How to Increase Public Confidence in Bitcoin Exchanges

Digital currency exchanges have faced some trying times of late, with lawsuits due to negligence, closures because of regulatory pressure and collapses brought on by outright theft. All of which have fuelled the bitcoin media frenzy in recent weeks.

With so much dour news, what is the best way forward for the bitcoin industry? Are there methods to prove that an exchange has the asset holdings that it claims?

In fact, there are ways to verify this vital information, but implementing them will be a challenge.

Lack of disclosure

When doing business with a digital currency exchange, events like those mentioned above mean it is getting more difficult to entrust your bitcoins to hosted wallets and mysterious accounting structures.

Furthermore, to protect their interests, most exchanges do not disclose this sort of information.

Proprietary business knowledge is important to protect, of course, but surely transparency would be a better safeguard than a damaging leak, as seems to have happened with Mt. Gox.

There are certainly worthwhile digital currency exchanges that are trying to move bitcoin in a positive direction, but there have been far too many that have had serious problems.

Fiat currency institutions are not immune from all this, of course – payment card issuers, merchants and acquiring banks lost $11.27 billion to fraud in the calendar year 2012.

However, given the issues surrounding decentralised digital currencies, criminals are looking to profit within this environment. It's low-hanging fruit versus the highly regulated banking industry's estimated $1 trillion in IT spending year-over-year in the United States alone.

These problems permeate the mind and create a degree of uncertainty and mistrust concerning the industry. So, what can be done?

Public transparency

Proving legitimacy within the digital currency industry is becoming ever more important. When Bitstamp conducts audits and Coinbase allows a third party to review its infrastructure, this creates positive sentiment that there are people in the bitcoin sphere doing things correctly.

Jaron Lukasiewicz is the CEO and founder of Coinsetter. The company is an exchange and has a trading platform that links in with other exchange APIs.

Lukasiewicz has been gathering consensus about adopting a public transparency system. Coinsetter's goal is to enable proof. Said Lukasiewicz:

"You can prove that you have a total amount of assets on the one hand and then prove or demonstrate the balance."

'Trustless proof' of solvency gives exchange users a way to confirm that an exchange is doing what it says. It's influenced by Gregory Maxwell's proposal of 'nodes', which has seen increased interest over recent weeks.

Lukasiewicz explains the idea thus:

"What would happen is no one would ever know who a person is. They will benefit from cryptographic proof that shows their 10,000 BTC, for example, is theirs. I think any sort of downside is outweighed by the potential upside."

Many exchanges are doing the right thing, but Coinsetter wants to go even further. Lukasiewicz is hoping that other exchanges will see the significance of an initiative like this.

"No one would give up privacy in the interest of assets. All I know is what we’re doing, but my hope is that other exchanges [will] do it," he said.

Smart contracts

One problem with public transparency is that while it does provide information, how can you tell if the data you are getting is accurate?

Perhaps public transparency is only part of the equation. Smart contracts could further benefit everyone and are integrated within the Bitcoin protocol itself.

What a smart contract would do is guarantee users the existence of funds. When it comes to the US dollar and traditional banking, it is understood that the system is based on the backing of the federal government.

Bitcoin lacks a third party in the form of a powerful financial institution, so legitimacy may require reliance on some sort of cryptographic contract.

There are a number of efforts currently under way to provide smart contract concepts in some alternative digital currencies. However, employing this type of safeguard within bitcoin might be the most important goal for influencing adoption as a whole.

The banking industry is one sector that needs to see the iterative potential of digital currencies. Innovation in bitcoin would be one way to prove that the protocol can better adapt to the needs of the people than fiat currencies.

Mike Hearn, who oversees development of the bitcoinj Java client, has said that overall bitcoin development is falling behind, attributing the problem to fewer people putting in effort to move things forward.

Lukasiewicz agrees, and said that one of the reasons why he started the conversation is the lack of one right now:

"Bitcoin as a protocol, it’s had additions, it’s had fixes, but it hasn’t innovated on some of the more novel but very important things."

Inherent risks

No matter if it is credit cards, banking or bitcoin there are always financial risks. Even transparency can come at a cost, because more information is being given out to those who may want to intrude and steal.

New ideas like security crowdsourcing are helping to combat this. The startup CrowdCurity, for example, brings more eyes to application-level security in the form of rewards-based incentives.

However, no matter how much is spent on securing a system, someone will always be there to try to get in. Just ask the banking industry.

Not everyone will like the idea of public transparency and/or utilizing smart contracts within bitcoin exchanges. Those uncomfortable with such ideas may simply go elsewhere.

When presented with that notion, Lukasiewicz couldn't deny that people will always have options, but he contends that the expectation of privacy within this system is part of the plan. As he explained:

"People would probably go to other exchanges, but what I would say is that all the initiatives we’re looking to implement are anonymous. No one would give up privacy in the interests of assets."

That is, at least, an improvement over the services existing financial providers offer.

Difficult choices image via Shutterstock