Bitcoin: A layman's guide to the mysterious digital currency
A poll conducted by Bloomberg says 42 percent of Americans know that Bitcoin is a digital currency, but I'd bet less than a tenth of that understand how it works. It's complicated, it's innovative, and it will, without a doubt, shake up the fundamentals of money that have been in place since governments began printing paper. It is the closest thing to a perfect currency the world has ever seen, and no government is at the helm. But how does it work?
A Bitcoin is simply a piece of data that is created out of nothing through computers, a process which is called "mining." It is, by definition, a fiat currency because there is nothing physical backing it up, much like the US Dollar. Anyone is free to mine Bitcoin by running a computer program which uses processing power to constantly attempt to solve algorithms that are agreed upon by a decentralized peer-to-peer network. When an algorithm is solved, Bitcoins are generated. The creator of Bitcoin, who to this day remains anonymous, had amazing foresight with his or her creation. Bitcoin is coded to adjust itself based on the computing power that is exerted on its infrastructure. For example, if IBM were to build a super computer with globs of processing power to mine large amounts of Bitcoin, the network would not only recognize this, but make the algorithms much harder to solve, so the same amount of currency is being created. In other words, Bitcoin has a built in inflation regulator, which only allows the currency to grow at a rate which mimics the aspects of a finite commodity, for example gold.
Over time, the amount of gold occurring naturally in the world will drop and production numbers will fall, much like Bitcoin is programmed to do. But because of this, the price should rise due to a steady reduction of supply.
So financially, Bitcoin is sound. But what if the anonymous creator wants to sabotage the creation for personal gain? For example, he or she could extract Bitcoin from the network through a programming change to the source code. Fortunately, Bitcoin's under workings are completely open source, meaning any programmer or layman can view the code which makes the digital currency tick, so it is constantly under supervision by some of the world's best and brightest computer geeks. This means that changes to it will not go unnoticed, and if the creator of Bitcoin wanted to alter the program for personal benefit, it would be noticed and would ultimately lead to the demise of the currency, something that would not be beneficial to anyone. This is one of the most important aspects of Bitcoin; it has a built in "mutually assured destruction" faucet that prevents it from being tampered with for personal gain. In general, unregulated power put into the hands of others leads to corruption and abuse, but Bitcoin avoids it beautifully.
Now it's time to complicate things even more. Bitcoin, although known by many to be a digital currency, is actually more than that. Bitcoin also serves as a payment processing network, much like Visa or PayPal. This aspect of Bitcoin revolves around the "blockchain," which operates as a digital wallet to hold coins or can be used to transfer them to another individual or company. Transactions occur near instantly and are processed for a fee of .0001 Bitcoin, which equates to about eight cents at present day value.
Let's do a quick recap of what we know so far: Bitcoin is a digital currency that allows holders to send money instantly to anywhere on the planet for a fee of nine cents and cannot be influenced by Quantitative Easing or any government legislation.
Bitcoin may be considered a fiat currency, but that is some serious intrinsic value if you ask me.
The implications for small businesses alone being able to save on credit card or PayPal processing fees (which can be as high as 3 percent) are huge. In addition, put yourself in the place of an American emigrant with family who live in Singapore. Money transfers back home can take days to process and generally carry a large cost.
In addition, the US economy experienced an $800 million loss in 2004 alone from credit card fraud, according to a study by the International Journal of Computer Science and Network. All of Bitcoin's transactions are irreversible. For a seller of merchandise, this is great, for the buyer, it depends. This may be construed as economic Darwinism, but does a person that gives credit card information to a "prince from Nigeria" really deserve the money refunded? It pays to be smart with your money, especially in Bitcoin's case. Bitcoin's network is secure, due to its open source nature, and offers no back door for hackers to infiltrate.
Bitcoin isn't all sunshine and roses, however. The media have given plenty of attention to the fact that Bitcoin can be used online near anonymously, allowing criminals to use the digital currency without leaving a "paper trail." Isn't cash also in this category? People use cash to buy drugs, prostitutes and partake in illegal gambling. In fact, the criminal element was the first to adopt Bitcoin and thrust it into use as a currency. Now, there are thousands of legitimate online and brick and mortar businesses that accept the currency. PayPal President David Marcus announced last month that he owns Bitcoin and sees a bright future for it. If there's one thing for certain, it's that criminals will find a way. They always have, and they always will.
Why own Bitcoin?
Bitcoin has also garnered huge attention from media outlets in 2013 for its growth, which has shown to be nothing short of spectacular.
At the beginning of 2013, one Bitcoin was $13, and on Dec. 31, it could be sold for over $700. This type of growth has attracted many day traders, short term investors, and critics, who are quick to point out that such a volatile currency is not desirable. They have a valid point.
Bitcoin's price fluctuations exist because no one can predict what place decentralized digital currencies have in the world. If Bitcoin becomes successful, the US government is unlikely to willfully give up the monopoly they hold on money in the country, which could cause bring harsh restrictions that kill the digital currency. Bitcoin itself may not survive the future, but currencies like it will continue to exist. JP Morgan has tried to patent a Bitcoin-alternative 175 times, all of which have been rejected. The interest in the idea is there, and it's too good to just disappear.
Unfortunately, Bitcoin's rise in price, which from 2010 has soared over 800,000 percent is also a negative in the currency world. Bitcoin's success depends on use as a currency, not an investment. Any economist worth his salt will tell you a small rate of inflation is healthy for an economy, but Bitcoin continues to soar. Currencies that rise in value, or deflate, result in people being unwilling to spend their money, and instead hold onto it. For example, in 2010 a Florida man purchased two pizzas from a local shop in exchange for 10,000 Bitcoin. At today's current price of $800 per Bitcoin, those two pizzas cost that man $8 million. No one wants to be that guy. Few want to spend Bitcoin, which effectively stifles its adoption rate. Over time, as Bitcoin finds its natural place in the world and experiences less volatility, I expect this problem to disappear and Bitcoin to become more widespread.
How do I own Bitcoin?
Famous investor Warren Buffett is well known for investing advice that centers around investing in what you know and investing in what you believe in. So if you believe in Bitcoin, and have done the research, here's the next step. Create an account at Coinbase.com, go through the typical loops that most online brokers require, and purchase some coin. Just remember, only invest what you can afford to lose, especially in the case of Bitcoin.
Tim Zyla can be reached at (570) 265-1634; or email: email@example.com. For breaking news updates, follow Tim on Twitter, @TimZyla.