A bit about bitcoin

If you were fortunate (or freak of some sort) to have invested 1000 dollars in “bitcoins” six years ago, the value of that investment would have become 4 million dollars today. Why go so back; investing 1000 dollars in “bitcoins” a year ago, in December 2016, would have fetched 20,000 dollars now. What else can multiply your wealth twenty times in a year?

Many of my friends have discussed with me the bitcoin phenomenon. Some of them are PhDs. The conversations are usually short, ending with something like, “I don’t understand it at all. Is it a new currency of some kind? Where can I buy it?” Since nobody I know knows even as much as I think I know, I will venture to use my limited knowledge about economics and superficial research to share with you my understanding of the bitcoin phenomenon.

What is a bitcoin?

It’s a currency, but unlike the currencies in your pockets, it is virtual. Interestingly, no government or regulator introduced or controls it. Apparently, bitcoin was the innovation of one Satoshi Nakamoto. The name sounds Japanese. However, no such person has ever been found in Japan or anywhere else. We can be certain of the existence of Jesus Christ, possibly of lord Krishna, but Satoshi Nakamoto has remained enigmatically missing since bitcoin’s launch in 2009. To pay him tribute, the fractional denomination has been named Satoshi. (Dollar-cent/ pound-penny/ bitcoin-satoshi, except 100 million Satoshi make a single bitcoin). People have wondered if Nakamoto was a group of software engineers rather than a single person.

Do banknotes or coins exist for this currency? Banknotes don’t, coins may. However, the coin itself has no meaning or value. The currency is virtual. You can create, acquire or sell it without having anything to do with physical coins.

Can anything be a currency?

For centuries, perhaps millenniums, world ran its business through barter. A carpenter built a shed for a farmer. The farmer in exchange supplied the carpenter with potatoes. A need was felt for a medium of exchange that would make such transactions convenient. Initially gold was used. When rulers launched money as we know it, it had to be backed by enough gold in the government treasury. This was the Gold Standard. In theory, you could take your cash to the government treasury, which was obliged to give you equivalent gold. Over the years, the gold standard was abandoned. As we know, money supply got further expanded with plastic cards. One may get his salary in the bank account and pay online or with credit card. Transactions can and increasingly do happen without involvement of any physical money. Governments, through their monetary policy, still need to monitor the total supply of money. Very loosely speaking, if the total supply of a particular currency is doubled without any change in the number of goods that money can buy, the prices of those goods will double as a result of the money supply. Printing of money usually fuels inflation, and done in excess can result in hyperinflation like in Germany (1923) where you carried money in bags to buy something that fit in your pocket.

It is, therefore, very important for any currency, however created to have at least four elements. (A) Hard to earn (b) limited in supply (c) easy to verify and (d) trust and acceptance. We will now see how this applies to ‘bitcoin’.

Mining of bitcoins   

Bitcoins, like gold, need to be mined. But gold is a natural commodity; the deposits of gold exist in places like South Africa, China and Russia. Through a laborious physical process, involving miners wearing helmets and risking lives, gold needs to be extracted and refined.

Mining of bitcoins is a computer, software process. In theory, you or I can mine bitcoins. In practice, perhaps only those with a PhD in computer science, cryptology and game theory can mine them.

The mining process is like solving a giant mathematical puzzle. Imagine you are a hacker. You need to crack somebody’s birthday and a four digit numeral (pin) to access his account. You have no idea how old the person is, but feel he was born between 1965 and 1974. Let’s also assume you are allowed any number of attempts online. (If you insert a wrong pin number three times, some ATMs swallow your cards. Not a case here). You need to start with 1 Jan 1965 and go till 31 Dec 1974, each day combined with 9999 numbers. In effect you will need to try 3652 days x 9999= 36,516,348 times. To perform this manually at the rate of one try every minute, you will take 300 years.

bitcoin mining farm 

Mining a bitcoin is as difficult as this. It requires huge computer power, and astonishingly high power consumption.  The global bitcoin mining activity is estimated to consume 3.4 gigawatts, about the same that the whole of Bulgaria consumes in the same period. To lower the costs, mining is set in places like Iceland with its cheap geothermal energy. In China the miners use hydroelectric power. To save on time, mining pools are formed. They share the reward when anyone from the pool succeeds in mining a bitcoin.

In short, I’m certainly not volunteering to become a bitcoin miner.

Limited in Supply

A successful miner is rewarded with 12.5 bitcoins per block (I will explain what a blockchain means later). In 2020, the reward will be halved to 6.25 bitcoins per block, and every succeeding four years it will keep halving. By 2140, when neither I nor any reader of this article will be around, the bitcoin supply will stop at 21 million bitcoins. That is the limit set by whoever has created this game. After that, the miners will be rewarded only by way of transaction fees (similar to how your bank charges you for  transactions), and not bitcoins.

Easy to verify: Blockchain

Since no government or regulatory body controls the mining or the transactions, how can we trust the bitcoin manufacture and trading? The mechanism is complex but transparent and fairly secure. The bitcoin software takes care of this.

The “blockchain” is a public ledger (of course, not physical but virtual) that records all bitcoin transactions. If X pays Y with bitcoins, the transaction is broadcast with its history not only to X and Y, but to all the bitcoin owners in the world.

In our normal world, when X pays Y through a bank transfer, the bank statements of X’s bank and Y’s bank will reflect that transaction. However, those statements will be available only to X and Y. With bitcoins, it is as if those bank statements are available to everyone in the world. Through this public ledger, blockchain, you can trace the history of each bitcoin and every transaction. Every ten minutes, the system stamps the page with a special serial number (hash) and glues it permanently into the ledger book. With the bitcoin price skyrocketing, there is huge competition to get into that ledger. It’s like thousands of volunteer software geeks (miners) putting their names into a hat, and every ten minutes a single name is drawn out from it.

Private key

Each bitcoin or its fraction has a complex but unique private key. A bit like a password. All transactions happen anonymously. This private key is the only way to preserve your bitcoin wealth. If you lose the key, the money is gone; there is absolutely no way to recover it. In the early days, when people were casual about bitcoins, some owners have left the private key written on slips, misplaced those slips, and have potentially lost millions. Someone can also hack into your key and steal your money, but this is not as easy as with conventional accounts and credit cards.

Private Key is similar to the Swiss bank account keys. In the past, I believe the notorious Swiss banks let the clients hold money with them anonymously. Anybody with the key to the locker could withdraw its contents.

Who accepts bitcoins?

Of course, not everybody. Paypal, Microsoft, Dell and Newegg accept bitcoins for payments in certain countries. Reportedly, some hotels and airline tickets can also be booked. Last month, PWC, the big accountancy firm began accepting bitcoin for advisory services in Hong Kong. (Inspired, I hereby announce I’m willing to work as an advisor for anybody for bitcoins as well).

As can be expected, bitcoins are popular with drug dealers, smugglers and other tax evaders.

Globally, an estimated 800 bitcoin ATMs can allow you to buy bitcoins, most of the ATMs are located in the USA.

This month, apart from stock market trading, futures trading is allowed for bitcoins.

Trading in bitcoins as opposed to mining

I have established above that people without PhDs in computer science are unlikely to succeed in mining bitcoins. If you notice, most critics including Warren Buffet who call bitcoins a fraud are old. They are too old to understand the structure and complexity of the bitcoin game.

Now, middlemen like Coinbase have appeared. Without being a miner, you can buy and sell a bitcoin or a fraction of it using your smartphone. (Since 1 bitcoin was nearly 18000 dollars at the beginning of this week, most buyers are thinking of buying fractions).

You need to ask yourself a question. If you buy a bitcoin, who is getting the money that you pay? It’s not going to any government. The money goes to the bitcoin miner, the anonymous maker of the bitcoin, and the middleman who connects you with him.

Commodity or currency?

Finally, is bitcoin a currency or a commodity? It’s a money-like global commodity. However, as a commodity it has no intrinsic value, you can’t wear a bitcoin necklace or eat from a bitcoin plate. In that sense, it’s clearly an absolutely useless commodity. Because it has no intrinsic value, and is not tangible, its bubble not only can but ought to burst. If you want to buy it as a commodity, I have a one word advice. DON’T!

If bitcoin was merely a currency and not a commodity, its life expectancy would have been longer. With a stable value, people wishing to conduct transactions anonymously would love to use it. Bitcoin as a commodity may destroy bitcoin as a currency. With the price volatility, its acceptance as currency is in danger. More than that, the volatility and gullible masses joining this new Ponzi scheme will make governments the world over regulate or ban it sooner or later.

Virtual coins, when they become extinct, are worthless as antiques.

Ravi