Blockchain, Bitcoin, Cryptocurrencies and ICOs – Everything I Wanted To Know

To understand blockchain and cryptocurrencies like Bitcoin, it needs us to understand stocks and markets, currency and it’s working, and a fair amount of technology, not to mention monetary policy. Consequently, very few people truly understand cryptocurrencies and bitcoin. Right now though there’s a feeding frenzy going on. Remember, when adding a .com to your company name increased your market value? Long Island Iced Tea Corp – which actually makes iced tea recently announced that they are changing their name to Blockchain Corp and their stock surged on the news. I started this post a while back and it kept growing. This is now, as the title suggests, everything I wanted to know about blockchain, Bitcoin, cryptocurrencies and ICOs.

What is Blockchain?

How do we know a transaction has been completed? Where do we keep these records? The history of accounting pre-dates the evolution of money – with the advent or writing and numeracy, records were kept way back in the Mesopotanian and Egyptian civilisations, but it was only much later in the 15th century, under the Mediccis that double entry accounting came into being. This dual entry system provided the bulwark of accounting and transaction records for over the next 500 years. The double entry system was reliable but not foolproof – you could go back and change the records and alter the ownership of assets, or erase records of transactions. Also usually the caretaker of financial transactions was the banking system, or another nominated institution. Which was both a blessing and a curse because it created a single point of both ownership and failure. Blockchain is an entirely new way of capturing transactions that goes from double entry to a ‘multiple entry’ system. How do we explain blockchain?

Here are a few excellent explanations of blockchain:

The Economist: a system that lets strangers transact using a dependable ledger

Colin Thompson has a great series explaining blockchain – here’s Part 1

And Part 2, Part 3, and Part 4

And this one from Kaspersky Labs explains Hashing in some detail

And finally from the FT

But if you’d like to skip reading the links, here’s a summary of blockchain in lay terms.

The first thing to remember is that blockchain is a network technology. Networks have certain features and properties which make them measurable, distinct and predictable. The way information travels on the Internet, and the way peer to peer streaming works also work off network capabilities. And just like peer-to-peer was created by Napster for music streaming, blockchain was created by the founders of Bitcoin. Both technologies have a life far beyond these initial cases. Peer-to-peer is used today for money transfers, loans and many other scenarios. Similarly, blockchain is being used for dozens of new and interesting use cases – from land registry to asset management.

How does it work? When a new transaction enters the network, it is added to an existing set of transactions to form a block, which is a predefined number of transactions. Let’s say a set of 5 transactions forms a block. This block has a lot of data including numbers, strings and connections. This set of instructions is then put through a ‘hash’ function which generates a long alphanumeric string. Which looks something like this. “7ae26e64679abd1e66cfe1e9b93a9e85”.

At this point, let’s do a quick exercise. If I give you a simple problem, say (3×4)+(5×6), you will quickly be able to work out the answer – which is 42. Note that we could get to 42 also by adding up all the numbers from 3 to 9, or multiplying 2,3 and 7. In fact the number of ways we can get to 42 (or any answer) is theoretically infinite. Now if I go all Douglas Adams on you and reverse the question – if the answer is 42, what is the question? You would have no way of logically ascertaining the original numbers. You would have to resort to guessing. This is what blockchain mining is about. Blockchain miners have the fiendishly difficult task of guessing a hash which they do by generating millions of options till some node on the network stumbles onto the right answer. The hash function can be tweaked to be harder or easier, which, in a network can define the time it takes to solve one block.

Once the ‘answer’ has been found (remember, verifying is easy, guessing is hard, just like our 42 problem above), a block is committed to the registry, which means that all the nodes in the network now will add this block to their registry of transactions. So the information lives not in a single place but in every computer on the network. This makes it exponentially harder to tamper with since you would have to change the data on every computer on the network, else there would be an immediate mismatch. This method of deriving the answer is done using an algorithm called ‘proof of work’ in the Bitcoin blockchain. As you can see it’s computationally very inefficient – which is one of the criticisms of blockchain. The Etherium network which is another blockchain network is proposing to switch to a different, more efficient algorithm called proof of stake, for this reason. In fact one of the criticisms of blockchain and bitcoin is the amount of energy and computation it uses. A switch to proof of stake will solve this problem.

So we understand the block, but what about the chain? Well, every time a new block is added, it’s added to the history of all previous blocks. And the header hash of of each block goes into the body of the next block and forms a part of the ‘hash’ of the next block. So now if you went back and changed a block, to keep it consistent, you would have to change the previous block and by extension the one before that and the one before that all the way to the first transaction. So not only are the transactions on every computer, they are also linked in a chain through to the first transaction.

This is why the blockchain is considered to be so superior – it relies on the network rather than an individual. And tampering with the transaction is fiendishly difficult because there is no single point of control, it’s near impossible to predict which computer will solve the hash problem, so you can’t hack the transaction itself.

To better understand the science of networks, read Albert-Laszlo Barabasi’s book Linked. And to understand the power and significance of networks, Niall Ferguson’s The Square and the Tower is a great starting point.

A Note on Ethereum

Ethereum is a “decentralised platform that runs smart contracts”, using a custom built blockchain, and accessible by developers across the world to build transaction applications on. It is built and run by Ethereum.org, a Swiss not-for-profit organisation. Note – Ethereum is a blockchain platform, and while it has its own cryptocurrency (Ether) it also allows developers and 3rd parties to create its own cryptocurrencies. You can use Ethereum to create a crowdfunding exercise with your own cryptocurrency, to build and sell an idea, platform or products. Needless to say, this opportunity has been seized by the ‘ICO’ market. More on that later. According to Ethereum, you can also build democratic autonomous organisations or decentralised applications.

Ethereum is the most mature blockchain platform available to developers and organisations across the world. For example, my colleagues have built a working prototype for a smart contract to enable electric vehicles and homeowners to create a market for charging EVs, with the management of contracts and settlement done intelligently in the background. Other use cases include clearing and settlement for banks, financial services firms, and many others.

Let’s talk about Bitcoin

If you’d like to get your head around bitcoin, I would suggest you read the book “History of Money” by Jack Weatherford. Among other things, it traces the evolution Fiat money which doesn’t have any intrinsic value, but is supported by a government decree, or a ‘promise to pay’. So a lot of currency today is already a result of what Yuval Harari calls ‘Intersubjective realities’ – i.e. something that has a meaning only because we collectively agree to the meaning – such as national borders, or the value of paper money. In this sense Bitcoin is just another level of abstraction – you also abstract away the role of a central bank or monetary authority, in favour of a collective, systemic governance, and a pre-fixed money supply (21 million).

Understanding Bitcoin

Many years ago, deep inside the bowels of the hype machine that was Silicon Valley in the late 90s, a few well-known entrepreneurs put together a spoof company. The only product of this make-believe company was its own stock. And the sales pitch went thus: the more you buy our product, the more valuable it gets. So please keep buying. The echoes of that satire have certainly been seen in the bitcoin mania (and by extension, the cryptocurrency craze) that is sweeping the world. The price of bitcoin is bungee jumping on a daily basis, confounding investors, economists and bankers alike.

bitcoin prices

 

At its core, there are 3 sources of confusion with Bitcoin: (1) is it a currency? (2) is it a stock and (3) how to value it? Let’s look at them one at a time.

Bitcoin as currency

Bitcoin is notionally a currency, but it fails a few key features of currencies. First, is not universally accepted at stores without workarounds, and by most creditors (you can’t pay your mortgage with bitcoin). Second, the ‘money supply’ while fixed, is not subject to any visible or discernible monetary policy. And finally, can it be taken seriously when it fluctuates as wildly as it has been? See chart 6 in this link. Stability is one of the key requirements for a currency. You don’t want to go to the market not knowing whether the money in your pocket will be enough for your monthly shopping or just a loaf of bread.

Sometime in the 1980s, the buses in the city of Kolkata printed coupons to solve the problem of change, on buses. Instead of giving coins and change back for tickets, they would give you printed coupons which could be used in lieu of coins on your next bus trips. Commuters accepted these with the odd grumble but got quite used to them. Then cornershops and other vendors started accepting them too and pretty soon, there was a parallel currency system flourishing. The government stepped in and banned the use of these coupons because the volume of these transactions had become significant, and it was creating a system of transactions which could neither be monitored nor controlled. After all, there was nothing stopping somebody from printing a bunch of fake coupons and using them at unsuspecting stores.

With any traditional currency, all the clearing is done by the banking system, for all ‘non-cash’ transactions such as checks, electronic transfers, etc. But no bank is involved in clearing bitcoin transactions. So in this aspect, it resembles cash as an extra-banking way of money, similar to the bus tokens of Kolkata.

The history of currency and payments is a story of layered abstraction. From barter systems to silver and gold coins, through to promissory notes and paper money, and ultimately through ledgers and information. (The book “History of Money” is a fascinating read, by the way). In a sense, cryptocurrencies such as Bitcoin are just the next step in this abstraction stack. What if we replaced ‘government’ with an abstract algorithm to control the amount of money and implement ‘monetary policy’. The problem is that with governments, we know or can ascertain the underlying objectives for the economy and for citizens, whereas with privately controlled cryptocurrency, the motives are opaque. We should, in fact, assume that a private enterprise wants to maximise profits, so in a sense we are playing the game of enabling somebody else’s profitability buy participating in a private cryptocurrency system. This is not by itself bad if the underlying decision making is transparent. After all we willingly participate in ecosystems governed by Uber, Google, or Amazon. But the complete lack of transparency for Bitcoin, is a real challenge.

Imagine what would happen if we all agreed to use black pebbles as currency. If we could magically all agree to value them at (say) £1 each. We would all go out and start gathering black pebbles from beaches, quarries, and wherever we could find them for all we were worth. But of course if we could find black pebbles for a cost that to us was less than £1, we would keep collecting them, and the supply of pebbles as currency would keep going up. If we wanted to buy something worth £10, it would be the effort of collecting 10 black pebbles. Perhaps the pebbles would start trading at a discount if they were really easy to get and people would start trading them in for other coins if they felt that the price might fall, thereby triggering, a sell off. Conversely, if black pebbles turned out to be in short supply, the price would rise to higher than £1. In this world, the value of the currency is connected with its supply and cost. With fiat money though, we have disconnected the cost of the currency from its value.

In the global economy of the 20th century and beyond, money has had to balance increasingly complex requirements of balance of payments, exchange rates and interest rates, acting often as a mirror of the goods and services being traded. There is no interest rate for Bitcoin, there are no balance of payments, and the currency value is driven primarily by speculative activity.

At a very practical level at present one transaction takes on average 10 minutes to conclude, which by itself disqualifies it from everyday purchases. In extreme cases one confirmation has taken up to 16 hours. You don’t want to be waiting with your bitcoin wallet at your coffee shop or your tube station waiting for your transaction to be authorised!

Bitcoin as an Investment Vehicle’

Of course bitcoin isn’t a stock, it’s not listed as a stock on any exchange. Yet, there are Bitcoin futures which have been launched by a number of investment banks, and fundamentally, the behaviours of bitcoin punters are similar to speculating on a stock. One that is fuelled by market rumours and short term spikes, but lacks any kind of underlying economic activity.

Any stock is valued on the basis of future earnings which pay out as dividends. As such Bitcoin doesn’t qualify. There is no interest and no dividends. So there is no future stream of income.

My co-panelist at a recent event pointed out, major banks are looking to set up bitcoin trading desks. Although for Goldman Sachsthis seems to have been an inadvertent step. But even if banks start trading in bitcoin, all it means is that that Bitcoin is similar to other arcane financial instruments and the average punters are likely to burn their fingers given that trading is a zero-sum game.

What Is The Value of Bitcoin?

The economist Robert Shiller says “Real understanding of the economic issues underlying the cryptocurrency is almost nonexistent”, and when a Nobel Prize winning economist can’t figure out the value, calls it ‘exceptionally ambiguous’,  and has to invoke ‘animal spirits’, what chance have the rest of us got?

One of the ways to value any asset is to look at the value of its underlying economic activity – for example, the activity of a firm. Clearly, that is not applicable here. There is no income stream – just pure speculative activity. The attractiveness of Bitcoin is its non-traceability and its popularity stems in no small part from its acceptance and use on the more nefarious parts of the internet – the Silk Road, and for contraband substances, for example, on the darknet.

Yuval Harari talks about our inter-subjective realities – the shared fiction that allows us to operate with conceptual constructs such as countries and currency. In this light, as long as people value bitcoin it has value. It’s a classic self-fulfilling prophecy.

Some people like to compare Bitcoin to gold, as a store of value. After all, they say, Gold is also only notionally valuable – if we stopped desiring it, it would lose value. But gold has specific metallurgical properties – it coruscates and is a malleable material which allows it to be turned into fine jewellery, and it has a history of demand dating back to the start of human history.

Is there a social value to Bitcoin? This is a far more interesting question. Going back to the beginning of this discussion, we said that blockchain is a decentralised and network-based technology. It eliminates the need for central banks and central authorities. In this sense, Bitcoin and other cryptocurrencies can be quite subversive and potentially act as disruptive agents in the face of repressive regimes, governments and act as an extra-national standard of transactions. On the other hand, as a currency that lacks any transparency of monetary policy, it remains a huge risk. The entire premise of bitcoin value is based on the principle of a finite supply. But there are scenarios where the Bitcoin community could fork and create more coins. And what happens if the faceless Satoshi Nakamoto sells his estimated 1 million coins?

In a lot of discussions around Bitcoin and blockchain, there is a tendency and a danger of mixing up the two faces of Bitcoin – as a store of value or an investment vehicle, albeit of a largely speculative nature, it definitely has a cachet, but as a currency for everyday transactions and for smoothening global transaction flows, it’s a different ask altogether, and one that bitcoin is a long way from delivering.

Bitcoin Hacks and Cybercrime

If you’ve followed so far, one of the questions that must have come to your mind is, if blockchain is so secure, how are there so many bitcoin hacks and heists in recent times?

Just to name a few, Coincheck a cryptocurrency exchange in Japan suffered a $530 million hack– for NEM coins, in 2017.

In 2014, Mt Gox, another Bitcoin exchange suffered a $480m hack and filed for bankruptcy.

In 2016, Bitfinex, a Hong Kong based Bitcoin exchange was hacked for $70m.

Here’s a longer list. There are some differences in the technicalities, but the point is that most thefts and hacks occur when the coins are stored in ‘wallets’ which are ready for spending. The point is, you are not hacking a transaction, which is still secure. You are hacking a store of coins. Typically done through copying a user’s cryptographic key which is used to unlock the wallet & transferring the coins to other pseudonymous addresses. Again, while blockchain can track the chain, the pseudonymity prevents actual tracking down of criminals. Further use of ‘tumblers’ or mixers, ensures that the stolen Bitcoin is mixed with others, creating new strings making it near impossible to track.

If you’re on the other side, the primary suggestion is don’t hold your coins in a hot wallet – i.e. one that is connected to the Internet. A cold wallet, by contrast is not connected to the Net, making it impossible for  hackers to access the coins.

And What about ICOs and other Cryptocurrencies?

Ah, this is where we’re in shark territory. At last count there are almost 1400 cryptocurrencies listed in Wikipedia. The first and obvious thing to say about this is that a currency is a standard of value and with standards, less is more. Imagine walking around with dozens of currencies in your pocket and not knowing which currency will be accepted when. Every transaction would be longer and more complex!

There are those who ponder whether governments could issue cryptocurrencies. While technically feasible, you would have to question the motive. As of today, it’s more expensive to manage, does not reach the entire population, and its adoption, use, value, and acceptance are still unclear. Besides, I don’t know of a government that willfully wants to give up control over its currency. Perhaps one for the future.

And what about ICOs? We have an absurd number of them now. Once again, it feels very much like the dotcom bubble. Then, a lot of Indian techies who had spent much time changing their names from Krishnamachari to Chris to fit into American culture were changing it back when it became fashionable to have Indian CIOs while wooing investors. In much the same vein, nobody seems to want to just raise money nowadays, without also attaching an ICO to it. The ICO or initial coin offering implies that the company will raise money to create its own cryptocurrency and investors will get these newly minted coins. The underlying promise is that the company will create an effective market for this currency, which is the difficult bit. In reality, there is no guarantee that these coins will be any use, but FOMO is driving investors in droves to the ICO market. Only 48% were successful last year but that yielded $5.6bn.

There have been ICOs from a very wide range of providers, including former lingerie tycoons, and online poker platforms. Although 90% of ICOs are expected to eventually crash, there are people who believe that future ICOs will be more tightly connected with the activity of the company, in what they call ICO 2.0.

One of the most eagerly anticipated ICOs in 2018 is from Telegram, the messaging app. On the plus side, having an existing network, user base, and value certainly gives Telegram a better shot and platform for making a success of a cryptocurrency. Telegram is looking to launch a new blockchain, potentially challenging Ethereum’s primacy. If Telegram can follow the path created by WeChat and integrate commerce into messaging, via it’s Gram coins, as it suggests, then we may have a winner. However, you do have to decipher terms like ‘Instant Hypercube Routing’ and ‘Byzantine Fault Tolerant’ protocol. Most importantly, it wants to make a million transactions per second. This is far ahead of the Bitcoin speeds we spoke about earlier, and even orders of magnitude faster than Visa and MasterCard, who collectively do 2000 transactions every second. Be warned, Telegram plans to keep 52% of its cryptocurrency – so the value of the currency will be significantly managed by the owners of Telegram.

In Sum

This has turned out to be a much, much longer post than I intended initially, but I think I can summarise my thoughts as follows:

Blockchain: a potentially massive new technology that can change the world, but still in its early stages of development and fine-tuning.

Bitcoin: a great option for speculative investment, but definitely not useful yet, as an alternative currency.

Cryptocurrencies: a minute fraction of them will be useful, finding the right one may be a matter of luck. But in 20 years we could all be using a extra-national cryptocurrency as legal tender.

ICOs – definitely a trap for FOMO investors looking to somehow get into the cryptocurrency game. Most will go nowhere.

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