I started thinking about this some time ago. I will kick myself once for not having gotten in on the ground floor prior to Bitcoin’s meteoric rise, and then leave it at that. I had in fact tried to look into it a few years ago, and technical though I was, I found enough hurdles that I gave it up. Ah well.I decided to look at it some more recently, and to follow through with actually buying some. This delayed me a further 2 months (while I awaited for the arrival of a hardware wallet), and once again missed the run up from $1800 -> $5000 in BTC. (as of this morning when I posted this article it is over $6,000)
However, in any case, there are some underlying facets of digital currency I wish to examine. I will then describe the process I went through to actually buy some Bitcoin.
So let’s discuss some core concepts first. Money and currency.
Money is any item or verifiable record that serves as:
a. A generally accepted medium of financial exchange [you can give or receive it in return for goods and services – It also allows ease of comparison when looking at the values of dissimilar objects]
b. Unit of accounting measure that is globally recognized. Needed to be able to execute activities like accounting, quoting of prices, and accomplishing trade.
c. A Store of value – To accomplish this function, the item being treated as money should be able to be reliably saved, stored, and retrieved. It should also be predictably usable as a medium of exchange when it is retrieved. The value of the money must also remain stable over time. (So what does inflation mean?)
How does BTC stack up?
Currency is where it starts to get interesting. And, predictably enough, there is lots of controversy over this. The synthesis of my research on this has been:
Currency is ‘money’, generally coins and paper notes, which is issued by a government and circulated within an economy. It is used as a medium of exchange for goods, services, and is generally is the basis for trade.
There are several types of currency (Fiat, Asset backed, Digital, Other):
Fiat: [Fiat is an authoritative or arbitrary order] Fiat money has no intrinsic value and is backed by the ‘full faith and credit of the issuing government’. That is, this type of currency is not worth little in terms of its value as a raw material. Paper money is fiat money, and its value comes from what it represents rather than what it is. To my uneducated perspective, fiat money is kind of a mutually sustained house of cards. It is important to remember, that fiat currency is only as good as the organization that issues it. If the entity defaults or no one has faith in them, the currency is worthless (Zimbabwe [On 16 January 2009, Zimbabwe issued a ZWD100 trillion bill (100,000,000,000,000 ZWD)], Hungary in the 1940s [In the middle of 1946, the highest denomination of 100,000,000,000,000,000,000 pengő (a hundred quintillion pengő) was issued], etc.)
Asset-backed currencies are tied to an underlying asset (such as gold). There are numerous articles about this on the web. I am not aware of any asset backed currency right now. Possibly something called the VEN, but I will research that and do an article about it at another time.
Other: Reward points 😊 … Well, think about it. I have reward points on my airline loyalty card and my AMEX, and from other institutions. They can be used as a medium of exchange. In case of the airline reward points, in a very limited marketplace. But nonetheless, a [branded] currency.
Digital: This is the core of this article. Digital currencies get their value through scarcity imposed on them by the need to solve difficult equations (mining, which consumes electricity, hardware, and time -- because of the amount of calculations that have to be performed in order to verify the blockchain). And in the case of Bitcoin, there is a cap of 21,000,000 that can ever be mined due to the underlying algorithm. They are not issued though, by a government, but more by a collective of people and computers that have ‘agreed’ that the currency will have value. They are to some degree, anonymous (although not as anonymous as one would think based on the hype).
OK – so, now on to the core of the article.
There needs to be a clear distinction made between the underlying technology for bitcoin, which is called blockchain, and Bitcoin and other digital currency themselves.
Blockchain is a distributed, encrypted open ledger system. What does that mean? Books have been written about this so I will try to summarize.
Well first, let’s define some of the problems. In today’s environment, here are some of the problems with respect to financial transactions worldwide:
- People and companies are unable to reliably know or trust another party in order to execute a transaction and/or exchange money without validation from a CENTRALIZED third party like a bank or a government.
- These centralized institutions gather our data – and then don’t guard it
- Cost structure of modern banking excludes a lot of the poor people from using the system (And is silly frankly. With today’s technology and communications, the cost & speed of transferring funds should be so low as to be trivial).
- Transfers can take a long time. Most banks will tell you 2 – 5 business days. That is absurd. Why? These are electronic transactions. They should take place in minutes at the most, and possibly seconds. I’m not a banking expert but I see several reasons to explain it. Financial institutions are isolated castles. So anytime you execute a transaction from one isolated castle to another, it takes time to get past the barriers that they put in place to be able to protect themselves from the outside world. In addition, since banks garner interest on any money that is in “float”, that in itself is an incentive to not make the transfers go quickly. I.e. they are harvesting ‘float’ monies.
- Inefficiencies – Are you aware that every transfer of USD from anywhere to anywhere in the world, has to go through New York? Why? If I’m sending USD from Thailand to Denmark, why on earth should that have to go through New York?
Figure 1 Current Situation (for a US$ transfer)
And everywhere there are binoculars in the diagram, these institutions are gathering data on you. And guarding it badly.
Blockchain was setup as the underlying protocol for a digital currency called bitcoin by an anonymous individual with the nom de guerre of Satoshi Nakamoto. This was in approximately 2008. This protocol established a set of rules— in the form of distributed computations (this is the distributed ledger) — that ensured the integrity of the data (bitcoin transactions) exchanged among thousands or tens of thousands of independent computing devices without any requirement for a trusted third party.
Although it sounds simple, this is a huge deal. Truly disruptive technology.
Figure 2 And this is a BitCoin Transfer
Can you see why governments and banks are so against this? No central organization. No easy way to monitor. It is not as anonymous as governments like to make out, but it is not easy to track or trace. No bank, credit card company, PayPal, or any government institution involved. Blockchain technology is what enables this to happen.
Blockchain is, by the way, open source code: anyone can download it for free, run it, and use it to develop new applications for managing online transactions. Who can say what potential applications can be created with something as powerful as this. https://bitcoin.org/en/download - in case anyone wants to check 😊
So how does it work?
The term ‘Distributed Ledger’ is key. There is no central database. All transactions are recorded in a single global ledger – ‘the blockchain’ – which uses a global P2P (Peer To Peer) network of computing nodes to verify and approve all transactions. [Currently, the Bitcoin blockchain is about 135GB in size – this contains verifiable information about every transaction conducted since its inception in 2008]. All nodes maintain a copy of this ledger.
- The blockchain is public – anyone can download and view it
- It is heavily encrypted
- There is no central auditing institution
- Every so often (I think it is about 10 – 15 minutes currently) all transactions are verified by a consensus of a predetermined number of nodes on the network, cleared, and authoritatively stored in a ‘block’ (1MB size). Each block is stored in the overall blockchain and is inextricably linked to the preceding block by cryptographic calculations. If this isn’t the case, it is an invalid block and it won’t be stored on the blockchain.
- This block permanently timestamps every exchange, and once the block is part of the blockchain, it can never be altered or erased. The “insect in amber” concept.
- So, to ‘steal’ a bitcoin, you have to get more than 51% of all the nodes to agree to rewrite the entire 135GB of the blockchain in ‘broad daylight’ so to speak. Not going to happen.
Some notable advantages to using blockchain for transactions:
- Lower cost
- Fewer errors
- No Single Point of Failure (SPF) from hackers, natural disasters, etc.
This technology (blockchain) can be used for far more than just digital currencies. And in fact, there are many initiatives to be able to put other processes (such as smart contracts) onto block chain technology. Just for a moment, imagine other things, that if instituted on a blockchain platform, could simplify life for people in today’s day and age. Birth & death certificates, licenses of all types, land titles, school records, insurance claims, etc. Anything that can somehow be expressed in code. I reside in a number of countries, most of them incredibly corrupt. Imagine the transparency that instituting blockchain could force onto the system in countries like this. Corruption hates transparency.
Just one example I’d like to explore in a tiny bit more detail; property titles.
Property and land titling. It may not be quite as common in places like North America, but in Asia, so much of the land is not properly surveyed or titled. And it is all on paper under the aegis of innumerable small governmental units. And I remember, many years ago, trying to work with a government agency in an Asian country on the concept of using satellite photography and GPS to create digital records for land so that the entire process of buying and selling land would be more transparent, more efficient, and far more resistant to fraud. To cut a long story short, they were not interested in doing this at all. They didn’t say it in public of course, but the underlying resistance was based on the fact that there is so much money that gets made through the buying and selling of land, and there were people at all levels of the process right down to individual city halls, who wanted absolutely nothing to do with a technological solution that would speed it up, remove the opportunity for graft and remove the opportunity for people to be cheated on how much land they were actually buying or selling. Now if property titles were stored in a distributed ledger like blockchain, imagine how that would improve the situation in any country where was done. Now being able to buy and sell land would become a very straightforward affair. At least in terms of the now minimal paperwork that would be required to be able to ascertain who owned the land, the exact dimensions of the land, and the financial historical trail of the land in terms of owners, property taxes, liens, etc.
Smart contracts are something I will go into another time.
So, in summary, block chain is a platform that supports the idea of a distributed ledger for numerous types of transactions. It has the advantages of being encrypted, secure, highly fraud resistant, and inherently quicker and more efficient than traditional closed system ledgers.
So now, what is Bitcoin?
Bitcoin is a digital currency set up on top of the blockchain protocol.
If you will recall above, I described a process where numerous notes on a peer-to-peer network, calculate and verify the transactions into blocks. This is in fact the “mining” process. It takes a significant amount of computer hardware, time, and electricity to be able to do this block calculation and verification. It is called “proof of work”. And it is the process of doing these block verifications, that is called ‘mining’. When a miner is able to show the POW, the system (the global peer-to-peer network of computers that are doing all of this work) then generates bitcoins, both as the transaction fees associated with the transactions compiled in the block as well as newly released bitcoin. This distributes and makes new bitcoin available in a decentralized way. Because the same miner will not always be the one to get the block reward.
This is one of the best explanations I found: ‘A mathematical problem is linked with each block. Miners are constantly processing and recording transactions as part of the process of competing in a type of race. They race to ‘complete the current block’ in order to win Bitcoins. When a winning miner is able to solve it, the answer is shared with other mining nodes and it is validated. Every time a miner solves a problem, a newly minted 12.5 BTC is awarded to the miner and enters circulation. The first record in that next block is a transaction that awards the winning miner (who completed the previous block) the newly minted BTC. It is the difficulty of the mathematical problem that regulates the creation rate of new Bitcoins since new blocks can’t be submitted to the network without the answer. Based on the fact that it takes around 10 minutes on an average to solve the problem, approximately 12.5 new Bitcoins are minted every 10 minutes. [Investopedia]
A couple of other points:
- The protocol is self-adjusting. I.e. It can make the mining more difficult so that the bitcoin ‘discovery rate’ is more or less constant. And it does this approximately every two weeks at this point.
- The amount of new bitcoin released with each mined block is called the block reward. The block reward is halved every 210,000 blocks, or roughly every 4 years. The block reward started at 50 in 2009, was 25 in 2014, is currently 12.5, and will drop to 6.25 in 2020 sometime. This diminishing block reward will result in a total release of bitcoin that approaches 21 million. This will be in the year 2140 approximately.
How do you buy it?
The process that I have gone through, is that you find a digital currency exchange of some sort. Some of the main ones are
I ended up using localbitcoin.com is because it was the only way I could find to actually purchase bitcoin. The first two exchanges, due to what I am presuming are overly stupid security regulations, consistently forbid me from being able to actually purchase through them. Well on coinmama.com the credit card transactions keep failing and I don’t know why. Coinbase.com requires that I have a US telephone number to which they can send a pin confirmation. I’ve asked them why I need to have a US phone number for that to work but have never gotten a response. Localbitcoin.com on the other hand has worked for me quite well. Whatever your country you are in, you go find a local trader and you arrange for a cash deposit to their bank account and then they release bitcoins to you. Yes, I am aware that this could be a risky proposition, however, that exchange is well-regarded, has a good reputation, and obviously would make sense to use a trader on the exchange that has the highest number of recommendations. I tried an initial purchase for a small amount, it went well. I just purchased another larger amount two days ago and that also went very well. No issues whatsoever. The other advantage I see to localbitcoin.com is that when you are dealing with cash transactions the premium that you paid for purchasing bitcoin is very low. The disadvantage I see to localbitcoin.com is that I can only purchase bitcoin. I would like to be able to purchase some of the other what are called alt coins (such as Ethereum or Ripple) but they don’t offer that. I have to go through one of the exchanges I mentioned above.
Another practical point. When you have an account on an exchange and you buy a digital currency, it will of course end up in your exchange wallet. If you are going to purchase and work with digital currencies, I would say that it is an absolute necessity that you purchase some kind of a hardware wallet. A hardware wallet is a device somewhat like a USB drive (examples are Trezor & Nano Ledger - Can buy from Amazon ~$100), that you set up and keep on your person. You purchase digital currency on an exchange, then stick your hardware wallet into your computer, transfer the digital currency you purchased to your hardware wallet, then you disconnect your hardware wallet from a laptop and store it somewhere secure. I am sure that people have heard about several high profile digital currency thefts, perhaps the two most well-known and are the Mt. Gox, and DAO. While this may be an oversimplification, I posit that both thefts occurred because even though one of the strengths of digital currency is its decentralization, and its ability for you to keep the digital currency yourself, the problem occurred when people once again, I don’t know for what reason, decided to trust a centralized entity. So, bottom line, get a hardware wallet, and keep it secure yourself, that way nobody can ever steal your digital currency. I will cover the details of hardware wallets and a separate article at some point.
There are a few other general comments I have about digital currency:
- Digital currencies are extremely easy to move physically or electronically. They reside on your hardware wallet, it looks totally innocuous and you can carry it through any border with probably zero chance of anybody taking a look at it to see if you’re carrying, in essence, a financial instrument. Currently of course, most countries have a limit of usually somewhere between $10-$20,000 that they wish you to declare if you’re carrying in excess of that in cash. How dare they? Or, of course, if you keep your digital currency in an online wallet (another option for not keeping it in an exchange), then you can access it anywhere you have Internet access.
- Governments hate it. They can’t track it and they can’t control it (and therefore tax it). Although they are certainly trying hard to catch up, primarily, at this point, by going after the exchanges where one can buy Bitcoin.
- If it wasn’t clear from what was said above, there needs to be no centralized authority to be able to authorize any transfer. Again, something that the financial institutions and governments are not fond of.
- A common thread that I have noticed every time I stand up for digital currency, is that many people, even people I would assume are otherwise fairly intelligent, saying that it is a refuge for criminals. Well, criminals use cash too, as they do cars, houses, land, etc. Yes, of course criminals will use digital currency. Why not? That does not mean that digital currency is a bad thing. I believe the issue of institutions like criminal organizations and terrorists using digital currency is played up a good deal by governments and financial institutions on purpose. Why? Because they don’t like it. They want to be able to track and tax everything. Every single financial transaction that occurs worldwide. And so of course, they use the “bad people use it” story line to be able to say that digital currency is bad. Really? Does this need to be explained?
- I just saw, over the last three weeks, headlines where both Russia and China (who have spoken out stridently against digital currencies because they’re not very controllable) are going to look into creating their own national digital currency. I see. Digital currency if it is decentralized, difficult to control, and difficult to tax, that’s bad. But if the government or central authority creates it, then all of a sudden digital currency is okay. Does any intelligent person looking at this not see the hypocrisy involved? Truly? And financial institutions like J.P. Morgan (are you listening to what your company is doing Jamie?) are looking at instituting blockchain technology as well. Of course, they want to keep it for themselves internally so that other people can’t get in, but they are still looking to implement it in one form or another.
Last Thing – I know this is the longest article I’ve ever written and I applaud the patience of people who have stuck with it to the end. And it can’t possibly cover every aspect of digital currency. But it was a journey for me that has enabled me to start understanding it. Because I, personally, have no doubt, that digital currency will become more and more a part of our future.
There are a lot of digital currencies, not just Bitcoin. I will cover Alt Coins in another article if anyone tells me they are interested.
Good resources for further checking into digital currency:
The interview with Schiff is where he voices all the genuine doubts that I too have about digital currency
Article in Forbes about Bitcoin – As usual, well written
Tapscott, Don; Tapscott, Alex. Blockchain Revolution: How the Technology Behind Bitcoin Is Changing Money, Business, and the World. Penguin Publishing Group. Kindle Edition.