Trading Bitcoin

November 16, 2017 02:25 PM
Despite all of the recent news, there still is much uncertainty among traders regarding what bitcoin is and how to trade it.

On Jan. 3, 2009, a wonder of technology was released into the internet wild. At that time, an anonymous contributor, named Satoshi Nakamoto, launched the bitcoin protocol upon the planet. Bitcoin was the result of a system outlined in a Whitepaper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.”

Digital money has been with us for more than 40 years. It is how most of us conduct commerce, not with physical currency, but with electronic cash in the form of direct deposit, credit cards, online bill pay, quick pay, Pay Pal, etc.  But all of these forms of digital money rely on a third party to process the payments and maintain the ledgers that validate balance information.

This digital financial system has served us well but it comes with costs and friction that were accepted as the only option, until now.

Digital money that requires a third-party custodial ownership of financial ledgers is providing a service and has expensive overhead and investor expectations of returns.  It’s also become much easier to defraud through theft of physical cards or theft of personhood.  Some say 50% of all fees collected by credit card companies go to combat and reimburse fraud. As consumers, we certainly value the protection that credit card companies provide against unauthorized transactions. Digital money has certainly made life much easier but we’ve learned to live with the ever-present risks of centralization, for lack of a better alternative.

The reason digital money could never be decentralized is that digital information can be infinitely copied for zero cost. This is called the double spend problem that has frustrated computer scientists since the 1970s.  So, our legacy financial system needs to remain as the third-party umpire of sorts. As it now turns out, a very expensive umpire.

Satoshi Nakamoto was able to integrate cryptographic algorithms for secure transaction security into an ecosystem of computer umpires and reporters called Miners and Nodes (see “Who is Satoshi,” below).

An Imperfect but Sporting Analogy
To understand the confusing world of cryptocurrencies, it may be helpful to turn to something timely and familiar. Consider bitcoin algorithms as the Major League Baseball rule book. The rule book can be changed, but it cannot talk or communicate, so the rule book needs umpires who memorize the rules and apply them to every play (transactions) in the game (block). These umpires are the miners, making sure all the rules are followed all the time.

But the umpires need their own checks and balances, so after every game there are the nodes. Think of the nodes as being a group of newspaper reporters that validate the proof of work of the game. As the nodes agree the umpires made all the right calls and recorded all the right stats, the nodes enter the game stats into the record book.

What is a Blockchain?
Keeping with our baseball analogy, every baseball game is collectively made up of many individual plays (transactions).  At the end of every game the transactions are validated by the umpires, double checked by the nodes and recorded in the official scorebook to be permanently added to the history of baseball.

Now think of an individual game as a block or page in an official score book. And that a block is played every 10 minutes, 144 blocks per day, 365.25 days per year (.25 accounting for leap year).

Each of these blocks is validated and published by the nodes. Each block is stacked upon every block that came before it and mathematically linked (chain) to every block going back to the beginning of Bitcoin history: Block + Chain = Blockchain.

Once a block is recorded it cannot be changed, making the transaction history immutable. This solves the double spend challenge. The reason it is immutable is because of its decentralization. When you record every play (transaction) of every game (block) and publish (Blockchain) in a publicly transparent way to a million newspapers and copies of record books, changing the recorded information is impossible.

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