Bitcoin

June 21, 2014

Bitcoin overview:
Bitcoin is a crypto currency, where “crypto” is from the Greek meaning “hidden” or “private” and whereby this is achieved through the use of encryption or coding. Crypto currencies have a complicated block of code that is unique to the investor or party in the transaction, and additionally, each unit of the crypto currency will also have its own unique alphanumeric code, which is dependent on the denomination.

Crypto currencies are often also termed as a “digital currency” or “alternative currency”. Bitcoin is considered to be the first big player of its time to emerge from the purely technical communities of the internet.

While Bitcoin is not the only crypto currency in existence, it is currently the most dominant, and many of the other currencies are simply slight variations on Bitcoin, eg:

  • Worldcoins – Designed to appreciate over time
  • Litecoins – Increase transaction speed
  • Anoncoin – Improved transaction anonymity
  • Stablecoin – “Military-grade”3 encryption

Where past digital currencies have failed, Bitcoin and others have succeeded, in particular due to their ability to cope with the issue of ‘double spend’, whereby a lack of security measures built into the transaction of a crypto currency has allowed users to use the same unit for two transactions in a short space of time. Whilst the value of a singular Bitcoin is currently very high, much like more traditional fiat currencies, smaller divisional payments are also accepted.

Bitcoin Mining
Bitcoin doesn’t have a central government to issue money and keep the system in flow. Instead it relies on a part of the community to keep the process in order. These are the so-called Bitcoin Miners, who keep the network in a constant state of flux and transactional regulation.

The primary purpose of mining is to help confirm and publish Bitcoin transactions to Bitcoins’ public ledger, which is termed the Block Chain. This enables transactions to be confirmed and increases security by removing the ability to double spend. The Block Chain is made of individual blocks which contain the latest transactions not yet recorded, a link to the previous completed Clock and a very complicated mathematical problem which once solved by Miners – who are first to submit the “Hashcash proof-of-work” results in a reward. These rewards are currently a proportion of Bitcoins as well as the payment of transaction fees (which are paid by the payer in this system). This all helps to administer new Bitcoins as well as providing a security framework to the system.

This process of producing Bitcoin cannot continue indefinitely or one of the touted advantages of Bitcoin – the fact that it is a finite currency – would not hold true. There is currently a target number of Bitcoins to be issued which stands at 21 million. Since the currency’s inception in 2009, the reward per mining the blocks has halved every 4 years from an initial 50 Bitcoins, with the expectation that the issuance will end in 2140. Although a simple calculation on the decay profile indicates that 99 per cent of Bitcoins will be issued by 2030. In order to regulate the speed of block creation the timestamps between blocks are assessed and the mathematical problems are increased or decreased proportionally as a result.

The term mining is adopted from that of mining traditional commodities because the process is similar in that an increasing amount of exertion is required to extract value as the commodity becomes scarcer.

As Bitcoin has become more popular and valuable, the attractiveness of mining has greatly increased. This has led to the search for more and more powerful hardware in order to solve the mathematical problems in search of the rewards. The hardware has become much faster and more efficient, consuming much less power, and since 2013 specific ASICs designed for Bitcoin mining have been released. This is the latest stage in the movement away from the CPUs adopted initially.

As competition has increased, miners have also started to pool their resources in order to help minimise the variance in their income and try to remove the gambling nature of the process. In addition to this, large data centres have also started to make mining services available to minimise operating and setup costs.

Origins of Bitcoin
Bitcoin was introduced to the world in 2008 as an online digital currency through the writings of Nakamoto Satoshi. By 2009, software was being developed to create the Bitcoin network which was soon to govern the currency. The actual identity of Satoshi is shrouded in mystery, with numerous mathematicians, cryptography students, economists, coders and geniuses all under suspicion. The analysis of the Bitcoin code led many to believe that Satoshi was in fact a team of people, however, those who have worked for the Bitcoin Foundation often regard the minimal interfaces and aged abstract code to be the work of a sole genius.

Much like all success stories the media has made numerous attempts to find the man behind Bitcoin. From stylometric analysis of Satoshi’s forum postings, both the writing and timing of posts had suggested that the founder could be English living in America. Then recently in March 2014, Newsweek published an article saying it believed it had tracked down the illusive founder. It described him as a 64-year-old model train enthusiast, mathematician with an engineering background, born in Japan but now based in California. An incredibly reclusive man with links to the US military, an old school English writing style exhibiting quirks consistent with the original Bitcoin Proposal from 2008.
Upon the Newsweek journalist’s first encounter with Dorian Nakamoto he quipped:

“I am no longer involved in that and I cannot discuss it. It’s been turned over to other people. They are in charge of it now. I no longer have any connection.“

Shortly afterwards, Newsweek published a statement from Dorian Satoshi (the birth name he had not used for 40 years) in which Satoshi intended to clear his name and deny all knowledge and involvement or links with Bitcoin.

It is possible he was originally taken out of context by the Newsweek journalist or that he had just decided to play along with the reporter. But more likely, is that once reality hit over his first steps out from anonymity, the thoughts of a possible media whirlwind and the required appearances and presentations, Silicon Valley lawsuits and the possible backlash over more recent high profile Bitcoin thefts – not to mention the links to Silk Road, made him reconsider his position. It is rumoured that the first Bitcoin transaction was conducted between Satoshi and a pre-Bitcoin cryptographic pioneer, Hal Finney.

Bitcoin is decentralised, meaning that unlike other centralised currencies such as Paypal and Visa, no one actually owns or controls it. Back in 2009 when Satoshi distributed the open source software, a peer-to-peer network was gradually set up over hundreds of computers all over the internet to process the Bitcoin transactions.

The network requires no permissions or assistance in order to set up related financial services and is unique in that it hosts its own currency, unlike the aforementioned for-profit companies.

This decentralisation raises a number of concerns around the appropriateness of using internet-based payment services and the related exchange of digital currencies. It has also been pointed out by the G7s Financial Action Task Force that such anonymous actions may “pose challenges to countries’ [anti-money laundering, counter/terrorist financing] regulation and supervision an area which has increasingly become a hot topic of concern over the last few decades.

Silk Road and Bitcoin
Silk Road is an online marketplace that was launched in February 2011. Getting to it is not as easy as ebay as it requires online anonymity through the use of TOR software (The onion Router – symbolising the layers of encryption as a route to anonymity). The reason it is so difficult to log on to is that its only restriction on sales is to prohibit anything whose purpose is to harm or defraud. However, it rapidly became known as the “Ebay for drugs”, as by March 2013, 70 per cent of all products for sale were found to be drugs, including Heroin, LSD and Cannabis9 This led to the FBI shutting down Silk Road in October that year, although soon after the site was re-launched in a Mark 2 version.

As a result, this was the perfect market for a digital currency with anonymity; they are not the kind of products willing purchasers would use their Visa debit cards for. So much so that in October 2013 when the FBI Shut down Silk Road they seized around 174,000 Bitcoins (close to 54 million at today’s estimates).

Governance
Bitcoin is governed by the Bitcoin Foundation, an independent body in existence since September 2012, with the aim of standardizing, protecting and promoting the use of Bitcoin cryptographic money for the benefit of users worldwide. However, the original members of the foundation were and still are, senior Bitcoin players, which has cast some doubt over the foundation’s independence and sparked claims of possible corruption.

  • Gavin Andresen, appointed as “Chief Scientist” is the lead Bitcoin developer
  • Mark Karpeles, former CEO of now bankrupt exchange, Mt Gox
  • Charles Schrem, former vice-chairman of the Bitcoin Foundation, was until earlier this year under 24-hour house arrest over his involvement in helping to supply Bitcoin for participants in trading on Silk Road

Ownership and Distribution
There are believed to be an estimated 12 million Bitcoins in circulation, but due to the anonymity of the currency it is difficult to calculate exactly how these are distributed. However, in 2013, Risto Pietila gave a breakdown to Business insider based on the Bitcoin block chain and the activity on the exchanges involving unique addresses. Some high-profile Bitcoin owners include the Winklevoss brothers of Facebook fame, who hold an estimated 120,000 Bitcoins, the FBI who seized 174,000 units with the closure of Silk Road and it is believed Satoshi still holds around 1 million Bitcoins, which at today’s exchange rate is estimated to be worth £300 million.

Trading
In much the same way as fiat currencies can be traded, there are also digital currency exchanges. They exhibit the traditional model in which market makers offer bid/ask spreads to account for transaction commissions.

One of the more notable exchanges of late was Mt. Gox based in Tokyo, which by 2013 was the forefront of Bitcoin’s transaction base covering an estimated 70 per cent of all Bitcoin transactions. A site that originally started as a trading site dedicated to the exchange of Magic the Gathering Trading Cards developed quickly in 2 years following its acquisition by Mark Karpeles. However, after the value of Bitcoin began to gather momentum in the first quarter of 2013, the regulatory bodies starting to express an interest. It was around this time that the US Treasury Department’s FinCEN found Mt. Gox to be an unregistered money transmitter in the US and seized $5 million in assets when two of its American bank accounts were shut down.

Over the following months, further concerns were raised that Mt. Gox was appearing as a Ponzi scheme as investors found it increasingly hard to cash out of their investments. This was exacerbated in February 2014 after a security flaw was exposed in which hackers had, for a considerable period of time, been manipulating the IDs of transactions and making it appear as if they had not been sent from one account/wallet to another, when in fact they had. This led to further suspended trading periods. It was finally exposed that more than $400 million worth of Bitcoins had been lost, making it possibly the largest cyber theft of all time, and resulting in the shutdown of Mt. Gox that February.

As Mt. Gox started to fail, popularity increased for Bitstamp and BTC-e exchanges, which are estimated to handle around 75 per cent of all current Bitcoin trading. There is a general consensus in the market that the exchanges have improved as a result of Mt Gox’s demise, with a closer focus on the importance of internal regulation. However, as with Bitstamp, which recently moved from a Slovenian to a UK base, Bitcoin is still not universally regarded as a currency as it is not subject to the existing external regulations (as found by the UKs FCA).

The majority of newcomers to Bitcoin will buy their coins using a traditional Fiat currency through the exchanges, however there is a growing number of Bitcoin atms, the first of which opened in late 2013 in Vancouver. They are now popping up all over the world, including in London. Find your nearest athttp://bitcoinatmmap.com. They allow users to exchange domestic currency directly to their Bitcoin wallets.

Bitcoins are tradable because of the characteristics they exhibit which make people willing to accept them as payment.

  • Durability – Bitcoins exist indefinitely although change owner and they could be “lost”
  • Portability – Using wallets facilitates ease of trade
  • Fungibility – One Bitcoin has the same value as any other Bitcoin
  • Relative Scarcity
  • Divisibility – Divisible into units of 8 decimal places of a Bitcoin

The exact value of Bitcoin is driven, as with most goods and services, by supply and demand, and Bitcoin traders use standard manual fundamental and technical analysis to calculate this.

“Banking” Bitcoin
Bitcoin uses digital wallets for personal storage of your Bitcoin holdings. It does this by storing the private digital keys that allow you to access a Bitcoin address and spend your funds. In reality, the wallets do not actually store the Bitcoins themselves as these are held in the Bitcoin Ledger, relying on the public and private keys to enable a transaction. It must be noted that transactions are considered permanent unless reversed by the recipient.

These wallets can be stored on a variety of locations:

  • Desktop PCs
  • Mobile Phones – Allowing ease of transfer using NFC or QC codes in combination with the camera
  • Online – Although this often gives the host access to your private keys

It goes without saying that if you lose the access to your wallet you also lose your private keys and hence your ownership, ultimately your Bitcoins will be lost forever (It is estimated almost 5 per cent of all Bitcoins mined so far have been lost). Again, any user who may know someone’s private keys can easily take control of the associated Bitcoins, giving concerns over the day-to-day security. This can be minimised through the generation of keys on an uncompromised computer, external storage with no internet connection (cold storage) or simply as a paper printout (paper wallet).

Retailers and Acceptance
There are a growing number of established retailers accepting Bitcoins nowadays, with companies such as Expedia even accepting payments for hotel bookings since. You would think that given the high volatility in Bitcoin’s value over the past few years, it is a risky strategy and a chance for losses at the vendors. However, the customer and the payment processor are the ones that bear the risk in that once the customer has paid the Bitcoins, the payment processor immediately hedges them in the market by selling some on their books to limit their exposure. Even a newsagent in Swanage has now taken on the digital currency.

Summary of the key Advantages and Disadvantages of Bitcoin
Bitcoin uses digital wallets for personal storage of your Bitcoin holdings. It does this by storing the private digital keys that allow you to access a Bitcoin address and spend your funds. In reality, the wallets do not actually store the Bitcoins themselves as these are held in the Bitcoin Ledger, relying on the public and private keys to enable a transaction. It must be noted that transactions are considered permanent unless reversed by the recipient.

So the question is whether Bitcoin will be here to stay, whether it will be superseded by a more robust digital currency that is accepted worldwide, or disregarded completely. The most important thing to consider is that Bitcoin is the first truly successful currency of our time and that if it serves any purpose it has at least brought us all to discuss the nature of money. It may never become the gold standard but it has definitely started the ball rolling for change so much so that one country.

Ecuador, is in the process of abandoning its existing currency, the U.S Dollar (adopted after a crippling bank crisis in 2000), in favour of a digital currency. This new currency is to be released into circulation in December and it will be interesting to see if such a dynamic change will spell a future for the Ecuadorian currency or result in the same devaluation experienced by its previous currency, the Sucre.

Become a Brickendon Change Leader

What can we help you achieve?