Will you be giving your kids cryptocurrencies for pocket money?
Aristotle was the first to elaborate on the concept of money as a medium of exchange and an instrument for storing value. He also noted that whatever form it takes, money is most useful when it is:
- Durable; it doesn’t fade, corrode or change over time
- Portable; it carries a high amount of value relative to its size and weight
- Divisible; it can be separated or combined without changing its fundamental characteristics
- Intrinsically valuable; its value is independent of other objects and contained in the money itself.
Gold has historically been a preferred choice as it comes close to meeting all of these criteria; its one shortcoming is its portability. Today’s fiat currencies can also possess these characteristics, although their intrinsic value depends on the credibility and strength of the issuing authority.
A New Currency Emerges
Bitcoin and other cryptocurrencies also have the potential to satisfy Aristotle’s conditions. As a digital currency bitcoin is not susceptible to physical damage; it can be moved/transferred easily and securely; each coin can be readily divided into sub-units; and the characteristics of its digital architecture make it intrinsically valuable.
Bitcoin emerged in 2009. Its origins were mysterious, and its purpose was not readily apparent. Eight years later, however, cryptocurrencies, including bitcoin, are worth almost USD 16 billion – bitcoin still dominates with about 85 percent of the value of the entire cryptocurrency market.
Bitcoins are based on “blocks” that have to be “mined” using extremely time-consuming computational processes. A miner who succeeds in finding a new block is issued newly created bitcoins and transaction fees. (See the box below for more details on the mining process and how giant bitcoin mining operations are being developed in Iceland to take advantage of its cheap, renewable energy and cold climate.)
The protocol also specifies that the degree of difficulty in finding new blocks is automatically adjusted to reflect the total amount of mining power in the network. That means uncovering a new block becomes progressively more difficult as the network grows.
At the same time, the bitcoin rewards from new blocks is being halved every 210,000 blocks mined. The value of new blocks will eventually reach close to zero, and no new bitcoins will be created. The protocol sets the ultimate theoretical maximum at just under 21 million bitcoins; that limit should be achieved around 2140.
These features – increasing difficulty, decreasing value, fixed upper limit –in effect represent a monetary policy based on artificial scarcity. That scarcity serves as the source for bitcoin’s value, even though they don’t exist in physical form.
So how does an average user go about saving a currency that has no physical incarnation? There are two broad options for storing bitcoins.
The first is known as a “cold wallet” – keeping bitcoins on machines that have no external internet access, such as a USB stick, printed “paper wallet” or another form of offline storage. The other is called a “hot wallet” – storing bitcoins in a way that is accessible online.
While cold wallet storage is susceptible to conventional methods of theft, bitcoins stored online have also become a key target for hackers.
You might expect a bitcoin hack to involve complex programming functions, conjuring images of sleepless nights in front of screens full of code. Recent hacks, however, have exploited simpler weaknesses.
Last August, for example, one of bitcoin’s earliest users lost millions of dollars’ worth of bitcoin after a hacker impersonating him was able to convince his mobile phone provider to transfer his number to another device. This allowed the hacker to reset his email and other passwords, and transfer his significant bitcoin reserve to their own accounts.
Money, It’s a Hit
In addition to its murky origins, bitcoin’s short history has been turbulent.
Its value has fluctuated wildly, and it’s also attracted interest from criminal and terrorist organizations, both as an underground medium of exchange and as the target for several massive thefts.
Since bitcoin can be transferred securely and anonymously, drug dealers, for example, have used it to sell drugs on the dark web, and victims of ransomware attacks often have to pay in bitcoin for their data to be unencrypted. ISIS also reportedly relies on bitcoin to receive funds from anonymous donors.
Compared to established currencies and other commodities, bitcoin’s value has been volatile. After declining precipitously in 2015, its value more than doubled in 2016. In fact, bitcoin was the worst-performing currency in 2015 and the best performer in 2016.
Also, large quantities of bitcoin have gone missing from some of the exchanges that have sprung up. Most notably, USD 460 million worth of bitcoin vanished in 2014 from the world’s then largest bitcoin exchange, preceding the collapse of the organization. Mismanagement has been another challenge for new bitcoin exchanges as cryptocurrency enthusiasts and programming experts are suddenly thrust into the role of managing large, complex financial organisations.
These controversies and setbacks notwithstanding, the infrastructures needed to establish and sustain digital currencies, including bitcoin, are slowly being built. Moreover, they are starting to establish footholds in diverse corners of the global economy."
These controversies and setbacks notwithstanding, the infrastructures needed to establish and sustain digital currencies, including bitcoin, are slowly being built. Moreover, they are starting to establish footholds in diverse corners of the global economy.
Although few brick-and-mortar establishments currently take bitcoin for retail transactions, there is greater acceptance from online merchants. However, bitcoin could become more widespread in the consumer world as mobile payment platforms become more prevalent and widely used.
What seems more likely is that bitcoin could become a preferred medium of exchange in international commerce. As a “currency without borders” that relies on strong encryption algorithms and a distributed ledger – the blockchain – bitcoin is potentially appealing to companies dealing with customers, suppliers or business partners in multiple countries.
Since intermediaries aren’t needed to process or verify an exchange, transactions using bitcoin can be conducted securely, efficiently and anonymously. Moreover, the blockchain architecture creates the possibility for smart contracts that execute automatically once certain conditions are met. And, so far anyway, blockchains have not been breached. (Click here to read more about blockchain and how it could upend business processes in many industries.)
A few barriers will have to be overcome, however, before bitcoin is used extensively in international commerce. Perhaps most importantly, its volatility will have to lessen considerably; few CFOs/Treasurers will want to carry an asset on their balance sheets that fluctuates as wildly as bitcoin has recently. Also, companies will need to develop or buy new IT capabilities to incorporate blockchains into their business processes.
Investors seem to believe that the barriers will be overcome and that bitcoin – or perhaps another cryptocurrency – will become more commonplace in coming years; estimates vary, however, about the speed this will occur.
In the meantime, venture capital investments in cryptocurrency and blockchain startups continue to grow. Numerous exchanges have been created for storing and trading bitcoins and other cryptocurrencies. Coinbase, for example, has more than 5 million users who have traded more than USD 5 billion in digital currencies. itBit is another; it’s a regulated financial services company based in New York “built for financial institutions and active traders.”
Experts are divided about bitcoin’s viability for mainstream use; for most, “who knows?” is the most common view currently. Yet despite the many obstacles which fuel this uncertainty, bitcoin keeps springing back to life. In fact, it has been declared “dead” so many times now that some observers liken bitcoin to a zombie – both for its ability to endure and also because it continues to proliferate.
Interest has grown to the point where cryptocurrencies are undergoing increased scrutiny from regulatory agencies and some of the world’s biggest financial organisations. The New York State Department of Financial Services, for example, introduced ‘BitLicense’ in 2015 – essentially a framework within which cryptocurrency users should be operating. A former head of the U.S. FDIC, Sheila Bair, along with former Senator Bill Bradley, are both board members of the aforementioned itBit exchange, and companies like JP Morgan have adopted bitcoin style payment systems into their operational practises.
Considering what bitcoin has endured already, it seems a question of how, not if, bitcoin will be adopted into the financial mainstream in the future. Whether as a vehicle for investment, commercial exchange or even as a weekly candy-fund for your kids, cryptocurrency in some shape or form is likely here to stay.
Want to mine bitcoins? Iceland’s the place to go.
While the details can quickly become dense and complex, bitcoin mining essentially involves solving a puzzle and claiming the reward. As Investopedia put it:
“The mining process involves compiling recent transactions into blocks and trying to solve a computationally difficult puzzle. The first participant who solves the puzzle gets to place the next block on the block chain and claim the rewards.”
Not only are the puzzles “computationally difficult,” the degree of difficulty is automatically adjusted upward as more miners join the search. That also means that profitability decreases as the number of miners increases.
That’s not all. The bitcoin protocol also stipulates that the value of newly minted bitcoins – the so-called “block reward” – diminishes over time.
In other words, bitcoin mining just gets harder and harder, and miners earn less and less.
Nonetheless, as the increasing supply of bitcoin attests, miners keep chipping away and, per the protocol, 1,800 new blocks are added every day.
So what, exactly, do miners have to do to earn a block reward?
They search for a random piece of data called a “nonce” that enables them to create a new “hash” that conforms to a prescribed format that, in turn, can be bolted on to the blockchain. (Click here for a fuller description of the process.)
Finding the right nonce is a computational exercise that requires a lot of computing power. And since the search for the right nonce gets progressively more difficult, miners are engaged in an arms race to deploy ever faster and more powerful computer networks.
In the beginning, bitcoin could be mined on a home computer. That soon wasn’t enough and miners started filling their garages with scores of machines linked together and running 24-hours a day. That, too, proved to be insufficient. Eventually, special hardware known as an ASIC – Application-Specific Integrated Circuit – was developed specifically for mining bitcoin.
ASIC systems were first introduced in 2013, and the designs continue to get more efficient. In fact, as ASICs become more sophisticated and more resources are engaged in mining, the degree of difficulty has increased exponentially. When bitcoin was introduced in January 2009, the degree of difficulty – defined as “a relative measure of how difficult it is to find a new block” – was naturally set to 1. On 24 January 2017, it stood at 393 billion!
Which means a LOT of computing power is needed.
The solution? Create a “mining farm” where tens of thousands of machines whir away around the clock. (Yes, the metaphors are getting mixed, but this is how the industry refers to these operations.)
There are two significant challenges, however, in filling a giant building with computers that run nonstop. They consume massive amounts of energy and generate immense amounts of heat.
The newest trend in bitcoin mining is to locate farms in Iceland. The volcanic island offers an abundant supply of cheap, renewable energy plus a cool climate. A typical farm there is open on the sides and has fans on the ceiling to vent the heat; these spin so fast that rain or snow can’t enter. Since they are extremely noisy, mining farms are located in remote areas, preferably close to an electrical substation.
The network of computers mining bitcoins today is about 43,000 times more powerful than the world’s top 500 supercomputers combined. However, since artificial scarcity and increasing difficulty are at the core of the bitcoin protocol, the computing power devoted to mining will only continue to escalate.