How bitcoin evolved from post-crisis fintech innovation
The trillions of wealth wiped from the global financial system due to the Great Financial Crisis (GFC) triggered by a cascading failure linked together by systemic risk caused by derivatives reached $22 trillion, according to a report by the U.S. government accountability office.
In the last ten years since the GFC, a multitude of alternative asset classes emerged across the globe, with digital assets representing the newest breed with unique genetic characteristics and traits not seen in prior generations of technology.
Bitcoin is an example of the largest cryptocurrency to date, in terms of market capitalization and network size, and below are some of the drivers that helped propel this newly maturing cryptocurrency and the broader crypto-industry emerging since then.
Low rates shifted interest into fintech-powered alternatives finance
The low-interest rate environment that persisted as a result of the GFC globally has caused many institutional investors to seek higher yields in alternative markets.
This influx of [smart money] capital into alternative investments and alternative asset classes (i.e., non-bank products) helped fuel the emergence of new financial products thanks to innovative financial technology (FinTech).
The Era of P2P Crowdfunding and Social Networks
As investors sought higher yields in alternative markets, Fintech companies applied innovative experimentation with new financial products across industries to capture existing and expected demand for alternative financial products.
Venture Capital (VC) and private equity (PE) investments in FinTech companies have helped accelerate these trends across various industries as global markets for alternative finance continued to mature. The emergence of peer-to-peer (P2P) technology has coincided with trends in payments apps, social networks, as well as social trading, and crowdfunding.
The emergence of a new Crypto taxonomy of financial products: digital assets
During the midst of the GFC in 2008, a document was published titled: “Bitcoin: A Peer-to-Peer Electronic Cash System,” authored by the pseudonym “Satoshi Nakamoto.”
This white paper for Bitcoin described the use of cryptographic proof – to replace the need for any trust between peers in a network by using cryptography as a validation mechanism thus relinquishing the need for any trusted third party or central authority.
Bitcoin is a digital currency that runs on a distributed peer-2-peer (P2P) decentralized network on the global internet supported by its community of users. Users transact bitcoin between two unique public addresses, one belonging to the sender and the other to the receiver, and a small transaction fee is paid by the sender to miners within the network who help process the transaction (more on that below).
Being decentralized and public helps bitcoin to maintain its distributed network which consists of copies of its ledger hosted by users in what is called a node. The current size of the bitcoin ledger (bitcoin) is currently nearly 145 gigabytes and growing each day, and this represents the amount of hard drive storage needed for anyone to run a full node.
Hosting a full node, which can be done by nearly anyone, helps to support and run the bitcoin network. By running a full or partial node, users contribute to the collective network of nodes which act as a checkpoint for the entire ecosystem as each node contains the entire ledger with an immutable history of transactions that have already been deemed irreversible (more on how transactions are processed and mining below).
The potential supply of bitcoin is limited due to the code used in the protocol that bitcoin must follow without exception (not including forks, more on that later). There can never be more than 21 million bitcoins created, and there are already nearly 17 million in existence.
Bitcoins are created based on a multi-step process where user-operated/owned computers are dedicated to trying to guess a nonce, which is a sufficiently large arbitrary number that is generated randomly and with increasing difficulty to find. The increasing mining difficulty together with a limited potential supply creates a narrow channel to keep inflation contained, compared to traditional fiat currencies such as US Dollars or Euros (where inflation rates are attempted to be controlled by a central bank).
The difficulty rate to be the first to find the next nonce – to be rewarded the bitcoin produced in the next block – is so high currently that entire factories of interconnected servers running specialized computer processing (mining) hardware are dedicated to achieving the required hashing rates to make mining worthwhile.
Network incentives: Mining and Network Fees
Each time a nonce is correctly guessed, a new block is created, and the correct nonce number becomes hashed or connected to the prior block, acting as a liner chain between the prior and current block.
The miner or pool of miners that guessed the correct nonce is awarded the bitcoin amount contained in the newly minted block, which is currently 12.5 bitcoin per block.
Users who participated in mining the block also compete to add recent bitcoin transactions made between users transacting bitcoin in the network into the newly mined block to verify them.
Senders of bitcoin pay a network fee to miners and miners are incentivized to include these transactions in new blocks to earn the network fee paid by the sender of each bitcoin transaction.
This structure supports the flow of capital within the bitcoin network while keeping miners interest vested in supporting the ongoing maintenance of the network which in turn supports more users within the network which then again returns value to miners in the form of transaction fees.
Bitcoin cyclical price growth
The cyclical process that bitcoin’s network structure follows is similar to economic cycles. Bitcoin can be thought of as an economy and was literally in the top 40 globally when comparing its M1 money supply, as of November 2nd, 2017 when it’s market cap surpassed $110 billion dollars after the price of 1 bitcoin reached $7200.
Many consider bitcoin to be in a price bubble, yet when examined over its historical price action, bitcoin has already had numerous bubbles where its price inflated and deflated over nearly the last nine years.
Passive investing in cryptocurrencies
Despite rebounding higher in its last wave (current bubble) if the underlying drivers that are causing it to become accepted continue, some analysts believe it could reach $1million per bitcoin in just a few years, while others believe it will fail or be superseded by next-generation crypto networks with more advanced survival traits.
These challenges make it very difficult for even the most passive investors as maintaining a diversified portfolio in cryptocurrency markets may require very active rebalancing as the rankings of digital assets are constantly changing (when comparing the top 50 cryptocurrencies for example over just the last few months).
Social crypto networks
Just as FaceBook – which is not currently a crypto network – needs to maintain users to monetize their attention as the currency in its social network by charging marketing firms to display ads to users, the size of a crypto network is a major driver of its price valuation. Without any underlying users, the network wouldn’t be of value to anyone.
However, with FaceBook the “currency” in its network is paid to FaceBook from marketers, and users are not able to participate in those benefits beyond the utility derived from using the Facebook platform. Public crypto networks that are inherently P2P may eliminate the need for a middleman, but maintaining the network size and growth rate is the key to its sustainability, utility and any resulting valuation.
P2P transfers without the need for a trusted 3rd party
While the need for trusted third parties has been replaced in crypto networks such as bitcoin, there are still inherent risks such as ensuring there are enough users to generate enough transactions to incentive enough miners to support the network and the price of the digital asset that helps fuel it.
Bitcoin is no exception, and just like any crypto network, there must be enough users in the bitcoin network to generate enough transactions, to support the demand (price) while incentivizing miners to process transactions and supply mining newly minted bitcoins. Bitcoin’s network follows a cyclical process and is comparable to other natural economic cycles within global marketplaces across industries where commerce takes place.
All bitcoin transactions are made between public bitcoin addresses where the respective holders of each bitcoin address own a unique private key connected to the respective public address (except for coinbase transactions which are created by miners when bitcoin is awarded from mining a block).
Public nature of bitcoin
While purchasing or mining bitcoin may come under the control of law, anyone is free to do the math to generate a nearly-unlimited number of bitcoin addresses for free using the open-source public code, and this can even be done off-line, ideally on an air-gapped computer to reduce the likelihood of a screen-recording or keylogging malware.
Therefore, safeguarding private keys is another challenge on its own and is where significant risk remains as lost funds – whether due to hackers obtaining private keys or users forgetting or misplacing their private keys – means that lost bitcoin is unrecoverable.
Private key = digital asset
Each private key is akin to a secret password that is fixed and cannot be changed, and the address owner must safeguard this private key as it is the sole backup to control their digital asset (unless the key is safeguarded by a 3rd party exchange).
Anyone who obtains access to your master private key, known as a recovery passphrase or master seed, can access your digital asset. Therefore, safeguarding private keys becomes of paramount importance to protect bitcoin from theft or accidental loss due to forgotten or misplaced keys as they are unrecoverable.
Elliptic Curve Cryptography
Master Private Keys are generated using an open-source computer code that uses complex math to generate very large random numbers that are subsequently used in a multi-step computational process (involving more random numbers) with each step independent of each other.
This process which incorporates Elliptic Curve Cryptography (ECC) helps ensure a level of security that complies with some of the highest standards of encryption making it nearly impossible or improbable to guess/hack/crack the private key.
Crypto assets such as bitcoin follow some of the highest standards of encryption currently available, combining elliptic curve cryptography (ECC) to generate public/private key pairs, and the Secure Hash Algorithm (SHA) for mining blocks (more on mining below).
Securing digital assets
SHA-2 was developed by the U.S. National Security Agency (NSA) and the SHA family including SHA-3 is widely considered one of the strongest forms of encryption (sufficient even for military and Government top secrets).
Although the SHA2 family of algorithms was patented by the NSA, they were later released under a royalty-free license on June 20th, 2007 and are today widely used on the internet.
Today, SHA-related encryption can be found in many common computer applications and services across the internet as it is used for authentication (encrypting/decrypting) access to secure online services from both commercial enterprises and in free open-source software code/applications.
Mnemonic Passphrases For Recovery and Control of Digital Assets
SHA2 is considered secure because the resulting private keys that are generated (in which case with digital assets like bitcoin follow methods like BIP32 or BIP44 and then are converted into an easy to remember passphrase of 12-24 words via methods like BIP39) have between 256-512 bits of entropy. Entropy is a rating of the inherent protection passwords have against collision attacks (i.e., accidental guess or hackers trying to crack via brute force).
However, the risk for users to safeguard those keys is an entire different responsibility and is where the significant risk lies because hackers could obtain those keys and access your digital assets as described earlier.