Advisory and Structuring

Bitcoin Basics

Bitcoin Basics

Bitcoin, virtual currencies, crypto currencies, digital currencies, blockchain, smart contracts, peer-to-peer, private keys, public keys, API’s, DLT, altcoins, coins prefixed with the vulgar term for faeces, tokens, ICOs - even the terminology is evolving at a pace that is hard to keep up with. So what is all the fuss about? Let us start with the first term on this list - Bitcoin.

Satoshi Nakamoto

In October 2008, Satoshi Nakamoto, a still anonymous computer scientist, released a seminal paper on a cryptography mailing list. In this paper, he proposed a peer-to-peer electronic cash system. He followed this up in January 2009 by releasing the first software based on this proposal. It was this software that created the new digital asset called Bitcoin. Bitcoins are digital units of account divisible to eight decimal places. So one Bitcoin can be split into one hundred million .00000001’s of a Bitcoin. Each one of these hundred million units is known as a “satoshi”. The amount of Bitcoin in circulation is capped at 21 million. That is the total number of Bitcoin that will have been minted by the year 2140, if the project lasts that long. As of September 2017, the number of Bitcoins that has been minted stands at 16.5 million.

Bitcoin and the underlying Blockchain

The technology underpinning Bitcoin is called a blockchain, probably the most revolutionary innovations of our lifetime. A blockchain may sound arcane, but it is in fact, a giant eternally extendible ledger. Each block is the equivalent of a page in a ledger. Once enough transactions have been recorded to fill up that block or page, then that block is added to the preceding block, thus creating a chain of blocks that is, appropriately, called a blockchain.

Probably the most revolutionary elements of the blockchain is that it is decentralised. This means that a copy of this blockchain exists on the computers (or nodes) of every individual who downloads the Bitcoin client software. A block of transactions is only deemed valid and added to the entire blockchain if the entire network of computers running this software agrees, through some very complicated computation, that that block is indeed valid. This makes it impossible for any single, or even large group of attackers, to compromise the blockchain as the system requires validation by at least 51% of the network, a number impossible to obtain across a global network. Moreover, this decentralisation ensures that no matter how many countries knock out the Bitcoin nodes in their territories, so long as a single node is still running with integrity, the entire blockchain is preserved intact.

Anyone can mine Bitcoin but you need to download the Bitcoin software, which turns your computer into a node. You can then join the army of Bitcoin miners. The software uses your computer power to solve a very difficult mathematical puzzle. The first miner to solve the riddle discovers a new and valid block in the blockchain, which is the technological structure underpinning Bitcoin. The miner that discovers the new and valid block is rewarded with Bitcoin. Currently, the reward for finding the latest valid block is 12.5 Bitcoins. However, the reward is halved after every 210,000 blocks that are discovered until the entire 21,000,000 issue has been produced. The last Bitcoin is expected to be mined in around 2140.

An analogy may be drawn up between Bitcoin mining and gold mining. In the same way that gold miners expend resources on equipment and energy to increase the circulation of gold, which is a finite resource, Bitcoin miners expend electricity and computing power to increase the circulation of Bitcoin. This is the main way that miners make money. However, they also make money by validating all transactions of Bitcoin that take place across the Bitcoin network since each Bitcoin transaction includes a tiny fee for this validation to take place.

The mining process is an integral part of the system as it is also the way transactions are cleared and settled, ensuring that no Bitcoin is spent more than once. Bitcoin’s rapid rise has made mining a profitable business so most miners are now large warehouses rather than personal computers. The confirmation of transactions by miners, allow the transaction between party A and party B to be direct. Bitcoin goes directly from A to B it does not go through an intermediary. Compare this to a conventional money transfer through the banking system where they may be as many as five intermediaries. The ability for two parties to deal with each other directly is revolutionary and has wide-ranging implication far beyond Bitcoin. Indeed it is already transforming the area of clearing, settlement and other post-trade activities.

Hence, through mining and the validation of transactions, Bitcoin miners acquire a real interest in providing more nodes for the Bitcoin blockchain because they earn money by mining and confirming transactions simply from turning their hardware into a node.

Spending Bitcoin

It is worth emphasising that no Bitcoin can be spent more than once, a flaw known as the double-spend problem in the theory of digital cash.  Satoshi’s solution to the double-spend problem is one of those major breakthroughs responsible for making Bitcoin so successful in comparison with other similar concepts that have failed. When party A sends Bitcoin to part B, that Bitcoin transaction has to be confirmed by the mining community, using the Bitcoin software and recorded in block, which is a page in the virtual ledger of the blockchain. The entire blockchain, therefore, holds a record of every single Bitcoin transaction that was ever made. Therefore it is possible, and indeed easy, to scrutinise every single Bitcoin transaction that ever took place in its history. The permanent public availability of this transparency is an integral part of the Bitcoin blockchain.

DLT

This refers to Distributed Ledger Technology. As the name implies, the blockchain database is not located on any one system or in any one place. As laid out above, the blockchain database is distributed across all the nodes in the entire Bitcoin computer network. Moreover, transactions take place between individuals holding Bitcoin through its blockchain. There is, therefore, no central authority to guarantee, sanction and safeguard the currency and transactions using it. It all happens individual-to-individual, which is what we mean by peer-to-peer. The ledger itself is public information, anyone can have access to it but since any transaction or change needs confirmation by 51% of the network, it is beyond any single agent or even large group to compromise. Only the collected network, carrying out its mathematical computations can validate transactions and changes. This makes the system secure and there have been no security issues with the Bitcoin blockchain itself. Exchanges on which Bitcoin is traded have been breached or gone rogue, but that is another matter.

Owning Bitcoin

Bitcoin is controlled or held by private keys- an identity in the form of a unique string of alpha-numeric code. So anyone can own Bitcoin directly, by creating a private key. You can associate yourself with the private key or you can remain anonymous. To hold or transact in Bitcoin you simply need to provide your private key, the system does not care who that key is controlled by or belongs to. It could even belong to a machine or nobody at all. Without a private key, you cannot spend the Bitcoin stored in a particular address. The Bitcoin blockchain uses a system to protect private keys that is roughly analogous like hiding a single gold leaf in a forest the size of a galaxy. Good luck finding it, no matter how powerful your equipment and sophisticated your processes. Needless to say, it is of the utmost importance to keep your private key as safe and secret as possible.

Apart from a private key, a Bitcoin address also has a public key. A public key is another string of alpha-numeric code that you provide to someone else to send you Bitcoin to your wallet. Your public key is intended to be publicly available because the only thing that anyone else can do with it is to send you Bitcoin through that public key. You can safely distribute your public key to anyone who wants to send you Bitcoin or when soliciting payment in that currency.

A more common way of owning Bitcoin is by opening an account with an online exchange- the most popular one being Coinbase. The process is quite straightforward and similar to opening a bank account as you need to provide the usual KYC (Know Your Client) documents confirming your identity. If you own Bitcoin through an exchange, not only do you have to disclose your identity, but you also lose control of your private keys.

Purists do not like this as you open yourself up to counterparty risk through your dealing with the exchange. If the exchange goes bust or is hacked (this has happened) you might lose all your Bitcoin. The relationship is similar to that between you and your bank except that governments usually operate a deposit guarantee scheme which typically guarantees up to EUR 100,000 of deposits per individual.

Regulation

Many countries have paid lip service to the benefits of this new technology but there are still deep-seated concerns.

Bitcoin is pseudonymous. This means that while the blockchain itself is entirely transparent, with every transaction in its history easily and immediately searchable, the individuals carrying out these transactions are unknown. This is because the accounts themselves are expressed in alpha-numeric code (the public key). While everyone permanently knows what transactions took place between these accounts, it is very difficult to work out the individual behind that account because an alpha-numeric or QR-code carry no public identifier of its owner.  In that respect, it is just like cash but more scaleable- easier to transact in large amounts. Regulators are concerned that it could be used for fraud, money laundering, funding of terrorism and other criminal activity.

Bitcoin trades on internet market places, outside the control of any financial regulator. Even if an exchange were to become regulated, Bitcoin can still trade between users without the use of an exchange. Financial regulators are there partly to protect investors and iron out systemic risk, a redundant role in the Bitcoin market where the regulator is the Bitcoin community.

When it comes to investors holding Bitcoin through collective investment schemes, financial regulators cite the lack of clarity on custody arrangements and price discovery. Custody of Bitcoin means controlling the private keys. How is this done? Are they held on a pen drive in a safety deposit box or on a custodian’s server? Bitcoin does trade in large volumes so internet users do trust prices. This is very different to the official price being provided by a regulated exchange, as with the LSE or the MSE.

Official scepticism is partly based on serious concerns surrounding anonymity and partly the result of ignorance. As regulators become more familiar with this new technology it is likely that parts of it will be covered by regulation. Accepting anonymity, even if it is “only” pseudonymity, is another matter and this may ultimately lead to a showdown between governments and the Bitcoin community.


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