Greetings Dynalect Readers! I’d like to introduce a topic this week that has been on my mind for the past several months: Cryptocurrency.
Ah, yes; the time has arrived to discuss Bitcoin! We’ve all heard about popular cryptocurrencies such as Bitcoin over the past several years, especially as the value of Bitcoins has risen considerably. In 2010, the cost of 1 Bitcoin was less than $1. As of the time this article was written, a single Bitcoin was valued at $1,785.44.
I have a quick story of tragedy to tell now that I’ve disclosed the current value of Bitcoin. I developed an interest in Bitcoin a few years ago and bought about 5 coins at roughly $150 each. I then got excited when it rose to $160, and sold them all, claiming a huge victory in making a solid $50. If I had kept those coins until now, I would have made more than $5,000. But alas, thus is the nature of investing. Sometimes you just have to be ok with accepting relatively smaller gains instead of taking a risk by holding positions for longer periods of time.
Anyway, as I pick back up where I left off in studying the ins and outs of cryptocurrencies, and considering the implications for the investing community, I would like to share with you, loyal Dynalect Subscribers, my progress as I go. For this week, allow me to offer a basic history and articulate how cryptocurrencies work on a theoretical level. I will focus on Bitcoin just for the sake of familiarity, but it should be known up front that there are many different types of cryptocurrencies, such as Ethereum, BlackCoin, Dash, LiteCoin, and Nxt. I’ll discuss the diversity of cryptocurrencies in a later publication on this topic.
Prior to the rise of Bitcoin as one of the most dominant digital currencies in the world, there were a variety of similar digital “cash” schemes proposed by a researchers that articulated some of the early foundations upon which the Bitcoin program would later be built. One of the most prominent precursors to Bitcoin was a program called Bit gold, designed by Nick Szabo, who graduated with degrees in cryptography and computer science from the University of Washington in 1989.
One of the main contributions of Szabo and Bit gold was moving towards solving the problem of “double spending.” In a traditional financial system, everything has a time stamp on it. To illustrate why this is important, suppose you have an account with $100 in it. If two people show up at the bank and try to cash a check to withdraw $100 from the account, the bank will cash the first check and then deny the second. Without being able to determine which was the first and the second check, the bank would have no way of knowing which check to cash, and might end up accidentally cashing them both at the same time. This is what “double spending” refers to, and it is a serious problem to be considered in cryptocurrencies because it is very easy to just copy and paste data from one place to another without adhering to a particular time stamp. More on this later.
Once Szabo was able to work out how to combat the double spending issue, the premise for Bitcoin came into existence.
In 2008, an anonymous individual operating under the name “Satoshi Nakamoto” posted plans for the creation of Bitcoin on the Internet. In 2009, Nakamoto created and released the first software package that allowed people to access the Bitcoin ledger and mine Bitcoins; he was also the first person to create Bitcoins by mining the “genesis package” of 50 Bitcoins in the same year.
Without an existing market and a large enough community to determine the value of Bitcoins, the early users of the new currency negotiated on an online forum to establish how much each of the first coins would be worth. As the story goes, one of the first transactions involving Bitcoins was 10,000 BTC for two Papa John’s pizzas. Eventually, as more and more people caught on to the new cryptocurrency, the value of each coin was determined as it is now: via supply-demand forces on an open market.
So how does Bitcoin work? First, you can think of it as a type of “digital gold.” There is a finite amount of Bitcoin that can be mined — current estimates suggest the supply will run out around 2150 — and the value of each coin is determined by how much someone is willing to pay for it at any given time.
The backbone of the Bitcoin structure is something called a ledger. The Bitcoin ledger is just a list of people, identified by non-descriptive account numbers, and the amount of Bitcoin each person holds. People exchange money by simply manipulating the ledger to reflect the updated balances. For example, if I wanted to trade Conor 5 BTC for his bike, I would just subtract 5 BTC from my account on the ledger, and add 5 BTC to his. Any “power-user” — which just means someone who holds a copy of the ledger — can perform the transaction. And anyone can become a power user by simply installing the appropriate software. When someone wants to change the ledger, they have to perform the change and then send it out to everyone else who holds a ledger so that they can update to the newest version. This is why Bitcoin is called a “decentralized currency.” It is not regulated by any one body; anyone can change the ledger, and thousands of people around the globe are doing it every second of every day.
But what stops someone from just changing the ledger to reflect a much high number in their own account, or spending someone else’s money by changing the value elsewhere? This is where things get a little complicated. Each time an account is created, a private key, that only the account holder has access to, is intrinsically linked to that account. This private key is used to create a mathematical “signature,” which verifies the transaction just as your physical signature does when you write a check. Each user also has access to another mathematical function, which allows them to verify the signature of everyone else and to ensure that each of the transactions sent across the network are valid.
The bottom line is that everyone has the ability to check the validity of everyone else’s transaction. Everyone also has a strong financial motive to make sure that each transaction on the ledger is fair and correct. Ergo, because everyone can verify transactions, and because everyone has an incentive to do so, the system is self-regulating and secure.
The problem of “double-spending” is solved by creating a pool of all requested transactions as they come in, and then sorting those transactions along a chain according to who solves a particular math problem— called a cryptographic hash— first. The solution to the hash contains three distinct parts: the actual solution, a transaction from the pool, and a transaction to be completed on the chain. Thus, each time a solution is reached, it mathematically links a pending transaction to a time slot on the transaction chain.
Of course, that is a gross oversimplification of how the nuts and bolts of the system work, but for the sake of presenting the basic outline, it will suffice.
So there you have it! A basic history and technical overview of how one of the most popular cryptocurrencies, Bitcoin, works. Stay tuned for the next rendition of my exploration into the cryptocurrency world, which will eventually culminate in considering whether or not cryptocurrency is a good portfolio addition for investors like you!
Until next week…