When people hear about Bitcoin (and all other cryptocurrencies in general), most of them have a pre-set mind regarding them being a giant speculative bubble, nothing more than a fad. Some even classify them as a Ponzi scheme. And yet, very few people actually know what blockchain is, and very few of this small group know how blockchain works.
The reason why people have developed such negative views for cryptocurrencies is because of two reasons. One, they are really volatile. And two, their technology is a little complex to understand. Unlike stocks which are backed by real businesses or gold which is perceived as valuable and can be physically stored, cryptocurrencies are neither backed by anything, nor they can be stored physically.
It we really want to understand whether cryptocurrency as an asset class is worth investing in, it’s of utmost importance for us to first understand how cryptocurrency and its underlying technology works because it is the technology that gives cryptocurrencies a real use case.
The article focuses on Bitcoin and it’s underlying technology for analysis. With the intent of keeping this article as short as possible, only highly crucial information which will have a direct impact on our end decision of investing into cryptocurrencies has been written here.
What is Bitcoin?
Bitcoin, the biggest cryptocurrency in terms of market capitalisation is simply an Internet-based digital currency which is “intended” to serve the purpose of medium of exchange. There are roughly 7600~ cryptos already in the market as of writing, the largest ones being Bitcoin and Ethereum. One can get this information from CoinMarketCap.
Discussing little bit more here about Bitcoin’s purpose here – become the single global digital currency of the world that replaces traditional fiat system. But first, why do we need a new currency at all? Ignoring many advantages of going digital or using underlying technology, the main reason I believe is to tackle the problem of inflation.
Inflation is not really an increase in general prices of goods / services, but gradual decrease in purchasing power of traditional fiat currency. Since governments can and do print unlimited currency notes at their will, it leads to increase in supply of currencies which directly leads to decrease in its value or purchasing power.
Bitcoin, on the other hand has a fixed supply of 21 million coins. One has to work (in crypto terms – “mine”) to earn Bitcoin. Currently, there are around 18.5 million BTC released into the system. Additionally, BTC has a controlled supply which means even if every person in the world tries to earn Bitcoin, they cannot max out the entire supply of 21 million due to some constraints – more discussed below. Due to this very reason, BTC has a very controlled and decreasing inflation rate –
This rate would drop to 0% by the year 2140. This means that Bitcoin does a great job of maintaining its purchasing power over time which is the most essential characteristic of a currency (which ironically is lacking in traditional fiat currencies – read further: Gold vs Fiat).
How does Bitcoin work?
Bitcoin and other cryptos (though not all) use an underlying technology called blockchain to function. But why do they need this technology? Can’t it be as simple as receiving and sending cryptos?
Think about how fiat currencies work. Fiat currencies are nothing but physical form of currencies issued by national governments creating restrictions on who can print the currency and in what amounts. Most fiat currencies were gold-backed before World War 1, after which gold-standard was removed to allow unlimited supply of currency printing into the economy.
Fiat currencies when transferred physically do not need any 3rd party to regulate and perform operations. But, when transferred in other forms (like electronically), they need 3rd parties like banks to perform some vital operations like –
-> Checking availability of cash balance
-> Ensuring that transactions are correctly processed and in a timely manner
-> Serving as a redressal place to go to incase of dispute or issues
-> Complying with existing laws and regulations etc.
Without banks, fiat currencies cannot survive. One can easily double-spend his/her cash balance without any 3rd party verifying the existing cash balance in case of electronic transfers. If transaction fails or doesn’t reach where it was intended to, there would be no real place to go to address the problem! This is one of the reasons why we need banks.
In case of cryptocurrencies, there are no 3rd party services. Therefore, to perform vital functions like what banks do for fiat, (most) cryptos leverage a technology (imagine it as a software) called blockchain.
Basics of Blockchain
In a sense, blockchain is literally a chain of blocks (existing digitally) strung together with each block storing different levels of information. Imagine it like a bank clerk storing physical cheques into a cardboard box and once the cardboard box gets full, it gets sealed and added to the end of already existing sealed pile of boxes. These pile of boxes if considered digitally, are collectively called blockchain. Blocks in blockchain store 4 kinds of information –
The block will store information regarding the date, time and dollar amount of transaction made.
The block will also store information about who is participating in transactions i.e. payer and the receiver. The actual name is not recorded, instead your unique digital signature associated with your profile will be used (more on this later).
The block will also maintain the information that distinguishes it from other blocks. Each block generates a unique 64 character hexadecimal code called a “hash” that allows us to tell it apart from every other block. Hashes are cryptographic codes created by special algorithms (SHA-256 algorithm).
This block will also store hash of the previous block. This means, if the hash of previous block changes, it would change the current block hash too (being inter-dependent). What it does is create a sort of digital chain where the hash of one block is also stored in the subsequent block, the hash of that subsequent block is stored in the block next to it and so on. As a result, blocks becomes inter-dependent to each other.
A single block in the Bitcoin blockchain can actually store around 1 MB of data. This means each block can store only limited amount of data. Depending upon the size of transaction, one block can store few thousand transactions in itself.
(Image Courtesy – Investopedia)
The first block of Bitcoin (created by Satoshi Nakamoto, the inventor of Bitcoin) is called Genesis block. Once the Genesis block would have gotten filled up with information, another block would have been created and would have got added behind the Genesis block. The process of adding block continues in a similar fashion.
So imagine that you bought coffee using Bitcoin and paid 0.0035 BTC for it using your digital wallet where BTC is stored. Since BTC is moving from one wallet to another, this is considered as a transaction and this transaction would need to be verified before it gets added to the block. After all the transactions within a block are verified, that block gets added to the blockchain network for everyone to view.
Therefore, In order for a block to get added to the blockchain network, few things must essentially occur first –
A transaction must occur. If the preceding blocks are filled with maximum information they can store, a new block will only be created if a new transaction request comes up.
This transaction must be verified. Since there is no 3rd party over here (unlike banks in case of fiat currencies), transactions are verified by a network of computers called miners (most important concept in blockchain; more on this later). These computers verify each and every detail specified by the person making the transaction.
Once verified, the transaction must be stored in a block. Once the transaction gets stored, it becomes irreversible i.e. cannot be cancelled or amended.
Once all the transactions in a block are verified, the block is given its unique code called hash which distinguishes it from the other blocks which then gets added to the chain.
Now that we have a rough idea about what blockchain is, let’s get a little deeper into blockchain’s most important area which acts like banks to cryptos – mining.
The Process of Mining
The process of transaction verification is done by “miners” during the process of mining. Let us see how do they do it and what incentive do they have in performing this function. Bitcoin miners essentially have to perform 2 main functions –
Verify upcoming transactions for their details, ensuring there is no double-spending. (Just like fiats can be counterfeited, digital currencies can be easily duplicated, miners have to ensure that this doesn’t happen with the transaction in hand)
Add new blocks to the chain whenever required.
1. Verifying Upcoming Transactions – Miners are responsible for verifying transaction details and in order to do so, they require massive computing powers. They can verify around 1 MB of transactions in a block to earn transaction fees.
2. Adding New Blocks – We know that each block can store only limited amount of data per block so the process of adding new blocks one after another is a continuous process that miners have to perform. Once a new block is added to the blockchain, miners get rewarded with block fees (more on this in a bit).
So imagine this, there are currently 1000 blocks added to the Bitcoin blockchain. The #1001 block will only get added to the end of the chain once the miner verifies and adds the transactions to the block. It is up to the miner on how many transactions, and what transactions to add to the block in order to maximise his/her reward (block reward + transaction fee – more on this below). Note that, until and unless all the transactions in the block are verified, that particular block does not get added to the chain (This work of verification, in crypto terms is called Proof-of-Work).
Bitcoin has a public blockchain, what is means is anyone can view any block along with its transactions. Names of the parties involved in the transaction are not disclosed, instead we use digitally encrypted signatures to record transactions in a block. One can check all blocks and transactions through this website – blockchain.info
Miners mainly verify transactions and add blocks as and when required to get them added to the blockchain. For their services and making their computing powers available, miners are rewarded with block reward + transaction fees. Miners have a common pool where unconfirmed transactions come up so that they can verify only those transactions which are not already added to the blockchain (until the block gets added to blockchain, a transaction in that block can be verified more than once i.e. by more than one miner).
Mining sounds lucrative!! What is the reward and why doesn’t everybody do it?
Well, the thing is that not every miner gets compensated for his/her work (yes, thats true). Remember, what miners do is verify transactions and add blocks. Transactions can be verified multiple times but the block can be added only once every 10 minutes. The issue is that in order to get the block added, miners try to solve a mathematical puzzle by trial-and-error and try to guess the correct hash of the still un-added block. It’s worth exploring what is the correct hash they are trying to find and how can they increase their chances to win?
Bitcoin Halving – It should be noted that block reward (reward for adding new block to the blockchain) gets halved every 4 years. It started with a block reward of 50 BTC in 2009 ie person to add Genesis block got rewarded with 50 BTC. Now the reward rate just got halved in May 2020 to 6.25 BTC per block. The halving process will continue and is expected to reward miners with almost zero BTC from the year 2140 where the reward will be next to nothing. In this case, the only way to have miners incentivised is through transaction fees (more on this below).
Bitcoin blockchain can add unlimited blocks. Even when the block reward reduces to zero, blocks will continue to get added as and when the need to transact using BTC arise.
Mining Difficulty – Another thing to mention is that the supply of BTC is limited to 21 million. As of writing, around 18.5 million BTC have already been mined. Since we reward miners for every new block that gets added, we must control the speed at which the block gets added right?
If the speed is not controlled, the leftover BTC to be mined can be easily mined within a few days/months and there would be no block reward left to give to the future miners until 2140. To tackle this, Satoshi Nakamoto programmed BTC to add a new block to the chain every 10 minutes (on average). Depending upon the demand (upcoming transactions and their fees), blocks might get added in 1 minute or 1 hour, but it comes to an average of 10 minutes. Therefore, BTC mining algorithm auto-adjusts it’s difficulty to find the next correct hash so that miners are only able to add 1 block every 10 minutes.
To give it a little perspective, difficulty was ‘1’ back in 2009, now it is roughly 19.2 trillion. This controls the speed (and thus, supply) at which block reward is being distributed to the miners.
Therefore, mining difficulty is directly correlated to the total hash rate ie power of total computers trying to find the correct hash. More the competitors, higher the difficulty.
So how do miners find the correct hash? Their network of computers try to solve a complex mathematical equation and using trial-and-error, try to find the next correct hexadecimal number something like the below –
>> 000000000000000000033cf979a3a143b361c0a6fe3a3665316450593c095eed <<
This is nothing but the hash (unique identifier) of the block. This hash is representative of all the transactions included in the block and is also linked to the hash of the previous block already added to the blockchain. There is no set way to find the correct hash, it is just trial and error. Therefore, the computer which has the higher computing power to do more trials and errors per second has a higher probability to find the next hash and earn reward. In other words, computers with higher ‘hash rate per second‘ have higher probability to win the race!
This explains why mining through personal computers is not feasible anymore (you might win, but the odds are heavily stacked against you). Once your computer wins the race, you will get 6.25 BTC (as of now) + Transaction Fees as your compensation for your time and electricity. The other miners who were also verifying transactions and trying to find next correct hash lose as someone else did it before them. These losing miners actually incur a loss because of the high amount of electricity they would have spent on this operation!
We know that blocks are added to the end of the chain. As of writing we have some 6,60,040 blocks (source) already added to the blockchain. We also know the interdependency of blocks with each other as one block’s hash represents its transactions within the block and is also linked to the previous block’s hash. This map of 6,60,040 blocks strung together is collectively called, blockchain.
Now, apart from miners, there are many other computers and phones on the blockchain network that serve as record-keepers of this map of 6,60,040 blocks. These record-keepers are called nodes and they do not get any incentive for record-keeping. Once a miner finds the next correct block, he tells it to the entire server about this block in which case nodes simply validate this block and related transactions and add it to their copy of blockchain (There are actually 4 kinds of nodes, with miners being called as miner nodes).
Note that each node has its own copy of blockchain and just adds the information of newly added blocks to its blockchain copy. If the blockchain map of all the existing nodes matches with each other, we call it consensus between the nodes! Higher the nodes, superior the network. If any one node comes up with a copy of blockchain not matching the other majority, it simply gets rejected.
This feature of blockchain copy being available with every node is called distributed ledger (Blockchain recording transactions like a ledger and distributing it to its nodes).
Each block has a unique code called hash and is also inter-dependent on its previous block’s hash. Our block’s hash is influenced by the transactions included in the block as well as the previous block’s hash. Even if someone tries to modify even one bit of information already included in the previous/current block, it would completely change the hash of our previous/current block.
The problem is, since the hash of the previous block changed, the hash of the subsequent block would have gotten affected too! The hacker would need to recalculate the hash of all the blocks starting from the block with modified transaction up to the end of the chain.
As we already know that calculating the correct hash of 1 block about 10 minutes of time, the hacker would have to not only complete this exercise but also complete it before the next block gets added to the chain because that next block would already contain the un-altered hash of its previous block and the nodes will easily find out something’s amiss! If the hacker is unsuccessful in the attempt, the nodes will simply reject this alternate copy of blockchain that doesn’t match their records.
Let us talk about the concept of private and public keys in brief. Just like we have traditional bank accounts to store money, we use digital wallets to store cryptocurrencies. Similar to having unique account numbers for bank accounts, we have something called as unique private and public keys for our digital wallets. Each wallet has 1 private key and 1 public key.
But why do we have 2 “keys” while we have only one account number to identify our bank accounts? Imagine this, for someone to transfer money to your bank account, they mainly need your bank account number (along with some other minor details). Similarly, we have public keys which are publicly visible and can be used to transfer crypto to your wallet.
Now the money can only be accessed by the “owner” of bank account in traditional bank accounts. In case of digital wallets, we dont have any owner of a wallet. Instead wallets have something called as unique private keys which can be used to access cryptos within the wallet. Whoever gets hold of these private keys, gets access to the wallet contents within!
Now the question arises, if cryptos are stored in wallets identified by private keys, then how come if someone transfers crypto to public key automatically gets transferred to private keys wallet? The answer is that public keys are nothing but a derivation of private keys. To explain very briefly, these private keys are (sort of) double-hashed using SHA-256 hashing algorithm to get code for public keys. Public keys cannot be decrypted back to get private keys.
Now, since most of the technical aspect has now been covered which can impact our decision on investing in cryptocurrencies, let’s move on to the analysis part.
Analysing The “Risk” Component
Once we understand the technology, some obvious and important questions arise which question survivability of cryptocurrencies in the future –
Can SHA-256 Algorithm be reversed/decrypted?
Although, i have very briefly covered the technical aspects of working of blockchain like how do nodes validate transactions, what is block header or merkle root, what are SPVs etc, we still get how important is SHA-256 to the bitcoin network. What if public keys can be reversed to get private keys? What if SHA-256 can be decrypted which makes complete bitcoin network vulnerable and weak?
The thing is, SHA-256 is not an “encryption” mechanism which can be decrypted back to get the original number. This is a “hashing” mechanism which hashes a number one way leaving (almost) no possible way to reverse it back. The only possible way to get the original, un-hashed number from the hashed result is through guessing. But there is one problem with that, there are infinitely so many possible guesses that one cannot just solve it by guessing, making it irreversible (if certain conditions are met).
Let us take an example,
225 + 437 = 662.
In this equation, we have 2 inputs and an output. When you know the inputs, it is easy to guess the output. But if you only know the output, it becomes very difficult to guess the correct input. To add on top of this, Now you might think that it doesn’t matter – if the two inputs sum to the correct value, then they must be correct. But no.
What happens in a real hash function is that hundreds of one-way operations take place sequentially and the results from earlier operations are used in later operations. So when you try to reverse it (and guess the two inputs in a later stage), the only way to tell if the numbers you are guessing are correct is to work all the way back through the hash algorithm.
If you start guessing numbers (in the later stages) wrong, you’ll end up with an inconsistency in the earlier stages (like 2 + 2 = 53). And you can’t solve it by trial and error, because there are simply too many combinations to guess (more than atoms in the known universe, etc).
All of this adds up to a situation where the easiest way of finding a matching hash is just to guess a different input, hash it and see if it matches.
Can someone alter the dynamics of Bitcoin blockchain? Can someone increase its current limited supply?
In short, yes. But the change must be accepted by the majority.
There is a process in which the change happens. In essence, anyone can submit a proposal to change Bitcoin’s current protocol. This is called as BIP – Bitcoin Improvement Proposal. The first BIP was submitted by Amir Taaki in 2011 (link) called as BIP1 which set a standard for future BIPs. Therefore, once someone submits a BIP, it has to go through an editor to become a draft. If an editor rejects the BIP, the proposal is dropped.
Once we pass this layer, it is then proposed to miners. A BIP must get at least 95% support from the last 2,016 miners. Miners can vote for or against a BIP by including the appropriate data in their hashed block. Depending on the BIP “Layer” specification, a BIP acceptance may signal a “soft fork” upgrade wherein the community members (exchanges, companies building payment technologies, exchanges, miners etc) must upgrade their versions of the protocol to allow for the newly built functionality.
Recently, we had Segregated Witness soft fork (BIP141 and BIP148) which was accepted by the majority of the miners. Check acceptance rate on the right (source) –
Therefore, miners have a final say whether proposed changes must be accepted or not. However, if the community does not see it fit, anyone from the community can send a new BIP and perform economic activity on that new protocol.
Therefore, any changes deemed undesirable by the community can be forfeited as they can continue their activity on this other protocol. As we already know, the highest accepted blockchain network becomes the original blockchain.
Finally, to answer the question, yes Bitcoin’s supply can be increased only if it will be accepted by the Bitcoin community at large.
Since nodes have no incentive in providing validation services, will they survive? What cost do they incur in providing this service?
We briefly discussed that there are 4 types on nodes, with miners being a type of nodes. Full nodes perform the vital function of validating blocks and transactions. They also maintain their own copy of blockchain with them. The issue is this – full nodes do not get anything for their service. There is no incentive for them to continue performing this function. To add on top of this, nodes incur hardware, electricity and storage costs as well which can depend on variety of factors (to give a perspective, one node incurs $15/month on average).
Source: Coin Dance
So why do are even nodes performing this function without any incentive? The answer actually depends on the purpose. Some developers might run a full node to access Bitcoin network API. Although the most common reason that I have found is well, they do it for the community. They are providing this service to keep the Bitcoin network alive. One node user said that he doesn’t mind providing this service against his BTC gains.
Observe how nodes drastically increased from 5k in 2016 to 10k in 2018 which was also the period of bitcoin bull run. The greater the number of full nodes that are used to verify transactions, the more decentralised and resistant to certain types of attacks the network becomes. Without nodes, there will be no process of validation and consensus, and neither will the network be deemed safe thus eventually collapsing the value to Bitcoin to zero.
Right now, total Bitcoin blockchain size is approximately 300~ GB and as blocks and transactions continue getting added to the chain, the size will grow much beyond 300 GB as well directly increasing the cost of running a full node. The network will eventually need a solution to this, by either monetising the nodes directly or optimise the network in a way that does not add much cost burden on the full nodes.
When all bitcoin is mined by year 2140, will transaction fee rise enough to incentivise miners to continue their operations?
This is truly an intriguing question indeed. Currently the miners majorly consider only block reward as their compensation for their services and transaction fee is only considered a small part of the overall compensation. To give in more perspective, here is the latest block (source) mined as i’m writing this paragraph. The breakup of fees is as per below –
7.0967 BTC = 6.25 (Block reward) + 0.8467 (Transaction fee for 2,284 transactions)
Here, the transaction fee contributed only 12% to the overall compensation. The block reward currently contributing 88% will be reduced to zero by the year 2140. What will happen in such a scenario? There are 2 possibilities –
(i) The transaction fee increases to a great extent.
(ii) Block size increases to accommodate more number of transactions while keeping transaction fees relatively low.
Although some argue that it would make more sense for transaction fee to increase greatly, i personally think that is not feasible. Instead if Bitcoin’s core development team can alter/improve the current block process and accommodate more transactions into the block, it would mean more fees per block but relatively stable fee per transaction.
Again, if no solution is found to this or if demand/supply forces not bring equilibrium in such a way that adequately incentivise miners, they can slowly stop providing their services to the network. Without miners, transactions cannot be confirmed and the network will collapse.
The fact that the transaction fees is currently highly correlated to that of Bitcoin’s price movement, it tells that most of the transactions happening on the Bitcoin network are currently speculative and intended to trade (not real economical transactions).
MOST IMPORTANT – In case of mass acceptance, how will transactions be verified fast enough given that only one block can be added every 10 minutes on average?
The above mentioned questions collectively come under Bitcoin blockchain’s scalability problems. There has been growing concerns over how Bitcoin blockchain would not work in case of mass acceptability. We know that one can only mine 1 block on average 10 minutes and that block can on average take on 1 MB of data. This means simply limited transactions per day can be processed through the bitcoin network.
On average Bitcoin network can therefore, process 4.6~ transactions per second (TPS). This is nothing as compared to Visa’s network speed which is, wait for it – 1,736~ transactions per second! Two changes can be made to the core protocol to improve BTC’s TPS speed –
(i) Increase the block size from 1 MB
(ii) Reduce the difficulty to add blocks lesser than 10 minutes
Let’s see what happens when we theoretically go forward with change# 1 and 2 –
To match Visa’s TPS, Bitcoin’s blockchain has to increase the block size from 1 MB to 377.5 MB! (assuming one transaction is sized 380 bytes and one block gets generated every 10 minutes). Similarly, if we were to go about decreasing block generation time to match Visa’s TPS, we would need to decrease it from 10 minutes to 1.6 seconds! (not to mention the problems that bitcoin supply will be extinguished much faster and with all the new supply, price would crash which would ultimately discourage the miners to continue mining which would collapse the network).
There is another issue with this – 99% nodes have to validate transactions and blocks before adding the newly minted block to their copy of blockchain. As per Karlsruhe Institute of Technology, it takes 13,989.42 milliseconds or 15~ seconds for 11,000 nodes (current) to propagate new blocks to the nodes. Therefore, time to add new block cannot be decreased to less than 15 seconds otherwise the risk of a new block getting added before validation of previous block will prevail. This can lead to major threats like double spending of coins!
Increasing block size to lets say 4 MB would theoretically mean nodes have to download 4x data which would simply increase the relay time from 15 seconds to 60 seconds (of course unless nodes themselves improve their bandwidth).
Even if we reduce new block creation time to match relay time of 15 seconds, speed would only increase to 184 TPS. Bitcoin, which aims to become the world single currency needs much higher speed than that, even higher than that of Visa’s. Estimating an optimal speed for a world currency is impossible for obvious reasons.
So, what is the solution to this massive problem? Well, a perfect solution hasn’t been found as of now. However, we did have to interesting developments lately. Bitcoin underwent a change in its core protocol and the change was called Segregated Witness (SegWit).
Segregated Witness means separating the signatures. Every transaction contains signature of the sender which takes up 65% of the transaction size. By separating the signature component, SegWit effectively increased the block size from 1 MB to 4 MB thus allowing a lot more transactions to be verified within one block. On top of that, SegWit allows integration of Lightning Network on the Bitcoin blockchain network.
It is a “layer 2” payment protocol that operates on top of a blockchain-based cryptocurrency (like bitcoin). In other words, this feature is built on top of an existing blockchain and what it does is in simple terms – record a transaction on the blockchain between two people as opening of a channel. While the channel is open, the person can make end number of transactions with that person very quickly and for free / low cost.
Once the person makes a final payment to the other person, that final transaction is then again recorded on the blockchain. Note that payments other than the opening and closing payment are not recorded on the blockchain network thus freeing up space and allowing some other transactions to take place. Not only that, if 2 people don’t have direct channel open with them, the sender can route the payment through an intermediary (if that intermediary has an open channel with the receiver) for a nominal charge set by the intermediary for providing the service.
It is believed that Lightning network can be a potential solution to the micro-transactions that we currently conduct through cash on a daily basis. There are no fundamental limits to the amount of payments per second that can occur under the protocol. The amount of transactions are only limited by the capacity and speed of each node. Yes, it is a big step towards improving Bitcoin blockchain’s scalability issue but it is still not quite the perfect solution yet. It has problems of it own which can still limit Bitcoin to gain mass acceptance.
Apart from SegWit and LN, then there’s a technique called sharding, in which transactions are broken up into “shards,” and different nodes only confirm certain shards, effectively performing parallel processing to speed up the system. This can be applied to proof-of-work or proof-of-stake systems and is going to form a major component of Ethereum (2nd largest cryptocurrency). This offers the potential to improve the capacity and speed of the network, and developers are hoping that we will see upward of 100,000 TPS become a reality.
What happens to unsuccessful miners? What is their future?
We know that the block reward and transaction fee is given to only those miners which are successfully able to guess the correct hash of the next block before other miners. Miners who fail to do it first do not get anything. This means that they spent their hardware and electricity resources for nothing. All their computing power will go to waste. Nonetheless, there is no solution to that. This is how the BTC Blockchain has been coded.
Therefore, a solution is to join mining pools to increase the probability of success instead of opening an individual mining rig. Mining pool in simple terms is a group of miners coming together to combine their hashing power and mine Bitcoin collectively. The reward is distributed as per the hashing power contributed by individual mining rigs.
This leads to an important and unintentional consequence – Centralisation, which is a bane to everything cryptocurrencies stand for –
What happens if one mining party acquires majority of computing powers?
If that happens, that mining party can essentially take control over the blockchain network and launch something called as – 51% attack.
By controlling the majority of the hashing on the chain, an attacker can tamper with the process of recording new blocks. They can prevent other miners from verifying new transactions, allowing them to monopolise the mining of new blocks and earn all of the block rewards. They could also reverse transactions they made while being in control – leading to a double-spending problem.
Therefore, having a diversified set of miners would mean lesser chance of a particular entity gaining control of the network. Additionally, as Bitcoin network grows in size and no. of participants increase, it is obviously becoming more and more difficult for attackers to host a 51% attack against this particular cryptocurrency.
Other cryptos which are still small are much more susceptible to attacks though. Here is a pie chart estimating no. of blocks mined by some popular mining pools on BTC blockchain –
Note that this is just an estimation and may not reflect 100% true picture of the real hashing powers possessed by various mining pools due to a variety of factors. Also, “unknown” is nothing but smaller players which couldn’t be uniquely identified.
Due to what other risks/threats can the value of Bitcoin be collapsed to zero?
Apart from technical issues mentioned above due to which Bitcoin can be rendered useless if not solved, there are a lot of non-technical risks looming on survivability of Bitcoin as well.
Think of this, the person who built Bitcoin remains unknown. Doesn’t it sound very odd for something we are looking up to be a global currency one day? Apart from that, governments can simply come up with their own coin – like Fedcoin. Billions of people will obviously prefer Fedcoin over Bitcoin because of its credibility and trustworthiness. Governments can even take extreme measures and make its supply limited.
That is the sole reason why I personally prefer Bitcoin over other alt-coins because of its far superior adoption rate in the public. In the end a currency does not have any economic value, it is just a medium of exchange deemed valuable by the general public. Higher the people willing to accept it (adoption rate), higher will be its chances of survival.
Governments (and even large corporations like Facebook) can simply come up with their own version of cryptocurrency which will obviously have a higher adoption rate from the beginning. If a large number of people shift from Bitcoin to some other coin, its value will simply collapse.
Not only that, Bitcoin faces technological risk as well. We are currently in an experimental phase where high level of innovation is happening in this space. We already have multiple cryptocurrencies with far superior tech than Bitcoin. Again, such cryptocurrencies have a small market cap and low adoption rate having their own set of challenges. But you get the point.
Bitcoin is best in adoption and acceptance rate and is truly the most decentralised form of cryptocurrency when compared to others making it ideal to be use as a medium of exchange although it majorly lags behind its technology when compared to others (atleast as of now).
Timing Entry into Bitcoin
Bitcoin is known to be one of he most volatile assets investing community has seen. In short, BTC started off from $1 in 2009-10, rose to $1,000 in 2013, fell back to $150 by 2015 only to rise to $19,000 by 2017, falling back again to $3,200 in 2018 and rising back up to 2017 high of $19,000 as of writing this article.
This kind of volatility presents tremendous opportunities to trade and invest in Bitcoin and other cryptos. Bitcoin cannot be valued using traditional methods of valuation. It does not have cash flows, nor does it have any underlying assets etc. Bitcoin is intended to be used as a currency and currencies can be relatively valued in terms of other currencies more or less by their network strength and demand-supply factors.
Multiple fair valuation modes have been devised for Bitcoin. Interested readers can further check this excellent website providing multiple ways of valuation for Bitcoin – WooBull Charts.
There is no doubt Bitcoin might possibly become a global, digital currency of the world in the coming decades. It’s underlying technology – blockchain is not a fad, it has shown great promise and multiple real use cases that have not even been discussed in this article. One can say with almost certainty that core blockchain atleast is here to stay.
Bitcoin’s blockchain network although is still far from ready for mass acceptance. Although on-chain and off-chain upgrades like SegWit and LN have helped to some extent, there are still many major hurdles and risks that need to be addressed –
Resolving scalability problems for mass acceptance
No incentive for Bitcoin full nodes
What happens after all 21 million Bitcoins are mined
Mining pools moving towards centralization
Potential cryptocurrencies like Fedcoin may leave Bitcoin useless
Possible technological disruption
Future tech making it possible to reverse SHA-256 algorithm
It is even possible that Bitcoin continues to make headlines for the next 30-40 years and then slowly die as and when developers realise that maybe scalability cannot be achieved or there is not enough incentive for miners in case of low block reward.
Nobody has answers to these questions yet. Such risks bring high level of uncertainty to the future of Bitcoin and cryptocurrencies in general and this is the reason why one might be able earn superior returns for taking such high level risks if Bitcoin survives in the end.
I personally think of cryptocurrencies as small startups who have high risk but can also promise big returns if they survive. You as a VC manager have a responsibility to do in-depth technical research on multiple startups (cryptocurrencies) and invest in those whose tech shows real promise. I believe that 95 out of 100 startups might eventually fail to gain traction but the rest 5 can heavily skew the returns in your favour. I do not think that cryptocurrency space right now is a place to take concentrated bets. There’s just too much uncertainty involved!
Disclaimer: I have been investing a tiny portion of my net worth in a diversified cryptocurrency portfolio since 2016. Consider my views biased. Please do your own research before investing.
Let us know what you think of Bitcoin and cryptocurrencies in general. We would love to hear your thoughts in this domain. If you are further interested in valuation, do check out our Market Sentiment Tracker, our own index which reflects the greed/fear in the public and gives an idea of whether the Indian stock market is trading at a premium or a discount.