Bitcoin (BTC) Ushers in the Future of Finance..(1/5)

The decentralized, peer to peer,high secure and purely digital currency finally came of age in 2015. Bitcoin (BTC) & other variants (the AltCoins) got widespread & positive notice by all industry actors ranging from Consumers, Banking Institutions, Retailers & Regulators. Riding on the real pathbreaker – the Blockchain, the crypto-currency movement will help drive democratization in the financial industry and society at large in the years to come. This first of five blogposts will discuss Bitcoin (BTC) from a business & technology standpoint. The second post will take a deepdive look at the technology behind BTC. The third and fourth posts will focus on the Blockchain. The final post will bring it all together and will cover business models & native application architectures that will be created as part of this immense disruption.

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If there is something that touches all of humankind everyday across the planet & plays a central role in our existence – it is money & the monetary system. Money supply is the backbone of the financial system & as is typically considered a safe asset that households and businesses can use to meet their financial obligations (e.g payments) or to hold as short-term investments (e.g.savings & checking accounts).

Let us understand how the typical banking system has been structured from a monetary & historical perspective since the 1600s but is still very relevant even now. Please note that this is a very high level and basic explanation that segues into our examination of Bitcoin.

A Quick Primer On How Money Works – 

The simplest and most commonly accepted form of money is currency – a dollar bill or a euro coin etc.This paper representation can be converted into any commodity of suitable value. E.g  Lunch or a Cup of coffee or even downpayment on a Car etc. 

When the monetary system was first created,the unit of monetary value – typically a coin- had some intrinsic value in and of itself. It was either made of silver or copper or nickel etc & could be used to support the currency in the event of a bank run or economic downturn. The limitation with this way of doing things was that since the supply of silver or copper in the world is fairly limited, the money supply has no way of growing to accommodate an expansionary economy. 

After a few decades, the Gold standard was adopted which dictated that the money supply was backed up by a fixed quantity of gold. Any government adopting the gold standard guaranteed a fixed exchange rate with the currency of another country that uses a similar standard.  The Gold Standard worked well for decades.

However, as economies became more complex and increasingly non farm based, the inflexibility inherent in the gold standard was a big problem. Case in point, it was partly blamed for the Great Depression. After the war, the Bretton Woods conferences of 1944 (https://en.wikipedia.org/wiki/Bretton_Woods_Conference) helped create the International Monetary Fund with the aim of enforcing a set of fixed exchange rates that were linked to the dollar.However, in 1972 the Nixon Administration initiated a series of economic measures (in response to economic headwinds & unfavorable currency exchange rate) that disengaged the US from the Bretton Woods System. Essentially, direct convertibility of the US dollar to Gold was canceled rather unilaterally – which rendered the Bretton Woods agreements inoperative.

In a quick span of two years by 1973-74, the Bretton Woods system was replaced by the era of freely floating fiat currencies – not backed by any commodity but solely by the faith in the Central Bank & Government of the Country in question.

The point to then take note of is that a currency note of today  (made of paper) has no intrinsic value in and of itself – in that it cannot be redeemed for any commodity – if society & economic order collapsed. The value of a dollar bill is typically endowed by an issuing & regulatory authority typically the Central Bank such as the US Federal Reserve. This Central regulatory authority prints the currency, controls its supply based on macroeconomic conditions & recognizes it as legal tender for all transactions – public or private. Thus this kind of money is called fiat currency – in that the value of the currency is set by fiat (a Government mandated order). Fiat Currencies form the bedrock of the modern day fractional banking system.

Why Governments need to control the Currency Supply? 

The most important reason is that the money supply is the most critical lever in the Government being able to counter business cycles and to temper recessions & booms. Generally speaking, there are two broad ways to defend a present day economy that is typically complex & hugely diversified in terms of private sector participation –  monetary policy and fiscal policy. While fiscal policy deals with public tax policy which have a lagging effect and take time due to the political process involved – monetary policy can almost instantaneously produce the desired economic effect.

Thus, Monetary policy is the core function of Central banks and is concerned with setting benchmark interest rates (e.g the federal funds rate in the US) that directly influences the cost of credit throughout the economy. The biggest advantages of fiat money is being able to inflate it’s value (by printing more bills) to counter economic cycles or for other political purposes (e.g Zimbabwe Dollar, Argentina Peso & Weimar era Germany among the notable examples).

Fast forward to the financial crisis of 2008, governments all over the world were forced to inflate the value of their currencies by resorting to massive creation and printing of Dollars,Euros,the British pound etc. This inflationary or rather expansionary view of the economy originates with Keynesian (https://en.wikipedia.org/wiki/John_Maynard_Keynes) thinking and is in direct conflict with the libertarian movement associated with Hayek (https://en.wikipedia.org/wiki/Friedrich_Hayek) – which espouses the Gold standard.

As computer technology advanced over the years, the field of cryptography was originally used to ensure secure private communication between two systems or people who had a trusted business relationship. Its scope has since expanded to encompass  usecases as diverse as integrity for both data in motion & at rest, telemedicine, electronic transactions, digital cash, secure & massive distributed computation etc.

Bitcoin (BTC) has strong origins in the Cypherphunk movement  which itself is rooted in libertarian thinking. The goal of the Cypherphunk’s is to influence societal and economic change through the use of cryptography. [2] 

The Origin of Bitcoin

So what is Bitcoin? Bitcoin is essentially a novel way of stringing  together existing technology  (Cloud Computing, Big Data & Cryptography) to provide a disruptive service. The very concept and the software based implementation of Bitcoin were originally proposed in a white paper released (November 2008) by an individual(s) under the eponymous name Satoshi Nakamoto. The paper was titled –  Bitcoin: A Peer-to-Peer Electronic Cash System[1].  In this paper, the author(s) proposes BTC as a digital currency that overcomes two important challenges that bedeviled cryptographic digital currencies prior to the bitcoin.

These are  – 

  1. The problem of double spending that allowed the copy and reuse (effectively counterfeiting) of digital currency again and again (much like an mp3 file) after issue. What is different with bitcoin is that once a bitcoin has been purchased or transferred anywhere in the world – ownership is established and recorded authoritatively via the Blockchain , a network of distributed servers. The Blockchain operates at such a massive scale which makes it virtually impossible (and cost prohibitive) to hack or otherwise break into bitcoin. Thus there is no need for a central 3rd party to a issue, authenticate and validate ownership of the currency.
  2. For a peer to peer currency to truly work, each member of the millions of global nodes must be in agreement about the ownership of every unit of the currency & the total number of coins any member owns at any given time. This problem of global consensus in a distributed network is solved by the Blockchain. The Blockchain leverages peer to peer communication to achieve consensus on transaction blocks every 10 minutes (avg) while processing newer blocks constantly as business transactions occur using Bitcoin (or any of the other AltCoins).  Specialized nodes called Miners perform the issue of new units of currency while simultaneously performing large & complex calculations. Doing these ensures that the Miner node(s) can mine a block of transactions during the same time. The benefit to the Miners is that they can keep the transaction fees associated with that block as a reward. It is almost impossible for this system to be broken into as it is in the interest of all the miners to form a distributed consensus based on valid block information. This capability is termed as the proof of work

Since 2009, BTC has been widely accepted at a growing list of online merchants and Banks. A comprehensive list is maintained here [2] & includes players ranging from Amazon, HomeDepot, eBay to Expedia etc. Bitcoin is open source in nature and is essentially controlled by no one but by the consensus of the community.

What is the Bitcoin? 

So how does Bitcoin approach some of the limitations of traditional currency as we know it ? The central theme of bitcoin is its peer to peer (P2P) nature (driven by technology) where the total and complete absence of any issuing or central authority enables it to serve as a total digital ecosystem. As noted above, it has strong origins in a technocratic- libertarian way of thinking in that it democratizes the money supply while opening up vast new possibilities and business models.

Make no mistake, the original concepts behind BTC are extremely elegant and beautifully designed.

Please note that Bitcoin is a frequently overloaded term referring to a currency, a digital protocol and also an ecosystem of services. We will cover the currency aspect here, the next few posts will focus on the technology underpinnings and the ecosystem that it enables – along with the blockchain.

Let us enumerate the defining characteristics of the Bitcoin (BTC) –

1. The BTC is a virtual currency in that it is entirely digital – with no physical representation like paper or coins – and is created online using a process called “mining”.  BTC’s trade like any financial instrument and are issued on a fixed basis with an upward limit of 21 million units till 2040.
2.Bitcoins are peer to peer & not created or regulated or backed by any central authority – bank or government regulators (and their whims & fancies). It is technocratic and democratic at once. Technology operating at internet scale creates & transfers control of bitcoins to consumers & merchants as a way of buying goods and services. BTC will exist as long as the internet exists and it’s value is purely governed by supply and demand.
3. Advances in cryptography and distributed computing making it almost impossible to hack the BTC. It is thus much more safer than traditional currency to steal or counterfeit or to use over internet transactions. Further, transactions performed using bitcoin can be done by supplying minimal information which makes it extremely hard for malicious actors to hack into or otherwise modify it. Underlying BTC is the concept of a Blockchain.
The Blockchain is a shared public ledger or a massive & highly reliable database which serves as the foundation for the entire Bitcoin distributed network.Every time a user spends their bitcoins or millibits from their BTC wallet – these transactions are confirmed & recorded into the immutable blockchain with the highest guarantees for integrity & chronological order.
4. The BTC is deflationary in nature & this is by design. The total number of bitcoins that can every be created are limited to 21 million till 2040. This fixed number does not inhibit the creation of new bitcoins as they have an infinite capacity to be broken down into smaller divisions. This means that bitcoin cannot be used as a traditional currency can be – as discussed above – e.g. inflate it’s value to pay off debt.
5..Every transaction made using bitcoin is reliably recorded in an un-erasable public ledger the Blockchain (more on this in the next post). This opens up it’s applicability to a vast array of business capabilities.
5.BTC transactions are processed by independent (yet interconnected grids of servers called ‘miners‘). The advantage conferred by this approach is that a vast number of miners keeps the transaction fees very very low to 0.001 bitcoins. Hence bitcoin removes the omnipresent intermediary in financial services
6.BTC transactions while performed at a retail setting may seem slow taking upto a few mts for verification by the Miner infrastructure. However, its true potential becomes evident with use-cases like wire transfers, cross border payments etc which can take days with conventional banking networks just take a few seconds to minutes using BTC.
7.BTC supports the entire spectrum of the money supply employed in a fractional reserve system..M0,M1,M2 etc. It supports this notion by supplying off the chain transactions (more on that in the next post)
We will now examine how BTC works in a real world setting.
How does a traditional Credit Card Transaction Work

Let us consider the most common form of online transaction –  a credit card payment. Credit Card payment networks are high cost pipelines both from a consumer and a merchant perspective. Merchants complain of constantly increasingly interchange fees and consumers accuse it of predatory lending practices.

The below pictorial explains a highly simplified approval process (not clearing or settlement mind you).

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                                    Illustration 1 – Traditional Credit Card Transaction 
How does a BitCoin Transaction Work
All one needs to transact using Bitcoins is an address, a wallet and a private key. There is no need to register with a central authority or an intermediary as transactions are verified using internet based “miners” All of these are completely software based thus making bitcoin a true digital currency. As can be seen below in Illustration 2 – the same transaction with BTC is vastly simplified,
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                                    Illustration 2 – Credit Card Transaction performed using Bitcoin

Advantages of Bitcoin

  1. BTC promotes complete transparency & neutrality as to the creation,usage and movement of BTC. All transactions and bitcons issues can be tracked in realtime using APIs or mobile clients and 3rd party services
  2. Enables complete freedom from the intermediary structure that have been built up in Banking over the years. Different versions of this exist across the spectrum  ranging from Clearinghouses in Capital Markets, to Custodial Banking to the Payments industry. BTC enables the supplanting or even complete replacement of these structures
  3. Very low transaction fees compared to traditional payment networks and clearinghouses
  4. High speed of transaction settlement and contracts transfer compared to traditional clearinghouses
  5. Highest level of security owing to it’s complete transparency –  a huge selling point in these days of constant cyber theft and security attacks.
  6. BTC eliminates the dual challenge that plagued digital currencies before it. These are the problem of double spending and the problem of distributed consensus
  7. Potential lower regulation due to all of the above 

Disadvantages of Bitcoin

  1. Much lower degree of acceptance across the world as compared to traditional fiat currency
  2. Higher volatility as can be seen from the last few years
  3. Immature currency trading markets that need time to evolve
  4. Will supplant but never completely replace fiat currency 
  5. Scalability needs to be improved to matchup with e.g. Credit Card networks etc in the coming years

Summary

Bitcoin will never quite replace fiat currency and nor should aim to do so. As has been termed – it aims to be the currency of transactions In the online world affording consumers & merchants an enormous amount of independence from existing structures. Bitcoin can be employed across a diverse range of use cases (which we will examine in the last post in this series) ranging from online payments to recording complex financial transactions to Contracts to Clearing & Settlement. BTC (and a full blown ecosystem around it) can be truly disruptive in any business situation involving financial intermediaries.

However it’s true potential is being able to bring the vast percentage of the global population that has no access to the banking system into it. With Bitcoin, all one needs is a a cellphone, a bitcoin account and a Wallet app  to be able to begin participating in the financial system.

Much of the innovation around bitcoin is driven by the Blockchain.  The next post will be a deep technical look into the Bitcoin after which point we will move onto the Blockchain – the true disruptive innovation.

References

[1] https://bitcoin.org/bitcoin.pdf

[2] https://en.wikipedia.org/wiki/Cypherpunk

3 thoughts on “Bitcoin (BTC) Ushers in the Future of Finance..(1/5)”

  1. Fantastic post on Bitcoin and hugely educational both from an economics and technology standpoint.I could not really get this hugely complicated topic till this post..waiting for the others in this series.Thank you..

  2. Super awesome things here. I’m very glad to see your post on the BTC. Thanks a lot and i’m looking forward to contact you. Will you please drop me a e-mail?

  3. Fantastic article and great writing style. You are an amazing blend of management consultant, IT leader, tech architect and business owner.

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