an investor’s guide to understanding itcoin basics · 2018-12-03 · an investor’s guide to...

An Investor’s Guide To Understanding ITCOIN BASICS

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TABLE OF CONTENTS

Bitcoin’s Beginnings

Bitcoin Timeline

What is the Blockchain and does it Work?

Transactions and Bitcoin Balances

Figure 1: Transaction Life Cycle of a Bitcoin

Bitcoin as a Store of Value and Investment Vehicle

Bitcoin as a Censorship Resistant Global Transfer of Wealth

Is Bitcoin Better Money?

Figure 2: Comparing Traditional Money to Bitcoin

Bitcoin as a Form of Payment

Glossary

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6

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This Bitcoin primer is just the first in a series of white papers that Echelon Wealth Partners is producing to help investors better understand the changing landscape of digital currencies. This paper aims to provide a basic understanding of how Bitcoin and the blockchain work, and why these innovations are important.

Bitcoin is widely regarded as potentially one of the biggest disruptors of the digital age. This new currency could radically change our concept of money and provide the backbone technology for a decentralized peer-to-peer value network. Its potential advantages over traditional forms of money are substantial as it:

• Functions as a store of wealth;• Allows for an instant and inexpensive global

transfer of wealth;• Resists government censorship and intervention;• Facilitates “smart contract” payments;• Is faster, more secure, and cheaper than credit

cards;• Allows for machine-to-machine (M2M) and

micropayments.

To understand how Bitcoin is positioned to deliver all these improvements it is helpful to understand the origins of Bitcoin and the basics of the block-chain.

Bitcoin’s Beginnings

Bitcoin first emerged as a concept in a 2008 white paper published under the pseudonym Satoshi Nakamoto—a person or entity that remains anonymous to this day. The white paper, entitled Bitcoin: A Peer-to-Peer Electronic Cash System 1, outlines the framework for using a peer-to-peer network to create a system of electronic transactions that can be executed and verified without relying on trust or a central clearing house such as a bank.

The concept of digital money, however, is not new. In fact, the concept was proposed as early as 19822 and implemented in 1990 with David Chaum’s Digicash.3 Before Bitcoin, digital currencies had to be controlled by a central authority, and anyone using that system had to trust that central authority to maintain a secure and accurate ledger of transac-tions. Without a centralized administrator, any digital currency was vulnerable to being spent more than once as electronic files can be duplicated.4 This issue was known as the “double spend” problem.

Bitcoin is revolutionary as it solves both the double spend problem and the need to rely on a central authority. It does this by using the breakthrough invention of the blockchain.

Bitcoin Series | Part OneOne of the biggest disruptors of the digital age

Bitcoin is capitalized when referring to the entire Bitcoin network. When referring to bitcoin as a currency it is written in lower case.

AN INVESTORS GUIDE TO

UNDERSTANDING BITCOIN BASICS

An Investor’s Guide To Understanding Bitcoin Basics

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1 Satoshi Nakamoto (pseudonym), “Bitcoin: A Peer-to-Peer Electronic Cash System”, https://bitcoin.org/en/bitcoin-paper, October 2008.

2 E-Cash: Lecture 23. (University of Illinois School of Engineering)

3 Paul Vigna and Michael J. Casey, “The Age of Cryptocurrency: How Bitcoin and Digital Money Are Challenging the Global Economic Order”, St. Martin’s Press. (January 27, 2015).

4 “Digital Cash,” accessed August 10, 2017, http://www.cs.bham.ac.uk/~mdr/teaching/modules06/netsec/lectures/DigitalCash.html

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Bitcoin Timeline

BITCOIN

FROM THE BEGINNING

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2008 2009 2010 2011 2012 2017

OCTOBER 31Bitcoin design whitepaper is released

JANUARY 3Genesis block established at 18:15:05GMT

JANUARY 12First Bitcoin transaction, in block 170 from Satoshi to Hal Finney

MARCH1 BTC = $0.003USD

MAY 22Iaszlo first to buy pizza with Bitcoins agreeing to pay 10,000BTC for $25USD worth of pizza

JULY 11Bitcoin v0.3 release mentioned on slashdot, bringing a large influx of new bitcoin users

FEBRURARY 9Bitcoin reached parity with the US dollar, reaching $1 per BTC at MtGox

JUNE 9Admin account at MtGox was accessed and sell orders were issued for hundreds of thousands of fake bitcoins, forcing the MtGox price down from $17.51/BTC to $0.01. MtGox announced that these trades would be reversed. Trading was halted at MtGox for 7 days (and also briefly at TradeHill and Bitcoin to review security).

AUGUST 20First Bitcoin Conference and World Expo held, in NYC

AUGUST 32P2Pool, the first P2P decentralized pool, mines its first Bitcoin main net block (Block 142, 312)

MAY 8A single service, Satoshi Dice becomes responsible for over half the transaction volume on the Bitcoin blockchain.

NOVEMBER 28On this day, BTC experienced first halving on Block 210,000 is the first with a block reward subsidy of only 25 BTC.

OCTOBER 12Bitcoin trades over $5K USD

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If you bought $100 worth of BTC in 2010 it would be worth almost $73M USD today.*

*“$100 in bitcoin in 2010 now worth almost $73 million”, www.rt.com, May 22, 2017, https://www.rt.com/business/389190-bitcoin-historic-price-high/

At a high level, the Bitcoin blockchain is simply a database that maintains a ledger of transactions. However, the blockchain is much different from a normal database in several aspects. The main difference is that there is not just one copy of the blockchain—there are thousands. Bitcoin does not rely on a central authority to maintain the ledger. Instead, the ledger is maintained by all Bitcoin nodes using freely available open-source software that can run on the average internet connected computer. At the time of writing, October 2017, there were 9,589 active Bitcoin nodes with every node maintaining a synchronized current copy of the blockchain.5

The process by which information is added to the blockchain is also much different when compared to a traditional centralized database. Information is added to the blockchain in a series of containers called blocks. Each block contains bitcoin transac-tions that update the ownership of bitcoin as recorded on the blockchain. Bitcoin blocks (and the information within them) will only be added to the blockchain when all Bitcoin nodes agree that a new block follows the rules of the Bitcoin network. These are called the “consensus” rules.6 Any blocks that don’t follow these rules will be considered invalid and will be discarded, while blocks that are properly formed will be added to the blockchain. As described below, enforcement of the consensus rules is very important.

What Is Bitcoin Mining?

Blocks are submitted to the Bitcoin network through a process of mining. Bitcoin mining is the practice of running software and hardware to solve a computa

tionally difficult puzzle in order to be allowed to submit a block for inclusion on the blockchain. For every block added to the blockchain, miners first compete with each other to be the first to solve this brute force puzzle that typically involves trying many trillions of solutions. The first miner to solve the puzzle is allowed to submit their “candidate” block to the Bitcoin network; this process is called Proof of Work. If a candidate block conforms to the consen-sus rules of the Bitcoin network, it will be added to the blockchain, but if it does not conform, it will be rejected by the network. By creating a cost for miners to submit a block, miners are incented to create blocks that conform to the consensus rules. Otherwise, they risk their block being rejected and their resources wasted. If a block is accepted, a miner will receive a reward in the form of bitcoins. (The current reward for adding a block is 12.5 bitcoins.)

This system of incentives and raw computational power used for Proof of Work combine to create a blockchain that is exceptionally stable and secure. Each block on the blockchain requires Proof of Work to be completed and if a miner attempts to submit a revised block that is older, they must also redo the Proof of Work for all blocks that come after the revised block. This way, the amount of comput-ing power needed to change older blocks quickly becomes computationally prohibitive, typically in less than an hour after a block is mined. It is also for this reason that except for the most very recent blocks the blockchain is considered a permanent and immutable record. The amount of mining power securing the Bitcoin network is truly massive. In 2015, the total computing power of the Bitcoin network was equal to that of 525 times the comput-ing power of Google and 10,000 banks.7

A Database That Maintains A Ledger Of Transactions


Did you know? Anyone running a bitcoin node can be a bitcoin miner. Thus in theory anyone anywhere could be a miner.

WHAT IS BLOCKCHAIN

AND DOES IT WORK?

5 https://bitnodes.21.co, accessed October 2, 2017

6 “Bitcoin Developer Guide: Consensus Rule Changes,” accessed October 2, 2017, https://bitcoin.org/en/developer-guide#consensus-rule-changes, Bitcoin.org.

7 Reggie Middleton, “Bitcoin’s Computing Network is More Powerful than 525 Googles and 10,000 Banks!,” accessed October 2, 2017,

http://www.zerohedge.com/news/2015-11-19/bitcoins-computing-network-more-powerful-525-googles-and-more-10000-banks

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If the information on the blockchain is essentially just a record of every single bitcoin transaction ever made, what does it mean to “hold” bitcoin as a currency?

Public & Private KeysControl and ownership of bitcoin are managed through public and private key cryptography. In this type of cryptography, public keys may be openly published, while private keys are known only to their owners.

Every bitcoin (or fraction of a bitcoin) in existence is associated with a transaction and a public key, which is permanently recorded on the Bitcoin blockchain. The owner of the corresponding private key, for any given bitcoin transaction, is the owner of those bitcoins. As such, bitcoin ownership is just the ownership of a private key, which in itself, is just a long string of numbers. The public/private cryptography used is where the term cryptocurrencies was derived.8

When a bitcoin transaction occurs, it involves changing the associated public and private key pair. Transactions are submitted to the Bitcoin network from a user’s bitcoin wallet. When a block that contains a bitcoin transaction is “mined” and added to the blockchain, this bitcoin transaction will then be associated with a new public/private key pair. Below is an example of a bitcoin transaction lifecycle for illustration purposes.

Importance of Cryptography for BitcoinSimilar to other forms of data encryption, private keys used for blockchain technology are strings of random numbers 256 bits long. The total number of possible private keys is 2^160. To put that in perspective, there are only 2^63 grains of sand on all of the beaches of the earth.

Public key cryptography uses two pieces of information to authenticate messages. A public key identifies the sender or recipient and can be distributed to others within the network. A private key is used in tandem with the public key to create a permanent message signature. Both signatures are mathematically linked, and all transactions must bear a digital signature. Because signatures are virtually impossible to forge, anyone who receives a signed transaction can verify the authenticity of the message.

A Record Of Every Single Transaction Ever


TRANSACTIONS

AND BITCOIN BALANCES

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8 Richard Apodaca, “Six Things Bitcoin Users Should Know about Private Keys,” last modified April 23, 2014,

http://bitzuma.com/posts/six-things-bitcoin-users-should-know-about-private-keys/, Bitzuma.com

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Figure 1: Transaction Life Cycle of a Bitcoin

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Open your online

bitcoin wallet

Copy / Scan link

to business’s address

Fill in the amount

and the fee

Hit send!

The wallet signs

the transaction using

your private key

The transaction is

propagated and validated

by the network nodes

Miner’s include the

transaction in the next

block to be mined

A miner solves a

mathematical problem

to gain a private key

A bitcoin reward

is issued to the

successful miner

Proof of miner’s work

is provided and a

new block is created

The block is verified

by miners & nodes

and added to the chain

The business receives

confirmation of the

completed transaction

Your payment is

transferred to the

business’s BTC wallet

A bitcoin transfer happens almost instantly between sender and receiver. However, it is not “official” until it is added to a block and included on the blockchain. Blocks are added on average every 10 minutes.

Similar to gold, bitcoins cannot be arbitrarily created. Where gold is physically mined, bitcoins must be digitally mined using special software. There is a fixed schedule and technical specifications, which means that only 21 million bitcoins will ever be issued. Currently, about 16 million bitcoins have been created, and mining is expected to continue until 2140 when total bitcoin circulation will reach 21 million.9

It is important to understand that bitcoin is divisible to eight decimal places, and allows fractional ownership. With the current smallest division equaling 1/100th of a million of a bitcoin, supply is not really an issue. This division is called a ‘satoshi’ after bitcoin’s founder.10

Given its finite supply, bitcoin is often regarded as a store of value. This is certainly true in the current economic environment, where central banks are increasingly intervening in the market to curb systemic risks and stimulate economic growth. Even with recent developments, the value of bitcoin is decided by the free market, its users, and those that invest in it.

Bitcoin as a Censorship Resis-tant Global Transfer of Wealth Bitcoin is often described as censorship resistant because it is not directly influenced by governments and cannot be interfered with like many of the digital payment systems before it. Unlike traditional remittance markets, where the cost of moving money can be up to 9%, bitcoin transfers can be done very cheaply. This is true even when we factor in the broad decline in global remittance fees of the last few years. A report published by The World Bank found that the average cost of sending a remittance transfer fell to 7.45% in the first quarter of 2017 from 7.53% a year earlier.11

Bitcoin transfers are made through a bitcoin wallet, which can be installed on a computer or mobile device.12 This means transfers can be completed within minutes, saving users money, time, and effort. The pseudo-anonymity offered by the Bitcoin network stamps out government interference, allowing users to essentially become their own bank. At present, bitcoin’s value is still associated with its convertibility to and from fiat currency. However, this will likely change over time as more merchants start accepting bitcoin.

Only 21 million bitcoins will ever be issued


BITCOIN AS A STORE OF VALUE

AND INVESTMENT VEHICLE

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9 “Controlled Supply,” accessed October 2, 2017, https://en.bitcoin.it/wiki/Controlled_supply#cite_note-2

10 “Satoshi,” accessed October 2, 2017, http://www.investopedia.com/terms/s/satoshi.asp

11 “Remittance Prices Worldwide,” The World Bank Issue 21 (March 2017), https://remittanceprices.worldbank.org/sites/default/files/rpw_report_march_2017.pdf.

12 “How to use a Bitcoin wallet (for newbies),” last revised March 27, 2015, https://en.bitcoin.it/wiki/How_to_use_a_Bitcoin_wallet_(for_newbies)

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As the following chart illustrates, bitcoin is a new form of money that may be superior to any created before it. Bitcoin is also regarded as “programmable money” because it is entirely digital. This means it can be used in places where normal currency has never ventured. By doing so, it opens up new markets while creating the potential for programmable, universal cash.13 Money can now be sent as quickly and almost as cheaply as it can through email.

IS BITCOIN

BETTER MONEY?


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Figure 2: Comparing Traditional Money to Bitcoin

13 Alex Wilhelm, “Inside Bitcoin, The Programmable Currency For Our Digital Future,” Tech Crunch, September 10, 2013,https://techcrunch.com/2013/09/10/disrupt-sf-13-bitcoin-panel.

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Fungibility

COMPARING TRADITIONAL MONEY TO BITCOIN

It is much cheaper for merchants to accept bitcoin than credit cards.14 Bitpay, a bitcoin merchant payment processor, charges merchants 1.0% versus typical merchant account fees of 1.5% to 4.0%. For this reason, low margin businesses such as electronic retailers like Overstock.com have led the merchant embrace of bitcoin as a payment method. As of 2015, the digital currency was accepted by more than 100,000 merchants worldwide, including Expedia (EXPE-NASDAQ), Shopify (SHOP-TSE), Dish Network (DISH-NASDAQ), and Microsoft (MSFT-NASDAQ).15

The acceptance of bitcoin as a payment system is also being supported by a friendlier regulatory environment. In April, the Japanese government legalized bitcoin as a form of payment, and in doing so, initiated digital currency capital requirements, cybersecurity laws, and annual audit protocols. The nation’s Accounting Standards Board is also in the process of developing an overarching standard that governs digital currency usage.16 It is estimated that up to 300,000 Japanese stores will start accepting it as soon as this year.17

In ConclusionBitcoin’s evolution is still in its early stages and it can mean different things to different people. For those with access to the traditional banking and credit services bitcoin may not be a useful means of payment but could be used as a store of value. For those in financially volatile jurisdictions bitcoin can often be the only way to securing life’s necessities. And still for others, it offers a superior and sometimes only way to transfer money across borders in a cheap and reliable way.

Nevertheless, bitcoin still has many vocal skeptics and its path from obscure cryptography project to its standing today has been volatile. It is still far from an established form of money relative to historical forms of currency like gold, the British Pound or US Dollar. Naysayers aside, as bitcoin gains widespread acceptance it has the potential to redraw the existing financial paradigms. The possibilities offered by bitcoin are now starting to be recognized by the leaders of the traditional banking system. Just this month, Christine Lagarde, head of the IMF, said cryptocurrencies could give fiat based systems a “run for their money”19 . And with bitcoin as the first fully digital and decentralized currency, future possibilities are just starting to be explored.

In Echelon’s next white paper in this series, “Bitcoin as an Asset Class”, bitcoin as a unique store of value in comparison to other asset classes will be explored.

For more information contact:

Rob FursePresidentEchelon Wealth [email protected]

Accepted by more than 100,000 merchants worldwide


BITCOIN AS A

FORM OF PAYMENT

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Partners on this and other topics.

14 Adam Hayes, “How Much Cheaper are Bitcoin Fees than Credit Card Fees?”, Investopedia, September 13, 2016, http://www.investopedia.com/news/how-much-cheaper-are-bitcoin-fees-credit-card-fees/ 15 Anthony Cuthbertson, “Bitcoin now accepted by 100,000 merchants worldwide,” IB Times, February 4, 2015, http://www.ibtimes.co.uk/bitcoin-now-accepted-by-100000-merchants-worldwide-1486613 16 Sam Bourgi, “$100 Billion Cryptocurrency Market Showing Signs of Maturity as Mainstream Investment Appeal Grows,” Economic Calendar, July 8, 2017, http://www.economiccalendar.com/2017/07/08/100-billion-cryptocurrency-market-showing-signs-of-maturity-as-mainstream-investment-appeal-grows/17 Samburaj Das, “Bitcoin Could Be Accepted at 300,000 Japanese Stores in 2017,” CryptoCoinNews.com, May 23, 2017, https://www.cryptocoinsnews.com/bitcoin-accepted-300000-japanese-stores-2017/18 Evelyn Cheng, “Strategist predicts bitcoin, digital currency trading volume will 'soon surpass' Apple's,” CNBC.com, September 22, 2017, https://www.cnbc.com/2017/09/22/strategist-predicts-bitcoin-digital-currency-trading-volume-will-soon-surpass-apples.html,.19 Robert Hackett, “IMF Head: Cryptocurrency Could Be the Future. Really.,” fortune.com, October 2, 2017, http://fortune.com/2017/10/02/bitcoin-ethereum-cryptocurrency-imf-christine-lagarde/

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Bitcoin/bitcoin - For this series, Bitcoin refers to background technology, and lowercase bitcoin refers to the currency. Bitcoin is a digital currency and store of value that uses encryption techniques to regulate the generation of units, its transfer, and operates independently to central banks.

Bitcoin mining - The process by which the currency bitcoin is verified and added to the public ledger, known as the blockchain.

Bitcoin network - A peer-to-peer payment network that uses a cryptographic protocol to transfer wealth between entities.

Bitcoin nodes - Any computer that connects to the Bitcoin network is a node. Full nodes enforce all of the consensus rules, while most are lightweight nodes and do not enforce all the rules.

Bitcoin wallet - A software program where bitcoins are stored, including online websites or smartphone apps.

Bitpay - A global bitcoin payment service provider headquartered in Atlanta, Georgia, providing payment processing for merchants.

Blockchain - A digital ledger of continuously growing records, called blocks, which are stored and secured using cryptography.

Consensus rules - Bitcoin network rules based on a group decision-making process whereby a majority of bitcoin miners agree on rules for Bitcoin.

Cryptocurrency - A digital currency that employs cryptographic means to store, transfer, and secure the currency.

Cryptography - The science of coding and decoding information to keep messages secure.

Digital currency - Also digital money or electronic currency or money; allows for the instantaneous transfer of ownership through digital transactions and represents a borderless store of value.

Double spend - The risk that a digital currency can be spent twice due to fraudulent duplication of the transaction details.

Fiat currency - Money produced by a government as legal tender that is not backed by physical assets.

Micropayments - A very small payment made online; generally referred to as payments of less than US$1.

Private key - A cryptographic key linked to a transaction that allows anyone with the key to access the encrypted message, allowing for the transfer of bitcoins within the blockchain.

Programmable money - The ability to apply conditions to the transfer of money; for example, brands could reward consumers for loyalty with bitcoins after purchases, similar to loyalty point cards.

Proof of Work - Is an economic measure, usually computer processing time, to confirm verification procedures for transactions and prevent service abuses.

Public key - Is an identifier for sender or recipients within the blockchain and is a publicly available address. When used in concert with a private key gives access, control, and ownership to bitcoins.

Satoshi - The smallest fraction of a bitcoin, currently eight decimal places or 1/100th of a million of a bitcoin.

Satoshi Nakamoto - The pseudonym of the original creator of bitcoin and blockchain technology. The person’s identity has never been confirmed.

Smart contracts - Is a computer protocol that enables verification, facilitation, and enforceability of online transactions with the addition of partially or fully executing clauses.

Glossary


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Forward Looking StatementsForward-looking statements are based on current expectations, estimates, forecasts and projections based on beliefs and assumptions made by author. These statements involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.

The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Echelon Wealth Partners Inc. or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results.

These estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.

About Echelon Wealth PartnersWe’re a leading independent, Canadian-owned and operated wealth management and capital markets firm, known for our client-centered approach and entrepreneurial spirit. Echelon is a compelling option for investors seeking unbiased investment solutions, professional management and unparalleled service. We aim to build lifetime relationships and deliver superior service. Our financial professionals have the freedom to offer truly independent investment advice, always putting their clients’ needs first. We are also a growing firm, with more than $4 billion in assets under administration and management. We service clients across Canada from our offices in Toronto, Oakville, Ottawa, London, Montreal, Saskatoon, Calgary, Vancouver, Victoria and Tokyo.

Copyright © 2017 Echelon Wealth Partners. All rights reserved.

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