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The Blockchain Gang Part 2

Columnist: Michael E. Duffy
January, 2018 Issue
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Michael E. Duffy
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Last month, I introduced the idea of “distributed ledger technology,” which is another name for the blockchain, a way of accounting for transactions without a central trusted authority. The most well-known public blockchain is associated with the Bitcoin digital currency, and is used to keep track of transactions of that asset without a central bank.

A given blockchain, public or private, is maintained by a network of computers. Any computer on the associated network can see every transaction that has ever occurred. For example, you could examine every single Bitcoin transaction since the first one in 2009. In that sense, Bitcoin is completely transparent. At the same time, since there’s no personal information associated with a Bitcoin transaction, except for an account number, transactions are completely anonymous. You can see the amount held by every account—or “wallet”—which is interesting, but not useful. And anyone can have several, or even millions, of wallets (the number of potential wallets is monumental: 2 to the 160th power).

What’s in it for the people who own the computers that make up the network associated with a given blockchain? Why should they spend money on the computers—and the electricity needed to run them—to verify transactions on the blockchain? In the end, the answer boils down to this: participating in the network yields more value than it costs to own and run the computer. In the case of a private network, this can be true for any number of reasons.
But in the case of a public network, it’s slightly more obvious—they get paid to do it. Going back to Bitcoin again (because it’s the biggest live example), computers on the network are paid for verifying a block of transactions, called the “block reward,” as well as a transaction fee. The block reward began at 50 bitcoin per block, and halves every 210,000 blocks. At this time, it has “halved” twice, and stands at 12.5 bitcoin per block.
Brief aside: a government-issued currency, like the dollar or the yen, can be debased when the government decides to simply “print more money,” leading to inflation. Bitcoin caps the number of bitcoins (lowercase “bitcoin” is used to refer to the currency itself) that can exist at 21 million. Of those 21 million, almost 17 million have been created as of November 2017. You’ll find more interesting statistics at www.blockchain.info.
What this means is that eventually, the block reward will become zero (after 64 “halvings”), and transaction fees will become the primary source of income for bitcoin “miners.” It would cost $1,600 to mine a single Bitcoin (due to the block reward, computers on the Bitcoin network appear to be “mining bitcoins”). This makes sense, because in the early days, there weren’t many transactions, so a larger incentive was needed to participate in the network (and maintain its integrity). Since the sum of the block reward and any transaction fees must (on average) be more than it costs the miner to get them, transaction fees will rise as the block reward trends toward zero. One unanswered question about the future of Bitcoin is whether those fees will cover the cost of running the blockchain (and avoiding the “51-percent” attack mentioned in my last column). For perspective, at 12 cents per kilowatt-hour (about average for the North Bay), it would cost about $1,600 in electricity alone to mine a single bitcoin. This is one reason that most Bitcoin mining is now done in China.
Bitcoin transaction fees are quoted in terms of the number of “satoshi” (0.00000001 of a bitcoin) per byte. This handy calculator (estimatefee.com) shows that right now, a transaction could cost between 6 cents and $1.72. What makes for such a big difference? Speed. To have the transaction processed within the next 20 minutes would cost $1.72. If I’m willing to wait 24 hours, the free drops to 13 cents. This is because a transactions can specify how much it is willing to pay for processing. The current level of transaction fees makes Bitcoin uneconomical for small transactions, and it will get worse as the dollar value of a bitcoin increases.
I still don’t see the attraction of paying (or getting paid) with bitcoins. Aside from individual retail outlets, it seems that overstock.com and expedia.com are the only two mainstream entities that accept it for payment. I just don’t get it. Of course, buying and selling illegal goods on the so-called “Dark Web” is another matter.
As a speculator, however, the rise of Bitcoin from $968 on January 1, 2017, to $9,532 as I write this 11 months later, is astounding. The question is, will it go higher? There are many factors that can influence what happens next. Some, like proposed changes in the block size, are deeply technical. Some require understanding monetary policy, like Japan’s decision to make Bitcoin a form of legal tender. Some are related to market forces: will high transaction fees (which may be influenced by block size) deter the use of Bitcoin? If you plan to speculate on the appreciation of Bitcoin or Ethereum, please do it with money you can afford to lose.
Next month, I’ll finally get around to Initial Coin Offerings and close out this series on digital currency and the blockchain.
 


 

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