Bitcoin, A Primer

Published On: December 8, 2017

Written by: Ben Atwater and Matt Malick

With bitcoin soaring past $11,000 (a more than 10-fold increase in 2017) and with heightened interest in the cryptocurrency, the total market cap of bitcoin now stands at well over $190 billion.  The currency’s value is now greater than that of PepsiCo, Boeing or McDonald’s.

Presently there is no easy way to include bitcoin in an investment portfolio, but come December 18th the Chicago Mercantile Exchange will launch bitcoin futures contracts, which will enable investors to speculate on bitcoin.  Further, there are now more than 100 cryptocurrency hedge funds.  Undoubtedly, many other players are looking to get into the game as well.  It’s a feeding frenzy.

Coinbase, the world’s most popular way for consumers to buy and sell cryptocurrencies, has exchanged more than $50 billion in currency, reaches 32 countries and serves about 13 million customers.  This service allows people to use their bank account, debit card or credit card to buy or exchange bitcoin (and other digital currencies) while also serving as a wallet where you can store your cryptocurrency.

Like Dollars, Yen and Euros, bitcoin is a currency that users can exchange for goods, services and other currencies.  Some see it more as a store of value, like gold, and less like the exchangeable government-backed currencies we name above.

The best way to begin understanding bitcoin is to understand the technology that makes it possible – blockchains.  You can’t spend the same $100 bill at Target and Lowe’s because after handing it to the cashier it is no longer yours.  For a digital currency to work, this concept must hold, you can’t double spend the money.  Blockchains prevent double spending.

Fair warning that blockchain technology is complicated, but here’s an overview.  After a series of transactions occur with bitcoin, these transactions combine to form a block.   Powerful networks of computers (miners) run trial and error computations on the combinations of transactions within the block to determine a unique code for that block.  Once the miner unravels the challenge (or proof of work), nodes review it and confirm that the transactions are legitimate.  After the verification, the miner receives newly minted bitcoin as a reward for their computing efforts.

The blockchain acts as a public ledger (without identifying participants) that shows all transactions from the inception of bitcoin.  With each new layer of block, it becomes more difficult for a rogue miner to go back and manipulate the past, making bitcoin relatively hard to counterfeit.

On the other hand, bitcoin is easier to steal than to counterfeit.  For example, a hacker on Coinbase, or a plethora of other platforms, could get into your wallet and steal your bitcoins like what happened at Mt. Gox, a Japanese exchange.

The creator of bitcoin, Satoshi Nakamoto (a pseudonym), limited the creation of the currency to 21 million bitcoins, making it, like gold, a finite store of value.  Presently about 16.4 million coins are in circulation.  Each time a challenge is solved, bitcoins are created. The number of bitcoins generated per block starts at 50 and is halved every 210,000 blocks (about four years). The current number of bitcoins awarded per block is 12.5. The last block halving occurred in July 2016.

Huge momentum exists with bitcoin.  Everyone wants in.  And the more people that do, the higher its value may go.  Bitcoin has a technological and libertarian appeal.  It feels like a meritocracy free from government perversion, which in today’s world is especially appealing.  But bitcoin is not without major risks.

Stemming from a disagreement around the appropriate size of blocks, contingencies within bitcoin nearly split the currency (hard fork).  Prior to this recent scare, smaller splits (soft forks) have occurred in bitcoin (bitcoin cash and bitcoin gold), which users generally overlooked in part due to the surging price of bitcoin itself.  In other words, the precedent exists for possible civil war within the bitcoin community.

Vocal critics of bitcoin like J.P. Morgan CEO Jamie Dimon have called bitcoin a “fraud” and its investors “stupid,” while Ray Dalio, the founder of the world’s largest hedge fund firm, Bridgewater Associates, says it’s a “bubble.”  These comments may have their root in concerns over not only what bitcoin could do to itself but what outside forces might do.

For example, finding a flaw in its blockchain technology could make bitcoin unravel, as cryptocurrencies have no intrinsic value.  Meanwhile, additional cryptocurrencies are regularly coming online and another player could ultimately reign supreme.  And it’s possible that government-backed blockchain currencies could eventually compete, combining the best aspects of crypto and sovereign fiat currency.  Not to mention, the biggest risk could be government regulation as governments are skeptical of the anonymity (money laundering, tax evasion and illegal trade) inherent in digital currency.

For now, though, bitcoin is a first mover in a novel technology that promises to revolutionize payments and, perhaps, has other meaningful applications.  Like many other narratives in today’s marketplace, if you suspend disbelief, you might make some money.

 

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