Bitcoins and the Blockchain
I never thought a first day at an internship could have such an impact on me. The team allowed me to sit in on a client meeting and gain an understanding of intellectual property law and how they enable entrepreneurs and start-ups through low cost overhead and competitive pricing. Through this experience, I learned about digital currencies and how they are traded.
The client wanted to patent this type of algorithmic idea that would pay people who like and share content in the form of digital currency, or crypto currency. These currencies can be exchanged like stocks, sort of (I will get to this later in the post). This presents a way to overcome the problem of discovery. In the early 1990s, the Internet was a small, primitive platform with only a handful of websites. However, the Internet and its content grew at an exponential rate past what people could really conceive in real time. So, the client looked at how Google and other search engines first solved this problem of discovery. He, then, analyzed Facebook and their approach in overcoming this problem. I am not allowed to get into his idea too much for confidentiality reasons, but I will explain bitcoins and crypto currencies.
A bitcoin is a form of new currency that was created in 2009 by an unknown person using the alias Satoshi Nakamoto. These online transactions are made without no middle man, which means no banks. There are no transaction fees and you do not have to provide your real name. This man’s idea cracked a problem that had stumped cryptographers for years. The idea of digital money, both convenient and untraceable, had been a hot topic since the birth of the Internet. Some innovators tried, but none could get their feet off the ground.
One of the core challenges of designing a digital currency involves the “double-spending” problem. If a digital dollar is just information, the problem is preventing people from copying and pasting it as easily as a chunk of text, “spending” it as many times as they want. The answer to this issue involved using a central clearinghouse to keep a real-time ledger of all transactions - ensuring that, if someone spends his last digital dollar, he cannot then spend it again. The ledger prevents fraud, but it also requires a third party to administer it.
Bitcoin did away with this third party by publicly distributing the ledger, which Nakamoto called the “block chain.” Users willing to devote CPU power to running a special piece of software would be called miners and would form a network to maintain the block chain collectively. In the process, they would also generate new currency. Transactions would be broadcast to the network, and computers running the software would compete to solve irreversible cryptographic puzzles that contain data from several transactions. The first miner to solve each puzzle would be awarded 50 new bitcoins, and the associated block of transactions would be added to the chain. The difficulty of each puzzle would increase as the number of miners increased, which would keep production to one block of transactions roughly every 10 minutes. In addition, the size of each block bounty would halve every 210,000 blocks—first from 50 bitcoins to 25, then from 25 to 12.5, and so on. Around the year 2140, the currency would reach its preordained limit of 21 million bitcoins.
Bitcoins can be used to buy merchandise anonymously. In addition, international payments are easy and cheap because bitcoins are not tied to any country or subject to regulation. Small businesses may like them because there are no credit card fees. Some people just buy bitcoins as an investment, hoping that they’ll go up in value. Bitcoins can be stored in a variety of places—from a “wallet” on a desktop computer to a centralized service in the cloud.
Two twins recently proposed creating an exchange-traded fund based on Bitcoin (BTC) to the SEC, but it was shot down due to the SEC’s concerns about manipulation and other issues. The 30th of this month, another investment group called SolidX is proposing an ETF for BTC as well, so investors are eager to see what will happen. An ETF based on BTC would be incredibly volatile and hot.
Bitcoin is certainly fairly new, so it is definitely volatile, but so many other countries are using it, and the amount of people buying and selling it is incredible. Even though anyone can make a crypto, this does not devalue BTC at all. BTC is regarded as the strongest crypto and it always will be if the way of obtaining them does not change. Each crypto almost operates independently of one another in terms of value. BTC was first, so it managed to get integrated pretty deeply into people’s lives, hence why it will hold its value. It definitely suffers from manipulation, and a lot of skepticism follows it. Markets are all about psychology, and you cannot have people scared about it or it just will not catch on.
For this new currency, a primitive and unregulated financial-services industry began to develop. Online “wallet services” promised to safeguard clients’ digital assets. Exchanges allowed anyone to trade bitcoins for dollars or other currencies. Bitcoin itself might have been decentralized, but users were now blindly entrusting increasing amounts of currency to third parties, which were most likely not more secure than federally insured institutions. Most were Internet storefronts, run by anyone willing to operate a storefront.
Sure enough, as the price headed upward, disturbing events began to bedevil the bitcoiners. In mid-June, someone calling himself Allinvain reported that 25,000 bitcoins worth more than $500,000 had been stolen from his computer. About a week later, a hacker pulled off an ingenious attack on a Tokyo-based exchange site called Mt. Gox, which handled 90 percent of all bitcoin exchange transactions. Mt. Gox restricted account withdrawals to $1,000 worth of bitcoins per day (at the time of the attack, roughly 35 bitcoins). After he broke into Mt. Gox’s system, the hacker simulated a massive sell-off, driving the exchange rate to zero and letting him withdraw potentially tens of thousands of other people’s bitcoins.
As it happened, market forces conspired to thwart the scheme. The price plummeted, but as speculators flocked to take advantage of the fire sale, they quickly drove it back up, limiting the thief’s haul to only around 2,000 bitcoins. The exchange ceased operations for a week and rolled back the postcrash transactions, but the damage had been done; the bitcoin never got back above $17. Within a month, Mt. Gox had lost 10 percent of its market share to a Chile-based upstart named TradeHill. Most significantly, the incident had shaken the confidence of the community and inspired loads of bad press.
Bitcoin has risen exponentially, but fallen dramatically. The underlying vulnerabilities that led to bitcoin’s troubles—its dependence on unregulated, centralized exchanges and online wallets—persist. Indeed, the bulk of mining is now concentrated in a handful of huge mining pools, which theoretically could hijack the entire network if they worked in concert.
Beyond the most hardcore users, skepticism has only increased. Nobel Prize-winning economist Paul Krugman wrote that the currency’s tendency to fluctuate has encouraged hoarding. Stefan Brands, a former ecash consultant and digital currency pioneer, calls bitcoin “clever” and is unwilling to bash it but believes it is structured like “a pyramid scheme” that rewards early adopters. “I think the big problems are ultimately the trust issues,” he says. “There’s nothing there to back it up. I know the counterargument, that that’s true of fiat money, too, but that’s completely wrong. There’s a whole trust fabric that’s been established through legal mechanisms.”
It will be interesting to watch the development of digital currency and analyzing the makret for BTC is the best place to start. As I continue to intern and through my Summer Analyst position at JP Morgan Chase & Co., I will update this blog with more content about financial markets, mostly focusing on digital currency and trading.
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