The talk of Wall Street has been the big capital gains of cryptocurrencies like Bitcoin. Bitcoin passed the US$10,000 mark in November—a 900 per cent return for 2017. Still, many are left wondering what a Bitcoin actually is and why a Bitcoin is so valuable.
Let’s start from the beginning
The foundation for the blockchain technology was laid when the first Internet was created in California in 1969. Today’s widespread adoption of the Internet enables billions of users to engage in peer-to-peer (P2P) networks that share files and information. In a similar way to the Internet, Bitcoin’s P2P software is comprised of ‘nodes’ that broadcast information about transactions to other nodes on the network. However, simply having a P2P network would not be sufficient for building decentralized digital money.
The next part of the puzzle came when cryptographers discovered asymmetric encryption in the 1970s. Asymmetric encryption fundamentally changed the way people can share private information. Today, governments, banks, insurance companies and many other firms use encryption tools for applications such as storing sensitive customer data and enabling secure online payments.
Fast-forward a decade and the last piece of the puzzle was developed: the blockchain. Up until this point, changes to digital data could not be chronologically ordered without relying on external timestamps. This made it possible for counterparties to change, add, and delete digital files without leaving footprints. The blockchain data structure enabled internal timestamping for the first time. From this point forward, governments and companies could digitally track every single change made to each data file.
The first attempts at a cryptocurrency
Following these discoveries, the first attempts at digital cash were made. American inventor David Chaum designed DigiCash, an electronic cash system that was based on cryptographic algorithms in 1983. In 1997, Adam Back, a British cryptographer created HashCash that used encryption tools to block email spam. In 1998, Wei Dai and Nick Szabo released b-money as well as bit gold, respectively. All failed to gain significant adoption.
Then in 2008, the creator(s) of Bitcoin combined P2P networking, asymmetric cryptography, and the blockchain data structure to create a transparent and secure global monetary system. Cryptocurrencies and the blockchain allow users to generate units of currency and transfer funds without intermediaries. The rigour of the underlying technologies provides evidence that this is not a scam or Ponzi scheme. However, the adoption of this technology depends on several factors independent of the technology itself.
If you build it, will they come?
Government regulation and consumer preferences will play key roles in the success of the blockchain. For example, government regulation has the power to either crush or support this nascent technology. In addition to government regulation, consumer preferences are a crucial determinant of the use of blockchain-based money.
If consumers prefer ‘sound’ or commodity monies such as gold or government monies such as the euro, then the blockchain technology may not become a global decentralized currency. On the other hand, not everyone has to agree on using the same currency.
The past few years have witnessed an explosive growth of Google searches and social media posts about the blockchain technology and cryptocurrency. However, people aren’t only searching for these terms. Over 600 applications were filed in the US for blockchain and cryptocurrency related patents during 2016 and the beginning of 2017.
Mainstream interest in cryptocurrency began in 2014, when the price of the most famous cryptocurrency, Bitcoin, soared for the first time to over US$1,000 per Bitcoin. The exponential growth garnered worldwide attention and became the main topic at fintech and finance conferences. Following this rally, over 400 books on the topic of cryptocurrency were released on Amazon.com.
Amazon responded by creating a new book subcategory, “Digital Currencies”, which feature several best sellers. Cryptocurrencies are a medium of exchange and store of value like currencies; however, they have no physical or digital existence. Instead, cryptocurrencies are account amounts held in a digital ledger that can be transferred to other users.
The term cryptocurrency is really a misnomer because there is no such thing as a cryptocurrency with an identification number such as token number “1234567”. In fact, none of the cryptocurrency coins has unique identifiers because a cryptocurrency is not actually a coin in the traditional definition of the term. Rather, each cryptocurrency account name is linked to a certain number of cryptographic accounting units, and these accounting units have been given the name cryptocurrency. The terms cryptocurrency and blockchain are used interchangeably due to the inability of separating these technologies.
The blockchain is the cryptocurrency is the blockchain
A public and decentralized blockchain cannot exist without a cryptocurrency and vice versa, a cryptocurrency cannot exist without a blockchain. Bitcoin is the name of one cryptocurrency and blockchain. Ethereum is another. Ripple is another. There are over 1,000 different cryptocurrencies.
The first successful implementation of a blockchain and cryptocurrency was Bitcoin. However, different strategies for verifying transactions within a decentralized network have given rise to different cryptocurrencies such as Litecoin, Nxt, Monero, and Bitcoin Cash.
Rising from the ashes
After attempts at making a private virtual currency had failed for 20 years, Bitcoin emerged amidst the 2008 global banking crisis.
The creator of Bitcoin, unknown, was determined to create a decentralized, private and secure way to transfer value online, which did not rely on trusting sovereign entities, central banks, or financial intermediaries.
After being ridiculed as money for computer nerds and a conduit for illegal activity, investors are finally beginning to take notice of Bitcoin and the underlying technology, the blockchain. Bitcoin is still the most popular cryptocurrency and use of the blockchain technology. This system allows participants to send accounting units that store value, referred to as Bitcoin, from one user’s account to another user’s account without intermediaries.
As a cryptocurrency, Bitcoin is a store of value and a medium of exchange combined in one. Bitcoin has a fixed supply capped at 21 million and the currency’s inflation rate is programmed to decrease by half about every four years.
On a daily basis, around 1,800 Bitcoin are released onto the market. This rate will halve to 900 Bitcoin per day in 2020, and then to 450 Bitcoin per day in 2024.
The finite supply of Bitcoins
According to estimates, Bitcoin’s last coin will be mined in the year 2140 AD. At the time of this report, approximately 16.5 million Bitcoin have been mined. The finite supply gradually enters the market according to a mathematical algorithm that releases approximately 12.5 Bitcoin into the network’s supply of Bitcoin every 10 minutes. The inflation rate therefore decreases over time according to the algorithm until every unit of the finite supply has been released into the economy.
Since Bitcoin was launched in 2009, the transactions have doubled every year. Although blockchain transactions do exist in physical servers, Bitcoin are not physical or even digital coins. Instead, a Bitcoin is a chain of electronic signatures that represents units on a digital ledger.
Network users can trade and store these fungible accounting units by debiting the account controlled by one participant and crediting the account held by another participant.
Solving the ‘double-spending problem’
An individual that creates a Bitcoin wallet can transfer accounting units to other users by digitally signing a private key on a transaction. The combination of several innovations from distributed computing and cryptography form the basis of the Bitcoin ecosystem, including the blockchain and the Bitcoin protocol.
Satoshi Nakamoto’s invention was the first system that effectively solved the ‘double-spending problem’ and thereby enabled a safe peer-to-peer payment system.
Double-spending is the digital version of counterfeiting fiat currency or debasing a physical commodity money, such as gold. For example, Alice could attempt to pay two people, Bob and Charlie, using the same coin by duplicating the string of bits that represents the coin with serial number 1234567.
Centralized payment systems, such as PayPal, solve the double-spend problem by using a centralized mechanism of validating real transactions. In computing terminology, a centralized solution to the double-spend problem is called an example of a single point of entry because if PayPal’s server is jeopardized, the entire system fails. Instead, Bitcoin relies on the ‘proof-of-work’ consensus mechanism to achieve decentralized consensus.
Proof-of-work is an incentive structure in the Bitcoin software that rewards miners with transaction fees from users and with a pre-defined number of Bitcoin for successfully adding a block to the chain of previous transactions.
The proof-of-work protocol timestamps the transactions recorded in the blockchain. The correct blockchain is always the blockchain with the longest history of proof-of-work computing.
Using the simple rule to always mine on the longest blockchain ensures that miners all add transactions to the list of transactions that has received the highest amount of computing resources. Network agreement on the state of transactions eliminates the potential to double-spend the same coin without the presence of a central clearinghouse.
Almost negative correlation with gold
Originally, Bitcoin and the underlying blockchain technology were designed to replicate the characteristics of gold, which makes it uniquely suited to be money. However, Bitcoin constitutes an unparalleled asset class and can be a fundamental part of wealth management from the portfolio diversification perspective.
For the past eight years, Bitcoin’s daily returns have had a low to slightly negative correlation with gold. The main reason is that Bitcoin and gold have different use cases and different risks.
However, from a portfolio construction point of view, one must be aware of the extremely high volatility, which this asset class exposes. Bitcoin is entirely digital, and therefore, does not exist in a physical form like gold. Also, in contrast with gold, Bitcoin does not have industrial applications.
Prepared by Demelza Hays, Ronald-Peter Stöeferle and Mark Justin Valek of Incrementum AG, a Lichtenstein-based independent investment and asset management company.
This is an edited version of an article that was originally published for subscribers in the January 5, 2018, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.
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