Changing The Paradigm

Many entrepreneurs aren’t familiar with what Bitcoin is or exactly how it works. And those who have read about Bitcoin online have most likely been subjected to misleading information, thanks to a lot of lazy journalism by writers who don’t have a clue what they are talking about.

There are a lot of misconceptions about the digital currency being plastered all over the internet these days. Several major media outlets have covered this developing currency, but they aren’t explaining its fundamentals nor practicality properly. In fact, most mainstream media outlets are deeming the digital currency as somewhat of a joke - a fad if you will. I can assure you though, Bitcoin is no joke, and it has made early adopters fortunes in recent years.

Bitcoin, in my opinion, is a compelling example of free market innovation and if adopted on a large scale, could open up markets to entrepreneurs like never before (caveat: I don’t endorse Bitcoin in the slightest, but, conceptually, and if broadly adopted, it could be a force).

Simply put, since 2009 there has been no asset class on the planet which has increased in value more than Bitcoin. As entrepreneurs and investors, that makes Bitcoin extremely relevant.

Had you bought $1,000 worth of bitcoins in 2009 and sold today, you’d be sitting on over half a million bucks. Do I have your attention?

I believe it is imperative, as entrepreneurs and investors, that we understand this phenomenon developing in the global monetary system. When you peel back the layers of this digital currency, the innovation behind it is indeed quite remarkable.

Given how unpredictable central banks have become in printing money and basically devaluing our savings, the founders of Bitcoin saw an opening for a new market, and started the digital currency in late 2008.

Bitcoin’s value in the last six to eight months has increased by nearly 1200%. It is being used 600% more frequently for commercial transactions than it was just 9 months ago. Last month there were 50,000 commercial transactions which used the digital currency. Many online shops and service providers are now accepting bitcoins for payment and if the currency can stabilize in value (still quite volatile), there is a great likelihood many more entrepreneurs will accept bitcoins for payment.

A man in Alberta, Canada is selling his house for bitcoins. Many online stores allow you to buy appliances, tablets, phones, precious metals, table wear, prepaid wireless cards, domain names, food, video games and a ton more with bitcoins. There is a pre-existing commerce infrastructure to pay with bitcoins online and it’s getting bigger by the day. No merchant was required to accept bitcoins, they are doing it by choice! In Finland, there is now a dentist accepting bitcoins for regular checkups. There is even talk that Cyprus may get the world’s first Bitcoin ATM.

While I don’t recommend accepting bitcoins for payment at this moment in time (given its volatility), it is something entrepreneurs need to be monitoring closely as we could be witnessing the birth of a new global online currency.

Take the time to read this article. I believe it is the most comprehensive Bitcoin study relevant to any entrepreneur selling products or services online. I used the guidance of two Bitcoin experts and market researchers to put together this article for our readers. I hope you enjoy it and the comment section awaits your feedback.

Bitcoin: Defining the Free Market

Bitcoin is the world’s first crypto-currency that uses a peer-to-peer network to create, track and trade its virtual coins with anyone, anywhere in the world. A ‘Bitcoin Client’ is installed on a computer or mobile device that effectively turns it into a peer-to-peer node. The original Bitcoin Client, also known as the Satoshi Client, was developed by Satoshi Nakamoto (pseudonym) and remains open source.

Bitcoin transactions are anonymous, instantaneous, borderless and irreversible. They can be stored on a hard drive, in a smartphone or even printed on paper and stored in a vault. Because bitcoins use specific cryptographic strings of characters that act as a medium of exchange, they can be easily transferred from one person to the next with maximum speed and efficiency and minimal risk of fraud.

Fundamentals of Bitcoin

How does a paperless currency that has no central authority and no enforcement body prevent fraud while allowing anonymity? Simple, it uses advanced cryptography.

At the core of this currency is the Satoshi Client, which is tasked with doing three things.

The first task of the Satoshi Client, after it has installed on your computer, is to connect to a number of other nodes in the Bitcoin P2P network and download a file containing data on every transaction since the first transaction. This data, which remains on every node, forms the way of keeping the currency secure as well as identifying the trail. This data is called the ‘blockchain’. This blockchain provides full transparency of every coin in existence and every Bitcoin transaction ever performed. Once the blockchain is loaded, the Client maintains a constant connection to the network, so that every new transaction that filters through the network will update your existing files.

The second function the Satoshi Client is tasked with is creating new Bitcoin addresses, which includes creating the public and private keys. This address is where your counterpart will send a payment to. So, assuming Mr. A wishes to send you a payment for your services, you use the Satoshi Client to generate a Bitcoin address and give it to Mr A. He then uses his Client to send the payment to the address you just gave him. When he sends a payment it is not just sent personally to you, it is broadcast to the world at large and that information permeates through the network that address A has sent X bitcoins to address B. This updates the entire system and creates transparency for users.

The third function the Satoshi Client performs is creating and maintaining a ‘wallet’. This wallet is where your coins are stored. The wallet is based on the address that was generated. Each address has its own wallet. It is also possible to create multiple addresses and send different amounts to different addresses for safe keeping in different wallets (spreading your bitcoins around for safety).

The Bitcoin community has grown to include multiple services that have their own Clients which conform to the original Bitcoin protocol. There are also web wallet services and exchanges that facilitate the exchange of bitcoins to conventional currency (Mt Gox is the largest).

Creating Coins

Before any bitcoin is spent, or used, it must be created. In my view, Bitcoin has one of the most ingenious ways of creating currency. It does not allow a central authority to decide when and how to create. The system is already built in with the internal time of where it stops producing new bitcoins (no more than 21 million bitcoins will be created – that is the max. Right now there are roughly 11 million in circulation). It cannot be changed. To change it requires that all previous coins be taken off the system and a new client protocol be developed. This is not likely to happen as the public interest to maintain Bitcoin as it is is prevalent - there is no central authority and there is anonymity, so there can be no collusion; which means, in theory, there can be no decision to increase the number of bitcoins.

The way coins are created is that a mathematical problem must be solved. This solution is accomplished at a predetermined and predictable rate and that rate reduces by 50% every year. By this reduction, the day will come when the output will no longer be a meaningful integer and at that time it ceases to produce usable bitcoins (quite the opposite of what the Fed is doing eh?). That level is 21 million bitcoins (20,999999.977) and is expected to be reached in 2140. But the practical number of 99% will be reached sometime in 2032.

The process of creating bitcoins is called mining and it requires expensive processors to calculate the solution to mathematical problems. The mining process results in blocks being created that are then released in to the Bitcoin community. The key feature of Bitcoin is that one day there will be 21 million bitcoins. And when that amount of bitcoins in circulation is hit, production will permanently stop (that is the max level of bitcoins ever to be produced). This hard upper limit is the reason some theorists speculate that bitcoins are deflationary.

Central Authority

The main appeal of Bitcoin is that there is no central authority governing nor manipulating it. It operates across borders and across political divides. It does not need to be printed and no one needs to guard it because it is collectively built, collectively maintained and transactions are monitored across the entire Bitcoin world. The lack of a central authority reduces any faction of politics from seeping onto the true exchange of goods and services. The currency is a true free market tool of commerce and not a tool of politics and ideology. It is made possible by the confluence of technology and advances in mathematics.

Bitcoin Math

Bitcoin uses the Elliptic Curve Digital Signature Algorithm, ECDSA for short. Specifically, Bitcoin uses the secp256k1 ECDSA range for private keys. The details of the ECDSA are beyond what is needed to understand Bitcoin, however, the following simple explanation will suffice to appreciate Bitcoin’s fundamentals.

The central backbone of the Bitcoin structure is the use of a computationally impractical mathematical string that cannot be reversed. In such a situation, proof rather than trust is used as the basis of integrity in the system. For Bitcoin, no third party is required as a clearing house, unlike when dealing with conventional currency.

The client creates a random number that is 256 bits. This is the private key. The private key can be expressed in hexadecimal. From this private key, a point is then chosen on the elliptic curve based on the random number. The genius of this system is that the random number that is generated can only have one unique public key, but that public key could have many different numbers using the equation. Trying to calculate the private key by knowing the public key is statistically improbable.

image source: www.flickr.com

The public key that is generated from the random number is then used as the Bitcoin address. This is why each address has its own private key. It is impossible to reverse engineer the private key using the public key. It is, however, trivial to generate the exact public key from the private key. So if you have your private key but forget which address it belongs to, it can be easily calculated. This private key is a string of approximately 64 characters (hexadecimal) and nearly every 256 bit number can be a valid private key - this range is determined by the secp256k1 ECDSA.

Risk Of Counterfeit

To be able to counterfeit the system, what is required is that the attacker be able to either spend the same coin more than once, or introduce new coins to the system. For the attacker to introduce a new coin, it must conform to the protocol and that coin is then verified by all the Bitcoin nodes. A coin that does not conform, is rejected. If the attacker attempts to spend the same coin twice, the coin that was spent first, according to the time stamp, will be taken as real and the second one will be ejected from the system.

The US Dollar - Not a Free Market Currency

Even though the US dollar is the world’s reserve currency, it is the sovereign currency of a nation. As such, it is subject to the political will of the government. If that government, in the advancement of the will of its people or in advancement in the goals to improve the lives of its citizens, deems that it is necessary to create more money, then the individual value of the currency is diluted because of the addition of more notes. In economic terms, this is inflationary and it has an effect around the world as exchange rates have impact over trade.

If trade around the world is to be transparent, then no one must be superior to the other (a fundamental trait of free markets). A buyer and a seller come together for one purpose, to exchange a universal currency for a product or service.

Bitcoin - A True Free Market Currency

Since Bitcoin is not controlled by any nation or country, it can be used as a true medium of exchange. Bitcoin only looks at the transaction, it leaves everything else to the participants. It does not care about who the participants are or what it is used for. That is the true nature of neutrality - a characteristic of true freedom and one of the principles behind the internet. Other sovereign currencies are not neutral and seek to impose their will on users. Bitcoin is neutral and has the characteristics of a true reserve currency, or, even better, a single global currency. You can see why Bitcoin has some Libertarian-thinking entrepreneurs so excited.

Single World Currency

The concept of a single world currency, which favors no particular nation, has been mooted in economic circles more than once. The primary reason being is that economists look for the efficient allocation of goods and services and that ties in with the use of currency. It’s exactly how it started off in the beginning with bartering. However, the problem is that when a single currency is envisioned, along with it comes the notion of a global currency and a global central bank to monitor it. Once politics enters the equation, sovereign issues surface and disrupt the concept of a pure exchange value mechanism.

Economists believe that one single global currency will aid in the efficient distribution of resources and capital as well as ease trade; it’s hard to argue. In classical economics, it is commonplace to envision a global marketplace. A global market transcends the antiquated.

The Antiquated

The currency which is used across borders at present, as we all know, is the US Dollar. The US Dollar has the problem of being a currency at the control of one country, one agenda and one heavily indebted nation. This results in the possibility of anti-free market restraints and possible exclusion of entire groups of people.

For the perfect market to exist, and maximum opportunity for entrepreneurs to grow their customer base, a currency that is available to everyone without favor or prejudice must be established without a central authority. Such a currency now exists in Bitcoin.

An ideal currency is one that can transcend national borders, without political discrimination or non-market driven forces and is not controlled or monitored by any one group, but instead by the entire network, and that is truly transparent yet assures privacy. Such a currency is Bitcoin.

Arguments in favor of a single world currency are spot-on. Indeed the most obvious of the reasoning is that it will result in increased global trade. Yes, with reduced barriers, global trade will see a massive increase and online startups will grow at a rapid pace. Just think for a second what you could do with your business if you could sell your products freely to Chinese, Middle Eastern and Russian consumers. This kind of opportunity would result in higher average income levels as the velocity of money speeds up. If adopted on a massive scale globally, I believe Bitcoin’s velocity would be unprecedentedly high. With one global currency, nations would be built on the strength of their innovation, not the ability to exploit cheap labor.

Free Market Expansion

A totally free market, a true free market, has no limitations on what is bought or sold. In a free market, there must be no undue influence or power exerted from one player over the next.

The US government does not fall under the category of a free market promoter. And it can’t. It is not evil, but because the government is in control of the world’s reserve currency, it uses the reserve currency to protect its own interests.

The national interest of a government that is dictated by politics and its people will eventually seep into the policies and workings of an international currency (just as we’ve seen with the US dollar in recent years).

To be truly free, and to truly advance a global neutrality of commerce, there must be a medium of exchange which is not managed or regulated by any one country’s government. So far, only Bitcoin fits the definition.

S.W.O.T. Analysis

Bitcoin is the most robustly designed concept of a free market currency built over technical advances in computing as well as mathematical advances in cryptography. Nonetheless, Bitcoin has its inherent strengths and weaknesses which need to be understood in order to advance this currency on to the world stage and be adopted by entrepreneurs like ourselves.

Strengths

• Non-discriminating
• Increasing popularity
• Available to be exchanged for conventional currencies
• Secured by intractable cryptology
• Limited number of coins to be produced (cap at 21 million)

Weaknesses

• Deflationary (that is a weakness depending on who you speak to - some consider it a strength)
• Currently Bitcoin exchanges have been the victim of hacker attacks, which resulted in down time and a loss in trading liquidity. As with any new creation, there are glitches and vulnerabilities that still need to be worked out.
• The currency, while growing in popularity, still isn’t widely used like major currencies such as the USD, Euro, Canadian dollar, GBP etc.

Opportunities

• To replace global currencies or take a portion of the market
• Become a relevant currency for global online trade

Threats

• Possible copy-cat currencies
• Increased computer and networking power that could crash the system (hackers)
• Being deemed illegal by sovereigns (currently being looked at by US Treasury to impose regulations). This is my biggest fear with Bitcoin.

The strengths that come inherently in Bitcoin represent the makings of a true global medium of exchange. Because it has deflationary traits, it could benefit the consumer. And because of its inherent objectivity and global currency trait, it could be beneficial to entrepreneurs. However, it isn’t widely used enough for my taste, but it is certainly growing in popularity rapidly. For Bitcoin to remain successful, it cannot be subjected to rules external to its algorithm. It must remain outside the control of those who may wish to control it. It must remain outside the purview of governments and remain in the hands of the people and their computers. I have my doubts that it will be able to do so, but time will tell.

Bitcoin is a digital currency that has no real physical form. It is purely based on mathematical cryptography and knows no boundaries. It can be received and spent within select communities that appear to be growing everyday. It remains anonymous and its neutral nature makes it a possible candidate as the single global online currency. The genius of the system is that the currency cannot be created after a certain level.

This currency is attractive to many because it is of the people, by the people, for the people, to quote Abraham Lincoln. It is the people, after all, who say if a transaction is legitimate, or who owns what.

I have my doubts if Bitcoin will survive, but the concept of a neutral currency sure is interesting

Stay Hungry,

Aaron

This article represents solely the opinions of Aaron Hoddinott. Aaron Hoddinott is not an investment advisor and any reference to specific securities (including Bitcoin) in this article does not constitute a recommendation thereof. Readers are encouraged to consult their investment advisors prior to making any investment decisions. The information is of an impersonal nature and should not be construed as individualized advice or investment recommendations.