The next big thing – Bitcoin 101

Back in November last year, I was drinking coffee at HTW and chatting with a good friend. He started telling me about how much profit he made by investing in Bitcoin. “Bit… what?” I asked and he told me a story related to a virtual currency, invented by a pseudonym (Satoshi Nakamoto) that was valued 1 USD last year (per Bitcoin) and 800 USD now. Huge profit! He even made me download a wallet and gave me a few dollars’ worth of Bitcoins. My mind was full of visions of another “Ponzi Scheme” and I made fun of him together with the rest of the guys around the table. Went back home, researched. And I was intrigued. Researched some more. And I was surprised. More work and I was amazed. Eventually, in December, I was sold. Bitcoin is the next big thing. Get prepared for a long read.

Basics: What is bitcoin?

I am surprised to learn that, even though everybody speaks about it, very few people actually know what it is. And it is not that easy to put things together just by asking our friend Google, because you will either find information which is very technical or very shallow. So I’ll start with the very beginning and I’ll try to give you relevant information, not necessarily 100% technically accurate (for the benefit of understanding the bigger picture):

I will start by saying that “bitcoin” is actually two things: bitcoin the virtual currency (I’ll call this BTC here, just to underline the difference) and bitcoin the protocol (I’ll call this bitcoin). Bitcoin (the protocol) is actually a ledger of transactions of assets (underlying the general assets). And here is the first thing to understand: Whereas assets were recorded until now mainly via “Balance Sheets” (static pictures of your belongings at a certain moment), with statements of transactions as ancillary documents, bitcoin says that the main document is the “P&L”, which is the journey between two moments / balance sheets. Based on the huge computer power to which we have access today, we register the transactions in the ledger and, if we want to know how much money (or other assets) there are in a specific account/wallet, we just crawl the full ledger and do the math. This protocol is distributed and democratic. Which means the ledger is stored on millions of computers (so it cannot be killed) and any transaction needs to be accepted by more computers to get into the ledger. This seems very idealistic, but it works.

And BTC (the currency) is only the first asset to be stored in such a way, using this technology. It was created and used only as a starting reward for people to volunteer the use of their computers until the critical mass of fees (see what transaction fees are in the next paragraph) was reached.

Technology/ Process

So, there is a ledger of transactions. Each line is one transaction, which says that wallet 1 gave wallet 2 this asset (potentially for this fee) and a timestamp. Lines are organized in groups (blocks) and the ledger is called “block-chain”. When a transaction is being initiated, it is placed in a queue before being accepted in the block-chain.

There are a lot of computers (miners) that are part of this system. Their main job is to confirm / settle / approve transactions (I would have called them settlers, not miners – but this is a different story). So each of them copies (as opposed to move) a transaction from the queue, approves it (by crawling the block-chain) and puts it into his block.

Each miner is doing two things:

(A) Approving transactions and trying to create a block of transactions. Every approximately 10 minutes a new block is started. Every miner is piling up transactions on his own, creating a block. So every 10 minutes millions of alternative blocks are being created, but every 10 minutes only one block is the winner that makes its way to the block-chain. Since this is a race to process transactions, miners prefer to process the transactions which have higher fees for processing. Transactions which are part of the “loser” blocks are not lost, they are left in the queue for processing.

(B) The second thing that a miner is doing is solving a math problem. The solution of this math problem is not the BTC and there is no connection between the problem and the currency. Solving the problem is just a way a) to get a time bomb for the block – as soon as the first miner solves the problem, the current block is completed and a new one starts and b) to decide who the winner is. The winner block gets into the block-chain (all the others vanish) and the successful miner gets the award.

The block winner award: in order for the system to work, miners need to get paid (because they spend resources – time and power – to run this process. This award has two components: some BTC and the fees associated to the processed transactions). In the long run, they will be paid by the (voluntary) fees attached to transactions. But to kick-off the process, until the number of transactions (and fees) gets to a critical mass they invented the BTC (picture below). Transactions can be free of any fee and miners will chose them out of the queue on a fifo basis, or they can volunteer a fee and miners will pick them quicker (of course 🙂 ). This is a very interesting mechanism that will settle based on the market: more transactions –> longer queue –> longer the time to wait for settling –> people choose to pay a fee –> bigger fees –> more miners interested –> shorter queue. Getting back to BTC – this is the only way BTC is being created (minted): Every 10 minutes a number of new BTC are being “printed” and awarded to the block winner. As in the picture, every 4 years the BTC award is halved: 2009 – 2013 the price was 50 BTC, now it is 25, in 2017 it will become 12.5 and so on. If you do the math, you realize that the total potential number of BTC is limited asymptotically to some 21 million BTC. Obviously, in the first 4+ years half of them were already thrown into the market, so now we have already printed about 12 million BTC. Some of them were lost (at the beginning people did not understand the value of BTC), some of them (1 million BTC?) are assumed to belong to the famous Satoshi, who promised not to use them (whatever this means).

Security

The protocol as well as storing of sensitive data may raise a lot of security issues. But then, the only way to be 100% secure is to be 100% disconnected from the world. I will not get into details (I am not necessarily a specialist, I will probably try to ask a good friend to write more about this in a separate post) but: the protocol seems to be as secure as the cryptography itself, and this has a very strong history. I guess that the biggest threat is in user misuse or mistake, which is very similar to what could happen to fiat money and money storage.

Financial

The obvious questions I hear are:

Money is supposed to be backed by something (gold, other valuables, government…). BTC is just smoke. Why would it survive?
Not 100% true. Today’s money is significantly less than 10% backed by gold, because of leverage by the banks. Today’s money is not backed by government – it is being used by the government. Today’s money (let’s call it fiat money, from the Latin fiat = existing) is being backed by trust. As long as people trust it, it has value. Same with BTC – as long as people trust that tomorrow they will be able to use their BTC, the currency will exist. And, one way or another, this trust seems to be here to stay. Look at all the hits that BTC got in the last 3-4 months, culminating with the death of Mt Gox (one of the BTC exchanges). BTC is still there, with a very limited value drop. And after each drop, it goes back up.

21 million units is a small number. We have 1.3 trillion USD (about 5 trillion USD worth of all currencies, worldwide). How can it be used?
BTC has 8 decimals. So, if you keep the last two for cents, we can actually have 21,000,000,000,000.00 units; this is 21 trillion units (plus cents 🙂 ). And today’s value of one unit (called one satoshi, with respect to the bitcoin creator) would be 0.0005 USD (based on 1 BTC = 500 USD). So, Yes – it can be used and there is plenty of space to increase the value.

The value is very unstable. Is this not bad for a currency?
This is bad for preserving value, but it is good for speculative business. The start of a currency can be (and should be) very speculative. This is how you create wealth in that specific currency. Moreover, if you look at the short history of BTC, it is becoming more and more stable. BTC gets a lot of hits and is still quasi constant in value.

I can buy a beer with my USD. Can I buy beer with BTC?
More and more shops accept BTC. You have BTC ATMs in most of the cities. Online businesses started accepting BTC. I know of people that made a point of living 100% with BTC, and it is possible. Not comfortable yet, but we are quickly getting there.

Political
The governments are losing some of their power – the power to print and control money. This is true and probably the most important threat for the BTC adventure. But the play has already got too far for governments to be able to kill it easily. The beast is alive and mature, and self-sustaining. As media companies could not kill torrents and (more important) as governments could not kill internet, they will not be able to kill bitcoin. So, based on the famous “if you cannot kill them – join them” I bet my two cents that eventually governments will choose to slowly regulate virtual currency, control it as much as possible and establish rules to mitigate risks. The more enlightened thinkers of the governments (hint, hint) will actually gain a lot out of this opportunity for their countries.

You can already see that things are moving in the right direction: many countries (including the US and Western Europe) have declared that they want to regulate BTC but they are generally happy with it; two (Iceland and Thailand) have said that they are forbidding the use of BTC, as they are in depression and don’t want wealth to leave country. Others are in the “wait and see” mode.

Very interesting story (that I don’t know how to read yet) is VISA and Mastercard shutting down operations in Russia for one day, apparently as a penalty and a reaction to the recent politics in the region. Using BTC/bitcoin can prevent this kind of dependency on the big credit card institutions and some states might even take advantage of this.

Fiscal

Another big questions for governments is “how to tax BTC”? And the core of this issue resides in the question “is BTC a currency, and should it therefore be taxed with VAT/sales tax, or is it an asset, and taxed with capital gain?”. I guess this is the biggest of today’s questions. The US taxman gave his views a couple of weeks ago: in the US BTC should be treated as asset.

Some people say that this decision of the US tax authorities is a setback for BTC, as it takes away the main feature of a currency: each unit is exactly as the next one. So if you have 100 BTC you should be able to spend any one of them and the specific BTC you use for the transaction should make no difference. With the US view, if you have one BTC acquired at 100$ and one BTC acquired at 200$, when you buy something it does matter which BTC you use. Because you need to declare your capital gain on that specific BTC.

I would say that US clarifying how BTC should be taxed is a huge step forward. It pulls the BTC out of the grey area of “what the hell is this?” and legitimises it. It is now obvious that we are not speaking about some tricky games or occult practice. It is also clear as to what you need to do in order to be 100% legal and in good standing. And this is the basis for solid business. Second, it actually creates an opportunity for companies to offer more services for and with BTC.

But my guess is that, at some point in time, if things work as they seem to work today – huge hype, lot of shops accepting BTC, accelerated learning process for consumers – we will get quickly to a point where the US and others will take the next logical step: they will treat it as a currency.

Legal

The legal side of the story is also very interesting. Living in a world where banks are under huge pressure for compliance, KYC (know your customer), avoidance of money laundry and terrorism – the use of an alternate, non-regulated currency looks like a big challenge. Therefore there is a need for the legal system to get updated. Now, please remember that we are speaking of the legal system of a lot of countries getting coordinated. This is not a simple task, but it will happen due to pressure from the users. I am already seeing most of the big law firms designating a “Bitcoin Partner” – this means that they see the opportunity and are taking it seriously.

The legal requirements will also eventually push for a move to treat BTC as currency rather than an asset based on the fact that assets cannot be easily monitored and regulated. Buying beer with BTC (asset) is a trade and nothing regulates it, and you can do this without any clearance from National Bank or any other fiscal regulator, whilst buying beer with BTC (currency) is subject to all currency specific laws and regulations that I was speaking about above.

Social

One very interesting aspect of bitcoin and BTC is the social part. This is now perceived as the next “Flower Power” movement. ‘69 was the last time when so many people spoke loudly for freedom – freedom of speech, freedom to sing, freedom to spend. BTC is supposedly (rightly or wrongly) the one subject that now makes people raise their heads and “fight the system”. The movement gets bigger and bigger. Sometimes such movements go the wrong way and are misused, but the vast majority of people are thinking about it as the savior from oppressive chains, the key to freedom of not being followed every moment, like we see in the movies (police using banks to track the plastic for fiat money usage).

Business

Both bitcoin and BTC are huge business opportunities. One needs to understand the way to get involved (and there are quite a few) and understand the risk / reward model:

BTC: an investor may choose to invest in BTC to speculate on its value. The general feeling right now is that the right price for BTC is (one / two years projection) around 4,000 USD. So, if you want to gamble on the currency itself, fell free to invest in it as you invest in any other financial instrument (shares, bonds, etc). There already are a lot of funds specialized in investing in BTC, so your wealth management bank can just acquire positions in such a fund if you don’t want to buy BTC yourself and monitor its value.

Infrastructure: the other new business potential is to build bitcoin related infrastructure. This does not have anything to do directly with BTC value, but it basically creates technologies and services that would help people use BTC or bitcoin. Some quick examples would be: hardware for miners, mining itself, processors, wallets, exchanges. I spoke to one bank the other day and asked “Is BTC/bitcoin a friend or a foe of the banking system?”. And, surprisingly, the answers was that it is a friend! A bank that openly thinks about the future will not perceive BTC as a threat that will eat into their existing business, but as a tool to gain more access to consumers. Now, this is only one of a lot of huge opportunities for innovative startups. Mining pools software… there are so many basic infrastructure things that are needed, that you can consider this as the opportunity to create a brand new industry.

In any case, my suggestion to bitcoin/BTC enthusiasts would be not to double-dip. Invest only in one of the two, don’t risk both sides.

Math

Is there a math problem that cannot be broken? It is a non-reversible function f(x)=y, where you know the result (y) and need to find x. The only way to do it is by trial and error. So one needs a lot of computer power to quickly test the function for a lot of x and see if the result is y. As the number of miners and the processing power grows, the time to solve the problem decreases – and the function is getting more complicated to keep up the 10 minutes.

PR Story

This may not have worked without a very good PR story. And we have two of them!

One is the glamour of an unknown, undercover, extremely clever creator. Bitcoin was designed by a Satoshi Nakamoto that nobody knows. It is almost as a religion now and he becomes a mystery man….. But the story is good, the plot is perfect. Last month, in a new episode of the series, Newsweek said that they discovered the guy. A lot of buzz, press, etc… no, it was not him, search again. 

The second story, even more mysterious, claims that such a big disruption would not have happened without the support of some very elite groups.

Philosophy

This is a mind twisting game changer. Hundreds of years ago we were sure that we cannot fly, and when we did, we were puzzled. Now we think about money as we know it today. Money means bank, cash, credit cards, gold… For some time, pressure has been building for a more efficient digital way to store and use money, and the solution has obviously appeared. We are scared, we see all the downsides, people misusing it. But eventually we end up embracing it and changing the world. As internet did so many years ago, when we did not think that it would ever be possible to do so many things, bitcoin is changing our lives every day.

The new thing – the internet of assets

The internet protocol first appeared in the 70’s. People did not know where this would go, as it was only a simple hand-shaking protocol between two computers, linked by a wire. Computers could exchange bits – who cares?

Then, in the 80’s, the first layer of infrastructure was built around the internet protocol – hardware. Companies like Cisco took over the world (and they actually became the most valuable corporation of the world at some point).

And still we were not there: in the 90’s, the second layer of infrastructure started to grow – software. Netscape and others like them built the dotcom bubble.

In the 2000’s Google appeared to organize the world’s information and in 2010’s apps and applications are showing us the real power of the internet. Facebook, Linkedin, Amazon are only a few names of companies that we now believe are so important to us. They are huge companies, life-changing businesses – but they would not have been possible without the protocol invented in the 1970’s.

I believe the bitcoin protocol is trending in the same way. It was invented (created, started?) in 2009 and we are now evolving at a quicker pace than during the internet boom. Five years instead of 10 (you know, we are now moving faster 🙂 ) and, in 2014, the first layer of infrastructure is being build: miners, pools, exchanges, processors, wallets, coins, security layers, ATMs… all the basics required for BTC to boom.

Like with any new game changer, the fans of BTC will have to overcome challenges – legal, taxation and the political environment. In less than five years from now the banking system will most probably be duplicated for BTC. Banks will learn that bitcoin is not a foe, but a friend and will start to use it. And the second layer of infrastructure will be there. Then things will get organized. Five years more and killer apps will show us why bitcoin was, and is, important. Will this be a wallet that can store all your valuable assets? Or some money replacement? Who knows… but I put my two cents on the table that it will be big, very big!