Over the past several years there has been increasing talk about Cryptocurrency (Bitcoin in particular), and the Blockchain. It’s been referred to as Digital Gold, a huge scam, and everything in between. So, what’s the real story? What exactly is Cryptocurrency? Does it have real world applications? Is it a good investment? And what is the Blockchain, and what role does it play in all of this?
This article will be a guide for newcomers to this technology that will attempt to answer these questions, and give a good base to those who wish to do further research on the topic.
Before we can talk about Cryptocurrency, or, Digital Currency, we need to take one step back and learn about FIAT Currency. (1) Essentially, FIAT Currency is money that has no intrinsic value, but has been established as legal tender, and is regulated by the Central Government. In other words, it cannot be converted to anything, and it is not backed by anything of value, like gold for example.
For the purpose of this article I will be talking primarily about Bitcoin, as it was the first Cryptocurrency, however all other Cryptos, also known as Alt Coins, (2) work in much the same way. So what is Bitcoin?
What Is Bitcoin
Bitcoin is an electronic payment system based on mathematics. It is decentralized, which makes it independent of any central authority. If you dislike the Federal Reserve, or central banks, then you’ll love Bitcoin! It can be transferred almost instantly and has very low transaction fees. In stark contrast to FIAT money that is created out of thin air by the Federal Reserve, there is a limit to the number of Bitcoins that can ever be created. That number is 21 Million. Once that limit is reached there will be no more, that’s it. Bitcoins are also divisible, meaning that you don’t have to transact in units of 1 coin. With the value of Bitcoin now being in the thousands of USD per coin, It would be very difficult for the average person to acquire this asset. A Bitcoin can be divided down to 8 decimal places. Therefore, 0.00000001 BTC is the smallest amount that can be handled in a transaction. If necessary the protocol and software can be modified to accommodate even smaller amounts. The smallest unit of Bitcoin is referred to as a Satoshi, named after Satoshi Nakamoto, the mysterious creator of the Blockchain protocol and Bitcoin. Bitcoin also affords a level of anonymity as your name is not tied to any transaction. Bitcoin came into being in 2009 and it’s success has led to the creation of many types of “alt coins”.
What Is The Blockchain
The Blockchain is a decentralized transaction ledger spread across thousands of computers. It is open to the public and is not corruptible. If, for example, you have your money at Bank of America, then the centralized bank controls your money. If you have your money in Bitcoin on the Blockchain then because of its decentralized nature, no one single entity controls it.
The Blockchain is made up of Blocks. Blocks hold batches of transactions that are hashed and encoded into a data structure known as a Merkle Tree (3)
Each Block contains the cryptographic hash value of the previous block in the chain, thereby linking the two. These linked Blocks form the Blockchain. This process serves to guarantee the integrity of the chain all the way back to the beginning Block.
The Blockchain is a simple, yet ingenious way of passing information from A to B in a fully automated and safe way. One party to the transaction initiates the process by creating a block. This block is verified by thousands, perhaps millions of computers distributed across the Network. The verified block is added to the chain which is stored across the Network, creating not just a unique record, but a unique record with a unique history. Falsifying a single record would require falsifying the entire chain in millions of instances and that is virtually impossible to do. Cryptocurrency uses this model for monetary transactions, but the Blockchain can be deployed in many other ways.
Some other potential uses of the Blockchain include:
- Financial Services
- Video Games
- Online Sportsbook Operations
- Smart Contracts (4)
- The Internet of Things (5)
You’ve most likely heard the term “Bitcoin Mining”, so what exactly is that all about, and how does it fit into the big picture?
People tend to place their trust in printed currencies. In the United States, for example, the US Dollar is backed by a central bank called the Federal Reserve (6). In addition to many other responsibilities the “Fed” regulates the production of new money. Even digital payments made with US dollars are backed buy a central authority. When you make an online purchase using your debit or credit card, for example, that transaction is processed by a payment processor such as Visa or Mastercard. As well as recording the history of the transaction, those companies also verify that the transaction is not fraudulent. Have you ever received a call from your Credit Card Company’s fraud department at 3am, wanting to confirm that you just purchased an expensive pair of alligator skin boots in Tokyo?
Bitcoin, on the other hand, is not regulated by any central authority. Instead, Bitcoin is backed by millions of computers scattered across the world called “nodes.” These computers perform the same function as the Fed, Visa, or Mastercard, but with some important differences. The key difference is that unlike those central authorities, Bitcoin nodes are spread across the world and record transaction data in a public list that can be accessed by anyone.
When someone makes a purchase or sale using Bitcoin this is known as a transaction. Bitcoin Miners clump these transactions together into Blocks and add them to the public record, which is the Blockchain. Nodes then maintain records of the Blockchain so that the blocks can be verified into the future. When Bitcoin Miners add a new block of transactions to the Blockchain, part of their job is to make sure that those transactions are accurate. In particular, they make sure that Bitcoin is not being duplicated, or double spent. (7)
With as many as a half million transactions occurring every day, the task of verifying them can be a lot of work for miners. This gets to another key difference between Bitcoin Miners and the Fed. As compensation for their efforts, Miners are awarded Bitcoin whenever they add a new block of transactions to the Blockchain. The amount of new Bitcoin released with every mined Block is called the “Block Reward.” The Block reward is halved every 210,000 Blocks, or approximately every four years. This serves to regulate the supply of Bitcoin. In 2009 the reward was 50 coins per mined Block. In 2013 it was 25. In 2018 it was 12.5, and sometime in the middle of 2020 it will halve to 6.25. At this rate of halving, the total number of Bitcoin in circulation will approach the hard preset limit of 21 million, making the currency more scarce, and therefore more valuable over time.
But, lest you think Bitcoin Mining is your ticket to fame, fortune, and your own private Island in the Caribbean, there is a catch.
In order for Bitcoin Miners to actually earn coins from verifying transactions, two things must occur. First, they must verify 1 Megabyte (MB) worth of transactions. This can be as small as a single transaction, but are, more often several thousand, depending on how much data each holds. This part is relatively easy. Second, in order to add a block of transactions to the Blockchain, miners must solve a complex computational math problem, also called proof of work. (8) What they are actually doing is trying to calculate a 64 digit Hexadecimal number (9), called a hash that is less than or equal to the target hash. At the time of writing, the odds of producing a hash below the target is 1 in 13 trillion. To put that into perspective, you are about 44,500 times as likely to win the Powerball Lottery than you are to pick the correct hash value on a single try. The difficulty level is adjusted every 2016 Blocks or approximately every two weeks with the intent of keeping mining rates more or less constant.
And, if all that doesn’t sound hard enough, wait, there’s more, another catch! Not only do you have to come up with the correct hash value, but oh snap!…you also have to be the first to do so! In the beginning, someone with a moderately powerful home computer could mine Bitcoin fairly successfully. These days though, since you are competing with millions of other miners, generating the correct hash value has everything to do with the speed of your computer. In 2013, miners began to use specialized hardware designed to mine as efficiently as possible. Without getting into too much technical detail, these machines are called Application Specific Integrated Circuits (ASIC) (10) and can cost into the thousands of dollars. Even one of these new computers would not likely be enough today to be profitable, so often many machines are grouped together into a “Mining Pool” so that resources and computation power can be shared.
A typical mining server farm…
A Real World Application of the Blockchain
Now that you have a basic understanding of what Cryptocurrency and the Blockchain are, I’d like to end this article by proposing a real world use for Blockchain technology that everyone should be able to relate to. This isn’t my idea though, it’s one that is already currently underway and is being pursued aggressively.
Since 1973 the SWIFT Network (11) has been the standard for global cross border monetary transactions. If you are wiring money anywhere around the world chances are you are using the SWIFT Network. While SWIFT is ubiquitous, currently connecting around 11,000 financial institutions, it does not come without it’s own set of problems, foremost of which is settlement speed. Even though technological advancements are being made to improve this, it can still take hours, and even days for a transaction to settle.
Enter Ripple (alt coin ticker XRP). Ripple, through the use of it’s product RippleNet, (12) has the goal of supplanting SWIFT as the go-to solution for worldwide money transfer. Currently around 300 financial institutions have committed, and signed on and that number continues to steadily grow. This video gives a nice overview of how RippleNet works. (13)
Of course nothing is ever guaranteed, but I think Ripple, RippleNet, and XRP have a bright future. And that’s also why I’m quite bullish on XRP as an investment.
This concludes part 1 of the series. In part 2 I will be discussing Cryptocurrency as an investment vehicle and why it may be a good idea to hold at least some crypto as a part of your diversified investment Portfolio.