The Satoshi Revolution: A Revolution of Rising
Expectations.
Section 1 : The Trusted Third Party Problem
Chapter 2: Monetary Theory
by Wendy McElroy
Satoshi’s White Paper Breaks Your Economic
Chains (Chapter 2, Part 5)
I think that the Internet is going to be one of the
major forces for reducing the role of government.
The one thing that’s missing, but that will soon
be developed, is a reliable e-cash, a method
whereby on the Internet you can transfer funds
from A to B without A knowing B or B knowing
A. The way I can take a $20 bill hand it over to
you and then there’s no record of where it came
from. You may get that without knowing who I
am. That kind of thing will develop on the
Internet and that will make it even easier for
people using the Internet. Of course, it has its
negative side. It means the gangsters, the
people who are engaged in illegal transactions,
will also have an easier way to carry on their
business.
—Milton Friedman
The Nobel Prize economist predicted Bitcoin
during a 1999 interview conducted by the
National Taxpayers Union Foundation. Milton
Friedman’s brief statement is remarkable. Within
a decade, a reliable e-cash was developed.
Bitcoin did and does have a profound political
impact on government by shattering its monopoly
on currency. Peer-to-peer transfers do not
require participants to know each other, and they
can be almost anonymous. Bitcoin benefits
criminals, as well as peaceful individuals, in
much the same manner as physical cash. The
quote’s one misstep is to envision an exchange
in which “there’s no record of where it came
from.”
E-cash and its surrounding issues had been
discussed many times before October 31, 2008
when Satoshi’s Paper, “ Bitcoin: A Peer-to-Peer
Electronic Cash System ,” was released into the
wild. Without the blockchain to enable peer-to-
peer transfer, however, the emphasis was
generally on how to achieve anonymity when
dealing with a trusted third party. It is the
blockchain that makes bitcoin remarkable
because it eliminates the need for a trusted third
party.
But, first, Satoshi laid the groundwork for his
paper.
Context for the Concept and Coding of Bitcoin
The coding of Bitcoin began in 2007. The timing
was no coincidence. The financial crisis of
2007-2008 is often viewed as the worst to occur
since the Great Depression devastated the
1930s. The 2007 crisis is a cautionary tale of
how dangerous it is to empower trusted third
parties, and how pitbull-protective the
government is of the banking system.
A collapse in the subprime mortgage industry
sparked the financial crisis. Typically, a subprime
mortgage is issued to a borrower with poor credit
who poses a higher-than-usual default risk. To
compensate the lender, the borrower pays a
higher-than-usual rate of interest. Subprimes
became increasingly common for several
reasons. One was the use of automated
underwriting software that sped up the loan
process, but often bypassed the standard review
of data and documents. In short, lending
institutions failed in their duty to authenticate a
borrower’s eligibility. Housing prices rose on a
flood of artificially-loose credit. Peaking in 2006,
prices then spiralled downward for years, which
caused massive foreclosures in the U.S. and
internationally.
The high delinquency rate, in turn, caused a
devaluation of financial instruments and
threatened to collapse the trusted-third-party
system. On September 7, 2008, the U.S. federal
government assumed the liabilities of the shaky
Freddie Mac and Fannie Mae; these government-
sponsored enterprises bought loans from
mortgage lenders, and sold them to investors on
the open market. Then, on September 15, large
investment bank Lehman Brothers filed for
bankruptcy. Other banks were expected to
follow, including Merrill Lynch, American
International Group (AIG), and the Royal Bank of
Scotland. The next day, the government
announced its intention to recapitalize the U.S.
financial system; it would bail out the banks. AIG
led the way with the government extending a
loan of up to $85 billion in exchange for an 80%
equity interest in AIG. On October 3, the
Emergency Economic Stabilization Act of 2008
was enacted, authorizing spending of up to $700
billion to purchase distressed assets and to fund
financial institutions, including foreign ones. The
hierarchy of trusted third parties not only failed
in its fiduciary duty but also passed-on the cost
of failure to taxpayers.
Satoshi watched the bailouts unfold, as the
message on the Genesis block attests: “The
Times 03/Jan/2009 Chancellor on brink of
second bailout for banks.” Solving the trusted
third party problem must have assumed urgency
to him.
Something else significant occurred in 2007. The
U.S. federal government filed charges against e-
Gold, Inc., which was then the leading digital
currency company. The charges were money
laundering and transmitting money without a
license. E-gold’s owners were tried and
convicted; the company was ruined and closed
its e-doors.
Satoshi must have watched this situation, as
well. No wonder he maintained absolute
anonymity.
Another piece of groundwork for the White Paper
was to invite feedback from cypher-experts via
private email. On August 22, 2007, for example,
Satoshi emailed famed cypherpunk Wei Dai. The
subject line was “Citation of your b-money page.”
Satoshi explained, “I’m getting ready to release a
paper that expands on your ideas into a complete
working system. Adam Back noticed the
similarities and pointed me to your site. I need to
find out the year of publication of your b-money
page for the citation in my paper. It’ll look like:
[1] W. Dai, ‘b-money’, http://www.weidai.com/
bmoney.txt , (2006?).” The footnote in the final
White Paper was: “1. W. Dai, “ b-money ,” http://
www.weidai.com/bmoney.txt , 1998.” Satoshi
provided Wei with the URL at which to
“download a pre-release draft.” He gave
permission “to forward it to anyone else” whom
Dai thought “would be interested.”
The draft, “Electronic Cash Without a Trusted
Third Party,” does not mention Bitcoin in its title,
but the abstract differs only slightly from that of
the White Paper; mostly, the latter is better
written. The freelance researcher “gwern”
compared both abstracts by using Mergely–a
powerful online diff and merge editor that
highlights changes between texts. Gwern could
not compare the texts, however. He later
lamented, “[t]he pre-release draft link is now
broken.” His dogged efforts to find the document
elsewhere came to nothing.
The next occasion upon which Satoshi emailed
Dai seems to be January 10, 2009. He wrote, “I
wanted to let you know, I just released the full
implementation of the paper I sent you a few
months ago, Bitcoin v0.1. Details, download and
screenshots are at www.bitcoin.org. I think it
achieves nearly all the goals you set out to solve
in your b-money paper. The system is entirely
decentralized, without any server or trusted
parties. The network infrastructure can support a
full range of escrow transactions and contracts,
but for now the focus is on the basics of money
and transactions.”
Satoshi’s White Paper
Satoshi defines “an electronic coin as a chain of
digital signatures.” The coins travel over a
distributed digital ledger, called the blockchain, in
which they are recorded transparently and
chronologically. Bitcoin.com’s easy-to-
understand “ Bitcoin Whitepaper: A Beginner’s
Guide ” breaks down the basic steps in a coin’s
journey:
- New transactions are broadcast to all nodes/
computers in the network. - Each node collects new transactions into a
block. - Each node works on finding a difficult proof-
of-work for its block. - When a node finds a proof-of-work, it
broadcasts the block to all nodes. - Nodes accept the block only if all transactions
in it are valid and not already spent. - Nodes express their acceptance of the block
by working on creating the next block in the
chain, using the hash of the accepted block as
the previous hash.
As mentioned in earlier sections, nodes always
consider the longest chain to be the correct one
and will work on extending it.
Technical explanations of the White Paper
abound and are available online for free. The
following analysis, therefore, focuses on the
most important non-technical aspect of Bitcoin;
Bitcoin resolves the trusted third party problem,
which is the White Paper’s raison d’être. The
paper opens: “Commerce on the Internet has
come to rely almost exclusively on financial
institutions serving as trusted third parties to
process electronic payments.” But inherent
problems attend trust-based traditional financial
systems, including corrupt politics and practices.
Due to the strictly technical nature of white
papers, however, Satoshi does not discuss the
political problems, foremost of which is the
alliance of government and banking, stripping
individuals of freedom and security. Instead, the
White Paper points to practical difficulties. For
example, “financial institutions cannot avoid
mediating disputes” that arise from the
reversibility of transactions or fraud. The
mediation creates negative consequences, such
as transaction costs and a limitation on “the
minimum practical transaction size.” What is
needed for online commerce is “an electronic
payment system based on cryptographic proof
instead of trust, allowing any two willing parties
to transact directly.”
The brilliance of Satoshi’s system is twofold. It
allows an online transaction that resembles one
person handing cash to another; it also
preserves the valid services that a trusted third
party is expected to perform. It preserves the
benefits of an honest and competent third party
while discarding the abuses. The main benefits
are: verification of a transaction, ease and
security of transfers, preservation of privacy,
prevention of double-spending, mediation of
disputes, and provision of a record. The structure
of the blockchain either provides these services
or obviates need for them.