Bitcoin and Blockchain Might Change Everything

by Royce Grayson Morse, IOFM Managing Editor

The most widely known virtual currency today is bitcoin. From its advent in 2009 to the present day, Bitcoin’s story has been complex, punctuated by mystery, drama, scandal and fraud. And yet, despite its difficult beginnings, bitcoin and other “cryptocurrencies” are gaining acceptance in the world of business and finance, as they are based on blockchain technology – an innovation with revolutionary potential.  But let’s start with a quick bit of bitcoin mystery history.

Who Is Nakamoto?

Bitcoin was introduced in a white paper attributed to Satoshi Nakamoto in 2008. Even from the beginning, bitcoin was fascinating: there was debate whether Nakamoto was a real person or a false identity assumed by one or more individuals. Newsweek reported just this past March that the real Satoshi Nakamoto is living in California, a physicist and engineer with a past working on classified material, and an extremely private individual who absolutely won’t talk about bitcoin under any circumstances. The person written about in the story emphatically rebutted the article soon after it was published.

A couple of months later, Craig Wright, an Australian entrepreneur, claimed to be Nakamoto, but at the time of this writing, his assurances that he would provide absolute proof have gone unfulfilled and Wright has since disappeared from the public eye. The mystery persists, made all the more intriguing by the fact that whoever “Nakamoto” is, that entity controls nearly half a billion dollars’ worth of bitcoin.

Regardless of the true identity of its creator(s), Nakamoto created the “genesis block” around January 3, 2009, the first transaction, or “block,” in the new bitcoin chain. The open source code for the supporting software was publicly released at about that same time, and from then on, bitcoin was in business.

A Universal Currency

Bitcoin was introduced as “A purely peer-to-peer version of electronic cash (that would) allow online payments to be sent directly from one party to another without going through a financial institution.” There are two noteworthy points here: 1) This is a strictly digital currency, without any physical backing like notes or coin; and 2) Bitcoin can be exchanged without a bank acting as intermediary.

Bitcoin has been supported by dedicated tech evangelist types who see it as a way to keep commerce beyond state control. With its own unit of currency and without banks required to pass transactions back and forth, bitcoin is not issued by governments and does not incur financial institution fees, as with other types of electronic payments. Merchants who accept bitcoin may pay minimal transaction fees—or nothing at all.

Every bitcoin transaction must be digitally signed, requiring the use of a private key held by the owner; if that individual loses the key, the bitcoin is irrecoverably lost. If a transaction is made in error, there’s no undoing it except by initiating a new counteracting one; there are no “undo” capabilities.

Getting, Keeping and Spending Bitcoin

Getting bitcoin works like obtaining any other currency. It can be used to buy and sell things: many businesses, including Starbucks and Amazon, accept it. It can be purchased online through a bitcoin exchange. There’s even a bitcoin payroll service that allows employee wages to be paid in bitcoin.

Bitcoin cannot be bought using PayPal, partly because it is a competitor, although this can be worked around by first buying Second Life lindens via PayPal and then converting those to bitcoin. The currency can also be purchased with major credit cards, through Western Union, wire transfer, gift card, personal check, cash, and even by SEPA transfer. In the U.S., a bank account can be connected to a third-party provider that sells bitcoin and stores the funds on the buyer’s behalf (a “virtual wallet”). There are even bitcoin ATMs in the U.S., Canada and elsewhere.

Bitcoin can also be traded in person, although this can be a risky business. There are online buyer exchanges that list local sellers and rate them as to how reputable they are. While most sellers have been scammed from time to time, face-to-face bitcoin transactions are desirable for some because of the level of anonymity they provide. The buyer simply hands over the cash and the seller logs the purchase to their encrypted ID using an electronic device.

While many online exchanges keep customer bitcoin in hosted virtual wallets, this places it in the hands of a third party and is generally not recommended by bitcoin purists; although the system underlying bitcoin, the blockchain, is virtually hack-proof, third-party wallets are not. The personal digital key may be stolen unless it is stored someplace not accessible by the internet.

The Good and the Bad

One of the criticisms of bitcoin is that it bypasses normal controls within the financial system, allowing it to be used for money-laundering and illegal trade. In late 2013, the FBI arrested Ross Ulbricht, aka “Dread Pirate Roberts,” the man behind Silk Road, an online black market allowing contraband to be bought anonymously from sellers all over the globe. Bitcoin was the currency of choice for Silk Road, which gave it a questionable reputation in the eyes of many.

Earlier in 2013, a Texas man had been charged by the U.S. Securities and Exchange Commission for operating a bitcoin Ponzi scheme, and almost from its inception, criminals were intent on discovering ways to steal bitcoin.

Still, bitcoin ATMs began to appear, complete with hand-scanners, and the U.S. Senate acknowledged that digital currency networks might in fact offer benefits to the financial system. A senior economist at the Federal Reserve Bank in Chicago called it “a remarkable conceptual and technical achievement.”

A more recent criticism of bitcoin is its ten-minute processing time, although that’s significantly faster than traditional financial transaction systems. And at this point, bitcoin is no longer the only virtual currency; many of the new upstarts are looking to reduce that transaction window to mere seconds.

One of the most interesting and compelling arguments for bitcoin, however, is its underlying technology, the blockchain, which is unusually secure, and has been described as mathematically impossible to hack. (This does not take into account, however, the possibility of the theft of a private bitcoin key left on a computer that is connected to the web.)

What Is Blockchain?

Where does bitcoin reside? Because it does not exist physically, like paper banknotes, and avoids the use of banks to store it, the information about who owns how much bitcoin resides in a public ledger database—the blockchain. Briefly, blockchain is a permission-less, distributed database that keeps a record of all bitcoin transactions.

Instead of a central authority like a bank that maintains this information, the blockchain is supported by a network of nodes. (Anyone with a powerful enough computer and the right software can run a node.) When the network receives a bitcoin transaction request from a sender, say, “Mary Smith pays John Jones 100 bitcoins,” the network will validate the transaction (see “Miners” below), make sure Mary Smith has the bitcoin, move that bitcoin to John Jones, create a timestamped transaction in the virtual ledger, and send updated information to all the other nodes.

As a distributed database, each network node stores its own copy of the blockchain. This information is updated about every ten minutes, at which point, a data block is created, added to the existing database, and published to all nodes. Each new block adds on to the aggregate of all the previous ones, creating a “chain” over time.

The blockchain maintains a record of every bitcoin transaction that has ever occurred. Its cryptography is considered extremely powerful, and even if one node were to be compromised, the other nodes would not authenticate its output. In order for a new block to be incorporated into the shared blockchain, the other nodes must agree. This allows blockchain technology to avoid the need for a centralized third party, like a financial institution, and the security of the system is in part based on a “safety in numbers” process. Even if several nodes were hacked, the others would detect it and prevent bogus transactions.

The blockchain software also performs automated conflict resolution, disallowing the same bitcoins from being spent in more than one place, for example. This is possible because bitcoin is not “fungible,” that is, bitcoins are not interchangeable with one another. People own specific bitcoins that each have a particular identifier, much as paper bills have serial numbers. The blockchain keeps track of all this.

Miners

Since no one person “owns” the blockchain and it doesn’t reside in any particular location (remember, it’s “distributed”), how is the information stored and processed, and what’s the incentive to do so? In fact, bitcoin uses a lottery system to reward “miners,” individuals whose computers form the network. To win the lottery to add a block, miners will generate random numbers continuously, until one of them hits upon the particular random number selected by the bitcoin software for the current block.

Bitcoin miners need powerful computers to crunch numbers very quickly—billions of calculations per second—and special circuitry has been developed that outperforms traditional computer CPUs and uses less electricity to be able to do so.

When the miner “finds a block,” the winner’s “mathematical proof of work” is verified by the rest of the network, the block is added to the chain and the miner collects a reward. The system itself makes the award (25 new bitcoins), and any transaction fees are also awarded to the winner. These fees are generally given at the discretion of the transaction senders, like a gratuity.

The 25 new bitcoins issued to a miner every ten minutes are created by the blockchain itself. In order to prevent an infinite number of bitcoins from entering the economy and devaluing it over time, the system is set to halve the number awarded to miners to 12.5 per block in mid-2016, halve it again in four more years, and so on, until 21 million bitcoins have been issued around 2140 and the system is capped. When all bitcoin has been issued, transaction fees will likely be implemented to award miners instead.

If more miners come online at any particular time, the mathematical difficulty of finding a block is increased to ensure a block is found and processed only every ten minutes. It’s been calculated that finding a block is less probable than winning the lottery, but in this case, somebody will find the block in about ten minutes due to the underlying math of the system.

One of the hallmark characteristics of the blockchain software is that it’s “open source”: the code is available for anyone who wants it, to develop as they wish. However, there’s also a downside: that can mean a lot of projects are being developed at the same time by different teams, who, in this new space, can be fiercely independent and have strong opinions about the technology.

Looking Ahead

The global economy is still assessing virtual currency, and there is no consensus among nations about how it is to be handled within their financial borders. Many countries have said that they do not intend to attempt to regulate it; some, like Canada, France and Brazil, have imposed various regulatory restrictions and taxes on it; some simply discourage its use; others, like Ecuador, Russia and Bolivia have banned it altogether.

Many other cryptocurrencies have joined bitcoin since its inception; there is speculation that while the virtual currency movement will continue, the ultimate winner of that race may not be bitcoin due to its complexities.

There has been a great deal of discussion about the 21 million bitcoin cap. What happens if and when it’s reached? The general thinking is that the cap won’t be increased, which would be tantamount to just printing more paper money and thereby devaluing it, but it’s topic that has sparked much economic theorizing. While it’s complicated, the simplest way to think about it is that bitcoin is infinitely divisible; it’s perfectly fine to purchase fractions of bitcoin. If and when the demand exceeds the supply, the value of bitcoin will go up and existing bitcoin can be subdivided into smaller and smaller chunks: a “satoshi” is 10^-8 bitcoin, or a hundredth of a millionth of a bitcoin, which is a tiny fraction of a U.S. penny.

The Future of Blockchain

Blockchain itself looks to have a bright future. Large companies like IBM, JP Morgan and VMWare are currently exploring creating new blockchain systems to go beyond bitcoin; the technology is attractive for a number of purposes besides financial transactions. Distributed ledger systems are being considered for—or already deployed for— copyrighted music industry payments; a comprehensive cross-institutional educational experience database; file storage; voting systems; and tamper-proof digital identity systems. Blockchain is also quite good at tracking how assets move through a manufacturing supply chain.

While one of the most obvious candidates for blockchain technology is banking, the financial industry is heavily focused on regulatory issues and is not known for having the resources or inclination to innovate.

However, blockchain will likely play a part in everybody’s future in ways we haven’t yet considered.

Takeaways

Bitcoin and other virtual currencies have the benefit of being borderless. There are no exchange rates or bank charges, and transaction fees, if they exist, tend to be less than those charged by financial institutions. However, since regulations vary by country, it’s necessary to understand those restrictions before jumping onboard.

The value of bitcoin is significantly volatile: in 2013, a single bitcoin was worth as much as $1,100; in 2016, it was around $300. Part of the reason is that the cryptocurrency faces fairly low and uncertain demand, unlike more traditional currencies. It’s different enough from regular money that it makes people nervous, and an economic event that might cause a small ripple in the value of the dollar may cause a disproportionate spike in bitcoin value. And because there’s a limited quantity of it, any vigorous trading activity creates a more pronounced effect on it overall.

As a result, bitcoin tends to be thought of by many as an investment rather than as a currency, with many people holding bitcoins speculatively rather than spending them. Thus, bitcoin can be said to behave more generally like an asset than a currency—although its volatility has decreased steadily over the years since its introduction.

Nasdaq doesn’t believe this is predictive of the collapse of the currency, only that it’s still finding its “natural level.” But because of that volatility, retailers are reluctant to accept it, given that it can lose a third of its value in a week, and with traditional currency having already been spent on inventory, it’s not worth the risk.

Further, those who hold large amounts of bitcoin would have a hard time liquidating it without creating a significant impact on the bitcoin economy.

From a business standpoint, it seems nearly inevitable that virtual currencies will become prevalent over time. With our decreasing reliance on the physical financial instruments of bank notes and even paper checks, in many ways, we all already utilize a form a virtual currency, albeit a centralized one. And while there have been instances of cryptocurrency theft, blockchain and many other systems like it are more resistant to hacking than traditional banking software and processing networks.

Ultimately, an increasingly global economy may drive the acceptance of a decentralized virtual currency. What remains to be seen is how that will be regulated and by whom. In our lifetime, the question, “Who owns the internet?” may be broadened to include, “Who owns the currency system?” Looking forward, the answer may be, “No one. Everyone.”