Last year, I wrote a column explaining how blockchain technology works, and what bitcoins, which are based on blockchain technology, actually are. Blockchain is an internet technology that is impervious to tampering where all transacting parties in a ‘chain’ of transactions always know the value of the initial ‘block’. A ‘block’ could be defined as a fixed number of anything—products, money, and so on.
The future of blockchain technology across industries is assured, but bitcoin is a special animal, as are other ‘cryptocurrencies’. A cryptocurrency firm creates a set of shares or ‘coins’ in its own entity, which have an initial set value and fixed number, in the hope that these shares will become a medium of exchange (a form of money) through which people settle transactions. Since the number of coins is fixed, demand for them goes up as more people use bitcoins to settle transactions. The bet is that each bitcoin’s value goes up stratospherically since there will never ever be any more bitcoins issued. Meanwhile, the creator and early owners sit on top of this pyramid. According to Bloomberg, less than 1,000 individuals own 40% of all bitcoins.
The total number of bitcoins was fixed by its creator at 21 million. However, only 12 million were issued on day one. Apart from the ability to buy bitcoins or to transact in them, one can also ‘mine’ them from the unissued store of 9 million using ‘miner’ software—and in most cases, specialized hardware as well.
Miners are at the bottom of the bitcoin pyramid, and work very hard, at great expense, to mine them. Their efforts have ‘mined’ 5 million additional bitcoins to date, from the unissued store of 9 million.
Mining bitcoins is accomplished by verifying other bitcoin transactions. For example, if I buy a Dell computer in bitcoin, miners will immediately start the process to verify that my bitcoin is genuine. Miners don’t verify a single transaction, they use powerful software and hardware to verify many of them.
Once miners find the key to the block in the blockchain being used by Dell, myself, and others, the block is verified as genuine and the miner is rewarded for the effort with a few bitcoins. Initially this reward was 25 new bitcoins, but is now much less.
Not only is the reward smaller, mining new bitcoin is now also much more difficult than in the early days of the bitcoin rush. The number of attempts it took on 8 December to find the correct key is around 1,590,896,927,258, according to Blockchain.info, a site for the latest real time bitcoin transactions.
This number of attempts is exponentially greater than it was in the early days of bitcoin. Mining was designed by the bitcoin creator’s system to become infinitely harder as the unissued store ran out. Mining now requires so much computing power that the UK’s Independent reports, rather unbelievably, that the electricity expended for the computing power used for bitcoin mining is already eating up more energy than 159 individual countries.
Meanwhile, both the Chicago Mercantile Exchange (CME) and the Chicago Board of Options Exchange (CBOE), which are large, official, derivatives markets, will launch trading in bitcoin futures this month. In theory, this opens the doors to regular investors who want exposure to bitcoin but can’t—or don’t want to—trade actual bitcoin, much like a buyer of gold futures doesn’t want to hold gold bars.
The expected flood of interest from mainline investors is supposedly part of the reason that bitcoin’s price recently shot past $15,000, but the euphoria surrounding bitcoin in the last few days is based solely on mindless speculation, and not on fundamental strengths. This is a repeat of the crazy days of the dot-com boom, when anyone who launched a business even remotely associated with the Internet, saw meteoric rises in their stock prices for no sane reason whatsoever.
The fact that a futures market exists doesn’t mean that the price of the underlying asset will go up, it just means that variances in the underlying asset’s value can be bet on. With futures, investor money will not be pouring into the bitcoin market. Instead, it will be buying derivatives that bet on fluctuations in bitcoin’s price. A derivative like a futures contract does not carry the same risk as the underlying asset (in this case bitcoin) does. Also, futures transactions are settled in cash and not in the underlying asset itself. It is entirely possible that investors who are negative on bitcoins will use the futures markets to bet against it, since it is much easier to sell a futures contract at lower-than-the-market price than to actually short-sell bitcoin. These investors will exert downward pressure that will signal the actual bitcoin market to tumble.
Also, sovereign governments don’t like allowing companies to issue their own coins and will eventually regulate or outlaw cryptocurrencies, much like Victorian England stopped allowing the East India Company to issue its own coinage in India after the First War of Independence in 1857. Alan Greenspan has compared bitcoin to Confederate money printed by the American South; that currency went defunct at the end of the American Civil War. Today’s governments are unlikely to wait for war to break out before they regulate something that affects their ability to issue and guarantee currency—their medium for exchange and storehouse of value.
Meanwhile, miners, and anyone else who owns bitcoins, need a bitcoin wallet, which functions like an encrypted bank account to hold what they earn. While bitcoin transactions themselves are protected by blockchain technology, the wallets are prone to attacks by hackers. On 7 December, the Wall Street Journal reported that NiceHash, which markets itself as the largest mining marketplace, revealed that approximately 4,700 bitcoin, or around $75 million, had been stolen from a wallet due to a security breach.
Stay away, unless you have nerves of steel and like to gamble without knowing your odds.
Siddharth Pai is a world-renowned technology consultant who has personally led over $20 billion in complex, first-of-a-kind outsourcing transactions.