Burn a Million Quid: the Rationale Behind Hacken’s Burning Principle


Burn a Million Quid: the Rationale Behind Hacken’s Burning Principle

It was morning on August 23rd, 1994 as one of the most expensive bonfires in the modern history of humanity burned in an abandoned boathouse on Jura Island of Scotland’s Inner Hebrides. The firestarters were Bill Drummond and Jimmy Cauty or The KLF — one of the UK’s most successful pop bands of the early 1990s. The fuel was £50 notes, in total worth around £900,000. It took 67 minutes for all the notes to burn to ash. In 2004 Bill Drummond admitted his regrets of burning the money in an interview to BBC.

Bill Drummond and Jimmy Cauty of The KLF. Courtesy:
Bill Drummond and Jimmy Cauty of The KLF. Courtesy: Weirdestbandintheworld.com.
This Photo originally appeared in Details magazine, 1991.

More Egalitarian Form of Philanthropy

There is still no better explanation for the KLF money burn other than the band’s never ending quest for originality. However, the burning, as well as any other form of destruction of the modern fiat money, might not seem so absurd when you get down to it. It naturally causes deflation of the currency that was burned.

According to The Armchair Economist, the book by Steven E. Landsburg, professor of economics from the University of Rochester, United States: “burning one’s fortune (in paper money) is a form of philanthropy more egalitarian than deeding it to the United States Treasury.”

For centuries money was a commodity that had real value expressed in the amount of the precious metal it contained. The situation changed dramatically in Europe with the invention of paper banknotes in the 17th century.

Paper Money and ‘Wallpaper Money’

Johan Palmstruch was a Dutch financier who helped establish Stockholms Banco, the precursor of the modern central bank of Sweden. Palmstruch faced criminal charges for financial fraud and narrowly escaped the hangman’s noose after miscalculating the amount of paper-based credit notes he had to repay.

Swedish Credityf Zedels or the first paper money in Europe
Swedish Credityf Zedels or the first paper money in Europe (1666).
Courtesy: Wolfram Weimer,
Geschichte des Geldes, Insel-Verlag, Frankfurt, 1997.

Since the Palmstruch moment, the face value of fiat money has been increasingly disconnected from their commodity value. However, no more bankers were imprisoned for this reason. The phenomenon peaked in the Weimar Republic. After Germany’s defeat in the WW1 it had to pay huge reparations as compensation to Allied Powers. Reparations caused hyperinflation. In November of 1923, the US dollar was worth 4,210,500,000,000 German marks. Using these banknotes as fuel or wallpapers was more economically justified than using them as a payment instrument.

In 1923 Germany banknotes had lost so much face value that they were used as wallpaper because it was cheaper than actually buying a wallpaper
In 1923 Germany banknotes had lost so much face value that they were used as wallpaper because it was cheaper than actually buying a wallpaper. Courtesy: Bundesarchiv Bild 102–00104 / Pahl, Georg / CC-BY-SA 3.0, discovered via Wikimedia.

Lessons of Hyperinflation

What was going on with the Deutsche Mark in the 1920s can be explained by inflation and volatility. Inflation existed even before paper money was introduced. In the times of gold ’n silver money, the sovereign issuing them could still dilute the coins made of precious metals with metals of a lesser value while continuing to claim a ‘pure’ face value. The resulting profit owned by the sovereign who issued these money is called ‘seigniorage’.

However, when the fiat paper money was introduced, they ceased to have substantial commodity value and it was now only a matter of trust between the sovereign, or the central bank, issuing them and ‘the subjects’ or participants of the financial system that was the realm of this money. Subjects had to trust the face value of money issued by the sovereign. Hence, the term “fiat”, standing for “let it become” in Latin.

The Chinese Yuan dynasty money are believed to be the first fiat paper-based money ever issued in the World
The Chinese Yuan dynasty money are believed to be the first fiat paper-based money ever issued in the World. Courtesy Wikipedia user PHGCOM, the photo was made at Tokyo Currency Museum.

Besides the natural economic causes of inflation, some governments like the one in the Soviet Union, preferred to print new paper money each time they needed more. Thus the trust between the sovereign and the financial actors was broken, inflation became more volatile, ultimately resulting in economic collapse.

In market driven economies, inflation and currency volatility became more complicated after three events that happened throughout the century. In 1871, Western Union introduced wireless money transfer, thus substantially increasing the mobility of money. In 1944, the Allied states of WW2 signed the Bretton-Woods Agreement, thus establishing the new global monetary order. Finally, in 1971 US president Richard Nixon unilaterally terminated the convertibility of the US dollar to gold, thus rendering the dollar a fiat currency.

A Currency That is Worth Less than Jeff Bezos

In 1981 David Lee Chaum, a computer scientist and cryptographer from UC Berkeley published a paper titled Untraceable Electronic Mail, Return Addresses, and Digital Pseudonyms. The paper pioneered the use of digital currency based on cryptographic algorithms. In 1990 Chaum founded DigiCash in Amsterdam, The Netherlands to commercialize his ideas. In 1998 DigiCash filed for bankruptcy.

In 1991, Stuart Haber and W. Scott Stornetta, both working for Bell Communications Research, Inc. or Bellcore, published a paper titled How To Time-Stamp a Digital Document. The paper explained a technology that would later become known as blockchain.

However, the general public didn’t really care for cryptocurrencies until 2008, when a mysterious author or collective of authors titled ‘Satoshi Nakamoto’ published a paper titled Bitcoin: A Peer-to-Peer Electronic Cash System. As of January 2017, the size of the blockchain database maintaining Bitcoin was 100 GB and roughly 16M bitcoins were in circulation.

With the current historical peak exchange rate of 4,950.72 USD per 1 BTC as of September 1st, 2017 the total volume of the bitcoin economy is roughly $79B. Frankly, this amount is trivial compared to the global economy. The net worth of Jeff Bezos, CEO of Amazon, Inc. is currently estimated at $83B, 4 billions more than entire Bitcoin ecosystem.

However, blockchain and the cryptocurrencies that are based on it keep fascinating modern economists by the tremendous potential they bring to global financial system. Unlike state-based fiat monetary system, which will be always prone to subjective unilateral manipulations by individual political leaders (remember Nixon and the Soviets), blockchain relies on an unbiased cryptographic algorithm. If maintained and protected properly, blockchain-based global monetary system will eliminate many externalities and transaction costs.

NameYourOwnCoin and Ethereum

The success of Bitcoin spurred public interest in cryptocurrencies. The tremendously quick exchange rate growth gave birth to the ‘early-stage investor’ syndrome, a psychological effect of becoming comparatively rich within a very short timespan and (quite often) with a minimum effort required.

Soon Bitcoin copycats started to appear. Most of them had moderate success. However, in 2013 Vitalik Buterin, a real ‘flesh and bones’ human being and Russian mathematician aged 20 at that time, introduced a platform called Ethereum. There was no paper this time. Just the source code on GitHub. Mr.Buterin currently resides in Singapore after being granted Canadian citizenship.

Vitalik Buterin, born in 1994, founder of Ethereum in 2013
Vitalik Buterin, born in 1994, founder of Ethereum in 2013.
Photo by John Phillips/Getty Images for TechCrunch. CC-BY 2.0, discovered via 
Flickr.

Ethereum is based on the concept of ‘smart contract’ technology that was first introduced in 1996 by US-Hungarian mathematician and computer scientist Nick Szabo. It enables a wide range of smart contracts, including the ones that can be a basis for a new cryptocurrency. Currently, Ethereum is one of the most widely used platforms for creating customized coins which are then used in a processes called a ‘coin sale’ or ‘initial coin offering’.

Volatility of Cryptocurrencies

While the conventional fiat national currencies are imperfect in many ways, they’re backed by national economies measured in the trillions of US dollars. For example, the dollar itself relies on an economy which had an $18.46 trillion GDP in 2016.

The emerging cryptocurrencies are often backed by a small team of startup founders. Tezos and Bancor, the two most successful ICOs to date, raised respectively $232M and $152M. It’s like comparing a SUP board to an aircraft carrier.

The outcome is that while delivering great promise and technology an ICO-baked cryptocurrencies are insanely vulnerable to market fluctuations. The lightest storm will bring an SUP rider into the water, no matter how skilled and tech savvy she may be.

The Howey Test

The noise party which various ICO teams started having after Ethereum was introduced left a powerful floor neighbour with severe FoMo. And this neighbour is the United States Securities and Exchange Commission. The SEC is currently shocked to see billions of dollars walking away unregulated as something that cannot be even clearly identified as money.

To make things worse, some of the folks started abusing the system and numerous ICO scams appeared, ultimately raising not for humanity’s benefit, but rather for a new Lamborghini or Tesla, a box of expensive jewelry and a ticket to some exotic island far far away.

Visualisation of the outcome for some ICOs that were not SEC regulated
Visualisation of the outcome for some ICOs that were not SEC regulated.
Free stock photo by
Max Pixel, CC0.

That is when a half-a-century old court case of SEC v. W. J. Howey Co. (1946) became relevant. Mr. Howey owned a large citrus farm in Florida. In an attempt to raise more money for his business he marketed buying the land around his farm to people from outside Florida. Howey then leased the land back from the new owners who had no time and desire to actually work on it. The neighboring farmers were not impressed and filed a complaint which finally landed on the desk of the SEC team.

Howey farm survived the SEC lawsuit and still exists as a town in Lake County, Florida. Compare the palm trees from the previous illustration.
Howey farm survived the SEC lawsuit and still exists as a town in Lake County, Florida. Compare the palm trees from the previous illustration.
Courtesy:
Webpage of Howey-in-the-Hills town council.

Howey Test consists of three criteria, each has to be met for the transaction to be SEC-regulated. Put in short, the SEC oversees: (1) investment of money, (2) in a common enterprise, (3) with the expectation of profit. Each element has a layered system of questions to help answer it. This system was explained quite well in an open source Blockchain Securities Framework prepared by the Coinbase team.

What do Hacken, Late Night, Hot Bath and a Glass of Wine Have in Common?

Dmytro Budorin had a tough day. It was a hot August summer, less than three month before the coin sale of Hacken, a startup which Dmytro set up with several former colleagues and friends. During a mid-day cup of coffee in downtown Kyiv, cafe a lawyer-friend explained the Howey test to Dmytro and advised him to be careful with the SEC. If Hacken had to be SEC regulated, the talks with the US regulator must be started sooner rather than later.

In the evening, a potential investor from the ‘big league’ of the local venture crowd clarified his doubts about Hacken. The big concern many interested professionals had about the upcoming token sale of Hacken was volatility of the new cryptocurrency.

It was a chicken or the egg problem. New cryptocurrencies always have greater volatility risks. They need substantial participation by the prospective token community to lower volatility. However, the target audience is often reluctant to acquire new cryptocurrency because its volatility risks are still unknown.

Dmytro did what many of us do after an exhausting working day. He opened Blockchain Securities Framework Tool by Coinbase on his laptop, poured a glass of red wine and took a warm bath. He started thinking about a solution to both issues which endangered the success of the whole venture. “Why don’t we start burning the tokens?” Budorin asked himself after some time.

How Are We Doing It?

When The KLF were burning £900,000 in 1994 the total amount of pound sterling notes in circulation was around £28B. So the actual impact of the KLF burn on the British monetary system was around 0.00003%, speaking only of the paper currency. If we take the UK’s GDP in 1994, that would be $1.14 trillion.

So The KLF burn did not have any substantial influence on the volatility of the exchange rate of the pound sterling. However, now imagine that 1% of the total amount of currency in circulation gets ‘burned’ on a regular basis. Will that change anything?

Alex Tabarrok, Professor of Economics at George Mason University, provides an explanation of how this approach works. His main argument is that by earning money, people create value for them, and when, for example, a person burns $100, he or she divides the value of these $100 among other members participating in an economy.

In fact, human psychology explains the mechanism of money burn influence on the volatility of the exchange rate and liquidity of the cryptocurrency. Anyone who lived in the times of hyperinflation, exactly like the one caused by the collapse of the Soviet Union, remembers the “preference for the stronger currency”.

When faced with inflation, people tend to spend the most volatile currency first and leave the least volatile “for another day”. This means currencies with lesser exchange rate fluctuations and inflation history get less exchanged less and thus become even stronger because people prefer to spend them last or never, accumulating their saving in these currencies.

Math Behind the “Burning Principle”

The Burning Principle uses simple math formulas to improve the currency performance of Hacken by stipulating periodical eliminations of active Hackens from Hacken’s blockchain.

We call such eliminations “burns” and they affect exclusively the platform fees, thus reducing the amount of Hackens which we, the founders of the platform, not our customers or clients, own.

Hacken’s Burning Principle explained in 4x4 cells
Hacken’s Burning Principle explained in 4x4 cells.
The burning principle visualized by an artist from our team
The burning principle visualized by an artist from our team

Who Will Benefit and Why?

Community Members Who Bought Hackens

  1. Permanently decreasing the amount of coins will cause permanent deflation, which will enable you to buy increasingly more services within Hacken Ecosystem with the same amount of tokens.
  2. After burning the critical mass of hackens, the amount of people willing to sell them will decrease exponentially. We expect this ‘critical mass’ to be within the 15–20% of the total amount of Hackens issued during the token sale. This will reward community members for seeing themselves as long term investors.

Security Researchers Providing Services via HackenProof Platform

  1. Deflation will improve the accounts receivable, enabling less risks and transaction costs when getting paid for your services.
  2. There’s no banking service fee, like the one for cross-border fiat money transfers. Exchanging HKN to BTC will get you access to a whole range of low commissions or commission-free local cash withdrawal options or over-the-counter local Bitcoin solutions.

Blockchain and Cybersecurity Communities

  1. Hacken enables transparent financial incentives for talented white hackers willing to improve blockchain security.
  2. Fosters cross-pollination of expertise between the blockchain and cybersecurity professionals.
  3. Diverts talent from cybercrime and unethical online businesses.

Please visit hacken.io to find more information about the upcoming pre-sale and main sale of Hacken Ecosystem tokens. Subscribe to our Twitter and Facebook to be the first to learn about our news.

Hacken Ecosystem

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