In the past few months, a couple of other writers for Money360, Holly Johnson and Michael Gardon, have offered their takes on Bitcoin, which in large part overlapped with my own (I offered my own nascent thoughts on Bitcoin back in the early days). Still, a week doesn’t go by when I don’t get two or three mailbag questions about Bitcoin, so I thought it might make sense to just address all of these questions at once in a single article.
What is Bitcoin, and how does it work?
This is probably the most common question that I get. People simply want to know what it is and how it works and why they should care, in very clear terms.
So, here’s my attempt at doing just that.
So, first, why would I be explaining this? I’ve been following Bitcoin nearly since its inception. I have a passion for these kinds of things – my previous career and my college studies drew heavily on computer science and mathematics and it remains an area of passion for me. Combine that with my interest in finances and economics and it’s not surprising that I have had an intellectual interest in Bitcoin since day one. I have personally mined a small amount of Bitcoin, way back in the very early days, and I’ve mostly just held it ever since. (Even with the huge spikes in value, I still don’t hold a lot of value in Bitcoin.)
Here’s how I describe Bitcoin to friends of mine, and even to my older children.
Let’s imagine for a second that dollars were completely digital, like a file on your computer. Imagine every dollar you have was a computer file, right? For some things, like paying some of your bills or giving money to friends, that would be super convenient. If everyone did things this way, it’d be really convenient – you could literally just pay for everything with the dollars stored on your phone.
Well, if that were the case, it’d be easy to become rich. You could just copy all of the files over and over and just make tons of money.
So, how do we fix that? Well, we could have a giant ledger that tracks every single dollar out there and who currently holds it. Whenever someone gives a dollar to someone else, it’s tracked in that ledger. You know how dollar bills have their own serial number – you’d just track them by serial number.
So, there’s a few obvious problems there. One, isn’t that a pretty big invasion of privacy? The solution there is to just let people create their own addresses, like email addresses, that keeps track of their digital dollars. That address isn’t tied to any individual person and is completely anonymous. Let’s call that a “wallet.”
A second big problem is trusting that ledger. Who gets to run the ledger? Who gets to record new entries in the ledger? Furthermore, what’s to stop the person running the ledger from just wholesale inventing more digital dollars and adding them to the ledger and giving them to himself?
Well, you could make the ledger trustworthy by letting pretty much anyone who wants it keep their own copy of the ledger. So, imagine that tons and tons of people have a copy of that ledger, and whenever a transaction occurs, all of the ledgers get updated. If you try to give a dollar to someone that you don’t actually have, the ledgers reject this and say it’s an invalid transaction. Someone can’t just add a bunch of dollars to their own copy of the ledger because all of the other ledgers would say, “That transaction doesn’t or can’t exist,” and reject that transaction.
It’s like an accounting firm that keeps a bunch of copies of the books for a business to make sure they’re all the same, except those copies of the books are distributed all over the world. If someone puts some bogus entries into one of the copies of the books, then that copy would get rejected and thrown away because it didn’t match the many many other copies out there.
This is what Bitcoin is. You have digital Bitcoins you keep in your wallet. When you want to spend them, you give them to someone else. (These steps are all password protected, of course, with some pretty clever cryptography to keep everything secure.) That transaction is shared in all of the ledgers in the world, so you truly no longer have the Bitcoin you spent – if you tried to “spend” a second copy somehow, all of the ledgers would just say “nope” and reject the transaction as bogus.
So, what’s the reward for keeping a copy of the ledger and dealing with all of the transactions? Well, they’re rewarded with occasionally receiving a “free” Bitcoin. This is called “mining” – part of “mining” is that you help maintain the ledger. The ledger that everyone has a copy of is called the “blockchain.”
So, Bitcoin is like virtual money where every time you spend any of it or receive any of it, that transaction is stored in many, many thousands of copies of a ledger (called the “blockchain”) to ensure that transaction is a valid one. Basically, instead of having a physical dollar to demonstrate that you have a dollar, the “proof” that you have that dollar is in the many, many ledgers out there that say you have this dollar. When you spend that dollar, rather than giving a physical item, you just tell all of the ledgers that you’ve given the dollar to someone else, an effort that’s handled electronically.
(I’m simplifying here in some places, but this is the core idea.)
OK, so… what’s the big deal?
The big deal is that the concept of Bitcoin – and the blockchain that supports it – gives virtual things most of the benefits of physical versions of those things. You can’t simply copy them at will, for one, and transactions are extremely difficult to rig. Most of the security issues that have happened with Bitcoin are due to people doing unsecured things with Bitcoin that they wouldn’t dream of doing with actual cash money, like letting the shady guy down on the corner “hold your money for you.”
In concept, Bitcoin – or at least the broader idea of how it works, even if Bitcoin itself isn’t exactly perfect – solves most of the issues with an actual digital currency.
Because Bitcoin was the first digital currency to do this, it’s the one that has been adopted most widely (there are some other currencies trying to do the same thing – we’ll get to those in a bit). I should note that Bitcoin started off as a proof of concept of a really clever idea, and I don’t think even the original creator of it ever believed that it would ever become wildly popular.
People started using Bitcoin at first for transactions as kind of a novelty. After a while, some people who wanted to do financial exchanges that were … shall we way, “off the books” … started using Bitcoin for those transactions, and this made people want to start buying and selling Bitcoin in exchange for both real world currency and for illicit goods. After that, people started investing in Bitcoin, with the idea that if they bought Bitcoin and waited, they could sell it for more than it was worth, because if more people were buying Bitcoins with dollars (or Euros or whatever), the value of Bitcoins would inevitably go up, and then eventually they could sell their Bitcoins and make a nice profit.
That leads us to where we’re at today. You have some people buying and selling Bitcoin as an investment. Others are using it as a legitimate online currency. Others are using it for the combination of privacy and security of long-distance buying and selling.
It would not take too much for Bitcoin to be accepted for payment at a store if you have a smartphone with you with a Bitcoin payment app on it. The backend for that is basically in place.
Why won’t Bitcoin just replace “real” money?
If a government decided that they were going to “back” Bitcoin in some fashion and use it for their official transactions, then it certainly could become “real” money. However, nations generally want a bit more control over the money in their country – Bitcoin would cause them to lose the ability to control the money supply in the country.
(Okay, a bit of economic simplification to follow.)
The big thing that keeps prices from swinging rapidly in a modern country is that the government keeps a pretty tight grip on the money supply. If there is too much money out there, it’s just like normal supply and demand – an individual dollar isn’t worth as much because there are so many of them everywhere and the price of things you buy in the store goes up and this can spiral out of control if they’re not careful. If there’s not enough money out there (and people are just holding onto what they have), then people stop spending money entirely, stores go out of business, and so on. There’s a balance needed there to keep economies going – a dollar needs to be fairly rare, but not TOO rare.
Just using Bitcoin wouldn’t work for a modern nation, because they lose all control over the money supply. Prices would start swinging like crazy, just like the value of Bitcoin. You don’t want the prices of all goods to fluctuate 10% on a daily basis.
My guess is that at some point, governments will start adopting something akin to Bitcoin, but with some government control over the money supply. Bitcoin inherently doesn’t have that.
What about other cryptocurrencies, like Ethereum?
With the huge success of Bitcoin, it’s not surprising that other people have jumped into the mix with their own variation on Bitcoin. Some of them are basically just copies of Bitcoin where someone has a bunch of the currency and hope that it’ll take off and they’ll get rich – those are virtually guaranteed to fail.
Some of the others that actually have a clever improvement on Bitcoin integrated into them have achieved some popularity on their own. Ethereum is one example of that. Ethereum works much like Bitcoin, with the “blockchain” shared ledger idea, but it basically allows more complex contracts to be written instead of just “buy” and “sell” transactions. For example, you might have a contract with someone that enables you to be paid automatically on a certain date and that contract is literally written into the blockchain.
In fact, a lot of large businesses are starting to use an Ethereum-like system to manage internal contracts or agreements, which saves a ton of time and effort for all involved once the system is set up.
So, should I invest in Bitcoin or Ethereum or any other digital currency?
In a word, no, not unless you’re completely fine with losing all of it.
Bitcoin is a real thing with real value, but there is no entity out there that is really concerned with maintaining that value first and foremost. It doesn’t have, say, a Treasury Department working to make sure that the value of it is stable. It’s not even comparable to a company’s stock, in which the company (usually) wants the value of the stock to go up.
Instead, you have a bunch of different entities out there with a bunch of different aims. Some want it to keep going up forever. Some want it to go down. Some want it to go down for now, then up. Others want the exact reverse of that. And there’s no regulating force behind it, no one that wants it to be stable and to maintain value long term. There is no one obligated to buy it if everyone starts selling it, or sell it if everyone starts buying it, for the purpose of adding stability.
With money, treasury departments do this directly. With stocks, companies do this indirectly with things like dividends, and occasionally directly with stock offerings and stock buybacks. With cryptocurrencies, as of yet, no one is doing anything for stability, (other than small startups solely piggybacking on a particular cryptocurrency, and they generally don’t have enough power to stop a flood of selling).
That doesn’t mean that Bitcoin is somehow bad, just that an individual investor shouldn’t be betting a significant amount of his or her net worth on something that can fluctuate so wildly. If you have a bit of extra money and want to dabble in it, I say go for it, but I wouldn’t based anything I was relying on for future living on it.
But aren’t people getting rich off of this?
Yes, there are quite a few people who have gotten rich off of cryptocurrencies, Bitcoin being the most notable one. Mostly, the people who have gotten rich are people who were speculating in Bitcoin with money they could afford to lose without disrupting their financial future – many had substantial wealth already, or had very little to lose to begin with and were willing to accept enormous risk.
I could invest a lot of my net worth in any number of highly risky things. Some might pay off enormously – most wouldn’t. If I have resources to spare, then this might make for a great way to spend my time and extra resources.
The reality is that most people don’t have that kind of flexibility in their finances. Investing enough money into something to actually make a huge change in their life would require risking a large portion of their net worth in something with a high risk factor, and if that investment didn’t pay off, that person is left destitute. It’s far too big of a risk for most people to reasonably take.
When you see the success stories around Bitcoin, what you don’t see are the twenty times as many failure stories in all kinds of other investments, or even the failure stories of people who bought into Bitcoin when it was near its peak and lost half of their money in a month. They don’t get reported because they’re not exciting. The guy who was already wealthy who invested $1 million that he could afford to invest and turned it into $20 million? That’s a story.
It’s honestly not that different than the gold rushes in the 1800s. Stories would spread of the person who struck it rich early on and that would cause a stampede, only for almost none of the next wave of people to do very well. The people who did do well were the ones who set up the hotels and sold the supplies.
So, what should Simple Dollar readers do?
First and foremost, understand in a basic way what Bitcoin is. Bitcoin is a virtual item that people can buy and sell. When one is given to someone else, that transaction is recorded in many, many ledgers around the world. That system of ledgers is called the “blockchain.” There are a lot of smart security steps in this process. That’s really all most people need to know. Other cryptocurrencies use basically this same idea, with some variations.
Second, don’t invest in any cryptocurrency unless you can afford to easily lose all that you “invest.” Never, ever put any money into a cryptocurrency unless it’s money you don’t need to survive on in the future. If you want to play around with Bitcoin or any other cryptocurrency, then do so, but use “fun money” to do it. There are a lot of scammers out there making up new cryptocurrencies, and even the reputable ones are bouncing around in value like a child in an inflatable pen.
Third, I virtually guarantee there will be versions of blockchain technology that you will be using ten years from now. The core idea is one that you should most definitely understand, because it is a really great way to make digital transactions secure and verifiable. There are already companies using this internally, and there are really brilliant ideas for blockchain being publicly considered and developed all the time. Understand it now, so it seems more natural later. I truly believe that some variation on blockchain is how all financial transactions will eventually be handled – it just likely won’t be through Bitcoin itself or any of the other current cryptocurrencies.
Finally, if you have any deep interest in math, computer science, and economics, cryptocurrency, Bitcoin, Ethereum, and all of these things are really fascinating right now. How the systems actually work and some of the uses and ideas being proposed right now are really, really interesting. If this kind of topic interests you, the best starter book I’ve found is by Andreas M. Antonopoulos, which will teach you the basics. Read it slowly, look up things you don’t understand, and you’ll get there.
What about you? Are you invested in Bitcoin or other cryptocurrencies?
In early 2012, I mined a small amount of Bitcoin while I was learning about it. (Remember, mining effectively means supporting the network of ledger copies called the “blockchain.”) I participated in a very early Bitcoin mining pool that was run in a very ad-hoc way, where it was more of a lark than anything. Bitcoin was valued at about $3 per BTC at that time. I ended up with only a fraction of a Bitcoin – approximately 0.05 BTC – but I only mined for a very short while. A year or so later, I donated 0.02 BTC to a website that I was enjoying. I still have the remaining 0.03 BTC. I haven’t bought any Bitcoin, nor sold the 0.03 BTC that I have.
I find Bitcoin pretty interesting and have followed it and other uses of the “blockchain” idea for years. I think Bitcoin will retain some value over the long term, but I am not at all convinced that it will remain over $10,000 per BTC. I expect that it will remain incredibly volatile. I have little faith in other cryptocurrencies other than as proof of concepts for neat ideas until one is backed by the full faith and credit of an extremely large institution that ties its financial future to it and thus has interest in maintaining some stability. I will not be investing in any cryptocurrency until something like that happens, though I may attempt to mine some for fun.
I do not feel someone is foolish for investing in Bitcoin provided that they have the financial resources such that it is not financially damaging to them to do so. If someone is well off and uses excess resources to invest, or someone is doing it with their fun money, then there are far worse things to do with your money than dabble and trade in Bitcoin. I just discourage anyone from using any money that they need for their financial future in Bitcoin or any current cryptocurrency.
Good luck, and have fun.