Bitcoin: What is it? Why do people want to own it?

by Peter W. Quigley, Renvyle Partners LLC

3Charm

 

Novel, ground-breaking, the first digital currency, are all apt descriptions of Bitcoin. But is it really money as so many millions who already own it and transact in it believe? If so, why exactly, and why is it valuable?

In the fall of 2008, an unknown entity calling himself, or themselves, Satoshi Nakamoto released the concept and technological framework for Bitcoin. By January 2009, it was up and running. Besides introducing the radical financial innovation of a stateless digital currency, Bitcoin was also the launching pad for a new security technology called the blockchain.

The blockchain is the software innovation of coding that makes Bitcoin possible. The blockchain is not just an encryption that keeps Bitcoin safe, it is also an accounting system that keeps an up to date ledger of each owner’s Bitcoin and transactions globally. In fact, this ledger is updated across the network every 10 minutes! It is pretty amazing.

The blockchain’s secure coding protects Bitcoin owners; but where are Bitcoin stored and can they be stolen? Bitcoin exchanges are the “banks” where users buy, sell and store Bitcoin. The protection of Bitcoin owners became an issue in 2013 when a major robbery took place. Mt. Gox, a prominent Bitcoin exchange was hacked and the Bitcoin taken. What prevents that from happening again?

A host of Bitcoin exchanges say they have added more network and account security. Some offer account insurance. In addition, the gangs of hackers itching to steal Bitcoin face the entire universe of Bitcoin users, many of whom are very tech-savvy themselves. Since the Mt. Gox scandal, Bitcoin investors have, to a great extent, repaired their confidence in the security of the currency, but a healthy sense of vigilance remains.

Blockchain’s encryption and ledgering has impressed the global finance and payments industry and it is investing heavily in the technology for its own use. But has the global financial system adopted Bitcoin itself? On the margins, the answer is definitely yes. Since 2009, having survived growing pains like Mt. Gox, Bitcoin’s credibility is strengthening. Both the user base and vendors accepting it as cash are growing. The value of outstanding Bitcoin is now $7 billion, and the idea that it is in fact real and here to stay is gaining traction.

What is Money?

Bitcoin has provoked important conversations. Because it isn’t backed by an asset or a government, how can it have any value and be considered a credible currency? Transacted over the internet, how can it be taxed? Hasn’t the internet’s global presence made Bitcoin inevitable? Is it really money?

Bitcoin’s advocates make good points. All money requires the belief that it is a store of value that can be exchanged readily with others. Even the most enduring money of all, gold, though it is indestructible, rare and expensive to produce, is only worth what people believe it is worth.

National currencies are confidently used for transactions in every land, but all currencies in the world are depreciating and printed on useless paper issued by governments who print more and more of it all the time. Despite these shortcomings, paper currency is used all the time and even used as a store of value. Despite constant depreciation, paper money’s credibility is seldom questioned.

Bitcoin advocates argue that the nature of money can be better understood in the purpose it serves. Money, they say, is essentially a way of keeping a ledger of payments and debts and as such has been essential to trade since before recorded history. For untold centuries, wampum, feathers and shaped stones served as money in North America. In the 1800’s there were dozens of currencies used in the US that had been issued by local authorities and private companies. Backed by very little that was tangible, these forms of money still served as currency.

Bitcoin advocates say Native American wampum and 19th century local currencies were useful in their time and in today’s digital networked global economy, Bitcoin is extremely useful and will become even more so. Bitcoin is perhaps even more credible than other currencies of the past and present if for no other reason than it is immutable, durable and since the quantity is limited a better store of value.

Bitcoin’s Unique Usefulness as Currency

Bitcoin’s is unique because it only exists on an information network. It has the unprecedented advantages of being accessible anywhere at anytime and existing outside of the banking system. How many currencies can say they are so useful in these ways?

Transacting instantly outside of the banking system, Bitcoin has proven uniquely useful to the Chinese who have been moving money out of China and out of the Yuan, for example. It has long been recognized that Bitcoin is useful for illicit money movements. It is becoming increasingly useful in daily trade and commerce by travelers and in cross border trade where it is possible no currency translation is needed.

Among the thousands of firms accepting Bitcoin payments are Microsoft, Dell and Expedia. This is a long way from Visa’s market share, but the use of Bitcoin can conceivably grow exponentially when companies and people decide they are comfortable holding quantities of money in Bitcoin rather than converting it to paper currency.

Whether Bitcoin even has a right to be money may in the end just come down to the point that in a networked world, isn’t a currency like Bitcoin not only very useful but also simply inevitable?

Bitcoin Looks Increasingly Attractive as a Store of Value

Holding cash outside of the banking system is increasingly sensible. In many countries, today negative interest rates on deposits and bonds exist in Japan and much of Europe. This means you pay to keep money in the bank or to own a government bond. Negative interest rates are a good reason to move some Yen, Euros or Krona into a Bitcoin exchange.

Some investors have learned the hard way that holding money outside of the banking system is a good idea when banks go broke. In 2013, Cyprus went broke and its banks were closed. When the banks were reopened, funds on deposit in excess of the insured 100,000 Euro maximum were largely confiscated by the European financial authorities. Holding money outside of banks is sometimes a good idea. Banking rules are being changed even in the US to permit the takeover of deposits like in Cyprus. If Bitcoin has arrived as money, investors will use it to avoid growing banking system risks.

Bitcoin’s quantity, like gold is limited, as both are increasingly difficult to produce. The rate of new Bitcoin “mining” has already slowed and in 2040, the number in existence will go from today’s 15 million to the end point of 21 million. The contrast between Bitcoin and its finite quantity in an era of unprecedented levels of paper money printing is stark.

Paper money makes a poor store of value. If in 1966, a child put a US dollar they had received for a birthday gift in a secure place in an effort to save the money, what would it buy today? In 1966, it would have bought 20 first class stamps; today a tad over two. It would have bought over 3 gallons of gasoline; today about 1 ½ quarts. That’s how money printing works and paper money fails as a means of storing value.

The number of Bitcoin will stop increasing in 2040 at 21 million. How can there be enough of them for it to be money? Rather than being divisible into 100 cents, Bitcoin is divisible by one million parts. So there will be 21 million, million Bitcoin cents. If Bitcoin becomes accepted by a billion people, its finite quantity will make it quite valuable while the value of paper currencies will be largely governed by the huge increase in their quantity in circulation. Bitcoin sitting in a digital “wallet” has a better chance of maintaining value than paper money over time.

Bitcoin is easy to use. It is really easy to transfer money back and forth from a checking account to a Bitcoin exchange. People do not yet realize how easy it is to transact Bitcoin.

Bitcoin is controversial and ground breaking. It introduces the concept of digital supra-national money. Governments are challenged by it. Yet the number of businesses globally accepting it as payment is growing and skepticism about it seems to be declining. The usefulness of Bitcoin is becoming ever more apparent to its users, including those who want to hold money outside of the banking system or national currencies.

Bitcoin’s Future is Not Assured

The future is not all glorious sunshine for Bitcoin, however. Its future is very much dependent on preventing another Mt Gox theft. People are more confident in the security of their accounts now but the Bitcoin exchange industry and user base have to remain vigilant. Increasing and protecting user confidence is critical if Bitcoin is to expand.

There are also the undefined risks of another digital currency superseding it or a government declaring “war” on it. Bitcoin is not without risks but if you think the US Dollar is risk free consider these facts. Since 2008 the national debt has almost doubled, or recall the loss of buying power we have seen over the last 50 years. Those are risks that have materialized and are operative today. All currencies have risks.

Frankly, many Bitcoin boosters believe it is going to increase a great deal in value. So far, the value of Bitcoin has been very volatile. It rocketed up to over $1,000 in 2013 and then crashed to the low $200’s last year. A two year bear market is over and it is around $450 at this time (May 15, 2016).

Coindesk chart from snippet tool (1)

Bitcoin’s growing adoption globally as well as the need for a digital currency outside of the banking system, points to an increase in its use and demand. Its proponents see a big future for Bitcoin as the world’s digital alternative to paper money and even gold. If the risk of digital theft is contained, maybe this vision will be realized.

 

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