Bitcoin, Blockchain and Cryptocurrencies

Bitcoin, blockchain and cryptocurrency entered the world stage in 2008 when the online publication of a white paper under a pseudonym envisioned a new way to transfer value over the Internet. Over the next ten years, the crypto asset market has gone through all the classic phases of a disruptive technology:

(a) massive bullish markets and crushing sell-offs.
(b) periods of euphoria and moments of despair.
(c) FOMO (fear of missing out) and panic.

As the crypto market enters its second decade, one thing is clear: crypto and blockchain will not disappear.

However, despite the enthusiasm, significant challenges remain for investors approaching the market. First, the quality of information is poor. Theories about the drivers of crypto asset valuations are untested and often poorly designed. Due diligence efforts by leading advisors are in their infancy, and few people have thought carefully about the role (if any) crypto-assets should play in a professionally managed portfolio.

The best starting point for understanding crypto and blockchain is bitcoin. Bitcoin was the first crypto asset and is now the largest, and the discoveries that allowed bitcoin to emerge are the basis for all other blockchain and crypto projects. As a result, understanding bitcoin, its origin, how it works and what new opportunities and challenges it creates, provide a solid foundation for considering the entire cryptocurrency and blockchain space.

Bitcoin was created by a computer programmer working under the pseudonym “Satoshi Nakamoto”, who published a white paper on October 31, 2008, entitled “Bitcoin: A Peer-to-Peer Electronic Cash System” to an unknown mailing list of cryptographers.

The author described a vision of how people could hold, send, and receive value digitally, with no trusted intermediary (e.g., a bank or payment processor) in between. On January 3, 2009, shortly after the white paper was published, the software was released, the first bitcoin was minted, and the bitcoin network was launched.

Although much of our lives have migrated online, money remains stuck in an analogue age. We don’t think much of it because we have fintech apps and online bank accounts, but the underlying structure of our ‘modern’ financial system is archaic. This can be seen, for example, in the fact that sending money abroad takes two to four days and paying bills using your online bank account could take an equal amount of time. Transferring cash and valuables online is difficult, far more difficult than moving basic information, such as text messages, e-mails, and photos.

Let’s consider a simple transaction in which Alice wants to send Bob $1,000. They do not live near each other, so Alice can’t give Bob cash, and she sends Bob a cheque. If Bob and Alice use the same bank, it is simple: Bob can cash Alice’s cheque directly. However, if Alice has a current account at Bank A and Bob has an existing account at Bank B, things slow down. Bank B will not credit Bob’s account until it knows that Alice’s cheque is not a “bad” cheque. Processing this check, making sure that Alice’s account is not overdrawn and that she has not written multiple cheques to the same banking account, takes days.

The right way to understand this problem is to think of it as a database problem. Bank A and Bank B both have the databases of their accounts, and neither bank can view the other bank’s database to find out whether a banking account has enough money to issue a cheque. The process of reaching a consensus on the status of each bank’s accounts takes time. If you try to speed up this process, the potential for loss is significant. Allowing the movement of money or other valuables, as happens with text messages between two people and without any central intermediary, requires a different solution.

Nakamoto’s solution to this problem (which represents the idea behind all blockchain databases today) was to create a single distributed database accessible to everyone. Thanks to the blockchain system, anyone in the world can exchange transactions, but where the ledger is not controlled by a single company, government, person, or entity. In other words, a ‘distributed ledger’ that is ‘permissionless’ and maintained on a ‘decentralized’ basis.

The value of such a database is obvious. If all parties can agree on the state of the database at any time, the delays needed to allow database A to synchronize with database B can be massively reduced. Although simple in concept, implementing this new database architecture involved overcoming several significant technical challenges that had occupied computer scientists since 1980.

If you have copies of the same database floating around on a million different machines and no one is responsible, how can you make sure that all documents are identical, updated synchronously, and reflect only honest transactions? In other words, how can you reliably create a consensus on what is accurate and true? This is the real breakthrough of blockchain: creating a timely, safe consensus on all copies of a decentralized, distributed database.

This involves technological steps governed by smart incentives, cryptography, and other technological advances. These steps are at the heart of both the opportunities and challenges created by blockchain applications; therefore, it is worth understanding how they are structured and how they work.

The best way to understand how the consensus process works is to understand the flow of a bitcoin transaction from the start to the end. Alice has ten bitcoins she wants to send to Bob, so she sends a message to all the computers running a copy of the updated database (‘the Bitcoin network’) that says: ‘I want to send ten bitcoins to Bob’. Alice has a unique password (called a ‘private key’) that allows her to sign the message so that the network knows that the message only comes from her and no one else. Computers in the bitcoin network can easily confirm that Alice has ten bitcoins to send because they have a copy of the current database. It is important to note that the transaction has only been proposed. No one computer has yet updated its copy of the ledger.

Transactions are initially placed in a waiting room, where they wait to be confirmed. Since the transaction is only proposed and not finalized, the system can quickly forward the message to ensure that every participant is aware of it. Alice is not alone: while she is sending her message, others are also sending messages, wanting to send their bitcoins to various recipients.

Special actors come into play: the so-called ‘bitcoin miners‘. Miners are computers scattered all over the world that form a critical part of the bitcoin network. Their job is to aggregate groups of new valid transactions, like Alice’s one, and propose them for settlement. These groups of transactions are called ‘blocks‘, hence the word ‘block’ in ‘blockchain’.

At any given time, thousands of these computers are competing for the right to solve the next block. The competition involves solving a challenging mathematical puzzle, and miners can only propose a new block if they solve the current predicament. Whoever finds the solution first is entitled to a reward, which consists of newly minted bitcoins and potentially transaction fees paid by the entity initiating the transaction.

The reward is significant: each new block currently comes with a reward of 6.25 newly minted bitcoins. This payment is what incentivizes miners to do the work required to verify transactions and maintain the database. New blocks are placed on the bitcoin network roughly every ten minutes, although the exact time depends on how fast the puzzle is solved.

For now, only one network participant (the miner who proposed the new transaction block) can see the fully updated ledger; all other participants still see only the oldest blocks. Since the reward is significant, many miners compete to adjust each transaction block. However, competing is expensive (solving the puzzle requires considerable computing power and consumes a lot of energy) and knowing which of the thousands of miners will solve the puzzle first is impossible.

Once a miner solves the puzzle, however, he can publish the solution and
propose a block of transactions to the network. The peculiar advantage of the system is that although solving the mathematical puzzle is difficult and expensive, checking the result is easy. When a miner publishes a solution and a block of transactions, other members of the network check the work. If the transactions are valid and the solution to the puzzle is correct, the network participants update their copy of the database with the new transactions. At that point, Alice’s transaction is considered settled.

This ‘chaining of blocks’ is why this database architecture is called ‘blockchain’.

Could it be that the unknown bitcoin miner sending a block is malicious and proposes an invalid transaction block that somehow benefits him? Network participants examine every transaction in every proposed block and reject blocks with invalid transactions.

The blockchain provides an improvement over existing settlement methods.
On April 12, 2020, someone transferred 161,500 bitcoins, worth over $1.1 billion at the time, in a single transaction. The transaction settled in 10 minutes, and the transaction processing fee was $0.68 In comparison, an international bank transfer, which can only be sent during banking hours, takes one to two days to settle and has fees ranging from 1% to 8%. In addition, bitcoin transactions can be sent at any time of day or night and from anywhere in the world.

This applies to large and isolated transactions: every day, users settle transactions on the bitcoin network with counter values as small as a penny or as large as tens and even hundreds of millions of dollars.

Bitcoin is not the only crypto asset. According to data aggregator CoinMarketCap, there are more than 6,000 different crypto assets and many new ones are created every month. Although most of these assets are very small, several are valued at more than $1 billion. The Bitwise 10 Large Cap Crypto Index is a market capitalization-weighted index of the ten most significant crypto assets, screened for liquidity, security, and other risks. It captures approximately 85% of the total market capitalization of the cryptocurrency market.

Multiple crypto-assets exist and are thriving because their underlying blockchains are optimized for different uses. The blockchain technology attached to each crypto asset is simply software. Any two blockchains are similar types of software, but they can be programmed to serve very different uses.

 

Non-Fungible Tokens (NFTs)

The Non-Fungible Token (NFT) expression incorporates two specific terms: Token and Non-fungible.

A token is something that is on a blockchain, has a value, and can be received and sent, but is not the official currency of that blockchain.

In law, the term fungible is associated with goods which, having no specific individuality, can take the place of one another in legal effects; the typical fungible good is money.
For example, if I were to give Giuseppe 10 euros and he was to provide me with another 10 euros, there would be no difference in the composition of our assets. Each 10-euro banknote represents an identical value, so the money can be considered fungible.
One Bitcoin is fungible since it can be replaced with another. On the other hand, a piece of artwork is non-fungible because it cannot be exchanged for a generic good but is identical in value. NFTs, in the same way, are unique pieces that cannot be replicated or replaced.

Non-Fungible Tokens (NFT) are “digital certificates” based on blockchain technology that uniquely identifies the irreplaceable and non-replicable ownership of a digital product created on the Internet: such as a photo, video, text, article, audio, GIF, etc. When a digital object is certified with an NFT, it is as if there was the author’s signature on it, and no one can say that it is not original.

Buying an NFT does not involve obtaining ownership of the workpiece but the possibility of demonstrating a right onto that work through a smart contract that automatically executes an agreement that is forever registered on the blockchain.

  • Ownership: NFTs are connected to digital wallets; being unique and indivisible, they are associated with a single owner.
  • Limited supply: the supply of NFTs is kept limited by smart contracts that preserve its properties. The number of NFTs can be defined by the developers by also defining rarity levels that increase their value.
  • Origin: blockchain technology allows to trace the source of a given NFT through the decentralized register; this allows to prove the authenticity of the property and prevent fakes.
  • Interoperability: NFTs are characterized by free exchange on different open markets (marketplaces). This allows users to move assets outside the original creation spaces: in this way, they move from closed economic systems to a free market.
  • Liquidity: the digital nature of NFTs and their integration into major cryptocurrency networks such as Ethereum lead to high liquidity compared to physical assets; however, compared to tokens and fungible currencies, NFTs are less liquid.
  • Standardization: NFT protocols are based on software such as Ethereum, a feature that determines their standardization.

There are several use cases for Non-Fungible Tokens:

  • Art market: there are real digital works of art (such as an image, audio, a video file) that people buy as collectables or as a form of investment. In 2021, the crypto-art market generated a turnover of approximately 2.8 billion dollars, with over 774,000 sales between the primary and secondary markets (source nonfungibile.com). The average price of a crypto work has increased nearly tenfold over the year, from around $ 300 to $ 3,000.
  • Collectables: real electronic cards. For example, the NBA used some clips of the highlights of the American basketball season and created NFTs. In this case, by purchasing the NFT, you are not purchasing the copyright on the image, but you are buying a digital picture, not a paper one, with the aim of collecting it.
  • Music: to collect songs by your favourite singers without purchasing the copyright. There are markets where you can also buy or sell copyright through NFTs to achieve investment; however, these markets are small and illiquid.
  • Gaming: some NFTs can be used within blockchain-based video games; NFTs become digital collectables or gadgets that can be used in virtual games.
  • Certificates: NFTs can be used to verify the authenticity of a person’s identity or birth certificates, academic credentials, licenses, or others.
  • Financial documents: invoices, bills, and orders can be transformed into NFTs.
  • Real estate: Real estate and other valuable properties can be tokenized to improve the property’s liquidity or speed up financing.

Initially, a digital version of the work of art is created, which, in computer language, is defined by a sequence of binary digits (0-1). Then, this sequence is compressed into another series called “hash” (fingerprint) which uniquely identifies that file: the hashing process makes it impossible to reconstruct the original digital document. This BIT sequence is unique and is transcribed on a decentralized ledger: the blockchain. Ethereum currently contains the majority of the NFT market, as it is the most tested and developed platform; Ethereum works with a protocol called Proof of Work.

Since most NFTs are built on the Ethereum blockchain, a digital wallet must be opened in which to deposit and keep the cryptocurrencies necessary for transactions.

Once you have created your wallet containing the cryptocurrencies, you need to choose the marketplace (the virtual shop) where you can buy or sell NFTs. If the NFT has a very cheap cost or is free, it is likely that a variable tax will be applied to be paid (gas fee). Since these are crypto tokens that are supported by a real blockchain, these tokens can be exchanged both through smart contracts and through a manual exchange. They are, in effect, assets that we can buy and sell. For this purpose, many markets have also been born that allow auctions or private agreements.

The available NFTs appear within the marketplaces. Interested buyers can:

  • purchase the NFT directly (fixed price);
  • make bids in the auction, at the end of which the seller receives a notice with the best bids from the buyers;
  • make a bid at the price that is considered the fairest.

Once the bid is accepted, the platform manages the transfer of funds for the digital asset, concluding the purchase and sale process.