brave new world

Hackers are trying to create an untraceable and comprehensive financial system using bitcoin

April 30, 2013
Obsession
Digital Money
April 30, 2013

What’s often missed about alternative currencies like bitcoin is that they weren’t just made for buying and selling things. Nor are they simply tools for financial speculation. Bitcoin is also a payment system, allowing anyone to transfer money anonymously, immediately, irreversibly—and, if you like, illicitly.

As virtual currencies grow, that could have profound implications for governments trying to keep track of and regulate the flow of money across their borders. What’s more, this ghost of a banking system is key to understanding that there’s a real demand for bitcoin—just not as a currency in the old-fashioned, pay-for-goods sense.

Anonymous banking

It is possible to remain anonymous online. Services like BitTorrent, for file-sharing, and Tor, for web broswing, route data through networks of computers in order to protect the identities of their users. Although it was developed by the US Navy, TOR has evolved into a public service, allowing political dissidents, journalists, government officials, and geeks to surf the web anonymously.

Bitcoin is, if anything, the opposite, perfectly transparent. A ledger of all transactions made on the bitcoin is broadly accessible—in fact, that publicness is what makes bitcoin work and maintains faith in the network. But people aren’t identified by name, just algorithmically generated public keys that serve as the user’s wallet.

“The exciting thing about these new currency schemes is that you have these anonymous payment systems grafted onto anonymous networks,” Chris Dixon, a partner at venture capital firm Andreessen Horowitz, which has invested in bitcoin startups, said recently.

A new initiative called Open Transactions, led by a programmer known only as FellowTraveler, is attempting to blend the anonymity of privacy networks like Tor with the openness of virtual currencies like bitcoin. The idea is to create decentralized transactions involving three completely blind parties: an issuer (who announces that he has some amount of currency up for sale), a server or network of servers (who manage the transaction), and a user (who wants to purchase the currency).

By routing the the transaction through intermediaries and using a privacy network, money can flow anonymously through the web. And the same concept can apply to other asset classes, as well—including, according to the developer, collateralized debt obligations, a financial product that’s about as arbitrary as bitcoin.

The means of exchange

In the world of Open Transactions, virtual currencies are just a means of exchange, another middleman. Traditional hard currency is converted to bitcoin—or, say, gold from the videogame World of Warcraft—and converted back into traditional currency at the end of the transaction. Bitcoin’s value, then, is not what it can buy at Walmart but the trust that others place in its network.

Given how volatile trading in bitcoin has been, it’s hard to imagine it will ever be secure enough to be trusted as a medium of swapping fiat currency or other assets. In fact, bitcoin exchanges are so vulnerable that hackers betting on the price of bitcoins to dollars seemingly crashed the market on purpose: They sell bitcoins, then overwhelm the primary bitcoin exchange (Mt.Gox) with traffic. This causes the site to fail, which sparks panic selling, and the market essentially crashes. At that point, the hackers can turn around and buy bitcoin again at a big discount, and pocket the difference in profits.

But it’s highly likely that bitcoin exchanges won’t always be so volatile. Mt.Gox’s programmers have been criticized by bitcoin traders and other bitcoin developers for failing to take even the most basic precautions to protect the most popular bitcoin exchange against hacker attacks. The new currency has already spawned multiple startups to compete with Mt.Gox, some with outside funding. New competitors are not likely to make the same mistakes, and bitcoin will probably be increasingly difficult to manipulate.

Moreover, bitcoin as an un-hackable payments system—with an indisputable record of irreversible transactions—clearly has a value. Just think, “internet gold” without the risk of shocks to supply.

Untraceable payments

Typically, regulation to discourage money laundering is carried out by banks. But if you can truly create a system of blind transfers, then every person’s online wallet becomes a bank. In an interview with AgoristRadio.com, FellowTraveler, the anonymous creator of Open Transactions, explained why it will be impossible to control these payments:

If you go down to the bank and withdraw, say, $100 and then you give it to a prostitute. and then she gives it to her pimp, and then he gives it to his drug dealer and his drug dealer goes and puts it back in the back, because he’s going to college or whatever. Now what does the bank see? They can see that you withdrew $100 from your account. Yes…They see that you withdrew $100 from your account and they also see that the drug dealer deposited $100. They can see that, too. But what they can’t see is that it’s the same $100. They don’t know that that’s the $100 that came from you…and they also didn’t know who had it in between…Digital cash does the same thing.

Whether OpenTransactions itself works out or not, it relies on a profound concept: Bitcoins will become the medium for a system of untraceable exchanges between one currency and another, a completely anonymous means of foreign exchange. Instead of a purely speculative investment, bitcoins are a commodity with demand determined by the volume of bitcoins being exchanged at any given moment.

What’s more, wallets themselves can serve as personal bank accounts, anonymous and separate from the traditional financial system and government control. Clearly, this comes with its own risks: Most citizens benefit from laws meant to provide oversight of the traditional financial system. But for those wary of governments and banks, OpenTransactions—and any system like it—can serve as a means of storing, investing, and exchanging money that could really be untraceable.

A decentralized financial system with a virtual currency traded by anonymous users poses a clear challenge to traditional legal and banking systems, a challenge governments may never really be able to control.

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