Lifeboat Foundation

So what is Bitcoin, anyway?

Bitcoin is a virtual currency. It is a string of 1s and 0s, much like a lot of what we interact with in this day and age. It’s something new. It’s unique. It’s controversial. The detractors say it’s only useful for terrorists or drug lords who want to move money around undetected, which no doubt they do. But much like the Internet is so much more than pornography, so is Bitcoin so much more than drug money. E-mail liberated the letter from the postage stamp, Skype liberated telephone calls from crippling AT&T long-distance rates, Facebook liberated photos from the dusty photo album sitting on your shelf unopened. You can think of Bitcoin as what will liberate financial transactions from the grip of the financial institutions and the state.

Technical/dictionary definitions can be found in many places. This short article cannot give a full account. But it will present analogies to make the concept of Bitcoin easier to grasp. Given that Bitcoin is virtual, the analogies can only go so far, but the first step is to think about bitcoins as though they were actual coins forged out of the shiniest and prettiest gold. This is the cornerstone to understanding that bitcoins are in fact a commodity, like a gold nugget turned into a coin and made to become money. The analogy is that the element from which the gold coin is forged requires to be mined. Sure enough, it exists in nature, but it is hidden from plain view. It has to be explored to be brought into useful existence, and this gets exceedingly hard as time goes by and as the easy pickings have all been found. Much the same is with Bitcoin. It is decisively unlike any other piece of software or any other electronic file to which we are accustomed. You cannot just copy and paste it and you cannot just reinstall it ad infinitum. The sense we should be getting is that Bitcoin is a scarce good.

Don’t let go of that mental image as I endeavor to explain a bit about the technical aspect. Bitcoin belongs to a new kind of asset class, one that is called a crypto-currency. Its very existence is predicated upon a network of computers that resides within the internet. This Bitcoin network consists of thousands of individuals who are online and connected to one another at every given second of the day, constantly communicating with one another through pieces of software designed with this one networking purpose in mind. Through complex cryptographic means, each coin and all of its transaction history is known to the network while keeping the identity of the owner of this coin completely private. Due to the fact that transmission from one owner to another (the financial transaction) is broadcast to the entire network, it is made virtually impossible to then use the coin again since everyone knows you’ve already given it away – thus it overcomes the problem of double-spending (think “copy & paste”) the same coin. The analogy to a gold coin (or any physical good) is that only one person can ever hold and own the coin, thus it is scarce (in the economic sense) and one person owning the coin prevents another person from owning it.

As to the technical aspect of ‘mining’ bitcoins, these again are computers running specialized software on this network. Miners solve complex algorithms to discover which string of characters would be the next Bitcoin to be produced. The computations are so complex, and increasingly so, that the computers required are expensive, state of the art computers using up time, space and energy. Inherent in the Bitcoin network design, there is a capacity to the network (21 million bitcoins) and inherent to the mining process, it becomes exponentially more difficult to solve these algorithms. Therefore, by nature, the rate of creation of new coins is decreasing and an upper limit is in place. Today over half are in existence, within 25 years over 99 percent will have been mined and by the year 2140 no more coins will be added to the supply. The analogy to gold mining is that gold is finite and it takes effort to discover it; ‘real world’ resources, time and money, are expended in the process. While, of itself, this doesn’t give Bitcoins their value, it does make it either profitable or not and it incentivizes entrepreneurs where the profit exists. Bitcoins cannot be created out of thin air by a Federal Reserve-like entity. It is a commodity that will attract miners should it be profitable, and likewise detract miners when loss-making conditions arise. It is a product of the free-market.

The value of money and Bitcoin

A brief mention was made that this is a new type of asset class. Also mentioned repeatedly is that this is a commodity. These definitions cause great discomfort to many who view assets and commodities as necessarily objects in the physical realm. Accountants have long held the view that a balance sheet can also be comprised of intangible assets. Value, it was argued, does not come from an object’s tangibility, but rather from its subjective utility by its owner and from its scarcity. Businesses, after all, pay great premiums to acquire others’ brands or to employ people for their talents or ideas. To be sure, a Bitcoin is a string of 1s and 0s and interacts only with software, but when this string of 1s and 0s is useful and its ownership boundaries are clearly delineated (meaning what I own, you cannot own at the same time), then it can be thought of as an asset and it can acquire value based on the subjective view of market participants.

Most discussions on forms of money invariably include references to ‘stores of value’ and to the money commodity as having ‘intrinsic value’. It is important to realize that any good arising from the free market will appreciate in value as more people want it and will act as a store of value as long as its popularity remains so. But with popularity dwindling or with marginal utility dropping any good is subject to its store of value diminishing, gold notwithstanding. Intrinsic value is itself a misnomer. Goods do not have intrinsic value. Goods may have intrinsic properties or characteristics that are valued by society or enable them to be well utilized for a specific purpose. Money’s properties, for instance, would include being fungible, divisible, recognizable, durable, portable, rare/scarce, etc. If a good or a commodity intrinsically has all of these properties, then it is likely, over time, to evolve to become a medium of exchange (money). This good will then acquire value with its increased recognition as a popular and well accepted form of money. But calling this ‘intrinsic value’ is fallacious, albeit somewhat common.

Historically, precious metals, especially gold and silver, have retained their values due to their intrinsic properties mentioned above. This has given rise to people’s perception of them as being a ‘store of value’ and of having ‘intrinsic value’. Another red herring introduced to the argument is that gold has other uses, say in dentistry, aerospace, or jewelry. True enough, this would imply that should the metals lose all perception as being money (a highly unlikely scenario, but theoretically possible), then at least the owner is able to sell off their existing holdings to goldsmiths and other industry participants. The resultant oversupply relative to demand would probably mean gold owners would salvage a few percent of the value at best. Therefore, for all practical purposes, the fact that gold has value other than money (a characteristic Bitcoin doesn’t share) is of little relevance when discussing it as a medium of exchange.

With Nixon’s closure of the ‘gold window’ in 1971, gold has ceased its official role as money. However it is quite evident that as an asset class, precious metals are still highly regarded and form a part of many prudent investors’ portfolios. Payment for goods and services with a Krugerrand or a Silver Eagle would constitute ‘barter’ if one were to go by today’s strictly legal definitions of money payments. But if (or when) the US Dollar system collapses, there is no doubt to an ever increasing proportion of the population that ‘payment’ with gold and silver would arise as legitimate forms of money. The creation of bitcoins has introduced another alternative, one which would be unwise to ignore.

Bitcoin adoption and its rise in value

As long as its acceptance as money is only to a narrow audience, its value will remain low and the possibility of a price collapse is a real risk. But one shouldn’t make the error in deducing, therefore, that it cannot acquire value as people learn about it and accept it. Every commodity starts its life as having no value until someone finds a use for it and starts exchanging it with others who also see the value in its use or its properties. If a commodity acquires value as a medium of exchange through voluntary free-market interactions, and is not forced upon the populace through legal tender laws (as fiat money is), then it no longer matters that it doesn’t have other uses. It will be acquired and exchanged for the sole purpose of acquisition and exchange. In a free market, after all, if people lose confidence or interest in the product – any product (money or otherwise), its value would decrease and potentially reduce to zero.

So why has its value gone up so greatly? Is it all attributed to an irrational bubble-induced craze? Perhaps. But perhaps ever more people are starting to realize that this invention fits the bill. It is fungible, divisible, recognizable, durable, portable, rare/scarce (an in-depth look at each will have to be the topic of another article). When one considers the design of this ‘product’ in light of these attributes, one begins to realize that the properties that led gold and silver to the fore as ‘natural money’ can exist in other goods. People gawk at miraculous inventions that enable us to perform heretofore unthinkable tasks. Transacting in money is no different. Money is simply the most marketable commodity. It shouldn’t surprise us, in this day and age, that someone was able to invent an alternative form of it – and let the free market decide what is more marketable. What we have witnessed over the last few weeks are volatile price fluctuations, as people rush into this craze wanting to make a quick buck. But with more people owning bitcoins and more businesses willing to accept payment in them, Bitcoin is gaining currency. This is exactly the process that took gold from ornament to payment, only instead of taking centuries, it is happening before our very eyes. For those seeking a return to free market currencies, consider Bitcoin as a successful alternative.