6 Years Later: Is Bitcoin Really Secure?

Guild Investment Management |

Bitcoin is a “cryptocurrency” -- a form of digital money that proponents hope will get all the middlemen out of financial transactions and permit the parties -- even ones who do not know or trust one another -- to conduct their exchange directly between themselves. If you think about who all those middlemen are, you realize that most of the financial ecosystem consists of middlemen: some state (governments who manage fiat currencies) and some private (everyone from small insurance brokerages to giant multinational institutions that provide a complete range of financial services from commercial banking to investment banking and asset management).

Financial services represent a huge market -- between 8 and 15 percent of U.S. GDP, depending on the industries included. Anything that could disintermediate financial institutions -- as Bitcoin advocates believe it might -- would be profoundly disruptive. At first blush, Bitcoin looks like it could be the harbinger of developments that will radically reshape the entire financial ecosystem. This is why commentators and analysts continue to discuss it. 

Bitcoin and the Promise of “Digital Trust”

Financial mediation arises because of the messiness of human relationships: we need to interact with people we don’t necessarily know and can’t necessarily trust. The intermediary stands between the parties of an exchange, making guarantees to each side and lubricating the gears of commerce. Without intermediaries, we’d be reduced to barter, and a robust, complex modern economy with all the benefits it provides would be unthinkable.

Of course, intermediaries are themselves not immune from the same messiness. Banks fail; fraudulent people inhabit and occasionally co-opt whole institutions; public financial policies can have disastrous consequences. There is ultimately nowhere to find total security and total safety. And likewise, there is nowhere to escape from the fees claimed by those intermediaries out of the capital flowing through the global financial system -- unless, that is, humans could somehow be removed from the equation.

Can Bitcoin Replace Old Structures With Crowdsourced “Digital Trust”? 

That’s what bitcoin proposes to do -- reduce the risk of fraud and the expense of transactions by replacing the middlemen with a suite of cold, hard technological tools. That way, you can still have the fluidity of a modern financial system, but without the risks and with far lower costs. “Digital trust at a fraction of the price!” 

Core Bitcoin Technologies 

The technical details of Bitcoin are abstruse, but here are some essentials. 

Bitcoin relies on two core technologies: the blockchain and public key encryption. Both are ways to eliminate the risk of fraud in transactions. 

The blockchain is a ledger like that in a bank. Banks have private ledgers whose accuracy is guaranteed by the bank itself, legislators, third-party auditors, and market discipline -- and the bank profits by possessing this proprietary information. 

But Bitcoin’s blockchain is public. In it, every transaction is recorded: “Bitcoin address X assigns 5 Bitcoins to Bitcoin address Y.” The blockchain is distributed, held in its entirety in countless network “nodes.” The distribution of millions of those nodes makes it theoretically impossible to corrupt or game the blockchain, since they would all have to agree (but more about that below). 

The other key Bitcoin technology is public key encryption. This is a way to send secure messages from one person to another, which cannot be intercepted by a third-party in between. Public key encryption needs two “keys” (long chains of numbers and letters) to unlock a secure communication. One is your public key, which everyone, including the person sending something to you, knows -- it’s for encrypting. The other is your private key, known only to you. Your private key, and only your private key, can “unlock” (decrypt) a message sent using your public key. These keys are generated in pairs by a mathematical algorithm. Again, the mathematics is abstruse -- but suffice it to say that with a public key in hand, no computer on earth could “reverse engineer” the private key (but more about that below). 

Together, these two technologies make Bitcoin what it is. The blockchain replaces the bank’s ledger. The Bitcoin network replaces the bank’s management. And public-key encryption ensures that only the real owner of a Bitcoin can reassign that Bitcoin to someone else, so that replaces the bank’s staff. Sounds great -- as long as you don’t own a bank. 

Yes, the Inevitable Problems 

We see the value, power, and innovation of Bitcoin -- and more than that, we see the applicability of Bitcoin’s technologies to a variety of situations where a “public ledger” could replace a private one and disintermediate the ledger-keepers. These technologies will work, will find niches where they shine, and will be disruptive. 

We also see that Bitcoin’s revolutionary character shouldn’t be overstated. We say this for two reasons. 

First, the “human factor” will never be eliminated. Bitcoin, in theory, replaces fallible or malign human actors with an algorithmic system. Yet humans are involved in this system at every stage -- and some of them will be seeking ways to exploit it. Wherever Bitcoin is deployed in real life, it will be “intersecting” with real people. And in the cracks between the human world and the pure mathematics of the Bitcoin algorithm, there will be opportunities for fraud, theft, and deception. 

For example, you need your private keys to send Bitcoins anywhere. As beautiful as Bitcoin’s encryption system is -- and as resistant to “brute force” hacking attacks -- you must store your private keys somewhere. Where will it be? In a “virtual wallet.” And where will that virtual wallet live? Perhaps on your computer -- where it will be vulnerable to viruses, keyloggers, and other cyber-threats. Perhaps on your mobile device -- where besides those threats, you have the risk of a lost phone. Perhaps written on paper or in some other location not connected to the Internet -- in which case it will be like cash, vulnerable to theft by any old-fashioned, low-tech thief. 

And here’s a particular rub -- there is essentially no way to recover lost and stolen Bitcoins. If your hard drive containing your virtual wallet goes to the landfill, it’s as if you put that money in a box and dropped it into the ocean. (This happened to a Bitcoin user in 2013 when he accidentally threw out a hard drive on which he left his Bitcoin wallet with the keys to $7.5 million worth of Bitcoins. Those Bitcoins still “exist” in the blockchain… but with the keys gone, no one will ever be able to spend them.) 

“Cracks in the system” have been seen elsewhere as well. Often, Bitcoin transactions include coins being held in escrow until goods are delivered -- and coins have been stolen from hacked escrow accounts. Wherever transfers into and out of Bitcoin occur, all the old risks occur as well. Since Bitcoin will likely never displace national fiat currencies, there will always be marketplaces for Bitcoins to be bought and sold in terms of those currencies… and wherever those interfaces occur, there will be the risk of fraud. 

Second, and perhaps more importantly, even Bitcoin’s theoretical invulnerability is ultimately a matter of hubris. Technical details aside, we can note that the integrity of Bitcoin’s ledger, the blockchain, is compromised at the moment a single actor has 51 percent of all the computing power deployed in support of the network (and potentially compromised well before that point). Radical technological innovation has been known to occur in human history -- who is to say when a computing revolution (such as quantum computing) might not suddenly make the blockchain’s computational integrity a thing of the past? And if, at that stage, the “market cap” of the Bitcoin universe had expanded dramatically, wouldn’t the inventor of such a technology have every motivation to use it clandestinely, leaching value out of the system?

And as far as encryption goes, the current public key standard relies on the mathematical intractability of factoring very large integers. But again, discoveries and innovations have been known to occur from time to time in the mathematical sciences. When will someone “break” public key encryption with a transformative development in the underlying mathematics? We don’t know. 

When we contemplate a monetary architecture with such distant but conceivably catastrophic threats, it begins to look less robust to us. 

Is Bitcoin Really More Robust? 

In fact, from this perspective, Bitcoin begins to look less distributed. Part of its appeal is the distribution of management across countless actors and computational nodes, which theoretically makes it less vulnerable to attack and manipulation. But it turns out that it is not vulnerable only where it intersects with the non-Bitcoin financial universe. It is critically reliant on a few technical and mathematical elements whose integrity looks unassailable -- for now. That reliance on a few pillars, someday, may make it look far less secure than it now seems in theory. The “messiness” of the world’s welter of fiat currencies and countless intermediators may begin to look more secure -- a chaotic system with surprising resilience that economic analyst Nassim Nicholas Taleb describes as “antifragile.” More opportunity for malfeasance -- but spread over more “critical elements.”

Furthermore, we think that most actors in the global financial system understand this intuitively, although they may not thoroughly grasp the underlying technical details. We believe this means that although Bitcoin is innovative and technologically interesting, it is not and never will be a looming threat to your investments in the financial sector.

Investment implications: Long-term investors in financials should not be overly concerned that Bitcoin is going to eat their lunch -- and investors with risk appetite looking for Bitcoin exposure should not overestimate the capacity of this technology to take significant market share from traditional financial intermediaries. On the other hand, elements of Bitcoin’s technology, such as the blockchain, may prove valuable -- so watch for startups that are implementing them.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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