Ask these key questions when considering a Bitcoin investment.

September 01, 2016

Ten years ago, if someone told you that a mysterious cryptographer code-named Satoshi Nakamoto was going to devise a system that would change the world of finance, you probably would not have believed it. Yet today, that very system, Bitcoin (XBT), is worth more than $10 billion, is accepted by Amazon and other major retailers, and is built on the most powerful computer network in the world. This article provides information to help individuals and businesses alike decide whether to use or invest in Bitcoin.

What is Bitcoin?

At its core, Bitcoin is a mathematical method that solves a basic problem: the inability to trust information without a known central authority vouching for it. In practice, Bitcoin is a form of digital money, or “cryptocurrency,” that enables monetary transactions to occur without a middleman, such as a central bank or a trusted third party, confirming each transaction. This decentralized trust model is what makes a cryptocurrency like Bitcoin a game changer.

How does Bitcoin work?

The Bitcoin protocol is built on a public ledger called the blockchain that records all transactions, including historical activity going back to the first Bitcoin exchange. When one party wants to transfer Bitcoin to a recipient, everyone on the Bitcoin network has the opportunity to review and validate the transaction. If it is validated, the transaction goes through and is permanently written into the blockchain. Transaction confirmation is accomplished through a process called mining.

What is mining?

Mining is the elegant process by which new XBT are created, or “mined,” simultaneously with the validation of Bitcoin transactions. Miners are people or companies that use specialized hardware and software with massive computing power to solve the complex mathematical problems involved in validating a Bitcoin transaction. When miners accomplish this task, they are rewarded with both transaction fees and the newly mined XBT. Once enough miners (typically six or more) have independently confirmed the transaction, it is considered safe to record in the blockchain. Because all transactions are publicly validated and thus recorded in the blockchain, they are considered impossible to forge.

One controversial detail of the Bitcoin protocol is that it has an upper limit: 21 million XBT. This structure is viable because the number of Bitcoin halves every four years, meaning the reward for successfully mining XBT decreases slowly over time. When the protocol first started, miners received 50 XBT per transaction, whereas today they receive only 25 XBT. The smallest unit of Bitcoin, called a satoshi, is one-hundredth of a million (0.00000001) XBT, so there seems to be plenty of Bitcoin to go around.

How do people get and use Bitcoin? Typically, Bitcoin is purchased on a currency exchange and then stored in an account, or “wallet.” A wallet is a program stored locally or online that holds a private key — a password that verifies the owner of the XBT associated with that key. To use the XBT, the owner of the wallet transfers them between Bitcoin addresses, which are unique, one-time numbers used to send or receive a payment. These transactions are accomplished and verified through the cryptography built into the Bitcoin protocol.

Does Bitcoin encryption work?

As with all secure transactions on the internet (e.g., banking, shopping), Bitcoin uses a form of cryptography called public key encryption to protect its data. The public key encryption process has been used on the internet for decades to protect information and is widely known to be secure. The process requires the private key (which only the XBT owner knows), a public key (which the whole network knows) and a message (the transaction details). To transfer Bitcoin, XBT owners use their wallet to combine their private key and the message into a new, unique number called a digital signature. This number, which acts like a personal signature, is used along with the public key to verify the owner’s identity and confirm the transaction.

Are there any security risks in Bitcoin?

When assessing the security of Bitcoin, it is important to differentiate between the Bitcoin protocol and the institutions and software surrounding it. The Bitcoin protocol — the mathematics created by Nakamoto — is considered secure. The potential risks come from the systems adjacent to the protocol: the software that runs it, the exchanges that trade it and the people who use it.

Why is the Bitcoin protocol secure?

The Bitcoin software is open-source, which means anyone can read and critique the code upon which it is built. Because of this, security researchers constantly review the source code and improve its security.

Can the blockchain be hacked?

Theoretically, a malicious party could hack the blockchain and change it for the hacker’s own purposes. Although many different types of attacks have been identified, almost all of them can be prevented by waiting on enough miners to validate a transaction.

One example of Bitcoin fraud, called double spending, occurs when a malicious party successfully spends the same XBT more than once, using them in a second transaction with another party before the first transaction is confirmed. The solution to this type of attack, however, is built directly into the Bitcoin protocol: Simply waiting 10 to 60 minutes for six or more miners to confirm the transaction permanently writes it into the blockchain and thus renders it valid.

Despite this elegant solution, Bitcoin presents certain issues when integrated into modern-day spending habits. For instance, shoppers are accustomed to exchanging money at the register or at online checkout, and then instantly owning the products they’ve bought. In contrast, a secure Bitcoin transaction requires waiting up to an hour for the transaction to be complete. Retailers can offer convenient zero confirmation transactions to busy Bitcoin users, but this exposes those retailers to the risk of double spending. They can reduce this risk by adopting a practice common in the credit card industry. Credit card providers calculate the percentage of fraudulent transactions among their users and automatically add the same percentage to the cost of all transactions. So, if a credit card company finds that 1% of all transactions are fraudulent, then adding a 1% fee to all transactions should cover the risk.

Retailers can find additional security through services that check for fraud. BitPay, which touts itself as the world’s most trusted Bitcoin payment platform, is one such service. BitPay’s plan for retailers features unlimited transactions for a 1% transaction fee, and users need only connect their payment system to the platform.1

If Bitcoin is secure, why are the surrounding systems vulnerable?

Bitcoin’s surrounding technology and businesses are only as secure as the designers make them. Bitcoin private keys are what prove ownership of the XBT, so if someone steals a private key, he or she owns the Bitcoin associated with that key. Various services securely store users’ Bitcoin wallets, thereby preventing theft of private keys.

What happens when those services are not as secure as they seem?

While Bitcoin may present a vector for a wide variety of security holes, it is no different from any other system. All monetary institutions have to guard against fraud, Ponzi schemes, hacking and physical theft.

A famous example of false security is Mt. Gox, which started as an online trading card exchange and morphed into the world’s largest Bitcoin exchange market. Unfortunately, the system’s security was built to the standard of a trading card exchange — that is, quite weak. The exchange was hacked multiple times, and hundreds of millions of XBT were stolen. Since the company’s liquidation in 2014, speculation has arisen that the employees themselves could have been behind the theft.

What does the future hold for Bitcoin?

Bitcoin and other cryptocurrencies are forming a new asset class in the world of finance, but exactly what type of asset class is it? This topic is up for debate. Certainly, one requirement for designation as an asset class is investability. The U.S. Commodity Futures Trading Commission says Bitcoin is a commodity, the Internal Revenue Service says it is property, and the Securities and Exchange Commission has stated its intention to approach this question on a case-by-case basis.2

In late 2015, the SEC approved an S-3 filing for Overstock.com (“Overstock”) to issue new publicly traded shares on the Bitcoin blockchain. Overstock sold the first cryptobond on the blockchain in April 2015, seeking the benefit of instantaneous equity trade settlement. With traditional equity trades, the markets operate on a settlement mechanism of trade date plus three days (“T+3”) — that is, the exchange and settlement of payment and securities can take up to three days.3 Overstock’s blockchain-preferred stock was anticipated to trade and settle exclusively through the platform of t0.com, Overstock’s financial technology subsidiary.4

Certain industry verticals are well-suited to the disruption that blockchain technology promises. In the realm of investment banking, for instance, the most interesting disruption would be blockchain-enabled distributed ledgers. According to Accenture, the key challenge at the intersection of distributed ledgers and blockchains is finding a way to meet auditability and regulatory reporting needs while maintaining the confidentiality of trading activity data. Blockchain technology solves two fundamental challenges associated with financial transactions: reconciliation and auditability. It also holds the promise of settlement optimization.5

Understanding the valuation possibilities of Bitcoin requires studying its popularity as an asset. Roughly 7 million people worldwide hold a material amount of Bitcoin, compared with 500 million people who hold stocks either directly or indirectly. Yet a surprisingly robust ecosystem has grown in the seven years since the protocol’s inception, giving retail investors the tools and opportunity to drive more than 1 billion USD in daily liquidity.

Throughout its relatively short life, Bitcoin has provided investors with stellar absolute returns, above and beyond those of any other asset class, but it is not volatility-proof. Users who invested $10,000 two years ago — in the midst of Bitcoin’s decline from its November 2013 price spike — are barely at breakeven now, given that Bitcoin experienced a 50% loss in value.6 The volatility of this asset often brings its daily valuation into question, and this uncertainty can impact company valuations as well. According to Stout Risius Ross Managing Director Andrew Fargason, “Because of the still relatively early stage of acceptance and market penetration of Bitcoin and Bitcoin-related companies, valuation of companies in this space can be challenging. The high volatility in the Bitcoin market can be viewed as a barometer of risk for investments in related companies, which needs to be included in value considerations such as discount rate selection.”

The pace of Bitcoin’s adoption as a viable currency will hasten as more transactions are processed using the cryptocurrency. And if mainstream legal and financial institutions marginalize Bitcoin’s ecosystem, the risk of fraud and untoward activity will increase too.

Anthony Murgio, a former operator of Bitcoin exchange Coin.mx, was indicted and charged with money laundering and the unlawful operation of a money transmission business. Under the Coin.mx scheme, the exchange acquired control of a New Jersey-based credit union in order to facilitate Bitcoin transactions. Murgio and his co-conspirator allegedly misled investors into believing they were completing transactions for collectible items, not for Bitcoin. Murgio and his co-conspirator were arrested and subsequently prosecuted. This scheme raises an important and memorable point for fraudsters and Bitcoin investors alike: “[B]ecause all Bitcoin transactions are preserved in perpetuity, the trail of fraudsters never goes cold.”7

Conclusion

Bitcoin and blockchain technology generally appear to be here to stay, but investors and other users should fully understand both the technical and the valuation risks associated with Bitcoin in order to minimize any exposure that could stem from the protocol’s use.