Adam Knott

Notes on Bitcoin




These notes have been provided by Adam Knott as a contribution to the debate on Bitcoin and as a clarification of some essentials points that have been, among others, the driving reasons for the introduction of this new and very interesting means of payment.



There has been a lot of discussion and debate about Bitcoin recently, but relatively little discussion about the merits of Bitcoin as a payment system. A better understanding of Bitcoin requires that we understand something about the original problem that Bitcoin was designed to solve.

Below this article I’ve pasted the first two introductory paragraphs written by Satoshi Nakamoto explaining the original intent of the Bitcoin payment system.  I've bolded the phrases that refer to “trust” and “nonreversibility.”  In his two opening paragraphs, Nakamoto refers to the idea of the “trusted third party” six times and to idea of “nonreversibility” four times.   As is clear, Nakamoto’s intent was to design a payment system that eliminates the middleman in an exchange between two people, and that therefore prevents the possibility of the middleman reversing the transaction. Bitcoin was designed to solve some specific problems that arise in Internet commerce.

For those who may not be actively involved in running a business that depends on third-party payment processing, the problem that Nakamoto proposes to solve with Bitcoin is an important problem not only from the point of view of commerce, but also from the point of view of libertarian contract theory.

Third-party payment systems such as Visa, Mastercard, American Express, and PayPal, act as a middleman when a customer makes a purchase from a merchant.  When a dispute arises, the payment processors may resolve the dispute using its own judgment, criteria, and procedures, in disregard of the contract that may have been agreed to by the customer and merchant.  For example, the customer and merchant may agree that the current transaction is a “final sale” and that no returns will be allowed.  The transaction occurs and the customer receives the good or service in question. Upon receiving the good or service, the customer then changes his mind and demands a refund.  The merchant refuses to process a refund, so the customer appeals to Visa or PayPal asking for a reversal of the payment. In effect, the customer asks the third-party payment processor — who ultimately controls the debits and credits — to force the merchant to issue a refund.  The payment processor (Nakamoto’s “trusted third party”) may in this case reverse the transaction and grant the customer a refund regardless of the contract that had been agreed upon by the merchant and customer. 

Essentially, the “trust-based” or “third-party-based” payment processing systems (Visa, PayPal, etc.) are not bound to enforce contracts between trading parties.  Since the third-party payment processor cannot be trusted to enforce a contract between trading partners, the parties to a trade must incur additional — and often high — costs, in an attempt to ensure that the trade is executed according to the terms of the contract. The parties must either meet face-to-face and conduct a physical exchange, or they may transact electronically and then seek to enforce the contract through the court system when one of the parties reneges on the contract .  “Trust-based” payments effected by a middleman who is not bound to enforce the contract between trading partners are inherently risky and uncertain. The middleman may at any time and for any reason reverse the payment regardless of the contract between trading partners. This is the important commercial problem Nakamoto’s Bitcoin system addresses.  The Bitcoin payment system also drastically lowers the cost of payment processing (the amount merchants pay to Visa or PayPal). For example, a small merchant can expect to pay between 2.5% to 3.5% of sales in payment processing fees. If a small merchant has monthly sales of $50,000, a typical payment processing fee could be $1,400 per month or $16,800 per year. By contrast, Bitcoin transaction fees are negligible.

What if we were to conduct a survey of all merchants who depend on third-party payment processors and ask them whether they would be interested in a payment system with virtually no processing fees and no possibility of charge-backs (payment reversals)? Many of the academics and social theorizers who are debating the merits of Bitcoin likely have little experience with the costs, problems, and limitations associated with payment processing in Internet commerce. They don’t understand the very real and important commercial applications of Bitcoin and how Bitcoin radically reduces transaction costs thus furthering free trade. Regardless whether the specific project Bitcoin ultimately succeeds or fails, we can be assured that demand for the services Bitcoin was designed to provide will remain. If Bitcoin fails, then other payment processing technologies along the same lines will be attempted, since the Bitcoin experiment has demonstrated the potential to radically reduced transaction costs for all merchants involved in Internet commerce. Market demand for a payment processing system that reduces transaction costs and enables irreversible payments constitutes market demand for the various components of such a system. Thus, it is easy to understand why individual Bitcoins, as components of a valued payment system, may themselves be individually valued. In discussing and theorizing about individual Bitcoins, we should keep in mind the Bitcoin payment system of which they are a part, and the important advance in Internet commerce that Bitcoin represents.



Bitcoin: A Peer-to-Peer Electronic Cash System - Satoshi Nakamoto - 1


Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non-reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.

What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers. In this paper, we propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.



Selected Documents on Bitcoin (in chronological order)

Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System (24 May 2009)

Jon Matonis, Why are Libertarians against Bitcoin (26 June 2011) [Blog: The Monetary Future]

Eric Voorhees, Bitcoin - The Libertarian Introduction (11 April 2012 [Blog: On Life and Liberty])

Jeffrey Tucker, Bitcoin for Beginners (2 April 2013) [Foundation for Economic Education]

Maria Bustillos, The Bitcoin Boom (2 April 2013) [The New Yorker]

Felix Salmon, The Bitcoin Bubble and the Future of Currency (3 April 2013) [Blogger at Reuters]



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