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Understanding the blockchain technology behind Bitcoin

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Written by: Freddie Cleworth
10/11/2017
You’ve probably heard a lot about Bitcoin, blockchain and crypotcurrency over the last few years, but what are they ? And why is cryptocurrency suddenly so hot?

Just last week, bitcoin soared past the $7,000 mark, which means the cryptocurrency has now climbed more than 600% since the beginning of the year.  At the same time, the price of the second largest cryptocurrency, Ethereum, has increased by over 2,080%. The technology underpinning these digital currencies is known as blockchain.

What is blockchain and how does it work?

At its core, blockchain is an accounting system, allowing a decentralised record of all transactions that have been made, updated and held by all users of the network – essentially a shared database or public ledger. Its distributed nature means making retroactive amendments to the ledger (i.e. to fraudulently amend transactions) is next to impossible. This networked approach removes the need for a central counterparty – like your bank – keeping score, in turn offering a secure alternative to a variety of financial processes.

Mining cryptocurrency

Bitcoin and other cryptocurrencies don’t just appear in your (virtual) wallet. Like any other form of currency, it takes work to earn them. Unlike traditional currencies, where a central bank decides how much currency is in circulation, cryptocurrencies are governed by pre-defined rules.

With cryptocurrency, ‘miners’ use special software to authenticate entries on the public ledger, earning bitcoin in exchange. This provides a smart way to issue the currency and also creates an incentive for more people to mine. Anyone with access to the internet and suitable hardware can participate in creating new coins.

Why are they growing so fast?

When it comes to the future of money, there is a growing interest in cryptocurrencies and the potential role they could play. Indeed, traditional central banks, governments and financial markets regulators alike are all investigating digital currencies to the point where the Swedish central bank (the Riksbank) is reported to be debating whether to become the first significant central bank to issue a digital currency as it responds to an increasing move away from cash in the Scandinavian economy.

Bitcoin surge

The soaring valuations of cryptocurrencies have been driven by speculation and a massive influx of capital from countries such as China and Russia, whose citizens had used cryptocurrencies as an avenue for capital to escape those countries’ capital controls. Although China banned the trading of virtual currencies on domestic exchanges in September, over the counter transactions are still permitted.

Are these currencies actually worth anything?

They don’t have intrinsic value in the same way as, say, raw commodities and they don’t offer ownership or income like equities and bonds. It is difficult to consider them as long-term investments or a store of ‘value’. Rather, we consider them more as speculative assets, and this is seen in the exceptionally high volatility of their prices.

Realistically, it seems too early to determine what value they hold. For example, the supply of Bitcoin is finite, capped at 21 million coins. This cap is due to be reached in 2040 at current mining rates. Ethereum is the leading alternative to Bitcoin and it is built to overcome many of its limitations, such as transaction speed (Bitcoin’s 10 minutes versus Ethereum’s 12 seconds) and the ability to handle smart contracts (helping exchange anything of value in a transparent, conflict-free way). There is much to overcome both in tackling development of the network as it grows and the pending regulatory reactions from countries around the world.

Wider adoption

Much like the initial stages of the internet in the 1990s, the technology is out there and it can’t be put back in the box. However it does face several barriers to mainstream adoption in its current form. Bitcoin, Ethereum and the many other cryptocurrencies are too volatile to be widely used as traditional currencies – if you pop into an Apple store to buy the new iPhone X, it’s pretty certain you will be paying £999 for at least the next year or so. Try to pay with Bitcoin and it could cost anywhere from 0.18 coins today versus 0.29 coins a month ago (that’s a 48% difference, in a month).

The encryption that makes these technologies so secure also provides anonymity to users and allows more nefarious users to hide and move funds unchallenged. Regulation is in its infancy, it is unlikely governments and regulators will tolerate it in its current form where identity of ownership is easy to hide. Corporates have long been looking at uses and many large companies (UBS, Fidelity, PwC to name a few) have dedicated whole new departments to the exploration of its application.

Freddie Cleworth is client director at EQ Investors

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