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TheDAO Hack: Basics of Bitcoin, Ethereum, and Futuristic Economies

An attempt to demystify first- and next-generation cryptocurrencies, and why you should care about the attack on TheDAO.

There’s a decentralized autonomous organization known as TheDAO, which runs on a next-generation cryptocurrency market called Ethereum, which was hacked and lost millions of dollars, effectively killing the organization.

If you don’t understand most of what I just said, or you don’t know why it’s totally fascinating, keep reading.

There was a time of heavy Bitcoin media coverage, which seems to have calmed. For a lot people this media coverage was their introduction to the notion of digital currency.

More recently there’s been some hype around Ethereum, which is in general harder to understand (not that Bitcoin is easy to understand), and can be thought of as an evolution of the Bitcoin system. Bitcoin is a first-generation cryptocurrency, Ethereum is a “next-generation” cryptocurrency.

The following is an attempt to engage people pretty much unfamiliar with the cryptocurrency movement, from the ground up. It’s designed for people without computer programming experience.

It’s going to gloss over details, make gross simplifications, and there are nuances that are ignored but important. In other words, highly technical users are going to have some gripes. But those gripes don’t materially change what these movements mean. I hope to produce a generally accurate essay that demystifies the novelty of these movements.

It also assumes that the current implementation of these ideas is actually being done effectively, which is highly questionable. However, effective implementations are not impossible, and I wish to convey the hype behind the movement without getting lost in those details.

“Bitcoin” (first-generation cryptocurrency ) Essentials

The United States government decides when to print dollars. The market decides how much dollars are worth.

I’ve been working hard my entire life, and have 10 million dollars when I retire. If the prices of food and housing don’t change, I’m in a good place. I can pull out $100,000 a year and live comfortably.

If there’s a natural disaster and there’s no food production, the price and availability of food will change. I can pull out $100,000 a year but maybe I still can’t eat. This is an act of God, there’s nothing that can be done about it.

If the government decides to print many more dollars, then each individual dollar is worth less (inflation). I can pull out $100,000 a year I still can’t eat, because the rest of the market has so many dollars that they’re not willing to sell me food for a mere $100,000. This is an act of government, I want to protect myself from it.

What if the market democratically decided when to print more dollars? This removes a central point of control from the monetary system, protecting individuals from the latter scenario.

Cryptocurrency is a way to implement democratic control of money supply. The market decides not only what money is worth (as they do with old-fashioned money), they also define what is and isn’t money (which the government does with old-fashioned money).

Bitcoin has a defined pattern of growth in its money supply. Everyone who participates in Bitcoin is voting to have Bitcoin behave like a physical mine of gold. When the gold mine is discovered, there’s a rapid injection of gold into the economy. As it gets mined clean, the rate at which gold goes into the economy dwindles until, given a long enough time frame, gold miners can’t get any more gold out of the mine.

There are alternative cryptocurrencies with different money supply patterns. If you choose to use these currencies, you’re voting to have your currency behave with that money supply pattern.

That’s why Bitcoin is exciting to people, particularly of libertarian flavor. They can remove a central point of failure in the economy (the government) while maintaining an usable form of currency.

The technology behind Bitcoin and all other cryptocurrencies is called the “blockchain”. Blockchain technology allows everyone in the market to democratically validate economic transactions. In conventional currency markets, only a central authority validates transactions.

A dollar is valid because the government created it. A crypto-coin is valid because a majority of the community has checked that it’s valid, and agrees.

Ethereum (next-generation cryptocurrency) Essentials

Bitcoin lets a community perform, in essence, the following operation:

  1.    Alice has 10 bitcoin. Bob has 0 bitcoin.
  2.    Alice gives Bob 10 bitcoin.
  3.    Alice has 0 bitcoin. Bob has 10 bitcoin.

When I say the “community performs” this operation, I mean this transaction only happens if the majority of the community agrees that (1) is true, then agrees that (2) is true, and then afterwords they will have concluded (3).

Ethereum is a technology that allows more flexible operations to happen as long as the community agrees on the operation. In fact, Ethereum permits any operation.

For example, Alice could put conditions on the coin she gives Bob. She could make the coin act like a stock, or a bonds, and this would only be valid if the community agrees that it is valid. In other words, Ethereum improves upon Bitcoin by allowing the formation of complex securities, not just currency.

But Ethereum can do even more than that. Instead of Alice having an account, you can create an account that’s owned by a company. The company will perform actions that are described by rules proposed by the founders, and agreed upon by the community. This agreement happens through blockchain technology.

In the real world, a company acts by rules decided by its board, and people who invest are at the mercy of the decisions of the board. If the board breaks its rules, the recourse is a lawsuit.

In Ethereum, a company acts by rules agreed to by the entire market (but proposed by its founders), so the people who invest in the company are not at the mercy of the board of the company. The company can only perform an action that is different than its agreed upon rules if a majority of the entire market agrees that it should be able to do so. It is impossible for the company to break its rules.

Such a company is a Decentralized Autonomous Organization (DAO). It is decentralized because its behavior is enforced by the consensus of the entire market, not the board of the company. If this sounds absolutely absurd, remember that a single person can submit rules for the company that allow it to make decisions as if that person was the CEO of the company. You can implement conventional corporate structures on Ethereum as well as unconventional democratic structures. The distinction of the DAO is that those rules are then enforced by computer code, not by a judicial system controlled by a central government. And they’re not enforced by threat of punishment, they’re enforced by making it actually impossible to break the rules unless the community allows it.

Why are these cryptocurrencies exciting?

As currencies, the success of Bitcoin and Ethereum depend on the stability of their value in relation to physical goods. If you care about removing centralized control of money supply, you should be interested in the performance of BTC and ETH on exchanges with conventional currency.

As a market platform, the success of Ethereum depends not only on the stability of ETH (the currency underlying the market) but also the stability of any organizations created in the market. If decentralized organizations don’t prove to be safe vehicles of investment, or reliable creators of value, then we won’t be able to create an economy enforced by code rather than law. If you care about removing centralized enforcement of contracts by the use of force, you should be interested in the performance of DAO securities on Ethereum.

Note that DAO’s provide a vehicle for corporate structures that distribute ownership among all stakeholders in a codified, equitable manner, without the risk of a board revoking and modifying this ownership distribution. This should be enticing to anyone with anti-capitalist tendencies. It’s also enticing to anyone with libertarian tendencies, by nature of removing government intervention in the free engagement and disengagement of economic transactions. You don’t enforce contracts and avoid fraud by introducing violence – you do so by making it impossible to break contracts unless a majority of the market chooses to allow it.

TheDAO Hack on June 17th 2016

Ethereum was launched on July 30, 2015. By May 2016 the aggregate value of “ether”, the Ethereum coin, was over 1 billion USD.

TheDAO is one of the first large attempts to implement a decentralized autonomous organization on Ethereum. TheDAO was launched in April 2016. By May, it had attracted more than $150 million of investment. It accumulated around 14% of the total capital in the Ethereum market.

On June 17th, it was discovered that the contracts that binded the behavior of TheDAO allowed an attacker to funnel money into a separate organization with different rules, effectively stealing large sums of money (~53 million USD) from TheDAO investors. This is not a flaw in Ethereum – the network behaved as it should have. It was a flaw in the formation of TheDAO, where investors who could read the contracts they agreed to were unaware of its implications. Note that the attackers did not actually break any rules here – they merely exploited a consequence of the rules that investors were not aware of.

All is not lost. By the construction of the “child DAO” (the new organization created by the attacker), the capital is stuck there for a few weeks. In the meantime, Ethereum developers have proposed a bailout in the form of a software upgrade. The new software will invalidate all of the stolen capital, so the attacker does not walk away with any profit. They will then release another upgrade which returns the lost capital to the original investors. This effectively undoes the attack, except for the lost trust.

However, the Ethereum developers can not single handedly alter the terms of the market. It is a decentralized platform, so in order for these bailouts to work, the majority of the market participants to download the upgrades and agree to use them. There’s some debate in the Ethereum community about whether participants should implement these upgrades, because doing so reflects being persuaded by a centralized force to bailout a failed investment vehicle. This mirrors the action that many early participants found discouraging about conventional economies, although in this case, the bailout is actually being done democratically.

This attack was not a complete surprise to everyone in the community. Researchers at Cornell studied TheDAO contracts and raised concerns about this sort of attack, but it was not enough to steer clear of TheDAO crash. This sort of vulnerability is guaranteed to shake investor’s trust in DAOs in general. There’s calls within the community to work on formal proofs for Ethereum contracts, so that instead of relying on human analysis of code, investors can prove for certain that different types of attacks are impossible. It’s not clear to what extent proofs can cover different kinds of attack.

In any case, it will be fascinating to watch how the community responds to the attack. We’re watching how financial crises are mitigated in decentralized economies, and the parallels between the market’s reaction to these crashes and government reactions to conventional financial disasters are fun to play with.

Further Reading:

Bitcoin Paper
Ethereum White Paper

Hacking Distributed Reflections on the DAO Hack