Demystifying Bitcoin by Sabyasachi Das, FIA, FIAI

Demystifying Bitcoin by Sabyasachi Das, FIA, FIAI

Mr. Sabyasachi Das, a Fellow Actuary, once heard a debate between a Regulator and a Technologist around Bitcoin. While both made perfect sense in their own worlds, he thought there was simply no bridge between the two. While following Bitcoins for a couple of years, he realized that trying to understand Bitcoin in isolation is futile. Mr. Sabya, with this article, takes you to the past to view Bitcoins alongside the concept of money. He is currently heading Valuation of Life & Health Re-insurance at Munich Re India Branch.

Neo – “What are you trying to tell me, that I can trade my Bitcoins for millions someday”

Morpheus – “No Neo, I’m trying to tell you that when you are ready…. You won’t have to”

I could not resist using the above meme not only because it may turn out to quite prescient but also as homage to my all-time favourite movie.

My interest in Bitcoin, and in general crypto currencies was stoked about two years back when I chanced upon a YouTube video titled, “Who Controls all our Money?” by Cold Fusion. It was such a mind bending revelation, that it sucked me into the world of monetary policy, central banking, fiat currencies and in general, money. As I fell deeper into the rabbit hole, I got introduced to crypto currencies, which, at the time, was quite a rage with Bitcoin having scaled its peak valuation in a speculative mania.

But unlike my eye-opening discovery of money, I just could not get my head around the concept of Bitcoin. It was simply incomprehensible, especially when viewed alongside the Blockchain. But I have to admit, I found it extremely fascinating. Hence I kept nibbling at it and watched scores of discussions, ted talks, interviews and videos to gain some understanding. By constantly drumming it into my head I could create a sort of a framework of understanding the concept, but it was not clear to me whether it was genuine knowledge or simply a manifestation of the ‘Stockholm Syndrome’.

Hence these are my musing on how I understand Bitcoin and the technology behind it. I realised that looking at Bitcoin or crypto currencies in isolation is actually futile. I try to understand Bitcoin in conjunction with money. After all if we already have money running the global trade and commerce why do we need another so called ‘digital money’. And don’t we already have ‘digital money’ which flows through online banking and e-commerce. What is the use case for something like Bitcoin which people say, consumes an insane amount of energy just to stay afloat. And yet, why does Bitcoin figure in the top 50 global currencies in terms of market capitalisation, ahead of the national currencies of Pakistan, Bangladesh and even Kuwait.

But before I start, I wish lay down a few statements, all of which are true, and all of which we shall revisit later in this conversation.

“Your Rupee (or Dollar, Pound, Euro) is not backed by Gold. In fact it is not backed by anything tangible”

“Currency is not Money”

“Bitcoin is not Blockchain and vice versa”

So let us start, what is Bitcoin?

Bitcoin is the first working prototype of a decentralised crypto currency, known to mankind. I understand that this makes no sense, but the key takeaway is that Bitcoin is actually a new invention.

Conceptually the definition that works best for me is that Bitcoin is “Digital Gold”.

However more than a description, this seems to be Bitcoin’s mission statement. Whether Bitcoin has achieved its stated ambition, is a subject of many a debates and discussions.

Let us explore further.

‘Digital Gold’? Can someone please remind me what is Gold?

Gold, as we all know, is a shiny yellow metal that occupies the 79th place in the periodic table with a symbol of ‘Au’. It is both rare and one of the least reactive elements occurring naturally. It is said that all the gold ever mined till date still exists in some form or other, and would fit into two Olympic sized pools.

But why would anyone want ‘Digital Gold’? What good is ‘Digital’ Jewellery?

Well we must remember that Gold isn’t valuable because it is used to create jewellery. Gold is valuable because it is money. And ‘Digital Gold’ is a form of ‘Digital Money’

And gold jewellery is a form of wearable money.

So Bitcoin is the same as ‘Digital Rupee’ or ’Digital Dollar’? What is the fuss all about then?

No Rupees and Dollars are currencies, and Currency is not necessarily same as Money. In fact none of the global currencies in the world currently qualify as money.

Really? Then what exactly is Money?

“Money is the probably the most successful story ever told.” – Yuval Noah Harari

Money is quite an abstraction. Anything that is perceived to be of value and can be used for transactions can serve as money. For something to qualify as money, it should firstly be a store of value and should maintain its purchasing power over a long period of time. For that to happen one of the key properties it should have is that it should be scarce and difficult to obtain.

Further money should be a unit of account, i.e. it should enable the measurement of value of goods, services or assets. It should be a medium of exchange and should be portable, durable and divisible. It should also be fungible, i.e. one unit of money should be interchangeable with another identical unit.

Money is a key basic human invention that has powered trade and commerce from the dawn of human civilization. Trade and commerce started with barter and then moved on to exchange of various items that had perceived value (including livestock and even sea shells). But since scarcity is a key attribute of money, things that are available in abundance like pebbles or sand cannot serve as money. Throughout history just Gold and Silver (to a lesser extent) are the only naturally occurring elements that have served as money.

But what was it about gold and silver which led to those two elements becoming money? To answer that question we need to look at the periodic table. If we remove all gasses (which clearly cannot be money), all elements like iron and sodium that can react with water or air or can corrode and all radioactive elements like uranium and plutonium, then that leaves us with just five so-called precious metals, gold, silver, rhodium, platinum and palladium. Neither rhodium nor palladium was discovered until the 18th century, so that rules them out as early money. And the problem with platinum is that its melting point is about 3,000 degrees Celsius, far out of reach of mankind’s earliest furnaces.

Hence all we are left with is gold and silver. And it was these two precious metals, which were eventually adopted as both stores of value and mediums of exchange.

The incredible fact is that Gold (and to a lesser extent Silver) has been a stores of value, a medium of exchange and a thing of beauty simultaneously across ancient civilizations in South America, Egypt, the Indian Subcontinent and China.

This is why perhaps that some refer to gold as ‘God’s Money’.

Gold’s role as money and the universal acceptance of its value enabled mankind to build a vibrant economy that transcended both borders and cultures. It allowed new worlds to be discovered and enabled trade to spread across the globe.

Cut to the present times, Gold’s role as a medium of exchange has certainly diminished since currencies like the Rupee or Dollar are used for almost all transactions. However the value proposition of Gold remains intact and is even firmly engrained into many cultures, including ours.

And although some describe Gold as a relic of the past, Gold’s value in the world today is not just due to nostalgia or cultural significance. Every nation preserves its wealth in Gold. The US has 8,000 tons, IMF 3,000 tons. Russia has tripled its gold reserves in the last 10 years. And China has been on a buying spree even after having the largest mining production in the world, with zero exports.

The value of currency used to be tied to gold, i.e. a currency note like a Rupee or Dollar was a claim to gold. An analogy that is often used is that of a valet receipt. It is a claim to your car, but not your car. One could, in theory, go to the bank and exchange a currency note for a predetermined quantity of gold. This is what gave currency its value and enabled its use as a medium of exchange. Depending on the issuer of the currency, users developed trust in that currency. Staying with our analogy, the valet receipt could be exchanged for your car.

However since 1971, when the dollar’s convertibility to Gold was suspended by President Richard Nixon, Dollar and all other world currencies were delinked from Gold and became ‘fiat’ currencies. The word “fiat” comes from Latin and is often translated as the decree, ‘it shall be’ or ‘let it be done’. So essentially, post 1971, Dollar has value because the government of the United States of America said so, and is backed only by the trust people have in the government. Every other currency in the world is now expressed in terms of the dollar and hence is also a ‘fiat’ currency.

So now extending our analogy further, a fiat currency is akin to saying that the valet receipt now IS your car!! In short, currency is not equivalent to money. One may still argue that as long as there is limited amount of currency, and it is backed by the faith of its users, it can still function as money (just like gold). Absolutely true, but, unlike Gold, which is physically limited in supply and cannot be replicated, currency notes can be replicated in the printing press. But one may argue further that as long as countries do not print currency at will, it may still serve as money. True again, however over the past decades there has been no limits on the creation of new currencies ‘out of thin air’ by all governments in the world. ‘Quantitative Easing (QE)’ seems to be the magic bullet used by most central banks to wriggle out of any financial crisis with the latest iteration being the ‘QE Infinity’ announced by the Fed in its battle against the looming financial crisis in 2020.

And due to the way this monetary system works, this unhinged currency creation disproportionately benefits the financial economy (equity and other investment markets) over the real economy (ordinary people, small businesses etc). This has directly resulted in an ever widening wealth gap between the rich and poor.

Wait a sec, we started with Bitcoin. Why this rant on Gold and ‘Fiat’ currency? Again what did you say Bitcoin was?

Ok, just one more point. It was this largess of governments and central banks that led to the genesis of Bitcoin immediately after the Great Financial Crisis of 2008. The founders of Bitcoin wanted to create digital Money that is free from government intervention and manipulation.

In short, Bitcoin is the digital manifestation of Gold, or ‘Digital Gold’.

Bitcoin was conceptualised by an anonymous person or group of people who go by the name of Satoshi Nakamoto. He/She/They published the ‘Bitcoin White Paper’ in 2008. It was a relatively small nine page document that laid down the foundation of a ‘Peer to Peer Electronic Cash System’. Bitcoin was conceived to be digital cash that did not require trust in a third party and whose supply could not be manipulated by any other party. This idea very quickly mushroomed into an open source global project which eventually led to the development of the Blockchain, Bitcoin and other crypto currencies.

At the time of writing this article, in a span of about 12 years since the ‘Bitcoin White Paper’ was published, there are about 3000 crypto currencies in the world with a total market capitalisation of $265bn. Of that Bitcoin is the most widely used crypto with a total market capitalisation of about $180bn.

That sounds impressive, but can you explain further?

Bitcoin is digital currency and is modelled on Gold. In general, all digital currencies like Bitcoin are called crypto currency or cryptos. This is because these are digital currencies backed by different types of cryptography algorithms. Bitcoin is decentralised, i.e. there is no central body like a bank that issues Bitcoins, and is managed on a peer-to-peer network. 

But we will not go deep into technical details right now. Instead let us focus on Bitcoin on a slightly macro level.

Bitcoin has all the features of a currency in that it is a unit of account, a medium of exchange, and given that it exists in the digital realm, it is obviously portable, durable, divisible and fungible.

In addition, Bitcoin is also scarce. In fact it is first digital scarce asset ever created. Arguably this is its most important property. Bitcoin’s future supply follows a predicable schedule and there can only be a total of 21million Bitcoins ever in existence. These limitations on the supply of Bitcoin set in stone within its core design. This is inspired by Gold. Gold itself is limited in quantity, and while there is no hard stop on the mining of gold, it increases in supply at an average rate of just about 2% p.a.

Objectively, Bitcoin as a currency is better than gold in most respects. In fact it almost appears as if Satoshi Nakamoto took all the monetary properties of Gold, supercharged them and put them into Bitcoin. However when it comes to the value proposition, it is where things get a bit contentious. Some say that Bitcoin has value due to the amount of resources that go into it (more on that later). Some say value is derived from its scarcity while others point at the network effect, i.e. as more people use Bitcoin greater is its perceived utility and hence value. And equally vociferous are those on the other side of the fence, who rubbish Bitcoin, calling it a Ponzi scheme.

I feel it would help to anchor back to Gold and understand where the value of Gold is derived from. In my opinion Gold gets its value from the trust that people have endowed upon it over centuries. Bitcoin is objectively a good currency, but it would take long for it to gain similar levels of trust.

In the meanwhile Bitcoin’s value is derived from speculation over its future. Markets are forward pricing mechanisms and Bitcoin’s value represents its potential to generate value in the future.

Some argue that Bitcoin’s value is due to irrational market behaviour and compare the Bitcoin market to the Tulip mania during the 17th century. It’s rapid ascend in price during 2017 did resemble a market mania but one cannot ignore the fact that Bitcoin has survived for 12 years and has found value in a free market without any central authority having forced its acceptance.

So I believe that while it is too premature to bestow upon Bitcoin the status of ‘Digital Gold’. We should recognise that it is a unique invention that has gained acceptance, unaided and in a free market. It certainly does not deserve to be brushed aside.  

How can money be digital without a Bank being in control. Why can’t I just copy-paste my Bitcoins and make myself a millionaire?

Good point. And this is exactly where the Blockchain comes in. Think of the Blockchain as a ‘trust machine’ powering Bitcoin. It basically ensures that each Bitcoin in existence is unique and is owned by one user only. It basically overcomes the ‘double spend problem’ of digital assets, i.e. a user cannot use the same unit of Bitcoin for two different transactions.

At it’s core, the Blockchain is simply a ledger. It contains the ownership record of every unit of Bitcoin in existence. When a transaction occurs, the ownership of that particular unit of Bitcoin is changed from the person who paid for the transaction to the person receiving it. This is exactly how, in the physical world, every authority like a registrar or a bank, maintains records of ownership, whether of property or currency.

What makes the Blockchain unique, is that it is completely decentralised i.e. there is no central authority like a bank establishing trust that every record on the ledger is correct, and is extremely secure (every record on the ledger is permanent and immutable). We will revisit this later.

The Blockchain works on some pretty intricate mathematics and uses consensus algorithm for verification and something called the proof of work protocol. These theories have been around for a while but Bitcoin and Blockchain were the first working prototype of a decentralised system ever created.

People who maintain the Blockchain trust machine are called miners. They basically ensure that this engine runs 24×7 so that bitcoins can be transacted at any time, just like cash. Broadly based on the resources that the miners have deployed, they are rewarded with new issuances of Bitcoins. The terms ‘miners’ and ‘mining’ is a throwback to the actual miners of gold who dug out ‘new’ gold from the ground.

Hmm this is interesting…tell me more!

“Be careful what you wish for..” – Aesop’s Fables (and Clint Eastwood!)

Before we start, bear in mind that veering towards the working of the Blockchain is actually a bit of a distraction in understanding Bitcoin. As an analogy, you do not have to master Einstein’s General Theory of Relativity just to understand what GPS is and how to use it.

Oh by the way, as a side note, the General Theory of Relativity somehow also explains Gold’s yellow colour and its resistance to corrosion, but I digress!!

I will still not get into the technical details and attempt to explain Blockchain in broader terms.

DLT or ‘Distributed Ledger Technology’ is the backbone of the crypto eco system and Blockchain is a version of a decentralised DLT.

We discussed briefly what a ledger was. Think of it as a book containing details of all transactions, “who transferred how much money to whom and when”. This ledger is at the core of any currency system and maintaining it accurately in the digital realm is the key to overcoming the ‘double spend problem’ of digital assets. 

In the traditional currency system there in one central authority, say the bank, which is responsible for maintaining the ledger. Now imagine, if, instead of having a single ledger, there are say 10 copies of the same ledger and they are distributed across different locations. A change in ownership happens only when all the 10 ledgers are updated and are exact replicas of each other. This is the distributed ledger system. This structure adds an additional layer of security as it is much more difficult for an insidious element to change all 10 copies of the ledger rather than changing just one ledger.

In the digital world these 10 locations would be ten different computers or nodes of a network. These computers have the job of maintaining an exact replica of the distributed ledger and have to update the ledger whenever a transaction is to be recorded. To gain full consensus, or agree that they have the correct version of the ledger, they depend on the central authority who instructs them on the changes to be made to the distributed ledger. This is an example of a centralised distributed ledger. Such a system is fairly straightforward to code. In such a system however, the central authority is also the central point of risk and failure.

Now let us remove this central authority. What we get then is a decentralised distributed ledger system. Every node is now independent. In theory the network is even more secure than the centralised system as there is no central authority to hack into. As the number of nodes increase the security of the system becomes even more robust. However in the absence of a central authority, how do the nodes come to a consensus on the transactions to be updated?

This problem actually has a name. It is known as the Byzantine General’s Problem – How do you make absolutely sure that multiple entities that are separated by distance are in absolute full agreement before an action is taken. In other words how can individual parties find a way to guarantee full consensus. Until now this has been unsolvable. And at its core it is about individual parties being able to trust each other directly.

Satoshi Nakamoto’s invention of Blockchain is the first decentralised distributed ledger system that solves this problem. It is an open peer-to-peer network with no owners or controlling authority. Anyone can sign up to run a node in the network, or in other words become a miner. Miners have the job to verifying the transactions so that there is no ‘double spending’ of Bitcoins, and then updating the Blockchain with these transactions. They are paid in newly created Bitcoins for the role that they carry out. Blockchain manages consensus through a system of incentives. It incentivises miners to act in the best interests of the network and makes it really difficult for an individual miner or a group of minors to hack the Blockchain, while making it really easy for others to detect a hack.

Let us take a closer look at how Blockchain works.

Whenever any transaction of Bitcoin is carried out, it first lands into a pool of unverified transactions.  

Miners are assigned a bunch of transactions at random to verify. The verification itself is fairly simple and uses a consensus algorithm. Basically it is something like a voting system, and for a transaction to go through a majority of miners have to agree that it is valid. 

Once verified, transactions are grouped into a block to be added to the Blockchain. The Blockchain is basically a ledger where each block is a page of verified transactions. The miner who successfully adds or chains his block to the Blockchain is rewarded the ‘Block Reward’ or freshly created or ‘mined’ Bitcoins. At this stage all other miners have to discard their blocks back into the unverified pool and have to update their copy of the Blockchain to replicate that of the winning miner. This way all the nodes of the distributed network are in full consensus. After this the process starts all over again and newer blocks get added to the Blockchain.

In the extremely rare event that more than one miner add their block to the blockchain at exactly the same time, the blockchain branches out or ‘forks’. It is a tie between the miners which is broken at the next step when a new block is added. Whichever fork the new block gets added to remains while the other fork gets discarded and all its transactions go back to the unverified pool.

Once transactions are updated on the Blockchain, they become permanently recorded and are immutable. It is nearly impossible for a transaction on the Blockchain to be modified. Also the entire ownership history of every unit of Bitcoin in existence is available to anyone who cares to look at it.

The interesting bit in this process is that in order to add a block, miners have to compete to solve a mathematical puzzle. Whoever solves this first wins the right to add a new block to the Blockchain and earn the Block Reward. This is the bit that makes the least intuitive sense in this whole process. The puzzle is really hard and miners have to expend a lot of computing power and energy to attempt solving it. This is the reason why mining Bitcoins is such an energy intensive process.

Interestingly this math puzzle has nothing to do with verification process of the transactions. The only purpose it serves is to ensure that the miner has to really work hard to earn the block reward for adding the next block to the Blockchain. This is actually a core innovation of the Bitcoin protocol. It acts as a sort of a speed governor so that the Blockchain operates at an optimum speed in order to maintain the stability of the system. It ensures that that Bitcoins are created or mined at a predictable rate. And it plays a pivotal role in incentivising miners to use their efforts to maintain the Blockchain rather than to hack it. This ensures the security of the network.

Before we move further let us take a step back and remember that Satoshi Nakamoto modelled Bitcoin on Gold which has a limited supply. Subsequent discovery of a scarce asset can be expected to slow down exponentially, after the initial discovery phase. This phenomenon has been replicated in the way the Block Reward functions.

In the Bitcoin protocol, a new block is added to the Blockchain every 10 minutes on an average. This is called the Block Time. As a consequence, new Bitcoins are generated every 10 minutes, via the block reward. When Bitcoin was launched the block reward was 50 Bitcoins. i.e. the supply of new Bitcoins was about 72,000 a day. The block reward reduces by half after every 210,000 blocks which takes approximately 4 years. When it started in 2008, the block reward was 50, in 2012 that reduced to 25, 12.5 in 2016, 6.25 in 2020 and so on. The 2020 Bitcoin halving is expected sometime in mid-May 2020, i.e. after this date the Block reward reduces to 6.25 or in other words, new Bitcoin supply will reduce to 9000 per day. If you do the maths, this progression adds up to the maximum 21m Bitcoin that can ever be produced. This is a defining attribute of Bitcoin. It has absolute scarcity and its supply is predictable. Bitcoin cannot be inflated away and is objectively even scarcer than Gold. 

The math puzzle, acts likes the pendulum in a mechanical clock and ensures that the Block Time is maintained at 10 minutes on average. Thus It ensures that the supply of new Bitcoin follow the intended schedule. The Bitcoin protocol uses something called a difficulty adjustment to the puzzle to ensure that the clock keeps ticking steadily irrespective of how much computing power the mining network throws at the puzzle. More the power, greater is the difficulty of the puzzle resulting in the same average time to solve it.

To draw an analogy in real life, initially when only a few people are involved in mining, it is relatively easy to mine but gets progressively difficult as more miners get involved and the asset being mined becomes harder to find. Over time it is expected that this ecosystem reaches equilibrium where the marginal cost of mining equals the marginal benefits. But there is an interesting difference. Hypothetically speaking, if every resource in the world was directed towards mining an asset, its supply is bound to increase. However with Bitcoin, neither the absolute quantity nor the rate of new production would change. The increased mining activity will only serve to make it more secure. Bitcoin is the hardest money known to mankind.

The math puzzle makes miners work hard to earn their Bitcoin. This is a version of the “Proof-of-work” protocol that has been around since a couple of decades. This also keeps the network safe from hacking because to do so, hackers would require an enormous amount of resources. In order to alter any particular block a hacker would have to solve the puzzle for that block and for all the blocks added subsequently. Also the Bitcoin protocol is designed in a way that it is very easy for other miners to detect any such changes to the Blockchain and reject them. Hence the hackers would need the control of a majority of the miners and immense resources to carry out an attack. The Bitcoin protocol basically incentivises miners handsomely to use their resources in the best interests of the network, and makes it really hard for them to do otherwise. Also since the minors are paid in Bitcoin their interests are aligned with that of the Bitcoin network.

The puzzle, in summary, is the keystone of the Bitcoin protocol.

One interesting perspective that I have also heard is that Bitcoin derives its value from the difficulty in mining it. There is no valuable asset in the world that is easy to find.

To wrap up, I would like to quote from Saifedean Ammous’ book ‘The Bitcoin Standard’;

“Bitcoin can be understood as a spontaneously emergent and autonomous firm which provides a new form of money and a new payments network. There is no management or corporate structure to this firm, as all decisions are automated and pre-programmed. Volunteer coders in an open source project can present changes and improvements to the code, but it is up to the users to choose to adopt them or not. The value proposition of this firm is that money supply is completely inelastic in response to increased demand and price, instead increased demand just leads to a safer network.”

Why oh why did I not take the blue pill?

I think I get it that Bitcoin is digital money. But how is it different from online banking?

Online banking has two components to it, the online payment system and the currency that is used for the transaction. So a rupee can be transferred from one account to another digitally using the online payment system (BHIM, Google Pay, Paytm etc), The payment system is typically a third party intermediary who would provide this service for a fee. crypto currencies are a currency and a payment system rolled into one. In a Crypto currency, the trust machine supporting the currency is also the payment system and hence eliminates the need of a third party intermediary.

So imagine a scenario where a payment system like Visa or Paypal gets hacked and has to be shut down (temporarily!). This would hamper online transactions that use the payment system. Or let us imagine that a bank suspends its operations and all withdrawals are restricted. Here clearly online banking ceases to work. However crypto currencies work like cash and are not dependent on an intermediary. As long as you have access to the internet you can carry out a transaction.

Another key difference is the unit of exchange itself, the Rupee vs the Crypto. Each unit of the crypto currency is unique and is tracked individually. When you transfer some crypto, the ownership of those units of crypto is transferred from you to the recipient. The trust machine stores an immutable record of ownership of every unit of unit of the crypto currency in existence. In the traditional currency system, while there is a similar system that records ownership and transaction of money, there is no way to track every unit of rupee.

Now this may sound like overkill, why should I want to track every unit of rupee? What purpose it serve? Right now the most significant implication is that a rupee note can be counterfeited while a unit of crypto simply cannot.

However this is not the key usage of this interesting feature. Think of programmable money, yes that is real star-wars stuff but bear with me. For now just imagine if you could attach certain attributes to money. What if we could program units of money so that it cannot be spent on illegal drugs or weapons? Could money be restricted only for providing relief to the agriculture sector? 

While this functionality does not exist in Bitcoin, the technology to create such a crypto very much exists. If the aforementioned objectives were to be achieved using traditional currency, intermediaries like banks, administrative services, enforcement agencies etc would have to be involved along with their inevitable inefficiencies and leakages.

This is a very important distinction between crypto currencies and traditional currency systems. It is very important for people to understand this distinction because whoever or whichever entity has the right to program money is being bestowed upon with a lot of power. It is important that people understand the implications before letting it happen.

How do I use Bitcoin?

To understand how Bitcoin works in practice let us draw an analogy with cash.

Bitcoin uses a public/private key encryption to create something akin to a swiss bank account, where the identity of the user is not recorded with the bank and a password is used to control the fund.

Bitcoin is just like cash, in the sense that it belongs to whoever holds it physically (digitally in case of Bitcoin).

Just like cash is stored in a physical place (a drawer, a wallet or a safe), Bitcoin can be stored at a digital address (wallet or account if you will). Each address has a public/private key that allows the Bitcoin owner to use them.

Both the public and private keys are in the form of an alphanumeric string or a scan-able QR code. In order to receive the Bitcoins a person just needs to provide his public key. Knowledge of the public key allows others only to deposit bitcoins into that address (wallet). It gives away absolutely no other information. You could broadcast your public key to the entire world and still have your money absolutely secure (if anything, other may just add some to it).

If however you need to transfer your Bitcoins another address or wallet you need to use your private key. The private keys is basically the access to your funds. If you lose your private key you lose your money. And this is very important to understand.

It is exactly like losing cash or leaving your wallet in a public place. You may recover it if a good Samaritan decides to trace you down and return it. However with Bitcoin, if you lose your private key, your money is lost forever, unless you manage to retrieve your private key. Anyone who has your private key can withdraw your money with it.

Also if you inadvertently send Bitcoins to a wrong address then there is no way you can reverse the transaction. There is simply no intermediary involved who could do this for you. Also since construct of the Blockchain guarantees full anonymity, there is no way you could find out the identity of the recipient just by knowing the public key.

Bitcoin gives you complete control over your money without any intermediaries. Hence nobody can confiscate your bitcoins or restrict your access to it. But that also means that you are fully responsible for its security. Lose your private key and you would lose your funds without any recourse.

That sounds scary…seems like there are many ways to lose Bitcoins.

As I said, security of your money is completely your responsibility. But it is a matter of getting used to using Bitcoin. There are several software and hardware wallets where you could store Bitcoins. You could have multiple levels of security on them so that they cannot be hacked. All these wallets also have backup options so that in case you inadvertently lose your physical wallet or delete your software wallet, you could restore it from the backup. Also you could actually even just take your Bitcoins offline.

Compared to cash or bank balance, Bitcoins are actually more secure but takes a bit getting used to.

I think I understand Bitcoin, but practically speaking, the Rupee (or any ‘fiat’ currency) works perfectly in both its physical and digital forms. Why would I want to use Bitcoin?

That is a good question and for the longest time this is the question I have personally been grappling with.

Let us carry out a thought experiment.

At the time of this discussion, we are in a lockdown in the midst of the COVID19 pandemic. Economy is in doldrums and unemployment is rampant. The Government decides carry out quantitative easing, i.e. print money and give it to the banks for lending out, in order to stimulate the economy. Remember that there is nothing really stopping the governments from doing this. However, this action fails because the banks are not able to lend out quickly and efficiently enough and to some extent they don’t want to because they fear high defaults. The government decides the only way out is to print more money and hand it over directly to the people; ‘helicopter money’ as it is known nowadays. To make a real difference, the government decides that one round is not enough and follows this up with a couple more rounds of ‘helicopter money’. Suddenly the amount of money chasing the same goods and services increases many times over leading to price inflation. It starts slowly with a minor increase in food prices but soon becomes a tsunami engulfing the entire economy. Basically the value of the Rupee plummets and rapidly loses purchasing power. The only way to preserve wealth is by exchanging it for gold or other real assets. But that is also very difficult to do so quickly. Everyone wants to withdraw their saving from the banks as the longer they retain it, more value they lose. This causes a run of the banks and to protect themselves the banks restrict withdrawals. People have no access to their own money, at the time it is rapidly depleting in value. Civil unrest follows and all you want to do is grab whatever little gold and the possessions you have and escape the country with your family. But carrying physical gold in such a situation is fraught with risk.

Now imagine, in this situation, if you have access to an alternate system of money that is outside of the financial system, cannot be shut down and is accessible 24×7. Also, unlike the Rupee, it is limited in supply and hence retains its purchasing power, much like gold but a lot more efficient in terms of usage. Liquidity and Portability are attributes that normally don’t matter, until they do.

While this scenario might be a bit of a stretch, it is not uncommon in the world we live in. In many countries with failing financial and banking systems, like Venezuela, Argentina, Syria, Lebanon and some African countries, Bitcoin offers a level of financial security and freedom that was previously offered only by gold. It could offer a real exit strategy.

And it is not only under such grim scenarios that Bitcoin can be useful. Bitcoin has emerged to become one of the key modes of remittance into Sub-Saharan Africa. It is actually viable alternative to the traditional financial systems, which can charge up to 10% as remittance fees. For a migrant worker that is more than a month’s savings.

Bitcoin offers an alternative payment option to carry out economic activities for millions of unbanked people in the world. MasterCard, in a 2017 study had estimated that there are about 600m people in the developing world that have access to the internet but do not have access to traditional banking services.

Many in the finance and technology world believe that the Blockchain powering bitcoin would one day be ubiquitous and buying Bitcoins might be a good a good way to invest in the future.

However there is no denying the fact that the number one reason why people hold it currently is speculation. As Bitcoin is still finding its place in the financial world, its value has been extremely volatile, leading to speculative positions. However, this, if anything, would lead to mass adoption of Bitcoin.

Also if, due to devaluation of global currencies, people start using Bitcoins amongst themselves, it could potentially become a democratised monetary standard or people’s money rather than government money, a sort of a bottom up development rather than a top down one.

Hmm….. Looks like Bitcoin then is the future of money

Well this is another difficult discussion. Let us first look at the facts

  • Bitcoin is the first digital object ever that is verifiably scarce and cannot be replicated infinitely.
  • Bitcoin is the first example known to mankind of a liquid commodity that has absolute scarcity. Until the invention of Bitcoin scarcity was always relative, never absolute.
  • It is also the first working example of a currency and payment system that is fully decentralised and does not depend on any third party intermediary.
  • What started as an open sourced proof of concept project, has, in just 12 years, become a fully decentralised global currency and payment network, with a market capitalisation of about $180bn or about 68% of the entire crypto market. It is relatively miniscule though, when compared to Gold (about $9tr).
  • Bitcoin has inspired the development of many new crypto currencies. Some are basically copies of Bitcoin, while others are based on newer platforms and have different functionalities. The top 5 currencies by market cap are, Bitcoin, Ethereum, XRP, Tether and Bitcoin cash with a total market cap of $220bn or 83% of the entire crypto market.
  • Crypto currencies can be designed to have very different properties from Bitcoin. The supply of new cryptos could be flexible, it need not be fully decentralised, Block times could be much lesser and there need not be any anonymity in the network. They could even work on consensus protocols which are completely different from Bitcoin’s. The point to note is that Bitcoin is just one type of crypto currency, and there can be others which are very different from it.
  • Bitcoin is an application of the Blockchain. However Blockchain, and in general DLT can be used in various applications for remittance, banking, registrar, personal identity management, insurance, logistics, finance, healthcare, Internet of Things, online gaming etc. There are many companies, both established and start-ups that are focused on innovating products and services around DLT.
  • Having said that, Blockchain has also become a buzzword and has been used to attract instant attention. At the height of the Bitcoin bubble in 2017, just adding ‘Blockchain’ to the name of your company could get you a better valuation! Blockchain is not the panacea for all ailments.
  • Bitcoin as a currency has been recognised as legal tender in some countries like Japan.
  • Countries like China, Russia, Iran, Turkey amongst others are believed to be working on developing their own state sovereign crypto currency.
  • Mining Bitcoin is extremely energy intensive. This is one of the biggest criticisms of Bitcoin.
  • Bitcoin is also extremely inefficient as a payment system. Bitcoin’s throughput, or transactions processed per second, is just 7 compared to Visa’s 24,000. Objectively Bitcoin is not even in the same planet as Visa when it comes to efficiency. That said, there are many ongoing projects to improve Bitcoin’s throughput.

The future of Bitcoin is a controversial topic and has invoked deeply polarised opinions. The narrative ranges from Bitcoin being the last bastion of liberty and freedom (Libertarian Bitcoiners obviously) to Bitcoin being a toy (some Regulators that I have personally heard).

Paul Tudor Jones, the legendary investor described Bitcoin as the fastest horse in the price inflation race and has invested in it as a hedge against inflation. Raoul Pal, another Wall Street insider and CEO of Real Vision, calls Bitcoin as the greatest asymmetric investment opportunity ever and likens it to a call option on the future financial system. Warren Buffet, on the other hand, believes that cryptos have no intrinsic value as they produce nothing. Jim Rickards and Nouriel Roubini, both well known economists and authors, dismiss Bitcoins as being overhyped and serving no purpose other than for gambling and criminal activities. In short the jury is out there on the future of Bitcoin.

Erik Townsend, a serial entrepreneur, former software professional and author of the book “Beyond Blockchain”, hails Bitcoin for being an invention as significant as the aeroplane. But he believes that its place in the future would be in a museum. He believes that crypto currencies are here to stay but Bitcoin would probably be superseded by a better, more efficient version, like any beta version software. He further goes on to say that private, non-sovereign crypto currencies may not be allowed to exist at all and would give way to sovereign cryptos and other concepts like a basket of sovereign crypto currencies (e-SDRs or even Facebook’s Libra). 

There is also the debate that Bitcoin is deflationary in nature and hence cannot be used as a currency. The argument goes that as GDP of a country grows; it requires an increasing money supply to function. Gold grows by about 2% per year which is roughly equivalent to the increase in human population. And there is no limit to the growth in ‘Fiat’ currencies. But this is debated on both sides. Some say that it is not a matter quantity, but that of price or value.

Personally, I have been swinging wildly in my views on Bitcoin (my views have varied even over the duration of writing this article). When I first began exploring, it was a bit of a novelty and admittedly a very good speculative bet, a ‘get rich quick’ scheme. But with time, its appeal as a censorship resistant hard currency began to grow on me. But that soon gave way to scepticism on its future survival. Why would a government allow it to grow at the first place? It could die at the flick of a switch. But as I delved deeper I have come to realise that the only way to shut it down physically would be to either destroy the internet or to switch off electricity completely. And apart from an extreme black swan event like the Carrington Event of 1859, both are nearly impossible. The only realistic way that Bitcoin could die is if people simply lose faith and stop using it. It would then automatically starve to death. And in my opinion the longer it survives the more improbable that gets.

The more I think about it the more I get convinced that Bitcoin was never meant to be a payment or currency system. It was always meant to be digital gold. Limited predictable supply, clunky, not terribly efficient, difficult to mine, but extremely robust, secure and private and conceived with the vision that someday it might also become a store of value. The built in inefficiencies almost guarantee that Bitcoin would never succeed as a mainstream currency. Hence, figuratively speaking, it would probably continue to fly below the radar, and governments would continue to view it as nothing more than a novelty, a toy, until it is too late for them to do anything about it.

I agree with Eric Townsend when he says that governments would never allow a private crypto currency to gain too much prominence. A case to this view would be that of Facebook’s Libra. When it was announced in 2019, it went down like a lead balloon with the regulators around the world. Of course the fact that Facebook has not exactly been a pole bearer for privacy rights played its role. But governments are unlikely to let go of the power that control over money gives them. Instead they are more likely to adopt the underlying technology to develop their own sovereign crypto currency. Providers of this technology, like say Facebook or Hadera Hashgraph, would become the next corporate super powers of the world. And this technology might spawn a completely new field of specialisation, like we have seen in the past with the growth of the Wall Street, Silicon Valley, Surveillance Capitalism and Artificial Intelligence. Existing legacy systems and institutions like banks, clearing houses, stock markets, registrars, insurance, finance, logistics, healthcare etc may either get disrupted or evolve to thrive in this new environment.

This technology has the potential to enable governments to manage their economy efficiently with surgical precision and minimise leakages and frictional costs. Left untethered however, sovereign crypto currency can potentially also allow governments absolute control over people’s finances and hence their lives. It is therefore critical that common people understand the ramifications of this technology and have educated discussions around personal freedom and privacy in the realm of digital finance.

In all this however, nobody can really tell with any degree of certainty what the future of Bitcoin will be.

My gut feel is that it will, over time, achieve it’s goal of becoming digital gold. History has proved that there is always room for a free, censorship resistant hard money like gold and this status may one day extend to Bitcoin. Of course, there is always the possibility that it becomes obsolete and disappears but on the flip side, some argue that Bitcoin might even become another reserve currency along with gold! 

As a parting thought I would like to quote Nassim Nicholas Taleb, in his foreword to Saifedean Ammous’ book “The Bitcoin Standard”,

“..Bitcoin is an excellent idea not because it is a crypto currency, but precisely because it has no owner, no authority that can decide on its fate. It is owned by the crowd, is users. And now has a track record of several years, enough for it to be an animal in its own right.” He further goes on, “Finally Bitcoin will go through hiccups. It may fail; but it will be easily reinvented as we now know how it works. In its present state, it may not be convenient for transactions… It may be too volatile to be a currency for now. But its mere existence is an insurance policy that will remind governments that the last object that the establishment could control, namely currency, is no longer their monopoly. This gives us, the crowd, an insurance policy against an Orwellian future”

Given the wide ranging implications that Bitcoin and in general crypto currencies and their underlying technology is likely to have on our future, It would serve us well to understand this space with an open mind and remain fallible. 

The article was written and published by Sabyasachi Das, FIA, FIAI on his LinkedIn and has been posted here with proper permissions.

References

ColdFusion, YouTube Channel by Dagogo Altraide

Hidden Secrets of Money, YouTube video series by Mike Maloney

Aantonop, YouTube channel by Andreas Antonopoulos

Beyond Blockchain – Erik Townsend

The Bitcoin Standard – Saifedeen Ammous

RealVision.com

Bitcoin: A Peer-to-Peer Electronic Cash System – Satoshi Nakamoto

Various Interviews, Ted Talks, presentations by Grant Williams, Jim Rogers, James Grant, Raoul Pal, Anthony Pompliano, Dan Morehead, Leemon Baired, Michael Casey, Chamath Palihapitiya and many many more.

Sabyasachi Das, FIA, FIAI
Actuary | Head of Valuations | Life & Health Re-insurance | South Asia

    1 Comment

  1. Avatar
    December 14, 2020
    Reply

    Absolutely insightful. Thank You for sharing!

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