Why Bitcoin Is Not Working

Why Bitcoin Is Not Working

Currency, in its many forms, has been part of human civilisation for thousands of years. A natural evolution of trade from the the arduous process of bartering, where traders needed to find an equivalent exchange of goods to complete a transaction. The advent of metal coins, which had a known and reliable value, allowed trade to flourish. It facilitated the diversification of jobs, and even invented a new one, the banker. As trade flourished, and coins were minted, the wealthy needed a secure location to keep their money safe. Banks became common place, where vasts amount of money was stored, and the responsibility of keeping track of it fell into the hands of these bankers. The banker could facilitate trades between people, without the physical coins, from which the currency gained its value, ever needing to be seen. This evolved to the world we now know where electronic and paper money is commonplace, a system based on trust. Trust that this money has intrinsic value, trust that became tarnished by the global financial crisis where bankers created excessive amounts of another new form of currency debt, a currency based on assumed future earnings. When this system fell apart with the crash in property prices, many ran back to the tried and true method of using gold as a safe and reliable currency, resulting in the prices peaking at the height of the crash, but one clever individual started to wonder is there are better way.

That person was allegedly “ Satoshi Nakamato” the mysterious founder of the first cyptocurrency, Bitcoin. Satoshi released this statement conveying his motivation for creating bitcoin: “The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.

We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible. “ Cryptocurrencies were invented primarily to eliminate the banking system middle men from this trust system. To ensure the security of people’s hard earned money and allow for cheap accessible transactions. A beautiful idea, that in practice has its flaws. In order to eliminate these middle men, we need to find a way of creating a trust system between individuals using the currency. A way of ensuring that someone cannot simply write a transaction crediting their account with bitcoin, without permission. This is where the blockchain comes in. In its purest form, Bitcoin is a currency that uses a system of complicated keycodes to verify transactions between individuals. Batches of transactions are filed into something called a block every 10 minutes.

For bitcoin the max amount of transactions per block is around 2,400, so bitcoin has a max transaction speed of 4 transactions per second. Each of these blocks needs to be verified in order to verify the transaction history and cryptocurrencies do this in a pretty surprising way. By guesswork. Bitcoin uses a system called a cryptographic hash function, in this case Sha-256. to verify each block and it works like this. SHA-256 simply outputs a string of 256 bits, that’s a 256 long string of 1s and 0s, for a given input. The output seems random, but it’s not. SHA-256 will always give the same output for a given input, BUT, as far as we know, it’s impossible to take the output and figure out what the input was. It’s a one way street. That means, in order to generate a specific desired output, the only way of doing it is by trial and error. Guessing inputs and checking the output. And to do this quickly requires a significant amount of computational power. Essentially employing millions of little monkeys in your computer to type numbers until one manages to get it correctly.

So how does this apply to the blockchain verification of Bitcoin? For a block to be added to the chain it needs to be signed with a SHA-256 input that will result in a predetermined string of zeros at the start. The number of zeros needed is determined by how much computational power is trying to verify the blockchain. The more zeros needed, the more computational power is needed.

We want the blockchain to be verified every 10 minutes, so in order to maintain that verification time, the number of zeros needed keeps rising as more computational power is dedicated to the network. It is through this huge dedication of computation power that ensures security of the blockchain. It would be unfeasible for an individual to rewrite the blockchain with false information, as they would first need to dedicate enough power to sign previously written blocks, and manage to keep up with the blocks currently being written by the rest of the network. A herculean task, as we are about to see.

There are more nuances to this system, and I highly recommend you watch 3blue1brown’s video on the subject if you want to learn more. This blockchain technology is fascinating, and has a huge amount of potential outside of just cryptocurrencies, but it has negative side effects, which have been exacerbated by the hijacking of the bitcoin hype train. The blockchain is verified by miners, these are people who guess the inputs for SHA-256 to generate the desired output, and they are rewarded for doing so with some bitcoin. To increase your chances of being the first person to correctly guess an appropriate input, you need to maximise your computational power, basically employ more monkeys, but obviously this has a breakeven point. Computation requires expensive equipment, and equipment prices have only risen as the demand for blockchain verification tech increases, and it also requires electricity. There are giant mining farms in the wastelands of Iceland that use the cheap geothermal energy and the abundance of cool air to minimise their electricity costs for this very reason. But the price of Bitcoin has inflated so dramatically that it’s still profitable to dedicate a huge amount of computation power to mine, and it has risen to damaging levels.

One Chinese mining facility was reportedly spending 80,000 dollars a month on electricity, but was turning over million per month. With returns like that, it would make perfect sense to expand and increase your electricity demands, and this is exactly what we are seeing. Digiconomist have constructed a Bitcoin Energy Consumption Index which has estimated that the network of computers that verify bitcoin transactions draw Gigawatts (GW) That 3.4GW adds up to terrawatt hours (TWh) of energy per year. That is on par with the energy use of the entire country of Serbia, or roughly percent of total energy demand in the United States, equal to million US households.

To put the energy consumed by the Bitcoin network into perspective, we can compare it to another payment system like VISA. According to VISA, the company consumed a total amount of terrawatt hours of energy globally for all its operations. This means that VISA has an energy need equal to that of around 17,000 U.S. households. We also know VISA processed 1billion transactions in 2017. Vastly more than the Bitcoin network’s 100 million transactions, at a fraction of the cost. Comparing to VISA may be unfair, as they require those pesky middle-men that we are striving to eliminate and move towards decentralisation. You should however consider that the brunt of Bitcoin verification is not being performed by individuals like you and me, we simply cannot compete with our consumer level technology, but by a small group of large mining facilities. Centralised facilities where the power is in the hands of a few. So is there any hope for Bitcoin? We need consider that the system is not in equilibrium.

The Bitcoin network is limited to a production of 21 million coins. Over time there will be fewer bitcoins left to mine, a feature of the original plan by bitcoin’s mysterious founder Nakamoto. Once the majority of bitcoins have been mined, the block reward will become an insignificant percentage of miners’ overall earnings. Instead, miners will get their reward from small transaction fees, which are already part of the network. So in equilibrium, the energy demanded by the network will only be driven by these small transaction fees, which is currently significantly below coin-value. Making it even less profitable to flood the market with computation power. This is where we come to our next point in why Bitcoin isn’t working.

Cryptocurrencies have been hijacked by the hype. The vast majority of transactions occurring for bitcoin are not to buy goods and services, as currency was invented for, but are simply trades of currency. Swapping traditional currency for a share of the bitcoins on the market. This may sound familiar to you, because it’s exactly what gold is used for. This is not what Bitcoin was created for. Bitcoin was created so that you would never have to use dollars again. That you would trade your dollars for bitcoins, and never trade back. But Bitcoin is too volatile for anyone to use it like that. Bitcoin has become an incredible volatile investment vehicle, with thousands of people attempting to trade on speculation and achieve this dream of becoming a bitcoin millionaire. But in order for a currency to work in a society it needs stability, people need to trust that the money the own today will be worth the same amount tomorrow, this is why the dollar is so successful.

Several countries around the world use the dollar because their own currency has become so volatile no-one can put their trust in it. How can we expect Bitcoin to become a useful currency when it’s value jumps so dramatically between dates due to irrational speculation, and market manipulation. For now Bitcoin is largely a useless environment damaging investment vehicle, which was not the vision Satoshi had for it. Even if the bitcoin prices manage to stabilise as equilibrium is reached, it’s limited transaction time of 4 transactions per second will likely prevent it from ever becoming a useful currency, and will more likely become a wealth storage method similar to gold.

Blockchain technology and cryptocurrency are a fantastic idea in theory. Just as paper money and debt are, but they’re flawed for the same reason. People. If there are ways of exploiting a system for financial gain, people will find it. The only way stopping that is to set up systems to prevent exploitation, and this is what other currencies like Ethereum are trying to do, while building upon the foundation Bitcoin laid, but if history has proven anything, if there are ways of exploiting a system for financial gain people will find it. You can learn how to manipulate system for your personal gain by starting this course on the Math of Quantitative Finance on Brilliant. Which will take from from an introduction to Quantitative Finance, through to probability, statistics and finally Markov Chains. Anyone who follows me on twitter will know that I enjoy tracking the stock market and understanding how it works. Even though I’ve rarely talked about Finance on here, it is just as important for you to know how to save through compound interest, determine the expected impact of opportunities like Bitcoin, and be confident that your retirement account will be sufficient.

And the best way to understand is by applying these concepts yourself, which is exactly what Brilliant allows you to achieve. These may initially sound complicated and scary, but Brilliant guides you through problems that are broken into digestible sections that bring you from knowing nothing to having a deep understanding of the physics and math that underlie everything in our lives. What’s more, if you go to Brilliant.org/RealEngineering, you can do the entire course for free! And once you complete this course, you could land a fast-track interview with top finance companies! To support Real Engineering and learn more about Brilliant, go to brilliant.org/RealEngineering and sign up for free. And also, the first 73 people that go to that link will get 20% off the annual Premium subscription. As always thanks for watching and thank you to all my Patreon supporters. I just released a new reward in the form of early access to scripts, so if you would like to see and influence the scripts to these videos over a week before they hit YouTube.

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