There’s been a lot of attention on bitcoins and blockchains recently, in particular the latter which is being heralded as a major disrupter in financial services. In a two part series this week, I will attempt to explain and demystify the concepts of bitcoins and blockchains and look at the potential evolution of both.
Back in October 2008, an anonymous person (or group) by the name of “Satoshi Nakamoto” published a paper called Bitcoin: A peer to peer Electronic Cash System, describing a cryptography-based alternative payments system that replaces the need for a third party to verify transactions with a distributed peer-to-peer network. (The paper can be downloaded at bitcoin.org/bitcoin.pdf.)
What is it? Is it Hype?
Put simply, Bitcoin is a new form of encrypted digital currency created, held and transferred electronically. It’s a person-to person electronic cash system, that works without the need for a middleman. (Bitcoin refers to the whole system and bitcoin to the actual currency).
There are three key characteristics of Bitcoin (system) that made the bitcoin (currency) usable.
- The system avoids double spending. It does so by writing all transactions in an open ledger (Blockchain) that are visible to everyone. However, the transactions are written in a way that they require a lot of computation to verify before they are written and are almost impossible to forge afterwards.
- The heavy computation needs require a peer-to-peer computer network. The computing capacity of the bitcoin network is huge. Some estimates suggest the amount of computing power today running the bitcoin network is 1500 Peta hash/sec or 10,000x a bank or 500x Google. And this computing power keeps growing.
- The network is rewarded with bitcoins for doing this work of verifying transactions and dedicating the computing capacity, through a lottery. This ensures enough computing capacity is available to run the system.
Finally, a currency must have some value associated with it. In the case of normal bank notes, the central bank underwrites that value and users trust the central bank (or the government). Somehow bitcoin has gained trust of its users as a store of value and as more people use it, the more that trust grows. In a way, a currency system is the world’s oldest network effects model – a currency has value, because its users agree there is value in it. From that perspective, bitcoin isn’t a fad anymore; its users are willing to trade one bitcoin for almost USD 735.
How widespread could bitcoin adoption be?
While the usage of bitcoins has taken off, it remains a very volatile store of value (see exhibit below). This doesn’t facilitate a more widespread day to day use of currency. Since late 2013, the currency has fallen by 80% and then tripled. If you’re planning on paying for next year’s family holiday in bitcoin, you probably don’t know whether you’ll be taking them to Monaco or Margate.
One may argue that volatility may go away with broader adoption, but there are other technical limitations. For instance, despite the huge computing power available to it, the Bitcoin system still takes 10mins to confirm a block. This is too long for most retail applications. Additionally, most of that computing capacity and wealth is very concentrated. Some estimates say 25-50% compute capacity sits in just one data centre in China. Such concentration of compute power and wealth creates perverse incentives to discourage innovation in order to preserve incumbent interests.
While bitcoin is real and has taken off, its usage will remain limited to niche applications. But all is not lost, bitcoins gave us a piece of technology that’s really useful and I think will have wider implications. More on that tomorrow.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.