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The People Who Burn Bitcoins


A new project called Counterparty is leveraging the technology behind Bitcoin to decentralize financial instruments.

In January, in one of the lesser-known corners of the Internet, people were burning bitcoins. Depending on where you pegged the price, anywhere from $1.6 million to $2 million worth of the digital currency was effectively destroyed, and a website called was stoking the coals. Run by a group of anonymous developers, Counterparty was distributing a newly created digital currency in exchange for bitcoins.

Except Counterparty wasn't actually accepting the bitcoins people sent them. Not a single one. Instead, these bitcoins were being delivered to a special online wallet that rendered them provably and permanently unspendable -- a process known as proof-of-burn. To those who called involvement in the fledgling Bitcoin industry foolish, the team behind Counterparty appeared downright nihilistic. But to those paying close attention, Counterparty had just kicked off Bitcoin's second act.

Bitcoin 101

It's important to note the difference between bitcoins -- what we're referring to when we say "that couch costs three bitcoins" -- and Bitcoin the technology. Bitcoin the technology is a way to transfer ownership of digital tokens (bitcoins) from one party to another directly over the Internet without using a third party. In traditional e-commerce, a bank or payments processors must act as a trusted third party to transfer money between consumers and businesses conducting transactions online. By using bitcoins, these two parties can avoid high transaction fees levied by traditional third-party processors. In this way, bitcoins effectively act as electronic cash.

Bitcoin forgoes the need for a traditional payments processor by using a distributed transaction ledger called the blockchain. The blockchain is a running record of every bitcoin transaction ever made, and it's constantly being updated by a global network of people called miners. Miners use computers to update the blockchain with new bitcoin transactions, which requires them to dedicate computing power. In exchange for their efforts, miners are rewarded new bitcoins. This mechanism is called proof-of-work, and it incentivizes people to keep the blockchain up to date, allowing bitcoin transfers to be completed while increasing the total supply of available bitcoins. Many alternate digital currencies, called altcoins, use the same proof-of-work mechanism.

While Bitcoin was developed as a payments tool, the blockchain can be used to store information that doesn't pertain to the ownership of bitcoins. What the Bitcoin technology really offers, then, is a way to transfer any kind of ownership in a decentralized way. This is the innovation that the Bitcoin 2.0 movement is attempting to build on.

Counterparty belongs to a movement of entrepreneurs and investors attempting to move the Bitcoin industry beyond online payments. If you compare the technology behind Bitcoin to the Internet, digital currencies are like the first websites. They're new and neat, but their practical uses are limited. The Internet's truly disruptive applications -- think Google (NASDAQ:GOOG), Amazon (NASDAQ:AMZN), and Facebook (NASDAQ:FB) -- came many years after the idea of sharing information over a network of computers was cooked up. The goal of Bitcoin 2.0 companies is to use the technology behind Bitcoin to decentralize all different types of assets, contracts, and even corporations. Projects such as Mastercoin, Ethereum, Colored Coins, Ripple, Next, and BitShares -- run by developers who could be anywhere in the world -- are all competing to launch Bitcoin 2.0 platforms this year. Counterparty is the first to deliver.

"The Internet was the democratization of information, Bitcoin was about the democratization of money, and Counterparty and projects like it are really about the democratization of markets," Xnova, one of Counterparty's anonymous developers, tells me. He and another anonymous developer, PhantomPhreak, began building Counterparty last November. (They chose to remain anonymous because they believed in putting their project in front of their names; there were also legal implications to what they were building.) They wanted to create a way for entrepreneurs and investors to trade financial instruments in a decentralized way. Bitcoin's distributed transaction ledger, the blockchain, offered a few advantages. It can be embedded with information unrelated to bitcoin transactions and is constantly being updated by a global network of miners. And, because it's decentralized, the blockchain operates outside of any jurisdiction. As long as the blockchain remains secure, so does Counterparty.

In a month and a half, Xnova and PhantomPhreak built what they call a peer-to-peer distributed financial exchange. It allows anybody to create and issue assets on top of the blockchain and pay dividends to holders of those assets, too. Users can also create and trade derivatives on Counterparty, as well as conduct bets. This, Xnova explains, would support the creation of prediction markets, which are currently outlawed in the US. All orders made on Counterparty are imbedded directly into the blockchain, which means there are no central servers processing Counterparty's buy and sell orders. As bitcoin transactions are confirmed, so are Counterparty transactions. Counterparty didn't invent the idea, but as of this writing it's the only platform allowing people to use financial instruments that function on top of Bitcoin.

For the past several months, users were only able to complete these processes through a back-end terminal that even a skilled programmer might find difficult to use, let alone the average investor. But with the launch of a user-friendly interface called Counterwallet on April 6, the platform is now positioned toward adoption by a broader audience. The newly created application, pictured left, will let users trade and hold all of their assets in one place -- no computer science degree required.

To operate the platform, the team behind Counterparty created a native digital currency called XCP. Xnova calls it Counterparty's "first-class citizen." A small amount of XCP must be used to create a new asset, a measure to prevent spam. All bets must be made in XCP. All callbacks on callable assets must be made in XCP, too. Since Counterparty can't function without XCP, it ultimately represents the value of the network. The same couldn't be said for bitcoins if they were used in XCP's place, since the value of a bitcoin is determined by far more factors than its relevance within Counterparty. And so, on January 2 the 30-day burn period commenced, in which people interested in Counterparty's project elected to send 2,140 bitcoins to an unspendable address in exchange for a total of 2.6 million XCP. Since then, XCP has been available to purchase with bitcoins on Counterparty, as well as on a few digital currency exchanges. 

Proof-of-burn is an unconventional approach to creating a digital currency. Many altcoins are created in the same way bitcoins are: through a proof-of-work mining scheme. Other altcoins are issued through what are called crypto-IPOs, where developers sell their newly created digital currencies in exchange for bitcoins. The developers behind Mastercoin, who've built a tool on top of the blockchain similar to Counterparty's, raised $5 million worth of bitcoins in a 2013 crypto-IPO.

With the potential for collecting such high sums, Counterparty's approach can appear perplexing. "It's like a startup saying if you want to invest in me, go burn a million dollars," says Daniel Larimer, founder of BitShares, a competing Bitcoin 2.0 organization that's focused on reinventing Bitcoin as a profitable company. "You're destroying capital. Counterparty benefits Bitcoin by burning bitcoins because it's reducing the money supply. But there is no benefit to [Counterparty], and there is no revenue."

However, Xnova says his team has two good reasons for using proof-of-burn. One is practical: There are legal risks with an initial public offering because the Securities and Exchange Commission could prosecute it as an unauthorized IPO. The Bitcoin 2.0 project Ethereum, which is creating a programming language for decentralized applications to operate on a blockchain-like distributed network, abandoned its original crypto-IPO plans because of this risk. By burning bitcoins instead of accepting them in exchange for XCP, Counterparty avoids the potential legal problems with fund-raising.

And then there's the ethical reason.

"We believe that this is a much fairer way to initialize balances," Xnova says. "We wanted to produce a technology and give people a way to participate that's fair, and as developers we feel we're on the same level as they are. In order to see a gain from my technology, I need to be there on the same level as everybody else. People took a chance by investing their bitcoins, and so they were rewarded with XCP. But XCP has very speculative value. ... We wanted the fund-raising to be seen as kind of beyond reproach and not tainted with potential issues [around] the fund-raising. We want to keep integrity high because that drives confidence in the platform."

And to those who still can't shake the fact that Counterparty threw away 2,140 bitcoins, Xnova argues that when compared to the total number of bitcoins that can potentially be mined (21 million), the burned sum is like "a flea on an elephant's back."

Already, those burned bitcoins are being put to use. Adam B. Levine is one of the first entrepreneurs using Counterparty to launch a new kind of digital asset. Levine is the editor-in-chief of the Let's Talk Bitcoin podcast network and a senior fellow with the Bitcoin Education project. He has an ambitious plan to turn Let's Talk Bitcoin into a 24-hour news source, and he wants to use a token called LTBcoin to fuel its economic engine. "In a nutshell, most [digital currencies] out there are basically trying to solve the same problem," Levine says. "That is to say, 'OK, we'd like to have trustless, decentralized transactions using a token that doesn't have to pay attention to artificial boundaries or geographic locations.' Bitcoin does that, and so does every other altcoin out there."

LTBcoins, which Levine created using Counterparty, will be used to pay contributors providing around-the-clock content -- including articles, videos, and more podcasts -- to the Let's Talk Bitcoin network. Advertisers and sponsors who want exposure to (what will hopefully be) a larger audience can purchase ad space as they normally would, with one exception: They can only buy it using LTBcoins. This creates an ecosystem where advertisers drive demand for LTBcoins and contributors provide supply. Levine explains that as the Let's Talk Bitcoin network gains in popularity, advertising space will become more popular, and contributors will be able to sell their LTBcoins to advertisers at higher prices. Let's Talk Bitcoin will then cycle LTBcoins back into the system by paying contributors. There will also be opportunities for fans to tip deserving authors in LTBcoins or acquire the currency by performing actions that add value to the network, like commenting on stories. Anyone can also just buy LTBcoins on Counterparty and treat it like a speculative asset.

"We're paying someone with a token that doesn't start off in value, but represents the entire value of the network," Levine says. "We're starting from zero, but it's easy to go up a couple of hundred percents from there. It's about finding value in a specific ecosystem, which is difficult to do now. But with something like [Counterparty] you don't need to create a new altcoin. You don't have to have miners. You don't have to have a completely separate ecosystem. It can simply be an ecosystem that lives inside the Bitcoin ecosystem."

Levine's isn't the only venture utilizing Counterparty to create new kinds of digital assets. The Bitcoin Tangible Trust is seeking to issue a gold-backed asset that effectively acts as a token for gold that the trust holds in escrow. This token can be traded as an asset on Counterparty and redeemed for physical gold by its owner. Bitlance is a online freelancing company that has issued shares as Counterparty assets, but it won't begin selling those shares until the company becomes profitable and can issue a dividend. Then there's the Permacredits project, which aims to support the global permaculture movement's goal to create sustainable economic ecosystems that respect and nurture the environment. Permacredits will be issued using Counterparty and exchanged for bitcoins, which will be used to fund permaculture-related start-ups. To close the loop, these projects will only be able to accept permacredits in exchange for their goods.

"The whole purpose of Counterparty was to create a platform that people could build on, and in doing so create value," Xnova explains. "Permacredit isn't just another altcoin. It's got substance behind it and that's the kind of thing we want to see being built."

These projects mark the beginning of what one might imagine could be a whole new world of possibilities. But while Counterparty is a first mover in the space, it's soon to be joined by the projects already mentioned in this story. The first should be Mastercoin, which in the next few months will add the ability to create and trade assets on Omniwallet, a platform that offers similar functionality to Counterwallet. "Right now there is a very, very simple transaction type in Bitcoin, basically sending people money," says Dominik Zynis, head of communications at Mastercoin. "One of the cool things with these protocols is [that], at least for digital goods, we can build in a way of transferring value between two or more parties in a very secure way."

"I think that it's important for people to realize that there will be incremental innovation steps over time," Zynis adds. "Let's say 10 or 20 of these steps later, 10 or 20 years from now, the technology based off this will blow people away."

Twitter: @brokawbrokaw
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