Blockchain 101, Bitcoin, and a history of investment bubbles | Part 1

Market bubbles

Bitcoin’s wildly volatile price swings have dominated recent headlines, and the meteoric rises in price of both Bitcoin and other cryptocurrencies have led many to declare it as nothing more than a speculative bubble.

The recent frenzied exuberance for Bitcoin by mainstream investors echoes the greed of the dotcom bubble of the 1990s.

To dismiss the underlying technology because of an investment bubble is short-sighted. History has shown that bubbles do not necessarily doom a technology to failure.

For instance, Railway Mania in 1840s Britain lead to runaway prices on railway shares. The overly optimistic speculation of investors combined with the ‘laissez-faire’ attitude of Parliament meant that anyone could form a railway company and receive investment funds. Eventually, investors realised the unviability of many of the enterprises, interest rates went up, and many of the railway companies collapsed overnight. Some families lost their entire life savings by picking the ‘wrong’ investments.

Despite the bubble bursting, there was a net positive result to Railway Mania. A total of 6,220 miles of railway line were built because of projects authorised between 1844 and 1846. Today, the total route mileage of the modern UK railway network is around 11,000 miles.

When the dotcom bubble burst between 2000 and 2002, $5 trillion dollars in market value for tech companies was wiped off the market. However, during the period of excessive speculation modern multibillion-dollar titans were founded, including Amazon (1994), eBay (1995), and Google (1998). The hysteria and destruction of the dotcom bubble resulted in the expansion of one the greatest technological innovations of the 20th century.

Introducing Bitcoin

The very first blockchain specification and proof of concept was Bitcoin. The whitepaper for Bitcoin was published in 2009 in a cryptography mailing list by Satoshi Nakamoto. Nakamoto is something of a ‘Banksy of the internet’ in that it is not generally known who he or she is. Nakamoto described Bitcoin as a ‘peer-to-peer version of electronic cash, which would allow online payments to be sent directly from one party to another without going through a financial institution’.

While the underlying technology of blockchain uses clever cryptography, the high-level concepts are simple. The first part of the Bitcoin blockchain is the ‘ledger’. This ledger is a list of every transaction ever made on the blockchain. The key aspect of the Bitcoin ledger is that it is not stored in a single central location. Instead, it is distributed to everyone and anyone, and everyone has the same copy of the ledger.

The first part of the Bitcoin blockchain is the ‘ledger’. This ledger is a list of every transaction ever made on the blockchain. The key aspect of the Bitcoin ledger is that it is not stored in a single central location. Instead, it is distributed to everyone and anyone, and everyone has the same copy of the ledger.

Anyone who wants to transact on the blockchain can use a program to create a ‘wallet’. Wallets are made up of two keys, a public key and a private key. A public key can be thought of as your BSB and account number – you can give it out to others to receive Bitcoins, but they cannot access them. Only the private key (think of this as your online banking password) allows you to access your Bitcoins and send them. There is practically no limit to the number of wallets that can be created. No personally identifying details need be provided when creating a wallet, allowing users to transact anonymously.

When sending Bitcoins to another wallet, the software announces the transaction to the entire network of users. Instead of a central bank, a group of individuals called ‘miners’ compete to process the transactions. Every 10 minutes, all of the announced transactions are grouped into a block. The miners are competing to solve a difficult puzzle for each new block. Solving the puzzle takes a lot of computing power. The miner who gets the answer to the puzzle first gets to validate the block to be added to the blockchain. That miner announces their version of the past 10 minutes of transactions to the rest of the miners and the block is added to the blockchain.

As an incentive to keep everyone mining, this winning miner receives the block reward (12.5 Bitcoins). The reward is also the incentive to keep everyone honest. If a miner solves the puzzle, but proposes a different version of the transactions (e.g.paying themselves extra coins) then the network will reject the block, and the miner will not receive the reward. When the block is added, it is linked to the previous block.

The linking and cryptographic puzzle solving creates a ‘digital wax seal’ making it practically impossible for an individual to hack the blockchain and pay someone twice with the same Bitcoin. The Bitcoin blockchain has never been hacked since its inception in 2009. With a current market capitalisation of over $100 billion dollars, the Bitcoin blockchain represents the world’s largest unclaimed bug-bounty. It is this trust and proof in the technology that allows two people to transact with each other without a central intermediary.

The total number of Bitcoins is capped by the network at 21 million. This is enforced by the software that the miners use on the network – if a Bitcoin 2.0 was created with 40 million coins, it would only have value if all the miners switched their computing power to the new network instead.

Blockchain technology can be summarised with a few key ideas:

Stay tuned for Part 2 which will explore some of the more recent and sophisticated applications of blockchain technology. We explore self-executing smart contracts, distributed records of human identity, and the potential for a blockchain based alternative to Facebook.

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