Understanding Bitcoin
A candid analysis of the digital coin that defined cryptocurrency,
Why we should long bitcoin and short the banks…
The Japanese have the word chokusetsu, which in the context of communication, expresses the desire for straightforwardness and honesty, without the usual sugar-coating. I settled on the English word ‘candid’ for my subtitle, but it just doesn’t quite have the same subtle nuance as its Japanese counterpart.
I could have also gone with more click-baity titles like ‘No BS Bitcoin’ or ‘What’s all the Fuss About Bitcoin?’, but again I look back at what made me interested in the Bitcoin space in the first place — and that was understanding the ideas and technology behind it.
This article, then, is my chokusetsu explanation of Bitcoin.
It was written as an introduction to the market leader of the still nascent crypto industry, therefore readers expecting to get a better grasp of technical terms like ‘SHA256 cryptographic algorithms’ or ‘pruning Merkle Tree hashes’, should await my following articles where I delve deeper into the technologies and theories (links will be inserted here).
With that said, for those that are still reading — let’s get started, shall we…
The Vision: What is Bitcoin?
According to Satoshi Nakamoto, the cryprocurrency’s pseudonymous creator, Bitcoin is a “peer-to-peer electronic cash system” that allows payments to be sent from one party directly to another, without the involvement of a financial institution.
So, in essence, Bitcoin is a form of digital money that is fully controlled by its owners. It is stored in compatible ‘wallets’ and can be sent or received without the need for a bank.
Let’s pause for a second and let that sink in, because this is what all the hype from the Bitcoin ‘maximalists’ is about — taking back control of the very thing that dominates our lives more than anything else… money.
And before you say “I’m not money-motivated. Money doesn’t dominate my life at all”, please remind yourself that on the primal level, money decides who eats and who doesn’t. Money decides where we can live; what we can wear; what we can drive; and what we can do — essentially money decides on the limitations of how we live our modern lives.
Yet, to this day, we rely on ‘trusted’ intermediaries to not only store our wealth and moderate our transactions, but to control the issuance and value of money itself.
The Problem: Why Do We Need Bitcoin?
I believe the continually advancing Information Revolution will lend us the wisdom and strength to address humanity’s previously unsolvable problems and help us make a positive impact on all of society — Masayoshi Son
Although Bitcoin was the culmination of years of study, research and testing, many believe that the catalyst for releasing the code was the 2007–08 financial crisis. This global crash is considered by many economists to be the worst financial disaster since the Great Depression of the 1930’s, although it’s easily forgotten now in 2020 as we all ‘get on with it’. The problem is, many of the same economists are now saying that another money meltdown is due.
What happened? Without going into too much detail, the banks over-leveraged their positions in more risky financial products such as sub-prime mortgages, while other shadow-banking entities such as hedge funds, borrowed short-term liquid capital to purchase riskier long-term illiquid assets. This led to the collapse of many ‘trusted’ institutions, such as Fannie Mae and Lehman Brothers, causing an economic global shock-wave effect spanning many years, known as the Great Recession.
In other words, greedy banks and institutions issued risky and often predatory loans or mortgages due to apparent low interest rates. To add insult to injury, even greedier hedge funds gambled on stocks, derivatives and whatever other seemingly profitable assets they could find. The credit freeze that ensued almost brought the collapse of the global financial system.
The result of all this irresponsible chaos?
Not one of the perpetrators were punished, either financially or criminally, while some were even rewarded with multi-billion dollar bail-outs. The central banks purchased almost $2.5 trillion of debt and troubled assets from governments and banks.
This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history.
The Federal Reserve also injected $600 billion into the US credit markets, with the hope this would bring liquidity to spur more domestic loans and mortgage refinancing. Did the banks learn from their lesson? It seems not, as these funds were utilized in more ‘profitable’ areas such as emerging markets and underhand currency wars.
Unfortunately, in every zero-sum game, there has to be losers. Yes, you got it — the people. Homeowners lost their homes; unemployment rates spiked; and borrowing became even more difficult and costly. However, another interesting consequence is that of wealth distribution. The top 1% earning power of the US surpassed the peaks of the post-Great Depression era, and as poorer families tend not to hold assets, the middle-class families were hit the hardest.
So the mega rich just got richer, the middle-class was diluted, and the wealth gap became even wider. Great.
“Buy when there’s blood in the streets, even if the blood is your own.” — Baron Rothschild
We need Bitcoin to level the playing field, bridging the gap of the despicable inequality we face today. We need Bitcoin to empower future generations to become responsible and accountable for all of their decisions.
The Technology: How Does Bitcoin Work?
The exact mechanism of how the technology behind Bitcoin functions is beyond the scope of this article, but I will give a condensed overview of the underlying processes.
Cryptography
The main technology behind Bitcoin is cryptography, which in coding terms is ‘the art of protecting information by encrypting it into an unreadable format (cipher text) to be later decrypted into plain text by those that hold the secret key’.
Technically, Bitcoin does not encrypt data as such. Instead, it uses two standardized cryptographic methods called ‘hashing’ and ‘digital signatures’ to validate transactions between senders and receivers. Hashing is the process whereby data of any size can be encoded into a fixed size. The outputs of this algorithm are called ‘hashes’. Digital signatures are a way to verify the authenticity and source of data transmissions, working much like a persons signature or fingerprint in the physical world.
Example: I want to buy a car from Bob, but he requests that I send him payment in Bitcoin, equating to 0.5 BTC. I decide to get some Bitcoin, so the first thing I need is a wallet. I create a wallet, which then generates two ‘keys’ — one private that must be kept secret, and one public key that I can share with anyone much like bank details. Behind the scenes, the cryptographic algorithm ‘hashes’ these keys into a 26-35 alpha-numeric character sequence (public) and 64 alpha-numeric character sequence (private).
Now I need some Bitcoin, so I go to BitPanda and buy 1 BTC with my credit card, and after inputting my Bitcoin wallet address (public key), I wait a few minutes until my BTC arrives. Armed with my new cryptocurrency, I then ask Bob to send me his wallet address, which he promptly does. I open my wallet and press the ‘send’ button, at which time I enter Bob’s wallet address and the amount of Bitcoin I want to send him. I copy and paste his wallet address (because if I make a mistake I might lose the funds) and then input 0.5 BTC as that was the agreed price, then confirm the transaction. Behind the scenes, the software digitally signs Bob’s wallet address (public key) with my private key and knows both the destination address and the recipient address, removing 0.5BTC from my wallet and adding it to Bob’s.
Ok, so during the timeframe to verify the transaction, how will the system know I didn’t try to deceive Bob by sending 0.5 BTC to John, Mike and Jill at the same time? This is known as the ‘double spending’ problem, and Bitcoin solves this by utilizing ‘blockchain’ technology.
Blockchain
Bitcoin uses an open public ledger to log every transaction, which it groups into a chain of data ‘blocks’ that string together in a linear chronological order to form what is known as a blockchain.
These blocks are ‘mined’ by powerful dedicated computers that use brute computational force to guess a certain hash, which is a sequence of alpha-numeric numbers. The rate of guessing these sequences is a measure of the ability to mine Bitcoin, and is called ‘hash rate’. The system attempts to time every block to occur every 8 minutes, and does so by adjusting the difficulty level of the hash puzzle.
So what are these blocks? They are simply a collection of all the transactions that occurred on the Bitcoin network since the last block was mined, combined with the identifier of the previous block (so it knows where to place this block in the sequence). The whole Bitcoin blockchain is open and transparent as it contains a record of every transaction that ever took place. However the wallet addresses themselves are anonymous, so even though we can see all of the transactions and balances, we do not necessarily know who they belong to.
Who is mining these blocks and what do they gain? In the beginning days of Bitcoin, you could mine with a personal computer, but as the increase in computational power was predicted by Satoshi, he made the hash puzzles exponentially harder with time, and now dedicated mining computers are pooled in huge warehouses known as mining farms. The incentive for mining is simple — solve a hash puzzle which mines a block, and earn a reward in the form of Bitcoins. Initially, this reward was 50 BTC, but this number halves every 210,000 blocks, until the reward becomes zero with the idea that by then transaction fees alone will be enough to sustain the network.
Ok, so this whole complex yet simple and elegant system (known as ‘proof-of-work) was created for one main reason — to eliminate the ‘double spending’ problem. The blockchain is generated using a ‘proof-of-work’ system, which guarantees that there is no nefarious activity that creates false blocks to allow ‘double spending’. The only way to create false blocks attached to the legitimate chain is to control more than 51% of the computing power of the network. However, the incentives of staying honest outweigh the advantages of the attacker double spending his balance, and once discovered this false blockchain can potentially be reverted.
The Economics: What’s Different About Bitcoin?
In terms of economics, Bitcoin is more similar to gold than it is to the cash or credit we use in our everyday lives. Money has changed drastically since the Bank of England removed the pound’s pegging to gold in 1931 or the enactment of the ‘gold-grabbing’ 1933 Executive Order 6102 in the United States, which technically didn’t remove the peg but devalued the dollar by almost half, until in 1971 Nixon finally removed the gold standard.
Much like gold, Bitcoin is mined; has a finite supply; and currently requires brokers (crypto exchanges and OTC desks) to trade it.
Monetary Policy: Supply
The major differences with today’s money is that it has an infinite supply, with central banks able to print money out of thin air, and banks able to utilize the ‘fractional reserve’ method to lend many multiples of their holdings. This is much like leverage trading — when things go well, lots of bonuses for fat cats, however, as we have seen many times before, when things go wrong they go spectacularly wrong! (look up REKT)
In contrast, there will only ever be 21,000,000 Bitcoins in circulation once the last coin is mined. In fact, due to the fact that many coins have been lost in inaccessible wallets, the final circulating supply will be considerably less. As it stands, there are only over-collateralized loans — where individuals can borrow a small percentage against their Bitcoin value.
Monetary Policy: Inflation vs Deflation
The average rate of inflation in the US over the last 20 years is 3.22% with a current inflation rate of around 2.2%. This figure represents the increase in price of general goods and services, and is effectively the rate in which money loses value each year. This is seen as a healthy way to stimulate the economy by promoting spending and discouraging saving.
Bitcoin, on the other hand, with its finite final supply and milestone reduction in mining rewards (halvings), will eventually have a 0% inflation rate. As of writing, the current inflation of Bitcoin rate is about 3.6%, with the next schedule halving estimated to arrive in May this year. Once that event occurs, the Bitcoin inflation rate will drop to 1.8%, lower than the world central banks’ inflation target of 2% for the first time. While central banks are renowned for manipulating inflation rates, giving them an excuse to print and inject fiat cash into the economic system, Bitcoin’s inflation is dictated by mathematics and cannot be changed.
Geographical Acceptance
The world has 180 fiat currencies, each of which is required to buy goods in their countries’ local economy. This allows banks and money changers to profit from unavoidable, excessively high exchange rates. Additionally, the foreign exchange (FOREX) market is worth almost $2 quadrillion (2.5x larger than global GDP), with $5.3 trillion traded every day. This market mainly exists as a tool for governments and central banks to gain more control on world finance.
If Bitcoin becomes an internationally recognized currency, then it will be redeemable in any countries’ economy. This could have profound effects and usher in a new global balance of fairness, the immediate result of which is unpredictable in terms of global pricing, but a long term equilibrium would surely be found.
Ownership, Custody & Control
At present, banks are trusted to take custody of customers’ money. In return they offer security alongside a plethora of services such as ATM withdrawals, bank transfers, and credit/debit cards. They also have the power to freeze or close accounts, block transfers, and deny or restrict free access to funds (think bank opening times or online services maintenance).
When you own a Bitcoin, you own a Bitcoin. It’s yours. No one can take it away from you (ignoring phishing and extortion), block you from sending or receiving coins, or charge you extra fees. As long as you keep your security tight, you finally have full control of your money.
The Future of Bitcoin: Hurdles to Decentralized Money
If you want to make enemies, try to change something — Woodrow Wilson
That’s it, right. Digital peer-to-peer cash. That’s what Bitcoin was envisioned to be, and that’s what Bitcoin does right now. But, does it? Even though ‘maximalists’ would tell you otherwise, Bitcoin is not a widely accepted currency.
Sure, you can buy some things and pay for some services in Bitcoin, but as taking payment in cryprocurrencies is optional and not demanded, then it is not yet legal tender. To Bitcoin’s defense, there are more and more stores going ‘cashless’ by only accepting card payments, which means that cash itself is not always king.
Herein lies the great crypto conundrum. Peer-to-peer, yes. Electronic, yep. Cash, well… no. Or at least, not yet…
Cash is legal tender — currency or coins — that can be used to exchange goods, debt, or services.
“Wait, don’t Bitcoins sell for thousands of dollars?”, I hear you say. Yes, they do. They sell for thousands of US dollars on cryptocurrency exchanges like Coinbase or Binance, or through regulated brokers like BitPanda. These exchanges run much like regular business do and need government approval to operate within the guidelines of local financial legislation. Essentially, that makes them proxies of financial institutions.
So, in order for the the true vision of Nakamoto-san to materialize, we need:
- a peer-to-peer method of trading Bitcoin with fiat (crypto on-boarding) — removing manipulation, bringing down fees and protecting the right to privacy (i.e not being retroactively connected to your Bitcoin wallet address)
- the general population to understand and embrace the core tenants of this new technology as something that is more planet-positive and efficient than current systems
- merchants around the world to accept BTC as their main payment system, seeing the benefits of a cryptographically-secured decentralized economy
This peaceful exodus of the current financial system could result in those in power using oppression and violence, as they have done countless times in history, to subdue the masses to prevent the rate of adoption. I hope this is a bloodless revolution, where game theory concepts render the use of such tactics non-viable.
But… we are human, after all.
