Bitcoin - An Overview

words by Nathan McNiece

With all the recent commotion surrounding its founders prosecution – you may have heard of the Silk Road. For those that haven’t, the Silk Road was an illegal underground marketplace that existed on the ‘Dark Web’. Sounds like the makings of a Hollywood action film right? However, the Silk Road is no Hollywood blockbuster; it was just another edgy, Silicon Valley start-up pushing the boundaries – perhaps just a tad too far. Ross Ulbricht, a physics graduate from the University of Texas, founded the Silk Road. Here, people could anonymously buy anything they desired, from their favourite strand of weed, to a brand new AK-47 and everything in-between.

Yet it was no traditional currency that was being traded on the Silk Road, for that would be much too easy to track. Rather, Bitcoin (BTC) was the currency of choice for the digital underworld.

It would be doing the story of bitcoin an injustice if I were to not start with the story of Silk Road, as it is both highly entertaining and largely responsible for the initial notoriety and adoption of the Bitcoin currency.

Well, what exactly is a bitcoin? For those who didn’t frequent the Silk Road, I will explain. Bitcoin is a digital currency; meaning it is controlled and stored entirely by a network of computers spread across the Internet. Therefore, it is completely decentralised (not governed by a central authority such as the Federal Reserve).

The technology was developed by a programmer or group of programmers (nobody knows), using the pseudonym Satoshi Nakomoto (no one has heard from Satoshi since April 2011) – adding to the richness of this very colourful story.

Bitcoin is a math-based currency which means that the rules that govern its accounting are controlled by cryptography. Hence, bitcoin is commonly referred to as a ‘cyrptocurrency’. How does it work? If you own some Bitcoins you also own a private cryptography key that’s associated with an address on the internet that contains a balance in the public ledger. It is the address and private key that allow you to make transactions. The address is public and can be thought of as analogous to a complicated email address for online payments. For instance: hy3091DTHusbu1082ewuigew8232jhDUiu24sd. In order for someone to send you bitcoins, they will need your address.

In order to send your Bitcoins to someone else, you will need your public address, the recipients address and your private cryptography key. This private key is an even more complicated string that you use to authorise a payment.

The result is a ‘pseudonymous’ transaction; not completely anonymous, since the public address makes it possible, in theory, to track a transaction back to the person making/receiving the payment – although this is highly unlikely.

Since to some, the concept of a digital currency may seem nonsensical, it is worth understanding just how Bitcoin has become a store of value. It is important to note that Bitcoin itself has no real intrinsic value; that is to say that it is not tied to any other currency or store of value. Simply, bitcoin has evolved into a form of value because it is something that an increasing number of people want – like the dollar or gold.

This digital cyrptocurrency is much more than a new store of value however; it is also the payment system. As the system is entirely peer-to-peer, there is no need for a third-party intermediary (think PayPal, Visa, Mastercard etc.). This results in an extremely efficient, frictionless and low cost method of transacting.

Have you ever been to a little Japanese restaurant, ordered some sushi, only to find out that the Eftpos minimum is $10? Reluctantly, you spend an additional few dollars. Well, bitcoin solves this problem. Because bitcoin transactions are nonreversible, there is no possibility for misuse of consumer charge-backs, which largely eliminates the need for a third-party intermediary to assist merchants. This allows merchants to make more money on transactions, enter markets that they previously could not have and hopefully pass such savings onto consumers.

The frictionless nature of the system also provides huge value to those looking to transfer ‘micropayments’ to family members in third world countries. There is plenty of anecdotal evidence to support this.

The transactions are verified and managed by special users called ‘miners’. The miners validate and add the transaction (block) to the public ledger known as the ‘blockchain’. Using the power of computation, miners compete against each other to verify the transactions as quickly as possible, and every so often, upon successfully verifying the transaction, the miner will be awarded a number if Bitcoins (currently 20 at the time of writing).

Additionally, miners may also be awarded a transaction fee for their services at the optional discretion of the transactor. For instance, Alice requests 5 Bitcoins from Bob. Rather than assigning 5 bitcoins to her own address, Alice may elect to receive 4.95 – leaving a .05BTC tip for the lucky miner. Whilst the system continues to dish out more and more bitcoins to those hard-working miners, the number of bitcoins rewarded for such work is slowly thinning.

This is because the system is capped at 21 million bitcoins. It has been calculated that the system will reach this total by 2140. Thus, miners will find their reward diminishing in quantity – however this may be offset by the value of the future currency. An attractive feature of the Bitcoin is that 1BTC can be easily divised into 0.00000001 units or ‘Satoshi’s’ – named after the founder. It is also worth noting that the number of bitcoins that will be further distributed into the Bitcoin system between 2100 to 2140 will be a measly 2 coins. Upon reaching the cap, miners will rely on the nature and goodwill of transactors to leave a transaction fee as a reward.

It is somewhat unclear what implications this potential lack of incentive will have on the Bitcoin ecosystem in the future.

When the system quits supplying new money, the value of the currency will necessarily rise as demand rises – this is what’s known as a deflationary currency. The idea was to invent a currency that could not be watered down by some central authority, such as the Federal Reserve – it is what makes the bitcoin currency so speculatively intriguing for investors. Ironically, it may be this fact that inhibits the currency from achieving worldwide ubiquity. Consumers and investors alike are less inclined to use bitcoin in a transaction today if they believe the said amount will be worth more tomorrow.

Thus, the deflationary nature of bitcoin incentivises hoarding rather than spending – around 75% of the addresses in operation with positive balances have not been used in a transaction in the last four months.

Mainstream adoption of a currency that promotes saving over spending will result in slow economic growth and high unemployment – certainly not an attractive combination. This highlights the importance of the economy’s principal currency being elastic, it’s supply increasing and decreasing to meet the demands of the economy and the important role which the central bank plays in implementing monetary policy to help achieve an economic equilibrium. The hazards of operating an economy with an inelastic currency were evident in the United States from 1880 to 1914, where the US operated under a gold standard. The result; the deflationary bias of the inelastic supply of gold led to elevated interest rates, caused periodic banking panics and increased instability of output.

Stores of value that have been adopted by the mainstream as a good for transacting, apart from the fact that they hold legal tender status (which bitcoin currently does not) is because that they are conducive for transacting – that is that a party to a transaction can safely assume that their $5 will be worth the same amount tomorrow and the same next month. Apart from a slight decrease in value that will result over a number of years due to the inflationary pressure of government-controlled currencies, the USD or AUD will remain relatively stable. In contrast, the future value of bitcoin is very uncertain. Bitcoin has seen its value rise from $5 to $1000 in a matter of 3 years and is currently resting around $250. However, the sharp fluctuations, which resulted in the currency surpassing $1000, can largely be accredited to large volume, single trades; a result of speculative investment.

Another factor that will greatly influence the future adoption of bitcoin is the concept of network externalities – the value of a product or service is determined by the number of others using it. This is the phenomenon that causes social companies like Facebook and Instagram to achieve such success; all of your friends are on Facebook, so naturally, you join Facebook. In relation to this concept, the metrics for bitcoin are actually promising. The current rate of new users joining the network is exponential; that is to say that the number of users is doubling – roughly every 8 months. There are purportedly between 200-300,000 active users trading in the bitcoin system at the time of writing.

Perhaps the most important aspect of the bitcoin system is the security of the network itself. Given the recent publicity surrounding hackings of bitcoin exchange and wallet services, it is no secret that bitcoins are not as safe as money in the bank (at the time of writing anyway). Whilst cash and traditional electronic payment systems have been riddled with security problems, a high incidence rate of such problems with a system that is trying to establish itself could have dire consequences with regards to consumer confidence. Below are a number of notable bitcoin security incidents:

  • In January 2015, Bitstamp, a large European Bitcoin exchange, suspended services after a security breach involving the loss of 19,000 Bitcoin, valued at about $5 million.
  • Hackers mounted a massive series of distributed denial-of-service attacks against the most popular Bitcoin exchange, Mt. Gox, in 2013. About 850,000 Bitcoin valued at over $400 million were stolen. Mt. Gox subsequently declared bankruptcy.
  • In late August 2012, an operation titled Bitcoin Savings and Trust was shut down by the owner, allegedly leaving around $5.6 million in bitcoin-based debts.
  • In September 2012, Bitfloor, a Bitcoin exchange, reported being hacked, with 24,000 Bitcoins (roughly equivalent to $250,000) stolen. As a result, Bitfloor temporarily suspended operations.21
  • On April 3, 2013, Instawallet, a web-based wallet provider, was hacked, resulting in the theft of over 35,000 Bitcoins. With a price of $129.90 per Bitcoin at the time, or nearly $4.6 million in total, Instawallet suspended operations.
  • On August 11 2013, the Bitcoin Foundation announced that a bug in the software within the Android operating system had been exploited to steal from users’ wallets.
  • October 23 and 26, 2013, a Bitcoin bank operated from Australia but stored on servers in the United States was hacked, with a loss of 4,100 Bitcoins, or over 1 million Australian dollars.

Sure, there are a number of security issues that must be addressed, but the Bitcoin ecosystem is only in it’s infancy – it is to be expected. As long as bitcoin can survive long enough to withstand such shocks, it is highly likely that the bitcoin security system will be strengthened as more and more money gets poured into the ecosystem. For instance, Coinbase, a bitcoin wallet service, just raised $75 million in series funding from esteemed VC firms such as Andreesen-Horrowitz.

With all that said, the idea of digital currency is out of the bag – whether bitcoin becomes the dominant currency or not, it is not hard to imagine that cryptocurrencies will play a greater role in the financial system in years to come. It is an exciting technology – perhaps the most exciting thing we have seen since the internet.

From an investment stand-point, it may prove to be a very lucrative long term play. Predictions of 1BTC being worth $500k-$1M in 30-40 years from now seem perfectly rational based upon the last few years growth and the deflationary pressure of the currency itself. However, if the value does not skyrocket, it is likely to plummet. For those who feel comfortable on the edge of their seat, bitcoin is the perfect vehicle for which to place some capital.

Regardless, the future of Bitcoin will be an exciting and richly documented one, so sit back, grab yourself a comfy office and enjoy the ride.

Posted on July 16, 2015 .