage issues such as fractional reserve banking (second part of the M1 equation mentioned above). Bitcoin does not have a way to regulate irresponsible lending. But perhaps, that might be the next breakthrough in the bitcoin network?

So, in Data we trust to provide a steady predictable monetary base to conduct commerce creating marketplaces and use cases previously thought impossible with centralized constructs of monetary policy. Data has replaced trust in certain instances. Previously we “trusted” the US Government to exercise responsible monetary policy. Now, it’s Data that ensures responsible monetary policy.

P.S. If you’re curious, below is a chart showing the growth in M1 in the US from the Board of Governors of the Federal Reserve System.

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