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Valuation & Litigation Advisor - September 2019

 

Better than Bitcoin?

Contributor: By Kevin Baker, Director, Advisory Services

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The consistent misinformation and lack of understanding surrounding Bitcoin is nothing short of astounding. From blatantly false articles propagated by major media outlets to comments from Warren Buffet who claims Bitcoin is akin to a “gambling device1”, “probably rat poison squared2”, and “only attracts charlatans3.” In response to these media publications and unfounded comments from Buffet, it is important to highlight that ignorance of the law is not a valid legal defense and ignorance of Bitcoin is not an excuse for misinformation. Meanwhile, Bitcoin has already impacted financial statement audits, marital disputes, and challenged the largely outdated evidentiary framework in courts. In order to better understand Bitcoin, it is important to understand what Bitcoin is, why blockchain serves only a small piece of a much larger purpose in Bitcoin, and how these factors play into the essence of Bitcoin.

First, Bitcoin, in its most basic terms is a ledger, or a listing of all transactions, that have taken place since the launch of the Bitcoin network on January 3rd, 2009. A listing of all of these transactions can be found on any block explorer4. A block explorer is a tool used to look up and visualize transactions contained in the Bitcoin blockchain. The blocks on the Bitcoin blockchain are mined in a sequential order and are cryptographically linked which creates the data structure known as a blockchain or a literal chain of blocks. A miner can be thought of as a group or individual who devotes computer resources to solve mathematical problems that help to secure the underlying ledger and add transactions or blocks to the ledger. Blocks of transactions that are added to the blockchain by miners are then stored on nodes, or hard drives connected to the internet with a copy of the complete blockchain. Due to this linkage between blocks, the entire state of the ledger must be stored in order to fully validate a transaction, as all previous transactions are referenced when making a new transaction. This trait of cryptographically linked blocks is one of the main attributes to Bitcoins “unalterable” ledger. It is considered to be unalterable since it would require an infeasible amount of time, money, and miner resources to alter. Speculators allege that only a nation state would be a formidable attacker as the Bitcoin community is likely strong enough to thwart any other organized or corporate effort. It is important to note that, to date, Bitcoin’s ledger has never been successfully altered in a hostile attack. It should also be mentioned that block alterations within the most recent blocks, approximately six with difficulty increasing exponentially every block further back, is actually a way in which the network protocol was designed to find consensus. Consensus ultimately governs the Bitcoin network and is reached by the network protocol from proof of work (POW), fully validating nodes, and miners. Bitcoin’s network protocol is an open source project with its code viewable at code repository Github.com. The network protocol defines certain hard parameters within the Bitcoin network such as block size, block time, and the total number of coins in the network. Any deviation from such parameters by nodes or developers would mean that a participant’s computer is out of consensus with the network protocol and would be shut off from the network at large.

Second, it is important to understand blockchains limited role in Bitcoin. While there is no official governing body to define a blockchain, it seems to be widely accepted that it is a data structure which contains blocks that are cryptographically linked together through Proof of Work5. All blockchains that have tried to replicate Bitcoin’s permissionless, open, and immutable characteristics while attempting to “fix” the low transactions per second count have failed for a simple reason. It is not possible to scale a blockchain without sacrificing one of the characteristics mentioned above. A perfect example of this trade-off can be seen with Bitcoin. Many people are under the impression that Bitcoin could never have more than 5 to 7 transactions per second. What these people fail to realize is Bitcoin could permanently raise the block size to 100x, 1,000x or 10,000x the current level tomorrow and theoretically “process” an infinite number of transactions. The reason this is not a solution to Bitcoin’s low transaction number is that it would centralize the number of nodes on the network to only those that could store an extremely large amount of data and hamper Bitcoins ability to be widely distributed to all parts of the world or easily downloaded in low bandwidth areas. Instead, the decision to compromise on Bitcoins “decentralized” nature has been delegated to solutions such as Bitcoins Lightning Network6 and Liquid sidechain7 that operate on top of the Bitcoin blockchain. Another key piece of Bitcoin’s function is that all inputs used by the network protocol are generated and contained within the network itself. Bitcoins are generated from mining activity in accordance with the protocol and then transferred between wallets without any external data being input to the Bitcoin blockchain. This is critical as any coin or blockchain project that attempts to reference or use inputs from the outside world will have to address the risk of inputting incorrect information into an “unalterable” ledger. This dilemma has been labeled the “oracle problem” and effects smart contracts or any blockchain that attempts to put real world assets onto the blockchain as it introduces data integrity concerns.

It has become clear to any longtime observer in the crypto space that the essence of Bitcoin can be captured in two words: censorship resistance. This single trait perfectly accounts for why all of “Bitcoins shortcomings” and design choices are actually a feature and not a bug. Everything from low transactions per second, 10 minute average block times, the use of electricity to secure the ledger (Proof of Work), was carefully thought out by the anonymous creator Satoshi Nakomoto. These seemingly arbitrary choices ultimately define the backbone of Bitcoin and have established consensus, not only within the code of Bitcoin, but also the Bitcoin community. In my experience providing audit and consulting services to both public and private cryptocurrency companies, I have found that these characteristics are one reason Bitcoin has been so widely adopted. Marcum’s Blockchain Services group provides a wide range of services related to Bitcoin, blockchain, and many associated technologies.

Sources

1. https://www.foxbusiness.com/business-leaders/warren-buffett-bitcoin-is-a-gambling-device
2. https://www.cnbc.com/2018/05/05/warren-buffett-says-bitcoin-is-probably-rat-poison-squared.html
3. https://www.cnbc.com/2019/02/25/warren-buffett-says-bitcoin-is-a-delusion.html
4. https://bitinfocharts.com/bitcoin/explorer/
5. https://cointelegraph.com/explained/proof-of-work-explained
6. https://dev.lightning.community/overview/
7. https://blockstream.com/liquid-faq/

 
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