by Stephen Stofka

This week’s letter is about the digital currency proposed in a 2008 paper penned by someone or some group writing under the pseudonym Satoshi Nakamoto. The two problems that Nakamoto’s proposal targeted have been mitigated by other means. That may explain why there has not been wider adoption of digital currencies as a transaction medium.

Although the idea of a digital currency has gained a fervent loyalty in the public, that was not the intended audience. As electronic payments became a greater share of global payments, chargebacks plagued both merchants and banks. By 2010 electronic payments were 8% of global payments. In a decade, they were an estimated 16%, according to a report from McKinsey and Company, the world’s top consulting firm.

The proposal was a method to “make non-reversible payments for non-reversible services” as Nakamoto stated in the introductory paragraph. I won’t dive into the details of the chargeback-to-transaction ratio but it was a much bigger problem in 2008. By 2017, the chargeback-to-transaction ratio was still 3.76% but has fallen to 1.52% by 2021, according to Midigator. I will refer interested readers to two reports published by Midigator, a subsidiary of Equifax, the credit reporting company. The first is the 2022 report on chargebacks and a 2020 explainer of the Rapid Dispute Resolution system used by participating banks and merchants.

The second problem the paper addressed was the minimum amount set by banks and merchants for debit and credit card transactions. In 2008, a common minimum was $5. Today, many merchants will process a transaction of less than $1. Apple routinely charges customers $0.99 per month for additional cloud data storage.

Cash payments solve a verification problem in transactions between strangers. Cash is a non-reversible exchange of money for goods or services. Transactions without cash involve some form of I.O.U. – a check or debit card, or a credit card. The customer gets the good or service. How can the merchant trust the customer’s I.O.U.? This requires a verification process of the customer’s identity and a commitment by a third party like a bank to pay the I.O.U.

The marginal cost to send one more email or one more http request to a web server is nearly zero. The spread of email in the 1990s exposed millions of people to dishonest actors who could send thousands of emails at little cost. A small number of computers could send thousands of counterfeit http requests to a server to overwhelm its resources in a Denial Of Service (DOS) attack. A countermeasure was to require a proof of honest intent by having the computer show some proof of work. An honest agent would do the proof of work to gain access to the server. Such a scheme would frustrate a dishonest agent trying to make repeated attempts to overwhelm a server’s resources.

Nakamoto proposed a currency based on a proof-of-work system rather than trust in a central agency. In a peer-to-peer network, verification is done by consensus. If each voter were defined as an IP address, a malicious actor could simply accumulate a lot of IP addresses then legitimate a fraudulent transaction. To combat that problem, Nakamoto proposed that a voter be defined by CPU, not IP address. Any actor who could amass enough computing power to defeat the system would find it more profitable to use that power to honestly make new digital coin.

Digital currencies have evolved beyond their original purpose. Nakamoto’s currency was designed to combat flaws in electronic payment systems that presented problems for merchants and bank intermediaries. Since 2008 the industry has developed other methods to reduce or resolve chargebacks and fraud. Meanwhile, Nakamoto’s proposal has become a favored security for some investors. Its adoption as a collectible like investment has introduced a pricing volatility that subverts its original purpose as a non-reversible payment, a digital form of cash.

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Photo by Bryan Goff on Unsplash

Keywords: Nakamoto, crypto  

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