Bitcoin And Blockchain’s Pivotal Moment – How We Got Here

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Bitcoin And Blockchain’s Pivotal Moment by PitchBook

Analyst Note

Bitcoin and blockchain have been some of the most exciting yet misunderstood technologies to emerge in the last decade. Investors have pumped some $1.8 billion into equity investments in companies utilizing the technology since 2013. This doesn’t include the individuals and groups pouring resources into the technology’s supporting hardware, which in aggregate holds 8x the processing power of the world’s 500 fastest supercomputers. Meanwhile, every bank, brokerage house and multinational worth its salt has issued a press release announcing one multimillion dollar partnership or another to explore the implications for their business.

This is a pivotal moment for blockchain. Institutional investors have wagered that the technology will more than pay off by revolutionizing global payments, securities clearing and financial services, with
further wide-reaching implications for monetizing media and content distribution, the sharing economy and IoT. While recent high-profile missteps have cast a shadow over the industry, its continued scaling only goes to illustrate how rapidly the technology has burgeoned thanks to outsized consumer and enterprise interest.

Evan B. Morris

How We Got Here

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Many of the emerging use cases of blockchain are still highly abstract. Examining the disruptive potential of a new technology requires first exploring the historical process and pressures that created the status quo. Above all, payment systems must insure that each unit of value is rightfully held by the spender so that each unit of currency can only be spent once. This is referred to as the double spend problem. Historically, this was solved with intrinsically valuable metallic coins, and later with bank-issued paper currency that was difficult to counterfeit. In order to facilitate overseas trade prior to electronic long-distance communication, the Medicis developed double-entry accounting listing two columns for assets and liabilities. For each credited account, another account would be debited so that each transaction took place in a closed system. Updated ledgers were copied and distributed to far-flung branches.

Bankers kept track of deposits and liabilities using double ledger accounts on each other’s books since banknotes were backed by gold deposits. These metallic reserves were difficult to transport, so banks needed a way to keep track of who owned what. This decentralized system had other inefficiencies. Having multiple banks issue their own banknotes opened up the possibility of fraud due to the sheer diversity of paper bills in circulation. Since consumers had to be sensitive to perceived solvency, this created a higher likelihood of bank runs. Central banks emerged to take over and standardize banknote issuance and further centralize the multilateral banking system, as each constituent bank now had an account with the central bank.

As we will examine later, blockchain has the potential to bring heightened transparency to asset ownership. Tracking ownership of alternative assets has always been opaque, in some ways even more so than gold or currency accounts. While stock certificates tracking claims on assets were hard to forge even in the days before high-quality printing, transactions—and thus overall ownership—could only be tracked through a central broker-dealer or clearinghouse. Cap tables listing equity ownership and creditors were only cleaned up in the case of a liquidity event such as a merger or acquisition. This lack of transparency makes events such as bankruptcy proceedings very costly and tedious.

Central banks became even more essential to providing liquidity and issuing standardized paper currency once fractional reserve banking emerged, as banks only kept a small portion of capital on hand as deposits. However, central banks gradually did away with the gold standard, as the Keynesian doctrine of running deficits in lean times and surpluses in good times proved difficult to implement during the Great Depression and World Wars.

In a democratic society—even if the central bank is independent—there is a bias toward more expansionary/inflationary monetary policy. In the current macro environment, central banks and governments have coordinated to promote inflation through asset purchases and perpetual budget deficits, which increase the money supply every year and dilute the value of currency over time. In addition to what we see in the developed world, the limitations of government-backed currencies as a store of value have been proven time and time again, such as in hyper-inflationary episodes in Germany, Zimbabwe and every few years in Latin America. Bitcoin exhibits opposite (deflationary) properties, as you will see in later sections.

Thus far, we’ve examined the gaps in historical financial infrastructure that have helped support bitcoin/blockchain’s importance and rise. Yet, similar to many other emerging tech, the invention of the internet has played a pivotal role in bitcoin/blockchain’s growth. The development of the internet, however, did not initially address any of the issues with the existing financial infrastructure, in part due to the reticence of institutions to relinquish tight control over centralized ownership databases. Even so, conducting fast and secure online payments was one of the obvious use cases of the internet.

However, developers took some time to fix the double spend problem—the issue of ensuring each currency unit is only spent once. Initial online payment platforms often took months to settle transactions in order to jump through many hoops including fraud prevention. David Chaum patented an early online payments system called DigiCash that operated similarly to how airlines now process credit cards in-flight. Payer and receiver exchange serial numbers and, once electronically connected to central digital ledger, the transaction could be verified. The system enabled much smaller unit payments than was cost effective with existing credit card payment networks, and had a much higher level of security. DigiCash filed for Chapter 11 bankruptcy in 1998 but, to be clear, its failure did not stem from issues driven by its technology being poorly adopted. The company offered a secure payment system that solved the double spend problem, the greatest issue bitcoin strives to solve, yet unfortunately, poor management at the executive level left many promising projects half-completed.

A confluence of seemingly unrelated early internet technologies enabled the development of cryptocurrencies. One early method to solve the ubiquitous problem of email spam was the forcing of a sender to complete a digital puzzle in order to send a message. Although the required computational power was insignificant to a home or business user, a spambot sending thousands of unsolicited messages would be cut at the knees. Since many forms of hacking require “brute force” to exploit systems, a built-in speed bump like solving a puzzle represents a considerable security upgrade and, as we explain later, is an essential aspect of blockchain technology. The 1990s also saw the development of anonymous browsing on the Tor network developed by research labs associated with the US military. Tor encrypts data and sends it through a network of peer nodes where it becomes impossible to track to any one point. This allows for near anonymization, as traffic becomes broadly distributed across the entire network. Rather than rely on one chain of centralized servers, traffic is requested and routed across whomever has available resources to handle the bandwidth. While each of these technologies has had varied standalone impact, the confluence of these and other tech has played a pivotal role in the emergence of blockchain.

How Bitcoin Works

In 2009, “Satoshi Nakamoto” pseudonymously released the paper “Bitcoin: A Peer-to-Peer Electronic Cash System.” Satoshi envisioned bitcoin as a distributed digital payment system that bypasses the status quo centralized financial intermediaries. The protocol incentivizes a peer-to-peer network to validate transactions and ownership on a shared public ledger known as the blockchain.

The legitimacy of each bitcoin is backed by a record of all previous transactions on the network. The owner transfers bitcoin by providing their address, the address of the sender, a private key or password to verify rightful ownership, and the hash of the previous block to serve as a timestamp in the list of all transactions. New transactions are broadcast to all nodes. Each node (miner) collects new transactions into a block, currently averaging around 1,500 transactions per block every 10 minutes. Nodes (miners) accept the block only if all transactions are valid and not already spent. They express acceptance of the block by using its hash as an input when working on creating the next block. To be confirmed, transactions are stored in the “mempool” of nodes that receive them, which has a capacity of around 50,000 pending transactions.

The cryptographic hash function is central to understanding what makes bitcoin tick. The hash function represents the process by which miners verify transactions and mine blocks. Functionally, the hash is a mathematical algorithm that converts data of any length (in this case a list of transactions) to a string (of characters) of a fixed length. Most importantly, the function works in such a way that the output will always be the same for a given input, but the input can only be calculated through trial and error.

Example of a hash:

Take the square root of 5. The result will be 2.236067977499789696409173 6687313. Take the third through seventh digits after the decimal. The output will be 60679.

This is basically a very simple (and weak) hash function. For any given prime number (in this case it has to be prime), one can create an otherwise unrelated five-digit output.

Bitcoin incentivizes individual “miners” to lend their computing power to the network. Computing power is the primary resource required to run a transaction network, and the bitcoin protocol allows miners to monetize their processing power. Senders of bitcoin typically attach between five and 20 basis points (.05-.2%) to a transaction to incentivize miners (nodes) to put it on the next block. The other incentive comes from the process to verify each new block, which releases new bitcoin.

The above process is called a “proof of work.” The inputs for the hash that miners need to guess include the sender’s private key, the transaction details, the last transaction from the blockchain and a nonce (random guess value.) The random guess value aims to find an output value with the longest string of zeroes at the beginning, making the process more akin to rolling a die than actual problem solving. The longer the string of zeroes, the more computing power is required to mine. As a result, the longest chain is always considered the correct one, and nodes (miners) will always work on extending it. Over time, the length of the string of zeroes at the beginning grows, exponentially increasing the difficulty of the problem to account for an increase in computing power.

Originally, bitcoin miners (nodes) were mostly hobbyists using spare computing resources to contribute to an emerging technology. Over time, miners discovered that the nature of calculations for the hash function made bespoke hardware, or application-specific integrated circuit chips (ASICs), far superior to general-purpose PCs or server farms. Canaan Creative, perhaps the first mass producer of bitcoin mining ASICs, accounted for by far the largest single investment in the space when it was acquired by Shandong Luyitong Intelligent Electric (SHE: 300423) for CN¥ 3.1 billion ($470 million) in June.

The total bitcoin (BTC) money supply will gradually reach a maximum. Every time a block is mined, the first node to calculate the hash is rewarded with 12.5 bitcoins. This reward is halved every four years, most recently in July from 25 BTC, and the reward will halve again around the year 2021. There are currently almost 16 million extant bitcoins, just over three-fourths of the maximum of 21 million BTC to be in circulation around the year 2140. The 21 million maximum is ultimately an arbitrary number that is a function of the halving schedule. As the maximum is approached and the block reward decreases, miners will need to be compensated with transaction fees rather than mining proceeds.

Bitcoin And Blockchain

Current Applications & Market Development

Consumer Payments

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