How Does Bitcoin Make Money?

Ok Bitcoin lovers, what is this chart of?

How does bitcoin make money

If you said NOT Bitcoin, well done. If you said Bitcoin, bad luck, this is Bitcoin.

how does bitcoin make money

What you were looking at is Microsoft.

msft and bitcoin chart

People are obsessed with arguing over whether Bitcoin is money, whether Bitcoin is a currency, whether Bitcoin is gonna make them rich.

I’m here to say to you that you already know what it trades like, even if you don’t have a clue what it is. It trades like a hot as hell tech IPO.

This you may have not realized – Microsoft is the big grandaddy of tech IPOs. It went from nowhere to taking most of the profits in the PC business. Now its breaking out as a play on cloud. How can a cryptocurrency be similar to Microsoft?

Chart images: Tradingview

What is Bitcoin?

I’ll give you the tl;dr here: the fundamental value of Bitcoin is a bet on (1) the ultimate share of distributed ledger technology in the financial sector, (2) how long it takes to get there, and (3) Bitcoin’s market share of these distributed ledger technologies.

It can be all these things because it is NOT a currency. It is just pretending. Sure you can use it to buy things but it ain’t a store of value and you actually have no idea what your bank balance is worth if its marked in Bitcoins.

Now jump back to Microsoft in its early days. It was a bet on (1) the number and market share of PCs versus mainframes, (2) the time it would take to get there, and (3) Microsoft’s share of the profits in PCs.

Sound familiar right.

Before we drill into the Bitcoin bet further, I have to start explaining. I kinda always feel a little embarrassed talking about what Bitcoin is. It is freaking complicated, but everyone who cares already knows. If I run you through 101 elliptical curve mathematics, you either don’t give a s h i t or you start correcting my mistakes.

Bad luck for those on either end, I cater for people seeking insights, not Paris Hilton or a Math major from MIT.

how does bitcoin make scrabble

Image: Airpix, Flickr Commons

Bitcoin is based on blockchain, which is the handy name for a distributed ledger technology. Ledgers are databases. So naturally it’s a database that’s spread around. I’m going to delve deeper than this, but let’s start by talking about trust. At this point, people often get ahead of themselves and start talking about trustless before trust. But trustless is necessary because trust costs money.

Trust and money

A thousand years ago, I lend my buddy a couple of sheep. As anyone who has mixed money and friendship, it’s the friendship that goes down the pan. He runs off with my sheep and I get a huge hard on of resentment.

“Resentment is like taking poison and waiting for the other person to die”, said Malachy McCourt apparently.

This is the risk of opportunism. A contract based on trust gives the other party an opportunity to do me over.

how does bitcoin make trust

Image: Zach Copley, Flickr Commons

I always remember, back when I was eight years old, another kid from school asked to borrow £1 from me. Dear readers from elsewhere, this is the money of the United Kingdom. You used to be able to buy twelve loaves of bread with this back in the 1920s.

Now you would be a few slices off a single loaf. Anyways, back when I was a small boy, it was worth two loaves of bread.

The kid never paid me back. I wanted to push him off an extremely high ledge. I ran into him years later; I didn’t mention it but I still wanted to push him off a ledge. His name was Jon and this was when I figured out “hey, I got a pretty good memory!”

This enduring hatred had a good reason. I’d thiefed the money from my mother for chips. No money, no chips.

I trusted him, that trust wasn’t worth the fluff on his butt cheeks.

What I needed was a go between. I needed a big kid that could kick his ass to make sure he paid up. I needed a bank.

Trust in sticks

Banks are referred to as a trusted counter party. They aren’t trusted, they aren’t counter and there definitely isn’t a party back at theirs. But they carry a big stick: lawyers, debt collectors, bounty hunters. You want to make your life a misery? Go do over a bank.

Trusted counter parties come in many forms. They might be a bank. They might be a clearing house, sitting in the middle of a futures exchange, collecting collateral. They might be your mom, making sure you and your siblings play nice.

how does bitcoin accept money

Image: Francis Storr, Flickr Commons

I quite like counter parties. I definitely needed one when I was eight. Others don’t. Central counter parties mean somebody with power. They can easily make a lot of money just sitting on their big fat ass in the middle. They often do not have your interests at heart.

One person that particularly did not like central counter parties (CCPs) is Satoshi Nakamoto. I use person in a legal sense, in the same way a company can be a person, because we don’t know who this guy, girl or collective is. Nakamoto hated CCPs so much they wrote a stack of amazing, breakthrough code that virtually eliminates the risk of opportunism. They relied on cryptography instead of a trusted central party.

99 problems but Byzantium ain’t one

Commentators like to say that blockchain solves the Byzantine general problem. Before I go there I’m going to have a history moment. If you don’t like history or Muslims, you should probably jump to the next section.

I have always been fascinated by the Byzantine Empire, which was actually the stub end of the Roman empire. By then, this stub of the old Rome was being run by the Greeks out of a town called Byzantine. It got rebranded to Byzantium partly because it’s a cool name, but primarily because they got beat by the Muslim Turks.

We did this even though Emperor Constantine renamed the city itself after himself. In other words, a group of people calling themselves Romans got named after a town they renamed Constantinople: the Byzantine Empire.

People just did not want to admit that it was the Muslims that ended the Roman Empire. They are determined to pretend it was white Germans.

Before you email in to complain, yes Germanic tribes did seize what we now know as Italy, Spain and France. But for many centuries later, Byzantine would still occasionally control Rome.

Consider when Germany got split in two after WW2. Is East Germany still Germany?

what has byzantine generals got to do with bitcoin

Image: Wikipedia

The Byzantine Empire has a really harsh rep. They lost so they must be weaklings. However, think about the dates. They fought off a waves and waves of Arab and Turkish invaders for centuries. Their first big defeat to the Arabs was in 636. Byzantine, now known as Istanbul, didn’t fall until 1453.

The reputation should be the other way round. If they were weak then Paris would probably have been renamed Pardad and Europe would be Islamic. Byzantium was the meat shield of Christendom for seven hundred years. People forget that there used to be more Christians on the other side of the Mediterranean than on the northern, white European side. Islam ate the world of the 10th century. It just happened that the next stubby end, the poor part of Christendom they did not eat, came to dominate the world of the 15th century onward.

Branding Algorithms, and no I don’t mean Coke and Pepsi

Interestingly, the Byzantine general problem is also a clever rebrand. Three computer programmers Leslie Lamport, Robert Shostak and Marshall Pease had an algorithm to solve a systems failure issue. You have a bunch of processes and some of them are faulty. Their algorithm sent lots of messages until it became clear who was using the tippex. The only things that they required were that the messages were unforgettable and that at least two thirds of the generals were loyal (or that two thirds of the processes actually worked).

They used generals and Byzantium to make their algo sound cool. This definitely worked. Never forget the importance of marketing.

So if these guys solved the problem when they wrote the problem, what is blockchain doing?

Blockchain solved coming to a consensus as effectively as their algo, but in a far more elegant way.

Ok, ok, I’ll explain a bit more on Blockchain

There are three things I feel obliged to explain. Ledgers, Digital signatures, and what people say that isn’t true.

You already know that ledgers are databases. Society is built on these things, from your driving license, to your bank balance to your health records. Equally you know that the government controls the first, your bank holds your money and your hospital or HMO keeps tracks of the last one.

There’s the punch. Blockchain opens the possibility of getting rid of your HMO, your bank and maybe even the government. All these three exist either to establish trust or to fulfill a contract. Blockchain happens to be pretty good at both of these.

Is this gonna happen? Are revolutions ever easy? Personally I suspect these institutions will change, but only a bit. The key problem with Blockchain smart contracts (the rules written in programming code), is there has to be no mistakes right at the beginning. Computer scientists don’t have a problem with this conundrum. If it is there at the beginning, then it is part of the contract. But others would certainly take issue with the many occasions when the details of a smart contract are not the same as the spirit of the contract. I mean have you ever bought a used car?

how do ethereum graphics cards make money

Image: Mirko Tobias Schafer, Flickr Commons

Digital Signatures

Digital signatures are the cryptographic trick that underlies blockchain. If I give you two big prime numbers, you can tell me the multiplicative sum of the two. You pull out your calculator, and you’ll have the answer as long as you have enough digits on there.

But if I give you the result, you won’t have a clue what I’ve multiplied together. Blockchain doesn’t use prime numbers, they use elliptical curve mathematics.

Now let’s throw in a public key and a private key. One of the inputs you are multiplying (or strictly speaking hashing) is your private key, and the other one is the transaction you want to do. You hash them together and then show off to everybody the result and your public key.

The clever thing about the public key is that other people can use your public key on your result and prove that the private key was used here. They know that a specific identity or wallet was involved in this transaction. They can see your digital signature.

Blockchain misunderstandings

So what do people say about blockchain that isn’t true? Couple of things. Like its immutable. Immutable doesn’t change, whereas the whole point about blockchain is that people say different things and then you’re forced to all agree. If everyone changes their mind, then the blockchain changes its mind. This is what you call mutable.

Blockchain isn’t mathematically 100% secure. Nothing is.

A mega hack might involve launching denial of service (DoS) attacks on all the big mining pools and then hiring all the capacity off of Amazon AWS to do half an hour of Bitcoin mining. This should be able to seize control of the Bitcoin blockchain from the miners that survive your DoS.

Click here to check out BlinkistBitcoin is actually game theoretically secure. And maybe that is better. Imagine, if someone did this mega hack, what is Bitcoin worth? Maybe nothing, negating the value of all the money you spent on AWS to steal those Bitcoins.

The other thing that isn’t true relates to the time stamp. I keep seeing people say there’s a time stamp on the blockchain. Time is of course mentioned, but no, Nakamoto dropped the time stamp because whoever gets to stamp the time is guaranteed to be more trusted and more powerful than everyone else. Nakamoto’s original paper mentioned time stamps. In practice it got dropped.

Credit where its due

Satoshi Nakamoto did not come up with digital signatures. Look up Wikipedia if you want to know the many people involved in creating digital signatures. Nakamoto also did not invent the proof of work that underlies Bitcoin mining. That was Adam Back.

Nakamoto’s breakthrough was linking all the public keys and digital signatures and transactions into blocks. He chained these blocks of info and made it totally public. Nakamoto used game theory and coinbase rewards to persuade individuals and companies to spend fiat money to process all this data.

Satoshi Nakamoto invented a third party funded payments processing system and called it a currency.

The Business Model of Bitcoin

  • Core developers invest their time to evolve the code base
  • Miners invest in specialized equipment to verify and process transactions
  • Each block that gets added to the chain earns its miner or mining pool some Bitcoins
  • Users get to transact pseudo anonymously at a socialized cost
  • Whoever held on to their Bitcoins (devs, users and miners) gets richer and richer

Once upon a time you could mine with graphics cards. Now most Bitcoin miners look like this.

how do bitcoin servers make money

Image: Bitcoin Opp, Flickr Commons

Is crime the killer app of Bitcoin?

Studies have figured out that there are criminal proceeds of illegal activities sitting in Bitcoin wallets untouched all around the internet. Not moving, just sitting. Maybe these crooks are true believers that Bitcoin is the one ultimate currency. But I suspect it is because they do not want to link the criminal activity to a real world account or real world action.

Bitcoin is pseudo anonymous. Certainly I don’t know who owns which Bitcoin or which wallet. However, despite the use of mixers, pretty much every Bitcoin transaction is public and can be linked back to all their prior uses. You try and turn your illegal Bitcoins into US dollars and then deposit it into your bank…however somebody can see that if they care enough.

Bitcoin is the protection of the flock. Yea lots of people are buying drugs on the dark web. But you do something really bad…well then they are watching you. Or more precisely, they are watching your Bitcoins.

Blockchain and Bitcoin: technological breakthrough or latest tulip bubble?

This is the name of the dissertation I wrote for my Masters at SOAS, University of London. If I ever get it published, I’ll link to it here. In it I find empirically that the Bitcoin price is correlated to market inflation expectations. Many have argued this because the total number of Bitcoins in circulation is limited algorithmically. I also give an example of a week where the price of Bitcoin on the Bitstamp exchange and the Kraken exchange are different.

Different is crazy, it means that a US dollar is not the same value in these two virtual locations.

We know what a price bubble is. It is something that goes up, then goes down. Importantly a real bubble stays down.

Tech bubbles often don’t stay down. A couple of guys called Bresnahan and Trajtenberg came up with the name General Purpose Technology for inventions that blow the doors off of the world as we know it. They start with steam engines, electricity and the IT revolution. Maybe the next one is blockchain. Unfortunately for the proving business, this is not quite confirmed yet.

how does bitcoin code make money

Image: Jonas Lejon, Flickr Commons

What’s the stock market for? It exists to allocate capital. Stocks like hot IPOs go through the roof because its saying we need to spend more money on this stuff. They often bust out because reality cannot live up to the hype.

But look at Microsoft. Look at Burlington Northern. Flick your light switch a couple of times. The reality for all of these turned out bigger than the hype. All that happened in each of these cases is that investors got greedy. And when they get greedy, they get burnt.

There is a large body of academic work, like Pastor and Veronesi (2009) and Greenwood and Jovanovic (1999), that shows how stock prices might go up and down, but underneath it society is taking a big leap forward.

Is Bitcoin a Bubble?

“Bubbles accompany technological disruption.  The companies in the bubble may not survive but the technology will.  As a result, we may (likely, in my opinion) see a bitcoin correction, however, digital currency is the future – the winners in the space are ‘to be determined’” said Ryan Daily.

I’m going to add something to this. What the academic work found was that often these technologies cannot be owned. Think about it. A single corporation cannot dominate the steam engine business, the electricity business or the blockchain.

A big chunk of Bitcoin’s value comes from the rest of the financial sector refusing to adopt it.

401k money dynamite

Image: Richard Stephenson, Flickr Commons

I’ve written a lot about rents. Cryptocurrencies collects a rent for (1) socialised cost of transaction processing, (2) pseudo anonymity and (3) eating the financial sector.

It can only do this as long as the financial sector doesn’t do it to itself. Followers of Bitcoin know what Bitcoin Cash is. It’s a hard fork in Bitcoin because of an argument over the future of Bitcoin. Bitcoin became Bitcoin + Bitcoin Cash.

Sensible people were amazed that not only did Bitcoin Cash end up being worth USD 400 a coin (approx. $10bn market cap), but that the Bitcoin price went up after the split too.

Let’s be clear, the price of normal stuff is supposed to go down when there is more of it. That applies to equities, money and loaves of bread. But not to crypto.

Vitalik Buterin, the founder of Ethereum, argues that this is because the utility functions of cryptocurrency networks are different (u(x)*ln(n) rather than u(x)*n if you’re wondering).

I use the general purpose tech framework to explain this a different way. New cryptocurrencies have the potential to retain economic rents associated with a superior technology. It is non cryptocurrency use cases that eliminates these economic rents.

We had a sell off of the crypto space when Jamie Dimon, CEO of JP Morgan, described Bitcoin as a bubble and seemed to imply that his own daughter was stupid. According to me, this is a buying opportunity. The tough patch for Bitcoin is when JP Morgan announces their own distributed ledger technology network. Or when it says it is going to rip and replace its infrastructure in favor of blockchain.

Bitcoin the IPO

ICOs, or initial coin offerings, are blockchain businesses that seek start-up funding via a sale of coins, or tokens, often exchangeable for their future product or service.

When I say that Bitcoin is an IPO for blockchain technology, I am arguing that Bitcoin is the original ICO.

So far it is the classiest one going.

Other people have thought this before. I’m not being strict with my usage but its selling coins to invest in a service that you can swap the coins for.

Now the academic literature hints that after the steam engine, after IT, and after the Internet got widely adopted, this drove a selloff in the wider stock market. They give a bunch of reasons, but let’s stick with the easiest to grasp: new tech capital destroyed old tech capital.

how does tech die

Image: Wikipedia

I wouldn’t read this through to Bitcoin. Bitcoin is still tiny. As of 19 September 2017, Bitcoin was only equivalent to the 84th largest stock in the S&P 500 index, between Chubb Insurance and Lowe’s. It has gotten bigger than then, but it still ain’t the 32% of the market that the tech sector got to during the Internet bubble.

Roadmap for Bitcoin

I’m going to put forward a scenario for crypto. This is not a prediction. It’s just a mini story from my febrile imagination.

Bitcoin is the tech prototype for distributed ledger technologies. Normally this happens off market in a private firm. Think Uber and AirBnB right now. Instead we have the most explicitly public development signalling process ever. The Bitcoin price is flashing deploy this tech.

Cryptocurrencies are just the beginning. The real bubble is going to happen when we get some leading firms changing the world with blockchain. Then we are going to see both some big transformations in society and some big blockchain firms to lead the stock market.

No idea when I’ll get time to write again, so here is the affiliate link to BlinkList for those who love a good get smarter read. Take care everybody.

Yuen Lo


Leave a Reply

Your email address will not be published. Required fields are marked *