Economic Analysis of Cryptographic Currencies on the Basis of Bitcoin


Bachelor Thesis, 2014
96 Pages, Grade: 1,3

Excerpt

Table of content

Relevant Terminology

List of abbreviations

List of figures

1 Introduction
1.1 Course of investigation
1.2 Information on linguistic usage

2 The evolution of money
2.1 Functions of money
2.1.1 Medium of exchange
2.1.2 Measure of value
2.1.3 Store of value
2.2 Characteristics of money
2.3 Creation of money
2.3.1 The European Central Bank
2.3.2 Money creation by commercial banks

3 The concept of cryptocurrencies

4 The infamous Bitcoin
4.1 History
4.2 How Bitcoin works
4.2.1 Double spending
4.2.2 Creation of Bitcoins
4.2.2.1 Difficulty
4.2.2.2 Mining
4.2.2.2.1 Solo Mining
4.2.2.2.2 Pool Mining
4.2.2.2.3 Time and costs
4.2.2.2.4 Revenue by mining
4.2.2.3 Alteration of the Bitcoin protocol
4.3 Characteristics of Bitcoin
4.3.1 Transaction security
4.3.2 Transaction fees
4.3.3 Storage security
4.3.4 Counterfeit protection
4.3.5 Anonymity

4.3.6 Irreversible payments
4.3.7 Volume of bitcoins
4.4 Forms of trading with Bitcoin
4.4.1 Wired transfer
4.4.2 Near Field Communication (NFC)
4.4.3 QR-Code
4.4.4 Coins
4.4.5 Debit cards
4.5 How to acquire bitcoins
4.5.1 Bitcoin exchanges
4.5.2 Mining
4.5.3 ATM machine
4.5.4 Donations
4.5.5 Businesses accepting bitcoins

5 SWOT analysis
5.1 Strengths
5.2 Weaknesses
5.2.1 Volatility
5.2.2 Supply shortage
5.2.3 Energy Consumption
5.3 Opportunities
5.3.1 Independent online payments
5.3.2 Micropayments
5.3.3 Developing countries
5.4 Threats
5.4.1 Crime
5.4.1.1 Silk Road
5.4.1.2 Money laundering
5.4.1.3 Botnet
5.4.2 Risks
5.4.2.1 Risk of loss
5.4.2.2 Risk of prohibition
5.4.2.3 51% Attack
5.4.2.4 Niche currency

6 Classification of bitcoin
6.1 Taxation
6.2 Comparative Analysis

7 Theory of speculative bubbles
7.1 Dutch tulip mania
7.2 Digital gold fever

8 Scenario Analysis

9 Discussion
9.1 Matter of trust
9.2 The great scheme
9.3 The evil Bitcoin
9.4 The question of questions
9.5 Deflation versus Inflation

10 Conclusion

11 Appendix: Excursus on hash function

12 Bibliography

Relevant Terminology

illustration not visible in this excerpt1 2 3 4 5 6 7 8

List of abbreviations

illustration not visible in this excerpt

List of figures

Figure 1: Closed source versus open source

Figure 2: Cryptocurrency market capitalization (November 2013)

Figure 3: First Bitcoin transaction ever made known as the “Genesis Block”

Figure 4: Example of a public key

Figure 5: Simple illustration of a Bitcoin transaction

Figure 6: Advanced illustration of a Bitcoin transaction

Figure 7: Simple Illustration of the block chain

Figure 8: Bitcoin Difficulty

Figure 9: USB Bitcoin ASIC Miner

Figure 10: Cost and time per Bitcoin

Figure 11: Total bitcoins over time

Figure 12: Bitcoin Core Wallet

Figure 13: QR-Code

Figure 14: Physical bitcoin Casascius

Figure 15: Bitcoin ATM machine from Lamassu

Figure 16: Bitcoin donation button

Figure 17: Bitcoin acceptance sign

Figure 18: Bitcoin volatility

Figure 19: Google searches about Bitcoin

Figure 20: Total power consumption of bitcoin mining per 24 hours

Figure 21: "New Technology" phenomenon

Figure 22: Network ranking (Quantity)

Figure 23: Typical money-laundering scheme

Figure 24: Comparison of the characteristics of Gold, Fiat money and Bitcoin

Figure 25: Comparison of the functions of Gold, Fiat money and Bitcoin

Figure 26: Stages of a speculative bubble

Figure 27: Bitcoin price development

Figure 28: Fixed supply of bitcoins

Figure 29: Cryptographic hash function

1 Introduction

Cryptocurrencies have gained increasing attention in the recent years. Especially Bitcoin is on his way from being a very little known phenomenon towards becoming a seriously recognized player in the economy. Its origin lies in the subprime mortgage crisis of 2007 after which crypto anarchists attempted to take the matter of money distribution in their own hands.9 In 2013, most people still didn’t know what the term Bitcoin is associated with. In a survey, conducted by a German newspaper, 51% of the interviewed persons couldn’t identify Bitcoin. The other half has heard about Bitcoin but could not give further explanation except of identifying it as a virtual cyber currency.10 There exists a great need for enlightenment about cryptocurrencies such as Bitcoin.

Cryptocurrencies are often associated with the Wild West,11 as there are still lots of open questions concerning its nature juristically, economically and tax status. The price of a Bitcoin has been growing with recurrences of high fluctuations in the last years and has shown similarities to the concepts of a speculative Bubble. Is this statement justified?

The media either praises Bitcoin as a great innovation,12 or demonizes it.13 This makes it very difficult to obtain an objective position about Bitcoin. This work analyses the characteristics of Bitcoin and evaluates their relevance for a sustainable existence. Are cryptocurrencies just a temporary phenomenon or should we expect them to prevail in the future?

1.1 Course of investigation

The intention of this work is to provide an economical analysis of cryptocurrencies by investigating its biggest representative, Bitcoin. The main research questions are therefore:

- How does Bitcoin work?
- What are the benefits and risks of Bitcoin?
- How is the price of Bitcoin determined?
- Can Bitcoin currently be identified as money?
- What does the future hold for Bitcoins development?

These questions will be answered throughout the whole work. A scenario analysis and discussion will, among other things, compare the advantages and disadvantages of Bitcoin with each other and reinterpret certain perceptions. The conclusion will summarize the main discoveries of the work.

Since scientific publications concerning Bitcoin are relatively scarce, the initial research of this work consisted of reading through various kinds of newspaper articles and exploring discussion forums. During this stage it was important to objectively evaluate and extract the presented information’s. As Bitcoin is based on many technological theories, much time had to be spent in order to reproduce its functionality on an easy level. Fortunately, Bitcoin presents itself as a very transparent project, which makes it possible to study its mechanics with selected publications.

Bitcoins nature is quite different compared to money that we are using everyday. In order to be able to understand this difference, it is necessary to explore the origin and functional principles of money in general. The next step delivers a wide range of basic knowledge about Bitcoin, as of how Bitcoins are created, their characteristics and how they can be acquired and traded. The following SWOT analysis delivers first explanations on why the opinion about Bitcoin diverges so widely. Now that a solid foundation of knowledge is established, further analyses can be conducted. With the help of theories of prestigious economists, key questions concerning Bitcoins development and identification can be approached.

1.2 Information on linguistic usage

For the ease of reading and linguistic simplification of this work, only the masculine form is used, even if the statements relate to the male and female form. Bitcoin in its capitalized form is used to describe the concept of Bitcoin, the entire network itself or the Bitcoin currency system. The term bitcoin in its non-capitalized form is used to describe bitcoin as a unit of account. Additionally, the abbreviation BTC is describing bitcoin when it appears in conjunction with a value.14

2 The evolution of money

Imagine a village with citizens pursuing professions creating various goods. If individual A wants a good individual B produces and no sort of money is available, A´s only option is to ask B to trade that good for another good he possesses. This is generally known as the Barter System. Eventually, however, the situation will arise that B is not interested in any of the offerings from A. This situation is described as a double coincidence of wants and displays the largest difficulty of the Barter System.15

In order to cope with this problem, a commodity had to be chosen that holds several fundamental functions in order to serve as money. In the hunting ages the skins of wild animals were used as money and during history many other commodities were chosen, such as gold, silver and eventually paper money. Apart from paper money the selection of commodity was basically always the one with a high level of necessity or beauty.16 Nowadays there exist many additional appearances of money such as book money and electronic money. Among many different forms of electronic money there is the cryptographic currency Bitcoin.

2.1 Functions of money

The creation of money serves more functions than presented in this section. For understanding the broader context of this work, the following are the most important. I will use abbreviations for the following currencies Euro (EUR), US Dollar (USD) and eventually Bitcoin (BTC).

2.1.1 Medium of exchange

As shown above, various commodities have served as money. Substantially anything can be used as a monetary unit as long as it is generally accepted as a medium of exchange.17 In Germany a 5 EUR bill is a medium of exchange since the other party is willing to accept it. During World War II and even nowadays in many prisons all over the world, cigarettes were and are counting as a medium of exchange.18

2.1.2 Measure of value

Since apparently everything can be used as means of payment, the question is how to determine the value of the money. We use money in order to exchange it for goods, services or resources. The amount of what we can obtain of these desired goods, services or resources determines the value of our money. Additionally this enables us to compare how much of one commodity is equal to how much of another commodity.19

2.1.3 Store of value

It has been clarified that in Germany 5 EUR or the euro in general counts as a medium of exchange. However, in order for the medium to be generally accepted it needs to provide a consistent value. Prior an exchange the new owner of the 5 EUR needs to be certain to receive an equivalent amount of value for the 5 EUR in the near future.

2.2 Characteristics of money

In combination with the functions, certain characteristics have to exist in order for money to establish itself in an economy. These count for every kind of money and are mandatory for its existence. There are six characteristics namely acceptability, divisibility, durability, scarcity, portability and uniformity.20

Acceptability correlates with the function as a medium of exchange. In order for money to be a medium of exchange it needs to be widely accepted. Divisibility is important for transactional purposes. Imagine possessing a 10 EUR bill with the intention to buy an ordinary apple. If the 10 EUR bill would be the smallest monetary unit, you theoretically had to purchase as many things until they reach the value of your 10 EUR bill. A division into smaller denominations is therefore necessary to enable different types of transactions. Durability is important for the fulfillment of the function as a store of value. A coin of gold for instance will keep its shape and substance for a long period of time and does not easily change its form unless being melted. The paper used for our 10 EUR bill is designed to cope with exposures like dirt or liquids and to prevent the fading of symbols and colors that clarify its value. Scarcity is a crucial characteristic of money to demonstrate actual value. A limited amount of money has to exist in order for it to function. Gold for instance has a natural limitation, namely as treasures buried in the ground. The amount of gold in circulation will not increase unless someone discovers additional reserves of it. This becomes more and more difficult due to its before mentioned natural limitation. Portability is necessary for convenience and to assure usability. This is why commodity money was more and more replaced by paper money. Spending gold instead of paper money at a supermarket is more difficult due to its size and weight. Uniformity describes the situation in which same means of payment do not differentiate themselves from each other. My 10 EUR bill is totally identical to a 10 EUR bill from another person. This also includes that the creation of counterfeits is not easy or even possible in general.

2.3 Creation of money

In order for money to function it has to comply with the before mentioned characteristics. A highly important characteristic although is scarcity since the amount of money in the market determines its value. As stated before, in terms of commodity money such as gold and silver, nature regulates the amount supplied to us. Paper money is a form of fiat money, implying that it is not backed up by something with intrinsic value.21 Fiat money is declared as legal tender by the government.22 However, when using paper as money the problem of virtually infiniteness amounts occurs. To cope with this situation a higher authority such as a central bank is selected to manage the supply of money.23 Responsible for the largest economies such as Europe, United States and China are the European central bank (ECB), Federal Reserve System (FED) and the People's Bank of China (PBC).24

2.3.1 The European Central Bank

I will illustrate the creation of money based on the European economy and thus use the instruments of the ECB. The main objective of the ECB, this also counts for other central banks, is to provide a continuous level of price stability.25 In other terms, their monetary policy aims for a certain percentage of inflation or deflation of the regarding currency. The ECB aims for a permanent inflation level of about 2%.26

In order for commercial banks to receive money they will raise a credit at the ECB.27 After a successful examination of the banks requirements and a deposited collateral it will receive the requested amount of money by the ECB in form of a repurchase agreement.28 This enables commercial banks to sell securities to the ECB in exchange for money, however having the obligation to repurchase them for an the same price plus interest at a future date.29

Another way for the commercial bank to receive money is by selling assets such as gold, bonds and foreign currency to the ECB.30 As a result money will be created and transferred to the commercial bank.

2.3.2 Money creation by commercial banks

Since we are living in a capitalistic economic system, steady growth is an important factor. Imagine an entrepreneur investing in its company solely by using his savings or profits. Under these assumptions rapid and steady growth is nearly impossible due to time restrictions. The entrepreneur can overcome these restrictions by receiving quick funds in form of a credit. The question that arises is where do commercial banks acquire all that money provided to the entrepreneurs in this world.

Commercial banks have the ability to create book money. This book money is no legal tender; it is widely accepted as a mean of payment because it can be converted into cash.31 If an entrepreneur needs additional funds for investments, he can receive money from the commercial bank. This is usually not done via cash but by transferring book money to the entrepreneurs’ bank account. He however will continue to pay his liabilities accrued by the investments with this book money as well. Eventually the situation can arise that nobody in this cycle will actually withdraw money in the form of cash from his bank account. This gives commercial banks the possibility to create money and provide it towards the market. This also provides them with the possibility to create massive amounts of book money that is not actually backed up by sight deposits. In order to avoid a violation of the ECB´s main goal price stability, a minimum reserve system has been implemented.32 Commercial banks are required to have a certain amount of minimum reserves deposited at the central bank.33 In Europe the fraction of which commercial banks must hold as a deposit at the central bank decreased from 2% to 1% on January 18, 2012.34

3 The concept of cryptocurrencies

The commonly used definition describes cryptocurrencies as a digital medium of exchange.35 That’s only partially true since they also provide an administrative system. This system allows cryptocurrencies to get created, distributed and exchanged. Every cryptocurrency has its origin in Bitcoin, which was introduced in 2008.36 Bitcoin is an open source project whose code (similar to program instruction) is available to anyone at the open source online community, Github.com.37

In the context of cryptocurrencies it is important to differentiate closed source software with open source software by its accessibility (see Figure 1, p. 9). The closed source software’s code is not available to anyone but its developer or producer. Usually the objective is to sell it as a product and buyers are not allowed to distribute it further or tamper with the software’s code. An infringement gives the producer or developer of such closed source software the right to take legal actions.38 Open source software can be obtained by anyone and subsequently modified. Many developers are constantly improving the software and codes are often described as seeds. The open source model in Figure 1 can be visualized as a tree. The moment a seed is planted and developer’s implement improvements, its branches will grow and become stronger as time goes by.

illustration not visible in this excerpt

Figure 1: Closed source versus open source39

Bitcoin has a team of core developers that try to improve the code and react to environmental changes.40 In the Github.com repository anyone can make suggestions about how to improve Bitcoins code. After consensus of the core development team these suggestions might be presented to the whole Bitcoin community, which decides on it in a democratic process.41

In general, anyone having advanced skills in programming can use Bitcoins code and modify it in order to create a new cryptocurrency. Meanwhile, over 300 cryptocurrencies have been created.42 As Figure 2 illustrates, there are only few of them whose existence is noteworthy. The mother of all cryptocurrencies, Bitcoin, clearly dominates the market at a market share of 92% while the second largest, Litecoin, holds 5% of the market. Cryptocurrencies that are considered alternatives to Bitcoin are also called Altcoins.43

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Figure 2: Cryptocurrency market capitalization (November 2013)44

Sometimes Altcoins are created that are only available for a certain group or community. One example is Auroracoin, which is a cryptocurrency that can only be purchased by individuals that have an Icelandic passport and a permanent residency in Iceland. The idea of the developer was to create an alternative currency for Icelandic people since the home currency (Icelandic Krona) has suffered an extreme devaluation in the last 50 years.45

Cryptocurrencies often have to deal with accusations such as being created for illegal purposes (see 5.4, p. 45). However, the incentive of the first cryptocurrency was not to establish a platform for criminals but to provide people with a medium of exchange that is not controlled by a financial institution.46

4 The infamous Bitcoin

4.1 History

The history of Bitcoin has been very broad, considering it being a relatively young phenomenon. During the last 5 years the economies and societies all over the world had to cope with totally new situations, which were partially in no way similar and comparable to events in the past. This section will focus on the trend-setting events in the history of Bitcoin.

On October 31, 2008 Nakamoto Satoshi published the Paper “Bitcoin: A Peer-to-Peer Cash System” on the webpage Bitcoin.org. While the verification of the person Nakamoto is doubtful there is a wide belief that Nakamoto is actually not a single person but a group of several individuals.47 Except for the unanswered question of origin Bitcoin is considered a great amendment towards secure money transfer over the Internet. On August 18, 2008 even before Nakamoto published his work, the domain Bitcoin.org was registered.48 It serves as an information platform for users to protect them from common mistakes, to improve Bitcoin worldwide accessibility and it claims to remain a neutral informative resource about Bitcoin.49 On January 3, 2009 the first Bitcoin transaction took place between pseudonymous creator Satoshi Nakamoto and Hal Finney, a cryptographic activist.50 Merely considered as a test Nakamoto sent Finney 10 BTC, which at that time were basically worthless.51 It took over a year after that for the first exchange of Bitcoins for an actual product. On May 22, 2010 a programmer from Florida managed to exchange 10,000 BTC for two pizzas.52 During that time the value of those 10,000 BTC had a value of around 25 USD.53 Looking at the highest Bitcoin value as a reference those Pizzas will sum up to around USD 11.2 million, making it the most expensive Pizza of all time. Bitcoin reached an important mark in its history when the volume of Bitcoins and their respective value reached USD 1 million on November 6, 2010.54 The first legal concerns associated with Bitcoin arose in 2011 with the emergence of the illegal online marketplace Silk Road.55 On February 9, 2011 Bitcoin makes his next big step towards broader attention by reaching parity with the US Dollar.56 In the next few months several exchange markets for Bitcoin all around the world opened their business. On September 27, 2012 the Bitcoin Foundation57 is formed, an organization with the mission to protect and promote Bitcoin as well as to standardize its software design and infrastructure.58 In March 2013 the price of Bitcoin starts to grow rapid and the development of a speculative bubble becomes apparent.59 Due to the increase in value, Bitcoin becomes more and more attractive for hackers. Therefore, many attacks on bitcoin exchange markets arise in the following years with some of them causing great damages. On February 25, 2014 the largest bitcoin exchange market Mt. Gox abruptly stopped trading. Mt.Gox states that 744,000 Bitcoin were missing due to theft.60 At that day 1 BTC was traded for an average of 135 USD.61 In December 2013 the Chinese government banned financial Institutions from trading Bitcoins. The Chinese government also ordered every bank to close all accounts opened by operators of websites that trade Bitcoins, by April 15, 2014.62

4.2 How Bitcoin works

Bitcoin is a decentralized virtual Cryptocurrency that does not rely on any central authority issuing or controlling the amount of money.63 As with every Cryptocurrency, Bitcoin is protected by cryptographic algorithms. Bitcoins are traded over a peer-to-peer network, which includes all users that run the Bitcoin client.64

The users account in the Bitcoin network is called the wallet and works like an actual wallet in real life. It basically stores your money (in this case Bitcoins) and must be protected from loss and thievery.65 However, it doesn’t actually store Bitcoins since they are only transaction information comparable to a balance in a ledger (see Figure 3). There is a major difference between accounts in the Bitcoin network and an account held at a bank. The balance of a bank account is in principle merely visible to the bank and the owner of the bank account. Under blockexplorer.com every transaction ever made by each of the users in the Bitcoin network is shown. Figure 3 reveals the first transaction ever made with details such as the addressee and the amount of Bitcoins transferred. Basically everyone is in possession of a ledger containing all the transactions ever made. The users are not directly identifiable since they are only listed as long strings of numbers and letters better known as key´s.

illustration not visible in this excerpt

Figure 3: First Bitcoin transaction ever made known as the “Genesis Block”66

Each user owns a set of private and public keys that are corresponding with each other. Simply put, the public key works like a bank account number and is also labeled as a persons address (see Figure 4). If person A wants to transfer money to person B, he signs a message with his private key and sends it to B´s public key. Person B will then validate the truthful ownership of this public key with his private key. The public key can be seen as a temporary password that you can share without revealing your actual password, which is your private key.67

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Figure 4: Example of a public key

It is important to remember that no entity such as a bank has control over the processes involved in a transaction. Because there is no entity to trust on, an algorithm ensuring safe transactions needs to be implemented. This is partially established by the keys, however certain components still need to exist for a transaction to work. Figure 5 illustrates that if person A sends person B money in forms of Bitcoins, he will initially create a message with the information including how many Bitcoins to send and B´s public key. By doing so, person A is able to create a Signature, which is uniquely composed out of A´s message and private key. This Signature is generated by a mathematical function and is unique for every single transaction. These Signatures are comparable to those of a money transfer via bank, yet they are digital and not copyable.

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Figure 5: Simple illustration of a Bitcoin transaction68

4.2.1 Double spending

Solving the problem of double spending is one of main focuses of Satoshi Nakamotos publication in 2008. In order to understand the solution one must first understand the actual problem. The root of the problem is the matter of transaction order. Imagine person A giving out checks with the same value to two other persons B and C. However, person A only has enough money in its bank account to cover one of these checks. Under these

circumstances only one person (B or C) will be able to cash the check at the Bank and the other person will be refused. 69 In this example time determined if person B or C were able to cash the check. The Bitcoin network is globally connected and a transaction will never proceed as directly as shown in Figure 5. It will transfer indirectly over a lot of nodes to the final destination. The point of time a transaction was originally caused is not perfectly identifiable and could even be manipulated.

If person A would buy products in exchange for Bitcoins from person B and C, the problem of double spending could potentially occur. “Network delays might cause transactions to arrive in different orders in different places”70, causing persons B and C to think they received their payment first and ship their products. As a result, if person A only had sufficient funds for one product he would receive both products for paying only once.

To eliminate the problem of double spending Satoshi Nakamoto introduced the following solution. When transferring money from one user to another all the ledgers in the Bitcoin network are registering that transaction. In the Bitcoin network, transactions are gathered in Bitcoin blocks.71 “A block is a record of some or all of the most recent Bitcoin transactions that have not yet been recorded in any prior blocks”72. The blocks are linked together in a form of a block chain, which records all executed transaction that ever took place in the network.73 All current transactions in the Bitcoin network can be viewed on blockchain.info.

As Figure 6 shows, each transaction passes nodes that will perform hash algorithms and forward the transaction after a succeeded validation. “Cryptographic hash functions take input strings of arbitrary length and map these to short fixed length output strings”74.

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Figure 6: Advanced illustration of a Bitcoin transaction75

These hash functions act like mathematic problems that need to be solved in order to verify a block. Finding the solutions of these hash functions demands lot of computing power. Users all over the Bitcoin network contribute by calculating the hash function with their computers. You can think of this mathematical problem as a kind of a race. For a fraudster to successfully affect the creation and content of blocks, he ought to be able to posses the majority of computing power than the total Bitcoin network in order to solve the hash function first.76 Further explanation of the cryptographic hash function is available in section 11, p. 74.

4.2.2 Creation of Bitcoins

The creation of Bitcoin is closely associated with the matter of preventing double spending. As explained in section 4.2.1 the verification of a block demands a lot of computing power. Hence, it is often compared to the extraction of gold from the ground and ultimately called mining. Users over the Bitcoin network contribute by solving mathematical problems to verify blocks. If a user successfully solves a problem (consequently verifying a block) he will receive compensation in form of Bitcoins. This is not done by manual labor but by operating the adequate mining hardware and software. Solved blocks are added to the block chain. Since the Bitcoin network has many miners it can happen that multiple blocks are solved at the same time but only one can be added to the block chain. The Bitcoin protocol is designed to always work on the one it thinks is the longest block chain.77 Figure

7 illustrates that if multiple blocks are solved the Bitcoin network will build its block chain on the next blocks that are solved faster. For miners “the general rule is that you always immediately switch to the longest branch available“78. Transactions that were in a block that didn´t got placed in the block chain will eventually be processed in the next block until they are included in the block chain. This method keeps the transaction order synchronized throughout the decentralized network. In the Bitcoin network blocks will be solved at an average of one every 10 minutes.79

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Figure 7: Simple Illustration of the block chain80

4.2.2.1 Difficulty

The term difficulty in regard to mining stands for a “measure of how difficult it is to find a hash below a given target”81. Simply put, it describes the extent of computing power necessary to solve a hash function and verify a block.

The supply of Bitcoins is limited to a total of 21 million.82 In order to guarantee a steady provision of Bitcoins, the level of difficulty rises. Figure 8 illustrates the level of difficulty during the past year. After an increase of transactions within the Bitcoin network in November 2013 a skyrocketing of the difficulty becomes apparent.

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Figure 8: Bitcoin Difficulty83

4.2.2.2 Mining

In order to obtain Bitcoins by mining, no specific software and hardware is required. Basically everyone can become a miner, as long as he owns a basic computer and provides its processing power to the Bitcoin network.84 The calculation of a hash function is also known as “finding a block”85.

The level of difficulty is often described with a required hash rate. The hash rate is the “measuring unit of the processing power of the Bitcoin network”86. The higher the hash rate the higher the demanded computing power and ultimately the time that your computer requires to complete tasks. While in the early days a simple setup of computers was sufficient for mining Bitcoins, it has become more and more necessary to acquire additional equipment. Figure 9 illustrates basic equipment for Bitcoin miners. It enhances the computing power of computers and increases the speed of which it is able to find blocks.

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Figure 9: USB Bitcoin ASIC Miner87

“The coin value of a block is 50 BTC for each of the first 210,000 blocks, 25 BTC for the next 210,000 blocks, then 12.5 BTC, 6.25 BTC and so on“88. This system of reward also defines the total number of Bitcoins in existence and leads to a finite supply. Block 210,000 has been mined on November 28, 2012 so that the reward for finding a is now 25 BTC.89

4.2.2.2.1 Solo Mining

Solo mining only utilizes the resources of one users Hardware. All the Bitcoins generated by finding blocks are entitled to the solo miner. However, increasing hardware requirements and thereof increasing costs are making solo mining less profitable.

4.2.2.2.2 Pool Mining

Pool mining has become more and more common in the past due to increasing hash rates. It internalizes the concept of strength by the numbers and enables small miners to become part of a community and absorb small pieces of the large cake. Miners that are operating in mining pools will usually get paid Bitcoins by their share of computing power they submit to the pool.90 There are also websites that offer certain amounts of computing power that you can add to your mining account (whether solo or pool) at a monthly fee.

4.2.2.2.3 Time and costs

There are multiple factors influencing the costs per Bitcoin including costs of electricity, the level of difficulty, the equipment and a hard calculable component namely luck. This is why the definition of a general formula calculating the costs is a hard task.

The basis for successful mining of Bitcoins lies in possessing the adequate equipment. While usual computers where sufficient in the early days, an economically sustainable mining of Bitcoins is now impossible without investing into specific equipment also known as a mining device or a miner. The market supplying these miners has developed rapidly in the last years as more people were chasing the possibility of easy money related with Bitcoin mining. The processing power of these miners is indicated with Hashes it can solve per second (H/s). The term Hashes actually describes the number of guesses a computer can make to solve a math problem. Figure 9 illustrates a basic USB Bitcoin miner with 336MH/s (336 mega Hashes equals 336,000,000 Hashes).91

The difficulty is a number calculated out of a required Hash rate that is needed to solve a block. After 2016 solved blocks the difficulty will change to a different value, resulting in a different required Hash rate.92 The level of difficulty depends on the time it took to solve these 2016 blocks. If the current series took longer time to solve 2016 blocks than the previous the difficulty will drop. If the current series took less time than the previous the difficulty will rise. Since more and more people are joining the mining business those blocks are getting solved at a faster pace. This means that the difficulty increases and the before mentioned equipment might become slow or obsolete.

Many miners are active in the Bitcoin community and their success on finding a block might not only depend on the power of their equipment but also on luck. Let´s look at the example of throwing a pair of dices with the goal of each showing the number 6. Individual A can only throw one time each turn while individual B is able to throw two times.

[...]


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19 Mehta, Principles of Money and Banking. p. 16

20 Gary Rabbior, (1994). p. 8

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22 Ibid. p. 622

23 Dr. Dwivedi, (2005). p. 188

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25 Otmar Issing et al., (2001). p. 67

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27 Deutsche Bundesbank, "Das Buchgeld: Geldschöpfung," [Accessed May 2, 2014].

28 Ibid.

29 Peter Moles, (1997). p. 464

30 Deutsche Bundesbank, "Das Buchgeld: Geldschöpfung".

31 "Glossary: Book money," [Accessed May 2, 2014].

32 Dwivedi, Macroeconomics: Theory and Policy. p. 189

33 Otmar Issing, (2001).

34 Deutsche Bundesbank, "Mindestreserven," [Accessed May 2, 2014].

35 John Stevenson, (2013). p. 6

36 Bitcoin.it, "History," [Accessed June 30, 2014].

37 Alec Liu, "Who's Building Bitcoin? An Inside Look at Bitcoin's Open Source Development," [Accessed July 3, 2014].

38 Andrew Grant, "Open vs. Closed Source Software," [Accessed July 3, 2014].

39 Amel, "SOD: Sistem Operasi," [Accessed June 30, 2014].

40 Liu, "Who's Building Bitcoin? An Inside Look at Bitcoin's Open Source Development".

41 Ibid.

42 Coinmarketcap.com, "Crypto-Currency Market Capitalizations," [Accessed July 3, 2014].

43 Altcoins.com, "Altcoins," [Accessed July 3, 2014].

44 Lisa Melnik, "Bitcoin: The Future of Currency or Speculative Bubble?," [Accessed June 30, 2014].

45 Auroracoin.org, "A nation breaks the shackles of a fiat currency," [Accessed July 3, 2014].

46 Satoshi Nakamoto, "Bitcoin: A Peer-to-Peer Electronic Cash System," (2008). p. 1

47 Adrianne Jeffries, "The New Yorker’s Joshua Davis Attempts to Identify Bitcoin Creator Satoshi Nakamoto," [Accessed May 15, 2014].

48 John Kelleher, "Who Is Satoshi Nakamoto, Mysterious Bitcoin Founder?," [Accessed June 12, 2014].

49 Bitcoin.org, "About bitcoin.org," [Accessed May 15, 2014].

50 Andrea Peterson, "Hal Finney received the first Bitcoin transaction. Here’s how he describes it.," [Accessed May 15, 2014].

51 Ibid.

52 Eric Mack, "The Bitcoin Pizza Purchase That's Worth $7 Million Today," [Accessed May 15, 2014].

53 Rob Wile, "These Infamous 'Bitcoin Pizzas' Are Now Worth $6 Million," [Accessed May 15, 2014].

54 Blockchain.info, "Marktkapitalisierung," [Accessed May 15, 2014].

55 Nicolas Christin, "Traveling the Silk Road: A measurement analysis of a large anonymous online marketplace," (2012). p. 3

56 Timothy Lee, "Five years of Bitcoin in one post," [Accessed May 15, 2014].

57 See https://bitcoinfoundation.org for additional information

58 Bitcoinfoundation.org, "Our Mission," [Accessed May 16, 2014].

59 Blockchain.info, "Handelspreis (USD)," [Accessed May 15, 2014].

60 Ruairidh Villar, Sophie Knight, and Brett Wolf, "Bitcoin exchange Mt. Gox goes dark in blow to virtual currency," [Accessed May 16, 2014].

61 Bitcoincharts.com, "Mt. Gox (USD)," [Accessed May 16, 2014].

62 Sophie Song, "The Rise And Fall Of Bitcoin In China: Central Bank Shuts Down All Chinese Bitcoin Exchanges," [Accessed May 21, 2014].

63 Nakamoto, "Bitcoin: A Peer-to-Peer Electronic Cash System." p. 1

64 Daniel Kerscher, (2013). p. 8

65 Ibid. p. 11

66 Onbitcoin.com, "Bitcoin Milestone: The Blockchain Turns Five Today," [Accessed June 22, 2014].

67 Scott Driscoll, How Bitcoin Works Under the Hood, (2013).

68 "How Bitcoin Works Under the Hood," [Accessed May 22, 2014].

69 How Bitcoin Works Under the Hood.

70 Ibid.

71 Piotr Piasecki, "Design and security analysis of Bitcoin infrastructure using application deployed on Google Apps Engine". p. 8

72 Bitcoin.it, "Blocks".

73 Piasecki, "Design and security analysis of Bitcoin infrastructure using application deployed on Google Apps Engine." p. 8

74 Henk Tilborg van and Sushil Jajodia, (2011). p. 543

75 Nakamoto, "Bitcoin: A Peer-to-Peer Electronic Cash System." p. 2

76 Driscoll, "How Bitcoin Works Under the Hood".

77 Scott Maxwell, "Bitcoin algorithm - A Brief Description," [Accessed June 26, 2014].

78 Driscoll, "How Bitcoin Works Under the Hood".

79 Bitcoin.it, "Blocks".

80 Maxwell, "Bitcoin algorithm - A Brief Description".

81 Bitcoin.it, "Difficulty," [Accessed May 26, 2014].

82 "Controlled supply," [Accessed November 4, 2014].

83 Created by Excel with data from Blockchain.info, "Schwierigkeit," [Accessed May 27, 2014].

84 Bitcoin.org, "Some Bitcoin words you might hear," [Accessed May 26, 2014].

85 Devtome.com, "Mining Pools vs Solo Mining," [Accessed May 26, 2014].

86 Bitcoin.org, "Some Bitcoin words hou might hear," [Accessed May 26, 2014].

87 Amazon.co.uk, "ASICMINER Block Erupter 336MH/s - 4th Generation - ASIC USB Bitcoin Miner," [Accessed June 15, 2014].

88 Bitcoin.it, "FAQ: What's the current total number of bitcoins in existence?," [Accessed June 18, 2014].

89 MineForeman.com, "Dissecting Bitcoin Block 210,000," [Accessed June 18, 2014].

90 Devtome.com, "Mining Pools vs Solo Mining".

91 Amazon.co.uk, "ASICMINER Block Erupter 336MH/s - 4th Generation - ASIC USB Bitcoin Miner".

92 Blockchain.info, "Schwierigkeit".

Excerpt out of 96 pages

Details

Title
Economic Analysis of Cryptographic Currencies on the Basis of Bitcoin
College
Rhine-Waal University of Applied Sciences
Grade
1,3
Author
Year
2014
Pages
96
Catalog Number
V283747
ISBN (eBook)
9783656855200
ISBN (Book)
9783656855217
File size
3944 KB
Language
English
Tags
Bitcoin, Economic Analysis, Bitcoins, Cryptographic Currency, Cryptocurrency, Cryptocurrencies, Economic, money laundering, litecoin
Quote paper
Snorri Christian Glaeser (Author), 2014, Economic Analysis of Cryptographic Currencies on the Basis of Bitcoin, Munich, GRIN Verlag, https://www.grin.com/document/283747

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