Bitcoin for (Value Investing) Dummies like myself

Background:
Some of my readers might have noticed that starting in the last year I have become more interested in Bitcoin and Cryptocurrencies. Don’t worry, I will not invest gamble with them but I do think it is important to understand what is going on in this area as this could change many things especially within financial services. As this blog functions primarily as my own diary, I have decided to do a few posts about my own learnings so far.

Bitcoin explained (maybe wrongly) in 10 Points:

  1. At its core, Bitcoin is (only) a network software protocol which defines the way the potential  members of the network communicate via cryptographic techniques
  2. Based on this protocol, the network then runs many copies of a transactional database which records each and every transaction since the beginning of Bitcoin
  3. The database itself consist of blocks of transactions which are “chained” together by clever cryprocraphic “trees” and pointers (“blockchain”), allowing relatively easy verification if the database has been retroactively changed
  4. The main challenge of this structure ist to avoid “double spending” or what one would call counterfeiting for normal currencies. How does the Bitcoin network  make sure that no one is able to spend his Bitcoins more than once ?
  5.  This problem has been solved cleverly by decentralizing the verification process to the socalled “Bitcoin” miners. Bitcoin miners in principle collect transactions into a new “block” and then verify each transaction if it is valid or an attempt to doublespend
  6. In order to incentivize miners to actually perfom this task on an ongoing basis, they are rewarded a certain amount of Bitcoins if they succesfully post a verfied block onto the blockchain
  7. As the Bitcoin network is totally open (anyone with a computer can join, open an account or become a miner) , it is important to defend this process against malicious members who might verify for instance their own double spending attempts
  8. For this reason, the protocol contains a  competition feature. The miners compete against each other for posting a block (and reaping the Bitcoin reward) by solving a cryptographical puzzle which resembles to a certain extent a traditional lottery but requires significant amounts of computational power (“Proof of work method).
  9. Interestingly, this combination of reward and puzzle is the truly innovative feature of Bitcoin. So far this mechanism has ensured that the integrity of Bitcoin has not been compromised, without any control of a central authority. Up until Bitcoin was invented, no one really succeded in establishing such a decentralized verification process.
  10. Finally, Bitcoin cointains a feature which also makes it a truly electronic currency: If one sends Bitcoins via the protocoll, one can embed a set of instructions attached to the Bitcoin which then gets executed at the recieving end. In Bitcoin this is rarely used, mostly for a kind of trust account, but within Ethereum, this feature has been expanded to what is now called a “smart contract”.

 

Some Myth busting:

A) Bitcoin is fully anonymous
This is not true. Although anyone can open an account without verification and transfer Bitcoins, it doesn’t seem to be too difficult to track for instance IP addresses. Plus it is really easy to track back Bitcoins as all transactions are recorded forever. Only in combination with other tools (Tor etc.) , some sort of anonymity can be insured. In my opinion, cash bills still provide better anonymity than Bitcoin.

B) There are only 21 mn Bitcoins
This is just a number set in the current protocol and could be changed at any time. However this depends on the consent of the miners. Plus, every “hard fork” of the protocol automatically creates 21 mn new Bitcoins (or something similar) as it has happened with “Bitcoin cash”

C) Bitcoin is great for Micropayments as there are no transaction fees
There are several types of fees within Bitcoins. Indirect Transaction fees are currently mostly paid by issuing new Bitcoins to the miners.  Direct transaction fees need to be paid if fore some reasons the transaction should be executed quickly, as miners prefer transactions that offer them fees. One of the big issues is what will happen if no new Bitcoins can be created anymore and then miners are only compensated by fees. Or if the Bitcoin price falls significantly and the significant electricity consumption cannot be refinanced by the block award alone

D) Bitcoin works without Trust or a central authority
It is true that no central authority decides what is going to happen with Bitcoin. But as a normal user for instance you have to trust either the Bitcoin Exchange if you buy Bitcoins or the programmers behind your Bitcoin Wallet Software that they don’t rip you off. There is also a small Group of people who are responsible for developing the “Bitcoin Core” which is the central protocol software. However their power is limited as the miners can decide which version of the protocol they want to run. Theoretically, a very large mining pool could influence Bitcoin (and even try to double spend) but then trust in the system would vanish quickly and the miners have achieved exactly nothing. Personally I would describe Bitcoin as a relatively well-balanced system with different authorities. Not unlike the power distribution of a country where the power is divided between the legislative, jurisdictive and executive branches. As Bitcoin is relatively new, it needs to be seen how stable this will be.

E) Bitcoin could replace theoretically any currency in the world

In its current form, Bitcoin has no chance to replace any currency. The main reason is that the transaction volume on the Bitcoin Blockchain is very limited. Due to its limited Block size, one Block can contain only around 1500-2000 transactions. As new blocks can only be created every 10 minutes, this limits the amount of transactions to around 12.000 per hour. Visa in contrast for instance claims to be able to handle 56.000 transactions per second. Technically it seems to be possible to improve Bitcoins transaction speed, but so far the Bitcoin “community” seems to have problems to agree on how to do this. So independent of any price fluctuations, Bitcoin in its current form is not a very good payment device from a technical point of view. It will be interesting to see if Bitcoin evolves quickly enough or if other crypto currencies will steal the thunder. Ethereum for instance is a lot quicker as they create blocks at a much faster rate.

F) Bitcoin is a fraud

Just a few days ago, Jamie Dimon called Bitcoin “a fraud”. Acccording to Wikipedia is defined as follows:

In law, fraud is deliberate deception to secure unfair or unlawful gain, or to deprive a victim of a legal right.

The founders of Bitcoin clearly didn’t intend anything in this way. They wanted to create a peer-to-peer payment system which cannot be hacked and I think they were succesful. That Bitcoin now is worth ~70 bn USD is clearly the result of a lot of speculation, but so far I see no intentional fraud.Many things are worth something because people believe it is worth something. When an old painting is sold for 180 mn USD, it is clear that this is a price that is not justified by the cost of the underlying material etc. but that this is the value that the buyer thinks it is worth.

In contrast, some (or all ?) of the hundreds of Initial Coin offerings happening at the moment do have all features of a typical fraud. My favorite coin is PonziCoin which clearly states its true nature. Bitcoin in contrast never did an “ICO”, it just developed the way it is. In a few years time we will see what value then will be assigned to Bitcoin, personally I think that this is not predictable.

More material:

For those who are more interested in the topic, I can highly recommend the Princeton lectures

Bitcoin and Cryptocurrency Technologies

Although this is ~3 years old (and Ethereum was only a theoretical concept back then) this is a really comprehensive and relatively easy to digest series of lectures which helped me a lot.

I found this attempt at valuing Bitcoin quite funny (Edit: funny in a positive way.  I do not have seen any better approach to value Bitcoin yet.)

 

 

 

 

 

 

 

 

 

 

 

12 comments

  • Great overview, thanks. Two more points:

    People are buying BTC because they believe that its price will rise. Hence, they are hesitant to use it for payments (you don’t want to act like the guy who spent 10.000 BTC for 2 pizzas in 2010, do you?). But if BTC is not used for payments, then how can it become a widely accepted currency? And if it does not become a widely accepted currency, how can it be valuable for any other reason than pure speculation? To me this seems like a contradiction in itself.

    Satoshi Nakamoto owns approximately a million BTC. This gives him (or them) a strong influence on the BTC market – if he would publicly destroy half of his BTC, the BTC price might explode. If he started monetizing his BTC without proper communication, the price might collapse. And he really is an enigma: he became a multi-billionaire in a couple of years, but still he hasn’t monetized his BTC or touched any of his net worth – what person would act like this and what motives could drive someone to not even monetize a couple of insignificant millions for the next summer vacation or to pay one’s home? Not knowing who he is (apart from that he seems to be very intelligent) and what his motives are lowers my trust in the BTC system.

    I think that the blockchain technology is highly important. But as an investment, I think that BTC is too difficult to assess.

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  • Brilliant overview.

    A couple of minor additions.

    The puzzle competition to add a new block is run every 10 minutes (roughly). A miner’s chance of winning the puzzle depends on the proportion of compute power the miner contributes out of all the compute power busy working on the bitcoin puzzle. This has implications for centralisation – in theory I could use my desktop PC to contribute, but in practice because it’s such a tiny % of all the compute power I would expect to be paid once every 1000(or million) years (or so). This effect de-facto has a tendency for the mining activity to coalesce in a somewhat oligopolistic distribution of players (the so called mining pools). The implications of this going forward are hard to predict, but likely to be important.

    The other thing to note is the energy efficiency. The debate on technological improvements of the protocol for me are a bit of a side issue. I strongly suspect (though don’t have the numbers) that the Bitcoin network defacto expends massively higher amounts of energy per transaction than Visa – this to me is a more fundamental issue than the speed issue you’re right to mention. I have yet to see a good way to get around this – and if such a way doesn’t exist then the currency is likely doomed.

    A final point on quantum computers. The whole of bitcoin (and cryptography) rests on the assumption that large numbers are hard to factor. Should a quantum computer running Shor’s number factoring algorithm become a practical reality (which BTW does have some chance of happening in the next 100 years), then the whole premise of cryptocurrency will rapidly evaporate into a historical curio.

    I myself remain a sceptic like you – cryptocurrencies today seem like a fascinating solution to an as yet not found problem….

  • Thanks a lot for your insights on Bitcoin and cryptocurrencies in general. I especially like the myth busting-part because there I can find many counter-arguments for friends and colleagues that are actively ‘invested’ in this ‘next big thing’. I always warn that it might not be the best idea to do that, but they say they need some diversification for Netflix and Tesla 🙂

  • Nice summary, I think you got most things right, which is no mean achievement! A couple of comments:

    “Or if the Bitcoin price falls significantly and the significant electricity consumption cannot be refinanced by the block award alone”

    That’s not a problem at all: if the BTC price falls enough to bankrupt some miners, they will turn off their equipment, which will make average block time a bit longer, until the next automatic difficulty adjustment which will make it easy enough to go back to normal.

    For example: imagine that half the mining power disappears suddenly. What happens? The next blocks will take an average of 20 minutes (a bit inconvenient but not in any way fatal). The next difficulty adjustment update will calculate the amount of live mining power implied by the recent average block time, and adjusts it so that the block time goes back to 10 minutes (the algorithm assumes live mining power in the next period will be similar to that of the measurement period). In this case it will halve the difficulty. Repeat as much as you like.

    “this combination of reward and puzzle is the truly innovative feature of Bitcoin”

    That’s debatable whether the reward is as relevant as many people think. Imagine you create a clone of Bitcoin where everything is the same except (1) you find an outside method to distribute the seed coins (2) the block reward is always zero (for simplicity let’s assume fees are burned and are only used for congestion control).

    Does it still work? If not, why not? Technically, it 100% works, the only issue is behavioural.

    I would say the core invention of Bitcoin is the distributed lottery (you can use it in a non-coin setup wherever you want a lottery without a central source of randomness). The reward system is on top.

    Where the block reward was a brilliant idea is that it was a fair way to distribute the original coins very widely and encourage adoption.

  • it’s not possible to pay with bitcoin at the corner shop and I am unable to value it. So why bother spending time on it? – That’s my quick evaluation of crypto currencies 😉

  • “I found this attempt at valuing Bitcoin quite funny.” -Completely agree. I saw that last week and had a nice long chuckle.

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