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Why there is no such thing as a trustless financial system

BTC-e may have been taken down by the Feds last week, but the setback hasn’t stopped the exchange’s mysterious owner/operators from allegedly distributing this message to their client base via a bitcoin forum (h/t Buttcoin):

The text is in Russian, but the Google Translate version reads as follows (our emphasis):

More detailed information about what happened to the BTC-e service.

On July 25, 11:00 the FBI staff came to the data center where our server equipment was located and seized all equipment, the servers contained databases and purses of our service.

Almost for 6 days we could not get from our hosting provider the sane information, what happened to our servers because of this information we publish only now.

July 28, the domain was confiscated.

At the moment, part of the service facility is arrested by the FBI.

The next update will be information on what options are available to restore the service, as well as the procedure for obtaining funds, in the event that the service is not started. In the current situation, if the service is not started before the end of August, Then from September 1 we will start the process of refund.

In the next 1-2 weeks, we will evaluate and publish information about how much money fell into the hands of the FBI and what amount of funds is available for return.

For all those who buried us, I will remind you that the service has always worked on trust and we are ready to answer for it.

The funds will be returned to everyone!

Arrest of the Russian Vinnyk Alexandra:
Officially declare – Alexander was never the head or employee of our service.

Sincerely, btc-e

It’s nice to see that even the shadier parts of the cryptocurrency economy understand the importance of trust and reputation.

Bitcoin, of course, gained technical notoriety for allegedly having constructed an entirely “trustless” financial system, no longer dependent on greedy rent-seeking intermediaries. Maths had solved the problem of trust. Or so we were told. Without such parasitic middlemen, the story went, the little guy would finally be free to flourish financially.

Except, this was soon proved to be an egregious lie. From its onset, rather than discarding the middlemen, bitcoin spawned a new legion of intermediaries the average little guy had to depend on if he was to operate in the sector without having to give-up his day job. After all, the sheer weight and volume of information that needs processing on a contemporaneous basis for bitcoins to be handled securely, makes using a bitcoin a near full-time job — a major obstacle to mass adoption.

If bitcoin was ever going to take over the world, it had to appeal to the passive entities in the system who wanted the gains of cryptocurrencies without any of the cognitive load. As a consequence the more “user friendly” the system became, the more dependent it became on trust (much in the style of the old system).

From exchanges, wallets, developer foundations, hedge funds and crypto investment managers, the eco-system that is bitcoin is chock-full of entities that require trust to operate. One could further argue that cryptocurrencies’ very existence depends on the community trusting a small group of developers getting the coding right, and ensuring everyone’s interests are represented, rather than just the super senior operators.

A quick note on the upcoming Bitcoin fork

In the next 24 hours, the trust in the bitcoin system is going to be even more severely tested than usual. The community of miners, nodes and developers is initiating a so-called hard fork which hopes to expand the network’s processing capacity, allowing it to scale more effectively. In the process bitcoin will be split in half, and two new systems will emerge.

The hope is that faith will be channelled into the newly evolved, expanded and improved chain, while the old chain will be abandoned. But anyone and everyone who has a bitcoin will via the process suddenly be endowed with two assets instead of one, with a free option to support one and render the other useless. If the effective split makes people feel twice as enriched, it’s worth asking, why they shouldn’t feel inclined to keep hold of both of them? And that too will be an option. The only constraint preventing them from doing so may be the increase in the real-world energy that would have to be dedicated to supporting both chains simultaneously without a breakdown in security or the protocols of exchanges which hold their currency on their behalf.

And herein lies the problem with cryptocurrency’s lack of central authority.

When the fiat world initiates system-wide currency updates, they can rely on a central authority to guide and order the transition process (most of the time). Think of revaluations in inflationary environments which change the numerairie values of their domestic currencies? Or the introduction of the euro. In the former case, authorities dictate that large bills of say, 10,000,000 unit-values will from a certain point be classified at a “new-currency” rate of 10. They then dictate when and how quickly the older denominations, no longer needed, should be retired from the system. In the transition period, old notes and new notes might be allowed to trade simultaneously, but it is always assured their respective values remain pegged until the expiry point of the former. Eventually, as the new notes are phased in the old notes are retired. Society adjusts to the new norm.

What never happens, however, is a situation wherein old notes continue to circulate and compete with new ones indefinitely, or wherein new notes are phased in by way of an effective stock split entitling every holder to both an old note and a new note, with them left in charge of which one to favour and which one to drop.

The next 48 hours, as a consequence, will be interesting, not least because exchanges and wallet services are already taking the rule of central authorities by dictating which version of bitcoin they will support or discontinue.

We, however, would say that it’s human nature for users (left to their own devices) to want to support both for as long as possible, especially if there’s a perception that doing so will double your net asset value overnight. The precedent for this is the Ethereum hard fork, which spawned the offshoot “ether classic” (ETC) and boosted the collective market value of both overnight. To a rational person, of course, it’s precisely this sort of instantaneous value creation which will have hinted at the intrinsic funny-money nature of the whole system. But as we’ve long catalogued, nothing in this world is rational or sane.

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