Following the steps of many other public authorities around the world, the Mozambican central bank issued Tuesday a warning on the risks associated with the cryptocurrency known as “Bitcoin”. Banco de Moçambique (BdM) indeed observed the circulation of the decentralized, peer-to-peer-exchanged currency within national borders.
The word “bitcoin” entails more than just a cryptocurrency. It is above all not a currency but an Internet payment system.
Professionals and companies focus more and more on the underlying blockchain technology for their own operations.
Moreover, many alternative cryptocurrencies exist today and some of them are attempting to correct the failures if the original Bitcoin.
The idea of creating cryptocurrencies comes from the observation that the value of current fiat money from the fractional reserve system does not reflect market or natural forces but questionable political objectives.
What is Bitcoin?
A currency is any type of object accepted by the public as a means of payment. Therefore, there can be as many currencies as we can think of as long as there is an underlying demand for that currency as an instant means of exchange against goods and services, as an instrument of repayment of debt and as a transferable fund.
Bitcoin is a decentralized digital currency that was created in 2009 by an unknown person using the alias Satoshi Nakamoto. His idea was to create a “purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution” such as a private or central bank.
The word Bitcoin is formed by combining the words “bit” and “coin”. A bit or binary digit is the basic unit of information (01010011…) used in computing. Bitcoin is therefore an Internet currency with no jurisdiction, no central monetary authority or central monetary issuer, where people transact directly with each other (peer-to-peer) with no one in the middle.
A currency created through cryptography
Bitcoin is produced using a technique called “asymmetrical”, “public key” or “two-key” cryptography. Through public key encryption, the person who sends Bitcoins to another person actually encrypts a message (bits) using the address (public key) of the beneficiary. Then the beneficiary uses his or her private key to decrypt the message.
Anybody can see the public key of any person but no one can see the private key except its owner. A public key can be compared to a box, an address or a bank account number to which everybody can send letters or funds. But only the owner of the private key can open the box and see what’s in there as well as draw money from it. “The strength of a public key cryptography system relies on the computational effort (work factor in cryptography) required to find the private key from its paired public key.”
Asymmetrical cryptography also allows verifies the authenticity of those who use the system through “digital signatures”. Changing or replacing a single letter or data from the message will cause verification to fail, so that it is computationally impossible for anyone who does not know the private key to deduce it from the public key or from any number of signatures.
For more on the public/private key, see here a very simple illustration by Medium.com.
Transactions, in a decentralized system, are verified by a network of nodes called miners (computational nodes or machines) who apply the above-mentioned cryptographic technics to create bitcoins and validate all transactions. These are recorded in distributed “ledgers” that form a blockchain. Such system does not require any intervention from a trusted third-party such as a central bank.
Miners repeatedly verify and collect newly sent transactions into new groups of transactions called blocks, the whole sequence forming a “chain of blocks” or “blockchain”. To be accepted by the rest of the network, a new block must contain a proof-of-work performed through a hash function, this in order to deter attacks and other abuses against the network.
Mining is the process of adding transaction records to Bitcoin’s public ledger of past transactions (and a “mining rig” is a colloquial metaphor for a single computer system that performs the necessary computations for “mining”). This ledger of past transactions is called the block chain as it is a chain of blocks.
The block chain serves to confirm transactions to the rest of the network as having taken place. Bitcoin nodes use the block chain to distinguish legitimate Bitcoin transactions from attempts to re-spend coins that have already been spent elsewhere.
Mining is intentionally designed to be resource-intensive and difficult so that the number of blocks found each day by miners remains steady. Individual blocks must contain a proof of work to be considered valid. This proof of work is verified by other Bitcoin nodes each time they receive a block. Bitcoin uses the hashcash proof-of-work function.
The primary purpose of mining is to allow Bitcoin nodes to reach a secure, tamper-resistant consensus. Mining is also the mechanism used to introduce Bitcoins into the system: Miners are paid any transaction fees as well as a “subsidy” of newly created coins. This both serves the purpose of disseminating new coins in a decentralized manner as well as motivating people to provide security for the system.
Bitcoin mining is so called because it resembles the mining of other commodities: it requires exertion and it slowly makes new currency available at a rate that resembles the rate at which commodities like gold are mined from the ground.
Source: Bitcoin Wiki
The proof-o-work is actually a piece of data resulting from algorithm calculations which is easy for any node in the network to verify but extremely time- and energy-consuming to generate. This system also makes sure that Bitcoins cannot be spent more than once (no double-spend).
Bitcoin uses a mathematical algorithm (hash) called SHA-256 to mine blocks, where the block’s header (a number) must be lower than or equal to the target number in order for the block to be accepted by the network. The hash of a block starts with many zeros so that the probability of calculating a hash that starts with many zeros is very low, forcing many unproductive attempts to be made.
Here’s a less technical example of a proof-of-work
Say Bob wants to prove that he can do a really hard math question. Alice doesn’t know what the answer is, but she knows that the answer, when put through a SHA-256 hash, is:
Bob completes the question and hashes his answer. Alice can then look at Bob’s hash and compares it to the hash she has, and if they are identical, then she knows Bob found the right answer. Alice still does not know the answer or how Bob got that result – but she knows that Bob arrived at the right answer.
Bitcoin uses this type of a system for each block found – and each block relies on including the previously found block in the generated hash. This means as soon as a block is found and propagated through the network, all of the previous ‘work’ performed by miners is now irrelevant.
Source: Learn Cryptography
The successful miner able to find the new block is rewarded with newly created Bitcoins and transaction fees. The bitcoin protocol specifies that the reward for adding a block will be halved every 210,000 blocks (approximately every four years), so that the reward will eventually decrease to zero. The limit of 21 million bitcoins will be reached around 2140.
Therefore, contrary to fiat money, Bitcoin is a deflationary currency, associated to the “rarity” of precious metals such as gold, though Bitcoin’s original community of developers insists that its intention is not to make of Bitcoin a gold-like asset but merely “an experiment”.
Too much Bitcoin may kill Bitcoin
Now the media buzz and hype since last year is related to the impact of Bitcoin’s unexpected success on its price and on the way it functions, which has sent its price up more than 2000% at some point in 2017. As we saw earlier, transactions in cryptocurrencies are processed block by block, sequentially. Originally, it was designed to process six blocks per hour and a limit (1 MB or more or less the size of a 1980s floppy disk storage capacity) was set to the size of blocks in order to maintain the robustness of the system.
BITCOIN CORE (BTC), the most volatile asset in history
Source: Yahoo Finance
“At the time, this was still thousands of times higher than the actual usage of the network demanded. It is clear that the block size limit was never meant to stifle growth of the network, but merely to defend against a theoretical attack vector”, explains developers from the cryptocurrency exchange platform Bitcoin.com, who encourage the use of alternative crypto-currencies such as Bitcoin cash (BCH), whose block size can reach up to 8 MB (eight times that of Bitcoin).
Indeed, the original Bitcoin (Bitcoin Core or “BTC”) faces a scalability problem as the number of users and transactions have reached unstainable levels. From less than 10 transactions per block, the Bitcoin network started processing 250 transactions per block in 2012 and had reached 500 transactions per block in 2014. Today, the network processes approximately 2500 transactions per block, causing a huge congestion in the network.
When blocks are full, those who want to make transactions on time must pay extra fees to miners, making transactions more and more expensive for small amounts of money. “By the end December 2017, there were more than 280,000 unconfirmed Bitcoin Core transactions.
“When you first got in line, you thought that paying $20 would be enough to get you in quickly, but now several thousand more people have joined the line and said they would pay more than you. There is nothing you can do but wait until everyone paying more than you get in and the bouncer gets around to letting you in”, say developers from Bitcoin.com. At between $20-30 per transactions, fees are currently too high for transactions of very small sums of money and sale/purchase of goods.
Digital gold in the hands of an Internet elite
Its scalability problem have rarified the quantity of Bitcoin (a little more than 16 million Bitcoins are in circulation today) to the point where investors want to profit from capital gains stemming from the mismatch between supply and demand. From a few dollars in 2009, the value of all Bitcoins Core in circulation, or its market capitalization, has now reached $236 billon (as of January 10, 2018) due to the increasing investment demand.
Mike Hearn, a senior developer on Bitcoin Core and former chairman for the principles guiding the cryptocurrency, admitted it to be a failed experiment. Two years ago, in 2016, already, he criticized the fact the Bitcoin Core community refused to adopt new standards allowing Bitcoin to solve its scalability problem among other.
“What was meant to be a new, decentralized form of money that lacked systemically important institutions and ‘too big to fail’ has become something even worse: a system completely controlled by just a handful of people”, deplored Mike Hearn.
Exotic financial products on Bitcoin are flourishing
While Bitcoin Core inefficiencies are clearly identified, it must be noted that it is during the second half of 2016 and the whole of 2017 only that the popularity of Bitcoin Core has surged to its current levels. Statistics from Statista show that there were a total of 2008 Bitcoin ATMs as of January 2018 globally compared to just 503 ATMs in January 2016 and less than 1000 in January 2017.
Current projections suggest that there are between 1 million and 10 million Bitcoin Core users worldwide. Even if reality were closer to the 10 million upper limit, it would only constitute 0.46% of the target potential users (more than 2 billion people) globally (when we exclude under-aged and over-65-year-old persons from the sample), implying a strong adoption growth potential.
From an investment perspective, strong critics of Bitcoin had argued that investors were unable to manage risk with Bitcoin as there was only a cash or spot market, permitting only full long positions in order to be exposed to the cryptocurrency. Last year, launches of short mini-futures (which gain when Bitcoin Core loses value), by Swiss-based investment banks Vontobel and Leonteq Securities have partially solved that problem.
But the main instrument for risk management, so far, are the futures contracts on Bitcoin Core that were launched by two of the most prominent financial instruments exchanges in the world, Chicago Board and Options Exchange (CBOE), on December 10, 2017, and Chicago Mercantile Exchange (CME), a week later.
Those two moves gave Bitcoin Core a major confidence boost by professional and institutional investors seeking a flexible exposure to cryptocurrencies in order to capitalize on the huge demand expressed by their own clients.
Indeed, futures investors do not need a digital wallet to trade Bitcoins, because Bitcoin futures are financially-settled and therefore do not involve the exchange of the cryptocurrency. CME explains that in order to trade futures, investors must open an account with a registered futures broker who will maintain the account and guarantee the trades.
JP Morgan’s CEO, Jamie Dimon, who once compared Bitcoin to “a fraud”, threatening to “fire” his own traders “for stupidity” if anyone of them dared to trade the currency, now “regrets” those comments, conceding that it “is real” and that “you can have crypto yen and dollars and stuff like that”.
Source: AP – “JPMorgan CEO Jamie Dimon ‘regrets’ calling cryptocurrency a fraud”, The Independent
Now it was reported on Monday by Bloomberg’s Erik Schatzker that Wall Street trader Mike Novogratz, will start a merchant bank dedicated to cryptocurrencies and blockchain-based ventures, which he intends to take public. He said in a statement, Tuesday, that intends to raise $200 million “and, through a holding company, list shares of his Galaxy Digital LP on Canada’s TSX Venture Exchange.
He said Galaxy is building a “best-in-class, full service, institutional-quality merchant banking business in the cryptocurrency and blockchain space” and will be active in four areas: trading, principal investing, asset management and advisory work”, reported Bloomberg. The Securities and Exchange Commission (SEC) in the United States is now also reviewing close to 20 licenses that exchange-traded funds (ETF) promoters and issuers have filed for approval.
However, those who thought that the SEC would easily issue authorizations for ETF trading in the United States may find themselves disillusioned. Yesterday, trusts controlled by Rafferty Asset Management LLC and Exchange Traded Concepts LLC each canceled plans to launch three bitcoin funds, writes Reuters, citing “expressed concerns regarding the liquidity and valuation” of futures contracts based on the digital asset.
Alternative cryptocurrencies have emerged
In response to Bitcoin Core’s scalability issues, several other alternative coins commonly called “altcoins” have also been created, namely through “forks”. A fork happens when developers initiate a separate cryptocurrency project by copying and altering the source code or original protocol on which Bitcoin operates.
A hard fork results from a radical change in the consensus protocol, requiring all miners to update their software to be able to mine coins under the new rules. A soft fork is one in which the change of consensus rule does not require such upgrade, so that the older miners will still be able to mine under the new protocol. However, with a soft fork, older miners will not able to validate the new changes, reducing their security compared to that of the new miners.
Ethereum differs from Bitcoin in 7 main ways
- In Ethereum the block time is set to 14 to 15 seconds compared to Bitcoins 10 minutes. This allows for faster transaction times. Ethereum does this by using the Ghost protocol.
- Ethereum has a slightly different economic model than Bitcoin – Bitcoin block rewards halve every 4 years whilst Ethereum releases the same amount of Ether each year ad infinitum.
- Ethereum has a different method for costing transactions depending on their computational complexity, bandwidth use and storage needs. Bitcoin transactions compete equally with each other. This is called Gas in Ethereum and is limited per block whilst in Bitcoin, it is limited by the block size.
- Ethereum has its own Turing complete internal code… a Turing-complete code means that given enough computing power and enough time… anything can be calculated. With Bitcoin, there is not this form of flexibility.
- Ethereum was crowd funded whilst Bitcoin was released and early miners own most of the coins that will ever be mined. With Ethereum 50% of the coins will be owned by miners in year five.
- Ethereum discourages centralised pool mining through its Ghost protocol rewarding stale blocks. There is no advantage to being in a pool in terms of block propagation.
- Ethereum uses a memory hard hashing algorithm called Ethash that mitigates against the use of ASICS and encourages decentralised mining by individuals using their GPU’s.
Source: Crypto Compare
One of the most recently talked-about hard fork is Bitcoin Cash (BCH), launched in August 1st 2017, which increased the transaction size to 8MB. Forks such as Bitcoin Classics and Bitcoin XT also tried to manage the increase in size transactions but failed and discontinued. Another cryptocurrency, Ripple, functions both as a cryptocurrency and a digital payment network for financial transactions.
Built in 2012 for enterprise use, the Ripple Network is narrowly linked to traditional or real-economy financial institutions, such as banks, asset managers, brokers and market makers, offering them a reliable, on-demand option to source liquidity for cross-border payments. Its distributed open source protocol, consensus ledger and native cryptocurrency form the XRP.
Let us also mention Litecoin, created in 2011, which displays smaller time intervals between new additional blocks to its blockchain and whose mining is governed by the SCRYPT algorithm, as opposed to Bitcoin’s SHA-256.
By contrast, the Ethereum blockchain, launched in 2014, is a completely different protocol, especially designed for smart contracts, that is, applications that run exactly as programmed without any possibility of downtime, censorship and fraud or third-party interference. Smart contracts, also referred to as “tokens”, run on Ethereum’s custom built blockchain.
Cryptocurrency RIPPLE (XRP) gains from its focus on institutional, regulated clients
Source: Yahoo Finance; BTC= Bitcoin; XRP = Ripple
Those who hate cryptocurrencies all alike
Vivek Wadhwa, distinguished Fellow at Carnegie Mellon University College of Engineering in Silicon Valley, does not have sufficiently hard words to describe the bitcoin mania, comparing it to the tech bubble of the late 1990s, when “Silicon Valley venture capitalists and New York City investment bankers used phrases such as “monetizing eyeballs,” “stickiness,” and “B2C” to justify the ridiculous valuations of Internet companies”, says the professor in a post shared on his LinkedIn wall.
Small-time investors such as “taxi drivers”, “barbers”, “grandma” and “grandpa”, afraid to miss out the opportunity, are prone to believe Wall Street, thus putting at risk part or all of their savings. Vivek Wadhwa explains that “Bitcoin victims” are being sold the story that one cannot trust government-issued currencies because there are manipulated and, for that reason, a decentralized currency is the future of money.
“Yes, the price of Bitcoin may yet double or even quadruple — because its price is based on pure speculation, and these stories are feeding such speculation”, insists the Carnegie professor. “But Bitcoin’s market price is almost certain at some point to crash and burn, just as the dot-coms did”. This should be so because its price does not reflect its growing usage as a currency but merely the “demand for the mirage of its speculative value”.
Carnegie fellow and entrepreneur Vivek Wadhwa compares Bitcoin to the emtpy assets of the tech bubble of the late 1990s.
With a limited number of units at 21 million, the rate of increase in available Bitcoins is not keeping pace with the number of people keen to buy them. Miners and those who buy Bitcoins have no reason to sell their coins but “wait for the price to rise further”, turning the so-called means of payment into “a speculative empty asset”, according to Vivek Wadhwa.
He explains that real digital currencies are designed by bank-to bank models which provide customer support and security, such as China’s WeChat Pay and Alipay, which now process $5.5 trillion of payments, or India’s Unified Payments Interface, which makes it possible to transfer money between people within seconds and “for no fee”.
The promises of the blockchain beyond bitcoins
However, others focus on the possibilities (functions, utility, applications) that cryptocurrencies give rise to. In fact, they are not concerned with the future of Bitcoin per se but with the possibilities of blockchain-enabled distributed ledgers, especially in the financial services industry. In mid-2015, Accenture published a report on the potential impact of blockchain technology on the investment banking industry. Since then interest in and funding for this type of financial technology (FinTech) have grown exponentially.
An estimated $75 million was invested in blockchain efforts specific to capital markets in 2015 and by 2019, according to Accenture, that figure is expected to reach $400 million, amounting to a compound annual growth rate (CAGR) of 54%, which is a forecasts that Accenture think may prove conservative.
The global business and IT consulting firm states that a key difference between distributed ledger and traditional database technology is how they approach security. “Distributed ledgers encrypt individual transactions or messages in the data stored on the blockchain, whereas traditional databases typically have a database-wide layer of security that, once breached, offers access to all of the data inside”, specifies Accenture.
“In a world where the threats of hacking, data manipulation and compromised data are very real, the security and risk management implications of these two different approaches are important considerations.”
The most conservative banks embark on the blockchain
Accenture is of the view that distributed ledger and blockchain technology solves two of the most fundamental challenges associated with financial transactions: reconciliation and auditability. “It also holds the promise of settlement optimization, which would remove a tremendous amount of friction from the current trading lifecycle and unlock a vast amount of capital that is trapped in the settlement process.”
Monday, one the leading and oldest Swiss private bankers, Lombard Odier, announced that its Insurance Linked Strategies (ILS) team successfully completed its first bond transaction using blockchain. The team’s purchase of catastrophe bonds is believed to be among the first secondary market transaction completed on blockchain.
The ILS team acquired the securities for the LO Insurance Linked Opportunities Fund via delivery-versus-payment (DVP) settlement from Solidum Partners, a Swiss-based investment advisory company specializing in insurance-linked securities. Solidum initially issued the bonds in August 2017 using a private blockchain to participants on an invitation-only basis. According to Solidum, the $15 million Dom Re issuance is the first private catastrophe bond transaction to be settled this way.
Lombard Odier, the oldest “private banker” in Switzerland, has moved on the blockchain arena with its first secondary market bond transaction on blockchain.
Source: Association de Banques Privées Suisses (ABPS).
“Using blockchain markedly lowered the transaction costs relative to other DVP settlement methods where costs are prohibitive for transactions of this size”, said Simon Vuille, Portfolio Manager at ILS team, who sent us directly the information. He added that the technology mitigated counterparty risk and accelerated what would have been a partly manual settlement process, reducing what normally takes a few days to a matter of seconds. “We hope that this blockchain transaction will be the first of many.”
Stéphane Rey, Chief Technology Officer, Lombard Odier IM, added: “We are always interested in new ways of working and implementing technology that delivers value to the business. Through this blockchain transaction, we have learned more about using the technology and the more practical aspects that needed to be handled, not least legal and compliance to name a few. We are very pleased with the end result.”
The day central banks will issue cryptocurrencies
Thus we see that the word “bitcoin” embraces more than just a currency concept. The media hype is much focused on the cryptocurrency called Bitcoin Core because of its speculative interest as illustrated by the meteoric rise of its price over the last months and by the growing number of non-professional, unsophisticated retail investors who put their savings at risk in one of the most volatile asset of human history.
However, the focus of interest on the part of all regulated private institutions lies in the blockchain-enabled applications that are capable of enhancing margins and returns thanks to more efficient processes and cost-savings. Especially, those firms have found a compromise between efficiency, speed and cost through the adoption of private blockchains, which limit the number of participants and therefore increase the security of the platform as the chain is owned privately.
Simon Dixon, CEO of the online investment platform BnktotheFuture.com at The Internet of Value: Blockchain and Financial Services Innovation conference in London.
According to Simon Dixon, CEO of the online investment platform BnktotheFuture.com, even a public blockchain such as bitcoin (with a small “b” to refer to the platform or protocol by contrast to the currency “Bitcoin” with a capital “b”), despite much debate about scalability issues, presents important opportunities, especially for central banks.
“Digital currencies issued by a central bank would represent a way to reduce systemic risk in the financial sector and are likely to become more prominent during financial crises, he said. Investors would then be able to transact directly with central bank-issued digital currencies and bitcoin, thus cutting out the wider banking sector altogether”, said Simon Dixon as reported by Coindesk.
 Public-key cryptography, Wikipedia.