Everyone’s talking about Bitcoin and the cryptocurrency market lately. Get in on the conversation with this brief intro.
Cryptocurrencies, crypto-assets, crypto-trading, the cryptocurrency market… It’s practically a whole other language, and questions abound. How does it work? What is it backed by? Is it a government trap in disguise? Does it make it easier for someone to steal my money? Is paper money dying? Every time I’ve gone to a party or gathering recently, these questions have hovered over the conversation like a heavy cloud. So in an attempt to help you sound like the smartest person in the room, I’m gonna try to break it down for you in humanspeak. Steal at will.
What the hell is cryptocurrency?
You might’ve heard that cryptocurrency is the “currency of the internet” or “email for money.” Some even call it electronic cash or digital gold, which is fine. It’s also regarded as a medium of exchange, a basis for trade, and merely a digital ledger. In essence — it’s just math. But to better understand what it is, let’s discuss the problem it solves, in theory.
Let’s say you’re running an online business selling digital products, such as MP3 files or e-books for download. Sure, you could go through a vendor like Stripe or PayPal to accept credit card payments, but that also involves a bit of risk for both you and your customer. For example, you’ll be gathering a ton of personal information about your buyer that you don’t necessarily need, such as their name, address and credit card details. As the seller, you are expected to keep that information secure, which can be harder than it sounds.
Plus, it puts you at the mercy of various third-party entities. You’ve got to be able to trust that PayPal or whoever will uphold the transaction, that the banks will process it quickly and, more importantly, that your buyer (a) has the appropriate funds in their account and (b) can’t cancel the transfer of funds after downloading your product. Add to the mix that credit cards (and even PayPal) charge processing fees that can reach around 3-5%. That’s a hefty chunk of change for small-sum transactions, which tend to be many — if not the majority — of online sales. Moreover, it can take three to five business days for credit cards to process the transaction and get that money into your account. It can be faster in the case of vendors like PayPal, but they’re not always ideal.
Bitcoin and other cryptocurrencies strive to solve these issues. By cutting out the middleman, you can do business directly with your customer. Funds are transferred directly from their digital wallet to yours. Your customer can even maintain anonymity, if they choose, and all transactions are secure thanks to the blockchain, which we’ll get into later. You can also access your funds quickly without having to worry about double-spending, chargebacks, fraud, lack of privacy, or being at the mercy of a centralized third party.
Consider this: Let’s say you happen to run a business that’s not illegal but is certainly frowned upon by the global banking system or even major governments. Take Wikileaks, for example. After they published U.S. diplomatic cables in November 2010, the publishing organization found themselves blocked by Western Union, PayPal, Bank of America, Visa and MasterCard as a result of heavy political pressure. This financial blockade ultimately attempted to censor these journalists, with donations being brought to a screeching halt. However, Bitcoin enabled the organization to continue operations outside of mainstream channels, government scrutiny, and third-party involvement.
In this regard, Bitcoin and other cryptocurrencies could help to balance the scales for organizations fighting against war, government corruption, and the stranglehold of a centralized global banking system. This is why many early adopters of cryptocurrencies, such as Bitcoin, believe this technology could cause a paradigm shift in which the entire world might reorganize itself, and that this is just the beginning.
That’s cool and all, but how can I trust it? It’s not backed by anything… It’s just numbers.
Here’s where things get really interesting. True, Bitcoin and other cryptocurrencies are not “backed” by anything. There are no physical coins, it’s not tied to paper money, and banks are not involved, for the most part. All Bitcoin truly is, at its core, is a public ledger documenting the transmission of economic information throughout the network. Sure, one Bitcoin is worthless, just as a single telephone independent of a network would be worthless; but the power of Bitcoin comes from the global community that has essentially opted in and decided to use it as a means of conducting trade. And the only reason Bitcoin has value is that this network has allowed supply and demand to dictate that value. In addition, because a finite number of Bitcoins will ever be created, independent of the centralized debt-based financial system we’ve known since governments abandoned the gold standard, Bitcoin should be immune to inflation in the sense that the money supply itself will not inflate. No one is “printing” or creating more coins.
But to discuss trust is to ultimately critique what we’ve previously trusted. On the one hand, Bitcoin was created to solve a trust problem. As Satoshi Nakamoto, the secretive creator of the famed cryptocurrency, wrote in his original paper, “What is needed is an electronic payment system based on cryptographic proof instead of trust.” But what trust is he referring to here? Well, take gold for instance. We trust that gold has some intrinsic value; however, if we valued gold only for its industrial uses, it would not be worth its current trading price, since the supply greatly exceeds industrial demand. In addition, gold is a difficult medium of exchange, especially for small transactions. So why do we trust its value? Gold isn’t “backed” by anything at all, except our belief and agreement that it’s worth something. Also, it’s wasteful to mine gold from the ground, melt it into bars, then store it underground once more, no?
Next, consider paper money, or fiat currency. Sure, a currency by definition is merely a convenient unit of account; but fiat currency is not “backed” by anything other than a government’s promise of value. It other words, fiat is only worth something because the government declares that it is — not because it has some intrinsic value. Furthermore, fiat money is a debt-based system that uses interest rates set by a central bank, such as the U.S. Federal Reserve, to control inflation. However, the majority of fiat money is not cash (90% is never printed). Instead, these sums are merely represented as digits on a banking interface. As monetary scientist and investor Trace Mayer pointed out, “When you log into your online banking and you see that you’ve got digits in there, why do you trust that?”
On the flip side, no one really knows who Satoshi Nakamoto truly is; yet we’re expected to trust that he’s not a representative of a government agency, entity or worse. So while Bitcoin is meant to remove trust from the digital commerce equation, we’re asked to trust that the creator of the system isn’t trying to trap us. (Of course, if you’re interested in this particular topic, check out comedian Lee Camp’s recent segment on Bitcoin. It’s both informative and hilarious.) However, unlike traditional currencies, Bitcoin is mathematically provable and is bigger than a single person. So maybe we don’t need to trust Satoshi Nakamoto. Maybe all we need to trust is the code itself and the proof-of-work within the blockchain.
But how does it work?
Check out this great analogy for how Bitcoin works, which I can’t top.
Now, for the scope of this article, it’s important to reemphasize that Bitcoin is little more than a ledger. The history of transactions is the currency. And while Bitcoin is valuable because of trade, supply, demand and the people who choose to use it for their own economic purposes, the true value of cryptocurrency lies in the blockchain technology that makes it work.
Consider Ethereum, which some are calling the successor to Bitcoin. This up-and-coming cryptocurrency uses a blockchain to facilitate peer-to-peer contracts and applications while offering users the opportunity to create their own currency vehicles. (Cryptokitties is one example.) Yet while both Bitcoin and Ethereum utilize blockchain, Bitcoin is meant to be an alternative to regular money and a medium of payment, whereas Ethereum enables developers to build and run distributed applications. They’re different things with very different intentions ultimately running on the same technology. But what is this technology?
To oversimplify a very detailed system, a blockchain is a network of computers all maintaining the same history of transactions, or ledger, which enables peer-to-peer trade at scale without dependence on third parties. And all the computers within this network are continuously communicating with each other to guarantee transactions as they occur to provide proof-of-work. Ultimately, it’s a massive accounting system that promotes transparency and privacy at the same time, meaning you may not know exactly what happened, but you have proof it occurred. And instead of being owned by a central agency or a single individual, this system is owned by everyone involved.
As for blockchain security, in the case of Bitcoin, this network is maintained by military-grade cryptography, which is beyond the scope of this piece; however, in the case of stolen or lost Bitcoins, know that these occurrences have far more to do with an insecure digital wallet and human error than they do with the blockchain breaking down. In fact, many in the tech industry are most excited about the possibilities presented by blockchain entering a variety of industries, since it appears to reduce risk, ensure greater regulatory compliance, and lower costs for developers. As a result, it’s the hottest new thing in the tech world. (Here’s a video to better help you better understand the finer details.)
So should I invest?
Whether you should invest is completely up to you and your risk level. Like most things, Bitcoin and other cryptocurrencies are not guaranteed success, and there are issues that we still need to address. For example, the value of Bitcoin tends to fluctuate dramatically. The cryptocurrency was valued at almost $20,000 per coin in December 2017 only to plunge to under $7,000 in February 2018 before rising to a little over $10,000 a few weeks later. Clearly, it’s not a very stable currency at this time. And while transaction fees are optional, they can fluctuate drastically from very low to very high. In some cases, a lower fee could mean your transaction won’t be processed for days. In addition, this time lag gives more traditional payment processing tools the upper hand, while fees ranging from $20-30 often make Bitcoin impractical for small online transactions.
As Emin Gun Sirer, professor and cryptography researcher at Cornell University, points out: the Bitcoin network is processing an average of three transactions per second, which pales in comparison to the 3,674 transaction that the Visa credit card network can process in the same time. Granted, this is an area of opportunity for Bitcoin and other cryptocurrencies, but it will take time to see if the network can actually solve this particular problem, and that makes for a risky investment. Then, there are the energy concerns that come with mining for Bitcoins. For example, in Iceland, where Bitcoin mining is exceedingly popular, the energy required to maintain this cryptocurrency network is set to exceed the energy required to maintain all the homes in that area. Some are claiming that these energy needs are wasteful and dangerous, while others are excited that someone is at least using uncommitted energy no longer required for homes equipped with LED bulbs and other energy-saving tools. Again, only time will tell whether this makes Bitcoin a success or tragic failure.
And while the benefits of cryptocurrency mentioned previously are great in theory — that Bitcoin and others are a “new paradigm of value” — it’s also important to heed warnings from others. For instance, some crypto-enthusiasts are cautioning the demise of Bitcoin, while their eyes glow with excitement at the thought of Ethereum. On the other hand, noted political economist and straight-talking Scotsman Mark Blyth is not optimistic about these cryptocurrencies, calling them “gambling assets.”
In a recent interview, Blyth said: “If you got in early, fantastic! God love you…but here’s my line on Bitcoin: (1) Is it money? If you have to explain to someone that it’s money, it’s not money! (2) Is it a store of value? No, it’s too volatile. (3) Is it a unit of exchange? No, because everybody’s hoarding it because they expect the value to go up. (4) Is it a unit of account? Oh, maybe, if you like living in a basement reading dx files all the time, but normal people use dollars. So this is a bunch of rich people buying and selling stuff. That’s all it is. But what about blockchain, the technology behind it? I’ve been hearing this for 10 years and I’m waiting to see the results.”