Bitcoin for Dummies

The esoteric components of the crypto ecosystem explained in layman’s terms

For any of my readers who are new to cryptocurrency or would like to strength their understanding of Blockchain and other core components of the crypto ecosystem, I’ve created “Bitcoin for Dummies.” You should understand the function and purpose of all these topics before you put any money into cryptocurrency. If you have ever found yourself lost in cryptocurrency lingo, this paper may shed some light on the esoteric technology.

· Cryptocurrencies (such as Bitcoin, Ethereum, Litecoin, Monero, and myriads of others). Means of exchanging value over the internet, anonymously, without the use of a clearing platform intermediary (such as a bank, credit card company, or even PayPal). The lack of a “clearing” intermediary that under traditional money transfers would provide “trust” in exchange for a fee, is a key benefit of cryptocurrencies.

· Blockchain (and public ledger). Blockchain is the open source that makes these cryptocurrencies offer the paradoxical benefits of anonymity and trust simultaneously. In a traditional currency transaction, the buyer sends money to a bank/credit card company/PayPal/etc., then the bank/credit card company/PayPal/etc. sends money to the seller (most often there is a second set of intermediary financial institutions that receive the payment for the benefit of the seller). Anonymity and trust between buyer and seller are guaranteed by the intermediary financial institutions at the cost of a fee and the fact the intermediaries know the buyers and sellers. The databases that are used for these transactions are maintained by the financial institutions. Blockchain on the other hand, is a system where the databases for all transactions are publicly available, stored on thousands of computers around the world, and visible to all. This “public ledger” is not only viewable by all, but each transaction is verified by all, and once verified, its information is added to the track record of exchange “called the blockchain” following the money flow between buyer and seller. So not only is the money transferred, but so is the information that verifies a transaction as valid. Thus, the distributed nature of trade verification is embedded in the cryptocurrency a buyer is sending to the seller making the seller trust the payment, while preserving the anonymity of the buyer.

o Blockchain analogy: Imagine if U.S. dollar bills didn’t have all the artwork and fraud prevention inks and designs, but the only thing they had printed on them was the dollar amount and the serial number. Furthermore, imagine that the serial number wasn’t just a production run number, but rather computer code that verified the amount on the bill as well as the fact that the sender of the bill truly had that amount in his/her possession prior to sending it to the receiver. This is what blockchain technology does in a virtual world.

o Public ledger analogy: In a normal currency-based transaction imagine the buyer walking into his/her bank handing over his money. The bank then sends the money to the seller’s bank, and the seller’s bank hands the money to the seller. In a cryptocurrency transaction imagine the following: A football stadium full of people that witness two players walk onto the field (a buyer and a seller), both anonymous to each other and to the people in the stands. The buyer throws a football to the seller. The “football” is the cryptocurrency. The people in the stands, each individually witness the throw, verify the football was of the right size (amount), was unique (hadn’t already been thrown to someone else), and their verification efforts are stamped (new block added to the existing blockchain) onto the football (cryptocurrency) before the seller steps off the field. The people in the stands are the “miners”.

· Miners. Miners are the computers that host all the world’s cryptocurrency transaction ledgers, verify each new transaction, and add new “blocks” (new blockchain information) to the existing blockchain as new transactions occur. Yes, you too can become a miner if you want to dedicate enough computer hardware capacity to the task. Your payment will be in the form of fees per transaction verified as well as payment of additional currency, newly minted from your efforts.

· Money supply. Through “mining”, the number of currency units in circulation increases over time. But unlike government issued currency that may be printed on demand, most cryptocurrencies have a predetermined money supply growth rate as well as an ultimate cap on currency units (21 million for Bitcoin for example). Due to the lack of effective “lending” of cryptocurrencies, shorting is near impossible in the “cash” market. This is an important point, because the absence of lending by financial institutions doesn’t allow the money supply of cryptos to increase in sync with economic growth/demand. Although shorting through newly launched futures markets is available for Bitcoin, this is limited to investors wishing to make a directional bet on the price of Bitcoin, it cannot create “new currency” like a traditional reserve banking system can.

If you are skeptical of cryptocurrency’s legitimacy, security network, Store of Value (SoV) potential, or other use cases, then let me explain why you should at least monitor the progress of this technology. For several reasons, the crypto ecosystem has the potential to reconstruct our understanding and interaction with the world:

Represents real value. At the time of publication, Bitcoin alone has a circulation value (market capitalization) of $180 billion (at BTC’s ATH, the market capitalization exceeded $300 billion). This is greater than the stock market capitalization of companies such as Pfizer, Coco-Cola, and Citigroup. The top 100 cryptocurrencies (yes, there are more than 100, thousands in fact), at the peak of the 2017 bull-run had a combined value of more than $800 billion, a value greater to that of Warren Buffet’s Berkshire Hathaway. Whether you believe the future has a place for crypto, it cannot be denied that real capital has been invested into cryptocurrencies over the last few years, and exponentially so since 2017.

Asset correlation. Evaluating figures from the 2017 bull-run shows that the crypto market has been maturing even amidst unprecedented ROI (return on investment). Despite its nascent and meteoric rise, the cryptocurrency realm began to experience increased correlation with equities. Bitcoin for example, saw its trailing six-month average daily correlation to the S&P 500 increase from about 40% in 2015 to almost 90% (88%) currently. The periods of negligible to negative correlation occurred during equity market pullbacks while Bitcoin was continuing its exponential rise. Yet, during 2017, correlation stabilized at 80% or higher, which implies a certain maturity of the Bitcoin asset class as an alternative investment or SoV. With more than 60% of Bitcoin trading occurring in Asia and as much as 35% in North America, this is truly a global market. It will be interesting to gauge over time whether speculation in cryptocurrencies such as Bitcoin should have been adhered, or if crypto truly is the technology of the future. Keep in mind, one major lesson of the financial market is that during a financial panic, even previously uncorrelated assets become highly correlated. Even though (at the time of publication) most people have called the bottom of this bear-cycle and are anticipating their buy orders to be filled, a Black Swan event will not leave Bitcoin and the entirety of the crypto market unscathed.

The virtual world has real-world needs. Cryptocurrency mining is an exercise of converting conventional energy into monetary value through computing. This is done by design, to ensure that the creation of Bitcoins is slow, so as not to lead to inflation. The Bitcoin network is currently consuming power at an annual rate of ~73TWh — more than the economy of Austria, the 39th country in terms of electricity consumption. Each Bitcoin transaction consumes ~625KWh, enough to power an average US home for twenty-one days. Other cryptocurrencies are much more efficient, for example Ethereum, can mine at a rate of one and a quarter days of average home power per transaction. Nonetheless, the sustainability of Bitcoin and other cryptocurrencies may be dependent on solving this issue. Even as a long-term believer in crypto, it is difficult to imagine a sustainable business model for cryptocurrencies that relies to such a great degree on one of the world economy’s most important resources, energy.

For those who lived through the dot-com bubble, I’d expect a feeling of Déjà vu. At the time, a dot-com attached to a company’s name became instant branding of future world domination. In a way, today’s crypto-craze (especially the word “blockchain”) dwarfs the dot-coms of the 90s by comparison. Long gone are the even modest requirements of registrations with the SEC, annual audits by reputable accounting firms, and under-writings by investment banks. Today’s craze is driven by open source code, limited only by the imagination of computer aficionados while attracting global capital without restrictions of currency flow or regulation.

As always, I thank you for your interest and support, and welcome any questions or suggestions.

Answering what roles Bitcoin will have in the inevitable demise of fiat systems

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