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What the Hell is Bitcoin?

*I am not claiming to be an expert or even particularly well-informed when it comes to bitcoin and the likes, but having spent the past number of weeks working a lot with clients in this space, I have gotten some insights (all purely opinion-based) in the sector having educated myself in the basic principles behind it.

A lot of people are interested in this space but don’t really understand it, so I tried to break things down in an easy to understand manner

This is a question that seems to be on a lot of people’s lips these days.

Not a day goes by without some mention of bitcoin, blockchain technology or initial coins offerings (ICOs) in the mainstream media.

Everyone and their granny seems to be looking to invest in bitcoin or some other digital currency. 2017 is unquestionably the year of Bitcoin, having been priced at less than $1,000 at the beginning of the year, to now having passed the $16,000 mark for the first time ever.

In the past week alone, the price has increased by more than 50%. There are not too many asset classes that can see these levels of price increases at this price point in such a time period. Many are saying that it is out of control, that it is a bubble and there will be blood on the streets before we know it.

There have been comparisons made with tulip-mania, comparisons that are quite apt given this is the 2nd largest price inflation of an asset class since the Dutch went tulip mad in the 17th century.

For the last few years, people have been predicting the end of the road for the likes of Bitcoin, saying that the bubble is set to burst at any minute.

However, despite many ups and downs along the way, Bitcoin has continued to stick the middle finger up to these critics and continues its amazing ascent.

Nobody really knows what is going to happen, with many theories abound on both sides of the camp.

Whatever the case may be, digital currencies are undoubtedly here to stay and the technology underpinning them looks set to have massive applications in all walks of like.

Without further ado, here are some of my ramblings about Bitcoin and related technology, broken down in an easy to understand manner.

 

In basic terms, what is Bitcoin?

Bitcoin is a digital currency (as opposed to a fiat currency that you can actually hold like US$) and nobody has control over it. This is why it is called decentralised.

Fiat currencies are controlled by Central Banks, such as the European Central Bank (ECB) who control the Euro and the United States Federal Reserve who control the US$.

These central banks can control the supply of their currency as they see fit, raising and lowering interest rates as they please.

Bitcoin is different as it has a limited supply that cannot be changed and nobody has any control over this.

The total supply of Bitcoin is 21 million, with not all of them having been mined as of yet. Bitcoin can be broken down into smaller denominations, with the smallest denomination being one hundred millionths of a Bitcoin.

A central bank can create money out of thin air, but in order to create more bitcoin, they have to be mined. Mining is a process whereby computers use advanced software in order to solve complicated mathematical problems. When these mathematical problems are solved, the miner will receive part of a bitcoin as a reward.

In the beginnings of bitcoin, individuals would use their personal computers to mine Bitcoin. Many people who did so in the beginning often forgot they had this digital currency that was only valued then at a few cents.

There is one well-known story about a man in the United Kingdom who threw out his computer that had x bitcoin on his hard drive, then only worth a few dollars.

Fast forward a few years and these bitcoins were worth a fortune, resulting in people foraging the local refuse dump in an attempt to try and find the hard drive. To date, nobody has ever managed to find this treasure.

These days there are rooms filled with powerful computers that work endlessly day and night to mine bitcoin.

 

Who created Bitcoin?

Nobody knows for certain whom the actual creator of Bitcoin was, but the developer who created it has been dubbed Satoshi Nakamoto.

The initial aim of this digital currency (or cryptocurrency) was to create a currency that did not fall under the authority of any central authority (i.e. a central bank), it could be transferred electronically almost instantly and with extremely low transaction fees.

 

What are the main features of Bitcoin?

There are a number of ways in which Bitcoin stands out from traditional currencies.

  1. Easy to setup

To open a bank account, you need to go through a time-consuming process which can take weeks. The same goes for traditional merchant accounts. With bitcoin, it only takes a matter of seconds to create a bitcoin address, with no red tape and no fees needed to be paid.

  1. It’s decentralised

There is no central authority that controls the bitcoin network. The machines that mine the bitcoin are the network as they work together.

No one authority, therefore, is able to tweak the monetary policy and potentially bring the users of the currency to economic disaster or even take their money from them or devalue it so it is worth nothing (a la Zimbabwe and Argentina in recent years with hyperinflation).

  1. Privacy

A user is able to hold multiple bitcoin addresses which do not have any links to names, addresses and other personal data that can be used to identify the user.

  1. Transparency

The bitcoin network is completely transparent as every single transaction is recorded in a public ledger that is called the blockchain.

If you have a bitcoin address that has been used publically, anyone can see how many bitcoins this address stores. Of course, due to the privacy parameters in place they cannot use this account to identify the owner.

If you wanted to add extra levels of privacy, you could use multiple bitcoin addresses.

  1. Speed

You can send money across the world and it will take only a matter of seconds after the payment has been processed by the bitcoin network. With traditional banks, it can take a number of working days for payments to be processed and transferred.

  1. Minimal Fees

If you are sending money via a traditional bank transfer, you could be looking at a fee of $10 for doing so. There is no such fee with bitcoin.

  1. Non-repudiable

Once a bitcoin has been sent, there is no way of getting them back unless the receiver specifically returns them.

 

Why is there so much attention on blockchain technology?

Blockchain is a potential game-changer for how things are done. While Bitcoin and the likes have many critics, most of them make a point of emphasising that they believe the blockchain technology will have many future applications.

The blockchain is effectively a massive database in which anyone can view the records. There are no 3rd parties involved.  At the moment with bitcoin, it records the transactions between two bitcoin addresses, but the question is what else can it be used to record?

It can record any structured information, such as who owns certain land to who is married to whom. It is unhackable and immutable, meaning that it is a platform that espouses trust and the truth at all times.

The possibilities are amazing both in the financial services sector, as well as in all other parts of daily life.

Its role in bitcoin, in basic terms: when you send $20 to Mary, before she receives it, the miners (remember them?) utilise their computer software in order to authenticate the transaction. They are essentially looking for the truth. When they find the truth and solve the problem, they get rewarded for it via some bitcoin.

There is absolutely no way that it is practical to hack into this transaction before it is processed due to the practicality of all the computers in the world that are currently working on this problem simultaneously.

 

What are potential future applications of this technology?

Without getting far off the point, blockchain technology is very important and some of its future applications may, for example, be to protect the rights of creators (i.e. prevent illegal streaming, downloading of songs, movies etc.).

It could potentially allow for digital voting in elections or as a decentralised notary of documents. Smart contracts are a hot topic when it comes to blockchain technology and they essentially act as an escrow without all of the headaches involved.

For example, if you wanted to give $100 to John at a specific date and time in the future when certain terms were met (i.e. a bet on who wins the Premier League), all the relevant details would be programmed into this smart contract.

When that date comes, the funds will automatically be distributed to the person who met the terms outlined in the smart contract (i.e. John correctly said Manchester United so the $100 is instantly sent straight to his account). This can be used everywhere from making the legal system more equitable to having businesses be more efficient.

 

What are altcoins?

Altcoins is a term that is used for cryptocurrencies (or digital currencies) that are not bitcoin. There are now over 1,200 such altcoins on the market today, with more being released every day, such as litecoin and dogecoin.

Other significant cryptocurrencies which are not altcoins include the likes of Ethereum, which is the basis for a large majority of the altcoins. There have been a couple of bitcoin offshoots to date also, in the form of Bitcoin Cash and Bitcoin Gold.

The reasons for so many altcoins are because startups are using a new crowdfunding method called an initial coin offering (ICO) in order to raise funds for their business.

This means that in return for investment, they will exchange their own form of cryptocurrency (also called tokens). These tokens will usually be able to be used in the product or service that the specific company is developing in the future, as well as being able to be traded on the exchanges.

 

What is an ICO?

You may be familiar with initial public offerings (IPOs) whereby companies publically list their shares on a stock exchange in order to raise capital for their business.

An ICO has the same idea, but instead of offering an equity share in the business and a potential dividend, an ICO offers a form of cryptocurrency or token in return for this investment.

Usually, an ICO will have a whitepaper which lays out the structure of the ICO (i.e. total number of coins being released, the price per coin etc.), what the funds will be used for and what the product or service is all about.

While a lot of people invest in ICOs in order to fund exciting projects that have great potential, there are also a large proportion of people looking to simply make some decent profits by getting in early on the next potential bitcoin.

ICOs are a bit like the Wild West as there is little to no regulation or oversight at the moment. This has led to a number of scams taking place, whether they are phishing attacks or hacking the contributor address of the ICO itself and stealing the funds.

This is one of the reasons a number of large countries such as China and South Korea have banned ICOs, with other nations such as the United States and the United Kingdom advising people to not invest in them.

 

Bitcoin’s Bad Reputation

For many, people see bitcoin is a fraud and a way for criminals to be able to secretly funnel their money without getting caught and allowing people to avoid paying taxes.

For a long time, all people would hear about bitcoin was that it was the currency used on dark websites that sold drugs and other illicit services. Due to the untraceability of bitcoin, it was ideal for using for criminal activities and money laundering, as it could easily clean money.

There have also been a number of high-profile scandals involving bitcoin in recent years, such as the Mt Gox hack whereby in 2014 the bitcoin exchange discovered that more than $470 million worth of bitcoin had been stolen for them.

These attacks happen frequently, with the NiceHash mining platform being hacked as recently as two days ago, with early estimates saying they had $84 million worth of bitcoin stolen from them.

The lack of regulation and oversight in the sector is also a concern for a lot of people, but as it enters more and more into the mainstream, the relevant authorities are hard at work developing laws to protect participants in the markets as best as possible.

 

How do you invest in bitcoin?

As of this very moment (7th of December 2017), the main way of investing in bitcoin is by actually buying some. You can do so through an exchange platform such as Coinbase, which usually charges you approximately 1% more than the market price for it.

BTC is the symbol for Bitcoin in the markets and it is worth doing your research when you are looking to find an exchange to purchase Bitcoin with as there are a lot of scammers out there today.

If you are thinking about investing in Bitcoin or another cryptocurrency, do be aware that the markets are extremely volatile, much more so than equities (stock markets).

You should also be aware that there is the potential to lose a huge chunk of your initial investment, with many leading finance experts in the world clawing it a bubble that is going to end badly.

(I am not advising anyone either way as to what they should or should not invest their funds in).

 

A key date in the future of Bitcoin?

It was recently announced that for the first time ever, investors could utilise bitcoin futures contracts.

December 10th and December 18th will see the introduction of these by the Cboe Global Markets Inc. and the CME Group respectively.

A futures contract is essentially a contract you enter into that allows you to buy something at a specific price in the future.

Example

As oil prices play such a significant role in the profitability of airlines, they usually use futures contracts in order to hedge their risk.

This means that if the price per barrel of oil is currently $60 and they need to buy 3 million barrels in 12 months, they will enter into a 12-month futures contract that means in 12-months’ time they can buy these 3 million barrels of oil for $60 each and not have to pay the market price.

This could work out either way for them. If the price of oil increases, then they have made a good decision as they can pay less than the market price for oil, whereas if the price of oil decreases, they will be paying more than the current market value.

These could be momentous dates in the history of bitcoin, as the influx of institutional investors with big bucks will no longer have to hold bitcoin itself, they can simply use this financial instrument to bet on the price rising or falling.

It makes it a whole lot easier for people to short the market (bet that the price of Bitcoin will fall), which could lead to a big sell-off and price drop.

Whatever your view on the matter, these are key dates to watch out for.

 

How is the price of Bitcoin so high?

This is the million dollar question. To those experienced in the world of finance, it almost certainly looks to be a bubble. The likes of Warren Buffet recently said: “You can’t value bitcoin because it’s not a value-producing asset…it’s a real bubble in that sort of thing.”

Bitcoin is not backed up by or based on anything, so if everyone decided tomorrow that it is worth nothing, the price could topple to zero.

A lot of the people who invest in the likes of Bitcoin are mainly from a tech background and likely do not have too much experience when it comes to actively trading in the markets. This is one of the reasons for high levels of volatility, as little changes can cause large reactions.

There was a famous tale of an investor who sold all of his holdings in the days before the famous stock market crash of 1929 which led to the Great Depression. When he had been getting his shoes shined, the shiner tried to give him stock tips. This showcased that the herd mentality had taken over the markets and it was time to go the other direction.

With so many people seeing the massive profits being made by trading bitcoin and other cryptocurrencies and wanting some of the action, it is probably wise to proceed with caution.

As Warren Buffet said, “it’s only when the tide goes out that you see who is swimming naked.”

 

 

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If you have any opinions when it comes to bitcoin, cryptocurrencies or anything associated with them, please leave a comment and let me know your thoughts.