Bitcoin Miners: The Hammer and the Butterfly

butterflyA federal judge has ruled that a bitcoin mining company based in Overland Park , Kansas, with the wonderful name “Butterfly Labs,” may re-open, at least for limited operations. The modification of the earlier order, on October 2, is the latest development in a case that opposing factions are watching for different reasons.

On the one hand, if you’re suspicious of the whole bitcoin ecosystem, you probably are happy to agree with the Federal Trade Commission that Butterfly is a crooked enterprise, and you think it symptomatic. On the other, if you’re an enthusiast of bitcoin, you may be inclined to think this a case of government prosecution run riot.

In either case, though, it should make us wonder when asset-freezing injunctions are a matter of smashing a butterfly with a sledge hammer.

Bitcoin mining

Bitcoin mining is a critical part of the bitcoin ecosystem. A senior economist for the Chicago Fed explained the process well in a “primer” he wrote about a year ago. Indeed he explained it so well that I will avoid the task of paraphrase and simply quote Francois R. Velde’s explanation at some length:

The problem that miners solve is roughly the following: Let block chain [the ledger of bitcoin transactions until the present date and the latest proposed transaction] be x, let the proposed added block be y, and let an additional number be n. The goal is to find n such that the resulting hash function … is less than a set value ?. The hash function is deterministic but so complex that the output seems random. It is therefore nearly impossible to guess n, and the only reliable method is to try out many different values of n (using computing power) until the condition is satisfied. … Part of finding n involves verifying that no bitcoin transacted in the block y has already been spent in the block chain x.

 

Much of the vocabulary that surrounds bitcoins mimics that which has arisen in the world of the precious metals, and replicates (in the digital realm) the wide spread conviction that sovereignty-based fiat money is a disastrously misguided institution, that old-fashioned metallic money (or at least metals backed money) was wiser, and that the latter has to be replicated in some fitting 21st century way. That is why the cryptocurrency is called a “coin” not a bill, and why it is “mined.”

Broadly, the system works this way. When Joseph makes a deal with Josephine, and sends a bitcoin from his e-Wallet to hers, the proposed transaction is broadcast to various other nodes within the bitcoin system, these miners. They have to do the math described above in order to validate the transaction, so Josephine gets her money. In the process of validating that transaction, the miners create new bitcoins for themselves.

It isn’t the bad sort of creation-out-of-nothing associated with printing presses and central banks, though. This is a good sort of creation. The energy that has to be expended in the computer calculations that validate a particular bitcoin exchange is analogous to the energy that would be expended by a drilling [or panning] operation obtaining gold. Further, the necessary calculation changes over time to limit the rate at which new transactions can be added to the chain, as well as to obey an overall protocol limit that there will never be more than 21 million bitcoins in existence.

FTC Charges

This brings us back to the business of Butterfly Labs. It sells drillbits, so to speak. It sells the computers that are supposed to help its buyers mine bitcoins.

The FTC alleges that it sells drillbits that it never then delivers, or that it delivers too late to be of use.

The FTC went beyond suing for the disgorgement of ill-gotten payments, though. It sought and received a temporary restraining order that put BF Labs out of business. This may have made the resulting situation worse for some aspiring miners. Their vendor wasn’t just guilty of non-delivery, but was prohibited from delivering, since delivering a computer after the issuance of the initial order would have been a violation thereof. The court order froze any assets in the “actual or constructive possession of any defendant.”

October 2d

The October 2d order modifies the earlier order (of September 18th) in important respects. It appoints Eric L. Johnson as temporary receiver for the business activities of the defendant, and it allows individual defendants to “perform work and/or consult” at Johnson’s direction or under his supervision. This work may include shipping achiness “already completed, tested, and paid for to customers who desire machines rather than refunds or rebates, under conditions acceptable” to the new temporary receiver.

The question going forward will be whether the Butterfly is a real business, or simply a sham. If it is a real business (even if it is one that has fallen behind on its orders, even if it is in blatant breach of a lot of contracts) then there is a case to be made that the federal authorities have already acted in a heavy-handed manner.

 

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