Thoughts on Bitcoin Investing
Bitcoin is a currency based on blockchain technology. The key words here are “based on.” This is important is because Bitcoin itself can fail (i.e. have its price fall to 0) while blockchain technology can simultaneously thrive. For investors, this is a critical distinction that they need to be mindful of, as that is what fundamentally drives the decision to invest in Bitcoin instead of another type of blockchain tech like Ethereum.
I will first explain briefly what Bitcoin is, and the technology that underpins it. Then I will discuss what it means to actually invest in Bitcoin as opposed to other blockchain technologies.
Bitcoin explained:
A) Blockchain and decentralization
Bitcoin was created to be a decentralized currency system that isn’t reliant on banks or institutions to govern its stability. For example, if we transacted money, an institution (ex. Paypal, Chase Bank, etc) would be the arbiter of these transactions. But what if we wanted a system where the very same people of that community would verify and validate transactions among themselves? This is where blockchain comes in. The blockchain system is a method of verification and validation that tries to solve this problem.
Imagine each person in our society with their own ledger (a record of historical transactions) that records all societal transactions. This would be like Venmo if all transactions are public (though anonymized), because in blockchain, everyone records every single update that is made. Even if person A pays person B, person C’s ledger is updated with the same information even though that person was not directly involved in the transaction. These transactions/updates are appended as blocks in a long running chain, hence the name.
B) Cryptography and Mining
To prevent fraudulent transactions, each transaction produces a unique digital signature via a combination of public and private keys, with a SHA-256 hash function. Simply, this function scrambles a message/file into a 256 digit string; only when the correct digit guess is made (through guessing and checking) will the message be decoded.
This is essentially how “mining” for Bitcoin comes about. When people make a transaction such as a payment, this transaction is broadcasted to everyone else on the blockchain so they can update their ledgers. Miners are there to help validate whether the broadcast is correct/non-fraudulent. They run computer scripts to find the special numbers that when passed through the cryptographic hash function, will properly unlock the historical blocks of the chain. When miners perform this service of validation, they are rewarded in this system with a fractional amount of Bitcoin. This payment portion is inherent in the Bitcoin code, so no entity has to decree payment.
Implication for Investors?
There are a few that come to mind, many of which are quite unrelated:
1. Blockchain technology by nature is slow. In a recent Tech Crunch interview, Vitalik Buterin (Co-Founder of Ethereum) described blockchain as a “slow database”, which is a perfect description. A Bitcoin transaction goes through through validations – and becomes permanent after a certain amount of miners validate it. The rules for how many validations it takes can vary depending on the wallet service you are using, but take for example a payment I made in November 2017 via Coinbase. I paid $100 USD to someone and Coinbase required 6 validations to occur (6 miners finding the special numbers), which took 45 minutes to complete. It’s not speedy, but its not designed to be.
2. Invest for reasons outside of privacy. Bitcoin addresses are anonymized but that doesn’t mean digital wallets themselves can’t be hacked. To justify a Bitcoin market capitalization of +250 billion (as of this writing), normal citizens like you and me have to use it. For mass adoption, we need to rely on digital wallet startups to guard our data. If they are hacked then our transaction history is hacked as well. Even if our Bitcoin account addresses (essentially auto-generated usernames) are represented by a long string of numbers and characters, that address is still tied to our names during regular registration. Coinbase now requires drivers license pictures as well (if you want to register to trade Bitcoin through their gdax exchange). Nothing about this is private.
3. The promise of Ethereum. Ethereum is essentially a programming environment built on blockchain technology and used by programmers to develop their own blockchain applications similar to how iOS is the environment for iPhone apps. Buying Ether is making a bet on the use of the language to help blockchain development, and its success is independent of how Bitcoin as a currency performs.
Bitcoin has competition. This includes other coins like Litecoin which in essence is the same technology but with a different cryptographic hashing algorithm. If a different coin becomes more widely adopted, then Bitcoin’s value must go down as there as there is nothing inherently valuable about Bitcoin’s tech. This goes back to knowing the distinction between investing in Bitcoin vs. blockchain. Bitcoin (emphasis on the coin) relies on mass adoption - otherwise it’s payout is just as speculative as betting on a roulette wheel.
I will first explain briefly what Bitcoin is, and the technology that underpins it. Then I will discuss what it means to actually invest in Bitcoin as opposed to other blockchain technologies.
Bitcoin explained:
A) Blockchain and decentralization
Bitcoin was created to be a decentralized currency system that isn’t reliant on banks or institutions to govern its stability. For example, if we transacted money, an institution (ex. Paypal, Chase Bank, etc) would be the arbiter of these transactions. But what if we wanted a system where the very same people of that community would verify and validate transactions among themselves? This is where blockchain comes in. The blockchain system is a method of verification and validation that tries to solve this problem.
Imagine each person in our society with their own ledger (a record of historical transactions) that records all societal transactions. This would be like Venmo if all transactions are public (though anonymized), because in blockchain, everyone records every single update that is made. Even if person A pays person B, person C’s ledger is updated with the same information even though that person was not directly involved in the transaction. These transactions/updates are appended as blocks in a long running chain, hence the name.
B) Cryptography and Mining
To prevent fraudulent transactions, each transaction produces a unique digital signature via a combination of public and private keys, with a SHA-256 hash function. Simply, this function scrambles a message/file into a 256 digit string; only when the correct digit guess is made (through guessing and checking) will the message be decoded.
This is essentially how “mining” for Bitcoin comes about. When people make a transaction such as a payment, this transaction is broadcasted to everyone else on the blockchain so they can update their ledgers. Miners are there to help validate whether the broadcast is correct/non-fraudulent. They run computer scripts to find the special numbers that when passed through the cryptographic hash function, will properly unlock the historical blocks of the chain. When miners perform this service of validation, they are rewarded in this system with a fractional amount of Bitcoin. This payment portion is inherent in the Bitcoin code, so no entity has to decree payment.
Implication for Investors?
There are a few that come to mind, many of which are quite unrelated:
1. Blockchain technology by nature is slow. In a recent Tech Crunch interview, Vitalik Buterin (Co-Founder of Ethereum) described blockchain as a “slow database”, which is a perfect description. A Bitcoin transaction goes through through validations – and becomes permanent after a certain amount of miners validate it. The rules for how many validations it takes can vary depending on the wallet service you are using, but take for example a payment I made in November 2017 via Coinbase. I paid $100 USD to someone and Coinbase required 6 validations to occur (6 miners finding the special numbers), which took 45 minutes to complete. It’s not speedy, but its not designed to be.
2. Invest for reasons outside of privacy. Bitcoin addresses are anonymized but that doesn’t mean digital wallets themselves can’t be hacked. To justify a Bitcoin market capitalization of +250 billion (as of this writing), normal citizens like you and me have to use it. For mass adoption, we need to rely on digital wallet startups to guard our data. If they are hacked then our transaction history is hacked as well. Even if our Bitcoin account addresses (essentially auto-generated usernames) are represented by a long string of numbers and characters, that address is still tied to our names during regular registration. Coinbase now requires drivers license pictures as well (if you want to register to trade Bitcoin through their gdax exchange). Nothing about this is private.
3. The promise of Ethereum. Ethereum is essentially a programming environment built on blockchain technology and used by programmers to develop their own blockchain applications similar to how iOS is the environment for iPhone apps. Buying Ether is making a bet on the use of the language to help blockchain development, and its success is independent of how Bitcoin as a currency performs.
- Smart contracts is generally a term associated with Ether - a simple application can be “auto execute 1 coin payment from person A to person B if the Cavaliers win this year’s NBA finals”. The code executes based on the result, so no human intervention is needed. The code essentially acts as an unbiased escrow account that holds the money and then triggers based on a programmed event.) 4. Decentralization – a public ledger system isn’t meaningful for all purposes. As investors wise up about investing in blockchain technology, it will become clear that not everything should have to run on this “slow database”. For a decentralized money system – avoiding multiple currencies with no government control and oversight, money on blockchain tech makes sense. People are still experimenting with different applications (Search up Ether cats which eats up 20% of Ethereum’s transaction bandwith as of this writing).
Bitcoin has competition. This includes other coins like Litecoin which in essence is the same technology but with a different cryptographic hashing algorithm. If a different coin becomes more widely adopted, then Bitcoin’s value must go down as there as there is nothing inherently valuable about Bitcoin’s tech. This goes back to knowing the distinction between investing in Bitcoin vs. blockchain. Bitcoin (emphasis on the coin) relies on mass adoption - otherwise it’s payout is just as speculative as betting on a roulette wheel.
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