What on earth (or outer space) is a Bitcoin, anyway?

Dave Keil, P.Eng., MBA, CFA, runs a small closely held fund from his base at Providenciales in the Turks and Caicos. Originally from Toronto, Dave draws on a wealth of first-hand knowledge of many market sectors, having worked in oil and gas, chemicals, consulting, microelectronics, and others.

Sometimes, a concept emerges that’s so radical it forces you to rethink things you’d taken for granted.

Such a concept is Bitcoin, the on-line payment system first introduced in 2009.

To understand Bitcoin, I had to look anew at the way the world’s currencies work.

In other words, I had to think about what gives these currencies value, as well as what transactions ensure their legitimacy.

But first, a little history lesson

When gold became the currency of choice thousands of years ago, it wasn’t because of its intrinsic worth, but because its legitimacy as a medium of exchange was easy to test.

The vendor accepting gold as payment would first rub it on a black stone and then apply different types of acid to prove the metal was genuine.

Fast-forward to the present where cash has scanning devices that perform a similar function — that is, proving legitimacy.

Moreover, credit and debit transactions have a provisioning system wherein the risk of the transaction being fraudulent rests on the card issuer.

No one wants to make an exchange in which he gets nothing in return. So, the main function of any currency is to solve this problem.

What then are Bitcoins, or other crypto-currencies? Operationally, Bitcoin is very close to the system for prepaid phone cards.

When you buy such a card, its external number is scanned, activating the card in the system belonging to the issuing phone company.

When you actually use the card, you scratch off the back, entering the secret number which the phone company then validates, while crediting your account.

With Bitcoin, you effectively scratch off the code when you transfer it to someone else who then redeems it in the system.

He’s then issued new “cards” on which the code can be scratched off later when the “cards” are actually used.

So, if you picture someone going around with his pockets full of unused prepaid phone cards that are scratched off when he wants to buy something, you’ve got an idea how Bitcoin works.

But who takes the place of the phone company and where do the coins come from?

The easiest way to answer these two questions is to look at two distributed networks from the turn of this century.

First, consider Napster. Founded in 1999, but shut down in 2011, Napster was a peer-to-peer network in which users could share their music collections.

Napster consisted of users with the ability to run the network without a central co-ordaining entity — besides the Napster application.

Even though every user didn’t have every song ever recorded stored on his computer, he did come pretty close.

And although it’s a small wonder the recording industry was able to shut Napster down, it succeeded in doing so owing to how the protocol was designed.

Other networks emerged

Yet many other networks whose protocol couldn’t be shut down by court order sprang up to replace Napster.

Not surprisingly, Apple Inc. then realized the only way it could put an end to these networks was to offer something better. So, Apple came out with iTunes.

Yet another distributed network from a few years back was SETI@home: the search for extraterrestrial intelligence at home project.

Through SETI, a user could leave his computer on, allowing the SETI screen saver to put his hard drive to work doing numerical analysis on a data block recorded from a radio telescope somewhere in the world.

The hope was that an individual’s computer would be the first to discover alien intelligence.

SETI@home was one of the first experiments in distributed computing.

And it worked well, ultimately suffering from the problem of having more computing power for the analysis it had to do.

Together, Bitcoin’s provisioning model can be understood as a combination of Napster and SETI@home.
All its peers, as with Napster, have a copy of every Bitcoin transaction so far.

They then race against every other peer, as with SETI@home, to be the first to validate all the new transactions, organizing them in a certain way which, from a computing standpoint, is hard to do.

But the peer that wins that race gets the Bitcoin reward: a freshly minted Bitcoin.

Not only is this where Bitcoins come from, it’s the incentive for individuals to join the network and validate transactions, acting as what’s called a miner. In return for paying an increased power bill, miners get paid in Bitcoins.

But what can I do with Bitcoin and why is it so volatile? Personally, I find the concept of money so intertwined with modern living that I need to step back and think of a different token economy to get my bearings.

I like pizza. So, I naturally think of Chuck-E-Cheese’s, the California-based chain of family entertainment centres which serve pizza, but which also feature arcade games.

There, you can play different games for which you receive tickets. You can then take those tickets to a booth, exchanging them for various prizes.

Or, for the entrepreneurial-minded, you can go outside with your tickets, trading them in the parking lot for something else.

Tickets can be exchanged

Indeed, you might actually exchange them for tickets to Dave & Buster’s, another chain of family entertainment centres, if you prefer the latter’s pizza and prizes.

So, here’s how I map Chuck-E-Cheese’s move to Bitcoin: you can either trade your Bitcoin with someone else or use it for goods and services.

In fact, playing the games in Chuck-E-Cheese’s is like working as a miner in Bitcoin.

You buy tokens at Chuck-E-Cheese’s to play the games, but you buy power to feed your computer with Bitcoin.

The desks with all the prizes at Chuck-E-Cheese’s are vendors willing to accept Bitcoin for goods and services.

Going outside to the parking lot to swap your tickets is like going to a Bitcoin Exchange to buy or sell Bitcoin for tickets in some other token economy.

In the meantime, there are vendors popping up who will accept Bitcoin as payment.

Indeed, I’ve heard of pizza places in New York accepting them, as well as some computer security conferences.

More commonly, for shareware software authors, Bitcoin is being used as an alternative to PayPal.

Of course, with Bitcoin, it’s hard to track the paper trail generated, making it quasi anonymous.

As such, a major use of the currency is on underground websites to buy stuff that’s blatantly illegal.

One such website, known as Silk Road, has grabbed a lot of attention lately — mostly because of it’s being tracked and shut down by law enforcement agencies.

Indeed, the site, which operated in the so-called Deep Web, was often known as the Amazon.com of illegal drugs.

But when Silk Road was shut down, demand for Bitcoin dropped, while the price fell relative to other currencies.

Yet when Silk Road rebuilt itself as Silk Road 2.0, the demand for Bitcoin came back and the price increased. Truly, it was a classic case of supply and demand.

Of course, there are those who also speculate that Bitcoin will be worth more in the future, especially in times of crisis.

Yet, whenever I think through this proposition, as I do with any other instrument being billed as a panacea, I can’t get around what I call the Casablanca problem.

Remember Casablanca? The 1942 screen classic featuring Humphrey Bogart, Ingrid Bergman and Paul Henreid?

Casablanca, which was set in the Moroccan city of the same name, is not only one of the greatest romance movies ever made, but one of the best lessons ever taught in economics.

In the film, European refugees during the Second World War who end up in Casablanca try to buy letters of transit to go to the U.S.

During the movie’s first few minutes, a woman offers her diamond ring in exchange for the transit papers, explaining that it would be worth a fortune in Paris.

But her face becomes filled with dismay when she’s told by someone who sells the papers that her ring won’t cut it in Casablanca because the market there has been flooded with diamonds.

In a nutshell, the Casablanca problem shows what gives currencies their value — that is, what you can exchange them for.

When you exchange them, you need to have a system of proving authenticity at that moment — something Bitcoin does through a distributed network of volunteer computers.

All told, crypto-currencies are likely here to stay, given that their transaction costs are very small.

But such currencies are also likely to experience massive volatility as illegitimate uses thereof are shut down, only to be restarted.

It’s not something I’m interested in speculating in, but it is something which I’d like to use as a case study for currencies overall.

 

 

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846