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The Ten Year Project - Issue #3

| November 08, 2017
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Bitcoin

I began this project last December in the effort to study a new frontier technology.  I have stated on more than one occasion that I am not writing this as a recommendation to buy Bitcoin, but rather as a public learning experiment.  I bought my first batch of Bitcoins in April of 2015 after realizing that I knew little of the concept, but was beginning to field questions from curious clients.  I tend to learn more when I have some “skin in the game.”  I have transitioned from being dismissive, to highly skeptical, to intrigued over the last few years.  I still think it is possible that the potential value of a Bitcoin is either worthless or quite valuable in the future.  I have been in the financial services industry since 2001 and I would venture to say that Bitcoin is the most polarizing security that I have seen.  Mainstream investors and Wall Street firms generally hate it.  Most successful professional investors remain dismissive.  When I penned the first issue of this project the price of Bitcoin was around $775.  With Bitcoin piercing the $7,000 barrier in early November, it has clearly been a wild ride in 2017.

In this issue, I planned on delving into the basics of cryptography and explaining the role of bitcoin mining.  Due to the complexity of both elements, I’m aiming to tackle an intro into cryptography and then cover some other key events and observations.  I plan to deal with Bitcoin mining next time.

A trusty Merriam-Webster dictionary tells us that cryptography is the “encoding and decoding of messages in secret code or cipher.”  To illustrate a basic example, I take you to my past.  In the second grade some friends and I formed the Pac-Man club (early 1980’s).  Original, I know.  Best I can remember, our principal mission was to collect the pencil shavings from the sharpeners in our classroom and store them in our empty milk cartons while we plotted against our rival club (whose name unfortunately escapes me at this point).  As a random aside, I also had 2 simultaneous girlfriends around this time, and everyone was cool with it (apparently, the Pac-Man club was the place to be).  Moving back towards relevance, our club used a coded form of communication whereby we “bumped up” the letters in a message (E + 1 = F) to prevent the “bad guys” from being able to interpret our messages.  Little did we know, we were playing around with the concept of cryptography. 

According to the math nerds (meant as a jealous compliment) at Khan Academy (a website that parents love, and students hate for some reason), Julius Caesar created what would become known as the “Caesar Cipher” around 58 B.C.  His cipher shifted the letters in his military messages to make them appear meaningless if intercepted by the enemy (kind of like my modern-day Pac-Man encryption method or the word puzzles found on the back of kid’s menus in restaurants).  Shockingly this method was effectively used in military communications for hundreds of years thereafter.  It was busted when people realized that you could analyze the frequency of the letters in the messages and then compare that to the frequency of letters used in the native language.  If the letter “E” is the most common letter in the English language and you find the letter “I” as the most common letter in your encoded message, there’s a good chance you just shifted the letters up by +4 to encode it.  

What does any of this have to do with Bitcoin you may ask?  It has everything to do with it.  Bitcoin uses something called a cryptographic hash function to communicate across the network.  A hash function is an algorithm that takes an input and creates an output.  This gets thick in a hurry, so hang in there.  These algorithms are simple to compute given a set of inputs, but impossible to reverse engineer the inputs from the output.  You might see this referred to as the mathematical trap door in other places.  For example, let’s say our algorithm is set to add the input digits together to create the output.  If we add the inputs of 5,8,33,4 together we get an output of 50.  However, if you only had the output of 50, could you guess the inputs?  Good luck.

Bitcoin uses the cryptographic hash function SHA256 (Secure Hash Algorithm 256-bit).  Basically, this takes lots of different sized inputs and creates a standardized output.  Using this system, the output string will be the same length whether there were 10 inputs or 5,000.  The Bitcoin network then uses these outputs to verify activity (purchases, sales, transfers, etc.) on its network.  Let’s say that you downloaded a file from the internet and you want to verify that it has not been altered or modified.  Using a hash generator, you can create a hash of the file (think fingerprint) and then compare it to the one provided by the site that originated the file.  If it has been altered in any way, the output will be completely different.  Hashing serves as a verification tool which is at the very backbone of the Bitcoin network.  Hashing may sound like encryption, but it is not.  Encryption is designed to be decrypted, thereby making it a two-way function.  Hashing is not meant to be reversed.  It is merely used as a tool to compare two sets of data.

Now that we have covered hashing, let’s relate it back to how Bitcoin uses it to communicate.  If I choose to send Jeff a Bitcoin from my wallet, I’ll need to broadcast my intentions to the Bitcoin network.  In simple terms, I am going to broadcast the desire to send 1 Bitcoin from Eric’s wallet (at location X) to Jeff’s wallet (at location Y).  The hash function will take those inputs and standardize it into a string that looks something like this:

 A6h34nd9ilqs31hrivgbnjefr59iklqacgdmuf639h37d1e9opq947fhvec3y7f9

In the real world, transactions like this are grouped together and organized into something called a hash tree.  This begins to form what is known as a “block” which we discussed in the last update and the root of where the term “blockchain” comes from.   This hash tree (also known as the “Merkle Root”) is used to create a header for the block.  All this information will then allow the bitcoin mining community to compete to validate the blocks.  For a visual of this process, see below:

Executive Summary of what you just read:  Bitcoin uses an NSA-developed computer coding language to organize and standardize instructions that are sent across its network.  In hindsight, maybe I should have just said that. 

Now that we have spent some time in the plumbing of Bitcoin, let’s cover a frequent topic related to Bitcoin in 2017.  There has been a lot written about “hard forks” in the Bitcoin network.  A hard fork can occur when there is disagreement in the Bitcoin community about certain issues (scalability namely).  If the network cannot agree on changes or upgrades, then the Bitcoin chain can actually “fork” and go in two different directions.  One chain continues under the old regime, while the newly formed chain blazes its own trail using whatever software upgrade caused the impasse.  When Bitcoin was created, the size of each block was limited.  At the time there was plenty of capacity across the network, as transactions were minimal.  However, as adoption has grown the transactions across the network began to stack up and form a line.  Bitcoin developers wanted to activate a software patch called “Segregated Witness” (or SegWit) which would increase the capacity and speed at which transactions can be processed.  SegWit was activated across the network back in May.  However, some developers also felt the need to further modify the protocol by increasing the maximum size of each block (pending change referred to as SegWit2x, scheduled in mid-November).  So far, the gyrations to the Bitcoin ecosystem have been largely accepted and have happened without too much fanfare or price disruption.  However, it seems the more times the blockchain forks, the core concept of a digital currency operating in a united decentralized community might come into question.  If we use the price of Bitcoin to assess the perception of this risk, we might conclude that market participants are not concerned in the least.  Since the Segwit upgrade in May, Bitcoin has advanced approximately 200%.  However, using price to validate things that are later proven false is dangerous (see the tech bubble and housing mania).

I have reached a couple of new conclusions since last writing on the topic.  Though my opinions on Bitcoin are no doubt influenced by the tantalizing gains over the past few years, I’ll try to remain objective and reasonable as I spell these out.  As always, know that all of my conclusions may be completely wrong.

1. There are many competing cryptocurrencies available today (800+). Many of these coins have advanced much more than Bitcoin this year in percentage terms.  However, many remind me of failed ventures from the technology bubble.  Entrepreneurs striking while the crowd is interested, only to eventually flame out when things mature in the industry.  Most of the significant investment, top developer talent, and community collaboration centers around Bitcoin.  As a result, I cannot envision a scenario where Bitcoin is not a significant player in the digital currency space.  Bitcoin could go away altogether, but I would guess if it does, then every other cryptocurrency would have flatlined as well.  I don’t see other digital currencies existing and Bitcoin becoming worthless.  The network effect and first-to-market principles should be too strong to allow this to happen.

2. I previously referred to the hatred of Bitcoin by most traditional investors. This used to bother me, as some of the most successful investors I know are convinced that Bitcoin will eventually be like the tulip mania from the 1600’s.  This group might be correct, but we must also realize that for the adoption rate for Bitcoin to increase there must be a large pool of disinterested and skeptical people.  If everyone owned, used, and believed in the future capability of the currency there would be no new buyers.  A successful investor and current author of the Global Macro Investor newsletter, Raoul Pal, was a vocal proponent of the technology earlier than most.  He announced via Twitter in June (Bitcoin price in early June was around $2,600) that he had sold all his Bitcoins.  Mr. Pal makes a compelling case that Bitcoin has failed to develop a productive capacity and that competing products and services might be taking the torch and moving forward, leaving Bitcoin with unfulfilled promises.

Likewise, the CEO of JP Morgan Chase, Jamie Dimon, proclaimed earlier this fall, “if you’re stupid enough to buy Bitcoin, you’ll pay the price one day.”  He went on to say that Bitcoin only had value if someone else would hopefully buy it in the future (aka the greater fool theory).  He then completely contradicted himself when he recognized the value of Bitcoin to people in countries like Venezuela (hyper-inflation), and in countries where governments exert tight capital controls.  I would expect Mr. Dimon to be critical of Bitcoin. 

However, let’s consider the following example as we challenge whether Bitcoin has value.  If you visited France and had your wallet stolen and emailed me to borrow money, we have some options at our disposal.  I could use JP Morgan Chase to send you money (assuming I had an account with them).  Their website states that international wires can take up to 2 days and we will both be charged incoming and outgoing fees on the transaction.  Or, if we both had a Bitcoin wallet, I could send you the money for a minimal fee (paid to the Bitcoin miners who approve and secure the transaction) and you would receive it instantly.  Seems like a stretch to say all Bitcoin owners are “stupid” and that the concept is truly worthless. 

 

This has gone on way too long, so I will leave you with one final thought for this issue.  Below is a quote from Dan Morehead from Pantera Capital:

“It's MoIP – Money over IP.  Blockchain is going to disrupt business models the same way that VoIP disrupted the telephony market.  Back in the day, there used to be a monopolist in one country, a physical copper wire across the ocean, and a monopolist on the far end.  The only way that a person in the US could call a person in the UK was to use those two monopolists and their copper wire.  When we realized that you could route voice over the internet – and around these monopolists – the prices dropped over 99%, the quality went up, and the quantity exploded several orders of magnitude.   Bitcoin is MoIP – Money over IP.  It's a way to route money around the oligopolists who have controlled correspondent banking for five centuries.  It allows a person in any country to send any amount of money to anyone anywhere on Earth.  For a technology to be disruptive it must be better, faster and cheaper than the legacy technology.”

Will Bitcoin end up being better, faster and cheaper than our present-day banking system?  I really have no idea.   Do I think it is a reasonable speculation to trade some dollars for a Bitcoin (or a piece of a Bitcoin)?  Yes, if you won’t be upset if it vaporizes and if you won’t stress out when it randomly jumps or crashes hundreds of dollars for no discernible reason (which it does...often).    You also must be able to withstand being called stupid by really rich, successful, elitist bankers on Wall Street.  If the insults keep coming, maybe I’ll have to reconstitute the old Pac-Man club to seek some vigilante justice.  Save your pencil shavings.

Current Bitcoin Price: $7,449.14 as of November 8, 2017 at 11:31 am EST

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