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(For the Badgingarra Sandpaper April 2018)
So the “venerable grower” asks his not-quite-as-aged unpaid consultant on tech matters (aka “son”), “What is this bitcoin thing? How does it work? How much is it worth? And should we invest Grandma’s retirement savings in it?”
The short answers to these questions are: 1 - It’s a digital currency. 2 - It’s complicated, with lots of maths. 3- As much as everybody thinks it is (about 4 or 5 second-hand Hiluxes now). 4 - Hell no!
Answering the final question first: If you don’t read any further into the wall of tedious detail in this article, one message to take away is that while Bitcoin is very cool you can easily lose money with it. Bitcoin is at the VERY speculative end of the investment spectrum – you can make money or lose all of it. If somebody offers for you to buy into their multi-level-marketing driven bitcoin scheme guaranteeing you a profit, you should run away or at the very least get advice from somebody who knows about it!
The third question is a bit fuzzy. Bitcoin is worth whatever somebody will give you for it. In that respect it is not too different from other assets. Listed shares are nominally based on the value of the company but are only worth what somebody will buy them for and that can vary based on market sentiment. Fiat currencies like the Australian Dollar have defined value, but it’s worth really comes down to agreement by those people willing to accept it in exchange for goods or services. The difference with Bitcoin is that it is more divorced from any underpinning value, can be traded very fast and is not regulated so the conversion to other currencies can vary wildly. As mentioned above, this month it can be traded for around the cost of 4 to 5 second-hand 90s 2WD Hiluxes or 7,000 to 10,000 AUD. See online for the price right now: http://www.bitcoinprice.com/aud/
What is it? Bitcoin is a cryptocurrency. This means it is a type of digital asset that uses encryption to make it secure, prove that units of currency are legitimate and verify transactions. Bitcoin was the first and is still the most well-known cryptocurrency. Bitcoin is decentralised which means that there is no central authority controlling the value or administering transactions like a central bank does for a national currency. The decentralised approach was one of the original inspirations of the creators who were disillusioned with how governments and central banks were handling world finances.
“How does it work?” is complicated. I’ll explain a few aspects in a low level of detail, mostly because that’s all I can manage. Warning: heavy explanation ahead – skip to the end if you’re anti-tech.
Bitcoins are registered to the owner’s address. The address is simply a long string of letters and numbers like “169G4BRLY6p1CbZhiD3jvRUiEdpEmfk1Aj” that corresponds to a secret private key. A user (or their software) generates this address using a randomly selected and secret private key and generating the public address using a defined algorithm. This uses public key encryption algorithms similar to those used to authenticate websites. It is relatively easy (if you are a computer) to generate the address from the private key, but not feasible to calculate the private key from the public address. A user can be verified because their public key can be used to verify transaction data has been signed by their private key. If the private key is lost, there is no other way to recover bitcoin associated with that address.
No name or other identifying information is linked to the address, so bitcoin transactions can be anonymous. Because of this it has been popular with privacy enthusiasts as well as criminals. More correctly, transactions are pseudonymous because, as described below, all transactions between addresses are kept in a public ledger. With some investigation, patterns of use of an address may lead to identifying the owner.
Bitcoin transactions happen directly between parties and are recorded in a public, distributed ledger called the blockchain. The blockchain is the basis for the entire bitcoin system and for many other cryptocurrencies. Having a public ledger means that anybody can verify that a transaction between two addresses did actually occur and confirm the balance registered against an address so that it is not possible to spend bitcoins twice.
The blockchain uses a mathematical function called a “hash function” to sign the record of a block of transactions and link (or “chain”) to the next block of transactions.
A hash function converts an arbitrary block of input data into a fixed length output or hash value. Hash functions have two important properties. A very small change to the input data causes a large change in the output data and it is relatively easy to calculate a hash value from its input data but not possible to calculate the original data from a hash value. This means that given the original data and the hash value anybody can easily verify that the original data has not been changed but it is not feasible to create fake input data to match a given hash value.
In the blockchain, a block is formed by the hash value of the previous block (a 64 digit hexadecimal number) and all the transactions for a period (about 10 minutes for Bitcoin). A hash value is calculated from this combined data and is included in the next block. If a malicious person wanted to change the transaction data in a block this would be detected as the hash would no longer match the hash stored in the subsequent block which affects the hashes of every block in the chain
“Mining” is the process that creates more bitcoins while signing the blockchain. Each block has one more element in the data section: a “nonce” or arbitrary number that is specifically chosen so that the hash value of the whole block starts with at least a certain number of zeroes (currently 18). As described above, slight changes to the input data change the output hash value significantly. There is no easy way to predict the hash value from the data so miners must sequentially try every number starting from 0 and incrementing until the resulting hash meets the criteria. While each hash computation is relatively quick, the miner may have to quintillions of variations to find a successful hash so this requires a lot of computational effort. The reward for this computational effort is that the miner is given a certain number of Bitcoin. Currently this is 12.5₿ per block, decreasing over time.
When the bitcoin price was low, lots of people made money mining. Now competition has limited direct mining to groups with big investments in specialised hardware. Some people made money on the recent huge volatility. Some, like me, would have made a killing if they sold at the right time, but made a little money. My speculation is that bitcoin value will increase by an order of magnitude in the next ten years. It is also possible that the value will go to zero. Hold on for the ride!
If you want more than this very brief outline, search online or see http://www.williamsperth.com/articles/20180404-sandpaper-bitcoin. To see details of blockchain blocks see https://blockexplorer.com or https://blockchain.info/blocks
Keith Williams
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