In today’s Exponential Investor:
- How to understand the technology behind bitcoin
- What makes blockchain so special
- Why bitcoin’s structure contributes to price rises
Have you ever wondered why we now have printed notes? And why we had coins before that?
You certainly wondered why the government keeps bloody changing the notes to these crappy plastic things – not that so many people use cash much any more, but still.
The reason is technology. Because the capability has emerged to make the form of money better.
The new notes may be crap in many ways, and at first they didn’t even feel real, because we weren’t used to them.
But they last longer, they’re waterproof, etc, etc.
Card payments and online banking are another example.
Why bother taking cash out of my bank to give it to you to put in your bank, when with a simple flick of the wrist I can tell mine to transfer it to your account – saving everyone the hassle.
The point is that technology has always underpinned changes in the form of money.
And now there is a new one.
From shells to clay pots to gold and silver to coins to notes to cards, it is improvements in technology which have allowed money to develop.
And with bitcoin, the same is true.
As I explained yesterday, I like to think of bitcoin as a Holy Duality.
It is given power by the symbiotic relationship between an idea (money outside of government control) and a technology (blockchain).
What many people don’t realise is that the idea actually came well before the technology. Many people worked quite actively to achieve non-state money.
Indeed, as far back as the 17th century and beyond, people did this. Pubs and shoemakers and shopkeepers used to mint their own coins from bronze and copper and the like, so much so that in 1670 Charles II had to ban the practice.
In the 1980s, with the onset of the internet, the concept of a digital currency emerged, and a couple of companies (DigiCash and E-Gold) actually made a pretty good go of establishing a digital currency. Ultimately, both companies failed, taking the currencies with them.
Other attempts failed, mainly because of the problem of double money – where code representing a unit of currency could be copied and pasted. If you can mint your own pound coins, they quickly lose value, just as if the central banks start printing $3 billion then… oh wait, yeah, no that’s fine no problems there, carry on Jerome!
Anyway, at some point, blockchain technology emerged.
When the mystical Satoshi Nakamoto combined the idea with this new technology, bitcoin was born.
I’ll tell that story in a minute, but firstly, what is blockchain?
The blockchain, like an email system, is a protocol where you can send and receive things over the internet. So, in the same way as this article arrived in your inbox, on the bitcoin blockchain you could send your friend in Argentina some bitcoin. Completely free of banks, intermediaries, charges and the like.
It doesn’t yet have a user interface like Gmail or Outlook, but neither did email in the early days, and it’s getting there.
Each transaction is recorded on the blockchain, like bookkeeping on an accounting system.
These transactions are grouped together into “blocks”.
The sum of those transactions in a block creates a signature, or code, which represents all transactions in that block. It’s called a “hash” code.
A block chain is a series of these, linked together in chronological order, one after the other.
So a transaction takes place, and is given a short code. A few hundred or a thousand transactions all together in a block are given a joint reference code called a hash.
This means you can look back in time all the way to the very first block and every transaction which has taken place on the network will be recorded there.
The blockchain for bitcoin currency (lowercase) is called the Bitcoin blockchain (uppercase). Bitcoin is a network for transactions, while bitcoins are the currency in which payments are made and taken on the chain.
Each transaction which takes place on the Bitcoin blockchain (you fixed my roof in real life so I sent you 0.1 bitcoin) is codified in computer speak (oiasf9834jf3ir) and together the transactions from a much longer hash code.
Think of this like a signature. The hash code for a block in the chain includes in it all the information about the transactions which took place in that block of transactions.
And more than that, it also includes a reference to the previous hash code, which itself referenced all its transactions and also the block which preceded it.
That’s how one block of data becomes a chain.
They are linked because each signature is influenced by what came before.
This is important because it means if anyone, anyone, tampers with a single transaction in a single block, it will throw the whole chain out of whack. It won’t match up.
Like this iiiiiiiiiiijiiiiiiiiiiiiiiiiiiiiiiii. You see?
I’m not saying it’ll be easy to spot – it’ll be like the hardest game of Where’s Wally? you ever played, because you might just be looking for a single number or letter that’s out of place in a sea of millions, but it’ll be there.
So that’s blockchain.
A chain of blocks of data referring to transactions performed on the Bitcoin blockchain. It’s a way of keeping track, like any other method of accounting. And all the work is done by the users of the blockchain – it’s decetralised. The system depends on the users to maintain it, and the users need to maintain the system or it would fall apart.
The transactions, hash codes and continuity are all checked and verified by the users on the system. Everyone who owns bitcoin has a vested interest in the Bitcoin blockchain being authentic, trustworthy, and correct. Otherwise bitcoin the currency would quickly become worthless.
So they check it. Hundreds of thousands of times. Using really computers to do all the legwork, checking all the information.
I imagine it like the computer that Alan Turing used to break the German’s Enigma Code.
Right, so that’s blockchain. The technology underpinning bitcoin. But where does bitcoin actually come in?
For that, we need to get back to the global financial crisis of 2007-2009…
I said earlier that people had been chatting away and working on solutions to the problem of state control of money for decades, centuries even.
Well in 2008, an anonymous profile under the pseudonym “Satoshi Nakamoto” posted in an online forum saying, “Ho! Chaps looks like I might’ve gone and bloody solved the ol’ conundrum, don’t you know.”
Or something to that effect anyway.
And he followed it up with a “whitepaper”, a founding document for what he called “bitcoin”, a “peer-to-peer electronic cash system”.
“I’ve been working on a new electronic peer to peer cash system, with no trusted 3rd party”, he/she/they said.
And this was the Bitcoin blockchain.
He took a bit of feedback and questions, most people were sceptical, even on a forum dedicated to searching for exactly this kind of thing.
Can’t scale, won’t scale, or will get shut down by governments, was the rough response.
(I’m joking – ten years on and with mass adoption, brilliantly clever people are still very sceptical and for lots of good reasons.)
Some weeks later, Nakamoto posts again.
It’s 3 January, the same day that Alastair Darling has announced the second bailout of the banks, and Nakamoto announces the creation of the first 50 bitcoins.
Or to use the correct terminology, the first 50 bitcoins were “mined”.
Now when you or I think of mining, we picture JCBs, trucks, earth movers, pickups, bore holes, shovels and the rest.
But when reduced to its core concept, mining is essentially working for a reward.
And it’s in this sense that the word was chosen.
Because bitcoin and the blockchain are linked but they are not the same.
The blockchain is the technology for recording transactions, while bitcoin is a reward given to whoever verifies the transactions.
The hash code, which is the signature representing all transactions in the block, as well as a shadow of the previous block, is very hard to figure out. It’s hard to say what it should be I mean. It’s like a really tough maths problem, or puzzle.
And herein lies the beauty.
This is such a hard problem to solve, as it’s like trying to match a fingerprint to a person without an existing database of fingerprints to go from. You just have to try every combination to see if it fits.
This is mining.
Mining is not digging like for gold, it’s simply working for a reward. The reward for the first person to solve the puzzle of what the hash code should be for that block of data is bitcoin.
You can think of it like gardening.
It takes time, effort, and you get a reward at the end of it.
Originally, you could do it with a laptop computer.
There were few transactions so solving the code was easy.
And the Bitcoin blockchain was designed with a particular quirk.
Part of the reason the early digital currency advocates wanted to move away from state control of money was distortion and deflation – the fact that central banks could print money, reducing the value of savings.
So, when Nakamoto designed the protocol for the Bitcoin blockchain, he put in a solution.
There would be a finite amount of bitcoins given as rewards for solving the hash code puzzle for each block. Specifically, only 21 million bitcoins will ever be created or mined but solving hash puzzles for the blockchain.
And what’s more, the reward would also diminish.
The first ever block contained one simple piece of data – a line of text which read:
The Times 03/Jan/2009 Chancellor on brink of second bailout for bank
There could be no more profound comment on the reasons behind Bitcoin/bitcoin’s creation.
The system was wrecked. And over the next decade, the rich have got richer because of government and central bank policy, which drove asset prices higher as wages stagnated, leaving the poor further and further behind.
Meanwhile, the price of bitcoin in fiat currency terms has exploded.
Originally though, you couldn’t buy or sell bitcoin.
It took a while before someone set up an exchange for it.
And when they did so, they had to set up a dollar price for a single bitcoin.
How do you value something you can’t see, touch or use though?
Well, what this person realised is that the value could be directly linked, at the very least, to the cost of mining it.
The two inputs were time and electricity, in the form of human labour and the work your laptop put in.
That was then split by 50 – the number of bitcoins you received for mining (verifying or solving the puzzle for) a block.
Hence, it traded at around 1,500 bitcoin to the dollar. Less than a tenth of a cent.
Many people often wonder how you can value bitcoin.
Well there is more than one way, but this was the first, and it goes some way to explaining why the price has risen so much over just a decade.
Because the inputs have both changed dramatically. It’s much harder and more costly to mine, and you get fewer as a reward.
The number of transactions taking place on the Bitcoin blockchain has grown each and every year. That’s people trading and using bitcoin to pay for goods and services in ever greater volumes and with higher amounts.
The larger and more numerous the transactions, the harder it gets to solve each block.
And, because mining for bitcoin (remember – getting your computer to solve a hugely complex puzzle in return for a prize of bitcoin) was lucrative, more and more people started doing it.
As a result, to be the first (always the first person to solve it gets the reward), you have to have ENORMOUS amounts of computing power, which now requires a lot of expensive computers, software and hardware, and heaps of electricity too.
All in, it costs a lot to mine for bitcoin these days.
Just as mining for gold and silver is a lot more costly and complex than it used to be.
And because as I mentioned, the amount of bitcoin you win as your prize for solving the hash puzzle for a block (mining) diminishes over time, the costs involved with mining are split between a smaller amount.
So at the start, let’s say it cost 10 cents to mine a block and you got 50 bitcoin. So bitcoins went cheap back in ‘09.
Now, it’s very expensive and hard to do, and you only get 6.25 (the reward has “halved” three times now, roughly every four years – most recently in May 2020). And now the price is £9,000 or so.
The added factor is that the reason it’s harder to mine a block now – more transactions of greater amounts taking place – is also the other primary reason for the huge increased in fiat value for each bitcoin.
It’s more usable.
Like a social network or a telecom company, the more people use it, the more valuable it is to own.
If all you can do with bitcoin is buy things from 100 people worldwide, then it’s not worth much.
But if one million people, stores, property agents, restaurants and family members abroad can accept bitcoin as payment…. well then it’s actually useful.
So that’s how the technology works.
Blockchain keeps track of every transaction which takes place on it.
By verifying the truth of each transaction, the people who use bitcoin are also making it trustworthy (any errors resulting from theft or fraud would be spotted – like if you trash a place on Airbnb, you’ll get a bad review and everyone will know).
By verifying a block of transactions, showing that the signature for the block (the hash) is legitimate, you earn a reward because well, that wasn’t easy, and you’ve provided a service to the network.
That reward is bitcoin.
Editor, Southbank Investment Research
PS If you are enjoying finding out about bitcoin, how it works why people love it and why it’s important, you can make no better move than signing up for our crypto summit next week.
Cryptos like bitcoin are performing well, with lower volatility, and with good reason too.
We’ve put together a string of amazing guests, who I’ve interviewed, and they are going live in the form of a mini docuseries next week. It’s going to be brilliant, you’ll love it (I hope!).