The Beauty of Bitcoin definitely lies with the beholder!

I’m sure many people reading this have heard about how much money friends of friends made buying Bitcoin before the price spiked in late 2017 and feel like you’re missing out making risk less profit simply buying Bitcoin or other cryptocurrencies. Well I’m here to put that straight. This will answer 2 questions I’m sure many of you have, them being 1) Should I invest in Bitcoin?, and 2) What is a bubble? Bitcoin is the perfect example of what exactly a bubble is in finance.

As I mentioned in my first blog post, Bitcoin was made to facilitate transactions without the need of banks to act as the middle man and this is why cyberphunks back cryptocurrencies. It was never meant to be used as an investment tool. Investing in Bitcoin for the purpose of turning a profit is definitely not the main function of Bitcoin. The price of Bitcoin peaked in late 2017 at $19650.91 (£14748.90). But how on earth did the price get that high?

First, let’s consider a currency issued by a central bank such as British pounds, the Euro or the US Dollar.  The reason these currencies have value is because it is issued by central bank or government who have the power to raise taxes, has a monopoly on printing new money and is recognised by other nation states. This means that these currencies are relatively stable and are good for investments and deposits in bank because of low volatility in its value. In contrast, Bitcoin is decentralised and is not based in any specific country, making it very volatile. 

Put simply, a bubble is when prices of an asset increase with no fundamental reason behind the increase in the value. Before the recession, housing prices increased dramatically when in actual fact there was no fundamentals behind these increases. During 2008 we saw this bubble pop and the prices of houses decreased. This is the same thing that happened Bitcoin in December 2017 Bitcoin’s value is so arbitrary with no fundamental reasons behind the huge price increases up to December 2017. It is the best example of a bubble in modern times. Many of those who advocate Bitcoin investing argue that Bitcoin’s value is derived from the usefulness or success of the blockchain technology behind Bitcoin. This would be true if this blockchain technology used by Bitcoin was being updated somehow as time went on to facilitate more transactions or to increase anonymity or to do so using less electricity etc. when in actual fact the technology has remained unchanged since the first Bitcoin was mined.

I do believe that blockchain technology will become useful in later years and the technology has the potential to be revolutionary. Companies are using similar technologies in their business operations now, for example, Ford use what they call "blockchain technology" to make sure the cobalt sourced for their electric car batteries is not mined by children in Chinese mines. Although one of the fundamental components of blockchain is that the central ledger is public to anyone, but in this Ford example I doubt this ledger of where the Cobalt is sourced and for how much will be readily available to anyone who wants it. But this is a good example of how people are tweaking this technology to use in supply chain management. 

However, in saying that Bitcoin derives its value from this potentially disruptive technology is just simply wrong. Bitcoin gets its value simply from people saying it has value. This is what makes it so volatile because when a few people think the price should be higher, the price will increase significantly, and if a few people thin the price should be lower, the price will decrease significantly. Traders can only use the market sentiment on Bitcoin to judge whether the value of their investment will increase or decrease, and cannot use fundamental or technical analysis to see if Bitcoin is fairly priced. For this reason I would highly recommend not buying Bitcoin or cryptocurrencies for investments. They are far too volatile and at the price they are now (about £2880 on the time this blog was posted) I would not recommend the readers to investment and to invest in something more legitimate, less volatile and widely used.

Cryptocurrency Clangers: Playing the Devil's Advocate!

If you’ve been following the blog for the past couple of weeks, I hope you’re reasonably familiar with what Bitcoin and cryptocurrencies are. Now I want to discuss the two pitfalls of the technology behind Bitcoin: it’s sustainability and its legitimacy.

Sustainability

I briefly discussed the process of mining in my last blog post but want to go in some more detail to make you aware of the inherent problem this causes society and the environment. Since Bitcoin doesn’t have a central bank controlling the supply like normal money, the only way more Bitcoins can be put into circulation is through the process of mining. There are a number of websites that explain mining in great detail such as https://www.bitcoinmining.com and https://www.coindesk.com/information/how-bitcoin-mining-works. Miners use advanced mining software to solve a number of complicated problems in which they get rewarded with Bitcoins. These problems are integral to the Bitcoin system as these are how the network of computers approve transactions. In order to approve a transaction, the network must use trial and error to work out these problems and just guess the correct answer. Once they get the correct answer, the transactions can be approved, and the miner is rewarded with a bitcoin. The idea behind this is that it will encourage people to mine for Bitcoin which will make the network more secure and more transactions will be approved. However, the founder of Bitcoin put a limit to the number of Bitcoins that can be put into circulation, which is 21 million Bitcoins. To make sure they’re not all mined straight away the amount of work needed to mine a Bitcoin increases exponentially by making the problems more difficult to solve. At the time of this blog was written 83.61% of the Bitcoins have been mined at the current difficulty rate is 6,071,846,049,921 which means it is 6,071,846,049,921 times more work to mine a Bitcoin now than the first Bitcoin mined by Satoshi Nakamoto. 

With this increased difficulty comes a lot more computer power needed in order to mine Bitcoin which will in turn use a lot of electricity. This is where the sustainability of Bitcoin becomes questioned. As the graph below shows, Bitcoin miners are using more electricity more electricity than countries such as Iraq and Peru. To put this into perspective, the energy consumed to mine Bitcoins is the more than the energy consumed by countries with a population over 30 million people. Obviously this is a serious issue that is only going to get worse, and with people fighting to reduce the harm humans are doing to this planet, Bitcoin mining will only increasing out carbon footprint over time as the mining process becomes more difficult. Although there are more efficient computer chips called ASIC (application-specific integrated circuits) being used by miners that uses less electricity, this still won’t do much in the way of reduces the energy consumed by miners which is only going to grow exponentially in the coming years.

Legitimacy

The second problem with Bitcoin is the legitimacy of the currency. An important feature of cryptocurrencies is that all transactions are anonymous, and the identity of the buyer or seller is never known. Even common sense will tell you that this will lead to a lot of illegal activities being funded by cryptocurrencies. One of the first sites to widely use cryptocurrency called the Silk Road, was widely used for people to buy drugs, stolen identities, weapons and even buy services such as blackmail and extortion. Many Cypherpunks (advocates of using cryptography for privacy-enhancing technology) counter argument for this illegal activity is that cash is used to fund illegal activities too, it doesn’t mean that the cash in my wallet shouldn’t be widely accepted. A paper published at the start of 2018 called “Sex Drugs and Bitcoin: How Much Illegal Activity Is Financed Through Cryptocurrencies?” found that 46% of all Bitcoin transactions was in illegal behaviour. This amounted to $76 billion spent on illegal activities per year through Bitcoin. To put this in context, according to the US White House Office of National Drug Control Policy, drug users in the US in 2010 were estimated to spend $100 billion annually on illicit drugs and the EU Drug Markets Report for the year 2013 found that €24 billion per year was spent on illegal drugs in the European markets https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3102645. So I think that should destroy the Cypherpunks argument, clearly a large proportion of Bitcoin is being used to fund illegal activities, whereas the large majority of cash transactions are for everyday, legal living. Many agree with this sentiment. Bill Harris, the co-founder of Paypal said “Cryptocurrency is best suited for one use: criminal activity. Because transactions can be anonymous – law enforcement cannot easily trace who buys and sells – its use is dominated by illegal endeavours.” https://www.recode.net/2018/4/24/17275202/bitcoin-scam-cryptocurrency-mining-pump-dump-fraud-ico-value. Maybe he’s just bitter because PayPal is so legitimate that it possibly losses out in business in the criminal sector? Although Bill Gates, the father of Microsoft, did say on a Reddit AMA: “Right now crypto currencies are used for buying fentanyl and other drugs so it is a rare technology that has caused deaths in a fairly direct way.” https://www.reddit.com/r/IAmA/comments/80ow6w/im_bill_gates_cochair_of_the_bill_melinda_gates/dux49ll/. So maybe Harris isn’t just jealous… 

Although this anonymity feature is loved by all the Cypherpunks who back Bitcoin and cryptocurrencies like it, it is seen as a serious problem by many of the public and regulators. Governments want some regulation regarding transactions, but this leads to the government getting involved in the cryptocurrency which cypherpunks want to keep anonymous which the government don’t like and so on. This is a vicious circle with neither side seeing eye to eye. To take away the anonymity feature of cryptocurrencies is to take away the essence of the technology. 

It’s hard to get lost in the hype of Bitcoin as with many people who talk about it will be telling you all the great things about it. I just wanted to present the facts and maybe in most people’s cases play the devil’s advocate. The problems with legitimacy and sustainability of Bitcoin will not go away as changing the system that Bitcoin stands on to alleviate the effects of these problems will simply change the complete fabric of this and other cryptocurrencies, and simply turn cryptocurrencies into regulated, plain, boring currency.

So... How does Bitcoin work?

Now for the burning question. How does Bitcoin work? To start, lets talk about how normal transactions work. If I were to go into a shop and pay for something with my card, the shop takes my bank details (when I used my chip and pin or contactless payment). The shop then goes to the bank to see if I’m good for the money and do in fact have the money for the transaction. The bank will then check its records, or its ledger of customer details, to see if I do have the money in my account. If I do have the money, the bank tells the shop, the transaction is completed, and the bank will then update its ledger, taking the money out of my account into the shops. The bank will take an albeit small cut from this transaction but think of the millions of transactions that are processed everyday – the banks will make a fortune. This is what cryptocurrency wanted to stop. It was a system that wanted to remove the need for the middle man in our daily transactions. But there are still some issues with just simply removing the need for banks. First of all, where will the ledger of everyone’s account’s be kept without them being altered. Would you trust me to keep the records? Probably not, and I wouldn’t trust any of you to keep the ledger either (no offence). But we might trust every single person in the system. This is the idea behind cryptocurrency.

This is where blockchain comes in. Blockchain creates a digital ledger of everyone in the system’s account details and makes it publicly known to everyone in the system. Everyone who uses bitcoin will have access to view this ledger. This is called a peer-to-peer network and blockchain records every single bitcoin transaction that’s ever occurred in a chronological order inside a “block”.

But what is stopping someone altering this record and just giving themselves more bitcoin? Consider this example I heard once. Say you’re playing poker with your friends but none of you have any money or chips on you. So instead, every player takes out a piece of paper and records throughout the game who owes who what money. At the end of the game, you all compare what you’ve written on your pieces of paper. If someone tries to get more money and their record doesn’t match everyone else’s, this is caught and it will be forced to be changed by everyone else. This is the same idea of bitcoin. Instead of friends playing poker it is computers part of a network, who constantly compare ledgers to make sure there are no discrepancies and if there are then they change them. So instead of the bank checking the ledger is correct for a small fee, the network of computers checks all the public ledgers are correct. Every so often, a computer will be gifted a bitcoin by the system if it confirms a certain number of transactions.

Although all this information is public, there is still anonymity as everyone’s details are displayed in an encrypted way, which is called their “signature”. So all we can see is the different signatures on the ledger and how much they have or what they bought. Therefore transactions made are anonymous and irreversible as there no way of knowing who you just traded with. This leads to a lot of problems that I’ll talk about in a later blog post. 

In relation to the example given at the start, we now have a new system for transactions. Say this ledger that the bank used to be the sole owner of is now distributed around the world and every computer as part of the network records every single transaction. Now, I give my account details to the shop, the shop will go to the network of computers to confirm that I have the money. The whole network will have to agree that I have the money and if one has a discrepancy then the network will change its ledger to the correct one. The network will then get back to the shop and allow for the transaction to go through and every single computer will change their ledger to update the accounts after this transaction. This process will then produce a bitcoin for one of the computers in the network, which is called "mining". This simply means that computers are getting rewarded after completing complex problems involved in updating and maintaining this public ledger, and after a certain number of these problems are solved the network offers the computer a Bitcoin.

So, to sum up, bitcoin uses a network of computers to maintain a central ledger. This ledger is updated constantly with new transactions and the network has to agree on a change made to the central ledger in order for it to make it into the block. This means I can’t send bitcoin I don’t have as the network will see I only have a certain amount and will reject my transaction. All transactions are anonymous. Since this system is on a network of computers, no one person “owns” it or the ledger therefore no one can just give themselves bitcoins or alter the ledger themselves. To do this, an individual would have to hack essentially every single computer on the network and change all their ledgers at once which is virtually impossible. All these features are what makes bitcoin special: it is a decentralised currency (no one owns it); it cuts out the need for a middle man (the bank); it is anonymous and; hacker proof.

Bitcoin beginners, Ripple pupils and Dash dummies

Cryptocurrency has become a household name recently with the rise (and relative fall) of Bitcoin in the past years. Yet I fear many still do not fully understand what cryptocurrencies are or what purpose they serve. I have found myself explaining cryptocurrencies in layman’s terms constantly ever since I became interested in it. The purpose of this blog is to give the “layman” information regarding cryptocurrencies and will serve as a good starting point for anyone with an interest in this subject and who possibly think investing in Bitcoin or other cryptocurrencies is a sure thing. This explains the blog title: “Crypt”, short for cryptocurrency and “Tyro”, a synonym for beginner. That’s exactly who I am aiming this blog at; the Bitcoin beginners, the Ripple pupils and the Dash dummies. I aim to give readers information that is relevant to the new world that the technology behind cryptocurrencies is bringing us into. I should divulge that I am in no way an expert in this field, I am merely just an interested party. Up until now, all the research I have done on cryptocurrency was done out of my own interest but now as I complete my Masters in Finance at Queen’s University Belfast, one of my modules “Money and Banking” has included cryptocurrencies as part of the module so hopefully all those blogs, articles and opinion pieces read (as well as the countless videos watched) will become useful in my academic career! 

Dorain Satoshi Nakamoto - Bitcoin creater? 

So, let’s start at the beginning. Many people confuse cryptocurrency and Bitcoin as being the same thing which isn’t the case. Bitcoin, Ripple and Litecoin are all types of cryptocurrencies, just like how Ford, Toyota and BMW are all types of car. Cryptocurrency is just the general term for these ‘virtual currencies’. Bitcoin, the first ‘successful’ and probably most well-known cryptocurrency, was invented by a person, or group of people who went by the name Satoshi Nakamoto. No one ever met this mystery person/group of people, so no one could be sure if it was in fact just one man or a group of people. The press did think they found this anonymous man, but it turned out to be a man called Dorain Satoshi Nakamoto living in LA who knew nothing about Bitcoin, so this was thought to be a dead end. From reading the paper that outlined the components of Bitcoin and the technology behind it, written by our mystery man Nakamoto in October 2008, the author keeps referring to them self as “we” which indicates it was a group of people who are responsible for Bitcoin and the blockchain technology behind it. 

But I digress, enough of the conspiracies. I have noticed that a lot of people seem to confuse blockchain and cryptocurrency as being the same thing which is another mistake. Keeping with the motor example from earlier, blockchain technology is like the engine and cryptocurrency is like the car. The car needs the engine to function, just like cryptocurrencies need blockchain to function, but that’s not to say that you can only use the engine in a car: you can use it in a van, a motorbike, a plane, a boat and so on. There has been a lot of hype recently about blockchain technology and I’m sure many people believe it’s only function is providing the technology behind cryptocurrencies, but as you will see later this technology can be used in money and banking for different things. 

Nakamoto published the paper on Bitcoin in late 2008, after the financial crash, which is no coincidence. The paper (attached here https://bitcoin.org/bitcoin.pdf) outlines a “peer-to-peer version of electronic cash” allowing payments made online to be sent directly from one person to another without going through a bank or another financial institution. The intuition behind it is that there is no need for there to be a middle man in our transactions, and this technology can pave the way to a decentralised system without the need of financial institutions to get in the middle. The financial crash clearly destroyed a lot of people’s faith in the banks and the financial industry as a whole, so some wanted a way to break free from the shackles put on us by the banks making it virtually impossible for us to live life without their intermediation. 

How does one go about creating a currency that doesn’t need the banks to operate? This was the focus of Nakamoto’s work, he wanted to create a currency that was part of a decentralised system i.e. there was no central bank controlling it. This is the cornerstone of Bitcoin and what a lot of its original backers’ advocate for. In my next blog I will explain the technology behind Bitcoin which is used by other cryptocurrencies. I know many people have heard of the depreciation of Bitcoin and other cryptocurrencies and you’re maybe thinking this cryptocurrency fad is coming to an end. To those people, I would say I don’t totally disagree with you, there was a bubble in cryptocurrency value. I would also remind you however that there also was a bubble in housing prices before the financial crash in 2008, that doesn’t mean that investing in property post-financial crisis is a bad idea. I know this is a trivial comparison because properties do have fundamental value i.e. the value of the land it is located on, the type of property it is etc. I would also like to remind you the value of one Bitcoin today is about $3400, granted this is much lower than its high of nearly $20,000 in late 2017, it still shows that Bitcoin and other cryptocurrencies may not be fully irrelevant today. The graph below shows the rise and fall of Bitcoin over the last 2 years.

Bitcoin price in USD from 2017 to present (available at https://charts.bitcoin.com/btc/chart/price)

The purpose of Bitcoin has shifted from what it was originally set up to do significantly in my opinion, and I feel like public opinion on this cryptocurrency has been brought about by lack of research and new outlets using buzz words and not properly explaining what exactly Bitcoin is. This is where this blog will come in handy.