Tim Swanson on Crypto 2.0 in China, ‘Bad Apples’ and the Future of Bitcoin

Tim Swanson is a researcher who writing has appeared in Business Insider, CoinDesk, Let’s Talk Bitcoin, Cryptocoins News, Bitcoin Magazine and recently Cointelegraph. We reached out to Swanson earlier this week to get his thoughts on what he calls cryptoledger technology, China and Bitcoin itself.

Cointelegraph: Can you tell us a bit about your background and what you are currently working on?

Tim Swanson: Over the past six years, I worked in East Asia and primarily China. While I was initially an instructor at a couple of colleges, I ended up doing a lot of business development and market research for a variety of Chinese-owned companies; some of the data was compiled in a short book I wrote 18 months ago. Concurrently, I helped build mining machines for friends on the mainland, but it wasn't until I moved back to the US this past December that I began investigating expanded uses-cases of blockchains or what I prefer to call cryptoledgers (so that it encompasses Ripple as well). 

I spoke with several dozen experts in this burgeoning segment and compiled another short book that provided a general cross-section of what is typically called the "2.0" space within digital currencies. I currently do a significant amount of market research in this area now, primarily for startups but also for a couple of funds that are looking for objective analysis.

CT: I’d like to combine two thing you’ve written about extensively into one question: What opportunities do you imagine exist for cryptoledger technologies with applications beyond just currency in China?

TS: I think it is important to distinguish what a blockchain can do in a developing country like China and what it probably will be used for. The example I typically use is property ownership — no one really owns property in China, only the state does. And the state sells parcels of land typically as 70 year leases. Yet because of how some Deng-era liberalizations took place, numerous leases (and subleases) may only be valid for another 40-50 years, and in many cases, if you do not have the right guanxi (social connections), may be invalidated altogether. You see this happen today with so-called “nail houses” (dingzihu) — there is no Lockean labor theory of property.

One might think that a blockchain, with its ability to manage and track deeds, titles and registries, would be the panacea to this quandary, especially in remote areas, but ultimately it is a political issue and decision. Even if all residents hashed or stamped their leases onto a blockchain, without enforcement or recognition from the court system, they will be unable to defend their ownership claims. This could change overtime and in cities like Shanghai, as there is a lot less ambiguity today than in other rural areas.

If the political apparatus in China does find a competitive use-case for blockchains, it is difficult to predict whether or not it would be used like the Great Firewall to protect its self-interests or allow it to percolate in some organic, decentralized manner.

To be quite frank, however, a blockchain is not nearly as efficient or cost-effective as a centralized database in a data center tracking property titles. In most cities, there are departments that handle this. For instance, the Shanghai Real Estate Trading Center (Fangdi) is in charge of this matter. Thus, it is hard to see how this specific use-case would be used in the future since most towns and villages — even remote ones in Xinjiang — will eventually be connected via a centralized solution.

Currently, despite a variety of startups trying to expand its ecosystem (e.g., ATMs, exchanges, wallets), I do not see nor have I heard of many use-cases in China beyond the speculative asset portion. YesBTC attempted to build a merchant processing platform, but they have pivoted to selling mining gear, and none of the large e-commerce platforms like those of Alibaba currently allow merchant integration with digital currencies.

CT: It’s one thing to tell banks not to deal with a certain currency such as Bitcoin, but it would be something else entirely to dissuade people from using a specific form of technology. Has there been any movement in China to cast a cooling effect over technologies like smart property or other cryptoledger technologies, or is it still too early to know?

TS: It is really too early to know. I am in contact with a number of people in the cryptocurrency community in China, and for the most part they are collectively playing catch-up with the West. For instance, there is no Perkins Coie of China yet, and very few of these companies even engage in legal counsel.

I think it is also important to distinguish between smart property and smart contracts (which I tried to do so in my short book in March). Nick Szabo, the intellectual progenitor to these two concepts, has written several good articles on what each is. In short, a smart contract is computer code that self-enforces the terms of the contract. Smart property, in most examples are physical property, such as a house, car or boat, whose ownership can be controlled with a smart contract.

Currently, there are no known working examples of a physical asset (such as a car ignition system) whose ownership is remotely controlled by a smart contract residing on a cryptoledger.

Perhaps this will change, and there may be an explosion of innovation in China, though at the moment virtually all of the activity involves day trading on exchanges. One notable exception is YBEX, which is a voting-based crowdfunding platform that accepts bitcoins (and ybexcoins) to fund certain projects.  Lightspeed Ventures China, 500 Startups, Sequoia Capital China (ZhenFund) and IDG-ACCEL are active investment teams in China looking at entrepreneurs in this area.

CT: What are some applications of cryptoledgers that are still in their early stages you’re excited about?

TS: Appcoins (decentralized ownership and control of assets) seem interesting in theory, and I also like the idea of crowdequity or cryptoequity, yet as I noted in a previous piece, the legal issues surrounding that are nebulous and unclear at this time.

Furthermore, securitizing equity is not new, however, the ability to securitize your property in a decentralized manner and receive payouts and rents on your house or car may have some interesting use-cases that may work in tandem with endeavors such as Airbnb and Uber. Projects like Eris, Koinify and Lighthouse are at the forefront of this, and in the case of Eris is being led by a team of practicing attorneys.

Monegraph also appears to have some potential for verifying digital assets (like art), and Namecoin also has potential to work as a type of identity management tool, though its adoption remains muted since it was released as BitDNS in late 2010.

The two other areas that I find of interest are the plethora of wallets being put through the meat grinder, specifically the hierarchical, deterministic and multisig variety. While it is unclear which of the firms developing them have the ability to create a profitable business model solely around holding bitcoins (e.g., a feature, not a product), once the dust settles there will likely be several robust multi-platform wallets that could be used to manage a bevy of digitized assets beyond tokens.

I also think that Ripple is a very intriguing technology that is often overlooked because of the differing ideological attitudes in the community. The pathfinding algorithms alone enable a type of digital Hawala, which is empowering as a means to connect and create a global clearing house system (currently it is fragmented) as well as transmitting value for the underbanked.

CT: In your paper published April 27 on learning from Bitcoin’s history, you have this great line: “Some liken the current experiment as a five year condensed version of the past century in banking involving scams, booms, bubbles, fractional reserve schemes and outright theft.” Can you explain that for our readers?

TS: When it was launched, Bitcoin was presented and marketed as a payments system — that is what the title and Section 1 of the white paper detail. And over the subsequent five and a half years, the hardworking, dedicated community has tried to build out a payment system, reinventing the wheel for some portions of the entire banking and financial industries.

However, one area that is continually overlooked or hand waived are the bad actors involved in this process; there are more than a few bad apples, and as a consequence you have enormous wealth transfers and ill-gotten gains that have taken place, hence a neverending series of scams that have created real economic losses for some participants. When Mt. Gox was hacked in June 2011, the trading and sell-off created a short-lived boom and then prolonged bust (e.g., “the Great Depression of 2011”). Subsequently, as many as 10-15% (see p.10) of all mined bitcoins may have been accosted from the legitimate owners in some manner.

A large portion, such as the MyBitcoin Theft, took place during the “early years,” when there was low or no market value for the tokens, and as the space matures emphasis on security will likely reduce the threats and vulnerabilities. Yet every week there are new stories of scams and theft that surface — and because the ledger is public, you can actually view the movement or, in many cases, the non-movement of criminal activity — stolen bitcoins that cannot be moved because they have no exit.

A traffic analysis such as that from Sarah Meiklejohn (pdf) illustrates this phenomenon. This type of theft is not relegated to stealing private keys, either, as botnets essentially externalize the costs of mining onto outside participants, and they still exist (see also: Botcoin: Monetizing Stolen Cycles).

In China, you may happen upon a fly-by-night restaurant that offers relatively cheap food, being sold at a loss. Sometimes, these are fronts for organized crime, trying to anonymously mix their illicit funds into the real economy. There is a built-in incentive for criminals in the Bitcoin ecosystem to fund such exits, as well, especially mixing services.

While it is a controversial issue, and I have received plenty of disagreeing feedback, I think it is important to recognize that the theft of property (the ledger entry corresponding to a private key) has taken place, continues to take place, and there is no built-in mechanism to rectify that.

This does not inspire confidence for those on fixed incomes such as disabled or retired workers whose welfare would be destroyed in the event that their keys are compromised without recourse. In practice, “being your own bank” is incredibly difficult for people not wanting or unable to memorize a hodge podge of passwords or go through the dozen-plus steps to make and secure a paper wallet. Solving this not only would engender confidence, but successful Bitcoin-related institutions in the future may look a lot more like Coinbase, Circle and Bitreserve than someone running Electrum or Armory on an air-gapped laptop.

In terms of booms and busts, John Kenneth Galbraith wrote a very concise history of previous eras of exuberance. It is too early to tell if bitcoin (the token) is another example, yet the type of volatility we see today is related to demand volatility, the changes in demand for bitcoin as an asset. Yet nothing has changed in the actual asset; a bitcoin (a UTXO) today is fundamentally no different than it was in late November 2013, yet its market price is 30% less.

If the underlying conditions of an asset have not changed (such as the economic demand for it in commercial activity), yet the demand for it has sharply changes, this may be an indication of “animal spirits.” If and when bitlicenses are issued, it will likely bring new professional traders into this market, and traders are largely interested in volatility for arbitrage opportunities.

Thus, as Brian Hanley noted, in the event that bitcoin (the token) somehow absorbed the transactional economic value of the United Kingdom over the next five years, bitcoins would need to appreciate roughly 109% compounded per month, which would incentivize participants to not spend but rather continue holding (or rather hoarding, as there is no savings mechanism built into the protocol). It would thus function not as a type of money, but as some type of commodity (perhaps it is a money-like informational commodity).

This issue is compounded by what Robert Sams recently explained to me: What about ill-gotten performance of the 2.0 metacoin and digitized financial instruments? That is to say, in the event that sidechains, colored coins or other secondary protocols attached to Bitcoin begin issuing financial derivatives or even something as simple as a dividend, what happens in the event of theft?

For instance, if Bob’s colored coin representing a stock was stolen by Alice, does the company issuing the dividend still pay it? If yes, then this opens up the company to lawsuits, and if no, then Bitcoin (the protocol) ceases to function as a decentralized ledger, as the protocol would need to verify the identity, taking away the anonymity behind it. Currently, there is no way to do this on Bitcoin itself today without a major code rewrite and change in the social contract.

Lastly, the issue surrounding fractional reserve banking (FRB) is difficult to discuss with some of the community due in large part to the fact that many adopters are unfamiliar with how FRB actually works. On the one hand, it appears that post-2011, Mt. Gox may have been fraudulently lending out customer funds without informing them (publicly or privately) that Mt. Gox was not a 100% full reserve database.

Yet Mt. Gox was never a bank. In fact, it was never technically lending customer funds as banks do. Rather, it was a business that did not properly separate customer funds from its own, or there was some outright illegalities or bad management (e.g. security breaches). Financial institutions are required to separate their own funds from clients’, and Mt. Gox apparently failed to do this somehow.

In addition, in practice modern banks and institutions using FRB have certain lending requirements, depository requirements and independent oversight in place prior to the creation and lending of credit. On the other hand, Hanley and I (among numerous others) argue that Bitcoin itself (the economy) cannot expand, as the protocol has no dynamic method for lending or expanding credit, but this is a debate that will likely continue for decades. The Mt. Gox bankruptcy case is still ongoing, and despite data from the Willy Report, it is unlikely that we will know for sure what was actually happening for many more months and perhaps years.

CT: How do you imagine the next five years in Bitcoin could play out?

TS: I am cautiously optimistic yet skeptical of the long-term longevity of Bitcoin (both the currency and protocol) due to a number of factors that I have written about this past spring.

This does not mean I think that Bitcoin is doomed or will collapse anytime soon, but rather I think despite the best, concerted efforts of venture capital and brilliant engineers, ignoring all the public good’s problems and mining centralization issues, that the block reward halvings over the next 10 years (corresponding with a drop from 25 bitcoins to 3.125 bitcoins) will illuminate that the network is susceptible to the same self-terminating issues that all other proof-of-work-based blockchains are vulnerable to, most recently seen with Dogecoin.

This is an issue that has been raised by Nicolas Houy and recently Kerem Kaskaloglu. Despite this assessment, I also think that during this time frame that there are still viable business opportunities to build such as those catering to API (HelloBlock), analytics (Coinometrics) and KYC (Blockscore).

I try not to mention specific prices because the world has seen speculative euphoria before, and it is impossible to predict when this could stop — especially when you have such large emotional buy-in from passionate adopters. But if history is any indication, the removal of block rewards reduces the overall security of the network (as the labor force, miners, leave for greener pastures).

While there are dozens of solutions to the issue surrounding the economic incentives of mining, none of them can currently be implemented without forking the mining community (i.e., why should the labor force take a pay cut to hash and protect new code?).

Furthermore, in practice no one likes paying transaction fees, and it is difficult to foresee a situation in which the community collectively begins to pay for significantly higher fees (by at least two orders of magnitude) on a platform that is not competitive compared to other existing systems. As Bitcoin (both the protocol and asset) moves into its twilight years, it will likely fill specific niches, used for things that traditional systems such as credit cards are not as competitive with today; so perhaps some remittance corridors, commerce with high-rates of fraud and chargebacks (Amazon Web Services via StackMonkey, porn) and black market activities (gambling).

I could always be wrong, though; perhaps there is a silver bullet solution or killer app (like Blockstream or Peernova) that will reverse this course.

With that said, I do think the current “survival-of-the-fittest” fight in the altcoin community could produce a couple of niche winners capable of lasting more than a handful of years; maybe something like Hyperledger comes out on top — we are unable to know that up front.

In addition, perhaps with agent-based modeling (ABM), this “creative destruction” process could be sped up, discovering the most efficient economic attributes a blockchain would need to go the distance. Robert Sams, Ferdinando Ametrano, Morini Massimo and Dave Babbitt are working on ways to resolve this balance; I recommend readers peruse their analysis.

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