Editorial

What is Bitcoin? - Exclusive World Premiere Documentary on Why Bitcoin Matters

Bitcoin, as you're about to see, could revolutionize finance, banking, commerce and more - the impact this technology could have on global society is just beginning to reveal itself.

We think you'll agree after watching "Why Bitcoin Matters" that the future of currency could be digital, open-source, finite, mathematics-based, and truly game changing.

 

The above presentation features the following special guests.

Mark Yusko

Mark Yusko

CEO and CIO of Morgan Creek Capital Management

Barry Silbert

Barry Silbert

Founder of SecondMarket and Bitcoin Investment Trust

Steven Lord

Steven Lord

Editor of the Modern Money Letter

George Gilder

George Gilder

Author of Knowledge and Power and noted futurist

Alex Daley

Alex Daley

Chief Technology Investment Strategist for Casey Research

Worth Wray

Worth Wray

Chief Strategist for Mauldin Economics

What Is Bitcoin?

Bitcoin is a peer-to-peer digital currency that trades on public exchanges and can be instantly transferred between any two people, anywhere in the world with the speed of an email… and at far lower cost than transactions typically processed through the traditional financial system.

While a lot of people have experimented with digital currencies in the Internet age, Bitcoin’s mysterious creator, Satoshi Nakamoto, was the first person to solve the issue of “double spending” in a completely decentralized network… meaning all transactions are made directly between parties, with no middlemen—but also in a way that is verifiable across the entire network and virtually impossible to counterfeit.

Much like the Internet itself, the Bitcoin hive is essentially a distributed network of computers and people that are relying on a common technological process—the Bitcoin protocol—to confirm and validate every transaction made using a unit of account called a “bitcoin”… which can be broken down into fractions, thereby enabling previously impossible micro-transactions.

The genius behind the Bitcoin protocol is an element of the system called the “blockchain”—essentially a giant, globally shared ledger of every bitcoin and every transaction in the history of the network. Whenever two people follow through with a transaction, it is broadcast throughout the entire network, and the blockchain expands as that exchange is automatically lumped together with other transactions in a new “block.”

While it requires a massive amount of computing power to verify, confirm, and record every transaction that occurs within the network, it’s basically a self-funding system.

Bitcoins are created through a process called “mining”… which happens to be the same mathematical process that seals blocks of new transactions onto the blockchain by verifying that every exchange is valid and using real bitcoins. Thus, by rewarding “miners” with new bitcoins for devoting their time and computing power to performing maintenance on the blockchain, the Bitcoin protocol provides the incentives for the network to continue running in a completely decentralized manner.

There can only be 21 million bitcoins, and the protocol is designed to release a “reward” of new bitcoins every 10 minutes until every unit of the digital currency has been created. As of today, roughly 13.5 million bitcoins have been created, with roughly 7.5 million bitcoins to go.


Source: Coinbase

On paper, it’s an elegant and efficient way to streamline a global payments system; but in practice, the web of businesses and support structures around the Bitcoin protocol must pass a wide range of tests—from storage security and compliance to the creation of tradable derivatives and merchant adoption—before any kind of digital revolution can begin

That said, Bitcoin—or something like it—has the potential to do for finance what the Internet has done for communications and commerce… and we’re already six years into the process.

What Is Bitcoin? The Growth and Adoption of Bitcoin

When I heard about Bitcoin for the first time, I dismissed it almost immediately. It seemed like a half-baked scheme cooked up by a bunch of technically skilled but financially naïve computer nerds to disrupt a global financial system that none of them really understood.

Early adopters espoused ideas about freeing the individual from the tyranny of a government-controlled money supply… but in order to pull of their grand vision, Bitcoin’s programming forefathers had to convince enough people to put their trust in the system without governments shutting them down in the process. It seemed unlikely.

In the early days of 2009 and 2010, a single bitcoin traded for pennies—but its value was basically unknowable. The digital currency had virtually no daily trading volume; its price swung wildly (and its volatility only became more pronounced over time); and aside from experimental transactions within a small online community, it was virtually useless as a reliable unit of account or medium of exchange.

I only learned of this later, but Internet legend suggests the first real-world transaction in Bitcoin was a long-distance arrangement made on May 18, 2010 between an American programmer named Laszlo Hanyecz and a fellow enthusiast he met in a Bitcoin Talk forum. Apparently, Hanyecz offered to pay 10,000 bitcoins to anyone willing to buy him pizza, and an Englishman took him up on the offer… making an international phone call to a Papa John’s in Jacksonville, Florida in exchange for roughly $25 in bitcoins at the current exchange rate.

The second time I heard about Bitcoin (about a year later), it sounded a lot more interesting as a medium of exchange; but seemed immediately doomed to death by regulation. The virtual currency had risen from a price around $0.25 the day of Laszlo Hanyecz’s pizza purchase to nearly $30 in early 2011 as Bitcoin became an experimental basis for real-world transactions within the Bitcoin community… and the preferred medium of exchange for nefarious activities on the web.

Following the embarrassing release of US diplomatic cables to the general public in late 2010, the US government organized a financial blockade against the hacker/whistleblower Julian Assange and his nonprofit firm, WikiLeaks. But when Bank of America, Visa, Mastercard, PayPal, and Western Union refused to transmit donations to the WikiLeaks, the nonprofit started accepting donations in bitcoins.

As the price of bitcoins began to rise, it saw another big uptick in volume when an online black market named Silk Road launched in early 2011, enabling the sale of illicit drugs and forged IDs exclusively in exchange for bitcoins.

Business boomed, and the Bitcoin community expanded from computer nerds to mischievous hackers and anonymous drug dealers who wished to skirt the financial system and/or the eyes of the law. And for the libertarians and anarchists who embraced Bitcoin as an anti-QE investment at this stage, it essentially became an enlightened bet against corrupt governments.

Within a few months, the price of a bitcoin surged to nearly $30… and then Mt. Gox, the most popular Bitcoin exchange, was hacked and trading suspended for several days in June 2011.

The price collapsed in the following months by roughly 90% to less than $3, but that was not the end of Bitcoin.

“Naturally there were teething issues,” as my friend Grant Williams explained in his April 2013 note, Bit Happens, “Exchanges were hacked and wallets full of Bitcoins stolen after being left unprotected on users’ computers, and much bad press… but slowly and steadily the marketplace weathered the growing pains and, as more and more merchants began accepting payment in Bitcoins, the community broadened into something more than just a weird underground movement.”

Trading volume increased in the months that followed, and the price of bitcoins trended upward, albeit in volatile fashion, with two 35%+ drops in 2012…

... but Bitcoin generally stayed under most investors’ radar until March 16, 2013, when a banking crisis in Cyprus sent savers across southern Europe scrambling for a way to get their money out of harm’s way.

Google searches for the word “bitcoin” surged to all-time highs.


Source: Google Trends

Although the financial risks to the Cypriot banking system were rather obvious to economists in the months leading up to the panic, it struck almost without warning for most citizens, explains Sovereign Man’s Simon Black:

On Friday, March 15, 2013, practically everyone in [Cyprus] went to bed thinking that everything was just fine. Many had probably gone to the bank that very day to do business, or logged on to an Internet banking platform.

Yet the very next morning, they woke to a completely new reality: the nation’s banks were broke, and the government was in no position to rescue them.

All the promises they had been told about government guarantees and having a ‘well-regulated’, sound banking system turned out to be lies. The government proclaimed a bank holiday, and banks remained closed for the next several days. Accounts were frozen and ATM withdrawals were limited to only 100 euros a day.

Eventually the plan materialized [as a hard line demand from the island nation’s German creditors]: substantial portions of deposits over 100,000 euros would be confiscated in exchange for equity in the banks. (Just imagine—Bank of America, RBC, or Lloyd’s takes your money and gives you stock certificates that subsequently plummet in value!)

And for everyone else, severe capital controls were instituted—some of the worst in decades.

Here again, we see a peculiar property of Bitcoin bidding up its value in a time of desperate uncertainty: its ability to circumvent the traditional banking system and government imposed restrictions on capital flows.

Savers in Cyprus could convert their cash to bitcoins in an effort to escape local capital controls, but most of their funds had already been locked up in the bank holiday, aside from €100 a day (which in aggregate was actually meaningful for Bitcoin’s price). The only question at that moment was how much Cypriot savers could expect to recover.

It was a warning to savers across the other fragile euro-member states. With the rising fear that the same kind of policies could be imposed on their countries next, savers in Greece, Spain, Portugal, etc started fleeing their euro-denominated bank accounts for the “safety” of Bitcoin.

In the event of contagion and banking collapse, Bitcoin balances could be moved out of the country rather than getting clogged in the system… and so the price naturally surged to a peak of $230 by early April 9, 2013.

But with more trading volume than the exchange could handle, problems arose, and hackers attacked… forcing another trading halt and making off with over $8.5 million in customer bitcoins. Then the idea of widespread levies on Cypriot bank accounts were dropped, and fears subsided across the euro area. The price of a bitcoin fell more than 60%, although it remained far above its pre-crisis peak of $47.

While the virtual currency had been in the news and on the periphery of my radar screen, it was the third time I’d been forced to think about bitcoin. I assumed the price surge would be the beginning of a government crackdown and the likely legal death of the experiment… so I continued to ignore it as an investment opportunity. Wrong again.

Bitcoin fell back into relative obscurity for several months, as indicated by Google searches…


Source: Google Trends

… but rather than cracking down on Bitcoin itself, the US government went after nefarious dealers like Silk Road and effectively found itself invested in the virtual currency (which it later auctioned off to the general public).

Despite the price collapse, Bitcoin had caught the world’s attention, and venture capitalists started pouring real money ($88 million in 2013 compared to $36 million in 2012) into a wide range of related businesses—from wallet providers and exchanges to payment processing and other financial services. That meant that not only an injection of capital into the industry, but also a massive injection of expertise in an industry still dominated by inefficient and/or poorly run firms.

At that moment, it seemed that Bitcoin might just change the world.

Bitcoin downloads spread like wildfire across the emerging world by the summer of 2013…

… and the search term “bitcoin” was suddenly more popular than ever.

Then China’s state-owned TV station, CCTV, aired a documentary on the cryptocurrency around the same time serious cracks started to show in China’s “miracle” economy. Suddenly China’s credit markets were acting more erratically than during the global financial crisis, and Bitcoin saw its greatest surge in demand to date—again as a way of circumventing the traditional banking system and the limited mix of financial assets available to Chinese investors.

As China’s interbank market began to freeze in the summer of 2013, John and I were watching closely. Here’s an excerpt from the August 31, 2013 letter, How Do I Hate Thee:

The next chart shows the recent price spike in the Chinese SHIBOR (their short-term interbank rate, more or less equivalent to LIBOR). It is difficult to trust any of the economic data (positive or negative) coming out of China, so we really do not know whether China’s growth story is simply moderating or whether we are seeing a hard landing in progress; but the sudden shock in interbank lending rates is an important sign that all is not well in the Middle Kingdom. The big question: is the recent SHIBOR spike a harbinger of a banking crisis, or does it presage an RMB devaluation? Interbank rates do not spike from 3% to 13% (in about 2.5 weeks) in a healthy economy, and a big event along these lines in China would have enormous implications for global growth.

As I’ve written over the course of the past year, John and I have been nervously watching China’s slowdown and have voiced real concern over the possibility of capital flight if and when a debt crisis bubbles over; but we clearly underestimated the role that Bitcoin was already playing in the China.

By late November 2013, demand for the virtual currency had become so popular in the People’s Republic that BTC China quickly became the largest bitcoin exchange in the world, and over 100,000 bitcoins were trading every day in China alone.

The price of a bitcoin surged by more than 10x from $87 to over $1,000 as Chinese savers piled in…

... until emerging-market central banks in places like China, India, Taiwan, and Thailand started to grasp the threats Bitcoin’s rise posed in a world where US monetary policy was tightening and capital flows could reverse dramatically.

While the People’s Bank of China did not ban owning or mining bitcoins explicitly, it issued a statement in December 2013 saying the virtual currency is “not a currency in the real meaning of the word” and that “it cannot and should not be used as a currency circulating in the market.”

In addition to firm language intended to cool the speculative fever among Chinese investors, the State Council mandated a series of prohibitions on bitcoin trading and forced banks and other payment institutions from dealing in the cryptocurrency… warning that virtual currencies like Bitcoin pose “a risk to the public interest and legal status of the Renminbi.”

In other words, the People’s Bank of China all but spelled out that Bitcoin is an avenue through which local savings can circumvent longstanding Chinese capital controls. If Chinese investors continued to pile into Bitcoin, it could set up a situation where capital could leave very quickly in the event of a panic… or in the meantime, leave temporarily and “round trip” its way back into the Chinese economy seeking the benefits afforded only to foreign investors.

From its peak in early December, the price of a bitcoin fell more than 40% before finding its bottom. And the average daily trading volume within China has fallen from over 100,000 in November 2013 to only 2,000 today.

As if the crackdown in China and other emerging markets in December 2013 and January 2014 wasn’t enough, rumors began to swirl in February that the world’s largest Bitcoin exchange, Mt. Gox, had been hacked and more than $460 million in customer bitcoins had been stolen.

In a Wired magazine article published in March 2014, “The Inside Story of Mt. Gox, Bitcoin’s $460 Million Disaster,” Robert McMillan explained it was not just a one-time event, but a “years long hack” dating back to the June 2011 incident. “According to a leaked Mt. Gox document… hackers had been skimming the company for years.”

Mt. Gox quickly went offline and collapsed into bankruptcy. It was a devastating blow to confidence in the entire bitcoin system. With the shock that client accounts could be so insecure for so long, the value of bitcoins plummeted another 60%+ in the following months.

With each successive blow, bitcoin had fallen from nearly $1,200 in early December 2013 to less than $360 by April 2014—a whopping 70% loss.

Satoshi’s Revolution: Bitcoin Crosses the Chasm

While search volumes have moderated, the trend in broad public interest is rising.


Source: Google Trends

And while the price of bitcoin has continued its downward trend, it seems that the network continues to deepen and mature.

Over time, many investors have realized that it was not a problem with the Bitcoin protocol that allowed the security breach at Mt. Gox or the frequent theft of unsecured bitcoins… it was inadequate security—basically poor business practices—at the exchanges and wallet providers. Rather than exposing some flaw in bitcoin, the collapse of Mt. Gox revealed the desperate need for better management and the opportunity for improving the services that surrounded the network. And the venture capital community has certainly responded.

By the end of Q3 2014, over $290 million of venture investments have flowed into Bitcoin-related businesses compared to the $250 million poured into Internet-related businesses in 1995.


Source: CoinDesk

And the trend toward greater average daily trading volume continued to rise.


Source: Blockchain.info

Not only is real money starting to flow into the growth industries surrounding Bitcoin, but real businesses are starting to accept it as payment. At the end of Q3 2014, the top eight companies accepting payments in bitcoin had annual revenues totaling more than $85 billion—including Dell Computers.


Source: CoinDesk

The price of bitcoins may swing dramatically in the coming days, months, quarters, and years. It may not survive in its current form… but the technology underpinning it is not going away any time soon.