Bitcoin & Blockchain: A Primer
This document is a non-technical introduction to blockchain, what it is, how it works, and why it matters.
What is a transaction?
A transaction is a request to move $X from A to B. When this transaction is verified, A’s account is decreased by $X and the value of B’s account is increased $X. This system is called double-entry book-keeping. Any entry into an account requires a corresponding and opposite entry to a different account. This debit and credit system forms a record book, or ledger, for all transactions. It’s required in order to determine the veracity of each transaction and prevent double spending. Since at least the 14th Century, trust in this type of ledger has been managed principally by banks.
What is Bitcoin?
In 2008, an anonymous person or persons by the name of Satoshi Nakamoto released a white paper detailing a new decentralised electronic cash system called Bitcoin. For the first time, transactions could be trusted as accurate without the need of a central authority. One Internet user could now transfer a unique piece of digital property directly to another Internet user. But how do we know a Bitcoin transaction's valid? Well, everyone in the network can see the ledger and trace the history of each Bitcoin in circulation. All Bitcoin debit and credits since the genesis block, or the beginning, are placed on this vast public ledger which is called the blockchain. The blockchain is divided into ‘blocks’ which is like a page in the the record book of all Bitcoin transactions, and each ‘page’ is linked together like a chain. Bitcoin thus heralded a new age in the history of money:
How does it work?
Bitcoin is currently the most established blockchain. Fundamentally, blockchain is a distributed database - an enormous spreadsheet that runs, and exists, on thousands of computers. It's distributed, meaning it doesn’t rely on any one of these computers (or nodes) and is therefore practically impossible to shut down; a failure in one node will not disrupt the entire system. It's open-source, meaning that anyone can alter and verify the underlying code. And it’s fully peer-to-peer, meaning that it doesn’t require any third-parties to authenticate transactions.
Three key areas of Bitcoin contribute to its functionality: 1) private key cryptography, 2) a distributed network and 3) an incentive to service the network’s transactions.
1. Private key cryptography How can you transfer Bitcoin securely? Each Bitcoin wallet keeps a secret piece of data called a private key which is used to digitally sign transactions. Like a handwritten signature, a digital signature is used to verify the sender’s identity. The digital signature provides mathematical proof that the Bitcoin has come from the owner of the original sending wallet. The signature also prevents the transaction from being altered by anyone after the transaction has been issued.
2. A distributed network As explained above, the blockchain is a distributed network. Bitcoin wallets refer to the blockchain to calculate spendable balances. Responsibility for maintaining the ledger is shared by the network, not a central authority. The image below illustrates the security and strength of distributed networks.
3. Mining. Mining is the process by which transactions are verified and added to the public ledger, and also the means through which new Bitcoins are minted. The mining process starts with the miners trying to solve a computationally difficult puzzle. The node that first solves the puzzle places the next block on the blockchain and then can claim rewards. The rewards, which incentivise mining, are both transaction fees and the newly released Bitcoin. The ledger then compiles recent agreed upon transactions into blocks every 10 minutes. Approximately 16.7 million Bitcoins (79.5%) have been minted so far. The Bitcoin protocol stipulates a total number of Bitcoin is to be 21 million. The last coin minted will be in 2140 after which point the only mining reward will be transaction fees.
Blockchain technology has enormous potential for the global economy. It can be used as a currency, a store of value, to record a person’s nationality, their life-partner, the origin of a diamond, an entire supply chain, who owns what land, and even what home purchased power from which entity. For the Internet of Things, blockchain will be critical in settling the literally trillions of transactions between machines per day. Across diverse industries, blockchains are able to increase efficiency, lower cost, and bolster security. Fraud is minimised or eliminated as cryptocurrencies cannot be counterfeited or reversed arbitrarily by the sender, as with credit cards. Through smart contracts, settlement on property or agreements can be immediate. Fees for transferring money to other countries is dramatically cut in comparison to fiat currencies and privacy is secured.
An investment opportunity
The standard deviation of returns (‘volatility’) of Bitcoin and other crypto assets has been materially higher than other assets such as stocks, bonds or commodities. Volatility typically increases the risk of a portfolio, but it might also present opportunities for an active investor.
Bitcoin and other crypto assets have thus far demonstrated a low correlation to traditional assets. This means that they broadly move independently of other asset classes such as stocks, bonds and commodities. Including crypto assets in a portfolio may result in diversification benefits for an investor.
Apollo Capital provides an opportunity for wholesale investors to be exposed to this emergent asset class, within the structure and security of a traditional fund. Our fund reduces the barrier to entry into crypto by removing many of the ‘pain points’ of investing of investing in cryptocurrencies. Regulatory issues concerning this asset class- like taxation and security classification- are constantly monitored by our team. We also manage the ownership of targeted crypto assets, ensure their security, and actively trade the assets.
Written by James Simpson @jronsim - Analyst, Apollo Capital