The Bitcoin Basics all Articles and
YouTube Videos Cover
There are many articles and "explainer" videos out there that
give an introduction to Bitcoin, Cryptocurrency and Blockchain. If you
are like I was, after reading or watching, you are left with the feeling:
"I still don't get it". Most of these pieces do, however,
provide at least a starting point to understanding the key concepts. The
basics are as follow (with editorial comments sprinkled throughout):
Digital Currency
Bitcoin, and other cryptocurrencies are digital currency. They are
virtual. They are made of code, and not represented by paper notes, or
metal coins (fiat currency). Many sources point out that digital
currencies have been around for a while. The concept was introduced in a
1983 paper by David Chaum. A number of digital currencies were created in
the 1990's including Digicash and e-gold.
PayPal is considered by some to be a form of digital currency. In
essence, PayPal simply provides a ledger account (or “wallet”) which you can
add traditional money to. You can then use the PayPal system to transfer
money to, or receive money from, other PayPal accounts. Finally, you can
withdraw money from your PayPal account. To me, PayPal is not true
digital currency. You can use the PayPal system to transfer traditional
currencies (U.S. Dollars, Japanese Yen), but you are not making use of any
alternative currency. There are no "PayPal Bucks" that stand on
their own to be used to purchase goods and services. At least, not yet.
The Mysterious Satoshi Nakamoto and the
"Double Spend" Problem
In 2008, Bitcoin was introduced. It's invention is credited to
Satoshi Nakamoto of Japan. It is widely believed that "Satoshi
Nakamoto" is a pseudonym representing one or more people, likely not even of
Japanese origin.
The key feature of Bitcoin is its method of solving the "double
spend" problem inherent with other digital currencies. The double
spend problem is this:
If digital currency is just a piece of code, then what is to stop
someone from making one or more copies of that code, and then spending the same
piece of digital currency multiple times? Of course traditional
currencies face the double spend problem too. It's called
counterfeiting. Take a one hundred dollar bill, make a copy. Spend
two hundred dollars. National mints are constantly working to make
traditional currency more difficult to counterfeit. Banks and merchants
are constantly working to develop methods of detecting counterfeit
currency. Counterfeiters are constantly working to make better
counterfeits.
Digital currencies were especially susceptible to the double spend
problem because a copy of a piece of code, and the original piece of code, are
indistinguishable. There is no physical substance you can try to imbue
with special properties to make it more difficult to counterfeit.
Bitcoin solved the double spend problem through use of a public
decentralized blockchain ledger.
What is Blockchain?
A blockchain is a creation of math and cryptography. It is a public, sequential, decentralized ledger of transactions. It is public in that anyone with internet access can access the blockchain. It is sequential in that transactions are added to the "chain" in sequence. It is decentralized in that the ledger is not stored in one specific place. It is resident across a network of devices.
In the case of bitcoin, the blockchain is a record of every bitcoin transaction ever completed. For each bitcoin transaction, a record including the date of the transfer, the amount of bitcoin transferred and the bitcoin wallets involved in the transaction (the "from" and "to" wallets) is created and added to the chain. Each record is identified by a "hash", which is basically a transaction ID number. There are many third-party websites (eg. blockchain.com; blockcypher.com) that will provide details of any bitcoin transaction if you can provide the hash.
Bitcoin Mining
Mining is an important component of the bitcoin concept. Bitcoin mining can be done by anyone with
appropriate computer hardware and open source software. Mining is the process by which new bitcoins
are “released”. There will only ever be
21 million bitcoins created, the last of which projected to be released in the
year 2140. There currently have been
around 17 million bitcoin released.
A miner uses computer power to verify past bitcoin transactions, or
hashes. The miner is rewarded for
successful verifications in newly created bitcoin. By design, mining rewards are increasingly
difficult to earn. Miners must devote
considerable computer power and electricity to earn rewards. Currently, it takes approximately $4,700 worth
of electricity to mine one bitcoin in the United States.
Is Bitcoin Money?
One of the staring points of many introductory discussions of bitcoin is the question of whether bitcoin is really "money" or not. Invariably, the commonly agreed-to characteristics of money are listed.
Money is a social construct that serves three purposes:
First, money serves the purpose of being a medium of exchange that can
be easily traded in a predicable way.
Money offers an improvement over the system of direct barter. In direct barter, if you want some eggs, you
have to find someone with eggs and then get them to agree to take some good or
service you have to offer in exchange for some eggs. The problem – they might not want what you
have to offer at the moment.
Second, money serves the purpose of holding value. In many cases, it is preferable to holding
your wealth in the form of some good, especially if that good is perishable, or
difficult to secure.
Third, money serves as a dependable unit of account. Money is a convenient way of keeping track of
debts between parties and to quantify values.
Money has four main properties:
1. Money has to be
scarce in order to have value
2.
Money has to be easily portable and transferable
3.
Money has to be durable (non-perishable)
4. Money has to be
divisible
So how does bitcoin “stack up” against traditional currencies?
Scarcity? Check. Bitcoin has built-in scarcity in that only a
finite number of bitcoin will ever be released.
Also, new bitcoins are increasingly harder to create through the mining
process. This is by design. The mathematical problems a miner is required
to solve to “earn” a new bitcoin get increasingly more difficult as time
passes. This requires the miner to use
more computing power, and more electricity.
This feature makes it unlikely that disproportionately high numbers of
new bitcoin will be released at any given time.
On the scarcity scoreboard, it would seem that bitcoin wins over
traditional non-gold-backed currencies.
In the case of the latter, governments are free to print as much new
currency as they want.
Portable and transferable?
Check. Bitcoin is portable on
digital wallets that reside on the ubiquitous smart phone. Bitcoin can also be “cold stored” on paper
wallets not connected to the internet.
Bitcoin is easily transferable from wallet to wallet through use of any
internet enabled device. On the
transferability point, one of its largest selling features is how inexpensive
it is to transfer bitcoin when compared to the transfer of traditional currency
through use of expensive intermediaries like banks and EFT service providers.
Durability? Check – mostly. Bitcoin is durable in that it has no physical
embodiment such as a paper bank note, or a metal coin that can be torn up,
soaked, burned, or placed on a railroad track to be flattened. On the other hand, stories and legends abound
of bitcoins lost when their host hard drives or thumb drives are destroyed or
thrown away by now ex-girl/boyfriends.
Also, one of the largest knocks against bitcoin is the frequency, and
seemingly relative ease, with which they are stolen by hackers. I myself was a victim of the 2014 Mt. Gox
hack (more on that in a future post).
All that being said, I am not
sure that these instances really highlight a lack of “durability” of bitcoin,
so much as storage and security concerns.
The durability referred to in the context of discussing desirable
properties of money, is more to do with its non-perishable nature. To illustrate, bananas would not score highly
on the durability-as-a-desirable-property-of-money scale. A banana is arguably just as durable as a
paper bank note in terms of how difficult it is to destroy (which is to say,
not very). A paper bank note however,
will not decay into a slimy mess after a few weeks. As compared to a banana, a paper bank note
would be considered non-perishable. In
this way, a bitcoin is relatively non-perishable, and hence durable in this
context.
Divisible? Double-Check. To be a
desirable form of money, the subject must be easily divisible. For ease of commerce, one must be able to
easily “make change” in transactions where the value of the good or service in
question does not exactly match the primary denomination of the currency. Bitcoins are divisible to eight decimal
places (0.00000001 BTC). At the current
market price, the smallest denomination of bitcoin is worth $0.000065 USD. It appears that bitcoin has USD beat in terms
of divisibility.
Is Bitcoin a "Bubble with No Value"?
The debate continues as to whether Bitcoin is a bubble with no
non-speculative value with frequent references to the Dutch tulip mania of the
1600s. The main arguments of the Bitcoin
detractors are:
1. Bitcoin is not backed
by any government
2. Bitcoin has no
intrinsic value
3. Only criminals use
bitcoin
4. Bitcoin is too
volatile to be of use as currency
Bitcoin is Not Backed by any Government
This point seems theoretically important, but is less relevant given
that bitcoin is currently trading above $6,000 USD. Most if not all market participants are aware
that the bitcoin they are trading in is not government-backed. Many bitcoin-believers point to the
non-government nature of bitcoin as a plus.
They welcome a currency not tied to any one government and not subject
to the monetary policies of said government.
Of course government actions could damage bitcoin’s current value and
become obstacles to its adoption as a mainstream currency. Governments could easily restrict or outright
ban the use of bitcoin through regulation.
Governments such as Algeria, Bolivia and Ecuador have outright banned
the cryptocurrency. In other countries
such as Canada, Jordan and India, certain banks have restricted the use of
their credit or debit cards from buying or selling bitcoin.
I do not believe that the non-governmental nature of bitcoin means that
it cannot be a valuable currency. The
internet itself is non-governmental in nature and its value is indisputable. Like bitcoin, certain governments do actively
regulate use of the internet in their jurisdictions. Like many things, cryptocurrency will remain
a topic of debate over government regulation vs. individual liberties.
Bitcoin has no Intrinsic Value
Paper fiat currency has negligible intrinsic value. In the case of metal fiat currency, the
intrinsic value of the metal may be more significant. However, we have moved away from valuing
metal currency based on the actual weight and composition of the metal itself. Like paper currency, metal currency is
primarily a representation of value.
Before 1971, the US dollar was a least partly tied to the value of
gold. This is no longer true for the
United States and further, no other country is on the gold standard at
present. Given the current state of
things, neither fiat currency, nor cryptocurrency, have real intrinsic
value. Their values come from a
consensus among people who agree to use these currencies in value transactions.
Only Criminals use Bitcoin
The anonymous nature of bitcoin transactions would be appealing to
criminals. The same is true for hand-to-hand
cash transactions. Crypto-nerds point
out that bitcoin is not actually anonymous, but pseudo-anonymous. All bitcoin transactions are recorded as part
of the blockchain. Details recorded
include the numerical addresses of the sender’s wallet and the recipient’s
wallet. The anonymity part comes in
because bitcoin wallets can be created without the user linking his or her
personal information to the wallet.
The bigger point is that criminals are not the only users of
bitcoin. Mainstream retailers, including
Expedia, Subway and Shopify, have started accepting bitcoin as a form of
payment. Many investment firms and funds
have moved into the cryptocurrency space.
The air of criminality does not appear to be a major impediment.
Bitcoin is too volatile to be of use as a Currency
This is one of the biggest obstacle to the mainstream adoption of
bitcoin, in my view. It is a problem for
both purchasers and vendors. Bitcoin has
had many days in 2018 where the intra-day trading range was over $1,000 with
wild swings both up and down. With such
volatility, the purchaser is wary about spending bitcoin today that could be
worth much more tomorrow. Conversely,
the vendor is wary about accepting bitcoin today that could be worth much less
tomorrow.
The volatility in the price of bitcoin is fuelled by speculators. Speculation plays a big role in the
volatility of traditional currencies, but cryptocurrency is unique in that
speculative transactions would seem to out-number actual commercial
transactions (the purchasing of goods and services). Intense speculation is to be expected with
any new technology. It’s paradoxical
that the speculation as to bitcoin’s future value is actually a hindrance to
it’s future value – as a means to complete commercial transactions.
Conclusion
So, those are the basics. Future
posts will dig deeper into more narrow issues being grappled with by
cryptocurrency and blockchain developers, users, and regulators.
Disclaimer: the author believes that the statements of fact are accurate. Statements of opinion are the author's own. This content is not intended as financial, investment, legal, or other professional advice. The reader is cautioned to undertake his or her own due-diligence before making any investments or conducting any business related to cryptocurrency and/or blockchain.
© Copyright 2018, Michael D. Klinck. All Rights Reserved.
