Feature Stories | Apr 30 2021
Bitcoin, blockchain, crypto…No idea what they’re all about? Maybe we can help.
-How blockchain works
-The purpose of cryptography
-The trust factor
-Where’s this all going?
By Greg Peel
Six long term friends gather once a month on a Friday night for a drink and a catch-up. On this particular Friday, Bill pays John back the ten bucks he borrowed last time.
The following month a forgetful John asks Bill whether he had paid back that ten bucks. Yes, says Bill, and all at the table can verify that this did indeed occur.
Nothing unusual there, but let’s say the six friends are constantly borrowing from and lending to each other. Jane owes Mary twenty, and pays it back. George borrows ten from Mark. Bill also asks Mark for ten. So it goes on.
Worried that between them they’ll lose track of all these transactions it is suggested they write them down on a piece of paper and all sign it, to be brought out the following month for clarification.
The following month, they start again, repaying and borrowing and thus another piece of paper is produced to again keep track, with all present verifying both the first piece of paper and the second. This trend continues, and a file of papers is built.
In very simplistic terms, this is a blockchain.
Each piece of paper holds a ledger of transactions, which is the “block”. When the next block is complete, it is “chained” to the prior block. Each month each of the friends present verify both the prior block and the new block. Because they are long term friends, they all trust each other implicitly.
Verification and trust are two key elements of blockchain.
But what’s wrong with our picture?
Firstly, who writes things down on a piece of paper anymore, and keeps those pieces in a folder? More likely, each friend will use their phone to make note of the transactions in order to rightly verify them. That way each of the friends has access to the same information.
Secondly, who carries cash anymore? More likely, the borrowing and lending will be achieved digitally, via a bank app or some other fintech service.
Everything, these days, is digital.
Now let’s get a bit more “out there” with this analogy and suggest that the money being exchanged each week is not Australian dollars, but that the friends have actually created their own currency. This currency may not be worth anything to anyone outside this circle of friends, but based on trust and verification, each friend can be fully confident in the “money” changing hands.
This currency would only exist in a digital world of their own. It would effectively be a “crypto-currency”.
The Digital Code
“Crypto” is an abbreviation of the word “cryptography” — a method of protecting information and communications through the use of codes, so that only those for whom the information is intended can read and process it.
In our analogy, the verification process is based on a foundation of trust that is ethereal. Were our friends to introduce others into the circle, who were not previously known by all, the verification process would require something more concrete to ensure such trust.
Blockchain uses cryptography to ensure such trust. Each transaction in a block is given a code, each participant in a transaction has their own code, and when the block is complete, that block is assigned a unique code, which in this case is called a “hash”
Each hash is a long string of numbers and letters for which there are trillions of combinations. Each block of transactions has its own hash and the hash of the block before within the chain. The hashes are generated by a proprietary algorithm owned by whoever created the particular blockchain, such as Bitcoin.
To verify a block, someone – anyone – can run the algorithm and if they arrive at the same hash string (or a number lower than, but that’s getting too far into the complexity of it all for our purposes) the hash is verified and the block secured. Once verified, the block, and the ledger therein, is available for all participants to see.
If any “bad actor” attempted to break into the block and alter a transaction, everyone would know.
The process of finding that verification hash is called “mining”.
The mysterious creator(s) of bitcoin also created blockchain as its platform. The first bitcoins were effectively created out of thin air in the first block, providing start-up liquidity for the bitcoin market. Thereafter, any new bitcoins had to be created by bitcoin mining.
If a miner can successfully verify a block, he/she/they will receive an amount of bitcoins as a reward, and so the pool of bitcoins grows. Each block is restricted to a specific size in digital capacity terms, such that a block could contain only one big transaction or hundreds of little ones. As the pool of bitcoins grows, the reward for successful mining diminishes respectively over time.
Eventually bitcoin will reach the limit set down by the founders and no more bitcoin will be created.
It is a common misconception that mining bitcoin involves solving a complex mathematical problem, such that one day the geeks will indeed inherit the earth. Not so. Mining is simply a process of guessing, and the more guesses you have the more chance of landing on the right hash among trillions increases. Bitcoin can only exist because of the exponential leap in computer capacity and speed over the last couple of decades. Quite simply, your humble home computer just won’t cut it. Mining involves building your own supercomputer.
Or pooling a number of computers together, which is essentially what supercomputers are. Hence miners typically work in teams. They then run the algorithm and using their computing capacity, home in through a zillion attempts to the correct hash.
The bummer is, it’s a first past the post exercise. You may use up the electricity capacity of a small town arriving at the right answer, only to find someone just got in ahead of you.
No bitcoins for you.
The Trust Factor
Bitcoin is a peer-to-peer system. There is no central exchange, no clearing house, no regulatory overseer (yet). It exists only in cyberspace, and no one participant has an advantage over any other. All is transparent.
You’re saying but what about recently listed Coinbase in the US? Isn’t that an exchange?
Yes, but it’s a middle-man exchange between bitcoin and the real world. It’s where you can buy/sell bitcoin and other crypto-currencies in actual hard currency, plus it also provides “fractional trading”, by which bitcoins can be split into smaller increments of a bitcoin to thus be accessible to those who don’t happen to have a cool fifty thousand US.
When we deal in hard currency, or fiat currency as it is known, we typically deal through a bank (or these days, some new fintech). The bank is overseen by a central bank, which is controller of the currency issued by the Treasury. There is no “collateral” for this currency (such as gold), other than the backing of a mature economy and a sound system of rules and regulations.
We simply trust it. We don’t have a choice. We also trust our bank to look after our money, to clear our transactions and to handle our loans. Banks are, of course, the ultimate in trustworthy institutions.
See: Banking Royal Commission.
Atop the trustworthy banking system sits the even more trustworthy central bank. We trust central banks to control the monetary system through policy changes (mostly setting the cash rate that informs all borrowing rates).
But central bankers are only human. How can we trust them to always get it right?
In late 2018, recently appointed Fed chair Jerome Powell announced a rate hike to 2.50% from 2.25% — the fourth such hike post the GFC. Wall Street then experienced the worst Christmas crash on record, with a final capitulation on Christmas Eve.
The Fed subsequently, and infamously, “pivoted”, reversing its policy stance. No – central banks don’t always get it right. In response to the GFC, the ECB first put interest rates up.
Do I need ask whether we always trust our government?
While Australian politicians see a budget surplus as a holy grail, over in the US Congress has been “raising the debt ceiling” for years and years. They never lower it. This is the amount of money the US Treasury generates to pay for fiscal programs via issuing US bonds. There is no way this money will ever be “paid back”. But the US dollar is the world’s reserve currency, so the US borrows (and prints money) because it can.
All the above has over past decades led to a mistrust of fiat currency. Bitcoin was born of this mistrust. All it required was for digital technology and computing power to reach a sufficient level to provide for its existence.
Now there are thousands of crypto-currencies, more than 7800 at the most recent count by Coinbase, each unique.
When bitcoin first started to make its mark, most of the “old world” of finance scoffed. It was just an asset for speculators – gamblers really – and extremely volatile. It was not really an asset at all. If it were a “store of wealth” akin to gold, volatility assured you could lose your wealth in a flash.
It would be a passing fad.
The most respected banker in the US, arguably the world, is JPMorgan Chase CEO Jamie Dimon. He, too, famously dismissed bitcoin after it had just doubled in no time at all to US$20,000.
“My daughter made money out of bitcoin,” he revealed, “now she thinks she’s a genius”. Oh how we all laughed along with him.
On April 27, JPMorgan announced it is preparing to offer its clients an actively managed bitcoin fund, making it the latest, and largest, bank to do so.
And yes, Dimon is still CEO.
We should also note that while crypto-currencies are still being scoffed at by many, blockchain is not. Blockchain is being embraced as a superior ledger system in all sorts of applications worldwide, including by the ASX.
Blockchain is not just about currencies, it can be used for multiple data storage/verification purposes.
The Environmental Factor
For all its potential benefits of crypto-currencies, arguably the biggest drawback is the amount of electricity consumed in the process of crypto mining. The verification process is not made complex for no reason, and as the popularity of bitcoin and other cryptos grows, so does the carbon footprint of crypto mining.
It is projected that on the current crypto growth trajectory, it won’t be long before crypto mining’s annual electricity consumption will exceed Australia’s total annual consumption. That’s a lot of coal-fired power stations.
Exactly the same argument has been made with regard electric vehicles. Put the two together…
Crypto fans offer a counter argument. They suggest crypto is actually good for the environment because it will simply force the construction of renewable energy infrastructure to replace fossil fuels. It's not an argument that has garnered much agreement.
Besides, it’s every countries’ goal to replace fossil fuels (with one exception), but how fast can it happen?
Sometimes it feels like we’re already in it, especially if you are not as young as you used to be.
Crypto fans readily acknowledge the often quite scary volatility of the currency over its brief history, and that many a young and green punter would have been blown away in any one of the frequent sharp pullbacks. But they are confident that the more bitcoin is accepted as a legitimate asset in the wider world (see JPMorgan above), the sooner that volatility will ease.
Bitcoin fans also expect that one day they’ll all be telling their children about bitcoin, and how they used to trade it, prompting gales of laughter and the rolling of eyes. Bitcoin! That’s like so last year!
This article is intended as a lead-in to a series of articles delving further into the world of digital currencies, their future and their impact.
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