What exactly is Bitcoin?
Bitcoin is a decentralised form of digital currency. It is a digital store of value and payment system operated by a peer to peer network, eliminating the need for an intermediary such a bank or government. All transactions are verified by the network of nodes and are recorded in an online public ledger here. A node is just a word for a computer that is connected in a network.
In September this year, the US Commodity Futures Trading Commission declared that Bitcoin is a commodity covered by the Commodity Exchange Act. This week, the EU Court of Justice ruled that Bitcoin is a currency and is therefore exempt from VAT. It’s understandable to be confused over its trade status on digital markets since the concept of mining and storing value is similar to commodities such as gold and the deferred means of payment, unit of account and stored value being attributes of currency. As pointed out by the Economist, Bitcoin does possess three useful qualities of a currency: they are “hard to earn, limited in supply and easy to verify”. To add to that, Bitcoin cannot be counterfeited like physical currencies.
Since no centralised authority controls the supply of bitcoins, it’s hardcoded in the software to reward bitcoins to the first competing node that successfully hashes the transaction block, which is added onto the blockchain and updated with all peers on the network. The miners use nodes to process the transactions by computing mathematical problems and are rewarded for their work of verifying transactions with new bitcoins or they confirm the transaction in the network in return for very low transaction fees. The blockchain is like a trail of data containing transaction records that link back to the first ever transaction block. It is in a sequential order with the most recent block being added by a node and confirmed by the network of nodes which update their copies of the blockchain, preventing tampering since the ledger is distributed and stored by all computers in the network.
Originally starting at 50 BTC and halving every 4 years (currently 25 BTC), the reward requires more computing and electrical power to confirm a transaction as time, supply and the blockchain size increase. There is a set limit of 21 million bitcoins which can ever be created on the network. Currently, nearly 15 million have been coined into existence. However, this does not mean that the maximum number will be reached anytime soon. It’s estimated to be obtained in the year 2140 due to the compounding difficulty rate in the Bitcoin mining algorithms, a consequence of increased investment in this new technology and the resultant increase in miners on the network. This upward sloping difficulty rate shows how the miners have increased exponentially in the last year.
The rate is 62.3bn at the time of writing from 1.2bn at the start of 2014. This level can decrease when less mining activity is competing as electricity and bitcoin exchange prices affect profitability.
This graph shows Miners Revenue (USD millions). As you can see, the process, with current technology, becomes less profitable as the calculation difficulty increases. This, in a nice way, mimics a traditional commodity which is mined (such as gold). Technology increases in the tools used to mine makes it more efficient as a tool to profit against the cost of common factors of production.
Anyone with a computer can mine Bitcoin on the network by downloading the free software.
As partially suggested above, the increase in mining competition has led to redundancy in the use of normal CPUs (so you can’t use your laptop to mine Bitcoin at any profitable rate anymore)*. Instead, an ASIC chip has been invented specifically for the purpose of Bitcoin mining. This increases the efficiency in processing input/output for the SHA-256(Bitcoin’s cryptographic proof of computing work algorithm) or other Scrypt(for altcoins) algorithmic task. However, the exploitation of this new technology, fuelled by the actual and potential profitability, led to such innovation and inclusion in the mining field that the typical Bitcoin mining room looks more like this:
This investment in new technology capital goods for Bitcoin mining is necessary to stay above the margin in costs, due to this virtual gold rush effect squeezing new miners, without the Silicon Valley cash to buy the latest hardware frequently, out of the market altogether.
This rate of improvement in Bitcoin mining hardware technology causes miners to replace all of their instruments as soon as more efficient ones become available, usually every couple of months; making all other previous computers in the Bitcoin mining industry more redundant, obsolete and a burden since they can’t be used for any other operation outside of the crypto mining industry — they’re a special type of circuit board that only runs this software and cannot be used as normal computers. The capital goods used to mine Bitcoin depreciate rapidly as herd mentality and competition force too many resources to be allocated to a speculative industry and forms the basis of my argument that Bitcoin investment is showing signs of delusion. The following video is a good glimpse of the sort of exploitation occurring in this new technology frenzy.
*You would also burn out the components very quickly here from the exhaustion of processing at this level — before you even made enough revenue to pay for a fraction of the electricity wasted. Note how I stated that you can’t do this anymore. This is not entirely true, but it’s very unlikely to return to the difficulty levels at the start. If the difficulty rate were to decrease due to the absence of mining peers, sometime in the future, you may be able to use your home computer to mine Bitcoins but they would be worthless ~ a few pence. Most average PCs aren’t equipped to handle the SHA-256 Bitcoin algorithm though but scryptcoins are possible with your graphics card. The desktop and low-end hardware miners were hobbyists more than anything. I’ve seen experiments where some have downloaded the free mining software and run it on their average desktop computer. In one video, after 3 days of non-stop laud fans and overheated drivers, the wasted computer was only able to generate a fractional part of a Bitcoin worth $0.14 at the nominal price.
It’s not as if you can’t start mining without sums of cash to spend on hardware and electricity to begin with. Instead of trying to mine solo, you can connect to a mining pool consisting of thousands of other miners working on the same block simultaneously; the rewards being shared amongst the peers in accordance with their relative contribution of computational work. There are pros and cons of either choice. Unless you have warehouses stocked with ASICs working relentlessly in freezing conditions, your chances of hashing a block above the difficulty rate is mathematically unlikely. That 25 BTC (currently £7,320) payout is attractive to individuals with the necessary factor inputs to mine solo. Otherwise, you may have better chances of receiving regular small revenue in a pool as opposed to a highly unrealistic chance of solving the block on your own for that lump sum payout.
https://bitcoinchain.com/pools for comparison of the largest pools and their dominance in the network.
How do transactions work?
When a user wishes to send some Bitcoin to another wallet address, a request is transmitted to the network and assigned to part of a block. The peers verify the transaction block and update the public ledger (blockchain) for all nodes on the network. This requires multiple confirmation signatures to approve, protecting from a double-spend fraud — I’ll come back to this. Nodes also have their transaction fees but usually the incentive for the computational work is to be rewarded new Bitcoins.
Actually owning a Bitcoin essentially means being able to change a public record by using your private key to verify that you own the public key address by sending a digital signature with the transaction message to the network.
A private key is like a password that only you can use to decrypt something that has been encrypted with the public key which you give to others. The public key is shown to the network and the private key is kept to yourself. A digital signature acts like a check to a bank asking them to pay a sum of money from one account to another with the validity approved by checking that the signature corresponds to the correct one on file. In Bitcoin terms, the digital signature is a message broadcast to the network with the transaction instruction and your signature which confirms that the transaction can be made. The miners’ (or nodes’) job is to simply confirm that the digital signature is proof of the message being transmitted from the owner of the wallet address(public key) which can only be legitimate if it was made with the private key. Hence, Digital Signature = f(message, private key) where f is a hash function.
Since account balances aren’t stored, ownership of Bitcoin values in an address are verified by links to reference input transactions to that address on the block chain (public ledger). Therefore, the transaction validity is dependent on previous transactions which are searched for in the blockchain. While this may seem like a time-consuming process, given the size of the blockchain, it’s more efficient now that unspent transactions are indexed. The Bitcoin address balance is thus the value of the unspent input transactions pointing to that address in the block chain. Double spend fraud could occur if the timestamps on transaction records were created falsely in order to reference the unspent input. Bitcoin counters this with the block chain which keeps track of the order of transactions unlike the history of ownership recorded in the transaction chain. It establishes this order by each block referencing the previous block to it. This chain traces back to the very first transaction, the Genesis block. Any transactions that occurred at the same time are grouped together in blocks and transactions which aren’t yet in a block are called unconfirmed or unordered transactions. Nodes can collect these transactions in a block and broadcast to the network where this block should be in the chain. Since multiple nodes could create blocks at the same time, each block is verified by finding a valid solution to a complex cryptographic hash function. The algorithm guesses for answers below a certain value by trial and error and a solution is usually found by a miner within 10 minutes. The first to solve the math problem gets to broadcast their proof of work, the block is added and new bitcoins are rewarded to the nodes. The coinbase is a small sum of bitcoin in the block which is given to the nodes as a transaction fee. The size is optional and determined by the sender — if you were to set it as high, it would get a greater priority by nodes and the transaction time would be quicker as more peers would compete.
Wallets are, as the name suggests, a location where your Bitcoins are stored. I’ve briefly explained a few of the technical terms, but just to clear a few things up: The virtual wallet consists of two things, a public address* where people can send their bitcoins to you and a private key which unlocks your wallet and allows you to spend its contents. There are plenty of free wallets available to download or accessible online at exchanges* but the traditional way to get a wallet requires you to download the official bitcoin-qt client (Currently 20GB in size and takes several hours to download all the transactions that have ever taken place).
*a generated string of 26–35 characters like this: 3J98t1WpEZ73CNmQviecrnyiWrnqRhWNLy
The blockchain technology
The applications of a distributed public record of ownership extend beyond currency uses. From secure land ownership registries, private company share trading to preventing diamond or art theft, the distributed ledger offers a technology with the advantages of a trustworthy record which can’t be tampered. The blockchain is a record of who owns what at any given time and no third party is in charge. The mathematical hashing maintains the distributed record and the consented changes to a database of transactions amongst the peers. Financial institutions are already investing in the new ‘trust machine’ technology to reduce the costs of accessing databases between banks and the errors which current technology for transactions is prone to. New private blockchains are being established which are modelled off the Bitcoin’s cryptographic and node networking technology.
Cryptographic techniques and the hashing algorithm
The Elliptic Curve Digital Signature Algorithm
Bitcoin uses an algorithm which defines an elliptic curve formula (y2 = x3 + ax + b) where a = 0, b = 7 in the context of a finite field.
Fields are basically defined in terms of the operations’ rules of arithmetic. Everyone has used the real number field for essential maths and some of you may be familiar with the complex number field. A finite field is a field with a limited number of elements whereas in the real number field we have an infinite number of elements.
This curve is useful for defining the properties of a cryptographic system as a straight line (y = mx + c) which intersects two tangent points on the curve will intersect a 3rd point on the graph (You may need to graph this with greater axes than this one to see how this works). This is used to create a key pair with the parameters of y2 = x3 + 7. The private key is the point between 1 and 2²⁵⁶(a limit incomprehensibly large, almost the number of atoms in the observable universe). The base point is the line origin on the graph. The base point multiplied by the private key is equal to the public key and it’s as simple as that to define and virtually impossible to reverse engineer with the public key (which is the wallet address) due to the unknowns. The bitcoin wallet address is not the public key but a hash of the public key. This hash creates an address shorter than the public key.
How do these mathematical properties get applied to Bitcoin in simple terms? Well, a user would get a wallet which would have a private key (the translation of their password) and a public key (an address used by the network to reference the wallet). A brute force is an attempt by a computer program to crack this ‘password’ by guessing every combination of characters (trial and error). 2²⁵⁶ is a huge number and so the number of permutations for a point which intersects a curve from an unknown equation of a straight line whose origin is a factor of the public key is not possible to find* (if someone other than the owner of the private key tried to forcefully remove Bitcoin from an address, they can’t — it’s mathematically safeguarded). This means that only the wallet owner with access to that address contents (by using their private key) can alter the value of BTC sent/referenced/input by creating a digital signature for the network to verify. The mathematics behind Bitcoin is stronger than the level of protection for any other currency because banks/third parties/authorities can overrule and cash is at more risk than unbreakable cryptographic proof (the digital signature needed to verify the transaction can be made because it was requested by someone with the private key). So it may be the safest store of nominal value (BTC) out of the global currencies. Which raises the issue with criminal proceeds — I’ll develop this below.
- I read somewhere that even a computer big enough to consume all of the power from the Sun would take several decades to even run through all the combinations for the SHA-256 bitcoin algorithm.
Use of Bitcoin
There are obvious advantages for business that use BTC: they can receive payments without a bank charging big fees for processing the transaction; and it’s more advantageous when a foreign currency transaction is otherwise used which would have been a victim of generous exchange rate commissions. The transaction time can also be a lot quicker than banks’. Bitcoin’s use for global transactions due to the smaller transaction fees compared to other providers of quick international transfers such as Western Union and MoneyGram is a reasonable assumption as to why Bitcoin overtook Western Union in average transaction volume. ‘Market analysts’ (or Bitcoin enthusiasts) emphasise the likelihood of the virtual currency to soon surpass Paypal in average volume. These figures were taken in 2014.
Bitcoin’s potential risk to the world due to its fairly anonymous nature is certainly open to debate. Anonymity is obviously a concern here with Bitcoin as it can facilitate tax evasion, money laundering and other criminal activities. Others like to think that Bitcoin’s freedom from the shackles of government manipulation is what makes it such an interesting experiment as the currency reacts to the forces of free market economics. Bitcoin supply is finite and therefore escapes the clutch of central bank inflationary policy and consequently the saddening effects of quantitative easing from remedial objectives. This also makes Bitcoin a deflationary currency.
However, this decentralisation has sullied the consumer market. The lack of any form of control by third parties comes at a loss of obligation to refund. A bitcoin transaction cannot protect the client when the receiving address is exempt. Once some bitcoin is sent, there’s no way of getting it back unless the wallet owner decides to; and their identity may not be known. In other words, there is a fundamental lack of user safeguarding. Bitcoin’s limited growth and adoption suffers from the inability to protect consumers from unlawful trade under the Consumer Rights Act in the UK. On the other hand, you could argue that it protects the seller from fraud.The intermediary can be useful in respect to fair trade and there is unlikely to be a precedent set anytime soon given the expectations an investigatory body faces with this untraceable cyber trail of money which is easy to disseminate and impossible to retrieve. This scenario is clearly more perplexing and faces obstacles that a bank simply changing an account database value would not. All bitcoin transactions are public but this only implies the wallet addresses are visible. Bitcoins can be traced back through to their origins on the blockchain but the personal details of the wallet owner are not known.
I do not know of a sensible reason why Bitcoin could not be a more effective store of value for non-government agents than traded derivative contracts of Gold — both affected by the floating rate of fiat currencies. If you purchase some Bitcoin, then you are the sole possessor of the asset which is mathematically protected for you. Physical gold is outdated in this sense because you would need to protect it at additional costs. This cannot happen with Bitcoin as only the owner of the wallet can create the digital signature required to send a transaction. Gold is also not easily used as a means of payment. You would normally need to trade gold for a standard currency to then buy something. With Bitcoin, you can use it to directly make purchases as well as mining and storing it.
Problems and the future for virtual currency
The high volatility has continued to discourage the claims of Bitcoin advocates since the bubble collapse of December 2013. Lessons weren’t learnt this year when a second bubble rallied in late 2015 amidst increased demand from China over further government taxes prompting Chinese exchange rates to spike when savers looked for a tax free store of value. Adding to this was the approaching 4 year end mark of the 25 bitcoin reward, halving in 2016 and raising costs of production significantly. This reduced the rate of supply whilst more of the smaller miners are pushed out of the market. Consequently, the media attention added to the bullish momentum. This is just another sad reminder that Bitcoin’s low market capitalisation makes it an unstable haven for storing value. Even a 1% daily fluctuation is too risky for savers. Bitcoin backers still uphold their notion that the volatility is short term as the currency is still in its infancy. This may be due to a lack of liquidity and uncertainty over its long term value; the latter being highly responsive to newsfeeds. Without a central bank to protect it with foreign reserves, the currency will always be at risk from speculative attacks as Bitcoin lenders have grown in numbers — this is actually quite plausible given the arbitrageable state that it’s in during shocks. We’re still trying to evaluate its uses and effectiveness as digital cash anyway.
The lack of regulation and a disproportionate ownership of Bitcoins are offputting to investors. This infographic shows the abundant risks such as manipulation of the market price with 47 individuals controlling 29% of the cryptocurrency. If the currency were to develop into a standard means of payment for online services, this would cause vast amounts of wealth to be accumulated into a few hands. Even so, the supply against the demand is keeping the price propped up as so much of the commodity is privately hoarded and not traded.
This is just one of the troubling aspects of Bitcoin’s status quo that I’ve come across in my research. Another regards the lack of implementation and usability in markets. The hurdle still consists of uneducated producers and consumers. As Bitcoin is still in the development stage, it isn’t wise to rule out the effectiveness of new features at influencing adoption by this generation of average consumers.
In a search to find out where Bitcoins can actually be spent on goods and services, I was surprised to find that Microsoft, Dell, various airlines, Amazon (gift cards), Nike, jewellers, properties, bars, restaurants, Takeaway.com, PayPal and Shopify, bullion traders and donations have been accepting Bitcoin payments since late 2014. I think the benefits are clear for companies and not as pronounced for consumers. Bitcoin’s failure to integrate with everyday transactions could derive from there not being enough positive reasons for consumers to switch to this currency. There aren’t a lot of incentives for customers to go through the hassle of using Bitcoin other than for the online discounts which businesses are using to attract this form of revenue. Additionally, as the HMRC regards Bitcoin to be a foreign currency, it is now subject to corporation and capital gains tax. Whilst the UK government may have been the first to take an appropriate and modern stance on the new era of these digital assets, they cannot enforce these regulations in the same way as traditional property due to the anonymity that comes with it. It is believed that the creator(s) of Bitcoin, ‘Satoshi Nakamoto’, was/were motivated to do so for the liberal freedoms associated with no government control. Although there’s still a lot of mystery around its origins, for their intended reasons. A transition phase is a term that can be thrown around in promotional Bitcoin context. Such an example would be
“I believe we are witnessing a transition from one phase (monetary and speculation driven) to another phase (new applications and bitcoin as a platform) and there will be a shakeout as the transition happens”
I have become more suspicious of the underlying value of these claims recently. The problems are worsened when consideration is taken to a rather grim consequence of this peer to peer currency platform. If you hadn’t noticed the ‘Lost’ segment, scroll back up to the pie chart which shows the approximate slices of the Bitcoin as determined by reference input (unspent) transactions to wallet addresses. This represents a staggering figure of ‘burned’ coins from either deliberate or accidental reasons. It’s rather poignant to read stories of individuals like the man who lost 7,500 bitcoins by accidently throwing away a hard drive which contained his private key during an office clear out. He had mined those years ago when they were worthless. The reason he stopped was because his girlfriend complained about the noise of the fans. At the time when he threw the key to his forgotten coins away, they were worth £500,000 and during Bitcoin’s peak, over £5m. Those coins are irretrievable thanks to Bitcoin’s level of security — effectively burned as he was unable to find the hard drive which is believed to be located under several tonnes of landfill in Newport. Many of the early miners disregarded the software and subsequently forgot their wallet keys. After all, the coins were worth practically nothing as Florida programmer Laszlo Hanyecz buying two pizzas with 10,000 bitcoins highlights. At bitcoin’s peak, these would have cost over $12.4m. Over 1 million coins were mined by ‘Satoshi Nakamoto’ at the start of the open source project and have not been moved from their wallets since. This effectively made an anonymous billionaire when these coins surged in value to over $1000 each. All it takes is for one to forget a password to be unable to access their bitcoins. The network won’t allow for it to be changed without cryptographic proof unobtainable without the private key. To be fair, who at that time would have predicted such value would evolve from this program in the future and consequently protected these bits of data? Bitcoin was clearly very well thought out by its anonymous creator and I am cautious nonetheless of its future value. One thing that I’m sure of though is that the technology behind it will become a precedent of future exchange.