Hudson Luce writes about an article which analyses bitcoin traffic.

The pertinent bit of Shamir’s article is this:

“The Bitcoin system is the best known and most widely used alternative payment scheme, but so far it was very difficult to get accurate information about how it is used in practice. In this paper we describe a large number of statistical properties of the Bitcoin transaction graph, which contains all the transactions which were carried out by all the users until May 13th 2012. We discovered that most of the minted bitcoins remain dormant in addresses which had never participated in any outgoing transactions. We found out that there is a huge number of tiny transactions which move only a small fraction of a single bit coin, but there are also hundreds of transactions which move more than 50,000 bitcoins. We analyzed all these large transactions by following in detail the way these sums were accumulated and the way they were dispersed, and realized that almost all these large transactions were descendants of a single transaction which was carried out in November 2010.”

“In other words:

1. There’s no transparency and no outside auditing – as any central bank in a republican democracy ought to have, including the US Federal Reserve System;

2. There’s evidence that there’s been massive manipulation of bitcoin accounts being performed within the system which frankly smells of some sort of fraud; and

3. Most bitcoins ever produced have never once been traded, which sets the ground nicely for a pump and dump scheme which can make Bitcoin’s creators quite rich when repeated multiple times.

And this last point is the most interesting – figure out a digital currency scheme based on some sort of relatively unbreakable cryptographic scheme, which has a large but finite number of keys, say 21 million or so. Devise software to calculate 80% of the possible keys, and do so.

Then you announce this system to a small subset of the world – hackers and computer nerds. They tend to be a rather lawless bunch and they tend to like secrecy and suchlike and the things which can be bought with relatively secret transactions.

Remain anonymous – generate a “Japanese” alias to appeal to all the anime fans, but no one knows who the insiders are – and if they’re smart, they’ll use compartmentalization amongst themselves so that you’ve got an inner cadre of, say, no more than 7 people, and then the other 71 are compartmentalized. And of course, no one knows the physical location of this exchange.

You put the software out which discovers the keys and you set it up so that it starts out from the last key generated, generates a new key and communicates sufficient info about that key so that the searches (and keys) won’t be duplicated.

Over time the searches become harder and harder, requiring better and better software and faster and faster hardware, something which hackers can get their heads around, and you make the projection that in 20 years or so there will be an end to discovery of keys.

You don’t actually know this, but it puts time pressure on the hackers to concentrate on key discovery, a bit of prisoners dilemma. Of course, they’re missing the forest for the trees, because a very small number of people already own 80% of the keys – which they generated essentially for free.

Now, along with the software, the insiders to this scheme sell off (relatively) small amounts of keys at a set value in real money – US dollars, Euros, the works. They control the major exchange on which 100% of the transactions at the start are transacted, with a conversion fee to be paid in real money; eventually others catch on that they can make money off transaction costs and set up their own exchanges, and cut deals with the central exchange as well as buying keys from hackers who discover them on their own.

Now, there’s got to be merchants selling goods for this system to become fixed in people’s minds as providing an asset with tangible value. Some of these merchants luckily exist, and some of them sell illicit goods in which it would be advantageous for buyer and seller not to know each other’s identity or location and have the transaction be relatively untraceable. It would be quite interesting if one or more of these merchants were insiders in this currency scheme – but I digress. With time, word spreads about this currency system, and more and more people buy in.

Of course, there’s advertising after a certain point, the word gets out to the broader world beyond that of the cognoscenti, and since there are a finite number of keys in existence, the value of these keys goes up as for any perceived scarce commodity.

Speculators come in, and it’s a good thing that the exchange controlled by the insiders has control over 80% or more of the transactions, because they can win in two ways – first, by collecting a transaction fee, and second, by manipulating “lag times” – the time between when a buy or sell order is received and when it is filled. Insiders can do this per order to ensure that insider transactions always result in profit – a little profit is all that’s needed, you don’t want to skin your players or they won’t come back.

Finally, since the insiders control such a huge percentage of the total inventory of keys, they can use hype to pump up demand and price – and who doesn’t want to gamble on a rapidly appreciating asset? But then they drop the price precipitously by “dumping” – selling- a large number of keys (relative to the size of this thinly-traded market) all at once. Traders panic, a sell-off ensues, and the price gets driven down sharply, and the insiders buy the keys for the sharply lower value, and harvest a big profit in real money.

So far this has happened about once every two years, and as the paper by Shamir shows, it can happen once every two years for the next twenty years – or until people figure out the con, which might be a lot sooner, but you never know…

So, how to fix this so it’s an honest operation which can be trusted and used by people without fear of loss? That’s another post, for later…”