AZPI GORRI

Th e Bitcoin scheme does not have a central institution acting as issuer or manager of participants’ accounts: it is a peer-to-peer mechanism, where users are at the same time consumers and producers of the medium of exchange. Two private organizations (Bitcoin foundation and Bitcoin.

org) are pursuing the objective of fostering the bitcoin experience, espe-cially by information, and software updating, but their role is not essen-tial to the transactions. Th e issuance of new bitcoins is intertwined with their validation, and it proceeds as Bitcoin’s transactions progressively grow. All participants to the scheme have theoretically the same opportu-nity to enter the validation process, and so to gain new bitcoins. Actually, because the internal algorithm to be solved has an increasing complexity, single users may not normally have available hardware resources needed to do that, and, consequently, the mining function is reserved for a small number of well-equipped participants.

18 A synthetic analysis has been developed by Reuben Grinberg, “Bitcoin: An Innovative Alternative Digital Currency”, Hastings Science & Technology Law Journal , Vol. 4, December 2011 and by Financial Action Task Force – FATF, Virtual currencies key defi nitions and potential AML / CFT risks , Paris, June 2014.

19 See for example European Central Bank. Virtual currency schemes , Frankfurt, October 2012.

20 Quoted from European Central Bank, Virtual currency schemes  – a further analysis , Frankfurt, February 2015, p. 25; the same defi nition has been expressed in European Banking Authority, EBA Opinion on virtual currencies , 4 July 2014.

Th e lack of a central bank rests on the solution of the trust problem in a transaction mechanism proposed by Nakamoto, according to which the trusted third party (central or commercial bank) is a costly solution, requiring intermediation and transaction costs. We usually accept legal tender or banking money because we trust the state or the banking sys-tem, but these institutions simply check that a single unit of money can-not be spent twice at the same time. Th is multispending problem can be solved by a cryptographic method, which is by a mathematical proof that the payer is the eff ective owner of that unit of money. A control on the circulation process can be realized by a system of digital signature and a by complex validation process, shared by the same participants: in such a way there is no need of a central bank. Bitcoins are transferred as compensation of a single transaction between two users without account monitoring by third parties: it is the algorithm itself that checks regular-ity via the process of validation, by which a set of transactions are added to the blockchain. Th is is a public ledger, freely available to all the partici-pants to the scheme, reporting the sequence of all executed transactions since the beginning of the scheme, in 2009, when the genesis block was created, and the fi rst 50 bitcoins were released and spent by the founder of the system.

Every participant downloads a software application (client software) to be installed on the personal device, where a digital wallet is created, gen-erating an address code to store the bitcoins received. ²¹ Th ese wallets can be opened at specialized bitcoin service providers or others fi nancial oper-ators accepting bitcoin accounts. ²² Each owner of a wallet can later gen-erate unlimited further address codes to be used for future transactions.

Balances available in each address are used to pay a single transaction, transferring them to the receiving address of the payee. If the outgoing bitcoin payment exceeds the amount to be paid, there will be a reverse transaction for the diff erence that automatically generates a new address

21 Bitcoins can be received as payment for business transaction in goods, services or fi nancial instru-ments, or by charity contribution. Bitcoins are also exchanged with other foreign currencies on specialized electronic platforms. Th ere exist also a very few number of ATMs accepting cash like euros or US dollars in exchange for bitcoins.

22 Examples are the websites Coinbase.com and Paymium.com : the latter is incorporated under the French law.

2 Economic Issues on M-Payments and Bitcoin 39

code in the sender’s wallet. A distinctive characteristic of the Bitcoin scheme is that usually in the wallet the balances do not cumulate in the same address, as in traditional banking current accounts, because each received value would have to be sent to a zero balance address formerly generated. ²³ Th e amount to pay for a new transaction is then managed by the software application, pooling the various addresses in the user’s wallet: in such a way a track record of the transferred bitcoins, from one owner to another, is easily done. A transaction does not imply a corre-spondence between one outgoing address and one destination address, as usual in bank accounts, because balances of multiple outgoing addresses are gathered to the destination address. Every amount of bitcoin can be paired with an identifi cation address, so as to make it possible to verify if the sender is the eff ective owner.

A digital signature process is the way to prevent multispending: for each single transaction, each participant uses two separate alphanu-meric strings, named “keys”. ²⁴ Only the public key is transmitted to the network, whereas the private key is needed to couple the owner to the amount transferred ²⁵ ; when the payee receives the message from the sender they can easily verify the integrity of the transaction: only if the private and the public keys are correctly paired, the transfer can be done.

When the transfer has been executed, it is not yet completed, because the payment has to be validated and this takes about ten minutes: during this time the transaction status is “not confi rmed”. Th e transfer of bitcoins is just a message, where much information is included: all used to verify the transaction and to validate it. Each transaction is broadcasted to the nearest nodes and then to the entire network so that all participants, theoretically, can compete to verify it.

Non-confi rmed transactions are collected and gathered in a block by nodes that start the validation procedure via a complex cryptographic algorithm: when the node, that is a single participant or a pool of users,

23 Using a new address for every transaction is a suggested behaviour by bitcoin.org .

24 When the software generates a new address, the user has an additional pair of private and public keys. Th e public key represents the code to store or receive bitcoins.

25 A simplifi ed description can be found in Anton Badev and Matthew Chen, “Bitcoin: Technical background and data analysis”, Federal Reserve Board Finance and Economics discussion series , 2014- 104, October 2014.

fi nds the mathematical solution, that block is added to other existing blocks in the blockchain. Th e blockchain is the sequence of all transac-tions executed from the beginning and its structure prevents that a pay-ment could be cancelled once it has been submitted to the network. ²⁶ Th e transaction included for the fi rst time in the block receives a con-fi rmation; later when other blocks of additional transactions are vericon-fi ed and added to the blockchain, the original transaction receives a second confi rmation message and so on, until the sixth confi rmation. Th is last confi rmation states that the original transaction is included (and verifi ed) in six blocks: at this point the transaction’s status will change to “con-fi rmed” and the amount of bitcoin transferred will be eff ective; the pay-ment from the sender to the payee is then completed. New blocks are of variable length: they are composed of a diff erent number of transactions and diff erent values of bitcoins transferred. ²⁷

Th e validation process plays a central role in the scheme, since it allows a function usually carried out by central banks in traditional payment systems: in the Bitcoin scheme this function is decentralized via a peer-to- peer mechanism ²⁸ ; this is an example of cooperation (all nodes contribute to validate blocks) in a competitive form, because the fi rst node which solved the algorithm to validate a block is rewarded by new bitcoins, generated by the system itself. Th is second aspect is crucial in the supply of bitcoins. Validation is at the same time a means to permit bitcoins to be accepted as a medium of exchange and the issuance mechanism, not directly controlled by third parties. Th e reward halves every four years, corresponding to 210,000 new blocks added to the blockchain, ²⁹ as determined by an internal growth rule: this activity is conducted on a voluntary base and its participants are named “miners”, just like the gold mining in the past. We already stated that solving the mathemati-cal problem to validate a new block is progressively more diffi cult, thus

26 Th e complex algorithm used in the scheme makes impossible a recalculation of the whole sequence, so a transaction cannot be denied by the sender.

27 Useful information on daily transactions are reported in the website blockchain.info where in real time one can see progression of the new blocks verifi ed and added to the blockchain.

28 Th is democratic feature is more apparent than real, due to growing diffi culty of validation proof and to the consequent requirement s of expensive processing machines and energy.

29 Every day about 144 new blocks are added to the blockchain.

2 Economic Issues on M-Payments and Bitcoin 41

making the validation process unsuitable for single participants lacking ample resources: the resulting concentration in mining also leads towards pool-mining, accessed by single users to share the generated revenues.

Besides the new bitcoins granted to miners of new blocks, a voluntary fee on every submitted transaction constitutes a further form of compen-sation: when the validation process is completed the user pays a variable amount ³⁰ ; even if this fee is completely on a voluntary basis, probably transactions without fees are never validated.

To foster the bitcoin process of payment many operators have entered the “bitcoin’s ecosystem” and they act as service providers to make trans-actions easier: in a strict sense, their function is not essential to the mech-anism described above, but it surely has had a positive impact on bitcoin’s acceptance by users and merchants. Th ese services concern three cate-gories: transaction facilities, real-time exchange with other currencies, information and communication; all are provided by web-based fi rms.

“A growing number of start-ups has been emerging to provide new tual currency products and services that facilitate use of decentralized vir-tual currency payments network, particularly bitcoin.” ³¹ Th ese fi rms are wallet providers, virtual currency payment processors, virtual currency exchangers and bitcoin automated teller machine (ATM) operators ³² ; this is an example of how an infrastructure can autonomously grow, even if its existence had not been considered at the launch of the system. Wallet providers facilitate users in managing bitcoins and exchangers guarantee convertibility with fi at currencies, minimizing in such a way the time spent to transact. Th e most important function is probably that of pay-ment processors, particularly for merchants. When a merchant receives a bitcoin balance they can immediately convert it into traditional money, so as to prevent intraday volatility and possible losses. A fundamental complementary service is to reduce volatility and improve connection

30 Usually 1 % of the value transferred is charged on sender: variable fees can be applied according to the type of transaction, as explained in the website bitcoin.org . Transactions can be labelled as high-priority, depending on fee and on creation date of bitcoins used, to stimulate spending of idle amounts stored in wallet.

31 Quoted from Financial Action Task Force – FATF, Guidance for a risk-based approach to virtual currencies , Paris, June 2015, p. 43.

32 Th ere are only a few manufacturers of bitcoin ATM: at the end of 2014 there were about 300 machines operating in the world, provided by merchants accepting bitcoin payments in their shop.

with the traditional payment systems, making available bitcoin facilities on fi nancial accounts with SEPA address codes. In such a way traditional or new payment service providers could act as risk-taking operators, managing daily volatility.

Th e growing infrastructure fi rms engaged in mining activities concen-trate computer capacity in an industrial plant, using specifi c high-power machines manufactured by specialized hardware vendors; in such a form, mining activity is not anymore a single user’s participation to the feasibil-ity of the scheme and it becomes an eff ective business activfeasibil-ity. ³³