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Blog Home > Bitcoin 
 
 
Published by: Glen Brink 10-Apr-18
What is Bitcoin

What Is Bitcoin?

 

By now, you've heard of bitcoin.

It's one of the most talked about subjects in finance these days… But if you don't understand what it is exactly, you're not alone. And even among the initiated, bitcoin is a polarizing topic.

Bill Gates, the founder of Microsoft, has said that bitcoin is "better than currency."

Some enthusiasts say it will revolutionize everything from banking to government. These proponents believe that the technology behind it will radically transform the economy.

Others are skeptical, warning that bitcoin should be avoided or will eventually become worthless.

In 2016, Jamie Dimon, the CEO of JP Morgan said, "bitcoin the currency is going nowhere." And Charlie Munger, the vice chairman of Berkshire Hathaway, was so put off by the idea of bitcoin that he once called it "rat poison."

It's worth noting that the market has sided with Bill Gates… at least so far.

But what is bitcoin exactly? Is it the currency of the future? Does it even deserve to be called a currency?

Whether you decide that bitcoin is an asset you want to hold… It's important to understand how it works… and why so many people believe it could represent a critical change in the way we think about and use money.

We've put together this introduction to bitcoin to help demystify this new asset, which may be the most fascinating and controversial development in money and finance in generations… if not centuries. We'll also cover an exciting new phase of bitcoin's evolution – what we call "Bitcoin 2.0" – that's just now beginning.


Rummaging through garbage cans for food is a daily activity for some Venezuelans.

Father José Palmar, a Venezuelan Catholic priest, has implored his fellow citizens to separate food from other waste and label their garbage. He hopes this will aid the poverty-stricken as they forage in dumpsters.

The country suffers from widespread shortages of food, medicine, and necessities. It has been in a state of chaos since the bolivar, Venezuela's currency, collapsed.

Venezuela's currency crisis has caused prices to skyrocket for some 30 million people. The annual inflation rate hit 800% in 2015. And the currency continued on a path to worthlessness with the inflation rate soaring past 1,800% in 2017.

Meanwhile, capital controls make it difficult to get money in or out of the country. Converting bolivars to U.S. dollars at "real world" exchange rates must be done on the black market.

At this point, low-denomination bolivar notes are better suited for use as toilet paper than as a medium of exchange.

Venezuela's currency collapse is the best recent example of an economic reality: All government-issued currencies are flawed.

The euro, yen, and dollar – major currencies of developed countries – may be more stable than the bolivar… But they're still faulty. There is perhaps no better proof than the central banks' grand experiment of negative interest rates.

In 2014, the European Central Bank (ECB) introduced negative interest rates to the eurozone currency union. Basically, this means that euro bank deposits cost money instead of paying interest. These negative rates are either borne by commercial banks in Europe or are passed on to savers.

This drastic measure is part of a plan to do "whatever it takes to preserve the euro," as promised by ECB President Mario Draghi in 2012. Of course, it doesn't exactly inspire confidence in the euro when Herculean efforts are needed just to keep the currency from fracturing.

Savers in Japan (if there are any left) face a similar situation. The Bank of Japan (BOJ) introduced negative rates to its banking system in January 2016.

The BOJ has been clear that it is on a mission to debase the yen and produce inflation.

But what about the greenback?

Inflation has ravaged the dollar over time. The U.S. dollar has lost 96% of its purchasing power since 1913, the year the Federal Reserve – the U.S. central bank – came into existence.

In other words, $1 in 1913 would only be worth the equivalent of around $0.04 today.

Even the dollar – the reserve currency of the world – isn't a good long-term store of value.

Also, we can't assume that negative interest rates will only be a problem faced by European or Japanese savers. At a congressional hearing in 2016, Federal Reserve Chair Janet Yellen said she "would not completely rule out the use of negative interest rates" in the future.

All of these deficiencies stem from a currency's reliance on the government. And all major currencies are issued by the government.

However, governments are beginning to lose their absolute control over money…

You see, bitcoin has no central authority. The government doesn't issue it or control it. A mysterious computer programmer designed bitcoin to be decentralized, much like the Internet.

Bitcoin isn't a fad… It's a new form of money.

Since money is the lifeblood of an economy, this is a huge development. And to fully appreciate bitcoin's significance, we have to fully understand how modern money came to be.

The Progression of Money

Money has gone through several major transformations throughout history.

Of course, gold and silver have served as money for thousands of years.

The first official coins made out of precious metals appeared around 600 B.C. in Lydia (part of present-day Turkey). King Alyattes had coins minted that were made of electrum, an alloy of gold and silver.

On the front of the coin was a roaring lion's head, which was the symbol of Lydian kings. On the back was the impression left by the hammer that pounded the electrum into the die that shaped its face.

These coins, which have come to be known as "Lydian Lions," performed the three main functions of money:

  1. Medium of exchange

    Without some form of money, goods would need to be bartered for other goods. Or if there was no payment, the buyer and seller would need to keep track of the debts incurred. Since the coins were a widely accepted form of payment, they facilitated transactions.

  2. Unit of account

    The markings on the coin signified a specific value, so they provided a common measure of different types of goods. Each coin might have bought 10 sheep, but only five oxen. Therefore, an ox was twice as valuable as a sheep. Also, the coins wouldn't need to be weighed and verified before each transaction like unstandardized pieces of gold or silver.

  3. Store of value

    A sheep herder could store a coin until he needed to buy more sheep. Of course, he would have to be confident that the coins wouldn't lose their purchasing power in the meantime.

For more than 1,000 years, coins were adopted as forms of money around the world. But coins can be inconvenient… They're bulky and hard to carry in large quantities.

In the 7th century A.D., the Chinese began to use paper bills. This allowed wealthy Chinese to leave their cache of iron coins with a trustworthy person in exchange for a piece of paper that recorded how much they had deposited.

Then, around the 10th century, authorities of the Song Dynasty began issuing official "Jiaozi," the oldest government-issued paper currency.

Paper money came to America in the late 17th century. The Massachusetts Bay Colony issued America's first paper money in 1690. The Continental Congress – the governing body of the 13 colonies – began issuing paper money in 1775. And in 1792, the U.S. Congress created the dollar as the country's standard currency.

Then, as the Great Depression unfolded, the prices of goods and services collapsed. In 1933, the U.S. abandoned its commitment to buy or sell gold at a fixed dollar price. This allowed the Federal Reserve to "print" money to stimulate the economy.

In 1971, President Richard Nixon closed the gold window. After that, not even foreign governments could redeem their dollars for gold. The surprise move severed the final link between the U.S. dollar and gold. At that point, the dollar became a fiat currency – backed by nothing but the "full faith and credit" of the U.S. government.

Today, the monetary system is based solely on trust. The Fed, which controls the base monetary supply, must be trusted not to debase the currency. The financial crisis in 2008 and 2009 revealed the problems with this system of trust.

With the banking system on the verge of collapse, the Fed resorted to emergency stimulus measures. In October 2008, the Fed initiated quantitative easing – basically printing money – to avoid a repeat of the Great Depression.

There was nothing to stop the Fed from increasing the base money supply, either. The dollar was no longer backed by anything, so it could be printed out of thin air.

During the monetary mayhem of the financial crisis, a radically different form of money emerged. It wasn't conceived by a king or a committee of bankers… but a computer programmer.

The Birth of Digital Gold

In August 2008, someone anonymously registered the bitcoin.org domain name. That was the first known appearance of the word "bitcoin."

Then, in October 2008, a coder going by the name of Satoshi Nakamoto published a white paper describing the basics of bitcoin.

Satoshi said that he had been writing the computer code for a year and a half. And in January 2009, bitcoin was born.

Satoshi claimed to be a 33-year-old man from Japan… But his true identity remains a mystery. It could even be a group of people.

What we know is that Satoshi developed an elegant solution to the problem of trust with traditional currencies.

Bitcoin is purely digital. It's just zeros and ones (known as "bits") on a computer network… hence the name bit-coin.

That's not as radical a departure from today's currency as it sounds. Economists estimate that only about 8% of fiat currency exists in physical form (coins and bills). So most of our dollars already exist in electronic form.

When your employer direct deposits your paycheck... or you swipe a debit card to pay for groceries... no physical bills exchange hands. But that's where the similarities between digital dollars and bitcoin end…

At its heart, bitcoin is a computer protocol – a set of rules in computer code that control how the system works. The Internet has its own protocol that governs how data and information is transferred. Instead of data, the bitcoin protocol is basically a means of transferring value… something that it's exceptionally good at.

You can quickly and easily transfer bitcoin from one "address" to another. And it doesn't matter where in the world the sender or recipient is: bitcoin knows no borders. (Technically, you don't "send" bitcoin from one place to another, as we'll explain later.)

Bitcoin exists entirely outside of the traditional banking system. It doesn't rely on commercial banks to manage accounts or verify transactions. As a result, there are no middlemen, such as Wells Fargo or Visa.

Bitcoin is transferred via a peer-to-peer network, which doesn't have a central computer server or authority.

Unlike dollars, bitcoins aren't a central bank's liability (or "IOU"). bitcoin shares this characteristic with gold, which isn't a liability of the central bank either.

But bitcoin is far more easily transferred than gold…

In 2013, the Bundesbank – Germany's central bank – announced that it planned to hold half of its gold reserves in its own vaults in Frankfurt, Germany.

The only problem was that much of its gold was held at the New York Fed and in Paris, France. So the Bundesbank had to conduct an arduous, phased transportation of 674 tonnes of gold. (That's the weight equivalent of more than 300 Ford Explorer SUVs.)

The operation cost $9 million and took about four years to complete. Bitcoin, on the other hand, can be transferred to anyone – anywhere in the world – securely, cheaply, and almost instantaneously.

It's electronic and more easily transferrable than gold, but isn't a liability of any central bank. So you can think of bitcoin as "digital gold."

It is like a digital commodity that – like the Lydian Lions – serves the three main functions of money:

1. Medium of exchange

Although far from universal today, more and more mainstream businesses are accepting bitcoin as payment.

The retailer Overstock.com accepts bitcoin… so do Microsoft's Windows and Xbox online stores. And you can pay for DISH Network's satellite television service with bitcoins.

In April 2017, the Japanese government officially recognized bitcoin as a legal payment method and currency. And in September 2017, apartments in two residential towers in Dubai became the first major real estate development in the world to be priced in bitcoin.

Granted, bitcoin isn't an ideal medium of exchange because its price is so volatile. In November 2017, bitcoin declined from more than $7,800 to about $5,600, only to recover and surge past $18,000 before the end of the year.

Again, this is why we view bitcoin as more of a digital commodity, or digital asset, than a digital currency. (Currencies are forms of money, but not all money is necessarily a currency.)

Over time, if bitcoin's volatility moderates and more merchants accept it as payment, it will better serve as a medium of exchange.

2. Unit of account

Bitcoin is fungible: One bitcoin is equivalent to any other.

Bitcoin is also extremely divisible. A bitcoin can be divided into 100 million units (each unit is known as a "satoshi").

Because of its standardization and divisibility, we can easily measure the value of goods and services in bitcoin.

3. Store of value

Bitcoin is designed to become more valuable over the long term because of its limited supply.

With the dollar, the total amount of circulation is up to the whims of the central bankers. Bitcoin, on the other hand, has a predetermined supply. It doesn't suffer from the inflation problems of traditional currencies. So it can be a long-term store of value… like gold.

Gold is scarce. Miners continue to extract more, but the total supply is limited by nature. The Earth's crust only holds so much gold.

Bitcoin's supply is limited by computer code. The bitcoin protocol controls how many bitcoins will ever be in existence.

Currently, around 17 million bitcoins are circulating. Ultimately, there will be 21 million bitcoins. These may sound like large numbers, but they're not.

Credit Suisse estimates the number of millionaires in the world (in U.S. dollars) to be more than 32 million. So not every millionaire could own one… There aren't enough to go around.

Currency vs. Money

People often use the words "cash," "currency," and "money"… but they are not always the same and their meanings are nuanced…

Cash is the paper bills and coins in your pocket. Cash is physical.

A currency is really a commonly used medium of exchange. Today, most currencies are issued by governments. And currency can exist in the digital realm.

Money has the broadest meaning… Anything that is able to fulfill the three functions of money can qualify.

For example, gold is still money. But it's no longer a currency since it's not commonly used as a medium of exchange… although it can serve that purpose.

Bitcoin is money. But until it's commonly used as a medium of exchange, it can't truly be considered a currency… Until then, we'll just call it a digital asset.

Bitcoin's portability and scarcity are perhaps its greatest strengths. Because of its special qualities, bitcoin could represent an evolution in money… just like the Lydian Lion coin and the Jiaozi paper money.

However, bitcoin aims to break up the government monopoly on money that has progressed ever since the first Lydian Lion was minted.

Before you continue reading, keep in mind that it's not necessary to understand the technical aspects of bitcoin to grasp its basic concept. You can simply create a digital wallet and start obtaining and sending bitcoin.

You don't need to understand the complexities to use it… just like you don't need to know everything that goes on behind the scenes with the banks and payment-processing network when you swipe your credit card.

However, we believe everyone should have at least a basic understanding of the technology behind bitcoin. And as an investor, this knowledge is invaluable.

At this point, we're going to get a little more technical and take you deeper into…

The Science of Cryptography

How often do you log in to your bank's website to check your account balance? Or when was the last time you entered your credit-card information and billing address into a website to buy something online?

If you're like us, you do this all the time and don't think twice about it.

Thankfully, your sensitive data are secure because of modern cryptography – the study of sending and receiving secret information.

Web browsers and Internet protocols help us create digital secrets automatically when we send private information from our computers and smartphones. Similar cryptographic technology is used by the bitcoin network. Bitcoin is known as a crypto-currency because cryptography plays a crucial role in making bitcoin secure.

To help show you how, let's consider the following scenario… You walk into a coffee shop that happens to accept bitcoin as a form of payment.

You order a large coffee, which costs $4 (or 0.0008 bitcoins).

At the counter, you take out your smartphone and open your bitcoin wallet. You scan a QR code (a two-dimensional barcode) posted next to the cash register. It looks like this…

You then enter 0.0008 bitcoins as payment and press "send." You just used bitcoin as a medium of exchange.

You transferred value directly to the merchant. No bank accounts were involved. Also, because you didn't use a credit card, the merchant didn't have to pay an interchange fee to the card-issuing bank or a payment-processing fee to Visa.

The merchant and you had never met each other before. And yet, he was comfortable giving you his bitcoin address. He also knew that the bitcoin you were "sending" him wasn't double-spent somewhere else.

Bitcoin completely removes the need for trust between you and the coffee shop merchant and allowed you to transfer value directly.

Let's examine how bitcoin did this…

The digital wallet on your phone (or computer) is just a few computer files that hold your digital "keys." There are private and public keys. These key pairs are how bitcoin ownership is determined.

There might be many key pairs in your wallet, but we'll simplify to just one pair here.

The private key is a long, random number. It proves ownership of bitcoin and must be kept a secret.

The private key and its corresponding public key are related. Apply some fancy math to the private key, and you're left with the public key.

The coffee shop merchant has his own set of keys. But he gave you his bitcoin address (in the form of a QR code). bitcoin addresses are created with the help of cryptographic hash functions.

A hash function takes an input and applies some calculations to produce an output (known as a "hash").

A hash can be thought of as a digital "fingerprint" of the input. No two people should have the same fingerprint. Likewise, no two inputs should have the same hash.

Here's an example of a hash:

B4056DF6691F8DC72E56302DDAD345D65FEAD3EAD9299609A826E2344EB63AA4

All hashes from a particular hash function are the same length. The input could be a single letter or the entire novel Moby Dick and their outputs would be the same length as the string above.

Also, it's impossible to take a hash and work backwards to figure out the input. This is why the coffee-store owner could give you his bitcoin address, which is the hash of the public key.

Just by knowing his bitcoin address, you wouldn't have been able to figure out what his public key was. And even if you knew his public key, it would still have been impossible for you to figure out his corresponding private key.

The coffee-shop merchant can safely display his bitcoin address in public. And public keys can be broadcast… which you did whether you knew it or not.

You see, to pay for that coffee, you had to prove that you had possession of your private key. But you had to do that without showing the private key to anyone.

In the background, you created a digital "signature" with your private key. Every bitcoin transaction needs a valid signature, which is unique to each transaction. So if you bought a cup of coffee yesterday from this same coffee shop, your signatures on the two transactions would still be different.

Today, you broadcasted the signature for this transaction and your public key to the bitcoin network.

Because your public and your private keys are mathematically related, the bitcoin network can validate this signature without seeing your private key. In other words, the network can verify the private key that corresponds with your public key was used to create this signature.

This example shows how cryptography keeps private keys confidential, while making verified transactions possible.

This leads us to the next big question… How does the bitcoin network know that you have enough bitcoin in your wallet to pay for this coffee? After all, to transfer the 0.0008 bitcoin to the merchant, you first must have obtained it.

This is how the blockchain comes into play.

The Money Ledger

Bitcoin is money. And its blockchain is the ledger that keeps track of who owns this money.

The blockchain is basically a database. It stores data about every single bitcoin transaction.

The bitcoin blockchain began on January 3, 2009, when Satoshi's computer established the "genesis block."

The blocks are groups of transaction data. Each block is organized like a ledger, or record book. Let's take a look at some hypothetical transaction data.

This particular block contains data about your coffee purchase.

Instead of names, like Alice or Bob, the actual ledger shows bitcoin addresses. Everyone can see the block data. But since it only records bitcoin addresses, it offers a degree of anonymity.

A bitcoin payment is just a credit to one user and a debit from another. This is why you don't really "send" bitcoins. Your 0.0008 bitcoin was just transferred from your address to the coffee shop's address.

In this ledger, you can also see the unique signatures needed to verify the transactions.

Since the blockchain data is visible, bitcoin users can agree on its accuracy. In other words, we can trust the blockchain instead of having to trust other bitcoin users.

But that means we have to be confident that the blockchain can't be changed…

The blocks have a "header," which includes a timestamp of the time and date for the block.

The header contains a compact summary – created using hash functions – of the transactions within that block. So if a malicious hacker were to try to change the amount you paid for the coffee from 0.0008 to 8 bitcoins, the transaction data in block 79 would no longer match its header.

Each block header also has a hash of the previous block's header. Therefore, there's data from the previous block inside of each block. This is how the headers link, or chain, the blocks together… hence the name "blockchain."

The linking mechanism makes the blockchain immutable… No one can alter it.

Changing any part of the transaction data within a block would change that block's header. Then, that header would no longer sync with the next header.

Essentially, the blockchain is a trustworthy accounting system.

Since the blockchain contains every bitcoin transactions since the genesis block, we can tally all of the bitcoin credits and debits and determine how many bitcoins each address has. This is how the network could verify that you had enough bitcoins to pay for that cup of coffee.

Besides immutability, decentralization is another crucial security feature of the blockchain.

The Distributed Ledger

A centralized database exists in a single location. There is one copy on a computer or server that users can access.

If the server fails, the entire network is shut down. Also, if the data on the server are compromised, then all of the users will see faulty data.

A distributed database, on the other hand, has no single point of failure. Many copies of the database exist. And these copies can be used to verify each other's accuracy.

Bitcoin is distributed. Not even governments can shut down bitcoin because of its global, distributed structure. (What governments can do is control the exchanges that help you turn your fiat currency into bitcoin.)

The bitcoin network consists of around 10,000 computers running the protocol around the world. If some of these "nodes" fail, the bitcoin network continues to function. Also, thousands of copies of the blockchain exist, which helps ensure the integrity of the data.

Let's say a node received your coffee transaction. It's a valid transaction that the node hadn't seen before, so it passed the information on to other nodes. In turn, those nodes sent the transaction on to even more nodes. Within seconds, virtually the entire network had received your transaction data.

However, the transaction doesn't become part of the blockchain until it's included in a block and attached to the chain by a process called "mining."

Specialized nodes (called "miners") take the next group of unverified transactions and bundle them into a block. They verify the transactions and then race to solve a math problem involving the block data and a hash function.

The only way to solve these math problems is to guess and check to see if the answer is right. The miners plug in the block data, along with a random number (called a "nonce"), until they find a nonce that produces the desired hash.

The first computer that solves the math problem receives newly created bitcoin. This bitcoin reward (which is now 12.5 bitcoins) is the incentive for the miners to use their computers and processing power to validate transactions on the bitcoin network.

The competition to solve the math problem is a "proof of work" system. The miner that comes up with the solution to the problem first has proven that it has done a lot of work to come up with the right input.

The other miners then check that the math problem has been solved correctly and that the header of this block and the previous one match up. Once everything is verified, they add the block to their blockchains.

Now that you're familiar with what a blockchain is, you'll be able to see through the hype.

Every time you hear that blockchain technology will revolutionize our way of life, think to yourself… A blockchain is just a ledger. It may be a special type of distributed ledger that serves as the basis for a new type of money. Nonetheless, a blockchain is just a shared record book.

A big benefit of this distributed system is that verification comes from the consensus of many nodes. The network has agreed that the transactions in a block that is being added to the blockchain are all valid.

It would be hard to hijack this network. A malicious group would need to control more than 50% of the processing power of the bitcoin network to corrupt the blockchain. That's an unlikely scenario, given the size of the network.

Computing Power

IBM's Watson computer famously won the television trivia show Jeopardy! in 2011. At the time, the supercomputer could perform 80 trillion operations per second (with decimal numbers). And since then, the computing platform has been repeatedly upgraded.

Watson has helped companies solve complex problems and cut costs. Watson has even helped doctors diagnose cancer.

Indeed, Watson is versatile. But it would be nearly useless for bitcoin mining…

Most bitcoin miners use specialized computer systems with hardware that's specifically designed to perform hash functions – and nothing else. The more hashes these mining "rigs" can perform per second, the better the chances they'll solve bitcoin's proof-of-work math problem first… and win their owner some bitcoin.

The "hash rate" measures how fast miners can compute hash functions. The hash rate for the entire bitcoin network is more than 7 million terahashes (trillions of hashes) per second. That's 7,000,000,000,000,000,000, an outrageously large number.

Prior to 2016, the hash rate hadn't exceeded 1 million terahashes. So, the aggregate computing power of the bitcoin network is growing exponentially.

With the bitcoin network growing more powerful, you might assume that blocks are being mined faster. But that's not the case. Miners still add a block to the blockchain every 10 minutes, on average.

The reason that it continues to take about 10 minutes to mine a block is because the difficulty of the proof-of-work math problem is adjusted dynamically. If miners are consistently adding blocks faster than 10 minutes, then the math problem gets harder.

The difficulty target is a crucial aspect of the bitcoin protocol. Without it, miners could mine blocks in rapid succession and be rewarded lots of bitcoin. The amount of bitcoin in circulation would mushroom, depressing the price of existing bitcoins. In other words, it would be hyperinflationary – not unlike what has happened with the Venezuelan bolivar.

In fact, the hyperinflation in Venezuela has caused some people to turn to bitcoin mining.

Bitcoin mining rigs use up a lot of electricity, but power is inexpensive in Venezuela. Therefore, Venezuelans can turn cheap electricity into money (bitcoin) so they don't have to rely on rapidly depreciating fiat currency (bolivars).

Bitcoin may not be a true disaster hedge, like gold is. But bitcoin is certainly a currency disaster hedge, as the situation in Venezuela shows.

As we've explained, bitcoin uses cryptography, a distributed ledger, and a colossal amount of computing power to verify transactions. Given all of that security, you might be wondering why you keep hearing about theft.

Security Threats

In 2011, a French coder named Mark Karpeles bought Mt. Gox, a Tokyo-based bitcoin exchange.

The exchange provided customers with a way to convert traditional currencies to bitcoin and vice versa. It brought together buyers and sellers in a marketplace. And its customer base swelled as the popularity of bitcoin grew.

By early 2013, Mt. Gox routinely handled around 70% of global bitcoin trades, making it the leading bitcoin exchange.

Then in early 2014, Mt. Gox made a stunning announcement… The money was gone. Hackers had been slowly draining the exchange for over a year. The total theft amounted to nearly $500 million worth of bitcoin.

The news shook the bitcoin world. From its high in 2014, bitcoin's exchange rate with the U.S. dollar collapsed more than 60% before the end of the year.

However, the Mt. Gox hack wasn't due to a flaw with the bitcoin protocol. Instead, the problem was the centralized exchange and Karpeles, who was in over his head.

Karpeles lacked the business expertise necessary to run an exchange. His short career had spanned only 10 years at a few companies, including a French video-game designer. Before taking control of Mt. Gox, he had been a software developer. He didn't have a shred of management experience.

Despite Karpeles' technical skills, Mt. Gox's software development environment was terrible. For a while, untested software changes were released to the customers. Mt. Gox implemented security fixes slowly because Karpeles was the only one who could approve changes to its computer code, which was in disarray. One former Mt. Gox insider told WIRED magazine, "The source code was a complete mess."

With all of Mt. Gox's problems, it's not a surprise that it suffered a catastrophic event.

Karpeles may even have stolen the bitcoin himself. Japanese authorities have charged Karpeles with embezzlement and data manipulation. He faces up to five years in jail, if convicted.

Karpeles denies that charge. But regardless of whether Karpeles is a cook or simply incompetent, it's clear that Mt. Gox had a vulnerability… but that's not the same as a problem with bitcoin.

Think of it this way: A bank robbery doesn't demonstrate a security problem with the U.S. dollar. Likewise, theft at an exchange doesn't demonstrate a security problem with the bitcoin blockchain.

The failure of Mt. Gox does serve as an important lesson, though. Holding cryptocurrencies at exchanges can be insecure.

If you hold bitcoin at an exchange, it's not really your asset. Unless you control your private keys, the cryptocurrency isn't really yours.

When you paid for that cup of coffee, you used your own bitcoin wallet. You had possession of your private key, so you had ownership of that bitcoin.

The private key is crucial and must be guarded. If you hold your private key properly, no one can take your bitcoin… The government can't even confiscate it. But if you lose your private key, your bitcoin is gone forever. And if someone gains access to your private key, they can transfer your bitcoin freely. This brings us to another potential security threat: quantum computers.

Quantum computers are still in development. These powerful computers hold the promise of being exceptionally fast because they'll utilize the special properties of subatomic particles.

Theoretically, a quantum computer could break bitcoin's cryptography. If it's fast enough, it would be able take the output from a cryptographic hash function and determine the input. This would allow someone to take a public key and figure out the corresponding private key. The blockchain would be compromised.

For now, quantum computing is a theoretical concern… not a practical one. And bitcoin has the ability to adapt. The blockchain may be unchangeable, but bitcoin is not. The bitcoin protocol undergoes periodic updates and enhancements. Satoshi built this flexibility into the code… He (or they) even oversaw several of the updates.

If quantum computing starts to represent a legitimate threat to bitcoin's current cryptographic standard, then bitcoin can migrate to a new standard… one that is resistant to quantum computers.

A static protocol would be fragile. Bitcoin's protocol is dynamic, and the network implements updates in two main ways.

Forks

The bitcoin protocol recognizes two types of upgrade, or "fork," – soft and hard. A "soft fork" is a bit of a misnomer. There's no split in the blockchain. Rather, it's more like a transition.

Bitcoin developers can present a proposal for an upgrade. If the majority of the bitcoin miners agree to the upgrade and start running the new software, a soft fork will occur. Because soft forks are backward compatible, nodes that don't upgrade will still recognize the new blocks as valid.

A "hard fork," on the other hand, results in two blockchains… It really is a split.

Let's say a hard fork occurs after the Block 2 of a simplified blockchain.

The split would result in two blockchains. The blockchains are identical up to a certain point. In other words, the blocks mined prior to the split are the same. In this case, they would be blocks zero, one, and two.

Then, the blocks mined after the split are different.

A hard fork occurred on the bitcoin blockchain on August 1, 2017. Basically, there was a disagreement as to how bitcoin can be scaled to process more transactions. The result was a new cryptocurrency called "bitcoin cash."

If you had one bitcoin before the hard fork, you had one bitcoin and one bitcoin cash after the fork. You basically got a special dividend in the form of a new cryptocurrency.

But bitcoin is still the top dog. Bitcoin cash has a much smaller network and hash rate.

Litecoin is another cryptocurrency that was created through a hard fork of bitcoin. These hard forks may seem puzzling, but they're a result of the free market.

The bitcoin code is "open source," meaning that it's available for anyone to download, inspect, and improve upon, if they wish.

Anyone can create his own cryptocurrency, although the real challenge is attaining a critical mass of nodes and users.

Bitcoin has a first-mover advantage. It was the first cryptocurrency and is the most recognizable. It also has a vast network, as we've shown.

In 2013, bitcoin's total market value was more than 90% of the overall cryptocurrency market. That's declined as other cryptocurrencies, like ethereum, have flourished. Despite the surge in prices of ethereum, litecoin, and other cryptocurrencies, bitcoin's market value is still around 50% of the overall market.

What's a Bitcoin Worth?

Bitcoin doesn't have earnings. And it doesn't pay a dividend.

Therefore, it's impossible to value because it doesn't have any cash flows. But bitcoin does have a price… an exchange rate with U.S. dollars or other fiat currencies.

Like any other freely traded asset, bitcoin's price is the market's consensus of its worth. Its price is the equilibrium that balances supply and demand at that moment in time.

Since gold doesn't have any cash flows, we can't value it either.

What we do know is that the price of gold tends to track the marginal cost of mining gold – which makes intuitive sense.

We've also found a similar relationship between the price of bitcoin and estimated mining costs. We can use the bitcoin network's total hash rate as a proxy for the difficulty to mine bitcoin. That is, if there's more computing power on the network, we can assume it's more expensive to mine bitcoin. Basically, the higher the hash rate, the higher the electricity and hardware costs for the miners.

Bitcoin's price does seem to track the hash rate, as you can see below:

Based on that logic, bitcoin's meteoric rise since mid-2015 seems to be justified. The hash rate and bitcoin's price are both rising exponentially.

More computing power is on its way, too. In September 2017, Japanese tech firm GMO Internet announced that it would spend $320 million to start mining bitcoin. The company will use chips that are four times more energy efficient than the current standard. It expects its mining operation to be fully online by the middle of 2018.

How high bitcoin's price can go is anyone's guess. There are certainly some lofty price targets out there. But even some of the seemingly ridiculous figures are achievable, assuming that bitcoin takes share from other forms of money.

Here's how…

The total value of all the gold that has ever been mined is around $8 trillion. Given many of their shared traits, it wouldn't be surprising to see a shift from gold to digital gold.

One global macro expert agrees…

Dan Morehead has had an illustrious career in finance. He was the former head of macro trading at Tiger Management and, before that, the global head of foreign exchange options at Deutsche Bank. After graduating magna cum laude from Princeton University, he started his career at Goldman Sachs.

Morehead is now head of Pantera Capital, an investment firm focused on blockchain technologies. Morehead noted in a Real Vision interview:

Gold has been doing great for 5,000 years. It's going to be around my whole lifetime. But I think it's going to slowly lose market share to bitcoin…

Younger generations that grew up with the Internet are more comfortable with digital assets. For many of them, bitcoin may replace gold as a store of value.

Plus, if gold is held in large quantities, it's expensive to store and insure. Bitcoin doesn't cost anything to hold no matter how much you own.

Bitcoin can also take share from traditional currencies.

The Central Intelligence Agency's World Factbook says there is about $80 trillion worth of broad money globally. ("Broad money" includes coins, bills, time deposits, money-market, savings, and checking accounts.)

Over the next decade, bitcoin can take share from both gold and broad money. Ten years from now, there will be about 20 million bitcoin outstanding. Let's consider some hypothetical bitcoin prices and market values in the year 2028…

At a bitcoin price of $5,000, the total market value of bitcoin would be $100 billion. At $10,000 per bitcoin, it would be $200 billion.

At $100,000 per bitcoin, its total value would be $2 trillion. That's still only 25% of gold's current total value and less than 3% of global broad money.

At $500,000 per bitcoin, its total market value would be $10 trillion. That exceeds the current market value of gold. But it would only be about 13% of global broad money.

The next time you hear about an astronomical half-a-million – or even million-dollar – price target for bitcoin… don't laugh. It could happen if bitcoin becomes a global money standard and takes a sizeable share from fiat currencies.

Widespread bitcoin adoption could create a borderless economic zone. And this global free-trade zone would give global economic growth a huge boost. But to participate, you would need to have the new universal money standard… bitcoin. Again, this isn't far-fetched.

Bitcoin could also be propelled higher by investors, not just users.

A New Asset Class

Like most central banks, the BOJ holds currencies as part of its foreign exchange reserves. It has U.S. dollars, euros, Japanese yen, British pounds… and, of course, some gold bullion.

The BOJ also has a big portfolio of Japanese government bonds. And it holds a large percentage of all Japanese exchange-traded funds (ETFs) outstanding.

Basically, the BOJ is at the forefront of radical monetary policy. And remember, Japan declared bitcoin legal tender in 2017. That's why we believe the BOJ will be the first central bank to add bitcoin to its reserves.

We think that many institutional money managers will warm up to bitcoin as well…

Asset managers help their clients put together diversified portfolios. The major benefit of diversification is that you can both increase return and decrease volatility at the same time. This magic is made possible because asset classes aren't perfectly correlated.

Correlation is the degree to which asset prices move in unison. If you combine less than perfectly correlated assets, it can reduce overall portfolio volatility while increasing returns. (This dual benefit is known as the "free lunch" in investing.)

For example, when stocks decline sharply, government bonds often rise as investors seek the relative safety of fixed income. So you would say they have a negative correlation.

But stocks and government bonds tend to have modest positive correlations over the long term. They're not perfectly correlated, though, so bonds do provide diversification benefits.

Asset managers are constantly looking for assets that aren't correlated at all with other financial asset prices.

Enter bitcoin…

Bitcoin and cryptocurrencies are a new asset class. They have unique combination of qualities that makes them hard to categorize.

Bitcoin's price movements don't correlate with stocks and bonds. At this early stage, bitcoin is a perfect portfolio diversifier.

The global market of stocks and bonds is more than $200 trillion in size. For bitcoin to be a portfolio diversifier available to a meaningful amount of asset managers, it will have to attain a total value closer to that of gold… in the trillions of dollars of market value.

Stocks, bonds, real estate, commodities… and now digital assets are joining this list of institutional asset classes.

The vast majority of institutional money managers haven't begun to allocate portions of their portfolios to cryptocurrencies. If even some of them do, then bitcoin can easily have a total market value equal to that of gold.

You can see Wall Street finally starting to get involved. Institutional trading and clearing platform LedgerX offered bitcoin options in October 2017. And in December 2017, bitcoin futures began trading on the Chicago Board Options Exchange and the Chicago Mercantile Exchange.

This "financialization" represents the next phase of bitcoin's growth and adoption – what we call Bitcoin 2.0. Bitcoin managed to attain a price of more than $15,000 without Wall Street. Just imagine how high it will go now that professional money managers can effectively buy it via bitcoin futures.

Bitcoin futures also pave the way for bitcoin exchange-traded funds ("ETFs"). Numerous companies, including leading ETF providers ProShares and VanEck, have filed applications with the Securities and Exchange Commission to provide that hold bitcoin and that regular investors can easily buy shares, like a regular stock.

A bitcoin ETF would help asset managers add exposure to bitcoin via a stock exchange-listed security – a familiar investment vehicle. This would facilitate even more institutional money flows, likely resulting in a much higher bitcoin price.

Of course, bitcoin ETFs would also allow individual investors to effectively buy, hold, and trade bitcoin in their existing brokerage accounts.

Money of the Future?

Bitcoin sits at the intersection of computer science, mathematics, and economics. And it could bring about a radical change in the way people think about and use money.

With every advancement in money comes skepticism. And bitcoin is no different. After all, it's a high-tech form of money created by a mysterious coder. Many people are reticent to accept an invisible form of money that can be sent anywhere in the world with the touch of a button. For them, it doesn't seem "real."

But remember, the first paper currencies were a hard concept for many people to grasp, too.

Bitcoin allows global, unrestricted money transfers, without a middleman. These money transfers are safe, quick, and verifiable by the entire network. Best of all, governments don't control bitcoin and can't debase it.

If bitcoin lives up to its promise, its price will be many multiples higher than it is today. Then, it may no longer be an attractive investment… But that's OK, because billions of people around the world would then be using and benefiting from this new form of money.

curated by Glen Brink, InvestmentMarketingTips.com

 
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