Bitcoin In 5 Minutes

Dominic Williams. Version 2014.01.22 (iii) About the author: Technology entrepreneur and bitcoin trader www.twitter.com/dominic_w www.linkedin.com/in/thedwilliams/

What is bitcoin? Bitcoin is the beginning of the Internet of Money. Technically it is a decentralized, peer-to-peer global crypto currency. More commonly bitcoin can be thought of as digital cash, but it actually packs many other important features too. The BTC/USD bitcoin exchange rate is currently about $820 per bitcoin but this fluctuates on a day-to-day basis. Bitcoins are infinitely divisible. A satoshi is one millionth of a bitcoin. Bitcoins can be transferred instantly (or in 10 minutes at full security). Transactions are final and there is no way to reverse them. The cost of transferring bitcoins and making payments is negligible. Initial applications include e-commerce, money transfer and store-of-value. The leading multi-billion-dollar e-commerce retailer Overstock.com started accepting bitcoin payments in January 2014 and made $140,000 in bitcoin sales on the first day. The website Porn.com now makes 25% of its overall sales in bitcoin (its industry has been an early adopter of many successful new technologies including VHS and Internet video). Vendors can avoid credit card processing fees and problems with chargebacks and can pass this cost benefit on to consumers. Consumers also do not have to worry about e-commerce operators storing their credit card details and later suffering a security breach (for example, hackers recently stole the details of 40 million credit and debit cards from Target in the US, including data that would allow the cloning of the cards). US consumers currently commonly buy and sell bitcoin using a company called Coinbase, which provides convenient online wallet functionality. Coinbase also provides services that make it very easy for e-commerce and traditional bricksand-mortar shops such as bars to accept bitcoin payments. Coinbase has raised $31.5m investment. Series B investors include leading venture capital firms Andreessen Horowitz and Union Square Ventures. See https://coinbase.com Bitcoin ATMs are now being manufactured illustrating how the bitcoin network can work in a more traditional way. See https://robocoinkiosk.com/

Exchange rate fluctuations mean most significant bitcoin deposits are currently held by investors and traders. However as the price stabilizes more and more ordinary people will use bitcoin as savings deposits and for the purposes of money transfer, which may disrupt businesses such as retail banks, card processing companies such as VISA and money transfer agents such as Western Union. A common misconception is that the currency is anonymous. In fact every transaction is recorded in a public ledger such that if you are connected to a real world transaction, then every other transaction made from your wallet can be traced back to you too. Contrary to press reports, avoiding complete anonymity was a design decision. Bitcoin has no central authority and the bitcoin network works on the basis of a revolutionary peer-to-peer cryptography protocol. The community as a whole represents its interests through organizations such as the Bitcoin Foundation. See https://bitcoinfoundation.org/ Anybody can join the bitcoin network as a miner and help process the transactions being made. In return the bitcoin system automatically issues bitcoins to miners, but the overall number of bitcoin issued every day is fixed, as is the total number that will ever be issued. The system is designed so that miners cannot subvert the network so no trust is required. Mining bitcoin has become a major commercial enterprise and the total power of dedicated mining servers supporting the bitcoin network is now greater than the worlds top 500 super computers combined, which has led to criticisms of the energy consumption and environmental impact. Colored coins allow assets such as stocks and commodities to be assigned to bitcoins such that they may be exchanged using the bitcoin network. Adoption of this feature is still in its early days but it is anticipated that it will become increasingly important too. The total market capitalization of bitcoin (calculated as the total number of bitcoins multiplied by the price per coin) is approximately $12,000,000,000. The total USD transaction volume is currently about $140m per day. During high volume trading periods this can reach almost $500m per day. More information at https://blockchain.info/charts Speculation has driven investment and trading in bitcoin and created high price volatility. Although speculation is therefore sometimes seen as a bad thing it is actually necessary to inflate the liquidity of the currency, which in turn increases its utility. A combination of increasing liquidity and the network effects of adoption by users and merchants drives the bitcoin phenomenon.

How is bitcoin traded? Bitcoin investors and traders buy and sell bitcoin on exchanges such as Bitstamp (see www.bitstamp.net), Huobi (see www.huobi.com) and Mt.Gox (see

www.mtgox.com). See http://bitcoinwisdom.com/ for current prices on all the exchanges. Because bitcoin became mainstream quickly, some exchanges were built by enthusiasts and not technically perfect. Initial concerns about regulatory hurdles have meant exchanges were initially founded in countries such as Japan (Mt.Gox), Slovenia (Bitstamp) and Bulgaria (BTC-e) rather than the US and UK. The largest exchange (Huobi) is based in China but serves predominantly Chinese nationals. New exchanges are appearing in the US and UK and other more mainstream places such as Singapore but for the moment nearly all the liquidity remains on the original exchanges, which are hugely profitable. The exchanges provide APIs and algorithmic trading is common. However the exchanges have very different APIs and creating automated trading systems that operate across several exchanges involves a lot of work. Trading software can be purchased that greatly improves upon the default human interfaces provided by the exchanges. See https://rtbtc.com/ MtGox was the first major exchange to be created and mid-2013 encountered difficulties in the US owing to poor compliance with money transmitter regulations. Consequently it became difficult to withdraw funds in US dollars from MtGox, such that traders may only withdraw funds as bitcoins. This has increased the price of bitcoins on the exchange and for these and other reasons, including relatively high trading fees, some people advise traders not to use this exchange and consider Bitstamp, which has the greatest liquidity outside China, handles deposits and withdrawals promptly, and has much lower trading fees.

Are there any bitcoin alternatives? Additional crypto currencies have been created that make adjustments to the bitcoin system to target different applications. Although bitcoin is likely to remain by far the predominant crypto currency, in the future several currencies will exist side-by-side and crypto currency traders will deal in all of them. See http://coinmarketcap.com/ Litecoin is designed so that small transactions can be performed faster and less expensively than they can with bitcoin. It has a $600m capitalization and is sometimes described as the silver to bitcoins gold. See https://litecoin.org/ The Mastercoin runs on top of the existing bitcoin network and is therefore very linked to bitcoin itself (each Mastercoin is actually a single bitcoin with additional data attached). Mastercoin enables advanced applications such as colored coins and self-adjusting derivative currencies that track external assets such as gold and the dollar in value. Mastercoin applications are in the early stages of development so it has a relatively small market capitalization of $77m. Although Mastercoin is open source, many of its developers hold mastercoins, which

provides them with an incentive to develop the system. See http://www.mastercoin.org/ Although there are numerous currencies, the personal opinion of this author is that bitcoin, Litecoin and Mastercoin are the main coins of the future. The lead held by bitcoin, which is the only currency in widespread commercial use, will make it the gold standard for many years.

What are the main commercial risks? Bitcoin and the Internet of Money the protocol has enabled cannot be uninvented and will become very important to the world over the long term. However there are many short-term hurdles. Short-term risks include destabilizing levels of price volatility caused by speculation, government regulation and technical issues. In the UK the HMRC suddenly indicated they would treat bitcoin as goods upon which VAT (sales tax) was due, effectively stalling UK bitcoin companies. After vigorous representations by the bitcoin community HMRC are now likely to reclassify it as a tradable commodity or private money however. The Peoples Bank of China has taken various steps to curtail bitcoin, which caused a 40% crash in the price at the beginning of December (China contributes a large part of overall trading volume but the PBOC is concerned it will enable people to avoid their strict capital controls). However, as it became clear that the Chinese were finding ways to continue trading bitcoins, and bitcoin users were not being imprisoned, the price of bitcoin recovered. This was one of the best recent trading opportunities. Many financial journalists, economists and bankers are affronted by the emergence of a new global currency that exists independently of sovereign state central banking and does not follow the old rules. They represent a significant lobbying force against bitcoin and impediment to successful resolution of regulatory issues. A relatively large proportion of all the bitcoins in existence are held by a small group of about 50 engineers and miners who worked with the crypto currency when it was first created in 2009. If one of these individuals decided to suddenly liquidate all their holdings, it would flood the market with bitcoins, depress the market and cause a crash. The drop in the price of bitcoin might be so sudden that there would not be time to trade out of holdings at a reasonable level. The situation would be similar if the founders of a successful technology company decided to liquidate all their stock post IPO.

What examples of altruistic applications exist? Currently as much as 80% of the world is unbanked. Bitcoin provides a mechanism that can be used independently of governments to change this.

Workers in the First World sending money to support relatives in the Third World lose approximately 15% of their cash in fees (when including the poor exchange rate received) and the transfers take a long time and parties must attend Western Union offices. Bitcoin can provide a way to escape these fees and the inconvenience. In the First World estimates are that 7-8% of GDP is consumed by financial services. In the long term Bitcoin provides a means to reduce this proportion dramatically and benefit our economies. E-commerce companies can free themselves from chargebacks and credit card fees, which often eliminate their profitability thereby creating more opportunities for startup operations (for example, many electronics retailers have margins of about 3-5% so credit card processing costs at 2-3% of revenue reduce their profit margin by more than half). Bitcoin provides an opportunity for entrepreneurs around the world to disrupt the status quo and deliver numerous improvements to our lives in much the same way the Internet has. Huge numbers of new financial applications and investment strategies will become available to ordinary consumers that they are currently denied.