29 July 2017

Bitcoin: profound invention or a bubble waiting to burst?

Bitcoin: profound invention or a bubble waiting to burst?

Introduction

With the advent of the internet came e-commerce and the ability for customers and merchants to transact directly with each other, with the exception of being able to transfer money without a third party. No mechanism existed to send cash over a communication channel necessitating either a face to face meeting to exchange cash or a third party that also acts as a mediator should disputes arise.

Serving as trusted third parties to process electronic payments is exclusively the domain of financial institutions. These financial institutions are governed by regulations to ensure that they can fulfil this role. Even with these trusted institutions fraud still exists making merchants wary asking more information from buyers than is necessary to protect themselves.

Legal requirements like FICA, KYC and AML together with the general mistrust that exists causes the traditional trust based model to exclude a large volume of the population to participate in the rapid growing digital economy.

A truly digital form of cash is needed where parties can transact with total anonymity whereby the system provides the trust to prevent double spending and whereby the transaction is irreversible, mitigating payment risks.

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Money

Before the advent of money people transacted directly with each other through bartering. Swap two goats for one cow. The system proved problematic since there was no standard for the value of goods and the goods cannot be easily divided.

Commodity based payment systems were invented were a type of product functioned as a currency. The product needed to be widely desirable, durable and easy to store. Dried corn was a popular currency in the 17th century although it served a useful purpose of being food as well. Precious metals like gold and silver was used as currency purely because it was perceived to be valuable based on its desirability.

Paper bills were first used by the Chinese (A.D. 618-907) in the form of privately issued bills of as a means of reducing the need to carry heavy gold coins. The coins were deposited at a trustworthy third-party and could be redeemed by the bearer of the bills at a later stage. As economies grew and gold supply could no longer keep up with the demand another system needed to be invented.

Fiat based payment systems discontinued the need for a physical commodity to back paper bills where its value is backed by the government that issued it. In 1971, the U.S. dollar was taken off the gold standard. The price of gold was no longer fixed to a dollar amount and dollar bills was not redeemable in gold.

This gave governments the power to print more money than there was gold to back it up. Economics 101 – Supply and demand: Currencies began to devalue in its purchasing power. As long as people have faith in the currency, a central bank can issue more of it. If the bank issues too much money, the value will go down. The number of currency issued is control by the government’s monetary policy.

Crypto currencies – A digital form of cash

An electronic currency generated by cryptographic proof instead of trust. Bitcoin was the first digital currency to solve the double spending problem. Coins are made up of chains of electronic signatures. Double spending is prevented through a peer-to-peer network using proof-of-work to record a public history of transactions.

The Blockchain in a nutshell

Bitcoin is not generated or controlled by a central authority but rather through a distributed time-stamped server network. The server network acts as a transaction database and is called the Blockchain.

The blockchain is a ledger of facts, called blocks, and is duplicated on anonymous servers around the globe called nodes. There are currently more than 6500 nodes.

Before a block is added to the blockchain consensus needs to be reached by a process called mining. In order to stop double spending transactions are broadcasted publicly.

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Blocks contains a list of transactions as well as information about the previous block linking them into a chain. This will ensure that all blocks can be verified right to the genesis block. Nodes always consider the longest chain to be the correct one and will keep working on extending it.

In order for a block to be accepted by the nodes, miners must complete a proof of work which covers all of the data within the block. The concept is the same as rolling a dice. If a miner rolls a double 6 that block gets published. In actual fact the problem being solved is a very complex one entering random number until a solution is found. The difficulty of the solution is adjusted so a single new block can be generated by the network every 10 minutes.

This is what gives the network its security. Imagine thousands of miners rolling a set of dice vs a single malicious player rolling a set of dice. In order for a malicious player to edit a block it must edit all the proceeding blocks as well, since they are linked into a chain, at a rate faster than what current blocks are being created at, using more CPU power than all the combined miners.

The cumulative CPU power of all the miners are estimated at 100 times more than that of Google. Miners are paid incentives by earning transaction fees as well as the generated Bitcoin.

The number of Bitcoin created is set to halve every four years with a total maximum number of 21 Million. This will ensure that Bitcoin will be deflationary.

Transaction process

  1. New transactions are broadcast to all nodes.
  2. Each miner-node collects new transactions into a block.
  3. Each minor-node works on finding a difficult proof-of-work for its block.
  4. When a minor-node finds a proof-of-work, it broadcasts the block to all nodes.
  5. Nodes accept the block only if all transactions in it are valid and not already spent.
  6. Nodes express their acceptance of the block by working on creating the next block in the chain

Conclusion

Marc Andreesen, co-founder of Netscape:

“Eventually mainstream products, companies, and industries emerge to commercialize it; its effects become profound; and later, many people wonder why its powerful promise wasn’t more obvious from the start. Personal computers in 1975, the Internet in 1993, and I believe, Bitcoin in 2014. “

Will Bitcoin be as profound as the PC or the internet or will it blow up in everyone’s face? There is just not enough adoption around for one to truly know. I will most certainly not cut up my bank cards and close my accounts, nor will I bet my entire savings on it. I do think it’s profound enough for me to have some skin in the game.  

You will have to make up your own mind. 

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