Sunday, May 5, 2013

Bitcoin: What Why and How.

What is Bitcoin
Bitcoin is a virtual currency. It's management is completely decentralized and done by open source software running on millions of nodes on the bitcoin network. The production of bitcoins depends on finding a block of data which has a certain property. When such a block is found the bitcoin network awards the finder with a number of bitcoins. At first the award was 50 bitcoins, but at present it is 25 bitcoins. Every 4 years the award reduces to half. In the first 4 years 10.5 million bitcoins were created. There exists about 11 million bitcoins at the present time. By the year 2140 all the bitcoins (around 21Million) will have been generated.

The creation of bitcoins is controlled through a parameter called difficulty. The difficulty is adjusted in such a way that only one block can be found every 10 minutes. The whole things depends on an algorithm called SHA-256 (Secure Hashing Algorithm version 2 with 256 bit output). This algorithm is as yet unbreakable. Its not clear whether quantum computers would break it. But in any case they are too far off in the future.

The task is to find a block which results in a hash value that has a predetermined number of zeros at the beginning of the 256bit hash output. Since there is no way to determine what block will have this property, so all sorts of blocks must be tried till one such block is found. The difficulty is directly proportional to the number of zeros in the hash. The difficulty is recalculated after every 2016 blocks are generated. This event would be after 14 days if the networks computational capability did not change.

The network's computational capability is calculated in Hashes per second. Currently the network capability is around 75TerraHashes/sec or 75 Trillion hash computations per second. As more computers are added to the network, its capability increases, and the corresponding difficulty must increase so as to keep the block generation capability constant. Currently the difficulty is nearly 9million.

To find the blocks we use a software called miner. It is a software that searches for a block that has the required difficulty. The block is basically a piece of data plus a nonce. This nonce is a 32 bit integer which is incremented every time to get a new block. As such 2^32 blocks can be generated. Hashing functions have the property that even a single bit change will cause the hash output to change completely. So big changes are not really necessary.

Initially people were using their PCs to compute the hashes, and that was enough. Then some people ported the miners to GPUs. These provided a big jump in hashing capability. Next the miners were ported to FPGAs. These resulted in an even bigger jump. The latest machines in town are the ASICs. The CPUs on the PCs are long past their usefulness. You will spend more money on power bills than you will make money from the bitcoins they generate. GPUs are also on the way out. They are profitable at the moment, but in a few short months they will not be anymore.

More info in this link.

Why the interest in Bitcoin
Bitcoin is an internet currency, which has same property as any other Store of Value item. Its supply is more or less fixed. It cannot be generated at will. This makes bitcoin similar to gold, but with a new property of being trade-able in the digital world. Currently it is under the radar for most of the people. As more and more people realize its benefits, its value will increase.

Its value has been related to recent crises. During the Greece crisis its value had risen 35 times, from less than a dollar to 30$, after that it came back down to about 10$, with an effective jump of nearly 15times. Then during Cyprus crisis it jumped from around 12 dollars to 240$, a jump of 20 times, and then settled down at around 130$ presently, an effective jump of 10times. I believe that the jumps have been due to the requirement of moving money offshore during these crisis.

I am expecting that during the coming financial meltdown lots of money will be looking to move. This will attempt to go into bitcoins, as gold will not be available. This will cause bitcoins to jump a whole lot. I would think on an unprecedented scale.

A unique thing about Bitcoins is that they can be traded by speculators, and still retain its store of value property. For gold to be traded, we need to have paper contracts. Since in the future paper contracts for gold will be frowned upon. The traders are likely to move to Bitcoins, and gold will serve as the international reserve. If this is true then bitcoins are poised to become an international currency competing with other currencies of the world.

Currently there are about 11million bitcoins, with the market price of around 140$/bitcoin, the market capitalization is around 1.5Billion$. This is way too less. The market capitalization must grow many many times to achieve the required capitalization. I would expect atleast a 1000times increase in the long term. And around a 100 times during the crisis.

If the price of a single Bitcoin goes to 10,000$, one would think how the trading for smaller items will be done. Actually there is no problem. A single bitcoin is made up of 100 million Satoshi's the smallest unit of bitcoins. At 10,000$s a microBTC will be equivalent to 1 cent. Even at that level Bitcoin can accept a 100times further increase, without it being a problem.

There are two potential problems. One is that the same theory that brings about Bitcoin can be used to create other virtual currencies. Actually there are several now, but none of them are anywhere near Bitcoin. And are not expected to grow up to challenge Bitcoin. As time goes on, it will become more and more difficult for an incumbent to overthrow Bitcoin. The second issue is quantum computing. Quantum computing is still in its infancy. It will be probably at least 20 years before it is able to cause big problems for the current Public Key Cryptography, which is the most vulnerable. By that time we will probably move to QC resistant algorithms. Ultimately Quantum Computers may allow a much faster generation of Bitcoins. This is not a problem in itself.

Both of these do not look very problematic at this time.

Probably the most serious problem is that govts can try to clamp on bitcoin exchanges. These are the entities that allow exchange of bitcoins with local currency. This has been tried by the govt of Canada, and others are thinking about it. But their main motive would be to prevent black marketing in the bitcoin world. These bitcoin exchanges actually allow the govt to make sure people do pay their taxes, and they can track the transactions. People looking to avoid taxes will be trading on other P2P networks. Only time will tell, but I expect that the govt will not try to stop legal exchanges as they result in people using legal methods of transactions. Preventing exchanges will make people move to illegal methods.

Bitcoin is not anonymous. Bitcoin uses the Wallet Address for transactions. This wallet address can be changed for every transaction, but the wallet address can be linked to the IP Address. To avoid using your own IP Address you can use tor to anonymize the transaction completely.

Bitcoin is an open source currency, so stopping it is near impossible. Remember MP3. The Media companies managed to shut down several companies that allowed sharing of MP3, but eventually they had to give up. Same thing will apply to govts, if they try to go against people's will. This does assume that Bitcoin is as useful as MP3s. It is not going to be beneficial for them in the long run. Better would be go along and keep the maximum people in the taxnet.

As compared to gold, gold is expected to not have any taxes once it becomes the international reserve. But bitcoin will continue to attract capital gains tax. This will make Gold a better store of value, but bitcoin should not be a bad store of value.

The last problem with bitcoins is that a certain technical understanding is required at the present time. The situation will improve slowly. There is a bitcoin card introduced recently. Paypal is also thinking of getting into Bitcoins.

Now that I have put some wildly optimistic spin on Bitcoins, lets have a look on how to use them.

How to use Bitcoins
You have to first create a wallet. There are two ways to create them. You can go to any number of internet websites that allow you to create the wallet, or you can download the bitcoin software and create a wallet on your own computer. A wallet is defined by a large number called an address. Bitcoin transactions happen between two wallets. So when you buy some bitcoins, you give a person some money via credit cards, or some other means and your wallet address, and the person transfers bitcoins from his own wallet to your wallet. The amount of bitcoins your wallet contains is known to the network. Because of this nobody can forge your wallet. But if you lose your wallet address you will lose your bitcoins, so it is a good idea to keep it safe somewhere, not easily hackable. Encrypt it preferably.

To obtain bitcoins you can buy them on an exchange or you can also create them. For that you will need to buy a mining hardware. The most advanced machines are ASICs, and are in very high demand these days. The technology is very new so there are delays in making them as well. But hopefully the situation will improve in a few months. Of course the difficulty will rise very fast. But I don't expect it will rise as fast as the value of BTC. It will still be wildly profitable.

There is a tradeoff, if you buy the mining rig, and the crisis comes too fast, you won't be able to collect enough BTCs, so it might be beneficial to directly invest in Bitcoins. If the crisis is far away, it is probably better to go with a mining rig.

Ofcourse the mining rig option is only open for technical people. There are some companies that are providing mining rigs on rental, so they manage and you can earn the BTCs produced by the mining rig and pay the managers some rent.

Friday, January 11, 2013

What happens if Gold Price goes too low?

Many people fear if the gold price will become too low and they will lose their investment. I, on the other hand, am waiting for the Gold price to get too low :-).

People who fear gold prices getting too low are thinking in terms of currency. This is the wrong way to look at gold. Gold is the currency that measures other currencies. Measuring it in terms of other currencies is a mistake.

If you look at the amount of gold held by Central Banks you will notice that they have increased their holdings since 2008. If the value of gold could drop, why would Central Banks increase their holding?
Bron Suchecki of Perth Mint has written a nice summary of the CBs activity over the past decade. You can also look at the data per country, almost every country has increased.

Now lets look at how the price can drop without crisis and why it will be a good thing for physical gold holders.

The first thing to understand is that gold price at the present time does not depend on physical gold demand, it depends on paper gold demand. There is a huge amount of paper gold trading that goes on in the world and it dwarfs the physical gold trading 1,500,000:4,500. My number in previous articles was way too low. Wikipedia also corroborates those numbers.

Currently the price of gold is down, and has been down since Sept 2011. This does not mean that there is no demand for physical gold, it just means that there is little demand for paper gold. If the demand for paper gold keeps on reducing the price of gold will drop. Lets see what will be the consequences of such a drop.

There is 4500mt of gold traded in the world. Of this 2500mt comes from mining and 2000mt is from scrap. Scrap means the gold sold by people. Of the 4500mt, over 2000mt is used in Jewelry. The jewelry use is typically by Asian people. This demand is very inflexible, as in it cannot be replaced by paper gold. Another 1000mt is used by bullion investors. This demand is somewhat flexible, as it can be replaced by paper gold. But note that people who buy physical gold are paying extra costs for it. If they really wanted it for short term trading they would not be buying physical gold and instead would buy paper gold. So the majority of this demand is also inflexible. About 300mt is industrial demand which is very rigid.

It is very likely that if the price of gold goes down demand of physical will go further up. The Indian govt is trying to convince people to buy paper gold, but unfortunately you can't make jewelry from paper gold :-).

Now lets see what other effects happen when the price of gold goes down.

Mines are affected with a low price of gold. There are two kinds of costs that we read about in the mining industry. Cash Costs, that are actual running costs. These costs are minimum, and are required for running the mines. Below these costs the mines will not be able to run. But this is not the actual costs at which the mines will close down. There are other costs involved, exploration, and profits. No business will operate at no profit. Even share holders want profits. The total of these is the Running Cost of a mining company.
Running costs are probably crossing 1500$/oz at the present times. Cash costs were nearly 700$ in 2011, and are now upto 900$-950$/oz. Barrick Gold had a cash cost of only 460$/oz in 2011. The present price of gold is around 1650$/oz. It is expected that the mines will be in deep trouble at 1350$/oz.

What happens if the price of gold is 1350$/oz? Or if the costs of mines increase further owing to inflation, reduction in yield, and reduced exploration.

The mines will start closing down, reducing the mining output. If the Output goes much below the current level, the demand for physical gold will outstrip the production. This can only be managed with a higher price, but the problem is due to a lower price. The demand for physical cannot be reduced by unavailability of physical from mines, because there is a huge above ground stock in common people's hands.

What will happen is that some people will be willing to sell gold at a higher price than what the paper gold market suggests, and Asians (particularly Indians) will be willing to pay the higher price. If this is done commonly and openly, the price of paper gold and the price of physical gold will diverge. It is highly likely that this problem happens in India, because the Indian Physical market is much more active than the rest of the world. At that time true value of paper gold will be revealed which is zero.

Once the paper gold's value is revealed, immediately the value of physical gold will rise. There will be a discontinuity as the physical gold will more or less disappear from the market as lots of money will be after gold, and slowly the real price will be arrived at in the actual market.

Remember the above treatment is done in the case of no crisis situation.

The above case is highly improbable. It is highly likely that if this situation happens, the 1.5million tonnes of paper gold which is equivalent to 70T$, more than the global GDP, will be gone. This will cause a major disturbance in the Economic health of the world. It is highly likely that we will plunge into a crisis situation.

Because of this consequence to the world economy, the price of gold will never be allowed to drop so low that mines start closing down, or people wanting physical are not able to get their physical easily. The price will drop when the crisis happens, in that case lots of paper investments will become worthless, including paper gold. Note: Stocks are not paper investments, but you do need to have the papers in your possession. The crisis will happen overnight as it is a consequence of loss of confidence, which happens overnight.

Another issue is China. China is at present the largest producer and consumer of gold. It is actually turning into a black hole for gold. It has been buying a whole lot of gold via Hong Kong. It is also buying up large mines in South Africa and elsewhere. Rest assured it is not buying these mines to sell the gold in open market. China seems to be intent to have 10,000tons of gold as reserve. Once the effective production of gold (not including gold in Chinese control), gets too low, the economy is in trouble. The Chinese have already shown that they are now, not too much concerned about the economy going south. China was the country that bought US Treasuries in the last decade to allow the system to survive for so long. Since Sept 2011, it has stopped providing that support. Since then China's UST hoard has been reducing.

The countries worst affected by the economic downturn are US, UK and Japan, so these countries can help keep the price of gold up. Of these really US is the only one which can actually do something about it. It seems Europe has also given up. There was no surge in the price of gold before the 4th Jan ECB's quarterly update.

My estimate for the crisis is between 2 to 5 years. Possibly earlier than later. It seems to me that UK will be the first to plunge into crisis, and then trigger the rest.