Monday, March 28, 2022

Why does crypto work for Russian ransomware, but it wasn't useful for the Ottawa truckers?

[This is a repost of my recent article for CoinDesk exploring why bitcoin has been demonstratively useful for certain illegal activities, like ransomware, but fails when it comes to others, like the Ottawa trucker convoy. Spoiler: bitcoin's usefulness for engaging in non-permitted transactions very much depends on the onramping and offramping processes, and whether these threshold points are tightly controlled or not.] 

 The Ramps Killing Bitcoin's Dissident Thesis

 Crypto is marketed by its fans as an unstoppable dissident technology and feared by governments for its subversiveness. But the many shortcomings of a recent bitcoin fundraiser to support an illegal Ottawa, Ontario, trucker convoy (more on that later) suggests that crypto isn't as unstoppable or subversive as it is often made out to be.

But if Ottawa contradicts the standard crypto narrative, we also have an example that confirms it. Waves of successful Russian ransomware attacks relying on the Bitcoin network to extract ransom payments suggest that crypto is an incredibly effective technology for evading rules.

So which is it: unstoppable or not? The short answer: It depends on the off-ramps and on-ramps. Let's explore why crypto was a dud in Canada, but is highly successful for Russian ransomware operators.

What crypto brings to the table is the ability for two people to make a digital peer-to-peer transfer that cannot be preempted by a third party. But a peer-to-peer crypto transfer is only the middle step in a three-step circuit that begins with on-ramping into crypto and ends with off-ramping out of crypto. If either the on-ramping or the off-ramping processes are closed or guarded, much of crypto's fabled ability to circumvent restrictions is neutered.

The Ottawa trucker convoy bitcoin fundraiser is a good example of the off-ramping process being leveraged by law enforcement to defang crypto. I described the convoy’s financing last month for CoinDesk. Over the last few weeks various Canadian parliamentary committees and court rulings have shed more light on the fate of the convoy’s finances.

By early February, the convoy of truckers blockading downtown Ottawa had transitioned from legal protest to illegal mischief. Sending donations through centralized fiat-based crowdfunding sites became impossible. The convoy’s main fundraising campaign, hosted on GoFundMe, was shut down on Feb. 4. A pivot by convoy organizers to rival crowdfunding platform GiveSendGo [which is powered by Stripe] was rendered useless by an Ontario court's restraint order a few days later.

That left a bitcoin fundraiser by the name of HonkHonk Hodl as the only way to connect with the rogue blockaders.

The on-ramping stage of the convoy’s bitcoin fundraiser proceeded unimpeded. Any American who wanted to donate to the illegal blockade could freely swap U.S. dollars for bitcoin via an exchange such as Coinbase. Once the cryptocurrency was acquired, no force on earth could stop that bitcoin from being transferred from an American’s personal wallet across the border to the Canadian organizers' bitcoin address.

The bitcoin fundraiser eventually raised $1.1 million in bitcoin. It was at the final stage, off-ramping back into Canadian dollars, that things fell apart.

From the outset, the identities of the people in control of the convoy’s bitcoin wallets had been broadcast across social media. Once the convoy was deemed illegal mischief, these public-facing organizers and their wallet addresses became easy targets of police investigations, freezing orders, injunctions and class-action suits, all of which prevented them from off-ramping out of donated bitcoins into spendable fiat.

The strategy of publicizing the identities of the organizers might seem like a mistake, but it wasn’t. A fundraiser can't gain any momentum if the people collecting the money aren't identified. Anonymous organizers could very well be scammers, and the whiff of fraud would doom fundraising.

Nicholas St. Louis, the lead organizer of the bitcoin fundraiser and a suspect in a criminal investigation, was forced to give up seed phrases for his fundraising wallets to the Royal Canadian Mounted Police, which is Canada’s version of the FBI. Parallel to that, a separate civil court injunction on behalf of an Ottawa class-action suit named hundreds of bitcoin addresses associated with the fundraiser. To comply with the order, St. Louis eventually forfeited $250,000 in undistributed bitcoins to a court-appointed escrow agent. That sum will potentially be used to compensate Ottawa citizens damaged by the convoy's actions.

Just hours before the court injunction fell, St. Louis managed to distribute two-thirds of the donated bitcoins to around 100 truckers. To prove they were honestly distributed, St. Louis recorded himself giving envelopes to each trucker and published the recordings on social media. That made it a cinch for the RCMP, litigators and aggrieved Ottawa citizens to determine the identities of the truckers who received the donations.

The transparency of bitcoin’s blockchain means that all of the distributed bitcoin has been flagged by law enforcement as well as being listed in the court’s freezing order. Anti-money laundering officers at exchanges are on guard, and any effort on the part of the 100 truckers to off-ramp their cryptocurrencies into spendable currency by selling marked bitcoin on an exchange will result in forfeiture. Worse, the truckers could run into potential legal trouble if they try, because ignoring the court’s freezing order is punishable by fine or imprisonment.

Truckers brave enough to risk contravening the court order might try to evade exchange blacklists by directly buying goods and services with bitcoin. (They would have to use retailers that don’t rely on compliant crypto payments processors like BitPay.) Given that bitcoin is so rarely accepted in trade, this is tantamount to barter, and bartering is inconvenient.

So the truckers have been left holding a bunch of mostly useless, even dangerous, injuncted crypto. As for the remaining undistributed donations, they have all been confiscated by the courts. What a mess.

If bitcoin failed the truckers, let's see why it has worked so well for ransomware operators. Ransomware is malicious software that takes control of a computer by encrypting files or threatening to publicly expose data. The ransomware operator, typically located in Russia, releases that control only after receiving a ransom payment, usually bitcoin. In one of the more notorious incidents, JBS USA, the world’s largest meat supplier, paid an $11 million bitcoin ransom to free its computers.

The ransom payment on-ramping process is completely fluid. That is, it is 100% legal for the U.S. victim of a ransomware attack – usually a corporation such as JBS, a school board or a government agency – to buy bitcoin on an exchange like Coinbase in order to pay the ransom. In fact, a new industry known as ransomware payments facilitation has emerged to service this need.

Whereas a wire payment to a Russian bank account might be frozen or clawed back, a bitcoin payment made to a Russian ransomware operator's wallet can't be. That's tremendously useful to ransomware operators.

Most importantly, Russian officials have made little attempt to inhibit the off-ramping process. As long as ransomware gangs don’t attack Russian companies, their ability to operate on Russian soil has been tolerated as has their access to Russian off-ramps. For instance, nested exchanges with Russian links such as Suex and Chatex have been used by Ryuk and Conti ransomware operators to convert bitcoin ransoms into useful currency.

And that's why ransomware has been so successful. The combination of 1) unimpeded U.S. on-ramping 2) a US-to-Russia bitcoin bridge and 3) unimpeded Russian off-ramping creates an unstoppable monetary circuit. By contrast, Canadians' closure of the off-ramping process crippled the convoy's bitcoin fundraising circuit.

(Incidentally, this is why one of the quickest ways to end the ransomware threat is to shut off the on-ramps: Make it illegal for U.S. entities to pay crypto ransoms. It also illustrates why Russians can’t rely on crypto to evade sanctions: the big off-ramps like Binance and Bitfinex can be controlled by U.S. sanctions policy.)

Governments, whether they be democracies or dictatorships, are often fearful of crypto's censorship-resistance, leading to calls for bans. The lesson from the Ottawa trucker convoy and Russian ransomware gangs is that as long as the on-ramping and off-ramping process are regulated, these fears are overblown.

As for advocates of bitcoin’s capacity to help dissidents, if the trucker convoy proves anything, it’s that these advocates have their work cut out for them.

Saturday, March 26, 2022

Christians minting Muslim coinage (and vice versa)

An Islamic gold dinar minted by Offa, a Christian king of Mercia [source]

If you follow me on Twitter, you may have noticed that I've been more excited about ancient coins than I usually am. The gold coin pictured above, for instance, was minted by Offa, an Anglo-Saxon king of Mercia, in the late 700s. Offa was a Christian, but his coin contains the words "there is no God but Allah alone." In this blog post I'm going to bring together a bunch of my tweets and explore why rulers sometimes produced coins that contained icons and text dramatically at odds with the culture to which they belonged.

Money is like language. Both are characterized by network effects, or lock-in. People living in a geographical location grow up speaking a certain language, and since all their friends, family, neighbours, and colleagues also speak it, it's almost impossible for a new language to get any sort of traction.

That's why the artificial language Esperanto has never taken off. Designed in the 1800s by L.L. Zamenhof to be easy to learn, only 2 million or so people speak Esperanto. Why bother learning a new language, even an easy one, if everyone you know is already speaking English, or Chinese, or Swahili?

The same goes for money. People grow up 'speaking' a certain monetary language: dollars, yen, pounds, hryvnia, whatever. Every Canadian, for instance, internalizes a full array of Canadian dollar prices in their minds: it costs $50 to fill up with a tank of gas, $1 to buy a chocolate bar, $150 to renew a driver's license, etc. And that's why it's difficult for new monetary units to intrude where an old one already dominates. Why adopt a monetary version of Esperanto when speaking in Canadian dollars comes so naturally?

Ancient coins are a good way to illustrate the idea of money as a locked-in language.

Islam emerged in the 7th century A.D., quickly moving from the Arabian peninsula into Africa and Spain. The heretofore dominant Byzantine Empire, with its base in Constantinople, lost Syria and Egypt to the emerging Islamic caliphate.

The Byzantines and the Romans before them had a long history of issuing the solidus, a high-quality gold coin. The solidus was a bit like the U.S. dollar of its day, circulating widely across Europe and the Middle East. Below is a Byzantine solidus from 638 AD, issued by Heraclius, who is pictured with his two sons. Their crowns and staffs have crosses on them, and the reverse side displays a large cross on top of a set of steps.

Byzantine solidus issued by Heraclius, 638 AD [link]

Having conquered such a huge territory in just a few years, the Muslims may have tinkered with the idea of issuing their own entirely new coins replete with Arab text and imagery. But they chose not to, at least not at first. Bowing to pragmatism, their first gold coins were replicas of Heraclius' solidus (below) dated to around 680 AD. That is, a Muslim ruler took the strange step of minting coins that portrayed three Christian emperors. The major difference between the 638 AD Byzantine solidus and the 680 AD Islamic imitation is that it has been "de-christianized" the crosses had been removed.

Islamic imitation solidi, est 680 AD [link]

You can imagine the tradeoffs that the Muslim invaders may have been making when they designed the coin. By creating a near replica of the Byzantine solidus, they were probably trying to harness its network effects and get the first Islamic gold coin into circulation; and by making only a few small changes removing the crosses they wouldn't be compromising too much on their religious values. According to numismatist Clive Foss, these changes may have been too much. Opposition to the crossless coins among the local population was strong enough that the authorities stopped minting them soon after. Foss speculates that's why archaeologists have only found a handful of crossless dinars.

It wasn't until 697 AD that the first fully Islamized gold coins were finally issued, pictured below:

Umayyad gold dinar minted in  Syria in 697 AD [source]

Like the Byzantine solidus that preceded it, the gold dinar circulated outside the Islamic world. Examples have been found as far as Scandinavia, Russia, and England. And like the Byzantine coinage before it, Islamic coinage was copied. Caitlin Green has a very good blog post showing how Anglo-Saxon Mercia (see image at top) and the Carolingian Empire issued their own imitation gold dinars.

The caliphate's silver dirhams were copied, too. According to Green, the first coins issued by Kievan Rus (below) were probably imitation silver dirhams to which a cross and bird were added. "The fact that the first Rus' coinage imitated an Islamic dirham is interesting, although perhaps unsurprising, given that many millions of dirhams appear to have been imported into northern and eastern Europe by the Vikings/Rus' as a result of their trade with the Islamic world (perhaps primarily involving slaves)," writes Green. 

Put differently, don't fool around with a good thing. Copy it with just a few modifications.

A 'Christian falcon' imitation dirham issued by the Kievan Rus' in c. 950 [source 1][source 2]

One reason that European kings may have been particularly eager to copy Islamic gold coins is that while silver coins were common the continent didn't have a long history of minting their own gold coinage. By imitating already-dominant gold dinars, Europeans could coast on the network effect of those coins. In the case of Offa's gold dinar, it may have been designed as a trade coin, similar enough to the original that it would be accepted in southern Europe.

Another example comes from Spain. By the 13th century the Almohads the last Muslim empire to rule Spain had been driven back to North Africa. The monetary influence of Islamic coins was such that the Christian conquerors continued to issue dinar-style gold coins, or maravedis. Around 1180 AD, Alfonso VIII of Castile, a Christian, minted maravedis with Arabic script rather than Latin, "Christianizing" them by inserting a small cross and changing the Arabic message to a Christian one:

Notice that in the previous examples, the new coin issuer used the incumbent coin's style while dropping its religious motifs. But the desire to latch on to the strong network effects of existing coinage sometimes trumped even the demands of religion.

As an example of this, when the Crusaders took over Jerusalem they issued dinar-style gold coins without even bothering to add Christian embellishments (see below). Initially minted in the late 1100s, the Crusader dinars only gained crosses in 1250 when an angry pope pressured the local princes to eliminate coinage which was "not well-formed enough to conceal the scandalous fact that its inscriptions praised Mohammed and bore dates of the Muslim era." Against the pope’s objections, the text on the new Christian design was still written in Arabic. So the idea that money is sticky and locked-in like language may explain some of the strange coins pictured above. It may also explain some of the phenomenon around us today, like:

1) why stablecoins have come to dominate the cryptocurrency space, and why the dominant stablecoins are U.S. dollar stablecoins and not, say, Turkish lira stablecoins. (Bitcoin and other volcoins are awful candidates as unit of account, whereas stablecoins are not only stable, but also benefit from the network effect of existing currencies, none of which is stronger than the U.S. dollar.)

2) why Facebook's original idea to create a new Libra unit of account was crazy overambitious.

3) why Canadians still use the Canadian dollar despite being right next door to the world's mightiest monetary power. We grow up speaking in loonies and toonies, and that's not something that is easily changed. It also explains why Quebecers sometimes refer to the dollar as a 'piasse,' which derives from the piastre or peso, and old coin that once dominated North American trade. The network effects of the long departed Spanish peso were so strong that shades of it still exist.

Monday, March 7, 2022

Stripe and the Ottawa trucker convoy

Why did Stripe, a global payments giant, decide to help the Ottawa trucker convoy? That's what I was wondering as I watched the recent House of Commons committee into the crowdfunding of the convoy, which aired last week. (You can catch it here.) 

If you recall, the convoy raised $10 million or so via GoFundMe, a crowdfunding site, only to switch over to competitor GiveSendGo on February 5 when GoFundMe froze its campaign. (I wrote about convoy financing here and here.) The $9 million or so that was subsequently raised on GiveSendGo was to be disbursed to truckers to pay for fuel, food, and shelter. These funds are currently frozen thanks to an Ontario government restraint order and a private class action suit's Mareva injunction.

The committee's inquiry makes for interesting listening. Representatives of Stripe, PayPal, and GoFundMe were questioned during the first hour. The second hour was taken up by GiveSendGo's two founders.

Stripe's role in all of this seems the most questionable to me, and credit goes to Members of Parliament Demoff, MacGregor, and Chiang for trying to tease out Stripe's line of thinking. Why did Stripe, one of the largest payments facilitators in the world, keep connecting GiveSendGo's convoy fundraiser long after it was clearly illegal under Canadian law?

Stripe is a payments processor. It provides online stores and websites with access to the all-important Visa and MasterCard payments networks. During the committee meeting, we learnt that Stripe is the payments processor for both GoFundMe and GiveSendGo. Crowdfunding sites like GoFundMe and GiveSendGo provide a set of tools that campaigners who need funds can use to connect to donors.

GoFundMe shut down the convoy's campaign on February 5 citing violations of its terms of service, specifically a prohibition on violence. In the first hour of the Parliamentary committee meeting, we learnt that GoFundMe based its decision on direct communication with Ottawa's mayor and its police chief.

It's important to realize that the terms of service for GoFundMe, GiveSendGo, and Stripe are broadly similar. They all prohibit transactions that will be used to promote violence. Neither GiveSendGo nor GoFundMe allow campaigns that promote hate. (Notably, Stripe doesn't say anything about hate in its terms of service.) Lastly, all three prohibit their platforms from being used for illegal activities.

GiveSendGo's convoy campaign came online on February 5, almost to the hour that GoFundMe closed down the convoy's original fundraiser. If you haven't heard of GiveSendGo, think of it as the Rebel News of crowdfunding sites. In addition to trumpeting its Christian virtues, GiveSendGo loudly & proudly reconnects any controversial campaign that GoFundMe has cut off, the idea being to exploit America's culture wars in order to gain traction against its crowdfunding competitor. For instance, after GoFundMe halted campaigns such as Kyle Rittenhouse's legal fundraiser and a number of anti-vaccine efforts, GiveSendGo reconnected them. (See my article for the Sound Money Project on this.)

(And that's fine, by the way. As long as people on all sides of the political spectrum are engaged in legal non-violent activities, they should get access to the payments oligopolies Visa and MasterCard. The combative competition between GoFundMe and GiveSendGo achieves that.)

So now you can understand why GiveSendGo would crave a controversial (even illegal) campaign like the trucker convoy. What a perfect marketing stunt for catching the attention of its broadly American user base. But Stripe's reasoning for welcoming the convoy is less clear. Stripe is not a small-time redneck organization mining the culture wars for attention. It's a big multinational payments processor.

Let's try and tease out the legal ambiguities that Stripe must have struggled with beginning on February 5. After conversations with Ottawa's police chief, Stripe's own customer GoFundMe had just cut the convoy off on alleged violence. Yet that very same day Stripe chose to allow the convoy-linked funds to flow across its platform via its other customer, GiveSendGo, even though Stripe's terms of service prohibits violence.

Did Stripe not agree with GoFundMe's assessment that the funds were facilitating violent activity? Perhaps it had better information sources than Ottawa's police chief?  

Maybe Stripe execs decided to treat violence as one of those things that's open to interpretation. A few incidents can be written off as bad apples, leaving the overall campaign in compliance. The just a few bad apples defence seems to have been GiveSendGo's justification. In his account to the House of Commons committee, GiveSendGo co-founder Jacob Wells rationalized hosting the trucker campaign by noting that there are always "fringe elements" in any protest. Perhaps Stripe execs felt the same?

Or was Stripe's decision to connect the convoy fundraiser a case of willful ignorance? That is, was it a case of avoiding becoming too informed about the situation in order to dodge having to make a difficult decision? Unlike GoFundMe, Stripe never seems to have reached out to Ottawa's police chief. And Ottawa's police chief never directly contacted Stripe. Might this combination have allowed Stripe to maintain enough distance that it could determine that the convoy was in compliance with its terms of service?

A version of willful ignorance was cited by GiveSendGo. “We were doing our business, allowing people to raise funds on GiveSendGo. Your government found issue with it, but yet they would not come to us and tell us they found issues," said co-founder Heather Wilson. "The Bible speaks to this, that when you have an issue with somebody you go talk to them and you resolve it." Like GiveSendGo, maybe Stripe deemed the lack of an explicit nudge from Canadian law enforcement to be sufficient to clear the convoy of suspicions of violence.

Let's move on. Violence is one thing, but the bigger issue to me is plain ol' illegality. If violence is open to interpretation, surely illegality is a black and white issue.

As MP MacGregor pointed out in his line of questioning, on February 6 the City of Ottawa had declared a state of emergency. But Stripe continued to process payments for the convoy. Here is MacGregor: "I think we all have a question here. How did Stripe allow this to go so far? Were you not aware of what was happening with these funds?" 

On February 9, the Ottawa police department notified protestors they were engaging in mischief, a criminal offense. The "unlawful blocking" of streets was resulting in citizens being denied the "lawful use, enjoyment and operation of their property," declared the police department's press release, and the convoy was henceforth required to cease its blockade of downtown Ottawa.

Even though the crime of mischief had been publicly cited by the police, Stripe continued to allow the GiveSendGo fundraiser to accept payments. 

Remember, Stripe says that it prohibits illegality. In Stripe's words, you must not use Stripe’s services for "products or services that are in violation of law in the jurisdictions where your business is located or targeted to." So the convoy was in violation of Canadian law, yet Stripe kept the funds flowing.

The illegal nature of the protest only got more explicit with the passage of time. On February 10, an Ontario Superior Court justice signed a restraint order freezing the GiveSendGo funds based on a police affidavit that the funds were facilitating the "indictable offence of mischief."

Surely this was the smoking gun.

Not so. With one hand Stripe froze the funds. That is, it complied with the restraint order by refusing to disburse the funds to the convoy. With the other hand it continued to allow the campaign to raise money. Yep, donors could still use their cards to fund a GiveSendGo campaign that was, by that time, plainly illegal under Canadian law. (The campaign remains open to this day.)

The parliamentary committee meeting never fully explored Stripe's thought process. But if I had an hour with Stripe executives, I'd want them to explain how they squared: 1) GoFundMe's finding of violence with Stripe's own prohibition on violence, and 2) law enforcement's description of the convoy as illegal with Stripe's prohibition against illegal activity. Stripe may very well have a sound legal basis for why they let the convoy fundraiser go on. (Perhaps it would have exposed it to liability in the U.S.?)

Or maybe this was a case of a platform enforcing its prohibition against violence and illegality as loosely as possible (or not at all) in order to continue a profitable relationship. I'd like to know more.

Thursday, March 3, 2022

Is gold safe from sanctions?

As Russia is progressively cut off from U.S. and European payments systems thanks to an ever tightening wave of sanctions, the idea of using gold as a sanctions buster is being discussed. Russia has some $130 billion worth of the yellow metal. Might these gold bars be packed into planes and used to buy vital goods & services from other countries? To complete this monetary circuit, why doesn't Russia start accepting gold bars as payment for Russian oil and gas exports?

Gold seems like an ideal way to evade sanctions. Thanks to its high value-to-weight ratio, it is good at condensing value. This makes transport easier. Gold is also a bearer instrument. Unlike a dollar, it can't be frozen at the click of a button.

But that doesn't mean that gold can't be stopped by sanctions. Here's how a putative Russian gold payments rail gets shut down.

As of now, the only sanctions that have been announced by the U.S. are primary banking sanctions. That is, the U.S. government has decreed that U.S. financial institutions cannot provide banking services to named Russian banks (like Sberbank), certain individuals (like Putin), and Russia's central bank.

But there is harsher type of sanction that remains to be implemented: secondary sanctions. With secondary sanctions, the U.S. government announces that U.S. banks must cut off not just named Russian entities; they must also stop doing business with any foreign bank (Indian, Chinese, etc) that provides banking services to named Russian entities.

Think of secondary sanctions as a strategy of the friend of my enemy is my enemy. Foreign banks cannot afford to be enemies of the U.S. banking system. That would mean no more access to the massive U.S. economy. And so they will comply and cut off designated Russian entities. Where primary sanctions sever Russian entities from access to the U.S., secondary sanctions attempt to remove them from the global banking system.

To close Russia's gold window, a few additional steps must be taken.

The wording of secondary sanctions must extend to non-banks and into markets like gold. The U.S. might simply say something to the effect that "any foreign individual, corporation, or institution that facilitates gold transactions with designated Russian entities will be shut off from the U.S. banking system." If a foreign buyer of Russian crude oil, say an Indian refiner, had previously accepted Russian gold as payment, they may not be so willing anymore. Touching Russian gold could jeopardize their entire refining business, which will inevitably have a U.S. nexus (say a U.S. parts supplier or technical consultant.)

To enforce sanctions, the U.S. would have to rely on whistle-blowers, snitches, and intelligence gathering. The sanctions would not entirely close the gold window. There would be rule breakers. But the sanctions would do a sufficient job.

The best example of the yellow metal being shut down comes from Iran in the early half of the 2010s.

In 2010, a harsh round of U.S. secondary sanctions came into effect. As these were tightened over the ensuing years, Iranian trade plummeted, as did the Iranian rial. Iran's difficulties were compounded in March 2012 when a set of Iranian banks were banned from SWIFT, a global financial messaging network.

The sanctions did not make it illegal for foreign entities to deal with Iran using gold. And so a gold window emerged. This was most apparent in Turkey with the so-called "gold-for-gas" market. (I wrote about this market here and here). In brief, Turkey relies on Iranian natural gas. A quid pro quo was achieved between the two nations by sending gold bars back to Iran. No need for U.S. dollar correspondent banking accounts. No need for SWIFT.

In July 2012, the U.S. began to close the gold loophole. First it issued an executive order extending sanctions to sales of gold to Iranian Government entities (EO 13622). It was still possible for Turkish institutions to sell gold to Iranian individuals, however, so in January 2013 additional legislation was passed sanctioning the sale of gold to any Iranian entity. (See Benjamin Fraser Scott's Halkbank and OFAC: a sanctions evasion case study for an account of the closure of Iran's gold-for-gas trade.)

And thus Iran's gold loophole was cutoff. 

Russia's gold hasn't been sanctioned yet. But it is eminently sanctionable. 

PS: Yes, this applies to bitcoin. (Bitcoin is traceable, which makes it arguably worse than gold.)
PPS: Sanctions could put an end to a nascent Russian gold payments rail. But just because sanctions can do damage doesn't mean that the target will change its course of action.

Tuesday, March 1, 2022

Make bitcoin cheap again for cypherpunks!

[For CoinDesk's Tax Week, I wrote about taxing proof-of-work, the mechanism used to secure Bitcoin. I'm still not 100% sure how to design the tax. In my CoinDesk article I suggested a one-time tax on purchases made at regulated exchanges. Another option is a continual tax on holding bitcoin, like a property tax. Give it a read and tell me what you think.]

The Case for Taxing Proof-of-Work

Bitcoin is an energy-intensive protocol designed for serious cypherpunks. Alas, bitcoin has been mobbed by unserious speculators, pushing up its price and blowing up its electricity usage. It’s time to enact a tax on proof-of-work. The tax would drive the tourists away, bring proof-of-work consumption back to a balanced level and make bitcoin cheap again for cypherpunks.

The Bitcoin network provides bitcoin owners with a unique sort of security – proof-of-work. Proof-of-work, or PoW, is a method for securing a network in a decentralized manner. The process, however, is incredibly energy-intensive, requiring thousands of competing processors, or miners, to perform redundant calculations. Other forms of security, say that underlying instruments listed on the Nasdaq stock exchange, rely on cheaper centralized methods.

Think of bitcoin as an M1 Abrams tank. A Nasdaq-listed stock is a zippy little Toyota. Most of the time a cheap Toyota works fine. But there are times and places when an expensive M1 Abrams is needed.

There is a small community of cypherpunks – hobbyists and technologically informed individuals – who like to consume bitcoin's tank-like security. They make PoW-secured transactions and eschew non-PoW-secured transactions. These cypherpunks are well-versed in self-custody. They have a deep understanding of what bitcoin is and can clearly articulate why they prefer PoW-based security.

Then there is the great unwashed.

Most of the people buying bitcoin these days are not cypherpunks. They are casual users. These “tourists” don't particularly want to make peer-to-peer bitcoin payments. They don't care about the Bitcoin network's tank-like level of security. They are quite content to keep their bitcoins lodged at Coinbase or Binance. They couldn't write a lucid paragraph on PoW if their lives depended on it.

What these casual users are after is "number goes up" – they want to get rich. And it's because of this influx of speculators that a tax on proof-of-work could end up being necessary.

We can all agree that it'd be overkill to routinely drive an M1 Abrams tank to shop at the local corner store. The odds of getting held up just for one's butter and eggs just doesn't justify the costly security of an M1 Abrams. A Toyota will do just fine, thank you. The same goes for proof-of-work. For most people, consuming expensive proof-of-work security is akin to using an M1 Abrams to go shopping. It's unnecessary, even frivolous. A cheap Nasdaq penny stock should suffice.

The sheer physical cost of filling up an M1 Abrams with gas is a major impediment to casual tank usage. Alas, this "brake" doesn't operate with proof-of-work. Casual bitcoin users get to enjoy bitcoin’s tank-like security without incurring any out-of-pocket costs.

The reason that casual bitcoiners don't feel the immense expense of bitcoin security is because the mining bill is (mostly) paid for with new bitcoin. Every 10 minutes, 6.25 new bitcoins are created to compensate miners. Issuance of new bitcoins doesn't hurt the price of the bitcoin in tourists’ wallets. The timetable of new bitcoins was built into the price of bitcoin ages ago.

And so the casual bitcoin tourist gets bitcoin's gold-plated security without having to endure any associated costs. It's as if they get to drive an M1 Abrams tank to Walmart, for free. If you could drive an M1 Abrams to Walmart for free, wouldn’t you?

Proof-of-work should never have been more than a neat niche product used by cypherpunks and other associated outsiders. Thanks to an influx of casual buyers, the Bitcoin network now uses a massive 141 terawatt hours per year of electricity, about 0.63% of the world's electricity, according to the Cambridge Centre for Alternative Finance. That’s more electricity than many countries and industries.

Bitcoin’s energy consumption could grow to much larger proportions. Say that casual buyers push the price of bitcoin up to $380,000 in 2023. That's 10 times the current price, a move that bitcoin has done many times before. With bitcoin at $380,000, the total market value of all bitcoin ever mined would be $7.8 trillion, just a little less than the value of all gold ever mined.

As the price of bitcoin rises, the real value of the 6.25 BTC mining reward increases, attracting more miners that burn ever more electricity. With bitcoin's price at $380,000, the Bitcoin network would be consuming a whopping 1,400 terawatt hours or so of electricity, around 6% of the world's electricity (I'm using a simple linear interpolation from today's price and energy consumption.)

That would be a tragic mistake. We shouldn’t be sacrificing 6% of the world's energy to produce tank-like levels of security for speculators who don’t need that security. There are far better uses for scarce energy resources than pure price speculation.

That's where the tax comes in.

Sometime before bitcoin hits $380,000, a tax on bitcoin purchases should be implemented. It would apply at regulated venues like Coinbase and Kraken and on large professional actors, like hedge funds. Casual speculators would finally feel some of the burden of producing bitcoin's security. To avoid the tax, they would likely select other types of volatile instruments, ones with a much lower electricity requirements. They might, for instance, purchase proof-of-stake cryptocurrencies, Nasdaq penny stocks, three times-levered exchange-traded funds or out-of-the-money Tesla options.

The tax would make most people better off than before (or at least just as well-off).

Casual tourists would remove bitcoin from their menu of bets. But there are hundreds of thousands of speculative instruments offering wild price gyrations, and so the tourists are effectively no less well-off than before. They would get Nasdaq levels of security rather than Bitcoin-levels of security, but for casual bettors that's fine.

Cypherpunks are better off. By purchasing their bitcoin on unregulated venues like Bisq, they wouldn’t have to pay the tax. They would also benefit from casual buyers being pushed out of the bitcoin market, and the subsequent decline in the price of bitcoin. When copper or lead falls in price, users of these commodities benefit: They can consume more metal than before. Likewise for bitcoin. A tax-induced plunge in the price of bitcoin would allow cypherpunks to acquire and consume bitcoin-the-commodity at a far cheaper price than before.

Finally, the rest of the world would be better off. Pushing casual bitcoin tourists away from unnecessary consumption of PoW would free up huge amounts of electricity – both renewable and non-renewable – to be consumed by other industrial purposes. It’s win-win-win.