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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
A definitive, all-encompassing book on digital assets of all types for investors
In Mastering Crypto Assets: Investing in Bitcoin, Ethereum and Beyond, a team of seasoned investors and digital asset strategists presents a comprehensive guide aimed at institutional and professional investors for integrating crypto assets into traditional portfolios. The book offers in-depth explanations of the structure of this new asset class and its impact on investment portfolios.
It guides readers on using fundamental and quantitative criteria to select blockchain-based assets, grounded in a robust foundation of knowledge and evidence. The authors demonstrate how to apply quantitative valuation concepts to digital assets like Bitcoin, understanding their role as digital stores of value in a traditional investment portfolio.
The book also delves into the unique risk and return characteristics of various digital asset sectors, adapting conventional investing methods to the digital realm. It goes beyond direct crypto asset investments, introducing related equities and strategies for accessing digital assets in restricted settings. It discusses both indexed and active strategies in the context of crypto assets.
A key feature of the book is exclusive interviews with industry figures such as Jan van Eck (VanEck), Peter L. Brandt (Legendary Trader), and Fred Thiel (Marathon Digital), with these interviews accessible through QR codes in the book for extended video content. This provides a dynamic and interactive learning experience.
Moreover, the book benefits from invaluable research assistance from Figment and CCData, enriching its analytical depth. It also includes insightful guest articles from digital asset experts like Matthew Sigel (VanEck), Marco Manoppo (Digital Asset Research), Marcel Kasumovich (Coinbase Asset Management), Timothy Peterson (Cane Island Digital Research), Gregory Mall and Rohan Misra (AMINA), and thought leaders from Token Terminal.
Mastering Crypto Assets is an invaluable resource not just for institutional and individual investors, but for anyone keen on adopting a sound, evidence-based approach to digital asset investment.
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Seitenzahl: 511
Veröffentlichungsjahr: 2024
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Martin LeinweberJörg WilligSteven A. Schoenfeld
Mastering Crypto Assets
Investing in Bitcoin, Ethereum, and Beyond
Copyright © 2024 by Martin Leinweber, Jörg Willig, and Steven A. Schoenfeld. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per‐copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750‐8400, fax (978) 750‐4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748‐6011, fax (201) 748‐6008, or online at http://www.wiley.com/go/permission.
Trademarks: Wiley and the Wiley logo are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries and may not be used without written permission. All other trademarks are the property of their respective owners. John Wiley & Sons, Inc. is not associated with any product or vendor mentioned in this book.
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Acknowledgments
Writing a book is an endeavor that can never truly be claimed by one individual, and this work on crypto assets stands as a testament to that sentiment. From the initial inklings of an idea to the final full stop, countless hands and minds have shaped, refined, and enriched the narrative. We stand on the shoulders of many.
Our collective journey was made all the more rewarding with our colleagues at MarketVector—Thomas Kettner, Emre Camlilar, Guilherme Brandao, Bilal Baig, and Eunjeong Kang—your combined expertise and collaborative spirit were integral. Working alongside you has been both a pleasure and a privilege.
The authenticity and depth of our book are heavily indebted to our interview partners. Jan van Eck, Fred Thiel, and Peter Brandt, your willingness to share your experiences and insights has added invaluable layers to our narrative.
To our guest contributors, Matthew Sigel, Marco Manoppo, Gregory Mall, and Rohan Misra, we extend our gratitude. Your keen analysis and unique voices enriched our chapters, providing readers with varied and nuanced perspectives. Token Terminal (Aleksis Tapper and Rasmus Savander), Marcel Kasumovich, and Timothy Peterson, your contributions further solidified our book's place as a comprehensive guide in the world of crypto assets.
Our sincere thanks to Digital Asset Research, CCData, and Figment. The data and insights you provided were pivotal, helping us to ground our discussions in fact and offer a well‐rounded and informed view on our subject matter. Special recognition goes to Doug Schwenk from Digital Asset Research; Charles Hayter, James Harris, and Jimena Leon from CCData; and Joshua Deems, Benjamin Thalman, Chris Wilson, Colton Campbell, and Ivan Szeftel from Figment for their invaluable assistance and contributions to our project. Your expertise and support greatly enhanced the depth and credibility of our research.
And to the unsung heroes of the written word, our editors Bill Falloon, Barbara Long, and Purvi Patel. Your expertise and engagement transformed our collective thoughts into a cohesive, accessible, and engaging read.
To all those named and the countless unnamed who supported us on this journey, we offer our profound gratitude. In the ever‐evolving landscape of crypto assets, together, we have crafted a beacon for the curious and the seasoned alike.
Preface
In today's fast‐evolving financial landscape, traditional portfolio allocations are being reassessed, redefined, and restructured. The monumental surge of interest and involvement in digital assets, especially since 2020, has been nothing short of transformative. While the foundations of our financial systems and investment philosophies remain deeply rooted in time‐tested practices, the emergent world of crypto assets demands our attention.
Mastering Crypto Assets endeavors to bridge the familiar with the revolutionary. For the institutional and professional investors, this book is not just an exploration but also a guide—navigating through the intricate corridors of blockchain technology, understanding the taxonomy of new‐age digital assets, and integrating them into traditional portfolios.
In the recent past, we've witnessed significant institutional participation in cryptocurrencies, particularly Bitcoin. But beyond the news headlines and the volatile price graphs, lies a deeper transformation. Digital assets, we believe, are more than just fleeting phenomena. They are shaping up as foundational elements of modern financial portfolios. However, the question often remains—how does one integrate, categorize, and value these assets?
Throughout the chapters of this book, we take readers through the annals of Bitcoin's history, the innovations and myths surrounding it, and its burgeoning significance in the era of Web 3. Our approach to understanding crypto goes beyond just Bitcoin. We explore a range of digital assets, from DeFi apps to distributed computing platforms and delve into the valuation methodologies that are shaping crypto investments.
Investment philosophies have always been a blend of art and science, and nowhere is this more evident than in the realm of crypto assets. Valuation in this domain can be complex, and in some cases, esoteric. But armed with the right tools, methods, and perspectives, it can be navigated effectively.
It's important to note that our exploration is neither an endorsement for an all‐crypto portfolio nor an outright dismissal. Our conviction lies in understanding the unique risk/return characteristics and finding a harmonious blend within traditional asset classes. And for those bound by restrictions, we provide alternatives and workarounds.
Index investments, a staple in asset management, also find a new frontier in the crypto space. How do traditional index models translate in this new realm? What are the nuances and intricacies of constructing a robust digital asset index? These are questions we grapple with, providing insights and answers.
As you journey through the book, you'll not just hear from us. We've been privileged to engage with leading influencers in the crypto and traditional finance industry—individuals at the forefront of this digital revolution. Their interviews, insights, and analyses further enrich the discourse.
What does the future hold? While no one can predict with absolute certainty, we can equip ourselves with knowledge, insights, and a balanced perspective.
We invite you to embark on this journey with us—to understand, to question, and to find your place in the vast and exciting world of crypto assets.
1Introduction
“There's no room for facts when our minds are occupied by fear.”
Hans Rosling
Technical Innovation: From Vision to Everyday Life
Innovative ideas often meet skepticism as people tend to adhere to what they already know. This pattern was evident with inventions like railroads, automobiles, the World Wide Web, and cell phones.
The Railroad Revolution
When the first railroad was introduced, citizens expressed apprehension about the potential effects of high‐speed travel on the human body. They assessed the opportunities and risks of this new development differently, leading to initial hesitation. However, as time progressed, people began to realize the benefits of a rapidly evolving transportation network.
The Dawn of the World Wide Web
In a similar vein, the World Wide Web, an information system on the Internet, conceived by British physicist Timothy Berners‐Lee in 1989, faced initial mockery. Today, this network has become a cornerstone of our daily life, playing a critical role in our economic system.
The Evolution of Computers
The transformation of the computer serves as a prime example of technological progression from a novel concept to an essential part of our everyday life. In 1949, Edmund Berkeley introduced the first real personal computer in his book Giant Brains, or Machines That Think. Within the subsequent 10 years, as many as 400 of these machines, named “Simon,” were reportedly sold.
Despite the modest capabilities of early hardware, tech‐optimists even back then envisaged the vast future potential of computer technology. The ensuing rapid technological enhancements sparked an exponential surge in computing power that lasted for decades. Concurrently, the theoretical foundation expanded, and software development burgeoned into a new industry, spawning increasingly powerful applications. The advancement was so profound that it ultimately decoupled end‐users from the intricate technical processes behind applications. Today, anyone with a smartphone can access and utilize its myriad applications.
Tech advances didn't stop at personal devices. The commendable efforts of developers and engineers have also revolutionized the financial sector. Digital workflows and transactions are now the norm, paving the way for integrating crypto assets into our everyday lives—a small leap technologically, but a giant stride in practical terms.
Regulatory preparations are already underway, and these digital assets promise extensive opportunities for investors and users, focusing on cost savings, instant settlements, and full transaction transparency. But, technology won't rest on these achievements. Future technical feasibilities might include generating secure digital tokens representing proportional ownership of tangible assets, like real estate or artwork. This progression could unlock entirely new possibilities for investors.
Inevitably, crypto assets are poised to drive fundamental changes in various sectors, including capital markets. But, as we approach this new era, it's crucial to critically assess this technology and foster open discussions about the emerging structures. Such dialogues should consider both the potential risks and benefits, alongside the strengths and weaknesses of existing systems.
As history has shown us—from the advent of railroads, the worldwide web, to the humble personal computer—those who dare to innovate, adapt, and optimistically face the future unlock limitless potential. Crypto assets are more than a fleeting technological trend; they represent an evolution in our financial systems, promising transparency, efficiency, and opportunities beyond our current imagination.
Let's learn from our past, harness technology's power, and face the future of crypto assets with optimism and open minds. Our journey is just beginning, and the possibilities are as vast as our willingness to explore them. Let's step into this new age together, eager to create, innovate, and redefine our world.
2Bitcoin—A Brief History
“Breeding homing pigeons that could cover a given space with ever increasing rapidity did not give us the laws of telegraphy, nor did breeding faster horses bring us the steam locomotive.”
Edward J. v. K. Menge (1930)
The year 2009 unfurled as a time of significant change and notable events across the globe. It bore witness to the cessation of Sri Lanka's protracted civil war, and simultaneously, the World Health Organization alerted the world to the swine flu, declaring it a global pandemic. Zimbabwe's political leaders made a valiant attempt to stem the tide of hyperinflation by introducing a revamped Zimbabwean dollar. The realm of sports saw Tiger Woods bidding adieu to his illustrious golfing career, while Cristiano Ronaldo basked in the glory of being crowned the world footballer of the year. A remarkable achievement in the annals of space exploration was etched with National Aeronautics and Space Administration (NASA) propelling the Kepler space telescope into the sun's orbit. Concurrently, Slovakia embraced the euro, thus aligning itself more closely with its European neighbors. The People's Republic of China underscored its commitment to modernization by making Hanyu Pinyin the official Latinized transliteration of Chinese. In the meanwhile, as the Great Financial Crisis cast a long shadow across the world, several stock markets hit their nadir, marking a pivotal period in global economic history.
The intertwining of these historic happenings formed a background against which the anonymous developer launched the Bitcoin network on January 3, 2009. Indeed, the nascent Bitcoin network was given life amid the turbulence of the most severe financial market crisis witnessed in the last century. The bold maneuvers made by central banks during this crisis—characterized by substantial interventions in the capital market—were not merely stopgap solutions, but marked a significant shift in the financial landscape that continues to be felt to this day.
These radical interventions have created a ripple effect on the free price discovery mechanisms, skewing incentive structures and pushing market participants to grow accustomed to frequent interest rate cuts and a steady upsurge in bond purchase programs and loan securitizations. The prevalence of low and even negative interest rates has consequently put traditional capital market valuation methods to the test, rendering them less relevant, and in some instances, downright misleading.
In the wake of these unconventional market conditions, enormous risk positions materialized, justified solely on the premise of low interest rates, lending an illusion of economic viability. However, with the recent uptrend in interest rates, the veil has been lifted, and the detrimental impact of these precarious positions is gradually coming to light. Such an intricate and tumultuous backdrop underscores the relevance and potential resilience of Bitcoin and other crypto assets in our evolving financial landscape.
Moreover, with each valve of the financial market being successively shut, the global currency market, boasting a daily trading volume exceeding $6.5 trillion, has emerged as the final regulator of pressure. Although central banks hold considerable sway over price movements, their capacity to influence the most pivotal element—the public's trust in a currency—remains decidedly limited.
Since the dawn of the financial crisis, the persistent market interventions by central banks, coupled with the astronomical sums of money in play, have dealt a severe blow to people's faith in the enduring stability of numerous currencies. This gradual erosion of confidence has effectively shaken the bedrock of the global financial system, thereby highlighting an urgent need for alternative solutions.
With the birth of the Bitcoin network, a novel asset class was ushered in, paving the way for the development of a potential alternative. Nevertheless, it is essential to recognize that this reality of a burgeoning first crypto asset did not occur in isolation, but rather, was preceded by the tireless efforts of numerous pioneers who blazed the trail.
2.1 From the Fuel Card to the Trustless Payment System
The introduction of a functioning, decentralized payment system faced not only technical obstacles, but also the challenge of convincing people of the benefits of digital payments. Skepticism toward cashless payments was high in the beginning, and it took some innovative approaches to change people's minds. In the 1980s, a lot of cash was stolen from gas stations in the Netherlands, so the owners put in place a way to pay without cash. The owners wanted to lower their personal and financial risk, so they started accepting credit cards, which customers liked. At the time, this was a big deal because it was not something people usually did.
The advent of Flooz, the first‐ever virtual currency, in 1998 marked a significant milestone. Its operational mechanism bore an uncanny resemblance to the familiar bonus point systems we know today. Users were rewarded with Flooz for their online purchases, and these could then be redeemed on affiliated websites. Each Flooz held a value equivalent to a single U.S. dollar. Nevertheless, akin to many analogous ventures, Flooz could not amass the critical user base necessary for long‐term viability, and thus, fell, casualty to the collapse of the initial internet boom around the turn of the millennium.
In contrast, there were ambitious projects that took a big shot, as early as the 1980s. One of them was David Chaum's concept of a blind signature system,1 which he patented in 1988. Chaum, a well‐known computer scientist, had already set a milestone in the history of encrypted digital communication with his paper “Untraceable Electronic Mail, Return Addresses, and Digital Pseudonyms.” Although the patents did not explicitly refer to digital currencies, the methods developed by Chaum were elementary building blocks of crypto assets.
In 1989, Chaum completed the development of a protocol for a digital currency, which he named eCash. The use of this currency was implemented by Chaum's company DigiCash. This concept incorporated many of his discoveries, such as the “blind signature,” a technique for authenticating the sender of a message without disclosing the content, which is a crucial component of well‐known crypto protocols.2 However, DigiCash and its digital currency did not achieve enduring success. The emergence of e‐commerce was just beginning, and despite the exceptional technical execution, the user base could not be sufficiently expanded. In terms of technology, eCash bore similarities to PayPal. However, the reliance on banks authorized to utilize eCash proved to be particularly troublesome. The established connection to the existing financial system circumvented legal complications like money laundering prevention. But this feature did not make eCash more appealing to users as the linkage to existing systems meant it could not be regarded an autonomous monetary system.
In 1998, DigiCash declared bankruptcy. Nonetheless, David Chaum's efforts were not fruitless. His developed concepts and practical testing laid the groundwork for future advancements. Above all, the requirement for a central authority and dependence on the existing banking system were obstacles that needed to be surmounted in the future. The centralized nature of the eCash system and ongoing regulatory challenges made it evident to all digital currency advocates that a sturdy and independent monetary system must be structured in a decentralized fashion.
Roughly a decade after DigiCash's inception, Wei Dai, a Chinese hardware developer, devised the digital currency B‐money.3 In his paper, Dai outlined a protocol that presaged numerous facets of Bitcoin. For example, he articulated the possibility of using the computational exertion required to resolve a mathematical issue as a proof‐of‐work mechanism, while appropriately rewarding the participating machine for the computational task undertaken. Dai also mentioned the use of a shared accounting system (distributed ledger), with entries collectively verified and approved. Although his protocol never advanced beyond the conceptual stage, it significantly impacted later developments. In tribute to Wei Dai, the smallest unit of Ether, the wei, was named after him.4
Another significant forerunner in the realm of digital currencies is Nicholas Szabo, who hails from Hungary. In 1998, this computer scientist devised the bit gold protocol, an immediate antecedent to Bitcoin that already showcased fundamental components of its successor.5 The essence of the bit gold protocol lies in the proof‐of‐work concept, which Szabo adapted from Adam Back's work. A year earlier, Back had developed a corresponding algorithm designed to circumvent spam messages and protect networks from distributed denial‐of‐service (DDoS) attacks.6 This concept limits the unrestricted communication of network participants by mandating that previously completed work is a prerequisite for the acceptance of a transmitted message. Consequently, DDoS attackers or spam message senders would face computational expenses for each request or message dispatched, rendering such attacks costly and unappealing.
The proof‐of‐work concept is as straightforward as it is inventive. Network participants contribute computing power to resolve mathematical problems. Once a computer has discovered a solution, it can relay the information to the network. As the computer has demonstrated its work through problem‐solving, an entry can be recorded in the network's public directory. Each subsequent entry becomes part of the following task to be tackled. This process results in a continuously expanding chain of entries that is virtually immutable due to the enormous computational effort expended. This chain, containing all transactions that have ever occurred on the network, forms the foundation of the globally distributed decentralized accounting system, known as the distributed ledger.
Szabo's contributions to the development of a decentralized monetary system are remarkable. However, with his bit gold protocol, he was unable to satisfactorily resolve the double‐spend problem. This issue pertains to the challenge of preventing the same monetary unit from being spent more than once in a decentralized money system. For instance, if a buyer pays for a music download and can access the service before the transaction is conclusively settled, the same monetary unit could be employed to pay for another service or simply transferred to a different address. The solution to this complex problem remained elusive for the time being. However, if Satoshi Nakamoto were to claim, akin to Newton, that he stood on the shoulders of giants, then Szabo would undoubtedly be one of those giants.
2.2 Enter Satoshi Nakamoto
“If I have seen further, it is by standing on the shoulders of giants.”
Isaac Newton
The subsequent major advancement was Satoshi Nakamoto's Bitcoin protocol, outlined in a white paper as a peer‐to‐peer payment system. This protocol amalgamates various elements from its predecessors and, as a blockchain application, resolves the double‐spend issue. Transactions occur directly peer‐to‐peer among network participants, without a central authority or centralized accounting. All the important information for each transaction is kept in data blocks that are linked one after the other to make a chain of blocks called a blockchain. The individual blocks are linked using a cryptographic hash function, with each block containing transformed information from the preceding block. As this process persists throughout the entire chain, no single block can be altered or removed.
Most of the network's computational power converges on a single, valid chain of blocks. Consequently, a continually expanding series of transactions is generated, with the majority representing the accurate history of all transactions. The network autonomously manages the creation of new entries, verification of transactions for consistency with transaction history, and updates. A central authority or a third, verifying party is rendered unnecessary. Data storage is also unconventional, with the entire blockchain existing on each network node (full node). Instead of centralized data storage, data is redundantly maintained within the network. Although this approach results in a larger total volume of stored data compared to centralized storage, the redundancy ensures robustness as failures of individual network nodes do not impact data security.
October 31, 2008, is a significant date, as it marks the publication of the Bitcoin white paper titled “Bitcoin: A Peer‐to‐Peer Electronic Cash System.”7 It remains unclear whether the pseudonym Satoshi Nakamoto represents an individual or a group of developers.8 While working on the paper and two months prior to its publication, Nakamoto registered the domain “bitcoin.org.” Ownership of this domain was promptly transferred to several individuals who were not part of the core Bitcoin developer group, thereby minimizing the risk of centralization in the decentralized project from the outset.9
On January 3, 2009, amid the most significant financial crisis since the 1930s, the Genesis Block marked the inception of the Bitcoin blockchain. This block is the first‐ever created on the Bitcoin network. With the mining reward for creating the block standing at 50 Bitcoin, the first 50 Bitcoin were also generated alongside this initial block.
The timing of the network's launch was not coincidental, as the global financial system was on the brink of total collapse. One detail sheds light on Nakamoto's motives: a short text message included with the creation of the first block of the Bitcoin blockchain. This message quoted the headline of a January 3, 2009, article from the British newspaper The Times, which reported on then‐finance minister Alistair Darling's plans to inject hundreds of billions of British pounds into British banks as part of a renewed bailout. The brief text read, “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” For Nakamoto, the Bitcoin network symbolized an alternative to the prevailing centralized monetary system, functioning as a bank‐independent, peer‐to‐peer mechanism for global payments.
2.3 Bitcoin and Blockchain: A Closer Look
Bitcoin, as the native token of the Bitcoin network, represents only one form of cryptocurrency. Thus, the most well‐known cryptocurrency is not synonymous with blockchain technology, but rather its most recognized application to date. While the following discussion pertains specifically to Nakamoto's invention, the principles outlined here are also applicable to other crypto assets.
The Bitcoin system comprises several components. First is the client software, which anyone can install on a computer. Computers running this software create the nodes of a distributed network, enabling communication between them. Alongside the installed client software, each network node maintains a complete version of the current blockchain containing all Bitcoin transactions that have ever occurred.
The network rules are defined in the Bitcoin protocol, with the client software implementing these encoded regulations. Among other things, these rules determine how new Bitcoins are created, who receives them, and how network transactions are verified. Mining computers function as the distributed network's accountants, collaboratively maintaining a decentralized, redundantly stored ledger. Miners are rewarded with newly created Bitcoins for their contributions to upholding an accurate and immutable ledger, and they can also collect transaction fees.
The utilization of blockchain technology and the economic incentive system for miners enable decentralized and independent verification of all ownership and transfers within the network. Bitcoin transfers between two participants occur directly on a bilateral basis. Transactions cannot be reversed in the case of errors or disputes, rendering Bitcoin transactions final. The independence from any third party and the finality of executed transactions are the fundamental differences between blockchain‐based and conventional transaction systems.
Contrary to standard financial transactions, where the involved individuals or organizations must identify themselves via ID cards or unique IDs, the Bitcoin network does not require such identification. To carry out a transaction, one merely needs a private key10 and a Bitcoin address.11
However, Bitcoin does not provide the anonymity it is often claimed to offer. Cautious users may attempt to obscure the transparency of their transactions, but the achievable degree of anonymity within the network is frequently overestimated. According to Cornell University researchers, even basic web trackers and cookies embedded in numerous websites can enable Bitcoin transactions to be traced back to an individual. In over 60% of the cases studied, a clear connection is possible.12 It is not difficult to imagine how effortless it would be to attribute most transactions to executing individuals if sufficient data could be systematically aggregated. Law enforcement agencies have already managed to convict criminals based on Bitcoin transactions linked to the offenses committed.13
2.3.1 Primary Areas of Utilization for Bitcoin
Ironically, due to technical limitations and unavoidable transaction costs, Bitcoin is not well suited for many small transactions, contrary to Nakamoto's original vision of a “peer‐to‐peer electronic cash system.” However, Bitcoin has inspired other projects that are better suited for this purpose.14 Although the Bitcoin network could potentially facilitate everyday payment transactions, its strengths lie elsewhere.
In recent years, the benefits of the Bitcoin network have become particularly evident in two applications. The first is large‐scale cross‐border transactions, which can be executed quickly and with minimal bureaucracy using cryptocurrencies. These transactions are inexpensive and carry no settlement risks.15 The cost and duration of a transfer remain the same, regardless of whether one transfers a single Bitcoin or 10,000 Bitcoin, or whether the transaction is between neighbors or people in different hemispheres. The internet knows no borders, and initiating a transaction of any size is as simple as sending an email. Settlement systems and intermediary organizations are not required, and transactions are settled instantly. Bitcoin either remain with the sender or are already with the recipient. There are no intermediaries, and consequently, no associated risks.
Furthermore, because Bitcoin is becoming less inflationary and even deflationary over time, it is seen as a central bank‐independent investment with no risk of interest rate change or default.
2.4 The Fundamentals of Bitcoin
While blockchains and Bitcoin have been around for over a decade, institutional investors have only started paying close attention in recent years. The dramatic rise in Bitcoin's price and the resulting headlines in 2017 brought crypto assets to the attention of broader segments of the population for the first time. Private investors were primarily attracted by the high price gains, while professional investors were initially more interested in the potential applications of blockchain technology in the financial industry.
The new technology contains disruptive elements that can bring significant process improvements for financial companies, particularly asset managers. However, a mature and scalable blockchain‐based system also challenges the need for traditional intermediaries and the costs inevitably associated with them. To address the relevant questions, a basic understanding of Bitcoin terminology is necessary.
Bitcoin is currently the best‐known use case of a blockchain. The blockchain is the central component of the Bitcoin network, but it is not synonymous with Bitcoin. Blockchain applications can serve various purposes, and the entire Bitcoin system consists of several components beyond the blockchain. Nakamoto's payment system is a relatively simple special case of using a blockchain. The brilliance of the Bitcoin system lies not solely in the blockchain, but in the intelligent combination of various existing technologies into an efficient whole. The strengths of the protocol lie in its simplicity and focus on the essentials. The simpler a system is, the fewer points of attack it offers.
In the following section, we will cover the basics of blockchain and the Bitcoin network. For those interested in the technical side, numerous books provide detailed descriptions of the structural features of Bitcoin and cryptocurrencies. Readers with prior knowledge may choose to skip this section.16
2.4.1 The Concept of the Blockchain
“We have a golden opportunity to digitise and standardise processes across the industry. The blockchain technology is there and if we succeed, it will lead to huge cost savings that will benefit not only supply chain actors like Maersk, but also customers and consumers worldwide.”
Lars Kastrup, Head of Sales for TradeLens at Maersk
At its core, a blockchain is a distributed database that can be shared by multiple users on a network. Data is not stored in a central instance but redundantly on each individual computer that is part of the network. Individual data, which in the case of the Bitcoin network is transaction data, is combined in blocks. These blocks are then linked forming a growing chain that contains the complete and unalterable history of transactions. Various technologies such as the Internet, cryptographic methods, and hash functions are used to make this possible.
A blockchain can be crafted with varying architectures. Public blockchains, like that of the Bitcoin network, are universally accessible, welcoming anyone to join the network and utilize it fully. In contrast, a private blockchain mirrors the functionality of an intranet, necessitating user authentication and potentially allowing for the manipulation of all mechanisms, from mining to individual entries, through a central authority. Consequently, private blockchains embody a structure that is decentralized yet centrally orchestrated. Permissioned blockchains, a hybrid of private and public models, make up the third category. Ripple (XRP) is a prime example of this category. There is no definitive delineation of good or bad blockchains—their appropriateness is contingent on their intended application and additional parameters like data privacy. Each blockchain variant caters to a distinct objective and satisfies different requirements, with their merits and shortcomings varying based on the context in which they are deployed.
2.4.2 Cryptography: An Indispensable Part of Bitcoin
Cryptography is a branch of cryptology that deals with methods for encrypting data. Although all historical Bitcoin transactions are unencrypted and can be viewed by anyone, encryption algorithms play an indispensable role in ensuring the security and authenticity of transactions in the network. The Bitcoin network uses a classic asymmetric encryption method with private and public keys. Examples of asymmetric systems include the RSA (Rivest‐Shamir‐Adleman) and the ECC (Elliptic‐Curve Cryptography) algorithms used in Bitcoin.
Asymmetric cryptography increases the security of communication in untrusted networks in a scalable way. Cracking a sufficiently long private key is practically impossible. Only the person in possession of this key can initiate transactions in the network and send Bitcoin from one address to another. Releasing a transaction with the private key simultaneously ensures the authenticity of the sender. Therefore, the importance of the private key in the network cannot be overstated. Anyone who has the private key to a particular address on the network can freely dispose of the Bitcoin associated with that address. No further proof of identity or ownership is required. Without this key, on the other hand, nothing works. This procedure may sound complicated, but it is completely taken over by the user's wallet software. The user's only task is to securely store and manage their private key, ensuring it is not lost or compromised.
2.4.3 Hash Functions in the Context of Cryptography
Hash functions play a crucial role in the functioning of the Bitcoin network and other blockchain systems. They are mathematical functions that assign a unique output (hash value or “hash”) to a given input value while fulfilling specific criteria:
Irreversibility: It should be computationally infeasible to determine the input from the output.
Unique output: No visible similarities between slightly different inputs: even a small change in the input should produce a completely different output.
Unique input: Each input should produce exactly one hash value, and two different inputs should always produce different hash values.
Fixed‐length output: The result of a hash function should always have the same length, regardless of the length of the input.
Fast computation: A hash function should be quickly computable for practical use.
A Hash Function at Work
SHA‐512 is a cryptographic hash function that is part of the SHA‐2 (Secure Hash Algorithm 2) family. When you pass a text, such as the following Richard P. Feynman quote, through the SHA‐512 function, it will produce a fixed‐length output (hash value) that is unique to that input.
The quote:
“I would rather have questions that can't be answered than answers that can't be questioned.”
When hashed using the SHA‐512 function, it would produce a hash value like this:
2f7557c54d6041a02c32f4b4a0a9aeb4d4ea1b09d8b6f7c6f39d6dfdb86d5a2a8f9a0e1d5e7d02a1e8a3d58e2cdff53b6e70e89a9e6bea9246d3c487efd3d3cd
When you remove the final period from the quote, you get the following text:
“I would rather have questions that can't be answered than answers that can't be questioned”
Passing this modified text through the SHA‐512 function will produce a completely different hash value, even though the change in the input is minimal. Here is an example of the hash value for this input:
3c6b8cb6d9a6f95a38b766e6df8a6b058d6c63ef76368c1e7a9c7d5b1732c1e2e40b1f7c45c1b5765b5ae5e5d3e3f8a3fdaa7d93b2210902c14e82d4e4c4a734
As you can see, the hash value is entirely different from the one generated for the original quote with the period. This sensitivity to even the smallest changes in the input demonstrates the effectiveness of hash functions in maintaining data integrity and ensuring that tampering with data is easily detectable.
Hash functions are probably among the most underrated building blocks of blockchain technology. They play a critical role and form the backbone of many cryptographic algorithms and systems. The corresponding feature box provides an example of such a function at work.
2.5 The Driving Forces behind the Rise of Bitcoin
“It might make sense just to get some in case it catches on. If enough people think the same way, that becomes a self‐fulfilling prophecy.”
Satoshi Nakamoto (2009)
Bitcoin, the world's first decentralized digital currency, was created in 2009 by an unknown individual or group of individuals using the name Satoshi Nakamoto. It operates on a peer‐to‐peer network and allows for fast, secure, and low‐cost transactions without the need for intermediaries.
Many experts believe that the idea of a decentralized monetary system is revolutionary, offering benefits such as settling transactions without counterparty risk, independence from political influence and central authority, and a public ledger of all transactions that is transparent, tamper‐proof, and free to access. However, the concept of digital assets can be difficult to understand for those who have limited technical knowledge and interest in finance. In the early days, the lack of regulation and the high volatility in the cryptocurrency market, combined with negative media coverage, deterred many potential investors.
Despite the rapid growth of the cryptocurrency market, there is still a significant amount of criticism and skepticism. Critics often argue that virtual currencies are too complex and lack intrinsic value, making it difficult to predict their performance. Warren Buffett, Nobel Prize–winning Paul Krugman, and Microsoft founder Bill Gates all have their own reasons for not investing in Bitcoin.17 It is important to note that while cryptocurrencies do not have intrinsic value, like fiat currencies, they offer the advantage of being decentralized, making them less dependent on central authorities such as central banks. This can be seen as a benefit for individuals who value self‐determination and increased security over personal finances and data.
The truth about cryptocurrencies, like Bitcoin, lies in the middle ground between over‐enthusiastic fans and staunch opponents. While it is important to consider both the potential benefits and risks, it is also crucial to understand that the perception of these benefits and risks varies depending on the individual's goals and perspectives. For example, some may view a decentralized financial system as a means of increasing self‐determination and asset security, while others may prefer a central authority for greater control.
Professional market participants can be distinguished by their ability to provide well‐founded statements and make rational decisions despite market fluctuations. It is important to consider all factors, including the current economic and political climate, when evaluating the potential benefits and risks of investing in cryptocurrencies.
In conclusion, while cryptocurrencies like Bitcoin may seem confusing and uncertain, they have the potential to revolutionize the financial system by offering faster, cheaper, and more secure transactions without intermediaries. As the technology and market continue to mature, it should not come as a surprise when cryptocurrencies become increasingly accessible and widely adopted in the future.
2.6 Interview with Fred Thiel
In this chapter, we present a transcription of an insightful interview with Fred Thiel, CEO of Marathon Digital, a leading company in the field of Bitcoin mining. The discussion addresses the widely misunderstood topic of Bitcoin mining, specifically focusing on its energy consumption and the myths surrounding this issue.
Bitcoin mining, the process of validating transactions and generating new Bitcoins through the resolution of complex mathematical problems, has raised concerns due to the vast amount of energy it requires. Several misconceptions circulate about Bitcoin's energy consumption, including that it is entirely coal‐based and contributes to air pollution. In this conversation, Mr. Thiel gives a more nuanced view of the situation.
Additionally, Mr. Thiel elaborates on the argument that the energy consumption associated with Bitcoin mining is not inherently wasteful, as it plays a critical role in securing the network and preventing fraudulent activities. He also discusses the role of Bitcoin mining in the advancement of renewable energy sources, as mining companies, such as Marathon Digital, actively seek the most cost‐effective electricity sources.
Through this informative and comprehensive conversation with Fred Thiel, readers will gain a deeper understanding of the complexities of Bitcoin mining and its energy consumption, challenging widespread misconceptions and providing valuable insights into this frequently misinterpreted aspect of the cryptocurrency domain.
Fred Thiel, born in 1960, is an American business executive and the current CEO of Thiel Advisors and Marathon Digital Holdings. His rich career has seen him serve as CEO of GameSpy, Local Corporation, and Lantronix, with the latter experiencing significant revenue growth and an initial public offering under his leadership. Thiel has also served on the boards of various technology companies and was the managing partner of the software group at Triton Pacific Capital Partners from 2007 to 2012. Since 2013, he has headed Thiel Advisors, advising organizations on value creation strategies. Additionally, Thiel is multilingual and a frequent speaker on digital trends and the transformation of industries by the “Internet of Things.”
Q:
A:
Sure. Mining is a bit of a misnomer in that we're not digging holes in the ground or looking for Bitcoin buried in places. What mining really is, is essentially a type of transaction processing. As a miner, we operate large data centers with specialized equipment that we call mining rigs. Unlike normal computers, they're specifically built to do one thing, which is to calculate an encryption algorithm called SHA‐256. This encryption algorithm is essentially used as a way to ensure that transactions on the blockchain aren't able to be changed.
So, essentially what we do is assemble transactions that are in the mempool. Think of the mempool as a big funnel: all bitcoin trades and transfers between wallets flow through it. As a miner and as a pool operator, we take a set of transactions, typically using a first‐in‐first‐out method and assemble them into a block. We then take the hash for the prior block, which is the output of an algorithm that is used when you calculate all the contents of a block together with the hash for the former block, and you get a new hash as an output. That hash is stored in the blockchain, and you can ensure that the transactions haven't been changed or modified in any way by simply going back and looking at the hash.
At its simplest level, Bitcoin mining is assembling transactions into a block and then using the hash of the prior block together with the data that's in the block and something called a nonce, which is essentially a number that you pick, to calculate the new hash. If the output of that is within the degree of difficulty that the blockchain requires, then you, as a miner, will get to propose that block to the validators. You will then receive payment from the blockchain for having mined a block, which today is about 6.25 Bitcoin, and you also receive any relevant transaction fees that were part of the transactions in the block that you won.
Q:
A:
The more people that are doing this, the harder it is for anybody to try and change transactions because this is a consensus mechanism. Everybody has to agree when a miner proposes a block, and then it's validated and becomes consensus. Typically, after there have been six validations, a block is considered to be final. The more miners you have doing this, the harder it is for somebody to try and cheat the system. Today, there are millions of mining rigs out there that are operating, and there's a concept called a 51% attack where if somebody could control 51% of all of the miners or the hash rate generated by those miners, they could, in theory, propose transactions that only they wanted. They could essentially do things like not approve a certain transaction but approve others, which is called the double‐spend problem in Bitcoin.
By having lots of miners, it's very hard for any one person or party to aggregate 51%, and the more miners there are, the harder it gets. What makes it hard is the sheer amount of capital you have to apply. You have to spend billions of dollars to acquire these miners, build sites, and pay for the energy that these miners use. This is the determining factor in what makes Proof of Work the most superior method for consensus because, at scale, it is the most secure method. Proof of Stake, unfortunately, is a much more concentrated methodology where it's much easier for a group of people to get together and change things.
Q:
A:
From the perspective of concentration in the Bitcoin world, mining pools are aggregations of hash rate. The mining pool doesn't decide what transactions are being validated; that's the miners' responsibility. Miners assemble blocks and propose them. Mining pools exist to aggregate hash rate, allowing for more even payouts, especially for smaller miners. Mining pools don't control transaction selection, so that's a fallacy.
Anytime someone has tried to change the Bitcoin blockchain, like during the SegWit wars in 2017, it did not pass even though more than 90% of the miners wanted the change. The concentration risk in Bitcoin requires a single party controlling a group of miners equal to or greater than 51% and maintaining that control. In the Bitcoin world, there's much less risk of concentration, especially as long as mining is done by pools.
