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  • Writer's pictureDan FitzPatrick

Of Bits & Blocks

Last week I participated in three separate discussions of cryptocurrencies (the best known of which is bitcoin) and blockchain technology. While still new to these subjects, I thought I’d share some observations on both, as they are very much related (one begat the other) but of potentially drastically different significance.

Cryptocurrencies are a form of digital assets, intended to facilitate essentially instantaneous peer-to-peer value exchanges on a trusted network without the involvement of any financial intermediary (e.g., a bank) or centralized monetary authority. They differ from other digital assets, and earn their eponymous designation, because they rely on sophisticated cryptography (super-spy-level coding) to secure their transactions.

The origins of bitcoin, the granddaddy of cryptocurrencies, are tantalizingly shrouded in mystery (google Satoshi Nakamoto), but I believe it is fair to say that bitcoin gave birth to blockchain. Or rather, it was necessary to invent blockchain in order to create bitcoin.

Blockchain is a complicated subject, and there are many great resources on the Internet for further study, but here is my high-level summary:

Think of blockchain as one giant business ledger (like Bob Cratchit would have kept for Scrooge) in which each transaction is recorded, one after another, in linear fashion, in permanent ink, and timestamped.

Then imagine that ledger, not as a physical object, but as an electronic record, created by way of a publicly available, fully transparent and universally accepted programming protocol, access to which is governed by certain permissions, which captures each transaction permanently in a way which cannot be altered, all of which is visible (transactions, not necessarily party identities) to every participant at all times, simultaneously. The combination of immutability and complete transparency supports a very high level of trust in the accuracy and reliability of the record.

Next, imagine that electronic record existing, not on one centralized computer, but on many, again simultaneously. This is called a “distributed network.” Finally, imagine that that electronic record can be accessed universally – i.e., by anyone anywhere in the world with the appropriate permissioning. Voila, bitcoin! It’s all a bit mind-blowing.

Bitcoin was initially created as a utility, as means of value exchange. It has since come to be viewed as an item of stored value, i.e., something that has value independent of its use in transactions. We’ve all watched (enviously, if we are honest with ourselves) the “value” of bitcoin soar to stratospheric levels. I personally struggle to get comfortable with that; after all, there is no tangible commodity or government treasury backing it up. What then is driving this “value?”

As I see it, there are basically two factors driving the perception of value: scarcity and acceptance.

Scarcity: the bitcoin protocol strictly limits the total number of “coins” that can ever be created. The process of creating bitcoin is called “mining” and essentially involves solving extraordinarily complex cryptographic problems. Successful mining involves immense computing power, which in turn requires massive amounts of electricity. The electrical expense alone limits the number of miners, and it is no surprise that the majority are in China and other places where electricity is provided for free (note the tragic environmental irony here – it requires real physical mining to mine bitcoin!).

Acceptance: value is in the eye of the beholder, and just about anything can have value if someone believes it has value. A good part of bitcoin’s success is attributed to its growing acceptance. For example, in November of last year, a “big four” accounting firm announced that it is accepting bitcoin payments from its clients, and a “spectacular” Miami penthouse went on the market for 33 bitcoins with the strict condition that the seller will ONLY accept bitcoin. And rumors swirl that McDonald’s will begin accepting bitcoin by the end of this year.

I worry about bitcoin’s lofty valuations and explosive popularity. I have seen economic charts comparing its price history to the 17th century “Tulip Mania” market bubble; a very similar trajectory, but with bitcoin’s rise some orders of magnitude greater. And just last month, the bitcoin “wallet” application Coinbase became the most popular downloaded iPhone app in the United States. This all reminds me, uncomfortably, of the famous story of Joe Kennedy and others exiting the stock market just before the 1929 Crash “because taxi drivers and shoeshine boys were giving stock tips.” I am thus torn between “those who ignore history are doomed to repeat it” and “past performance is not indicative of future results.”

Blockchain is what really interests me. It is potentially disruptive on a scale we’ve never seen before. As a decentralized, anonymous, globally-distributed, transparent, trusted, direct peer-to-peer transactional network incorporating a permanent and self-reconciling record, it is the ultimate disintermediator. Think what this means for businesses built on intermediary and reconciliation models like banking (especially correspondent banking), proxy services, securities exchanges, institutional custodians, etc. And for just about any activity that currently depends on centralization and control. What effect might this have on geopolitics, and the ability of totalitarian states to monitor and control the lives of their citizens? What kind of efficiencies, cost savings and productivity gains might this bring to processing industries, transportation, inventory management, etc.? And what potentially new and exciting products and services might it give birth to? If you think bitcoin is mind-blowing, strap yourself in!

A final note on bitcoin. If the owner of the above-referenced Miami penthouse succeeds in selling it for 33 bitcoins, he or she will realize a gain on that sale of about $230,000 (a very nice return on property purchased only two years ago), and congratulations will be in order. However, come tax time, she or he had better have some good old-fashioned dollars on hand to pay the tax on that gain. The IRS is not likely to accept bitcoin!

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