Friday, February 28, 2014

Market-Based Reactions To New Bitcoin Regulation

By Jon Matonis
Sunday, February 23, 2014

Every action has a reaction, and the world of government regulation is no different. Recently, the regulatory chatter has picked up around Bitcoin and it appears to be focused on two major mandates as perceived by the financial regulators.

Number one is the attempt to apply invasive technology-specific money transmitter regulation to a technology that doesn’t seem to fit into any of their other regulatory boxes. Licenses are being crafted to ensure the same level of AML (Anti-Money Laundering) and KYC (Know Your Customer) guidelines for bitcoin companies as for other types of existing financial institutions.

Number two is protecting us “from ourselves” under the standard guise of consumer protection and fraudulent operators. In an interview on The Bitcoin Group, Andreas Antonopoulos describes a self-regulating method where the consumer protection holes can be solved by free market-enforced exchange solvency and implemented cryptography solutions.

New York-Style Licensing

Regarding technology-specific regulation at the state level, New York has put forth a bad idea with an unfortunate name, mostly because it sounds like an innovative Silicon Valley startup which it definitely is not.

It is, however, a grand attempt from a local regulator to overlay an inappropriate technology-specific regulation within the confines of the great state of New York.

Unfortunately, this will cause greater hardship for New Yorkers than it will for the bitcoin businesses that will most likely seek out other favorable jurisdictions. If New York wanted to drive new growth businesses away from the state, then this would be the way to do it. These antics are not predicted to be emulated.

Markets perceive regulation as ‘damage’ and route around it. This is true with Internet-related damage and it is equally true with Bitcoin-related damage.

For example, artificial damage to bitcoin’s semi-anonymous properties could be inflicted by tracking specific bitcoin addresses at the exchange endpoint level and beyond. Perhaps mandated by law in the near future, this type of regulatory action would be akin to to registering bank note serial numbers during a routine cash withdrawal.

Most people would reel in horror at the prospect of this because they naturally believe that they have a right to use their cash as they see fit without serial number tracking.

Surveillance techniques

Coin tracking and coin validation schemes are new types of surveillance techniques that Bitcoin’s public transaction ledger enables. Interestingly, either the free market or the law could spawn these invasive techniques as a business model.

In the case of an exchange seeking to bolster its compliance reputation, it might turn to an independent service provider that analyzes bitcoin address data and associated traffic patterns known to be involved in crimes.

Of course, the major underlying and still unresolved problem here is that subjective judgement must be exercised in data analysis of this type which could unduly harm the downstream owners of fungible bitcoin. That is, if anyone held title in bitcoin to begin with.

Markets provide solutions to these cases of bitcoin privacy ‘damage’ and this is where it becomes tricky for regulators. They are practically in a no-win situation because regulators must use their tools to regulate, but the more they do, the more they inadvertently encourage market-based responses.

Fortuitously, Bitcoin comes with built-in plausible deniability due to the many ‘mixing’ hops that can be traversed both on-block chain and off-block chain. Unless the user’s private key is seized, no one can prove with absolute certainty that a particular amount of bitcoin is owned by an individual without their consent. In financial privacy terms, this is referred to as “knowledge of balance” privacy and it is a key element of overall financial privacy.

Mixing services

As cited in ‘The Politics of Bitcoin Mixing Services’, mixing services for bitcoin may emerge as the next frontier in the battle for financial privacy. Coin mixing services for cryptocurrencies do not violate any laws and they merely attempt to re-balance natural deficiencies in the protocol.

According to CNBC, Ben Lawsky and New York’s Department of Financial Services are “still wrestling with whether to ban or restrict the use of ‘tumblers,’ which obscure the record and source of virtual currencies.” Lawsky said tumblers are a concern to law enforcement although they might have legitimate uses.

Is it even possible for New York to ban tumblers that exist on the global Internet? How will the cryptographic free market respond to encroaching regulation into the market for Bitcoin?

Zerocoin and CoinJoin represent two attempts to restore the balance in making digital cash as private as physical cash today. They operate in a decentralized manner without requiring trust in a third party.

Originating from Johns Hopkins University, the first Zerocoin plan was a proposed extension to the Bitcoin payment network that added anonymity to Bitcoin payments and used provably secure cryptographic techniques to ensure that Bitcoins cannot be traced.

After refusing to gain traction among the bitcoin user and developer communities, creators Matthew Green and Ian Miers decided to launch Zerocoin as its own independent cryptocurrency complete with separate block chain and reward incentive system. The Economist refers to Zerocoin as “washing virtual money”.

CoinJoin, first described by Gregory Maxwell as a method of increased coin privacy for the real world, is an urgently needed improvement, because:
“Bitcoin is often promoted as a tool for privacy but the only privacy that exists in Bitcoin comes from pseudonymous addresses which are fragile and easily compromised through reuse, ‘taint’ analysis, tracking payments, IP address monitoring nodes, web-spidering, and many other mechanisms. Once broken this privacy is difficult and sometimes costly to recover.”
Involving no changes to the Bitcoin protocol but requiring specific wallet implementations, CoinJoin operates as a unique transaction style for Bitcoin users to dramatically improve their privacy.

Both efforts succeed where the original Bitcoin protocol stopped short. In direct response to increasing and potentially onerous regulations, Zerocoin and CoinJoin stand as pillars of financial privacy in a world where surveillance has run amok.

Ultimately, society can have hope that if privacy becomes disrespected, the market can and will provide cryptographic solutions to restore the balance. If Bitcoin is to succeed, that is the real challenge for the talented individuals and leading companies in the Bitcoin ecosystem.

Monday, February 24, 2014

The Evolution of the Bitcoin Clearing House

By Jon Matonis
Friday, February 14, 2014

We may be witnessing the final months of the large international bitcoin exchanges for retail purposes. On the road to maturity, the survivors are most likely to emerge as supra-regional bitcoin clearing houses.

Today’s global bitcoin exchange plays the mega-role of both retail and wholesale exchange, providing the platform for individual traders, corporate traders, and smaller bitcoin exchanges. Due to a dearth of functioning exchanges in many active bitcoin countries, traders are forced to look outside of their home jurisdiction for liquidity and they tend to go international.

In finance, a clearing house is an institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions. The origin of cheque clearing for banks can be traced back to the 1770s.

With bitcoin, a clearing house can be thought of as a wholesale liquidity provider clearing transactions in an over-the-counter (OTC) market or a futures exchange.

By standing between two member clearing firms, a clearing house reduces the settlement risks by netting offsetting transactions between multiple counterparties and by providing independent valuation of trades and collateral accounts.

When bitcoin derivatives are inevitably introduced, margin deposits will be involved, requiring the clearing house to monitor the credit worthiness of member clearing firms and, ideally, to establish and maintain a guarantee fund that can be used to cover losses that exceed deposited collateral from a defaulting clearing firm.

The Russia-based ICBIT exchange offers a bitcoin derivatives market today.

As more and more trading for bitcoin occurs locally, the need for international bitcoin exchanges will diminish and the remaining exchanges will have to evolve in order to remain relevant. Initially, some may function in a dual capacity as both exchange and clearing house during the transition period.

Forces of change

Two separate forces are at work driving this trend within the local bitcoin environment.

Local bitcoin exchanges catering to a country or region allow the easiest method for buying and selling bitcoin because, as local players, they understand the existing electronic payment networks and the dynamics of how best to integrate with their country’s banks. Also, since bitcoin is ultimately more frightening to central banks than it is to normal retail banks, the inevitable is starting to happen.

Banks are beginning to explore methods of incorporating bitcoin services directly into their proprietary online offerings. And why not? Banks have the proven expertise in currency trading, deposit holding, secure IT environments, and payments. They should exploit this advantage.

If retail bitcoin exchanges cannot provide greater privacy and service than banks, then why are they needed to sit between you and your bank? The answer is that they probably are not needed – at least not in the same way. As more bitcoin exchanges request the opening of commercial bank accounts, the banks are gradually realizing that bitcoin services may be a direct opportunity for themselves.

Losing the middlemen

Exemplified by the recent announcement from South Africa’s Standard Bank, a bitcoin pilot program tested by the bank eliminates the need for a retail bitcoin exchange in the middle of the transaction. Partially owned by China’s biggest bank, ICBC, Standard Bank is the largest bank operating in Africa.

Similarly, Germany’s Fidor Bank pioneered the integration of bitcoin as a competitive advantage for the bank when, in July 2013, they agreed to a large-scale partnership with the exchange in Munich. The agreement called for a “liability umbrella” for bitcoin trading and represented the first direct banking cooperation in the regulated EU bitcoin sector.

Shortly thereafter, Fidor Bank signed an exclusive arrangement with Payward Ltd, operator of the Kraken bitcoin exchange. Under the deal, Kraken became Fidor Bank’s exclusive digital currency trading platform throughout the European Union, with the exception of Germany where Fidor Bank already had the local partnership with

Turning the tables on owning the bitcoin customer relationship, Fidor Bank CEO Matthias Kröner said: “Digital currencies are emerging as serious and useful alternatives to government-issued currencies. With Kraken we can enable our customers to trade bitcoin and other digital currencies just as securely, easily and flexibly as they trade other foreign currencies today.”

Shifting roles

These are still early days, but it could forecast the beginning of a trend where regional banks take on the role of building online platforms and interfacing with the millions of bitcoin customers.

In this scenario, the banks become local liquidity providers and bitcoin position takers. As the service offerings mature, banks will require a bitcoin trading desk, complete with portfolio-hedging strategies and multiple avenues for two-way liquidity.

Global bitcoin exchanges emerge as bitcoin clearing houses – less retail-oriented and more wholesale-oriented – providing deep liquidity and sophisticated offerings for the local market participants.

Friday, February 7, 2014

Legal Online Gambling Is Next Major Bitcoin Market

By Jon Matonis
Thursday, January 30, 2014

The international online gambling industry is an estimated $30bn market, and growing. More importantly for Bitcoin, it’s a global market that depends on fast, irreversible payments.

Just like a ordinary casino chip in any land-based casino, digital bitcoin provides privacy, immediacy, and payment finality. Unlike most typical consumer purchases (where returns and chargebacks are usually legitimate), a wager is a one-way transaction. Of course, you may be dissatisfied with the outcome, but that does not justify a reimbursement. The online gambling industry has struggled with this fact for years.

Plagued by chargebacks and fraudulent transactions, specialized payment methods and payment companies have sprouted up around the online casino world to address the problem of payment finality.

iGaming and bitcoin

For the first time ever, the world’s largest and most comprehensive trade event in gaming, ICE Totally Gaming 2014, will feature a half-day seminar on bitcoin in the iGaming environment on 4h February. The London-based conference represents every gambling sector: betting, bingo, casino, lottery, mobile, online, and social gaming.

Organized by Gran Via’s Willem van Oort, the seminar features two extraordinary panels: ‘Regulatory Aspects’ and ‘Bitcoin’s Competitive Edge’. I will also be speaking on the evolution and future of bitcoin as a new monetary unit.

Moderated by iGaming attorney David Gzesh, the regulatory panel will assess the compliance challenges in dealing with bitcoin payment processing applications, including currency conversion, reduced transaction costs, payment finality, Know Your Customer rules, and coin management techniques.

Panelists include; Stuart Hoegner, managing director at Gaming Counsel PC; Steve Beauregard, CEO and founder of GoCoin; and Michael Ellen, director of licensing and strategy at Alderney Gambling Control Commission.

The second panel of the day focuses on the competitive advantages offered by bitcoin in the iGaming industry and will explore potential for new games, new jurisdictional regions, and unique investment opportunities on the horizon.

Stellar panelists include; Esteban van Goor, indirect tax lawyer at PwC; Ivan Montik, CEO and founder of Softswiss; Erik Voorhees, founder of SatoshiDice; Brock Pierce, managing director at Clearstone Global Gaming Fund; Jiten Melwani, founder of Bitgame Labs; and Gabriel Sukenik, director at Coinapult.

Into the mainstream

We are now witnessing the long-awaited arrival of mainstream online casinos and betting establishments into the bitcoin universe. This is the beginning of the second-generation bitcoin gambling sites – the first generation exemplified by sites like SatoshiDice, BitZino, and Seals With Clubs.

CoinDesk reported on Wednesday that Malta-registered casino Vera&John has become the first of the major licensed and regulated online casinos to accept bitcoin deposits. The gaming operator accepts inbound customer payments which are then processed and converted into euros via Panama-based Coinapult service.

Following a trend common among existing online poker sites like WinPoker, Vera&John will only permit wagering in national currency units. The strategy of utilizing bitcoin only as a customer payment transfer mechanism eliminates the exchange rate risk for the operator and the player.

Alternatively, if the player uses bitcoin for deposit, betting, and withdrawal, then the exchange rate risk stays with the player. Examples of that approach include CloudBet and CoinBet.

Sports betting site Cloudbet claims to have revolutionized the online betting experience by introducing the world’s most advanced bitcoin betting platform accessible from desktop and mobile devices. Users can browse an intuitive, elegant site to place immediate and discreet bets on any world event – at zero fees.

CloudBet currently deploys 100% offline cold storage for all bitcoin assets and the site has received excellent reviews.

In addition, Costa Rica-registered CoinBet offers casino gaming, poker, and sports betting all under a simple email registration with password. CoinBet claims to be the first legitimate, licensed entity to re-enter the real money online gambling space since Full Tilt Poker, PokerStars, and Absolute Poker all had their sites shut down by the US Department of Justice in April 2011. However, that particular claim may actually go to Costa Rica-registered Infiniti Poker.

Unlike other regulated gambling jurisdictions issuing licenses, Costa Rica does not require operators to obtain and verify the identity of its players. On the policy of accepting US players, John Bauer, senior vice president of gaming at CoinBet, proudly emphasized:
“Look, to take away a person’s fundamental right to spend their money on whatever they choose is wrong, unconstitutional, and without question, an un-American thing to do.”
He continued: “We are not here to engage in a legal debate, we are here to serve up the very first legitimate workaround to the complex online gambling laws in this US market. We are returning to Americans their freedom to choose and giving them their power back!”

Internet gambling in the US operates in a legal grey area. Other gaming operators in the near future may come to appreciate Bauer’s statement because the US jurisdiction has yet to see a clarifying test case in the matter of bitcoin-only wagering without conversion.

Friday, January 31, 2014

The Implications of Bitcoin: Money Without Government

By Jon Matonis
Thursday, January 23, 2014

One of my favorite things about bitcoin is how it’s such an all-inclusive tent.

Bitcoin attracts political idealists from the right, political idealists from the left, Silicon Valley technologists, social science academics, philosophers, capitalists, socialists, and even apolitical speculators.

Alex Payne kicked off this latest round of analysis with his blog piece: “Bitcoin, Magical Thinking, and Political Ideology”. A self-described programmer and secular humanist, Payne worked as an early engineer at Twitter building the service’s developer platform and backend infrastructure.

Mostly, he criticizes Silicon Valley for its self-indulgent hyper-capitalism that lacks meaningful solutions to real-world problems. Oh yeah, and he specifically targets Chris Dixon, Andreeseen Horowitz, and their Coinbase investment.

Chris Dixon, Andreessen Horowitz’s partner on the Coinbase board, promptly shot back in defense with Why I’m Interested in Bitcoin where he disavowed himself of any libertarian ideology or “fantasies of a crypto-powered stateless future” and instead highlighted bitcoin’s technological promise in reforming the mismanaged financial system.

Personally, I prefer Marc Andreessen’s recent tribute in The New York Times, Why Bitcoin Matters.”

The divide between ideology and technology as the driving purpose behind bitcoin permeates the bitcoin investment community and the Bitcoin Foundation’s approach to public policy. Advocating and using a non-political monetary unit is a forceful political statement. Investing in a non-political monetary unit or its infrastructure companies is an equally powerful statement.

The bitcoin network cannot be separated from the bitcoin monetary unit and if the central bank, or the Federal Reserve in the United States, provided an important function, bitcoin would be unnecessary.

Carried through to its ultimate conclusion, the bitcoin unit competes with the government’s unit in a modern version of Hayekian currency competition.

More importantly, bitcoin is money without government: just as one cannot separate the bitcoin network from the bitcoin monetary unit, one cannot separate the bitcoin network effect from its central banking implications.

Personal Journey

My personal journey towards bitcoin began in the mid-1990s when David Chaum’s DigiCash company and technology debuted in America.

At that time, I was working in Silicon Valley at RSA Data Security’s new spin-out company, Digital Certificates International, that later became VeriSign. The new SSL encryption in Netscape browsers relied on these digital certificates for authenticating and securing web servers.

With Chaum’s DigiCash technology, for the first time ever, digital bearer features of physical cash could be emulated in software using cryptographic protocols.

This was pure genius and it hit me like a ton of bricks.

During the next two years, I started thinking through scenarios of monetizing equity mutual funds and real estate and how ideas like e-gold could be transformed into digital bearer instruments backed by gold, not just a ledger-based transfer system. I even published a research paper at the London School of Economics.

However, I quickly realized that the centralized nature of these two systems inherently gave them a limited life span due to a single point of ‘failure’ that could be used for suppression.

Predictably, the political pressures increased with DigiCash needing regulatory approval to operate as an issuing mint within a bank and then e-gold suffering a Department of Justice shutdown and asset seizure at the peak of its epic success.

My thoughts shifted to how precious metals and other commodities could be stored, assayed, and audited without revealing knowledge of their location. This proved to be a very difficult feat.

The Bitcoin Protocol Network Effect

In late 2008, five years ago, a developer named Satoshi Nakamoto devised a protocol which distributed trust across a decentralized peer-to-peer ledger and eliminated confiscation risk by replacing physical assets with a mathematical proof of work.

More than anything, it is these two features that would lead to bitcoin’s real world success because the system now had the attribute of survivability. When angels and venture capitalists invest in bitcoin-related business models, they are investing in a survivable protocol – a protocol that will survive political institutions.

Herein lies the dichotomy: how can VCs knowingly invest in a protocol that survives political institutions when it is those same political institutions that allow them to capitalise on their investments?

Money naturally operates like a virus and that makes digital bitcoin potently viral. It is viral cubed – money on the Internet with a network effect. A monetary unit does not stop expanding until it runs into artificially delineated boundaries or achieves widespread dominance.

It is naive to think that governments believe so much in competitive currencies that they would encourage and accept a digital monetary unit without a central issuer. Some smaller governments may believe in that, but only as a way to use it against certain other governments that currently have dominant monetary units.

What’s more likely is bitcoin growth in the developed world constrained by regulatory endpoints, legislative taxing powers, and bans on merchants, but only up to a certain maximum market cap for bitcoin. Sure, we’ll let it grow but not too much.

So what is that magical permissible level of adoption where going beyond that point jeopardizes central banking and monetary policy? Is it a $100 billion, $500 billion, $1 trillion market capitalization for bitcoin?

No one really knows, least of all the governments. A $1 trillion bitcoin economy may not be suppressible, but it definitely becomes a less friendly environment with respect to established political institutions.

I guess your viewpoint depends on what problem bitcoin is solving – high transaction fees and complex international remittances or the problem of central banking and the intertwining of money and state.

Fortunately, bitcoin solves for both. But, you can’t have one without the other. You can’t believe that central banks play an important and necessary role in society and also believe that bitcoin serves as a monetary solution.

I am pro venture capital. Building the bitcoin infrastructure around the world is important, but within certain jurisdictions it can also be a frustrating contradiction. The success of an investment depends less on the execution of a stellar management team and more on the degree of regulatory latitude. For venture capitalists, bitcoin is not like Facebook and Twitter where worldwide market saturation and dominance is the end game for the IPO home run.

Market saturation with bitcoin means that something else lost and it’s not a competing cryptocurrency. Therefore, it will be imperative for venture capitalists to remain astute about the evolving political landscape and agile enough in timing their exits.

Andreessen stated in The New York Times article that he’s with Ben and Milton when it comes to the promise of reliable digital currencies. However, Bernanke and Friedman were referring to digitized national units, not an alternative and independent numéraire.

The only plausible outcome may be jurisdictional competition. After World War II, wealth flowed to the US dollar as the world’s reserve currency.

Now, real wealth flows from the West to the East in the form of gold bullion and claims to natural resources. In the cryptocurrency future, wealth will flow to the regions that facilitate and exploit bitcoin’s massive potential for unleashing true economic growth.

Monday, January 20, 2014

Bitcoin Exchanges Go Local to Drive Adoption

By Jon Matonis
Wednesday, January 15, 2014

Much of the media attention surrounding bitcoin exchanges has focused on the larger global players, as they are the endpoints that have the majority of bitcoin’s trading volume.

This was satisfactory in the early days of bitcoin, as global price discovery was the driving requirement – but now there is a growing need for in-country exchange transactions, due in part to prevailing regulations.

A primary example of this can be observed by analysing the role of Coinbase. With a US-only customer base for buying and selling bitcoin, Coinbase is the leading domestic exchange in the United States. If you sign up, your account identity is closely integrated with your bank or credit union for superior ease-of-use.

However, Coinbase is not really an adequate exchange for bitcoin price discovery as its bid-offer spread is derived from wholesale partners, like Bitstamp. Also, Coinbase trading participants are confined to a single region, which reflects the demand and supply from that region only.

Separate functions

Price discovery and adoption operate as two separate functions within the global bitcoin ecosystem. The additional effort involved in establishing international exchange accounts may yield improved pricing, but at what cost?

Local country exchanges are simpler to use and they meet the needs of most local bitcoin traders. The larger international exchanges that provide two-way price quotes and accept deposit and withdrawal requests from around the world will always be around.

I predict that they will evolve into wholesale liquidity providers performing more of a clearinghouse role for the regional and domestic bitcoin exchange houses. Overall, global price discovery will be maintained.

Now, when we look at the local country exchanges, the precise role becomes slightly different: it becomes less about price discovery and more about ease of exchange and facilitating adoption.

One doesn’t go to a broker on the worldwide interbank forex market when they want to exchange pounds for dollars, they simply go to a local bank or airport currency kiosk. Increasingly, the ATMs in airports provide the best overall exchange rates for national currencies.

Similarly for bitcoin, users will tend to stay local even if that means paying a slightly higher price and commission. And, until bitcoin merchant acceptance is widespread, the localized exchanges and bitcoin ATMs provide an excellent way for global bitcoin travelers to acquire the necessary amount of local currency.

For example, some local bitcoin exchanges in Sweden have been setting up reputable physical offices for face-to-face exchanges.

Regarding person-to-person exchanges arranged at selected meeting places, I have written about before. They offer an incredibly useful service which will complement, and in many cases precede, local bitcoin exchange companies.

Local focus

The marketplace for bitcoin exchanges is rapidly maturing and taking on a more specialized and local role with specific features and languages. Depending on the jurisdiction, we will see things like Bitcoin ATMs, directories, and physical bitcoin storefronts.

Throughout all of this, the online bitcoin exchange will operate in the local language with tailored integration into that country’s financial institutions and payment methods.

In the Netherlands, the domestic exchange operates much the same as Coinbase with simple integration into a customer’s bank account. With just 10 major banks in the country, Dutch company Bitonic can link with all of them by just going through the iDEAL e-commerce payment network. Bitplaats exchange also operates in the Netherlands.

In Sweden, the country boasts at least four domestic exchanges that cater exclusively to the Swedish market for bitcoins, including, Safello, Kapiton, and FYB-SE.

Recently in India, it came to light that a burgeoning entrepreneurial class was driving bitcoin adoption in that country with domestic exchanges like buysellbitco, Unocoin, INRBTC,, and bitcoinex.

Hong Kong has probably seen one of the most rapid increases in bitcoin exchange activity. Outside of mainland China, Hong Kong operators enjoy access to a leading financial services center prompting many to speculate that it could quickly become a digital currency trading hub and pave the way into China. Both Bitfinex and ANXBTC are based in Hong Kong.

These are the exchanges that will be driving bitcoin forward in the developing world. Many of them are not really known outside of their local regions but they represent the trend unfolding in bitcoin trading volume where domestic retail exchanges cater to local needs and the global exchanges operate at the wholesale level.

The allure of the vast global remittance market has attracted entrepreneurs for years and the dream is slowly being realized as centralized and legacy infrastructure gives way to multiple bitcoin endpoints. We may not even notice the new network being built, but cross-border transactions in bitcoin operate on a 24-hour basis and they don’t require permission.

Soon, the domestic bitcoin exchanges in your country will start to seem as ubiquitous and pervasive as petrol stations or mobile phone stores. That will be a truly global network. The ultimate victory comes when received bitcoin is held and spent, not exchanged.