Why a fiat based blockchain is impossible

As Ecuador is preparing legislation to outlaw decentralized digital currencies, such as Bitcoin, it is also pursuing a quest of implementing its own digital currency, which, as they self stated, should be under government control backed by real assets. In essence, what they say is that they want a fiat based ”bitcoin”. I’ve touched this topic before and I firmly stand by my argument that this will be an impossible task, no matter what the modus operandi is.

I was recently interviewed by Rick Falkvinge on this topic, but in this posting I’ll try to reiterate my arguments in more detail why this is an impossible task; the government of Ecuador will utterly fail despite their vanity of creating such a digital currency.

Fiat is a latin word which means ”it shall be”. In the context of money it means that monetary units can be created out from nothing. The purpose of fiat money is to match money supply with real assets / work which are exchanging hands.

It’s important to understand why Bitcoin (the currency and the network) works. The first important concept is that the Bitcoin network is an open network. Anyone (with a computer and software) can connect to this network without asking for permission. Open networks are superior over closed networks for a number of reasons. The two most prominent I can think of are:

  • It provides a platform for innovation; the number of developers that can contribute is enormous.
  • It provides cheaper transactions, because competition is fierce.

One of the aspects of the Bitcoin network is the beautifully defined reward mechanism. Inflation (through increase of the money supply) is totally deterministic in time, and totally non-deterministic in space. What it means is that we know by definition that around 25 bitcoins are created every 10 minutes, but we have no idea whom those bitcoins will be given. Therefore, there’s no central point of control where new money is being created. Any so called ”miner” (a.k.a transaction verifier) that contributes with its computing power has a chance of ”winning” those 25 bitcoins, and every 10 minutes there’s a new chance of winning.

Suppose we break this fundamental rule for which a central bank (predictable in space, but non-predictable in time) has the ability of creating new monetary units to be added to the blockchain. Then suppose this process is called X and I will show that regardless of what X is (e.g. a secret set of private keys, some special designed hardware, a secret set of multi-sig keys, …) the designed currency will fail at some point in time.

Why? The problem is that X needs to be kept secret in conjunction with an open network (so anybody can perform transactions). If the network is not open then the concept of a ”digital currency” degenerates to what we already have today with bank accounts and credit cards.

The problem is that if the secret of creating new money X leaks, then any one on the open network will be able to create money on demand, and the currency collapses. The difference with the traditional fiat world is that counterfeiting physical banknotes is very difficult, but once a hacker figures out process X (either a priori or through an insider at the central bank), then the currency is bust. As a merchant, you simply cannot accept a currency that has a very high risk to be completely bust (and it’s just a matter of time when that happens).

To be more concrete, let’s speculate on X for a bit so you’ll see how difficult this is. One of the more promising aspects would be a multi-sig private key to create money from, so that the board of directors of the central bank needs to summit in order to create new money. You could imagine a majority rule of some sort (so not all need to be present, e.g. in case someone must call in sick). The problem with this is that staff needs to be replaced, so therefore there must be a way of creating new multi-sig private keys. The next question then becomes: what is the condition that defines a legitimate multi-sig private key? So now that becomes the weakest link for a hacker to attack. If you ponder for this a little bit more, you’ll realize that there’s simply no way out. If you have a privileged group of people who is supposed to know a secret X, it doesn’t matter modus operandi what X is, because that secret will be broken sooner or later. Once that happens, the currency will default (because an infinite number or a very large number of monetary units will be created out of nothing).

In contrast, Bitcoin doesn’t have a weakest link. It’s beautifully designed through the concept of a strict 51% majority vote. By solving the so called General Byzantine’s general problem, it means that the entire protocol and design is resistent from bad crooks manipulating the network. As long as the number of bad crooks is lower than 50%, then any attempt to manipulate the network will fail. These rules are set in stone. The network protocol can be changed, but it requires 51% majority and of course, that existing majority will naturally never allow any change that will diminish their monetary power. Thus, the money supply will remain fixed through a market cap of 21 million bitcoins; forever.

To conclude this discussion: If the Ecuadorian government ever reads this: your attempt of creating your own digital currency will fail, at least if that currency should be based on an open blockchain network. You are already using a foreign currency as your national currency. My warmest advice to the Ecuador government is to switch from one foreign national currency to another; from the U.S. dollar to Bitcoin. Once you realize that your quest is a hopeless task, perhaps this is a backup plan to consider.