A Fundamental Analysis of Bitcoin
I created this analysis specifically for my portfolio. Within, I demonstrate both the history of Bitcoin, and the driving force behind the cryptocurrency’s value.
Original date posted: Oct. 17th, 2021
What is Bitcoin?
On January 3rd of 2009, an anonymous developer mined the first bitcoin. In doing so, they delivered on the premise of a paper titled Bitcoin: A Peer-to-Peer Electronic Cash System. They referred to themselves only by the pseudonym of Satoshi Nakamoto – and they had just sparked a revolution. At first, users viewed Bitcoin as a novelty. A type of ‘monopoly’ money unique to the internet and its culture. It took years for Bitcoin to build momentum, but the value of an anonymous digital currency could not be ignored.
Bitcoin is a digital currency that relies upon a distributed ledger. A ledger is a list of all transactions performed using bitcoin – a way to validate who owns which bitcoin, and where it is currently held. Bitcoin’s ledger is ‘distributed’ because multiple copies exist in completely disparate locations. Every user that operates a full node keeps a record of all bitcoin transactions that have ever occurred. Blockchain technology exists specifically to ensure the integrity of this distributed ledger.
However, technology alone would not make Bitcoin relevant. Instead, Bitcoin’s first use as a real ‘currency’ occurred on the darknet. Users wishing to avoid government oversight and traceability turned to bitcoin to purchase illicit goods. An entire criminal economy flourished, with a website called Silk Road at its heart. For two years, 2011 to 2013, the Silk Road facilitated millions of US dollars in illegal drug sales. This ended with the arrest of Ross Ulbricht – pseudonym “Dread Pirate Roberts” – and the seizure of Silk Road’s darknet website.
It took several years for Bitcoin’s public perception to recover from the incident. In fact, cryptocurrency still suffers from a stigma of being associated with the darknet. Despite this, recent years show that the financial world is willing to investigate Bitcoin’s use case. Legacy software, often decades old, suffers from slow speeds and failures of interoperability. A common technological back-end may alleviate this problem – something that blockchain technology may be able to help.
History of Bitcoin and the Invention of Blockchain Technology
Little is known of Bitcoin’s creator, Satoshi Nakamoto. Despite the Japanese pseudonym, there is no direct evidence that they are from Japan. After all, Bitcoin’s initial whitepaper was released in English. The anonymity of Satoshi remains a fitting start to the world’s first decentralized digital currency. Such that a Satoshi is the name for the smallest tradeable denomination of bitcoin – one hundred millionth or 0.00000001.
Simple digital currencies existed long before Bitcoin – yet one major difference made Bitcoin unique. Satoshi solved a persistent digital complication, the Double Spend Problem. Due to a combination of variable speeds and disparate computing, digital currencies could potentially exist in two locations at once. After the currency is received, it must be removed from the sending source. If it is not, then two instances of the same currency exist, which can cause a myriad of problems for the associated economy.
To combat this, Bitcoin requires multiple validations. The process of sending bitcoin to another address requires independent verification from third-party nodes. If something goes wrong, or if only a single validation occurs, the bitcoin is not transferred. Such an error does not incur any damage – beyond the potential loss of a minimal transaction fee. However, if a set number of validations succeed, the bitcoin is transferred. Since the ledger is immutable and distributed, it cannot be edited by a single source – even if the bitcoin still appears in the sender’s wallet afterwards, the system would not acknowledge it.
Every transaction in the Bitcoin ecosystem is resolved within a block. Blocks consist of an amount of transactions – alongside arbitrary mathematical algorithms – such that solving them takes approximately 10 minutes. The process of completing both transactions and algorithms is referred to as mining. Once a block has been completed, all the associated transactions are added to the end of the distributed ledger in a chain. This is where the name Blockchain technology originated. The entire distributed ledger is therefore a blockchain.
What Justifies the Value of Bitcoin?
The belief that Bitcoin possesses no inherent value is a classic mistake made by people unfamiliar with the technology. In fact, Bitcoin exhibits many of the same features as other investment vehicles. The process through which bitcoins are created is finite – it will eventually stop. The current technological framework allows for a total of 21 million BTC before the block reward decrease to zero.
In addition to being finite, Bitcoin inherently holds some degree of scarcity. After every 210,000 blocks, the block reward is cut in half. Further, bitcoins are occasionally lost. If the owner of a wallet loses access, those bitcoins are now inaccessible. They will remain in the wallet in perpetuity. An address associated with Satoshi Nakamoto holds 1.1 million bitcoins. Luckily, this appears to be a dead address – it has not been involved in any transactions for several years. If that many bitcoins flooded the market, the economic impact would be disastrous.
Finally, bitcoin requires work to produce. It is not simply generated out of thin air. Rather, it is rewarded to miners who help to keep the blockchain running smoothly. These miners often use custom-made hardware to run the complex mathematical equations that Bitcoin requires to mine blocks. Miners also confirm transactions as a neutral third-party. In this way, ‘mining’ bitcoin is like other forms of mining. The difference lay only in the source of the work – computer versus human.
There are several economic factors that come into play when mining bitcoin. The first is cost of electricity. Few people think twice about the energy cost of running a computer. However, when you are trying to use it as a source of income, that cost becomes critically important. The exact power cost of mining is variable depending on the number of miners contributing to the network.
While high-end graphics cards once dominated the mining landscape, they are increasingly outclassed. Bitcoin’s popularity led to the rise of application-specific integrated circuits or ASICs. These highly-specialized computers are calibrated specifically for mining bitcoin. Most major mining concerns now use ASICs exclusively.
Factors that Impact the Price of Bitcoin
The entire concept of Bitcoin revolves around a decentralized and theoretically uncontrollable currency. As such, it’s ironic that public perception almost entirely controls the value. While the price fluctuates without significant news, spikes or drops correlate directly with major developments. The late 2017 cryptocurrency boom accelerated as more average people invested. The community focuses on the mantra of ‘Greater Adoption’ due to this effect. Similarly, when exchanges are hacked or large projects abandoned, the price sinks in response.
Despite this, technological advances seem to have little impact on the price of bitcoin. This may be due, in part, to average user fatigue. The blockchain space is dominated by aspiring projects that promise advanced technology. Yet, many are in a holding pattern as development finishes. As such, users take announcements of upgrades with a grain of salt. Bitcoin exists as a digital currency – and most users aren’t all that concerned about the speed of transactions until it begins to impact the blockchain economy.
Lesser factors that impact the price include the break-even point of mining. As discussed above, there is equilibrium between the cost of electricity and the price of Bitcoin. When miners are unable to recoup their losses, we see sell-offs of mining equipment at reduced rates. A leader in the mining industry, Bitmain liquidated a considerable amount of their hardware as Bitcoin’s price sank.
Additionally, there is a regular event where the block reward is halved. This occurs every 210,000 blocks – or just under 4 years if block completion continues to happen every 10 minutes. This halving event historically caused a spike in Bitcoin’s value – due to the sudden increased scarcity. This is a built-in defense mechanism to prevent inflation. As Satoshi Nakamoto believed that Bitcoin’s value would continue to rise, he understood the importance of reducing supply over time.
Significant Advances in Bitcoin’s Codebase
Due to its decentralized nature, Bitcoin’s development relies on consensus. There is no controlling authority that can directly implement changes to the blockchain architecture. Despite this, there is a leading “Bitcoin Core” development team that suggests the majority of changes. Users are free to adopt these changes at will, which sometimes hamstrings attempts to change the code. This feature led to a schism in the community that ultimately saw Bitcoin’s major hard fork.
The introduction of the Segregated Witness concept alienated a subset of Bitcoin’s followers. Each Bitcoin block includes separate subsets of information – transactions, signatures, addresses and related information. The process of implementing segregated witness, or SegWit, involves shifting the signature portion of data to the end of the transaction. This frees up considerable space for more transactions. As Bitcoin matures, the system gains more users. At certain points, Bitcoin’s transaction volume overloaded the chain’s ability to process. This results in significant slowdowns as transactions must wait for the next block for processing. SegWit helps alleviate this issue.
In the same vein, the third-party Lightning Network created the concept of off-chain transactions. Through a series of peer-to-peer channels, the Lightning Network allows transactions to compound without impacting the Bitcoin blockchain. Every transaction completed on the Lightning Network opens a channel between the sender and the recipient. As these channels link disparate users together, bitcoin can be sent back and forth on a temporary ledger. These off-chain transactions are not validated until a channel closes. Channels are closed when a user wishes to withdraw their bitcoin from the system – or when a series of transactions cannot be properly validated.
Summary
Bitcoin revolutionized the concept of digital currency. As such, the impact of blockchain technology will have long-reaching implications. Some of these effects are yet to be seen, but we are already seeing a shift in how legacy financial institutions conduct business. Back-end banking software rarely measures up to the expectations of the current generation of tech-savvy users. Many of these banks are now looking for a solution that leverages blockchain tech to their advantage. While that likely does not mean banks will adopt Bitcoin directly, it does mean that cryptocurrency is gaining legitimacy at a rapid pace.
Bitcoin’s first mover status is undeniable. It holds greater than 50% dominance over the cryptocurrency market. Smaller cryptocurrencies will move of their own accord with Bitcoin is stable. However, when Bitcoin sees major price movement, those same smaller coins will almost always move in lock-step with their progenitor. While Bitcoin may not be specifically suited to every need that blockchain can feel, it remains a weathervane for the entire industry – and is likely to remain as such for the foreseeable future.