Everything about Bitcoin

Bitcoin and crypto has been on the rise in the past few years. Some predict it to be the revolution of modern-day monetary system. Other see it as speculation to the future that will never happen. Most of us don’t know what it is at all. I wanted to deep dive the questions I had to help understand what is bitcoin and how to potentially value it.

History of Currency

  • Currency = Money + Trust
  • In history, money was backed by gold, hence gave it value
  • As we move toward the current day, the relationship between gold and money becomes more disconnected
  • Now rather than money being backed by gold, it’s backed by the government and we trust the government that the money today is worth the same or a little less (inflation) than tomorrow
  • Fiat money: currency that is not backed by a commodity such as gold. Fiat money gives central banks greater control over the economy because they can control how much money is printed
  • Risk today: Money is centralized (control by one party) + Money is not unlimited (risk of inflation)
  • Banks have a ledger of who owns what, so it has a record of truth of your assets

Centralized Money Issues

  • Corruption: Example of Wells Fargo uncovers up to 1.4million fake accounts inflating their revenue stream
  • Mismanagement: Example of Venezuela printed so much money that they have to weigh it instead of counting it
  • Control: Government can cancel the legal status of your currency or have the power to freeze your accounts

Double Spend Problem

  • Double-spending is the risk that a digital currency can be spent twice. It is a potential problem unique to digital currencies because digital information can be reproduced relatively easily by savvy individuals who understand the blockchain network and the computing power necessary to manipulate it
  • Similar to counterfeiting money, it’s the process of manipulating the digital file to create new digital transactions

Bitcoin

  • Transparent ledger without a central authority
  • Can see all the balance and transactions taken place with Bitcoin, just can’t see who owns it, and who is transacting to who
  • Unlike the banks, you only have access to see your own transactions and your own assets
  • No 1 computer controls the system. Every company that’s in the system is also keeping a copy of the ledger, also known as the block chain
  • Bitcoin is digital and no physical asset (no actual coin)

Blockchain

  • Blockchain is an innovative technology to implement decentralization: system for keeping records by everybody, without the need of a centralized authority
  • As an example, if traditional newspaper were the centralize system, blockchain is like Wikipedia where many people contribute to 1 site and is verified by the contributors, not by the Wikipedia website
  • Blockchain elements: Peer to Peer network (network of computers that are equally privileged), Cryptography (secure communication in hostile environment), Consensus Algorithm (agree of how we add a new block to the record – Bitcoin uses proof of work), Punishment and reward

Bitcoin Mining

  • Process of confirming transactions on the block chain
  • First, you can win in the participation of updating the ledger by guessing a random number that solves an equation generated by the system (more powerful the computer, more guesses you can perform)
  • If you guess right, your mining program will determine the block of transaction you will be processing
  • Then after you have processed the transaction, it is sent to the Bitcoin network to validate the transactions and updates its copy of the Bitcoin transaction ledger
  • After the processing is complete, the system will compensate you in bitcoin + transaction fees that you helped processed
  • Mining difficulty: As there are more miners and processing power, the equation gets more difficult. This is to stabilize the currency so that a new block will be added every 10 minutes
  • Miner evolution: CPU mining => GPU mining => FPGA mining => ASIC mining
  • Mining Pools: Combine mining power to compete more effectively, this is to combat professional miners
  • Profitability factor: Hash rate (guesses you can make per second), Block reward (Bitcoin generated per block), Mining difficulty, Electricity cost, Power consumption, Pool Fees (if you are mining through a mining pool), Bitcoin Price, Difficulty increases per year

Bitcoin Wallet

  • Wallet is a program to send and receive bitcoin, store bitcoin and monitor bitcoin balances
  • What defines a wallet is how the private key is stored
  • Private key: long key that acts as a password to your bitcoin wallet. Also used to generate your bitcoin address.
  • Full Nodes Wallet: Holds a full copy of the block chain to validate transactions
  • SPV Wallet (Simple Payment Verification): Faster and less disk space
  • Hot Wallets: Bitcoin that is connected to the internet => Most popular but least secure
  • HD (Hierarchical Deterministic Wallet): use of words and letters used to recreate the private key which is typically extremely long and impossible to remember
  • Multi signature: requires multiple keys to access the private key

Bitcoin vs Ethereum

  • 2 top coins by market cap
  • Both use proof of work consensus algorithms: energy and hardware cost required to secure the block chain (via hashpower)
  • Can both be used for P2P transactions
  • Bitcoin use case: designed to be p2p transfer of value and store of value
  • Ethereum use case: Not designed to be a digital dollar but rather fuel for wide range of transaction => Pay a fee for running code
  • Bitcoin inflation rate is hardcoded in the protocol: Never be more than 21 million Bitcoin in circulation
  • Ether has no max cap, but reduced during large network upgrades

How to Buy Bitcoin

  • Bitcoin exchanges
  • Trading platforms (connect buyer and seller automatically)
  • Brokers

What happens when Bitcoin is fully mined?

  • As of February 24, 2021, 18.638 million bitcoin have been mined, which leaves 2.362 million yet to be introduced into circulation
  • Miners will still be incentivized to process transactions with fees
  • Likelihood that the fees would increase to compensate for the nonexistent block rewards. Question is if the reward is high enough for the miner and the fee is low enough for those transacting with Bitcoin
  • Projected to take more than 100 years before the bitcoin network mines its very last token

How to Value Bitcoin?

  • Network Effect: similar moats to Facebook and Uber and using that can potentially justify the value of Bitcoin today
  • Matcalfe’s law: Value of a network is proportional to the square of the number of connected users of the system (n^2)

Advantages:

  • Core problem Bitcoin is solving is centralization
  • Full control over your money. Only you can access your funds
  • Cut a lot of middlemen from the process of transferring money: Cheaper + faster than wire transfers and money orders
  • Increase in accessibility: Those who are living in underprivileged conditions with no access to a stable currency or a trusted government, Bitcoin can bet the alternative
  • No single point of failure
  • Immutable
  • Censorship resistant
  • Alternative to Gold and Safe Haven asset since it’s uncorrelated to the market

Risks:

  • Volatility (herd mentality, availability for substitution, risk for increase competition, government regulation)
  • Central bank backed digital currencies could derail cryptocurrencies
  • Greater regulation of cryptocurrencies (e.g., China banning of Bitcoin mining)
  • Risk of losing the key (either from forgetting it or easily scammed out of it)
  • Question of regulation for tax purposes
  • No scarcity value – there are thousands of perfect substitutes for Bitcoin (easily switch from BTC to the next best crypto)
  • Unless Bitcoin is widely adopted a currency, huge cost to businesses of converting back and forth from cypto to fiat currency
  • To be valuable, bitcoin needs the foundation of a currency, but is now traded as an investment (“speculative” where those buying is expecting a sucker down the road to buy it off them at a higher price)
  • Centralized energy footprint vs. decentralized: argument that Bitcoin uses a lot of energy to uphold, but arguments are always that it’s a lot less than what the banks and other institutions are using today. The difference is that the large carbon footprint can be easily identified with Bitcoin (the largest miners), vs. split across multiple parts in the value chain of a financial institution

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