BITCOINS:

CURRENCY OF THE FUTURE?

M I L K E N I N S T I T U T E C E N T E R F O R F I N A N C I A L M A R K E T S
N A T I O N A L P R E S S F O U N D A T I O N


T U E S D A Y , F E B R U A R Y 1 8 , 2 0 1 4

BITCOIN BASIC FACTS

The nomenclature is Bitcoin for the en2re ecosystem, and
bitcoin for the currency itself.
The total supply of bitcoins is limited at 21 mm. Expected
2040.
There are about 12 mm bitcoins in existence now (57%)
By 2017, 75% will be in existence

Ledger about 27 mm lines at the end of last year

20,000 nodes in the system

WHAT MAKES GOOD MONEY?

Medium of exchange (no barter required)

Store of value (you can save to buy things later)
It is a unit of account (you can enumerate things)
This means:
It shouldnt decay or wear out
It should be easy to carry around/transfer
It should be fungible (indierent to individual units)
It should be veriable (not a forgery)
It should be divisible
It should have predictable (ideally) or at least understandable supply
dynamics
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SATOSHI NAKAMOTO
The root problem with conven2onal currency is all the trust
thats required to make it work. The central bank must be
trusted not to debase the currency, but the history of Fiat
currencies is full of breaches of that trust. Banks must be
trusted to hold our money and transfer it electronically, but
they lend it out in waves of credit bubbles with barely a
frac2on in reserve. We have to trust them with our privacy,
trust them not to let iden2ty thieves drain our accounts
With e-currency based on cryptographic proof, without the
need to trust a third-party middleman, money can be secure
and transac2ons eortless.
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WHATS WRONG WITH A USING A CENTRAL

COUNTERPARTY FOR MAKING PAYMENTS?

Access is regulated (barriers to entry can be high)

You have to trust that counterparty (credit risk)
Your account can be frozen, taxed, or conscated
Your counterparty could refuse to make your payment
Your payment could be reversed
Money transfer takes 2me
Somebody (not you) is keeping that oat

Money transfer is costly

Payment and transac2on banking revenue $524 billion last year (BCG)
Fees 2-3 percent; more in LDCs

Your transac2on reveals informa2on about you

Target 70 mm customers
Merchants have to reject 5-10% of orders
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WHATS WRONG WITH A CENTRAL BANK

CREATING FIAT CURRENCY?

Individuals make discre'onary decisions about how much
currency to create
There is an inherent 2me inconsistency problem
Ina2on is driven by expecta2ons

On the other hand

Full faith and credit of the government to defend the currency (oor)
Widely accepted because government insists that taxes are paid in the
currency

SPECULATION ON CHINESE EXCHANGE

Source: BofA
7 Merrill Lynch Global Research

BITCOIN IS A DIFFERENT SYSTEM

It is not a trust-based system:
It is disintermediated. There is no central counterparty in charge of
bookkeeping for your account (no credit risk)
The public ledger is transparent to everyone
All the soeware, architecture, and rules are open source

Its a consensual system

Peer to peer network of (currently) approximately 20,000 nodes
Everybody plays by the same set of rules
Decisions (addi2ons, changes, anything) require agreement by system
par2cipants (nodes).

BITCOIN MINERS

Runs on a massive peer-to-peer network of specially designed ASIC chips

Currently approximately 20,000 nodes in the network

Source: Alec
9 Liu, A Guide to Bitcoin Mining

BITCOIN HAS SOME REALLY GREAT PROPERTIES

Transac2on costs are low (trust costs money)
Barriers to Entry are extremely low
Its psuedonymous
Accounts are not maintained, only transac2ons are maintained
No email, username, password etc.
But traceability is inherent

Transac2ons are irreversible aeer about one hour (to be safe).

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MORE GREAT PROPERTIES

Micropayments can be made easily
Bitcoin is dierent than other currencies because its arbitrarily divisible.
It is now divisible to eight decimal places (currently)
So you can charge .00000001 for something = one satoshi

The bitcoin universe has 2.1 quadrillion Satoshi

There are approximately 1 quadrillion pennies out there.

There is no monetary authority that creates bitcoins.and the

supply dynamics are known ex ante

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DEFLATIONARY CURRENCY
There is a limited supply of bitcoins
21 million will be created in total
Expected to be reached in about 2040

The rate of supply diminishes over 2me

In a predictable way..this is really important

If somebody loses their bitcoins, they will never again be retrieved

This happens by losing your private key

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BITCOINS SUPPLY DYNAMICS

Source:
13 Bitcoin Forum; whitslack

WHAT IS INCREDIBLE ABOUT BITCOIN

Bitcoin is a distributed database where the order of transacJons
is agreed upon by everybody.

Therefore, there is no ques2on about legi2macy. Everybody
agrees on who has won (who got there rst)
It solves the double spending problem without the
requirement of a central counterparty.

There are other examples of the 2me-stamp problem.

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HOW DOES BITCOIN WORK?

Alice sends bitcoins to her friend Bob by lling out an electronic
order that includes his address and the amount.
She signs that order with her signature (to show that it is hers)

That transac2on is blasted out to the Bitcoin network, where all

the computers validate it.
To make sure she actually has the right to send the money

If its ok, the transac2on is added to the ledger

The money is now associated Bobs address
A bunch (10 minutes worth) of transac2ons are compiled into a
block and added to the main ledger. (a page in the ledger)
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EVERY TRANSACTION GOES TO THE LEDGER

By reading this ar2cle you are mining bitcoins, Quartz, December 17, 2013

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WHAT COULD POSSIBLY GO WRONG?

Bitcoin needs to solve three fundamental problems:
Keep the ledger as a whole secure (system failure/hacking)
Make sure each transac2on is secure
Protect the integrity of the ledger
Solve the double payments problem

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KEEPING THE LEDGER SECURE: THE

DISTRIBUTED MODEL
Every transac2on is stored on every computer in the system
Each computer helps keep the system secure (and is rewarded
for doing so)
Its a distributed network, so any change to the ledger or to the
system as a whole has to be accepted by everybody (the
majority of nodes)

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MAKING TRANSACTIONS SECURE

Public/Private key cryptography
All payments are veried by knowing someones public key
(pseudonym)
All payments are made secure by using the private key.
Anyone can see the balance associated with the public address,
but you cant spend the money without the private key.
Cryptographic Hash Func2on
Encrypts the payment message
A signature (Hashed message + private key) tells the world you are
allowed to make that transac2on (spend the bitcoins)
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LINKED BLOCKS MAKE THE LEDGER

By reading this ar2cle you are mining bitcoins, Quartz, December 17, 2013

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DOES THIS SOLVE THE PROBLEM?

This is cool because:
All you need to know is the public key in order to verify that the person
has the authority to transfer the money associated with a given public key
And, this process can be repeated backwards so that bitcoins can be
traced back in this same manner all the way to when they were created.

But what if Alice did this twice?

Which one would be legi2mate?
The one that came rst!
Which one came rst?
Who knows? This needs to be decided and everybody needs to agree on
the answer? >>> so that the transac2on is deemed legi2mate

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ITS TOO EASY TO PUT BLOCKS ON THE LEDGER!

An evil node could go back to a previous block and make a
change (double payment) and then recreate the block chain.
You need to make it impossible to do that
So, what to do:
Create a proof of work problem that is hard to solve.
The node that rst does proof of work wins
This is veried by all other nodes on the network
If accepted it is appended to the ledger (block chain)
Every other computer node wasted their 2me

There could be a branch in the ledger

The next block-winning miner decides which one survives

The ledger of record is the longest (most dicult) ledger

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YOU NEED TO GET LUCKY

By reading this ar2cle you are mining bitcoins, Quartz, December 17, 2013

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THIS IS HOW YOU GET BITCOINS!

Creates the incen2ve structure to do the work to keep the
en2re ecosystem secure
It is fair more work, more bitcoins
This is what protects the system against double payments
Huge computa2onal diculty --- you will never catch up
But also, the incen2ves are stacked for you to play by the rules

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MINING INDUSTRY
Mining industry is growing at an exponential rate

Advances in technology key to computational prowess

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Source: BofA Merrill Lynch Global Research

LIFECYCLE OF A BITCOIN TRANSACTION

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Source: Bitcoinchart.co.uk

HOW BIG IS THE MARKET

Overstock.com
Virgin Galactic
Wordpress
Zynga

The Pirate Bay

Reddit
eBay
Tesla
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Source: http://www.coinmap.org/

WHO ARE THE BIG PLAYERS

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Source: http://bitcoincharts.com/markets/