The rule in financial investment (and indeed in life) has always been high risk, high reward. Keep your money safe in a savings account: pick up your assured 4 percent at the end of the year; have the nerve to bet billions against the British pound and the Bank of England, and the returns are considerably higher.
And then there is Bitcoin.
While Bitcoin has been around since 2009, its recent increase in value has caught many by surprise. And with good reason too. For if you had the foresight to invest in it in January, you could have cashed in a 1,700 percent return on your investment come December.
Not bad for something which doesn’t exist in the physical world, has been known to be used by drug smugglers, is barely accepted anywhere in the general economy and does not have the backing of any government or banking institution.
The year was 2008 and the financial crisis was fresh in everyone’s minds. People had lost trust in the system and banks were everyone’s new whipping boys. At the same time, money was firmly entrenched in the system and with Internet commerce taking off, more and more people were exchanging products and services across the world. Thus, with the idea of “money” being what it was, it was going to take something truly remarkable to loosen the choke-hold that banks and governments had over the financial system.
Enter Satoshi Nakamoto.
Nakamoto, an individual or — more likely — a group of individuals (his real identity remains unknown), come up with a radically different idea of money. Detailing their thoughts in a lucidly written nine-page White Paper titled Bitcoin: A Peer-to-Peer Electronic Cash System
Now, it would be incorrect to say that Bitcoin was a completely new concept. It actually traces its roots to the Cypherpunk movement of the 1990s. A group of libertarians who fought the good fight for privacy, the Cypherpunks individually created many of the aspects which came together to form Bitcoin. From Adam Back’s Hashcash to Wei Dai’s b-money to Hal Finney’s Reusable Proof of Work, all of them were invaluable to the development of Bitcoin.
How does Bitcoin work?
The first thing to know about bitcoin is that it is a completely imaginary concept. There is no XYZ.bitcoin file which is passed around to conduct transactions. Instead the system works around a digital ledger where everyone’s ownership is recorded. Thus when A says that they have 10 bitcoins, what they are really saying is if you look at the Bitcoin ledger, the sum total of the transactions will net A 10 bitcoins.
Assume that the entries above are an excerpt from a ledger where B and C are appearing for the first time. By looking at the ledger, it is clear that B has 5 bitcoins while C has 25 bitcoins. Thus by looking at the entire ledger, anyone can tell how many bitcoins everyone has.
The question then arises as to how entries to the ledger are made. Take the transaction between A and B. The first step of the process is for A to securely create an entry which says A wants to send B 15 bitcoins. This is done using digital signatures in a way such that anyone can verify that only A could have created the entry.
Now, generally A will not add the entry to the ledger themselves. Instead, A will broadcast the entry to the Bitcoin network. The actual entry-making in the ledger is done once every 10 minutes by “miners”. Miners are paid volunteers who take up the task of maintaining the ledger. Individual miners will take a bunch of these entries which have been broadcast by different people and make a “block” out of them (while also checking against the ledger that people spend only what they have). However, only one miner gets to add their block to the ledger.
The decision as to which miner gets to add their block is done by exhibiting “proof of work”. Put simply, this proof of work is doing complex calculations which take up computing power. The first miner to generate an answer from the calculations gets to add their block to the blocks already present (which form the ledger) thereby creating a chain of blocks or a “blockchain”.
To ensure that the miner just hasn’t come up with a random answer, the system ensures that it is easy to cross-check the answer with the problem. Thus other miners don’t have to do the full calculations themselves but can simply check if the answer provided is correct. If the majority of miners approve the answer then the new block is considered part of the blockchain and everyone works from there.
The two checks — digital signatures and proof of work — when put together, ensure that only A gets to spend their money (because the entry is digitally signed), and gets to spend only what they have (because the miners as a whole verify the entry).
For the user, the transactions are extremely simple as Bitcoin functions as an app on their phone where they simply input how many bitcoins they want to transfer to whom and the system automatically takes it from there.
Miners driven by economic incentive
Miners are crucial to the entire system. They — as a whole — are the bookkeepers and because of the decentralised nature of the system, they keep a check on each other. This keeps the system very secure because to cheat it, a person would have to fool everyone else on the system. The possibility of this happening are very remote.
Mining itself is expensive work requiring special hardware and running up heavy electricity bills. To incentivise it, the system rewards miners with bitcoins. This comes in two ways. Firstly, a miner adding a block to the blockchain can add an entry giving themselves x amount of bitcoins. This is also how new bitcoins are created. Secondly, users also set aside an amount as “transaction fees” to incentivise miners to add their transaction to the block.
The maximum number of total bitcoins is fixed at 21 million and this number is expected to be reached around the year 2140. The x amount that miners give themselves is pre-decided and decreases every time a certain amount of bitcoins are generated. Eventually it will fall to zero and then the miners’ incentive will come entirely from transaction fees.
Exchanges and safety
Not everyone participates directly in the Bitcoin system. Most people take part in it indirectly through exchanges which make the experience more user-friendly. It is here that you can buy bitcoins in exchange for “normal” currencies like the dollar or the pound.
Where exchanges make the experience easier, they also form one of the biggest vulnerabilities in the system as they give a centralised target to hackers. In fact, the most famous hack in Bitcoin history took place at its then-biggest exchange, Mt. Gox when hackers took off with 850,000 bitcoins and caused the exchange to collapse.
There are numerous other examples of exchanges being hacked. The legal position around Bitcoin also remains unclear as the Indian government has said that it does not recognise cryptocurrency as legal tender in the country as of now.
Pros and cons
The major benefit of Bitcoin is that it is not controlled by a central authority. This means it is extremely difficult to hack (as all computers on the network must be hacked simultaneously) and cannot be shut down. It gives the user complete control as they decide exactly how much is paid to whom and when. They are unencumbered by any policy put in place by a central authority. Transactions can take place between any two people in the world as long as they have an internet connection.
There is also the great advantage of privacy. None of the users’ private data is revealed in the transactions. Their identity in the blockchain is simply a series of random numbers with no link to their personal identity. This prevents identity theft and allows users to pursue transactions which might otherwise be considered taboo.
The privacy however lends itself to more nefarious uses. Thus bitcoins have been used to buy illegal drugs and counterfeit goods, as ransom for hackers, for tax evasion, and even to order assassinations. Before the cries for banning the bitcoin rise however, it is worth noting that all of these activities are carried out on a much greater scale using cash.
As discussed above, Bitcoin at its core is based on a concept called the blockchain. And for many, it is this concept which is far more interesting than Bitcoin itself.
It is important to realise that the use of the blockchain for a cryptocurrency is a fairly low-level use of it. Over time, blockchain technology has evolved by leaps and bounds and is capable of doing a whole lot more.
One of the best examples of the blockchain’s potential is exhibited by Bitcoin’s biggest competitor, Ethereum. Created by a then-19-year-old Vitalik Buterin, Ethereum uses a cryptocurrency called ether and adds the concept of “smart contracts” to the blockchain. This allows a user to create conditions which must be met before a transaction is executed. This completely cuts out the need for any middlemen and reduces processes.
Let’s take an example where A wants to buy a computer from B. The price is decided and the smart contract monitors the transaction from there on. Thus if B sends the computer in time, they get the money, otherwise it goes back to A. All of this is monitored by the blockchain and cannot be tampered with by a middleman. Many such smart contracts can be linked together to form a chain such that once a computer is sold, B’s CPU manufacturer automatically receives payment to make another CPU for the next computer. This leads to greater efficiencies.
Another very important use of the blockchain is for voting. The political system in many countries like India is rife with muscle power and incidents of booth capturing are common. Even when the system isn’t biased towards one party, it can lend itself to systematic discouragement of voters as was depicted excellently in the movie Newton. A blockchain model will allow voters to vote using their phones safe in the knowledge that their vote will not be manipulated. The decentralised nature of the blockchain becomes extremely important here as no single authority is able to manipulate these votes thereby resulting in a near-ideal election process.
Further, a blockchain is by its very nature a safe record of things which is very hard to manipulate. Multiple users maintain it leading to multiple checks which need to cleared before the blockchain is compromised. This leads itself to some very interesting uses, one of which is maintaining land records.
Land records are tough to maintain as they are in different formats and can be manipulated by those who control the central registry. If they are instead put on the blockchain, they will be permanently in place and no longer be at the mercy of the powerful. This usage can easily be extended to prove ownership of any asset like art and gold. It would also stop the counterfeiting of medicine and electronics as there would an immutable record of their entire journey right from the factory floor up to you.
There is great application for the blockchain in the art field as well. In an article for The Baffler titled The Problem with Muzak, Liz Pelly laid down just how much streaming services like Spotify are harming musicians. However at the same time they have become necessary as a way for consumers to consume music. Blockchain technology could replace all that as it would allow musicians to put their music on the blockchain enclosed in a smart contract. Thus when you consume their music, the money will automatically flow from you to them. British singer and songwriter Imogen Heap has already released one of her songs on a blockchain-based website.
There are many, many more uses of blockchain technology, some of which are given in the video above. All of these underline the fact that this a technology for the future and will transform our world. As such you would be better off ignoring the ridiculous fluctuations in the prices of cryptocurrency and instead looking at how the blockchain will disrupt your industry and how you can stay ahead of the curve.
With that disclaimer out of the way, let’s jump into the question you’ve been waiting for.
Investment v. Speculation: Should you invest in bitcoin?
Let me begin by bursting your bubble: if you’re reading this article, you are not going to make billions trading in bitcoin. There are too many people ahead of you who have devoted their lives to studying and investing in Bitcoin. It would a remarkable feat if you managed to jump the queue and profited from it to a notable degree.
Also, if I knew where the price of bitcoin was going, I would not be writing this article.
What I do know however is that bitcoin is an extremely volatile financial asset. Its price fluctuates wildly and is currently riding a high due to increased attention around it. It is operating in a weird circle where the media hype is increasing its price and the increased price is generating more media hype. This will not sustain for long.
No financial asset is a slam dunk. However the prices of mutual funds and stocks and even art vary depending on certain known factors. In the case of bitcoin, it seems that practically anything can result in the price rising or plummeting. Amal Sethi, an amateur investor in cryptocurrencies says that anything from the head of JP Morgan calling bitcoins a “fraud” to China banning Initial Coin Offerings to South Korea’s second-largest exchange starting the sale of Litecoin to a rumour of Ethereum founder Vitalik Buterin dying have caused cryptocurrency prices to fluctuate. He adds that practically any major development regarding cryptocurrencies whether legal, political or market-based affects their price. And these changes are much more significant than are seen in other financial markets.
As far as financial prudence is concerned, Vice probably puts it best: Do not go into debt to buy bitcoin, you idiots. If you have some money lying around which you want to play with, sure, dip your toes in the water. But do not pull out money from your pension fund to put into something which Warren Buffett won’t touch.
The future for Bitcoin is uncertain. It has had a tremendous first-mover advantage and that has led to it capturing a lot of market space. However as other cryptocurrencies with their own special features come into the market, it is anyone’s guess as to whether Bitcoin will stay on its perch for long.
Investment in Bitcoin can be a hit or miss. What is here to stay however, is the blockchain. If allowed to flourish, it could very well spell the end of centralised institutions. As the people take back the power, those who adopt the blockchain first will be the ones leading the revolution for a better, more equal world. And that surely is more important than making a quick buck in a make-believe currency.
The author is thankful to Amal Sethi (@AmalSethi) for putting together a trove of resources on Bitcoin which are an excellent resource for anyone beginning their blockchain journey. In addition, for a technical understanding of how cryptocurrencies work, Khan Academy videos are extremely useful.