Why You Should Invest In Bitcoin and How

Originally sent to VIXCONTANGO subscribers on February 16th, 2014

It is often amusing to watch the current public debate about bitcoin (BITCN). On one side stands the financial community with its legion of bankers, highly credentialed academics and mainstream financial media. On the other side, a group of highly skilled computer programmers (cryptographers), venture capitalists and e-commerce retailers. These two groups are not comfortable around each other in real life and now they are forced to come to a consensus about a technology that sits at the cross-section of their respective industries. The learning curve in both of these industries is long and difficult. It takes dozens of years of study and practice for someone to become a seasoned financier and just as much to become a top notch computer architect and cryptographer. Very few are the people who can speak fluently both industry languages and so for the time being, we have two groups that are shouting past each other.

The general public knows little about high-finance and even less about grid computing. All they see is a lot of noise coming out from both camps and are rightfully confused and probably even a little amused. There is nothing like watching a good catfight.  But as a software developer in the financial industry for the past 10 years, nothing excites me more than the technology of money and I am a little frustrated by all the fracas. I am writing this article in order to bring some clarity to what bitcoin is, dispel some common myths about it, provide a valuation framework for it and educate investors about the current  methods for investing in it.

So.. What Exactly is Bitcoin?

Everybody who wants to learn about bitcoin should start by reading the Bitcoin Whitepaper. It is a succinct academic paper worthy of a tenured professor at Stanford. I will take the liberty and highlight a couple of important paragraphs and then I will  provide some clarifications about the concepts expressed for those not versed in computer programming.

Bitcoin: A Peer-to-Peer Electronic Cash System

Abstract: A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution..

We have proposed a system for electronic transactions without relying on trust. We started with the usual framework of coins made from digital signatures, which provides strong control of ownership, but is incomplete without a way to prevent double-spending. To solve this, we proposed a peer-to-peer network using proof-of-work to record a public history of transactions that quickly becomes computationally impractical for an attacker to change if honest nodes control a majority of CPU power. The network is robust in its unstructured simplicity. Nodes work all at once with little coordination. .. Nodes can leave and rejoin the network at will, accepting the proof-of-work chain as proof of what happened while they were gone. They vote with their CPU power, expressing their acceptance of valid blocks by working on extending them and rejecting invalid blocks by refusing to work on them. Any needed rules and incentives can be enforced with this consensus mechanism.

1. Bitcoin Computer Network

This is a peer-to-peer computer network that facilitates the transfer of digital property from one computer to another. A peer-to-peer network is a computer network that allows any computer to participate in it; there is no central computer that acts as a hub for decision making or transmission. As a result, you can’t simply target one or two computers and shut down the entire network. The computers can reside in any country in the world. Unless you shut down the entire internet, the bitcoin network computers will always be there to power the network.

2. Bitcoin Wallet

There is widespread confusion about what a digital coin is. We are all familiar with the dollar bill or a gold bar. Something tangible that represents a unit of value. The fact is digital coins do not exist. What does exist however is a digital wallet. The bitcoin wallet is simply an account with a balance. We are all familiar with the concept of a bank account – a unique identifying number that has another number (the balance) attached to it. In fact, this is how the Fed executes quantative easing – they simply credit bank reserve accounts with digital dollars. A bitcoin wallet carries a balance in a fictitious unit of value (currency) called a Bitcoin (BTC). When a bitcoin transaction occurs, one wallet sends an amount measured in BTC  to another wallet.

Bitcoin wallets come in two flavors – a personal computer wallet and an online wallet. The PC wallet is an application like Bitcoin Armory, which is installed on your personal computer and creates a file on it that becomes your bitcoin wallet. You need to secure the wallet (the file) with a password (also called 1-Factor Authentication). You can only send a bitcoin to another wallet if you provide the password. An online wallet, on the other hand, is an internet company like Coinbase.com which creates a bitcoin wallet for you which is stored on their computers. You can send bitcoin to another wallet by logging into the site and providing your password. The better online wallet companies like Coinbase employ 2-Factor Authentication. In addition to your online password, they employ a second verification procedure by sending a one-time code to your smart phone or via a phone call.

Incentive

By convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block. This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them.  The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.. … Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.

3. Miners

The miners are simply the computers that power the bitcoin network. They provide computing power in exchange for bitcoins. Mining is the only way to fund a wallet with a bitcoin balance without a transfer. Since computing power costs real money, the network awards them bitcoins in return hoping that the bitcoins carry enough value to justify the expense. This has the added effect of drawing participants to the network as miners instead of hackers trying to bring it down. Why would anybody incur a significant expense to bring the network down when they can just mint digital money from it? When the bitcoin money supply is reached in the future, the network will continue to pay miners by awarding them transaction fees in bitcoin.

4. Blockchain Ledger

This is a publicly available ledger available from each Bitcoin miner in which all transactions are recorded for everyone to see.  When one wallet sends an amount to another wallet, a transaction is recorded. The verification of each transaction is based on the previous transaction. Because the entire history of transactions is always available, potential hackers cannot duplicate transactions or reverse transactions. In other words, people can’t make digital balances appear from thin air. As a side benefit, every transaction is perfectly traceable allowing law enforcement perfect visibility into the flow of money. It should not be a surprise that all bad actors have been fairly quickly brought down by the FBI. The block chain and all currently happening transactions can be observed at blockchain.info

5. Proof-of-Work Algorithm

This is a SHA256-based computer cryptography algorithm that is used to execute a transaction. The algorithm takes a log of all existing transactions in order to verify the current transaction. This requires substantial computing power. Computing power can only be generated by electricity. So an inherent cost of running the bitcoin network is electricity and computer equipment. Electricity and computer equipment cost money. In order for a bad actor to try and take the network down, they have to have access to computer equipment and electricity larger than the combined resources of all independent miners participating in the bitcoin network.

Common Myths About Bitcoin

The following myths are widespread in the media, the blogosphere and general public opinion. I’ll take the time to rebut them one by one:

Myth #1 – Bitcoin is insecure, hacker heaven

The Bitcoin network uses SHA256 cryptography which is currently unbroken. All instances of hacking have occurred when hackers have hacked into people’s PC wallets and transferred money from their wallets. Hackers can hack into anybody’s computer and steal their bank account user name and password and transfer money. In fact, banks incur north of $1 billion in losses due to hacking. People who are not computer experts will always be hacked. The bitcoin network itself has never been compromised. It has been attacked, but it has never been breached or broken. Hackers have also attacked successfully online wallet companies such as the Australian company TradeFortress. It is very important that you do your due dilligence properly and only open accounts with leading bitcoin wallet companies who employ top notch computer security experts such as Coinbase.com or Blockchain.info.

Myth #2 – Bitcoin is untraceable, money launderer heaven

The presence of the block chain ensures that every transaction is publicly visible and publicly tracked. The openness and transparency of bitcoin transactions is at a far higher level than that of any current payment network – be it Paypal or interbank transactions. You currently cannot go and inspect Paypal or interbank transactions anywhere online. A bitcoin transaction occurs between two wallets and wallets are either the property of online wallet companies or individual computer. Law enforcement can always track down a wallet owner by requesting information from the wallet companies or inspect the IP address of a PC’s wallet. As a matter of fact, gold or cash is far more anonymous than bitcoin. There is no link between a gold bar or a dollar bill and its owner. In the bitcoin world, a computer IP address and a wallet can be linked (please note that the IP address is not recorded on the block chain, only the wallet).

Myth #3 – Bitcoins have no intrinsic value

The bitcoin network allows two people to make a transfer of value that is unquestionable, irreversible and recorded for posterity. It is unquestionably a medium of exchange.  The value of the bitcoin network, as anything else out there, comes out of the value that it provides. So long as people use the network to transfer value, the network itself will have value. According to Metcalfe’s law the value a communication network is proportional to the square number of its users. At present, there are roughly 140,000 bitcoin addresses used per day and 70,000 transactions. Clearly if 140,000 people use something every day, it has value. And the higher the number of users in the bitcoin network, the higher its value will go.  Since the access mechanism to the network is a digital wallet with a ballance, any user of the network will have to pay to get access to the network’s unit of account – the Bitcoin (BTC). That makes Bitcoin also a store of value. The best way to think of bitcoin is digital gold. While the price will fluctuate based on market conditions, it has inherent utility and people will pay to use it. Marc Andressen, the famous venture capitalist, recently wrote an excellent article “Why Bitcoin Matters” here on Seeking Alpha. He makes very compelling arguments in favor of bitcoin’s real-world usability and found a number of practical applications that will contribute to a further increase in its value.

Myth #4 – Bitcoin is illegal

The legality of bitcoin depends on what jurisdiction you live in. Certain countries have passed taxation laws regarding bitcoin. If it is taxed, it is legal. Other countries have banned it. The following is summary of important countries and their treatment of bitcoin. Note that bitcoin is problematic mostly for countries with a history of strong capital controls such as Russia, China, etc. The preponderance of countries seem to be leaning towards making bitcoin legal:

Bitcoin Valuation

I will attempt to provide a valuation framework for Bitcoin by looking at it from a variety of angles. I will employ a top-down valuation method (comparing it as a currency versus the global money supply and as a commodity versus gold), a comparable valuation method (comparing it against the market cap of other payment networks such as MasterCard) and a cost-based valuation method (what does it cost to run the bitcoin network).

Bitcoin as Currency

The definition of currency in Merriam Webster is as follows:

something (as coins, treasury notes, and banknotes) that is in circulation as a medium of exchange

Bitcoin is clearly a currency as it is a medium of exchange. While it doesn’t take physical form, many officially accepted currency transactions today are done in a similar fashion – electronically. Only about 10% of US Dollars in circulation – $1 trillion- exist in physical form as banknotes and coins. The remaining $9 trillion is all digital. Let’s take a look at global money supply:

I have decided to look into the top 10 economic areas of the world since that is where the overwhelming majority of global economic activity happens. In the table above, I have taken the 2013 year end money supply figure from Trading Economics  and the corresponding year end exchange rate to arrive at a valuation of all currencies in US dollars.

As can be seen clearly, the US dollar is only the third biggest fiat currency in the world superseded by the Yuan and the Euro. To all critics who think the Fed is too loose, they only need to look here to discover the worse offenders. China is by far the biggest printer of fiat currency in the world, followed by the ECB which for some reason has a hawkish reputation.

There are currently about 12.4 million bitcoins. About 1.8 million BTC will be mined in 2014. The lifetime money supply of bitcoins is limited to 21 million. If all the bitcoin ever minted backed the entire G10 money supply, that would give it a valuation of $2,714,000. If bitcoin ever backed the reserve currency of the world, the US dollar, it would give it a valuation of approximately $524,000. However, this is unlikely to happen, so instead we will value it based on possible adoption. There are 3.8 billion people living in the G10. According to the latest figures from Blockchain.info and Coinbase – the two largest online bitcoin wallet operators – they have a combined 1.4 million registered bitcoin users. There are 3.8 billion people living in the G10. So that gives bitcoin a current penetration of 0.04%.

At present approximately 1.5 million people give bitcoin an $8 billion market cap with 12.4 million BTC in circulation. The following is a table which models future increases in the bitcoin supply, user adoption in millions and a linear extrapolation of bitcoin value based on user adoption. According to Metcalfe’s law, the value of the bitcoin network should go up proportionally to the square of the nodes (users with wallets). I will be conservative here, however, and assume a linear increase.

According to this fairly conservative model, if less than 8% of the G10 population adopts bitcoin by 2023 and the bitcoin currency backs less than 3% of the G10 money supply, we are looking at a price of $77,000+ per bitcoin. Now granted, 8% of the G10 is 300 million people, population the size of the United States. However, this model assumes no population growth over the next 10 years which should also be considered extremely conservative.

Bitcoin as Commodity (Store of Value)

The definition of commodity in Merriam Webster is as follows:

an article of commerce especially when delivered for shipment

Bitcoin is often referred to as digital gold due to its limited supply. Bitcoin rose to prominence during the Cyprus crisis of 2013 as a safe haven store of value. Some countries such as Taiwan and Canada have decided to tax it as a precious metal and a commodity. As a result, it is not farfetched to see bitcoin emerge as a safe haven commodity during the next financial or market crisis.

All The World’s Gold (AWG) is currently valued at 6,300 billion dollars (168,000 metric tons times the 2013 year end closing price of $1200). In this model, I assume conservative increases in the price of gold as well as a conservative penetration of bitcoin as safe haven commodity. By 2022, I assume that bitcion will have only 10% of the value of AWG and gold spot will be trading at levels just below its all time high in 2011.

According to this fairly conservative model, if bitcoin emerges as a safe haven commodity that stores 10% of All The World’s Gold value, we are looking at a price of $54,000+ per bitcoin by 2022. If bitcoin truly emerges as a new money paradigm, it will not be farfetched to believe that such a penetration is possible if not downright conservative.

Bitcoin as Payment Network

There are already research reports out of Bank of America Merrill Lynch and Wedbush Securities that compare the bitcoin network to other existing payment networks. They assign different values to the potential bitcoin price ranging from $1,500 to $100,000. You can find more in information in depth here. The total basket of payment network companies has combined market cap of $315 billion. There are 5 billion credit cards in the world (1.5 billion of which are in the United States). This means that each credit card contributes nearly $63 to the market cap of the industry. At present levels, the corresponding number for a bitcoin user(wallet) is $5400. Clearly a very high value. Over time, the average market cap contribution will fall as adoption increases. However it is not out of the question, that bitcoin can one day carry a market cap of $315 billion. At that level a single bitcoin will cost $15,000. Assuming the more conservative bitcoin adoption that I have used in the prior two valuation models, I get the following table:

Bitcoin is currently only 0.03% of the global payment industry in terms of user penetration. At 300 million bitcoin users, the penetration will be roughly 6%. At 6% penetration, assuming a static market cap of $315 billion for that industry over the entire 10 year period, we are looking at a price of $900 per bitcoin.

Cost Based Valuation

One of the most geeky-fun aspects of bitcoin is the computing power required to run the network. According to a recent Forbes article, the computing power of the computers mining the bitcoin network recently passed 64 exa FLOPS (exa FLOP = 1,000 peta FLOPs = 1,000,000 tera FLOPs = 1,000,000,000 giga FLOPs). The combined computing power of the top 500 supercomputer in the world is 250 petaFLOPS. This means that the bitcoin network of computers employs 256 times the computing power of all the super computers in the world combined! To clarify a FLOP is a basic unit of measuring computing power. It stands for a Floating Point Operations Per Second. For comparison basis, the standard top-line Intel based desktop computer generates about 7 giga FLOPs. So the bitcoin network effectively employs 1 billion standard top-line personal computers.

Apart from the cost to purchase such equipment, it takes electricity to run this network. The network solves 7.5 trillion “hashes” per hour. Each of these 7.5 million giga hashes requires 650 watts of electricity to solve. This is equivalent to 5 million kilowatts per hour or roughly 120 million kilowatts per day. At the US average of $12 cents per kilowatt hour, this means that that the miners spend $15 million in electricity per day. According to Blockchain.info stats, there is the equivalent of $2.5 million in new bitcoins mined per day (at price of $650 BTC/USD). Apparently, the miners are operating at a steep loss here losing north of $12 million dollars per day. Now the numbers for electricity cost are based on US prices. Some of the mining pools are based abroad, if not most of them, and can utilize lower electricity rates. But taken as it is, this model projects that it takes $15 million to mine 4,600 bitcoins per day which gives bitcoin a fundamental price of $3260.

Risks

We cannot really have a complete discussion about bitcoin without discussing some of the risks it faces. Here in order of importance, I will discuss some of the challenges bitcoin will face over the next few years.

Rise of Alternative Digital Currencies

Bitcoin is the first digital currency but hardly the last. Since it is an open-source code (meaning everybody can access it, read it and modify it), the rise of alternative digital currencies is inevitable. All it takes is for somebody to copy the code, change a functions in it and call it a DoggyCoin (ok, I know it is DogeCoin). You can find a list of all digital currencies at Coinmarketcap.com .Most of the current alternative currencies such as Litecoin, Namecoin, Primecoin, etc . are based on the Bitcoin software framework. They simply try to improve on some of its basic features such as the Proof-of-Work algorithm. Keep in mind that because the code is inherited, any improvements put into the bitcoin code will automatically flow into the alternative currencies based on top of it. The plethora of new currencies significantly changes the narrative of limited supply of digital coins. If money starts to flow into the alternative currencies, the overall amount allocated to digital currencies will get diluted across them and that could lead to sharply lower valuations of bitcoin. If 50% of investment and transaction flows go through alternative digital currencies, it is inevitable that the BTC price will have to reflect that and this is a risk that needs to be accounted for in the valuation models presented above. Adoption of alternative currencies is still a question mark as it takes more than a guy with a computer to get a currency adopted on a world-wide basis.

I need to mention here that two alternative digital currency frameworks have emerged over the past year that can prove to be serious competitors to the bitcoin framework:

Ripple – a Google Ventures project and currently the 2nd highest digital currency by market cap

Ethereum – an audacious project that will enable corporations, governments and the like to create their own cryptocurrencies fairly easily.

50%+1 Attack

The bitcoin framework requires that at least 50% + 1 of the computers (miners) in its network to be “honest”. If dishonest nodes are a larger majority than honest nodes, they can try to reverse the block chain and create duplicated coins or erase prior transactions. Given the large scale computing power employed by the network, a 50%+1 attack cannot really be perpetrated by a random group of unfunded hackers like Anonymous. An attack can be perpetrated by two sources:

1. Rogue Government Attacker

If China decides to build a 100 exa FLOP computer deep in its mountains, it is entirely possible for them to launch a zero-day attack and disrupt the network. It is also entirely possible that the US government may already have a computing network with that power as recent NSA disclosures have revealed. The benefits to government related attack are unclear however. Most governments are rational operators and such an attack will probably not be started unless there is a war and the payment mechanisms need to be brought down.

2. Miner Collusion

Miners operate in pools. The distribution of mining pool mining share can be found here. The top 3 mining pools are GHash.IO, BTC Guild and Eligius and they command a 72% share of the mining capacity. If these 3 pools decided to collude to bring down the network, who is to stop them? As discussed above, miners are probably operating at a loss at present. It is entirely possible that computing power may be withdrawn from the network in order to make it a profitable enterprise. This consolidation can lead to unintended consequences, one of which could be a collusion and an attack on the remaining participants.

Instability in the network will slow its adoption and as such it can be a significant risk to its valuation. At present, the bitcoin network gets attacked daily but so far the cryptographic community that supports it has been able to successfully defend against all attacks.

Government Regulation

I need to mention government regulation as a potential source of risk although I highly doubt that it will in fact come to fruition. As mentioned in a segment above, most governments are on track to tax bitcoin and therefore legalize it. After all which government doesn’t want more money in its coffers, even if it is bitcoins!

Future Catalysts

There were two big catalysts for the bitcoin rise to prominence in 2013. The Cyprus Crisis in March established bitcoin as a safe haven and brought the world’s attention to it. The price spiked from $10 to $200 in a matter of days. The second catalyst was the US Senate hearing on digital currencies on November 18, 2013.

“We all recognize that virtual currencies, in and of themselves, are not illegal,” Mythili Raman, acting assistant attorney general at the Justice Department’s criminal division, said at the hearing.

The conclusion from that hearing was that bitcoin is not illegal (which means pretty soon it will be taxed and made legal). That made bitcoin spike from $100 to $1000 within days.

Looking towards 2014, what are the big catalysts:

1. Introduction of a Bitcoin Exchange Traded Fund (BITCN)

The Winklevoss twins of Facebook fame are major investors in the digital currency and have appeared on CNBC and various other venues to promote it. They have also filed paperwork with the SEC to establish the Winklevoss Bitcoin Trust which is an Exchange Traded Fund.  It is currently not approved yet as the government and the Winklevii are trying to determine whether bitcoin is a currency or a commodity. In due time, though, the fund will be approved and that will open up bitcoin to the liquidity of the world capital markets. I expect that event alone to lead to 10x spike in the price of bitcoin as various asset allocation funds start to allocate capital to it.

2. Major Retailer Adoption

Already Overstock.com and TigerDirect.com accept bitcoins. Overstock.com has already booked over $1 million dollars in sales from bitcoin sales. Major retailers are aware that bitcoin can shave their payment fees and in addition can open their website to the world. Every internet retailer out there can be accessed from abroad, the problem is that foreigners lack the ability to make a payment via a credit card or check. Bitcoin will very neatly side-step that problem and retailers can now increase their footprint on a global scale without investing a cent in additional infrastructure. They all will be very happy to ship to China or Europe. I look to bitcoin being accepted by major internet companies like Google and Microsoft or retailers like Amazon and Walmart as a major catalyst in its adoption and I think that will attribute to a 2x spike in the price of bitcoin. From the rumors I have seen posted online both Google and Microsoft are looking into adopting bitcoin. Google has a stake in Ripple and Bill Gates, through his philanthropy work in Africa, is well aware of the benefits of bitcoin as a micropayment system.

3. Introduction of taxation framework in the United States

When the bitcoin tax guidelines get released by the IRS, this will put uncertainty as to the legal status of bitcoin to rest. Bitcoin has already been declared not illegal, but most people are not aware of that fact. When the government issues bitcoin tax guidelines, that will be the final undisputable proof and the majority of skeptics will have to accept it. That will also remove uncertainty in the venture capital community as well and funds will be released to companies in the bitcoin economy.

How to invest in bitcoin now?

There are 2 ways to invest in bitcoin right now:

1. Open an Online Bitcoin Wallet at Coinbase

Coinbase is the largest US based online wallet. It has a US banking partner (Sillicon Valley Bank) and allows you to purchase bitcoins directly. It has opened wallets for over 600,000 customers. Coinbase employs Charlie Lee, a top notch cryptography expert, a former Google security employee and creator of Litecoin – the second most popular digital currency. One of its founders is a former Goldman Sachs employee. Coinbase keeps your bitcoins offline in case their systems get compromised. That hasn’t happened yet and the fact that prominent VC Marc Andreessen just invested $25 million in them should give you the peace of mind that no expense will be spared to protect you. Coinbase also has a very easy to use website and makes converting USD into BTC and BTC into USD a snap.

2. Buy Physical Bitcoins

You can buy physical bitcoins on eBay issued by official Bitcoin minters such as Casascius, Titan BTC and Lealana. These vendors are authorized by the Bitcoin Foundation to mint bitcoins and their purpose in life is to represent the bitcoin world with integrity and spread trust in the system. You can also buy the physical bitcoins directly from these vendors by contacting them via email or going to their websites.  Please note that due to their limited supply physical bitcoins often trade on eBay far above the spot BTC price. For example, a funded 1 oz Silver Cascascius 1 BTC coin with Gold Rim goes for north of $3,000.

Physical bitcoins are also collectibles and the earlier the minting date of the coin, the higher the price. I have seen early edition Casascius coins go for as much as $10,000. Physical bitcoin is probably the best way to invest in bitcoin for an investor who is uncomfortable storing money on the internet with companies that might get compromised. The only thing an investor needs to know is that the coin is funded and that it hasn’t been compromised. All of these coins utilize 1-Factor security. In order for the digital bitcoin to be spent, the hologram on the back of the coin has to be scratched to reveal the password needed in order to transfer the coin. The issuers of these coins destroy the private key behind the hollogram. Make sure you buy a funded coin with an untampered hologram, put it in a bank safe and you are good to go.

Conclusion

Every decade a new disruptive technology comes along that radically changes our lives. The new technology is always met with significant consternation by the public and it triggers a worldwide cultural debate. The proponents think it moves civilization forward, the critics denounce it as the end of civilization. The personal computer in the 1980s, the internet in the 1990s, the smart phone in the 2000s. Over time the technology gets adopted and becomes a part of our everyday life. The next generation can’t picture their life without it. The 2010s are here and the technology of the decade is digital currency. Bitcoin’s purpose is clear and audacious. Revolutionize the second oldest industry in the world – the financial industry! Such a significant invention threatens the status quo and its initial adoption will be difficult and meet a lot of resistance. Institutions need time to adjust to the change but adjust they will. There is no doubt that – in the end – progress always wins and civilization emerges the better for it.