Bitcoin – What is it?
Bitcoins are a blockchain-based, frictionless, anonymous digital cryptocurrency. Quite the mouthful huh… Let’s break that down a bit.
Anonymous Digital Currency
As you’re probably aware, Bitcoins are a digital currency which users can send and receive across the internet. The method by which Bitcoin users buy and sell coins through online exchanges is similar to acquiring foreign currency. Online exchanges make money by setting exchange rates that are discounted to the actual value. Although currently limited, there are a growing number of businesses which accept Bitcoin as a form of payment. Bitcoin owners have an online address, which acts as a digital wallet. Unless you choose to link your identity to it, your digital wallet is completely anonymous. This anonymity has been a point of controversy as it makes Bitcoin a favorite for criminals and money launderers. In fact, there have been a number of exchange owners who have received jail time for knowingly allowing criminals to use their exchange to facilitate elicit dealings.
For many Techies, Bitcoin’s use of a blockchain system is what sets it apart from other currencies. Comparing blockchain transactions to traditional electronic payments in the following example helps explain this.
Traditional Electronic Transactions: Jarvis purchases a new pair of shoes from an online retailer. The transaction is submitted to Jarvis’ bank, which then pulls funds from his account and wires the funds electronically to the retailer’s bank. Having received the funds, the retailer’s bank verifies the transaction and deposits the money into the retailer’s account. In this system, all individuals are connected to banks, which control all the transactions.
Blockchain Transactions: In this example, Jarvis similarly purchases a new pair of shoes from an online retailer. Instead of using his bank account, however, Jarvis uses his digital Bitcoin currency to make the transaction. The transaction is sent across a network of computers, all of which independently register and verify the transaction. Unlike traditional systems, in which banks control transactions, blockchain transactions are distributed through and verified by network users. Although this distinction may not sound like a big deal, two important factors result from the blockchain process: First, it’s nearly impossible to fake or corrupt transactional information. Second, because transactions are processed across an entire network, no single institution is controlling the flow of currency, and no institution is charging for the transaction. Although a more robust discussion of the blockchain and its implications are beyond the scope of this article, those interested can learn more by listening to this episode of the Planet Money podcast.
As illustrated above, Bitcoins can be sent and received in any amount, at any time, free of any fees through the blockchain network, where no controlling institution exists to impose fees or limitations. Economists refer to this as a frictionless currency system. While the system is regarded as “frictionless,” it is not free from problems; transactions through the Bitcoin network can often be processed very slowly or fail altogether.
Cryptocurrency and Inflation
Whereas the United States Central banking system uses monetary policy to control the supply of U.S. dollars in circulation, cryptocurrencies use cryptographic mathematics as their medium of currency exchange and creation. One of the most basic goals of monetary policy is to control the rate of inflation. In contrast, by ensuring that a known, fixed number of new currency units are created each year, cryptography stabilizes the value of cryptocurrencies such as Bitcoin, making them generally not sensitive to inflation, as traditional currency is. Cryptocurrencies are, however, subject to investor sentiment, which can – as we have seen recently with Bitcoin– cause massive shifts (positively and negatively) in price.
Blockchain-Based Frictionless Anonymous Digital Cryptocurrency
Viewing its components together, we now understand that Bitcoin is a digital system which allows users to make anonymous online purchases in any amount, at any time, free of transactional fees, as part of a larger distributed blockchain system that is resistant to inflation, but not investor sentiment.
Bitcoin and The Bubble
As illustrated in the above graph, Bitcoin price has risen by a staggering 3,118% since the beginning of 2015. It may be natural to look at the graph and kick yourself for not jumping on the bit-train earlier, but let’s look, for a minute, at why Bitcoin is functioning as an investment in contrast to Bitcoin functioning as a currency, and why that makes it look like a big, fat, bubble.
Bubble Reason #1 – Non-currency
The primary purpose of a currency is to provide a medium for the exchange of goods and services, and its relative value can be measured by the amount of it needed to purchase these things. The value of the US dollar, for instance, is reflected by the Consumer Price Index (CPI) which tracks the cost of a fixed set of goods. As the price of goods rise, the value of currency falls. Likewise, as the cost of goods falls, the value of currency rises. In other words, there is an inverse correlation to the utility of a currency and the rate of change in its value. Ask yourself this: Has the falling value of goods caused the rise in price of Bitcoin? The answer is obviously no, but so what?
To answer this, let’s consider the following hypothetical. At the start of 2015, I use Bitcoin to splurge on a new dining room table. Less than two years later, while eating breakfast at my table, I see a headline proclaiming Bitcoins’ new record price. Doing some quick calculations, I find that if I had held off on purchasing a new table, the same Bitcoins I used to purchase my table would now buy a new 2017 BMW 3 Series. I flip the table and, understandably, cry over my spilled milk.
This example is condemning for Bitcoin as a currency, because it illustrates how owners are discouraged from using the currency for its intended purpose. What rational adult would forgo exponential returns for purchases that could be made with regular currency? If you stop and reflect for a moment you’ll notice that while all the headlines focus on price, there’s an eerie lack of stories purporting its actual use as a medium of exchange…
Bubble Reason #2 – Speculative Risk
Last week the CEO of Credit Suisse said in a press conference that Bitcoin was, “the very definition of a bubble” citing the intensely speculative nature of the market. In financial terms, a bubble is the extreme over-valuation of an asset resulting from irrational exuberance.
The Dutch fell victim to one of the first recorded bubbles in an event which has now been dubbed Tulip Mania. In the early 17th, new breeding techniques led to the development of new tulip genotypes, resulting in interesting and never-before-seen petal colorations. It didn’t take long for these interesting bulbs to catch on and soon they were in highest demand. Nobles, wealthy tradesmen, and anyone-who-was-anyone wanted these tulips, but the demand greatly outweighed the supply. Sensing opportunity, new markets sprung up for tulip bulbs and futures with bulbs being bought and sold multiple times per day. Speculation took hold and bulb prices soared. At its peak, a single tulip bulb was worth as much as an affluent apartment on the Amsterdam canals. But as with all bubbles, it couldn’t last. Eventually sentiment shifted, and the price of bulbs plummeted. What was worse, individuals who had sunk their livelihood into bulbs were unable to offload their investments, as markets rapidly turned illiquid.
From Tulip Mania to the more-recent Dot-com bubble, the same pattern of irrational exuberance, overvaluation, and market collapse has been repeated, again and again. Rather than asking if the current Bitcoin price explosion is a bubble, a more appropriate question would be when that bubble will burst. Although it might be tempting to speculate on bubbles, it’s important to remember that they are impossible to time. And as the poor Dutch bulb investors can attest, once the bubble bursts it can be impossible to get out of the market.
Bubble Reason #3 – Political Risk
Generally speaking, governments are not fond of criminal activity. Especially when said criminal activity hinders their ability to collect tax dollars. Bitcoin’s complete anonymity gives criminals and money launderers any easy avenue for nefarious dealings outside Uncle Sam’s watchful eye. As it’s new on the scene, Congress has yet to enact any regulation surrounding Bitcoin, although forthcoming laws would be inevitable should it be adopted as a major global currency. Future legislation creates a large amount of political risk for Bitcoin as a currency. New laws and regulations may put restraints on the frictionless blockchain system or hinder its anonymity. Such changes could result in drastic swings in public perception, potentially imploding the market.
This article is intended for educational purposes only and is not a recommendation for or against cryptocurrency.