Things That Make You Go Hmmm: Bit Happens

Grant Williams |

Let's begin at the end.

Why? Well, because all anybody wants to know these days, it seems, is where you stand on the Bitcoin phenomenon.

The virtual currency has spawned a whole new label to bestow upon people who have bought in: 'bitbug'. And whether you are a believer or more prone to pooh-pooh the hottest topic in global finance right now, people are happy to stick a nice, tidy label on you and move on.

Many think Bitcoin is a bubble the likes of which we haven't seen since US housing or NASDAQ stocks or even tulips, while others think it is the future. Certainly, the behaviour of Bitcoin this past week has given the advantage to the naysayers, but to dismiss the virtual currency out of hand is to miss the point entirely.

Personally, I think Bitcoin is much more than a carnival sideshow, as it has frequently been portrayed. For what it's worth, I happen to think Bitcoin is one of the most important things to happen to the world of finance (and, indeed, to the numerous worlds that orbit it — which is to say, pretty much all of them) in several decades.

That being said, I think there are enormous problems with the virtual currency, which may well ultimately defeat it. However, now that the trend has started, if Bitcoin does crash and burn, something more robust will inevitably rise, phoenix-like, from the ashes.

Now you know my conclusion: you know where I stand on Bitcoin, and so those amongst you who think the whole thing is some kind of joke have just had fifteen minutes of your lives handed back to you, because you can stop reading, put me in the file labeled'bitbug', and get on with your day.

For those of you still with me — either out of mere curiosity or a burning belief in Bitcoin, let's go back to the beginning and see if we can make some kind of sense of this virtual phenomenon.

The history of Bitcoin has everything you could ever want from an underground cultural phenomenon, including a mysterious, shadowy figure at the heart of it, whose true identity remains a mystery.

In November of 2008, a man (or men, or women — nobody is quite sure) named Satoshi Nakamoto published a research paper outlining his ideas for a new digital currency.

All that was known about him was that he supposedly hailed from Japan and had an email address that originated in Germany.

However, though Nakamoto was (and remains) a mystery, his creation managed to solve a problem that had been causing cryptographers sleepless nights for years: the issue of double- spending.

(The Wire): If a digital dollar is just information, free from the corporeal strictures of paper and metal, what’s to prevent people from copying and pasting it as easily as a chunk of text, “spending” it as many times as they want? The conventional answer involved using a central clearinghouse to keep a real-time ledger of all transactions — ensuring that, if someone spends his last digital dollar, he can’t then spend it again. The ledger prevents fraud, but it also requires a trusted third party to administer it.

Bitcoin did away with the third party by publicly distributing the ledger, what Nakamoto called the “block chain.”

What does that mean to you and me? Well, The Economist takes up the story:

(Economist): For a new block to be deemed valid, some computer on the network must create a transaction log for it that dovetails with the previous blocks. To prevent acceptance of bogus logs, giving it a seal of approval has to be prohibitively costly to any individual user, but relatively cheap for the network as a whole. This is done by making it into a forced-work task, which involves using the valid blocks and the new transactions to generate a digest consisting of 256 bits (ie, any number between 0 and 2256). The task is complete when the system's algorithm spits out a hash value below a preset target. The target is set so that the puzzle is solved by someone on the network, and a new block approved, every 10 minutes. To keep this rate constant as the network's ranks swell and its combined computing power grows, the target is lowered in order to make generating a value below it harder. (Conversely, if the network were to shrink, it would get easier again.)

Part of the genius of this system lies in how difficult its complex structure makes it for anybody to cheat. Creating bogus 'blocks' requires the would-be counterfeiter to have control of over half the computing power of the entire Bitcoin system in order to outflank it and get his knock- off blocks validated in time. Yes, it's possible, but only theoretically rather than practically.

So there is the indisputable beauty of Bitcoin: it is the anti-fiat currency, completely decentralized and unable to be created at whim by thirsty central banks. It is also, of course, inherently deflationary — anathema to central bankers around the globe.

As it grew quietly amongst a small, tech-savvy internet fringe group, Bitcoin began to be used in real-world transactions (the first of which was a pizza, delivered in Florida but paid for in bitcoins through an English volunteer who accepted the coins and then called in the order from the other side of the pond). Prophetically, when Wikileaks suggested they might adopt the viral currency in 2010, the mysterious Nakamoto emerged from the shadows with these words:

The project needs to grow gradually so the software can be strengthened along the way. I make this appeal to Wikileaks not to try to use Bitcoin. Bitcoin is a small beta community in its infancy. You would not stand to get more than pocket change, and the heat you would bring would likely destroy us at this stage.

We will revisit Nakamoto's prophecy in a moment.

Shortly after he conveyed this message, Nakamoto sank back into the shadows once again, saying he had 'moved on to other things'; and he has not been heard from directly since.

To continue reading this article from Things That Make You Go Hmmm… – a free weekly newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore – please click here.

 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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