Bitcoin, as explained to John Tuld: What the hell is it?

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In the last six months, there’s no single thing I’ve been asked more about by people I know than Bitcoin.  That’s across the board: business people, roof tilers, consultants, family, friends, the lot.  I don’t move in tech circles, so I can safely say that not one of them understood anything about it other than everyone else is talking about it, and the price went up 1000% last year.

So, in two parts, I’m going to try to explain in in a way that John Tuld from Margin Call would have wanted it explained: like you would to a small child, or a golden retriever.

You can read about the Pros, Cons and Investment case here.  First up though – What the Hell Is It?

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The Bitcoin you hear about is generally just a price that, in 2017, moved up from USD$1,000 to $USD16,000, with price movements usually in excess of 10% daily. Or how Kodak – yes, that Kodak – this week announced they were adding “blockchain” technology to their photography systems, and their share price went up 200% in 24 hours.  That’s what has everybody’s blood racing, and everyone talking about it – and panic merchants like CNBC with their own “Crypto Desk!!!!!”

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There are two basic things to understand about Bitcoin that will lead you to at least understand the benefits and limitations that flow from it.

The first is Bitcoin the currency – that is, as a medium of exchange.  Specifically, its a digital currency (there are no physical Bitcoins), and not a “fiat” currency belonging to any country.

The second is Bitcoin the technology – specifically, a blockchain technology.

We’re going to run through those in turn.  If you’re considering it as an “investment”, read through it – I promise, it’ll be worth it.

 

BITCOIN AS A CURRENCY

Bitcoin has two advantages as a currency.

To understand the first, we’ll run through what happens when you buy a cup of coffee with something other than cash.  In a London Starbucks, a double Espresso costs you £2.00.

If you go to pay with a (debit or credit) card, here’s what happens – its comical:

  • The barista swipes or zaps your card, and the personal information in the magnetic strip – your account number, expiration date, postcode, and CVV (credit-card validation value) code – is sent to someone called a front-end processor (like Elavon or Worldpay), who is handling payment information on behalf of the merchant client (Starbucks) and their bank (the “acquiring” bank).
  • The front-end processor forwards your card info to the network of your card (like MasterCard, Visa, American Express, etc) which figures out which issuing bank your card came from.
  • Your personal info then goes to a separate payment processor representing the issuing bank (the one on your card). Once your bank verifies the validity of the info and checks you’ve got enough cash or credit, the signal goes back the other way as “authorised” on the card display (or not, in which case, you curse and look embarrassed or blame the cashier).
  • This series of electronic information transfers happens in seconds – but that’s just the authorisation. You’ve got your coffee, but Starbucks hasn’t been paid for it yet.  For that, it sends a follow-up request to its acquiring bank, usually as a batch at the end of the day.
  • The “acquiring” bank pays Starbucks, but only after placing a request for reimbursement from the issuing bank, via an automatic clearinghouse (ACH) network. You won’t have heard of these guys.  Before the request for payment, its antifraud team has been analysing the initial transaction, looking for red flags.
  • If its all good, the money goes to Starbucks’ acquiring bank, which credits Starbucks’ bank

That process typically takes about three business days to complete, long after you’ve pounded your coffee.

So, if you were counting, SEVEN different entities – on top of you and Starbucks – were involved in you paying for your coffee, and five of them had access to the identifying information on your card.  Each of them takes a cut of course, adding up to transaction fees of between 1-3% of the sale value.  You don’t care, because you get your coffee quick, and the fee isn’t (usually) added to your bill, at least not directly.

On top of those fees, there’s chargebacks the acquiring bank takes back if a customer disputes a charge, meaning Starbucks forfeits both the money and the coffee (it happens a LOT – I know; I used to own bars and hungover people LOVED to dispute charges).

It’s worse if, as a Londoner, you try to buy that coffee at Starbucks in Paris or Las Vegas.  More intermediaries join in to “facilitate” the exchange of pounds for euros or dollars: foreign-exchange trading banks and brokers, foreign-currency settlement and clearinghouse operators, and currency messaging services like SWIFT.   Direct costs are charged through foreign-transaction fees and hidden costs like an abusive foreign-exchange “spread”. These can add up to 8% on your end – plus what it costs the retailer.

Those costs end up costing merchants something like $300 billion a year, and card volumes are rising 10% a year. They’re part of the reason some ground up beans and hot water cost you £2.00.  The pretax profits of just the big three card companies last year were: Visa $12bn, Mastercard $7bn, American Express $7bn. Banks, wisely, don’t split out how they fleece you.

Cash is worse – theft, insurance, vaults, alarm systems, security guards, armoured cars, storage and distribution costs countries between 0.5 – 1.5% of their GDP – more than a trillion when applied across the world.

But without that system, and the hundreds of thousands of people it employs, the global economy wouldn’t work as easily as it does for you, and for merchants.  The ability of those electronic payments systems to “trust” your card allows trade, new businesses, new products, and new jobs.

What Bitcoin does – because of its technology – is eliminate all of those people, and replace their responsibility for maintaining a secure “ledger” of whether you can pay or not, with the Bitcoin system.  We’ll cover how it does that in technology – but that technology won’t work with traditional fiat currencies like the Pound, Euro or Dollar, because they’re just digits, not a nerd code.

The second benefit of Bitcoin as a currency is that it provides a medium of exchange to the “unbanked”.

The public stories you hear about are how much Bitcoin’s operation outside of the banking system benefits drug dealers (thanks to Silk Road), and money launderers.  And it can. But there are people in areas or countries that banks don’t service (because it’s too costly), and women in patriarchal societies who can’t have “jobs” or bank accounts, that a technology like Bitcoin provides the opportunity to enter the global economy.

Bitcoins are stored in digital bank accounts (“wallets”) that can be set up at home by anyone with an Internet connection: no trip to the bank, no documentation or proof of who you are in the real world. Bitcoin doesn’t know your name, location or gender.  You don’t even need a smart phone.

2.5 billion people from Afghanistan to Africa and even America are shut out of the modern finance system run by banks because of the requirements banks impose to do business through them. And without access to banking, they are essentially shut out of the modern economy.

In general, the benefits of cryptocurrencies like Bitcoin aren’t as obvious to people in the United States and Europe (the world’s biggest economies) because most of them already have access to the banking system, and most of the visible costs of the banking system are borne, at least directly, by merchants.  But it has the potential to open up the global economy to over 2 billion people – and give Muslim women in places like Afghanistan the chance to envisage a future in where they aren’t just an appendage to the men in their lives*.

Again, those two advantages: Bitcoin allows the digital verification of spending because it is code-based, and it doesn’t require expensive banks or their necessary personal identification.

(*We included this sentence to maintain our “He For She” compliance certificate).

 

BITCOIN AS A TECHNOLOGY

I won’t nerd you out here, I promise – but its worth it to understand the investment case.

You can’t, today, pay for your double Espresso at a London Starbucks with Bitcoin.  But if you could, all of the seven or more intermediaries we talked through above would play no part in the transaction between you and Starbucks.

A guy or girl who called himself Satoshi Nakamoto (but remains anonymous to this day) “launched” Bitcoin.  You can read how he did it here, but he was the guy who first solved the problem of the potential for “double-spending” an open digital currency (i.e. spending money you don’t have) that takes seven intermediaries to solve in the Starbucks Espresso transaction.  Plenty of “closed” digital currencies exist – like Fly Miles, or Avios points – but Bitcoin was the first to come up with an “open” digital currency that could verify local and global transactions.

Banking as a concept is really just a “ledger” – a track of who owns how much, and who owes how much.  Bitcoin figured out a way to do that that doesn’t involve (or need) payment processors or banks.

The genius is in two concepts: a verifiable, open ledger (the “blockchain”) where the validity of transactions are kept, and a unique (and pretty ingenious) set of monetary incentives to incentivise the network’s computer owners to keep that ledger up-to-date.

Don’t worry if you don’t understand these next three sentences, but:

In the Bitcoin ledger, transactions are arranged in chronologically ordered blocks that allow miners to verify their contents by comparing them to the historical ledger of account balances. Once a transaction is verified, they acknowledge their approval by moving on to create the next block and chaining it to the now-approved predecessor. This verification and chaining of the blocks, and the acceptance of each new one as the legitimate base on which to build future blocks, constitute a de facto consensus on the validity of the underlying transactions, making it theoretically impossible for a single person to “double-spend” a coin.

TL:DR – independent computers belonging to members of the Bitcoin “network” check all Bitcoin transactions so you can’t spend the same Bitcoin twice, effectively doing what the seven intermediaries do for you at Starbucks.

Why would they do that?  You’ve probably heard of people “mining” Bitcoins.

What these “miners” actually do is not produce new coins, but confirm the transactions that happen with existing Bitcoins.  What they get as a reward for being the first miner to solve a randomly generated, mathematically complex puzzle that must be completed before transactions can be confirmed, is some Bitcoin. That financial incentive gets the owners of the networked computers to commit the electricity and computing resources needed to help maintain the blockchain ledger.   The program to do that is roughly as simple as downloading a copy of Microsoft Outlook.

 

So one way to think of Bitcoin is this:  that it’s a payment processing company* that earns its revenues from transaction fees.  To pay for securing its payment system, it employs miners who are paid with newly issued bitcoin shares.

(*It’s not).

And as you can probably guess, without seven intermediaries, it’s cheaper than the banking system.

So Bitcoin as a currency and technology does have something of value: an ingenious system to facilitate low-cost, near-instant transfers of value anywhere in the world. This could eventually make this technology—if not Bitcoin itself—widely used.  Maybe one day that technology, or a derivative of it, will be the only money.

 

But that’s not really what you came here to find out, is it?  You want to know if it can still make you as rich as a Winklevoss brother.

OK, fine – click here, and I’ll give you some Pros, Cons and the Investment Case.

 

 

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Disclaimer: this isn’t investment advice. This is a blog, and most of what I write on this site is pure garbage. Definitely do your own research and don’t rely on my half-assed analysis. There are much smarter people than me, and I am biased because I am not smart enough to trade Bitcoin as a speculator.

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