The origin of Bitcoin

April 14, 2018
Chris Wheal

The history of Bitcoin shows that it has its ultimate origin in a so-called white paper published in 2008 by, allegedly, Satoshi Nakamoto. On 31 October 2008 “Bitcoin: A Peer-to-Peer Electronic Cash System” was posted to a cryptography mailing list, published under the name “Satoshi Nakamoto”.

The whitepaper outlined the foundation of how Bitcoin would operate. But it is important to note that no one knows who Satoshi Nakamoto is. Many have speculated upon his/her/its potential identity. No one has yet been proven right.

For what it might be worth, the specialist website Fast Company recently published an article suggesting that Satoshi Nakamoto could be a group of people, including the names Neal King, Vladimir Oksman and Charles Bry.

According to industry folk lore, Bitcoin was launched in January 2009 utilising a blockchain as a transaction ledger to securely record transfers of Bitcoins from one party to another. Bitcoin was not traded on any exchanges in 2009. Its first recorded price was in 2010.

Mathematical proof

Unlike traditional currencies, Bitcoin is not backed by silver or gold or any other tangible or intangible asset, such as official government backing (known as fiat currencies). It is based on mathematical proofs validated by a public ledger called blockchain technology.

Bitcoin is generated through a complex sequence of mathematical formulas that run on computers; the network shares a public ledger using blockchain technologies that record, and validate, every transaction processed. Anyone can access the open-source software that makes Bitcoin work, and it is those individuals interested that maintain it.

While no single institution or government controls or regulates the Bitcoin network, a growing number of credible institutions including some central banks say they are investigating the possibilities of crypto and its famous underlying distributed ledger technology, known broadly as blockchain.

Cryptocurrencies move from maverick to mainstream

Ivan Gowan, CEO at trading fintech specialist Capital.com, argues that regulatory concerns must be addressed head on if the cryptocurrency market is to be fully embraced by the mainstream of the financial services industry.

Nigel Green CEO of the deVere group, a financial services specialist adviser, says that regulation of the sector is now becoming inevitable. “This has been noted by the Head of the IMF and can also be evidenced by the July deadline for suggested cryptocurrency regulation set at the G20 summit this year,” he says, adding that he fundamentally believes in the potential of digital money in today’s world.

The Cambridge Centre for Alternative Finance (CCAF) global blockchain noted in its inaugural cryptocurrency benchmark study published in 2017 that wider interest in blockchain technology developed after the launch of Bitcoin by “Satoshi Nakamoto”.

However, it adds that Nakamoto’s original paper
does not mention the term ‘blockchain’, which first appears as ’block chain’ in a comment in the original Bitcoin client C++ source code.

Non-currency uses of blockchain

The CCAF adds that much of Nakamoto’s writing focused on Bitcoin as an alternative currency and store of value, with much less attention given to the many different ‘non-currency’ uses of blockchain technology.

It notes that as with many other buzzword technologies, such as machine learning, blockchain technology is less of a new technology than a combination of existing technologies (peer-to-peer networking, distributed timestamping, cryptographic hashing functions, digital signatures, and Merkle trees, among others) that have in some cases existed for decades.

When Bitcoin began operating in January 2009, it was the first decentralised cryptocurrency. The second, Namecoin, did not emerge until more than two years later in April 2011. Today, notes the CCAF, there are hundreds of cryptocurrencies being traded and thousands have existed at some point.

Bitcoin clones

The CCAF describes the majority of cryptocurrencies as largely clones of Bitcoin or other cryptocurrencies and simply feature different parameter values (for example, different block scheme, currency supply, and issuance scheme). These cryptocurrencies show little or no innovation and can be referred to as ‘altcoins’, it says.

Bitcoin has no intrinsic value. Its price is measured against traditional government-backed fiat currency, such as US dollars, Chinese yuan or euro. Bitcoin therefore appears superficially similar to any symbol traded on foreign exchange markets but it also has many differences, including exceptional volatility.

A recent piece of economic research by the Federal Reserve Board of San Francisco (FRBSF) shows that after its launch in January 2009, the dollar price of a Bitcoin remained under $1,150 until 22 February 2017, when it began increasing exponentially for about 10 months.

This explosive growth ended on December 17, 2017, when bitcoin reached its peak price. Mati Greenspan, senior market analyst at social trading platform eToro, says his records show that peak as $20,155 though other sources set a lower amount, $19,511.

Bitcoin measured against fiat currencies

The peak Bitcoin coincided with the day Bitcoin futures started trading on the Chicago Mercantile Exchange (CME), write Galina Hale, Arvind Krishnamurthy, Marianna Kudlyak and Patrick Shultz of the FRBSF.

For some market commentators, the fact that Bitcoin has a monetary value only in terms of traditional currencies that it might be exchanged for, demolishes any claims that it can be validly called a currency. Its unusually low transaction fees are another.

Many traditionalists will argue that Bitcoin does not meet the basic criteria normally required to qualify as money, to function as a store of value, a unit of account and a medium of exchange.

In this world view, it has less claim to being a currency than cashback vouchers issued by credit card providers or major high street retailers. At least those vouchers can be exchanged for real goods. Those vouchers have the added attraction of not being vulnerable to sudden wealth-destroying outside attacks that have hit the likes of Mt Gox, Bitcoinica and Bitstamp.

Transaction versus speculation

Having said that, a small but growing number of companies including such big names in their respective fields as Dell, Microsoft, Expedia and Scottish underwear empress Michelle Mone have begun accepting Bitcoin, the latter most famously for the purchase of real estate in Dubai.

Returning to their comment about the CME, the FRBSF quartet of Galina Hale, Arvind Krishnamurthy, Marianna Kudlyak and Patrick Shultz suggest that when discussing the price of a currency or an asset such as Bitcoin, it is useful to separate transactional demand from speculative demand.

Transactional demand arises from using Bitcoins in transactions such as purchases of goods and services. By contrast, speculative demand arises when people are buying Bitcoins purely in the hope that their value will increase.

Speculative demand is in effect a bet on the price of the underlying asset or currency increasing, because the investor does not need the asset itself. For most currencies and assets, investors have ways to bet on the increase or decline in their value using a variety of financial instruments based on the asset or a currency, so-called financial derivatives.

Shorting Bitcoin

Before 17 December 2017, there was no official market for Bitcoin derivatives. This meant that it was extremely difficult, if not impossible, to speculate on the decline in Bitcoin price as an asset owner or buyer. It was possible to speculate using derivatives called contract for difference (CFD) but speculators never actually owned the assets.

True shorting usually take the form selling an asset before buying it, or can be done using a forward or future contracts, swaps, or a combination.

Betting on the increase in Bitcoin price was easy – one just had to buy it. Speculative demand for bitcoin came only from optimists, investors who were willing to bet money that the price was going to go up.

And until 17 December 2017, those investors were right. As with any self-fulfilling prophecy, optimists’ demand pushed the price of Bitcoin up, energising more people to join in and keep pushing up the price, notes the FRBSF team.

With the introduction of Bitcoin futures, pessimists could bet on a price decline, buying and selling contracts with a lower delivery price in the future than the spot price.

Downward price pressure

With offers of future Bitcoin deliveries at a lower price coming through, the order flow necessarily put downward pressure on the spot price as well. For investors who were in the market to buy Bitcoins for either transactional or speculative reasons and were willing to wait a month, this was a good deal.

The new investment opportunity led to a fall in demand in the spot Bitcoin market and therefore a drop in price. With falling prices, pessimists started to make money on their bets, fuelling further short selling and further downward pressure on prices.

Bitcoin was designed to have a fixed supply of 21 million coins, more than half of which have already been produced. The supply growth of Bitcoin is therefore becoming more limited as the mining price increases. If transactional demand grows faster than supply, the FRBSF team says it would expect the price to grow.

“As speculative dynamics disappear from the bitcoin market, the transactional benefits are likely to be the factor that will drive valuation,” the team adds.

Bitcoin remains a high risk asset

Even some of its staunchest fans will concede that Bitcoin is an experimental project and is therefore a highly risky asset. There are many negative influencers of price, chief among them being the legislative risk of a major government banning or strictly regulating Bitcoin businesses.

The risk of the Bitcoin network forking along different development paths is also something which could undermine the price. Finally, the emergence of a credible competitor, perhaps with the backing of major (central) banks, could see Bitcoin lose market share, and market value, in future.

Mati Greenspan at eToro never fails to issue a suitable warning in his regular emailed trading output. Past performance is no indicator of future performance, he states.

Cryptocurrencies fluctuate widely in value and are not supervised by any European Union regulatory framework, he adds, ramming home of the concerns of traditional investors.

To put it another way, as already referred to above, Bitcoin, like many assets, has zero intrinsic value. It is worth only what someone else is prepared to pay for it at any given time. At the time of writing (15 May 2018) that was $8,837. One inescapable conclusion is that this is not a market for either the faint-hearted or the reckless.

 

Post written by Chris Wheal
Chris Wheal is editor of OpenLedger's news and features service. An award-wining business journalists himself, he runs a team of freelance journalists from across the UK and north America.

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