A lawyer friend asked me about bitcoin, blockchain, investing and bubbles

About two weeks ago, friends came over on a Sunday. At some point bitcoin was brought up and 2 hours later we were still discussing cryptocurrencies (crypto) and blockchain technology. My friend, J, wanted to know the following:

1) Is bitcoin something serious and why.
2) Is it something worth investing in.
3) What is blockchain and what is the difference.

This series of articles is a loose recap of our conversation and a follow-up, addressing questions like ‘how to invest in crypto in general’.

Before you read any further people, be aware of the following:
1. I am a great fan of cryptocurrencies and blockchain tech in general. So, you might say I’m biased in this way.

2. Crypto is new, complicated and difficult in the beginning. The learning curve is steep. So, if you are really interested, do your own research. A lot of it! Don’t take anything I, or anyone else for that matter, says at face value. (you too J!). Trust no one. Including me. I can only present my thoughts and opinions on the subject. I don’t even try to pretend I know THE truth or THE answer.

3. If you are looking for investment advice, here it is: invest in yourself, in your knowledge, understanding of the technology and economics, and in experience.

4. I will discuss some very complicated and complex ideas and technologies in the simplest way possible. But this requires (over) simplification and using analogies that are not always perfect or accurate. Luckily, with the internet you can find plenty of resources on the subject.

What is bitcoin?

Ok, let’s start with a confession. I totally missed out on bitcoin in 2010 when I first heard of it out of ignorance. I completely misunderstood it and the technology behind it. I thought it was a very interesting idea, but believed it similar to loyalty points, or air miles: there is a server with a database somewhere on the internet that keeps records of accounts that hold bitcoins. So, I thought, it’s all well and good until 1) someone pulls the plug and it’s all gone, 2) the admin sends all the bitcoins to his/hers account, or 3) someone hacks the system and wipes my account. In reality, as I learned much later, bitcoin is nothing like this.

What is bitcoin then? It is a database of transactions, an accounting system with a strict set of rules that define how bitcoin is created, who owns it and how can it be transferred from one account to another (to prevent double sending). In a general sense, it’s no different than any banking system. The specifics however, are completely different.

In the traditional banking system the 3 key issues (money supply, double spending and the ownership of money) are managed by laws and regulations imposed by national or international (Euro) governments. This requires the existence of an external authority, a regulator who will audit banks to check if the money is created and destroyed in line with the rules and that accounting is done correctly. This assures that not everyone can create money out of thin air (only commercial banks are allowed to do it) and transfers between accounts are recorded onto both accounts meaning that the same amount that increases one account balance has to decrease the other account balance. Banks are needed to verify identity and decide who has access to the money in each individual account.

With bitcoin it’s done via code. The technology itself manages the money supply, prevents double spending and defines the ownership of bitcoin. There is no central authority, no auditors, no governments or banks involved. There is no need for a trusted third party. People who use the bitcoin system to send each other bitcoins don’t have to trust each other or any third party to trust the outcome of the transaction.

The ownership of bitcoin and access to your account is guaranteed by cryptography. You need your secret private key to send your bitcoins to another account. Only as an analogy, think of it as your password to your online banking.

The double spending problem is solved by a clever peer-to-peer transaction validation mechanism that uses cryptography and monetary incentives. There is no central authority or central server, so all computers on the network have to ‘talk’ to each other and reach a consensus on which transactions are valid (and record them) and which are not (and reject them). On a very, very general level, here’s how it works: Each computer should have the same list of transactions. Each computer then checks that transactions are valid, approving the valid ones (no double spending). It then sends the outcome of this to other computers on the network. The other computers verify if they agree with the received data. If the majority of the networks agree, the transactions are recorded in the bitcoin database.

In order to validate the transactions, each computer needs to invest their processing power. This generates real costs for the owners like the cost of electricity, processing time that could be spent on something else and the cost of hardware. If the outcome is accepted by the other computers on the network (as described above), the computers receive rewards. There are no rewards when the calculations are rejected by the network. This mechanism makes it much more profitable for a computer to be honest and correctly process a transaction rather than to try tampering with records. It is easier, cheaper and much more probable to receive a reward for supporting the network than trying to fight against it (which is very expensive and chances of winning are very low).

The reward for processing transactions is paid in bitcoins. Computers processing transaction are allowed to create a set amount of new bitcoins and add it to their own account balance. This is how bitcoin supply is regulated. All new bitcoins are distributed to computers that process transactions. There is a predefined maximum amount of coins that will be created, and when it is reached, no new bitcoins will ever be created. From that point, computers will charge only transaction fees (this is estimated to happen in 100 years or so).

Because it is an open system, anyone can join the network, process transactions and earn rewards. The higher the price of bitcoin, the more computers join the network, making it safer. It is a distributed, peer-to-peer system, with no single point of attack. This means that hacking into the database (something like the Equifax hack) is physically impossible. The only option to successfully attack the network and tamper with records is to own over 51% of the computers on the network. Due to the cost of the infrastructure and the cost of bitcoin losing value as a result of such an attack, it doesn’t make any sense.

Peer-to-peer, distributed architecture also means you can’t turn it off. In this sense, the bitcoin network is like the internet: no one can pull the plug anymore. As long as our civilization continues, it will always stay on.
Ok, to wrap it up: think of the bitcoin network as a specific case of an online banking system: 1) it runs on a distributed network that no one can control, hack or turn off, 2) it has its own medium of exchange (bitcoins) with its own money supply policy, 3) it can’t be controlled by any government, regulator or corporation. So yes, it is serious. I hope this answers the first question.

What is blockchain?

Blockchain is one of the core technologies on which the bitcoin network is built. Again, in a very, very general sense: when computers process transactions (as described above) they bundle them in blocks. After a consensus is reached and a block is accepted by the network, it is recorded in the database on top of all previous blocks. This creates a chronological chain of blocks = blockchain. The important detail here is this: the newest block being processed has to include a cryptographic signature generated by the previous block. This is how the blocks are chained together. This has a profound effect on the integrity of the database: every new block added increases the integrity of the existing block. With every new transaction, the previous transactions become more secure.

The bitcoin blockchain is public, so anyone can view it, but it can’t be modified without corrupting it (and a corrupt blockchain will be rejected by the network). Only new, approved blocks can be added to the existing blockchain.

The fact that it’s public means anyone can see all of the transactions and check the balances. There are no names or personal details recorded there, just addresses (an analogy would be a bank account number) and amounts. But, if you know who owns a specific address you’ll know how many bitcoins they have.

There are other cryptocurrencies/coins/tokens out there (over 1,300 at the moment) and the vast majority of them are built on a public blockchain. Blockchains can also be private, meaning only selected, pre-approved computers have access (who remembers intranet?).

Is bitcoin something worth investing in?

[Again, this is only my personal opinion. It is NOT investment advice!!!]

What is investing in general? Let’s define it as buying something (an asset) and holding it — assuming it will be possible to sell it later at a higher price — instead of spending the cash right now. I’m not going to discuss trading activities here. By trading I mean actively looking for opportunities to make money based on price volatility of an asset (buying or shorting assets). If you are interested in trading activities, bitcoin and other crypto coins should be perfect — they are very, very volatile.

So, in order to make a decision to invest in an asset you need to expect it to be more expensive in the future than it is now. The fundamental questions here are: 1) where does the value of the asset come from and 2) why would anyone pay you more for the asset in the future?

Let’s start with the value part. Bitcoin was designed as alternative money. It has the ability to settle transactions and be a medium of exchange. But recently, especially after bitcoin broke the $10,000 price mark, no one wants to spend it. Everyone wants to hold it, hoping it will become even more expensive. Right now the value of bitcoin comes, paradoxically, from its ability to store value.

Comparing bitcoin to stocks, bonds, $ or EUR, is comparing apples to oranges. An analogy to gold is more appropriate. Gold is not used as a medium of exchange. Only 10% of the production is used by industry. 90% of gold production is used as store of value, either directly (reserves) or indirectly (jewellery). Other examples of assets that store value include art or wine. People pay millions for paintings or wine because they will be able to sell it for more in the future, not because they are art or wine loves.

By comparing bitcoin to gold or art, the advantages are clear. It is liquid, meaning you can sell it for $ any time, quick and easy. You can buy or sell any amount of bitcoin (1$ ot $1M worth of coins). Try doing any of this with expensive art or wine. Or even with gold. It’s very difficult. And you need a third party, an intermediary to do it: an auction house, a company that stores gold, or you need to buy shares in a fund that buys gold or art. This is another layer of intermediaries and costs in the mix.

The supply of bitcoin is strictly limited (as opposed to gold or diamonds). This means people looking to buy bitcoin in the future will have to buy it from the people who already own it. Scarcity makes it more valuable (like with a painter who has died: the art immediately becomes more expensive because potential buyers know there will be no more paintings). If demand increases and the supply is constant, people in the future will have to pay more for bitcoin than it costs today.

What about the bitcoin bubble?

It is clear (I hope) that the technology behind bitcoin is sound. The store of value utility depends therefore, on the future demand for bitcoin. Why would people in the future want to buy bitcoin? For the same reason! To store value. Will the demand be higher than today? It depend on what’s going to happen with the world. If the world and our civilization will collapse, then probably not, but then it wouldn’t matter anyway… However, based on recent history, we can reasonably assume that the world in general will continue to develop and people will be living better, more abundant lives. The number of millionaires and billionaires on the planet is increasing. Under these assumptions we can assume there will be more money looking for assets to store value. In the long term, the demand will increase.

At the same time, the price of bitcoin is very volatile. There will be many more bubbles that will burst. People will buy bitcoin, see it’s increasing in price and buy more. Some will believe the price will never go down. So they will start borrowing money to buy more bitcoin. Eventually, they will need to start selling some coins to cover their interest payments. As long as the increase in the value of the assets is higher than the interest on the loan it will work. But the moment bitcoin stabilizes they will have to sell the assets in order to repay the loan principal. A lot of people will probably do it the same time. Supply will increase, demand will decrease. The bubble will burst. The price of bitcoin will go down.

But it will not go down to 0. People with money, looking for assets to store value, will wait a little and let the inexperienced speculator bleed out. Then, they will start buying back bitcoin at a discount. This is what happened when the recent gold bubble burst in 2012. Gold was traded at around $1.8k, went down to around $1k and is now slowly climbing back at around $1.3.

Comparing bitcoin to the dotcom bubble is a misunderstanding. Dotcom was about stock — bitcoin is storage of value (apples vs. oranges). The main difference is that people buying dotcom stock were buying promises of future profits of the dotcom companies. Dotcoms were not able to deliver these profits. Bitcoin doesn’t promise anything. It is what it is. There’s no risk of unfulfilled promises or companies going out of business . The wave of recent ICOs (initial coin offerings) and token sales however, have many similarities with the dotcom bubble. (But this will be discussed in one of the next parts of this story).

Bitcoin is here to stay. If you are looking for a good store of value it might be a very good long-term option. BTW. The ‘tulip bubble’ never actually happened. (Daniel Jeffries thanks for the tweet)

What’s next?

In the next parts of this story I will discuss more specifics of investing in bitcoin and other crypto assets: how to buy bitcoin, what else is out there to buy, what is mining, what are ICOs and tokens.

[I published part 2 here: https://medium.com/the-mission/a-lawyer-friend-asked-me-about-bitcoin-part-2-picking-and-buying-coins-a6cd3a71f69b ]

Please feel free to post your comments or questions here, get in touch on twitter (https://twitter.com/HiEnergyPeople) or Linked In (https://www.linkedin.com/in/michalbacia/ )