Some observers say Bitcoin is the Blu-ray of currencies, the one we didn’t want or need but for some reason it popped up anyway. Others see Bitcoin as a much needed substitute for government and market regulated currencies. A departure that was an inevitable result of a technological revolution that democratized everything from government services to buying toilet paper.
Cryptocurrency supporters believe this new money will change the very fabric of commerce. Skeptics wonder whether Bitcoin has any real value. Is Bitcoin really a currency?
Simple questions about cryptocurrencies often produce complicated answers or no answers at all. Let’s start with the simplest, most basic question, how does Bitcoin work?
Cryptocurrencies came into existence to solve problems. The value of any currency springs from our collective willingness to believe a coin or piece of paper with ink on it has a value. If society or markets stop believing in a currency’s value, the value drops.
Take Venezuela as an example. People who were recently considered middle class have been reduced to rummaging through garbage cans to eat. Food, medicine, baby formula and other basic commodities have become too expensive for many citizens. Store shelves are bare.
Inflation hit 800% in 2015 as the national currency, the bolivar, went into free-fall. 2017 saw inflation of 1800% as the bolivar continued to lose what little value it had left.
Legitimate currency exchanges no longer convert bolivars to dollars. Capitol controls make the movement of money into or out of Venezuela nearly impossible.
The Venezuela currency story isn’t new. It’s simply the most recent example of a potential problem any currency, anywhere in the world could face. All government-backed currencies have built-in problems.
These flaws became blatantly apparent in Venezuela but more subtle examples have appeared in places such as Europe and Japan. Case in point, the 2014 European Central Bank (ECB) establishment of negative interest on deposits.
Instead of getting a little money to let the bank hold onto their cash, depositors had to pay for the privilege.
The ECB move was an example of what the European Union was willing to do to prop up the Euro. Without negative interest, the European currency might have ended up like the bolivar.
The Bank of Japan (BOJ) made a similar move in 2016. The BOJ intended to produce inflation where very little existed naturally. The central bank set an inflation target of 2%, which was not being achieved by consumer and durable goods price rises.
Economic forces in Japan were engaged in something of a stimulus frenzy at the time. The central bank doubled its purchases of Exchange Traded Funds (ETF). Government stimulus included spending on welfare, infrastructure and small to medium sized business assistance.
For its part, the BOJ did everything within its power to hit the 2% inflation target. By mid-year, it was generally agreed the needle hadn’t moved. All the government and central bank efforts had produced no measurable results.
In spite of the U. S. dollar’s apparent stability, the green back has lost value due to inflation since the Federal Reserve, the U. S. central bank, came into existence in 1913. In fact, the dollar lost 96% of its purchasing power due to inflation during that time.
While she chaired the Federal Reserve, Janet Yellen was quoted as saying she would not rule out the possibility of negative interest rates in the U. S. Venezuela, Europe and Japan don’t have a monopoly on currency manipulation for two simple reasons. All major currencies rely on governments for stability and governments are finding it increasingly difficult to maintain stable currencies.
Those are the problems (referenced earlier) Bitcoin has set out to solve. There is no government issuing or controlling Bitcoin. Cryptocurrency is global. You might say it’s everywhere and nowhere.
The concept of money was the world-changing technology of its time. If you need proof, consider it’s still working thousands of years later.
History shows us a few important paradigm shifts in the money story throughout the ages. Coins made from precious metals date back to 600 B. C. when King Alyattes of Lydia had coins minted from an alloy of gold and silver called electrum. The coins had a lion’s head, the symbol of Lydian kings, on one side and a mark from the hammer that shaped the coin on the other. These early coins became known as Lydian Lions and they performed the three main functions of money.
1. Medium of Exchange – The coins enabled trade. In a barter system, the two sides needed to find a balance between the values of items they traded. If one was more valuable than the other, they needed to keep track of the difference. You couldn’t expect to trade one chicken for one cow. The cow might be worth ten chickens but if the chicken farmer only had seven chickens, both sides needed to keep track of the three chicken debt.
Currency enabled trade without the need to compensate for transactions involving items of different values. Everything had a value in Lydian Lions.
2. Unit of Account – Coins had different denominations or values. When a buyer and seller agreed to a price for an item, that number of coins became the value of that item. That price was expressed in the units that divided the currency. Today we know what almost everything is worth in dollars.
Lydian Lions had their denomination marked on the coins. There was no longer a need to weigh the gold or silver to determine its value.
3. Store of Value – Unlike livestock, coins were easy to store and didn’t need to be fed. They wouldn’t die over the winter. Merchants of the day could collect coins until the time came to make a purchase.
Coins remained the primary form of currency for more than 1,000 years. One major drawback plagued the coin-based economy as wealth increased. Coins were big and heavy in any significant quantity. If you wanted to make a substantial purchase in some remote location, you had to lug your coin collection along.
The Chinese solved this problem in the 7th century. Traders began issuing paper notes that were redeemable for the coins they had hidden away back home. A few centuries later, the Song Dynasty began issuing government produced bills called Jiaozi. No doubt, the first counterfeiters came along shortly thereafter.
Paper money had plenty of time to develop before the Massachusetts Bay Colony became the first community in America to issue paper money in 1690. The Continental Congress standardized paper currency for all 13 colonies in 1775. Shortly thereafter, in 1772, the U. S. Congress created the dollar and declared it the official U. S. currency.
Prior to the Great Depression, the U. S. Treasury functioned much like the ancient Chinese traders. Paper money was issued against the country’s gold and silver reserves. U. S. dollars were used to buy and sell gold and silver at a fixed price.
The Depression saw prices of everything collapse. The Federal Reserve began to print money that was no longer connected to the price of precious metals. Debasing the dollar stimulated the economy and helped end the Depression.
Debasing currency simply means making the currency less valuable. Prior to 1965 a quarter was made up of 90% silver and 10% copper. The weight of the coin represented the value of those two metals.
Hold one of today’s quarters so you can look at it along the rim, rather than the heads or tails side. You will see a kind of sandwich, copper inside and nickel on both faces, no silver in sight. That coin is a representative of a silver quarter. The underlying metals have little or no value in those quantities. We trust that it will buy 25 cents worth of stuff but the coin itself has been debased.
The final link between the U. S. dollar and precious metals was severed in 1971 when Richard Nixon closed the gold window. Prior to that time, foreign governments could redeem dollars for gold. After Nixon’s move, the only value linked to the U. S. national currency was the “full faith and credit of the U. S. government”. That made the dollar a fiat currency as opposed to a commodity currency like gold or silver.
The value of U. S. currency is now based entirely on trust. Everyone in the world who uses the greenback must trust that the U. S. government will not debase the currency. If we do something to get a dollar today, we trust it will still be worth a dollar next week, next month or next year. But will it?
In 2008 after the collapse of major financial institutions and frightening declines in world financial markets, the Federal Reserve instituted quantitative easing to avoid another Great Depression. In other words, the U. S. just printed more money. With no connection to the value of any precious metal, all that was needed to create that money was to fire up the printing presses.
With the systemic weaknesses of our government-backed currency laid bare, a new idea emerged. This idea replaced governments and bankers with logic and reliable, yet extremely complex, math.
That same year a programmer using the name Satoshi Nakamoto published a white paper entitled, Bitcoin: A Peer-to-Peer Electronic Cash System. The white paper explained digital currency but Nakamoto’s true identity remained a mystery. He claimed to be a programmer from Japan who had spent a year and a half developing Bitcoin.
The mysterious programmer may, in fact, be a group of programmers. The true identity of Bitcoin’s inventor has become less important than the validity of the invention. While the entire world has no choice but to rely upon trust as the basis for every major transaction that affects our lives, Bitcoin offers an alternative with its basis in technology.
You cannot hold a Bitcoin in your hand (although there were some early coins minted). You can’t put bitcoins into a vending machine and you can’t bring a bag of bitcoins to the bank for a deposit. Bitcoin is completely digital. It exists only in the world of computers.
This may seem scary until you consider most banking and online transactions today are also digital. No one brings a bundle of dollars to the online merchant after you make a purchase. Money from your credit card or bank account is deposited in the recipient’s account. No actual money changes hands. Economists estimate less than 10% of all transactions in flat currency actually involve coins or bills.
Bitcoin would be best described as a computer protocol, a set of rules that govern the behavior of digital communications. Whenever you type a web address that begins with HTTP, you’re using a protocol. It’s called hyper text transfer protocol (HTTP) and when you send a message out from your computer and browser with those letters at the beginning, the set of rules that govern HTTP are applied.
You get the result you want. Your message is sent to Facebook or Google. The process of completing the task you requested, log in, search, etc. begins.
Instead of requesting a Google search or posting to social media, the Bitcoin protocol transfers value from one user to another, anywhere in the world.
Here’s the part that attracts many people. Bitcoin cuts out all the financial institutions that get paid every time you complete a transaction. Exchanges (more on this later) and banks can become involved in Bitcoin transactions but the basic value of Bitcoin is the same when it reaches the recipient as it was when it left the sender.
Bitcoin transfers use a peer-to-peer network. There is no central bank or server. Whereas a dollar bill is the central bank’s IOU, a Bitcoin possesses its own value, like gold. Best of all, bitcoins are much easier to transport than gold.
Germany’s central bank, the Bundesbank decided to hold half of its gold reserves in its own vaults in 2013. They had to move almost 700 tons of gold from New York and Paris. It took four years and cost nearly $9 million. If they had made the same transactions in Bitcoin, it could have been completed in seconds. Bundersbank would have saved $9 million.
Bitcoin supporters consider Bitcoin a digital commodity because it has its own value and it performs the three functions of the Lydian Lions.
1. Medium of Exchange – Bitcoin may not yet be accepted in as many places as Visa and Mastercard but more and more familiar companies have begun accepting the digital currency. Overstock,com, Expedia, Shopify, Dish and Microsoft are among the companies that advertise their acceptance of Bitcoin as payment.
In 2017 the Japanese government recognized Bitcoin as a legal payment method and currency. The same year, apartments in two residential towers in Dubai became the first major real estate to be priced in Bitcoin.
Market watchers see volatility in the Bitcoin marketplace and it causes some heartburn. In the last quarter of 2017 the price of Bitcoin hit a low of $5,600 then rocketed above $18,000 before year’s end.
Acceptance in the marketplace is in its early stages. Price stability will need to increase considerably before Bitcoin is considered a player in the world currency market. Bitcoin has become more of a digital commodity or asset than a currency, in part because it has its own intrinsic value just like gold.
2. Unit of Account – Bitcoin is fungible, meaning one Bitcoin can be equally exchanged for another and other goods and services can be priced in bitcoins. A Bitcoin can also be divided into 100 million units (each unit is known as a “satoshi”).
3. Store of Value – The number of dollars in existence changes according to the whims of the Federal Reserve. Bitcoin was designed to reach a maximum number and have no additional bitcoins minted.
There are approximately 17 million Bitcoin in existence. The maximum number of Bitcoin that were planned in the original Bitcoin scheme was 21 million. When that number is reached, there will be no more Bitcoin minted.
In early 2018 the Federal Reserve reported approximately $1.63 trillion dollars in circulation. The maximum number of Bitcoin compared to the current number of dollars is a tiny, nearly insignificant fraction.
By limiting the number of Bitcoin, the Bitcoin protocol ensures the value of a single Bitcoin will continue to increase. Store of value is built-in to Bitcoin. Sure, there’s no guarantee Bitcoin will retain its store of value in a year, two years or longer. That’s no different from any other fiat currency.
The major difference is that governments control the value of their currency. That isn’t the case with Bitcoin. In recent years, fiat currencies worldwide have lost their buying power by 5%-10% per year. The price of Bitcoin has moved steadily in the opposite direction.
Bitcoin is technology and technology has many vulnerabilities. Many factors could influence Bitcoin’s future store of value but for the moment it remains stable.
So what’s the difference between currency, cash and money? You can hold cash in your hand or put it in your pocket. You can stuff it into a vending machine and get a cold soda in return.
Money can include cash but it is really anything that fits the three functions of the Lydian Lions, medium of exchange, unit of account, store of value.
Currency is anything that functions as a medium of exchange. Governments issue most currencies but digital currencies are, in fact, currencies.
Gold isn’t used as a medium of exchange anymore so it really isn’t currency. No one buys their gasoline, refrigerator or home with gold nuggets so gold isn’t money or cash. Gold still has a value so it is more of a commodity than it is cash, money or currency.
Bitcoin fits the three criteria for money. Bitcoin needs to become more commonly used as a medium of exchange before it truly qualifies as a currency. Until then, it has more in common with gold but because it can’t be held in your hand or stored in a vault, Bitcoin should be regarded as a digital, rather than tangible commodity or asset.
It isn’t hard to see the characteristics of Bitcoin that release it from the constraints of traditional currencies. Even in the digital world, geographic borders and financial institutions impede the free flow of money. International money transfers can take days and involve at least two banks. Bitcoin moves at the speed of the Internet, which is basically the speed of light.
Limiting the quantity of bitcoins eliminates the possibility of indiscriminate and manipulative increases in the money supply. In theory, Bitcoin cannot be debased by issuing more bitcoins.
The success of digital currency will also take control of currency out of the hands of governments. Every government manipulates its currency to serve its own needs. No government can manipulate Bitcoin.
Four hundred years (give or take) BC, Aristotle defined five desirable characteristics of money. Ari (what his friends called him) believed good money was durable, divisible, convenient, consistent, and had use value in and of itself. These criteria vary slightly from the three characteristics cited earlier. How would Aristotle see Bitcoin?
1. Durable – It’s difficult to assess physical durability of Bitcoin because cryptocurrency has no physical form. On the other hand, you could say Bitcoin is infinitely durable because it exists only in the electronic world. So the question is whether Bitcoin is durable in the world where it exists. Bitcoin will endure unless the World Wide Web collapses.
2. Divisible – Check that box for Bitcoin. One satoshi = 0.00000001 BTC. That’s a lot of dividing.
3. Convenient – Bitcoin needs some improvement in this department. Convenience will grow along with acceptance. The electronic nature of digital currency also binds it to devices with Internet access. You’re not likely to be able to use Bitcoin to buy into a midnight poker game in basecamp on Mt. Everest. Although, match sticks could get the job done until you return to the wifi enabled world.
4. Consistent – Check another box for Bitcoin. Every Bitcoin is worth exactly what every other Bitcoin is worth.
5. Use Value – This means, does an item have a value when it is used outside of commercial trading? Commodities such as cotton, tin and oil have a use value other than just their trading value. You need to step out of Aristotle’s time to consider how this feature of good money might apply to Bitcoin.
U. S. minted coins have a use value based on the tiny amounts of nickel and copper in each one. That doesn’t amount to much. The use value of paper money is even less but it has something.
You can’t melt down a Bitcoin or use it to start a fire. You can use Bitcoin to transfer wealth from one person to another and from one location to another securely, privately and without the need to include a government entity or financial institution. That, most definitely, constitutes a use value.
In time, Bitcoin might replace the SWIFT system, which is used to transfer money electronically. International money transfers using SWIFT cost between $50 and $100 in service fees. They are slow, taking days or up to a week. All SWIFT transactions clear through New York. Use Bitcoin and you can enjoy instant, almost cost-free transactions anywhere in the world. (The people who own the computers that validate Bitcoin transactions receive a small fee.) The SWIFT system should be worried, very worried.
If you choose to delve deeper into some of the more technical aspects of cryptocurrency, keep in mind you don’t need to understand the complexities of Bitcoin to begin using it. Very few people understand how a jet manages to defeat gravity and fly at 500 MPH but most of us take advantage of this aviation miracle.
The best way to understand Bitcoin is to create a digital wallet and begin using it. You can download a Bitcoin Wallet to hold your bitcoins. Once you have some bitcoins in your wallet, you can start spending them.
Anything whose value goes from $130 to more than $17,000 in four years, gets noticed by investors, entrepreneurs and the media. When we hear stories about someone turning $5,000 into $100,000 in the time it takes to get delivery of a new Tesla, the world reacts like someone just announced gold was discovered at Sutter’s Mill.
The allure of Bitcoin may prove irresistible. What a story. Technology comes to the rescue of a failing, global currency system. Fortunes are made overnight. Nerds rule the world!
Early embracers of technology always lead the way for those who follow. They take the biggest risks and they often reap the biggest and sweetest rewards. Sometimes, the ride up is over by the time the rest of us find out about it.
That does not seem to be the case with cryptocurrencies. In fact, the most exciting part of the crypto story appears to lie ahead. There are now more than 1,200 different cryptocurrencies, seven times the number of conventional currencies. This explosion of new money options indicates just how strongly the entrepreneur community has embraced the concept.
The World Federation of Exchanges estimates $77 trillion in trades occurred worldwide in 2016. Cryptocurrency offers traders the rare opportunity to invest in an entirely new asset class. As you might expect, digital currency investment vehicles have begun to appear.
Investors need to look at this new marketplace the way they look at any other investment. Do your research and don’t bet your rent money. Investors are advised to fasten their seatbelts. It’s gong to be a bumpy ride.