Crypto… for the Rest of Us
This series is for the person that wants to understand the value proposition of the various different cryptocurrencies. This isn’t for developers/programmers, and it isn’t for investors. It’s for the person that wants to understand what the future looks like when some of these blockchain-based technologies start to become a part of our everyday lives.
Bitcoin: The Grand Daddy
Bitcoin is digital cash money. Think of it as another currency similar to the US dollar or the Japanese Yen. It’s the first, the biggest by market cap (total value), and has the strongest adoption, by far, of all cryptocurrencies. While other cryptocurrencies have functions beyond storing value (basically being money), bitcoin only has one job, and that’s to be money.
Like the dollar bills in my wallet, if I lose my bitcoin, it’s gone. If all my money is dollar bills, and I don’t want to be careless with it, I’ll develop a process. I’ll put my “walking around money” in my wallet, and I’ll put the rest in a safe. If I lose my wallet, I’ve lost my “walking around money”, but I haven’t lost my life savings. No big deal. Additionally, if my boss were to pay me in dollar bills, I’m not going to let him hold onto my money until I need it. I’m going to take all of it, put most in the safe, and the rest in my wallet.
Now let’s talk bitcoin. Start with my pay. My boss is either my literal boss and is paying me in bitcoin, or is a crypto exchange like gemini.com where I can exchange dollar bills to bitcoin. In either case, once the bitcoin is mine, I take possession of it. I put most in my safe, which for bitcoin would be a hardware wallet like a Ledger Nano X or a Trezor, and the rest, my “walking around money” I put in a software wallet on my phone. The wallet you choose doesn’t matter, it’s based on personal preference. You could use Jaxx, Copay, bitcoin wallet by bitcoin.com, Bread Wallet (all wallets I have used). Remember the ground rules for a software wallet are the same as the rules for your leather wallet that holds dollar bills, you’re going to be careful with it, but will never put more in it than you can afford to lose.
So bitcoin is just like dollar bills, right? No way! Much better. When you create a bitcoin wallet, you’ll be told to write down 12 words (sometimes 24). These regular words are the key to be able to restore your wallet, and the money in it, to another phone or computer. Write those words down with a pen on actual paper. Don’t type them anywhere, and don’t take a picture of them. You don’t want any electronic record of your “magic words”. Now, go put that piece of paper in a lockbox with your bitcoin hardware wallet (ledger Nano X or Trezor). OK, so far big pain in the butt right? Stink no! It’s much easier to write words on a piece of paper and put the paper in a safe than it is to go open a checking account, pay the bank it’s fees, and then deal with monthly statements, additional fees, and additional banking issues.
Now your “walking around money” can only be lost if you lose your phone AND didn’t have a passcode on your phone. In that case the person who took it can transfer your bitcoin to a different wallet. Even if you don’t have a passcode on your phone, there are other things you can do if you want tighter security on your “walking around money”. You can use what’s called a multi-signature wallet on your phone, like Copay, and configure your wallet for multiple signatures. That way, when your phone is stolen, and nefarious Norm tries to send your bitcoin to himself, the transaction won’t happen until the second person authorizes it. That second person would be someone you trust, someone you installed your wallet on the phone of when you created your wallet. There’s an easier way to secure your phone wallet. Put a passcode on your phone and if your phone gets stolen, remote wipe it. Then you can get the piece of paper, buy a new phone, install the bitcoin wallet app, and restore your money back to the new phone. Remember the money you store on your phone is “walking around money” and probably is less than the price of a new phone. Security has to be reasonable.
Secure what’s important to you with heroic measures, but secure within reason what has little value. — Me
OK, time to talk about your new hardware wallet. This little device is your bitcoin safe that you’ll want to store in an actual safe or lockbox. Your level of protection for this little guy depends on how much money is on it (note money here refers to bitcoin). When you take it out of the box and plug it into your computer, you’ll find the process very similar to setting up a wallet on your phone. You’ll create a wallet and write down the 12 or 24 words they tell you to write down (again, on actual paper, nothing electronic). In addition, you’ll setup a passcode to be able to use the device. This is your protection in case anyone steals your hardware wallet. When using the hardware wallet, you’ll either use your phone (Ledger Nano X), or your computer (Ledger Nano X or Trezor), but the important part is that it doesn’t work unless your phone or computer is connected to the hardware wallet. So, computer and phone get stolen? No problem. Hardware wallet gets stolen? Not a problem unless criminal guesses your PIN code. If you do lose your hardware wallet, get a new hardware wallet and ask the wallet provider exactly what to do. If it were me I’d get two new hardware wallets, set one up fresh (which would create new private keys) and set one up to restore my money from my 12 or 24 words. Since the thief has the device with my money on it, I won’t be safe with just restoring and using the same private keys, then both the thief and me can spend my money if he guessed my pin. I would restore my money to one, then transfer all my crypto to the freshly installed hardware wallet. Then I would factory reset the hardware wallet I restored the compromised wallet onto, and then keep that device as a spare in case this ever happens again.
So….why is the hardware wallet so safe? Two reasons: 1. The thief has to have it in his/her physical possession, and 2. All the processing/encrypting/bitcoin magic happens on the device itself, not in the memory of your phone or computer. Your phone and computer can be riddled with malware, viruses and trojans, and you can still plug in your hardware wallet and safely transfer your bitcoin. The private key never leaves the device. Think of your wallet as a car, and your private key as the key that you have to have to drive the car. Money can never be spent without the private key.
OK, I’m tired of writing. I’ll do another card for this series tomorrow on bitcoin mining if anyone wants to hear a lay person description of that. Oh, and please comment if there are any other crypto tokens you’d like to learn about. Thanks for reading.
Bitcoin Mining
A digital currency like bitcoin needs machines to make it work, right? It does, a crap-ton of them. Who makes these machines? Who buys these machines? Who spends their money on electricity and infrastructure to run these machines? The answer is capitalists. There’s money to be made in the manufacture and selling of a “bitcoin miner”, which is simply a device that guesses numbers at a very fast rate. More on that in a bit. There’s money to be made in selling them because there’s money to be made in running them. Every 10 minutes a “block” is created and written to the “blockchain”. A block is a listing of transactions summarized into one file, like your deposit at the bank. You give the bank an envelope (block) containing your multiple checks to deposit (transactions). That envelope gets added to your bank account as a deposit. The bank teller brings up your account, which is a ledger representing all the deposits and withdrawals you’ve made, and adds an entry (block) into your ledger (blockchain). Sometimes you’ll hear bitcoin or other cryptocurrencies referred to as a DLT. That stands for Distributed Ledger Technology. So, instead of your ledger being stored at one bank, and you being the only one served by that ledger and you being the only one that can benefit from it, instead the ledger is stored “in the cloud” and everyone on the planet can potentially access it.
OK, slow down you say? The cloud? Well, not the Amazon or Microsoft cloud. We’re talking about a cloud owned by nobody, and existing everywhere. It’s decentralized, no single point of control, and distributed. The ledger is stored in its entirety on many many computers. With something this big, with nobody controlling or regulating it, the rules that it operates by must be complex, right? Not at all. You see, even though it’s a digital form of money that is stored on computers and needs computing devices to be secured, the real security is based on humans, not machines.
The bitcoin blockchain is secured by a consensus protocol called proof of work. Consensus means we agree in some capacity. In the case of bitcoin, a transaction is either going to be legitimate or fraudulent. The people who make that decision are called miners. They make that decision by submitting the block and waiting….. Once more than 50% of the miners agree that the transaction is legit, it’s confirmed, finalized and at that point becomes immutable. Once a transaction is written to the block, it can never be changed or deleted. Think of a block written to the blockchain as “yesterday”. Once you’re done with it, there’s no going back and changing it.
OK, foggy understanding so far, right? Miners run machines, submit a file containing 10 minutes of transactions, and then wait for confirmation? Correct? Yes, but who gets to submit that file and WIFM (What’s in it for me)? The file is submitted by one machine somewhere on the planet, and the lucky machine is paid bitcoin for their troubles. The amount of bitcoin paid every 10 minutes started at 50BTC, and every four years that number is cut in half. I started mining the month before the revenue/fee/block reward went from 50 to 25. Since then it’s dropped again to 12.5 and in a little more than a year (bitcoinclock.com), it will halve again to 6.25. In addition to the block reward, which is the primary way the system introduces new currency into the network, and will continue to do so until there are 21 million bitcoin in circulation, there’s also the transaction fees that are paid to the lucky miner once every 10 minutes. So the idea is that the miners can stay profitable (make more money in block rewards and transaction fees than they pay in electricity and infrastructure costs) as long as the usage of the system continues to grow. As the usage of the system grows, the demand for bitcoin grows. As the demand for bitcoin grows, supply and demand causes the US dollar value of bitcoin to grow. It’s a combination of the transaction fees and the increase in value that keeps the miners profitable.
Super cool moment: The system is self-healing, self-balancing! Let’s say that there are 1000 miners that are making a small profit and the next halving comes. Now with a smaller reward, let’s say all miners are operating at a loss. The most inefficient of the miners start to turn their machines off (think anyone paying high electricity fees or living near the equator and paying high cooling bills). As a miner closes down operations, there are fewer people to share the same pie, which of course means everyone left gets a bigger piece of pie. Think of the guy who always makes that joke “you don’t want any? OK, that just leaves more for me”. Eventually, no matter what the market conditions are, the remaining miners are profitable and the system is healthy.
Alright, miners make money, are incented to keep the system running and healthy, what about that lucky miner? How is it chosen every 10 minutes? That’s where the guessing game comes in. Each miner is relatively dumb/simple. All it really does is guess a really long number, and it makes those guesses many many times per second. Imagine someone somewhere holding a stink-ton of fingers behind their back and waiting to see who gets it right? If the number is guessed too quickly, the number gets bigger for the next time. If it takes the machines too long, the number gets smaller the next time. In the marketplace, this is called the difficulty and it’s tracked over time along with the hash rate (number of guesses per second) to get an idea of how many miners are mining and whether or not a miner can be profitable given the current block reward and the cost he or she is paying for electricity and infrastructure.
Back to the story… Where does the security come from and why is it based on humans instead of machines? Well,
it’s humans, not machines, that do bad things, machines just do what they’re told. — Me
The proof of work can also be thought of as “skin in the game” or “money invested”. The only way to cheat the system is to control more than 50% of the miners. The amount of money it would take to control that many machines, pay that much infrastructure and electricity, is astronomical. The security of the system comes down to a simple premise: a reasonable thief would not spend $500 to steal $100. So we aren’t counting on our inherent goodness or honesty, we’re counting on the fact that humans will generally act in their own self interest. It’s not a moral judgement, just a pragmatic one.
Pretty exciting, so should I mine for bitcoin? Unfortunately, it’s no longer profitable on a small scale. There are still thousands of miners mining so we don’t need to worry about bitcoin becoming centralized or about any one miner controlling more than 50% of the hash rate. Miners today need the economies of scale to make a small profit. My mining business has 2000 machines running in a datacenter, and my percentage of the whole is teeny-tiny. We are currently making a very small profit.
Tomorrow I’m going to answer the question many of you are thinking…Aren’t you a bad person for using all that electricity? (Hint: I’m not.)
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