How Bitcoin Became a Thing

By Scott Stockdale,

When we think about the financial markets in 2017, things are pretty strange. They’re certainly not like they used to be a decade ago.

For example, many countries around the world have negative interest rates (or close to it). Sweden, Cyprus, Denmark – even Germany – have yields of less than 0% for their 2 year sovereign bonds.

How’s that even possible? If I lend money today, why would I ever settle for less money back when it’s returned?

It makes no sense whatsoever!

The reason this is happening is extremely complex and difficult to understand. Billionaires Charlie Munger and Warren Buffett say that if you feel like you understand it, you’re probably missing something.

However, if we’re going to try and simplify this so it makes a little bit of sense, one of the key factors we might turn to is the operations of central banks around the world.

 

The Role of Central Banks

At present, many central banks are playing a major role in the buying and selling of financial assets.

Over in South-East Asia, The Bank of Japan is practically nationalising the entire securities market.

Why are they doing this? Why are central banks buying all this stuff?

The simple answer is that they are trying to stimulate or sustain their economies by providing cash injections into the system.

Made famous by FDR in the 1930s, central banks are trying to ‘prime the pump’ by injecting as much cash into the system as possible.

Why? Because there are enormous deflationary forces that have been at play for 35 years – at least in the U.S.

The way central banks like the US Federal Reserve (FED) do this is by buying back bonds or short-term bonds at the base interest rate.

This process of ‘printing’ money to buy back bonds is known as quantitative easing (QE).

In the last credit cycle, the FED conducted QE for numerous years after the 2008 crash. Essentially, they were buying bonds off the market and putting the cash into the hands of the people that were selling them.

Those sellers would then use the money to buy things, whether that’s general consumer goods or some other assets or stocks – hence why the stock market has gone wild through all of this.

The problem with this approach is that it manipulates the markets. They’re not as free and open as they used to be.

The amount of trillions of dollars they’ve spent on doing this is somewhat mind-blowing. The European Central Bank (ECB), for example, has an ongoing programme of €80 billion per month, although this is set to be scaled back to €60 billion per month in the next fiscal year.

 

The Problems Escalate…

Because these global economy players have no incentive to have a strong currency, the continual printing of money appears to be the only solution to create growth inside their own countries.

Take Japan, for example. For them, debasing their currency and making it cheaper is a good thing because it creates an inflow of international investment into the country.

In its simplest form, exports are cheaper whilst imports become more expensive. This contributes to a positive balance of payments and so contributes to growth.

Larry Summers, a famous American Economist, describes this process of everyone competing to devalue their currency like watching a show.

So you’re watching a show or a movie or whatever. Suddenly, the person in front of you stands up.

The only way you’re going to be able to see it if you’re behind him is if you stand up too.

The next thing you know, everyone in the entire auditorium is standing.

The only thing that’s happening is everyone’s legs are getting weaker and they’re more annoyed that they’re having to stand up. They can’t get high enough to see the show because everyone around them is taking advantage of this.

Through this analogy, what Summer is explaining is this idea that all these central banks around the world are trying to devalue their currency and they’re just trying to devalue it faster than the next guy.

Problem is, this is at the expense of everybody else in the global economy.

 

Gold Rush…

So the issues for the people around the world at this point – especially the ones that are dealing with these currencies that are devalued faster than others – are the following: the currency is a terrible store of value and the buying power for people of these countries continues to disappear.

This is why the price of gold back in 1960 was $35 whilst today it’s $1300.

The gold supply has barely changed, relatively speaking. What has changed is the enormous amount of currency that’s been added to the system.

Whenever we look at a currency that’s pegged to gold which has a fixed supply, we find we don’t have these big, slow, gradual bubbles. They’re more abrupt because people can basically exchange their Fiat currency (currency backed by the government that issued it) for gold at that point.

This keeps everything in check.

It keeps it all pegged.

Whenever we don’t have that peg any longer (this has basically been the case in the US since 1971), it creates the situation we’re seeing today.

One of the advantages to having a pegged currency is it forces decision makers within the country to spend reasonably. Whenever they don’t, the currency devalues because everyone will suck the gold out of the country.

This is how it’s basically kept in check. But if there’s no peg, there’s no incentive to do that.

There’s only an incentive to debase the currency.

This is where Bitcoin comes in. Ultimately, this is the problem Bitcoin is trying to solve.

It’s trying to become a digital gold – a digital global currency – that will peg all these fiat currencies.

It wants to hold all the governments behind the currencies responsible for their decision making and their debasement.

 

Where Bitcoin and Cryptocurrencies come in…

The idea of Bitcoin is fairly simple. However, it’s application and technical sides are anything but.

The only difference between gold and Bitcoin/cryptocurrencies is that you can spend Bitcoin with a smartphone instead of having to physically deliver gold.

One can send Bitcoin via smartphone to the other side of the globe instantaneously without having to physically move it.

In the past, this could never be done. No one had ever figured out how to ensure a digital file was unique and uncopyable.

For example, if you and I were standing in a vault and I gave you one ounce of gold, there’s no way anyone could argue I still possess the ounce of gold: I physically don’t have it.

However, when you move into the digital space, this was very difficult to replicate.

And so in 2008, a guy named Satoshi Nakamoto – or at least that’s what he/she/they go by – invented a thing called blockchain. It’s this blockchain technology that solves this issue in the digital space.

Blockchain is a software protocol. Think of it like https which is the protocol that’s used to run the Internet.

Bitcoin is a protocol and it uses this blockchain technology. This technology solves a mathematical problem to prove that something can’t be copied or reproduced.

If you have one unit or you have one bitcoin on this protocol and I send that Bitcoin to another person, I literally do not have that digital unit in my name or digital wallet any further.

The person I sent it to is the only one who has it.

This is what makes this technology so fascinating.

Everyone probably hears blockchain, blockchain, blockchain. However, they probably don’t understand what it represents; this idea that I can’t replicate a Bitcoin and keep one for myself whilst sending it to another person.

Encryption (hence the name ‘cryptocurrencies’) and the blockchange technology that’s been invented with this protocol stop this from happening.

With this technology, there’s no need for a clearinghouse. Everyone participating in the network effectively has a bank in their pocket.

 

Potential Gamechanger…

If this internet money we’re talking about proves to be a better store of value (the monetary baseline can’t be manipulated and increased every time a country outspends its tax revenues), there’s a potential for citizens, businesses and even governments around the world to start using this technology.

At present, people can take their fiat money and exchange it for this internet money/bitcoin/any other crypto coin.

If enough people continue to do this, the price of each Bitcoin or crypto coin will continue to get bid higher until this global currency hits a steady state.

Today, the Bitcoin protocol is worth about $70 billion. This means if you take all the coins in the market and multiply this by the price of one coin, you’ll come up with about $70 billion.

The price of one bitcoin today is around $4400.

When we think about how big this market could get, we’re really talking about replacing fiat currency in the world right now.

Theoretically, then, 1 trillion to in excess of 100 trillion is where this thing could go.

Today, it’s only at $70 billion.

It’s easy to see why many investors think there’s an asymmetrical upside to a lot of this.

 

Should Bitcoin Be Taken Seriously?

Bitcoin is one of the most searched things on Google at the moment.

On the 6th of October 2017, the Wall Street Journal wrote a significant article about the International Monetary Fund (IMF) looking into the idea of turning their special drawing rights into some form of blockchain or cryptocurrency.

In fact, the chief of the IMF, Christine Lagarde, has written the following:

It may not be wise to dismiss virtual currencies. Instead, citizens may one day prefer virtual currencies.

One could argue the IMF is the only central bank which is a global central bank. It’s likely to bail out all the domestic central banks during the next crisis.

If they are open to the idea of using cryptocurrencies then, it could have major implications.

On one side, we have Silicon Valley working at a rapid pace to create this new, digital cryptocurrency. On the other, we have governments and global authorities looking into the implications of using the technology – whether it’s the IMF or other central banks around the world.

They’re talking about using some form of crypto to back their monetary baseline.

Interesting right? Well, this is just the beginning…

 

The Plot Thickens (and gets a bit technical)…

When Bitcoin was originally introduced, it had one megabyte blocks.

These blocks are produced every 10 minutes. Inside of each these blocks are a bunch of transactions.

Within the past year, the number of transactions occurring has become so numerous that the one megabyte amount of space that was allocated for each block wasn’t enough to fit all the transactions.

As a result, people were having to increase the transaction fees.

What does this mean? Perhaps the easiest way to understand this is to think of it like a tip.

If I wanted to complete a transaction with someone and I wanted it to be included on the blockchain but they’re running out of space on the blockchain, I could include a tip.

If I include a tip (like “hey, here’s an extra dollar for this transaction I’m trying to have with my buddy”), that tip went to the miners – the people who ‘mine’ the bitcoins.

It would essentially sweeten the deal.

(‘Mining’ coins is a whole other discussion. Basically, people with computers compete to solve the mathematical problems the Bitcoin protocol chucks out and are rewarded with Bitcoins if they figure them out. They’ve effectively ‘mined’ them.)

(It’s thought this term was coined to make Bitcoin feel more real. If you can mine gold, surely you can ‘mine’ Bitcoins too, right?)

But that tip would go to the people who are basically processing the transactions through the encryption.

As a result, the tips were starting to go up.

This pushed the fees up for these transactions. The fact people were having to pay large fees to conduct transactions meant it was almost no better than fiat currencies.

This was clearly a problem.

Fortunately, the Bitcoin community saw this coming a mile away.

They saw the transactions increasing – they saw they were approaching the one-megabyte threshold for the block size – and so there was a solution in place to resolve this ‘bottleneck’.

 

Segwit2x

This solution called for the de-centralized group of programmers that work on Bitcoin to produce a thing called Segwit2x.

The solution is broken down into two parts.

The first part is the ‘segment’ part which stands for segregated witness.

The second part is the ‘2x’ part which is the increase of the actual block size so that it’s bigger than 1 megabyte.

After this agreement was reached on updating the protocol, the solution would occur at two different points in time.

The first point was to say what part and that happened in August of this year.

The 2x part was phased out later and it’s expected to occur in November 2017.

 

The Solution in Detail…

The first part of the software update – the Segwit part – allows people to do off-block transactions.

Picture this.

Say I want to have a transaction in Bitcoin with one of my friends. We could conduct that transaction or transactions.

I send my buddy 100 bitcoins and then he sends me back 50. The balance comes to 50 bitcoins.

This transaction difference is what would then be shot up into the blockchain whilst the actual transactions can be done off-chain.

This off-chain action is called the ‘lightning network’ and this is all part of the Segwit upgrade that happened in August.

By allowing for these off-chain transactions, there was an enormous alleviation of the need for larger block sizes. People simply weren’t shooting as many transactions onto the blockchain.

They were doing them off-chain.

This off-chain action is still in development. At present, only around 7% of transactions are happening off the blockchain.

As a result of this change, many people in the community want to avoid conducting the upgrade in November for the ‘2x’ part. They don’t feel there’s really a need for it anymore.

Because of these off-block transactions, it’s freed up a lot of  space and people aren’t having to add the ‘tips’ and fees.

 

All in all…

The cryptocurrency space is absolutely fascinating. What’s more, it’s evolving at break-neck speed.

My suggestion? Find out more about this stuff, whether it’s for investment purposes or just for your own education.

Bitcoin – this ‘thing’ – is likely to be around with us for quite some time.

Is it a gamechanger?

Possibly.

Quite possibly.

 

 

Source: TIP with Preston Pysh

One comment

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s