Asset Insights: Bitcoin

What is Bitcoin ?
Bitcoin is both currency and a payment network or electronic payment system which runs on blockchain. Bitcoin network is Open Source Code Full Consensus Distributed Ledger also called the blockchain.

Bitcoin network allows people to transfer value to each other using the internet (point to point) without any intermediaries (decentralized). The transaction can be done using the Bitcoin Client or a service provider (although that defeats the purpose of decentrilization but more about it later). The Bitcoin blockchain handles the problem of double spending by using validation of transactions by miners on the Bitcoin Network.

Privacy just like cash. Pseudonyms are used instead of real world names for transacting so Anonymity is not exactly there as some of the drug dealers found out mixing use of Pseydonyms to anonymity.

Bitcoins value propositions are:

  • Decentralisation: Decentralisation means that there no need for a third-party like a bank to do the transaction. The bitcoin network handles the confirmation and addition of the transaction to the ledger. And these ledgers are distributed on all the nodes in the network.
  • Security: The block on chain in bitcoin network are secured using a hash function which makes it impossible for the rogue nodes to alter the transactions on the chain frauduelently. Every account has to keys public and private, the public key is used to make deposits and the private key is needed for making withdrawals.
  • Predicatable monetary policy: On Bitcoin network, it is already fixed that the maximum number of bitcoins that can come in existence is 21 million. Also, there is fixed schedule for the reducing “block reward” for securing the network and would be “zero” year 2140.

What is Bitcoin the Blockchain ?

The process starts with a bitcoin transaction being added to a pool of unconfirmed transactions. Next, the unconfirmed transaction picked from the pool and then placed in their own transactional block by millions of computers (miners or nodes) on the Bitcoin network. When one of the computer qualifies (by solving/computing an extremely difficult math problem or mining) to put it’s block of “validated transactions” on the chain and gets Bitcoins as reward (value) in return. At this point, all the other computers then throw away the transaction back to the pool of unconfirmed transactions from their own block and take a copy of new block on the chain and update their ledgers.

Happy Flow of a Bitcoin Transaction

Soft forking
It might happen that more than one computer is able to solve the math problem at the same time and this is called Soft fork. And when this happens all the computers add both blocks on the chain to their ledgers. But because of the different network speed different computers recieve different blocks first and instructed to add a new block chained to the block they recieved first. The tie is broken when on the computer is able to solve the math problem and its block gets added to chain. And the longest chain wins. The block on the other fork gets discarded from the chain and transactions get pooled again to be picked up by the computers on the bitcoin network.

“Soft forking” is the main reason the system must be slowed down on purpose via the math problem. If the system was instant it would be forking everywhere, all the time, & there would be no consensus. No one would have any idea of which ledger is the correct one, and every computer would be busy building a different block to create yet another fork.

Use Cases for Bitcoin

Bitcoin as a Medium of Exchange:

Use Case: As a currency for everyday transactions

Firstly, The decentralization or distribution of the ledger on a bitcoin network means that the clearance of transaction take much longer time than if it was done by a centralized server. On bitcoin network, a block of transactions is added on chain every ten minutes. Also, the size of the block is limited to 1 MB and together with average time for adding a new block on the chain of ten minutes means that the maximum transactions that can be processed is limited to an average 4,7 transactions per second making the Bitcoin Network not so scalable for huge numbers of small transactions. It takes time to achieve consensus and reaching confidence requires atleast 6 blocks. So a single confirmation of transaction takes ten minutes and increased certainity of transaction is achieved with atleast six blocks added on chain which can take upto an hour to happen. For a comparison, Visa‘s payment network has the capacity to process more than 65 000 transactions per second. This can be solved by using a payment network similar to Visa, MasterCard or Lightening network to have the transactions off-chain and the final settlement on-chain. So Bitcoin network can be seen more as an alternative to inter-country or inter-financial institution settlement network for large transactions.

Secondly, the transactions added to the blockchain are immutable. That means once the transaction is confirmed, the buyer cannot reverse the transaction if the seller doesn’t delivers the promised product or service according to the agreement. Again, this can be solved by a second layer payment network with a “dispute period”.

Bitcoin as an Asset for Storage of Value

The maximum number of Bitcoins that can ever come in to existence is capped to 21 million and this limit is immutable. That makes Bitcoin the scarcest monetary asset which cannot be diluted by anyone and has an predictive monetary policy. So as long as there is demand for the bitcoins the value of bitcoins would increase in dollar terms preserving the purchasing power at the very least if not increasing the purchasing power of the bitcoins. So bitcoin is a better alternative to storing value than keeping cash, which is diluted by the States in collusion with central banks without any kind of predictably.

Conclusion: Bitcoin is in my view digital gold which gives the holder its soveriegnity plus all the advantages that come with it being digital, secure and decentralized. Bitcoin being scarcest thing in itself doesn’t makes it valuable. The value of the Bitcoin comes from others valuing it to be valuable just like some think gold is valuable. You cannot use DCF or other valuation models to come a value of Bitcoin as there are no cash flows associated with this asset just like Gold. Also, equating Bitcoin to a stock of a growth company is totally is wrong on lot of levels and is like comparing Apples to Oranges.

I don’t believe that Bitcoin will be the only currency or asset that will survive the eventual crashing of Fiat Currencies. And I am unsure of the scenario that will ultimately play out but if there is one percent chance that Bitcoin will endure the test of time as the store of value then it deserves at the least one percent of my Net Worth (and if I feel the probability is 50 % than it would get 50% of my Net Worth). I intend to keep saving a part of the spare fiat cash in to Bitcoin spread over time (Dollar Cost Averaging).

Disclosure: I have a position in the Bitcoin and may or may not increase my position within the coming weeks and months. See my complete cryptocurrency portfolio here. Please read the disclaimer before acting on the information provided on the website. Some of the links in the post may be affiliate links.

References:

  1. The Bitcoin Standard: The Decentralized Alternative to Central Banking: Ammous, Saifedean: Amazon.se: Books
  2. lightning-network-presentation-time-2015-07-06.pdf
  3. IGFX_Inside-Visa_v09082017_abridged_digital
  4. https://drive.google.com/file/d/1FAfhOAU9g5DJ2E1KlZYMqd543hPZbZ-8/view

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