An Intro to Bitcoin

Over the past year we have seen a pandemic, social unrest, all-time market highs, and a meteoric rise in the price of Bitcoin. In the early days of Bitcoin, few people knew about it and even fewer people discussed it. In January 2017, Bitcoin was trading under $1,000. By October of that year, the price had jumped to over $5,000 and by the end of December it was trading over $19,000. Needless to say, Bitcoin quickly grabbed the attention of retail investors and Wall Street. However, Bitcoin would soon fade away as the price dropped to $4,000 in 2018. Bitcoin had lost traction and wall street stopped talking about it.

In 2020, Bitcoin saw returns north of 300%, bringing it back to the center of attention. Not a day goes by where Bitcoin isn’t being talked about on major media outlets. If they are covering the markets, they are discussing Bitcoin. From fund managers to blue chip CEOs, Bitcoin is the talk of Wall Street. Furthermore, the cryptocurrency market as a whole has gained popularity. Since 2013, the estimated number of cryptocurrencies has increased from 66 to 4,500, representing a 6,718% increase.

So what is this mysterious asset? There is a lot of confusion and misappropriated terms out in the general public so I will do my best to provide clarity. First, Bitcoin as the digital asset is truly a public ledger that details transactions between anonymous individuals. The technology that is underpinning the creation of Bitcoin is Blockchain technology. Blockchain is the system of recording information through the use of decentralization and cryptographic hashing that is spread and duplicated among an entire network of computer systems. Confused yet? Don’t worry, you are in good company. The simplest way to remember the difference is that Bitcoin is a decentralized public ledger and Blockchain is the storage of information.

While the technical terms can confuse individuals, it is important to understand that Bitcoin is very similar to how our banking systems work today. When you send/transfer money from one account to another, there is a ledger that keeps track of your transactions. That information is stored and your balances change within each account. Surprisingly, a lot of banking and other high traffic webpages encrypt their sites with the same hashing that Bitcoin uses.  

So what makes Bitcoin so exciting if it functions the same way a bank would? First, Bitcoin removes the need for a “middleman”. Bitcoin is a decentralized network, there is no need to have a third party verify transactions. Once two parties use their digital signature to sign off on a given transaction, it is executed and irreversible. The benefit added to individuals is low/no transaction costs, quicker transactions, and no regulatory oversight. It is the truest form of a peer-to-peer free market that we have seen in the modern era.

Second, is a sophisticated security code. While no system created by human hands is perfectly secure, Bitcoin and Blockchain are certainly getting close. What makes the system so secure is the utilization of a digital signature (cryptographic fingerprint) and consensus protocol. In the real world, your signature can be forged and copied if someone spent enough time mimicking it. In computing, your signature is a string of 0s and 1s that are 256 bits (characters) long. In order for someone to “hack” or copy your digital signature they would have to correctly guess all 256 bits in perfect order. For the math enthusiasts, the probability of that happening, is 1 / 2 to the 256 power. To say that number is astronomically high is giving too much credit to astronomy. As an added safety precaution, each time you use your digital signature, the 256-bit sequence changes. With that being said, if two signatures are validated on a given transaction, you can be almost certain that a valid transaction has occurred.

The other component of the sophisticated security is the consensus protocol. There are a few different types of consensus protocols, but for simplicity we will only discuss Bitcoin’s protocol which is Proof-of-Work (PoW). To understand Proof-of-Work, you first have to understand that the public ledgers are distributed across series of computers called nodes. These nodes communicate with one another to verify transactions across the blockchain network, and each node maintains a full copy of the ledger. When a transaction occurs, these nodes check to make sure that if a Bitcoin was sent, a Bitcoin was received. This transaction, if verified, is added to the ledger across all nodes. If someone were to try and add a fraudulent transaction within a given ledger, there would be disagreement among the network ledgers. Based on the technical consensus protocol in place, the fraudulent ledger would then be ignored. For example, four friends go on a trip and each individual keeps track of the group’s expenses. If three of the friends come back showing the same transactions, but one of the friends has an additional transaction, it is probable that the one friend made an error. That is how consensus protocol works. It is a method of nodes verifying that the ledgers are accurate and agreed upon by group consensus.

The third promising component of Bitcoin is that it is inflation protected. Bitcoin has been built so that there is a limited and finite supply. Unlike the Federal Reserve, there is no entity or program within Bitcoin that can alter the supply. Rather, the way Bitcoins enter the market are through the miners who are paid for their services with Bitcoin. These coins that are paid to the miners are not coming from the current supply, but are introduced as new coins. This ensures a steady supply increase without causing massive amounts of inflation. The total number of Bitcoins that will be in circulation when all is said and done will be twenty-one million. Currently, there are about nineteen million coins in circulation which means we are getting pretty close to the max supply. Once it is all mined, miners will still be incentivized to process transactions by being paid in small transaction fees from coins in circulation.

With all the promising components of Bitcoin, there are a few causes for concern. Ironically, some of these concerns are also the things that make Bitcoin attractive. Take my first point for example; removing the middleman. While this can produce a true peer to peer market, this also allows for transactions to go unregulated. One of the original uses for Bitcoin was buying and selling illegal substances on the web due to its lack of regulation and anonymity. The structure of Bitcoin and blockchain technology make it hard for anyone to trace who is sending and receiving funds. While the ledger itself is public, the identity of the sender and receiver is private. This creates a tough task for the financial crime divisions within the government and FBI to monitor and act on potential threats. It is tough to see how the US government would allow a currency to circulate without their ability to monitor and regulate flows.

The second concern is the security of digital wallets and Bitcoin exchanges. While the technology of blockchain and Bitcoin are secure, our methods of access and investment are not at the same level of security. Take for example the Mt. Gox Bitcoin exchange. Mt. Gox was at one point the largest Bitcoin exchange, handling over 70% of all Bitcoin trades worldwide. In 2014, it was discovered that the exchange had been hacked and over 700,000 Bitcoins had been stolen from customer accounts: the equivalent of over $33 billion today. Two weeks later Mt. Gox filed for bankruptcy. Recently, a popular crypto wallet provider, Ledger, had experienced a customer security breach in which over 1 million email addresses and 272 thousand names, addresses, and phone numbers had been released onto “RaidForums” (a marketplace for buying and sharing hacked information). This resulted in many customers being targeted for phishing attacks as well as threats from hackers via phone calls and emails. As is true for all financial institutions, there is no perfect system. Because this technology is so new and so heavily reliant on data storage and security, it is the target for a lot of hacking attacks.

The last area of concern is the long-term use of Bitcoin as a currency. In order for a currency to be widely accepted and used, it is imperative that the currency have stability. If you have watched the price of Bitcoin over the last few years, you can see it is anything but stable. One item that is contributing to this instability is the speculative nature of Bitcoin. Since there are a lot of unknows about Bitcoin, it has been treated more like a high-risk gamble than an actual currency. Numerous investors have viewed it as a “get rich quick” strategy, rather than a long-term investment. When you have massive amounts of trading on an unknown asset, the volatility can be chaotic. Until we see Bitcoin being used in the world as a legitimate currency, it is tough to see an investment as anything other than speculative.  

Cryptocurrencies and Blockchain are drawing a lot of attention from the tech and financial sectors… rightfully so. These advances in computing have the ability to revolutionize the way we think about transacting and storing data. From the security provided by blockchain, to the decentralized nature of sending and receiving currency, there is a lot about this new phenomenon that is exciting and has the power to change lives. However, there are still numerous unknowns about the future of Bitcoin and cryptocurrencies alike. Issues with regulation, security, and long-term staying power remain in question as Bitcoin continues to generate popularity.