Bitcoin: security vs volatility

Henry Birt of JM Finn’s research team looks into the mechanics of the world’s largest cryptocurrency, Bitcoin

by Henry Birt

Research Assistant

Bitcoin is the first of a series of digital coins called cryptocurrencies. Launched in 2009, it is the world's largest cryptocurrency by market cap, which can be traced back to a paper published by an unknown person/group of people using the alias Satoshi Nakamoto. In this paper, Nakamoto presents a problem: in the world of digital payments, financial institutions are essential as a mediator between sender and receiver and thus we have no option but to place trust in a central organisation. Enter Bitcoin, the decentralised and anonymous electronic payment system ‘allowing any two willing parties to transact directly with each other without the need for a trusted third party’.

How does it work?

It is easiest to think of bitcoin as a universal database of transactions. Every computer, or node, in the network holds a copy of the universal database of transactions. Every time a new transaction takes place, it must be projected to the network so every node can update their copy of the database. Trust is placed in the network to verify the transaction history instead of a central authority and it is thus decentralised.

Bitcoin differs from traditional fiat currency as it uses a technology called blockchain. A blockchain is, unsurprisingly, a chain of ‘blocks’. Once data is recorded in the blockchain it becomes very difficult to alter. These blocks contain information, in this case transactions. A block is comprised of a list of transactions, something called the ‘hash’, and the hash of the previous block. A hash is most akin to a fingerprint: it identifies a block and all of the transactions within, and is always unique. When a block is created its hash is calculated. If the transactions in a block are changed, the hash changes too. Therefore, it is very easy to identify if a block changes. As mentioned above, the block also contains the hash of the previous block which in effect chains the blocks together. This is what makes blockchain so secure. If one block changes, all subsequent blocks must change too, otherwise this chain would be recognised by the network as invalid.

However, after changing one block a computer could easily calculate the changed hashes for all the following blocks and make this new version of the chain valid. To prevent this, bitcoin’s blockchain uses a ‘proof-of-work’. This is a system which slows down the creation of new blocks by forcing bitcoin ‘miners’ to solve a complex algorithm before making a new block. The miners are essentially trying to calculate the hash by solving a very tricky puzzle. If they get there before everyone else, they earn the right to create the new block containing the transactions, the new hash and the previous block’s hash.

All this means it’s very hard to tamper with the chain as this would require you to recalculate all of the proof-of-works for all the subsequent blocks. Miners are rewarded for solving the algorithm with bitcoins and so there is an incentive to extend the chain. The chain is distributed to all nodes in the network and they all make sure their blockchain is up-to-date and matches all the other chains. If someone wanted to tamper with the chain they would have to recalculate all of the proof-of-works whilst all the other nodes were adding to the chain and therefore the likelihood of one node being able to do this and catch up is incredibly low. From a purely technical standpoint then, blockchain is very secure.

Bitcoin’s security in relation to fiat currencies and gold

Bitcoin was invented as a replacement for fiat currencies, or government-issued currency, and so we begin with the security of transferring bitcoin. For this you will need a wallet. This wallet contains your private key, which can be thought of as a unique signature. This generates a bitcoin address which is shared with others, allowing them to send you bitcoin. The private key uses a cryptographic function to generate the address and so the most effective method an attacker has to derive your key from the public address is to guess it. Given that your private key will likely be a combination of 256 zero’s and one’s, a potential hacker has a one in 2256 chance of guessing correctly. This is inconceivably unlikely; far more unlikely than guessing your four-digit pin.

The problem arises with where to keep the key. There are wallets connected to the internet or ‘hot’ wallets which, whilst convenient, open you to the risk of hacking and so many opt for an offline or ‘cold’ wallet. This can be a memory stick, a piece of paper or even a mental note. Unlike a bank though, losing this cannot be remedied by a call centre or banking app. As I’m sure the Welsh IT worker who has been imploring his local council to let him search their landfill for a laptop with £230m of bitcoin on it, will attest!

Beyond this, the bitcoin network is also rife with fraudsters. As with any system that transfers money, there are people trying to trick you out of it but, it is particularly common within the less regulated bitcoin market.

When compared to traditional fiat currencies, any scams or hacks in bitcoin present a more material risk. If your bank account gets hacked or your card gets stolen, chances are you will get your money back, however with bitcoin there lacks a central authority to reimburse you. It is true however, that those of us with more assiduous organisational skills who are not easily duped could probably avoid ruin from key loss or fraud.

The main weakness then, is bitcoins ability to act as a store of value. If I go into a car dealership with a debit card on which there is enough money to buy a car, I can be pretty confident that the next day that money will still buy me a car unless I happen to live in the Weimar Republic. However, bitcoin’s volatility removes that certainty. This is especially important as some now flout bitcoin as a safe haven asset with properties similar to gold. The argument follows that bitcoin and gold are both scarce (only 21m bitcoins can ever be mined) and so therefore this imbues the cryptocurrency with gold-like inflation hedging abilities not afforded to fiat currencies. However, scarcity does not translate into value automatically. For bitcoin to represent a gold alternative it would also need far more active investors to add liquidity to the market. As it stands, only a tiny portion of bitcoin ever trades and thus it remains, for the moment, far too volatile to replace gold effectively.

Both the European Central Bank (ECB) and Financial Conduct Authority (FCA) have voiced their concerns. In October 2020, the FCA denied retail investors access to cryptocurrency derivatives and more recently, issued a stark warning that crypto investors should be prepared to lose 80% of their investments. This led the bitcoin community to label the FCA ‘crypto-fascists’ which, whilst a bit strong, does highlight one of the issues with these regulatory remonstrations: it is hardly surprising that the governments bitcoin aims to cut out of the loop, are not hugely bullish on the idea.

Despite dubious regulators, price increases have piqued the interests of some big institutional names.  BlackRock has, for example, recently gained approval for two of its funds to start buying bitcoin futures. A strong endorsement, however you look at it.

In summary, whilst blockchain technology does have its issues, in general it appears safe. The same goes for the buying and selling of bitcoin using a wallet and private key, however, volatility concerns are harder to pacify. It is this problem which makes bitcoin a poor substitute for dollars, euros, sterling or even gold.  Investors with a higher capacity for loss and appetite for riskier assets could speculate on price movements, but that makes it a very different proposition to fiat currencies.

For now, if you are looking for a way to transfer and store value digitally, you may be better off sticking with the conventional methods. Bitcoin’s technology may protect you from theft and hacking, but it cannot protect you from the daily price swings that remain an innate part of bitcoin trading.

Henry Birt, Research Assistant

This article is intended for educational purposes and should not be viewed as a recommendation or invitation to transact in any Cryptoassets. JM Finn cannot advise on, facilitate or execute any transactions in such assets. The price or value of any Cryptoassets can rapidly increase or decrease at any time (and may even fall to zero). All views expressed are those of the author.

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