An Expert's Guide To Navigating The World Of Bitcoin

In this picture taken on December 10, 2015, a collection of Bitcoins stand in this arranged photograph in Danbury, U.K. (Bloomberg/Chris Ratcliffe)

Elaine Ou, a blockchain engineer and Bloomberg View columnist, answered questions about cryptocurrencies from Bloomberg Terminal customers in a TOPLive chat on Tuesday with Julie Verhage, who covers markets for Bloomberg News. Since then, bitcoin has skyrocketed to new heights and Cboe Global Markets Inc. plans to launch bitcoin futures trading on Sunday. Here's a lightly edited transcript.

Verhage: Bitcoin and other crypto-assets have had crazy runs this year. As I type this, bitcoin is closing in on $12,000 after starting the year around $1,000.

Elaine, what have you seen as the big drivers for this year's run up in price?

Ou: Earlier in the year, there was a lot of hype around Initial Coin Offerings as a way to raise money. People were going totally overboard with marketing. The only way to buy into these tokens was to first acquire bitcoin or ether, so demand for ICOs created demand for bitcoin and ether. This is still going on, although the craziness has died down a bit.

At the same time, we're seeing increased interest among institutional investors. Discussions about the possibility of a bitcoin exchange-traded fund gave the currency greater legitimacy. This year wasn’t the right time for an ETF, but we’ll have bitcoin futures next week and an ETF should follow soon.

JV: Hedge funds and other large investors are starting to get more involved. What kind of impact do you see them having?

EO: The price of bitcoin may stabilize due to increased information efficiency and liquidity. Right now, most of the trading activity occurs on overseas exchanges with questionable reputations. If more of the volume moves to U.S.-based exchanges, that will likely give traders confidence that the price isn’t being manipulated.

JV: Given the velocity of money (and number of counterparties that touch it) isn't there a limit as to how much data we can keep and track on the ledger?

EO: Sure, right now the bitcoin blockchain can handle about 7 transactions per second, Ethereum about 10 per second. There's a limit to how much work you can expect to happen on a global computer. People are building second-layer solutions so that less-critical transactions occur on ad-hoc networks that are later settled on the main blockchain. The blockchain is append-only, so information in the chain never changes once written.

JV: How will the use of electricity for bitcoin mining impact its ability to scale? I understand that mining even just one coin uses a lot.

EO: Bitcoin mining is a competitive process, so miners will continue expending as much electricity as needed to win the bitcoin in block rewards. It's basically an arms race, and not that different from how militaries amass munitions.

In other words, the amount of electricity wasted will always be proportional to the market price of bitcoin.

JV: On a scale of 1 to 10, how risky are crypto assets?

EO: It's very risky. It's experimental technology that relies on a community of volunteer software engineers.

JV: I think that means Elaine is going for closer to 10 than 1.

What incentive do miners have to maintain the ledger once the 21 million coins are in circulation? Who will maintain the blockchain?

EO: Every transaction has an accompanying transaction fee, so miners are compensated in transaction fees as well as the bitcoin block reward. Transaction fees will continue to increase as the block rewards decrease.

The blockchain itself is maintained by thousands of computers around the world -- generally these are Bitcoin-related businesses or users.

JV: Do you have a view on when a bitcoin ETF will be approved? In the past, these types of vehicles have been ruled against in this space, but now that futures have been approved...

EO: The Securities and Exchange Commission declined a rule change that was required for a bitcoin ETF this year, but fund managers will likely try again soon.

JV: Noting China's inhibitory policies, how would you characterize bitcoin's current global footprint, or ability to expand internationally?

EO: When China tried to stop exchange-based trading, a lot of the trading activity moved over-the-counter. Bitcoin will be extremely hard to regulate, and the governments that are most motivated to ban bitcoin are likely the ones where bitcoin would be most valuable. We're seeing a lot of adoption in Venezuela right now, for example.

JV: What's the outlook for the possibility of shorting this new asset?

EO: It's already possible, but mostly through unregulated exchanges. Once the Chicago Mercantile Exchange and Chicago Board Options Exchange list bitcoin futures, it will be easier to short bitcoin.

JV: What concerns you and excites you about the future of this space?

EO: Cryptocurrencies are decentralized projects, so no one is really in charge. There’s no resolution process for disagreements. In August, a group of disgruntled users cloned the bitcoin blockchain and created a new coin called Bitcoin Cash, also known as Bcash. A few months later, people created another clone called Bitcoin Gold. This can be really confusing for new users, because if they download the wrong wallet or buy the wrong coin, they can lose their money.

This is also a good thing, that no one is in charge, so people don’t worry about seeking permission before building new features. We’re seeing new developments in digital currencies that protect user privacy, and projects to bring Bitcoin to people without internet access.

JV: How high could fees go and what impact does that have on the possibility of using bitcoin as a currency?

EO: Since fees are expected to eventually substitute for block rewards, we might see transaction fees in the tens or hundreds of dollars, depending on the future price of bitcoin. The good news is, people are building second-layer solutions where transactions can be netted and batched in payment channels before being settled on the blockchain. This should keep fees low for non-critical transactions.

JV: How does the personal key that each bitcoin user has actually work? Are there security concerns?

EO: Bitcoin uses public key cryptography, where each bitcoin account has a public key and a private key. The public key is the bitcoin address and the private key is used to authorize transactions. The concern is that people might lose their private key, in which case the account is locked forever. A lot of users turn to wallet providers or exchanges like Coinbase to maintain custody of their keys, but then the concern is that these providers often get hacked.

JV: What determines whether a mined block is full or not full?

EO: A bitcoin block can currently store up to 4 megabytes of data. Transactions vary in size, so miners will generally include as many transactions as possible in a block to collect the associated transaction fees. Sometimes blocks are less than full when there aren't that many users submitting transactions.

JV: What will happen if/when China starts to re-allow exchange trading? Earlier this year, Chinese bitcoin volume (on exchanges) was 10 to 20 times current volumes before there was a crackdown on it early this year.

EO: It's possible that nothing will change. A lot of the Chinese bitcoin volume moved to Hong Kong-based exchanges after the People's Bank of China crackdown. Right now most trading activity is happening in Hong Kong and Korea.

JV: Right now there are a slew of different crypto assets. How many can succeed in the long term?

EO: Probably only a few. Or, as many bitcoin enthusiasts believe, only one. Currencies benefit greatly from network effects. Even with thousands of assets right now, the market is dominated by bitcoin, Litecoin, and Ethereum.

JV: What is the average daily volume of bitcoin transactions? Going off of that, have we seen greater usage in everyday life over the past year or is it still mostly just a trading strategy?

EO: Maybe 400,000 transactions per day actually make it into the blockchain, equivalent to a few billion dollars. The trading volume is several times that. Bitcoin is being used every day -- as a store of value (if that counts as usage).

JV: Can you describe the process the team of volunteer software engineers goes through to make a change to bitcoin? How many active members of the development community are there?

EO: Typically someone will propose a software update by creating a Bitcoin Improvement Proposal, which is then discussed over forums and mailing lists for months. When there is rough consensus among people who care to participate, then it will be implemented in software and reviewed by dozens of developers before being taken live. Even then, users and bitcoin miners are free to reject the software updates if they disagree with them. There are hundreds of casual contributors, but maybe only a dozen active at any point in time.

JV: There's been a lot of talk about bitcoin as the new gold. What are your thoughts on this dynamic? Earlier you mentioned bitcoin as a store of value.

EO: Bitcoin is the new gold in that it is uncorrelated with other assets. Ultimately, it's main value is as a permissionless medium of exchange -- that's what makes it a good store of value. Recent developments in second-layer networks could enable it to be a low-cost global payment solution as well.

JV: If someone wants to learn more about this area, where are the best places to look for more info?

EO: The original bitcoin paper is still the best introduction to the technology. The Satoshi Nakamoto Institute is also a great repository of historical references describing the ideas that led up to cryptocurrencies. – Bloomberg

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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