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Understanding Bitcoin

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Through recent conversations with various friends and colleagues, it has become apparent that Bitcoin is somewhat of a mystery to the majority of the population. The common query, even among seasoned investors, is inevitably, "What is Bitcoin?"

The term Bitcoin can be a bit confusing. In the US, for instance, our monetary system is not referred to as the dollar; the dollar is simply the unit of currency. However, the word Bitcoin refers to both the system and the denomination of the currency. So when referenced, the term Bitcoin can either refer to the Bitcoin Currency System, or the denomination of the currency (a Bitcoin as opposed to a dollar or a euro). For the purpose of this blog I will indicate the difference, although common usage does not.

The Bitcoin Currency System is a form of currency developed in 2008 by an unidentified programmer known as Satoshi Nakamoto, with both similarities and differences to other currencies. It is similar to any nation's currency in that it is traded and the market ultimately determines its value through pricing goods and services. However, the Bitcoin Currency System does not have the backing of a nation, nor is it currently regulated by traditional means (it actually self-regulates via a computer program). Though still small compared to nation currencies, Bitcoin is the only decentralized currency in the world today. Unlike other currencies, Bitcoin is actually transparent, and it is easy to quantify the amount that exists within the market. Just Google "the price of Bitcoins," and you will be directed to any number of sites that give you the daily price and the total value of the entire currency -- a process that is calculated by multiplying the value of Bitcoin on that day by the total number of outstanding Bitcoins. What could be more transparent and straightforward than that? By contrast, the actual value of all outstanding money of any nation's currency is at best subjective and very confusing on an international scale. Each country determines its own policy and prints money. Hence, most currencies can be diluted if a country simply decides it needs more of it.

Each Bitcoin has a unique ID analogous to a serial number on a dollar. Bitcoins can be transacted over the internet like any other currency, so long as they are accepted by the vendor. When an internet transaction occurs with Bitcoin it is recorded in a public ledger known as a "block." The block is a record of the transaction, which includes the details concerning the transfer of ownership of the Bitcoin, and is then recorded in a blockchain. This simple process serves as oversight to police the currency and ensure that transactions are authentic. The ledger is publicly available, but the identity of the owner is hidden.

How did it start and how are Bitcoins created?

The Bitcoin Currency System was designed to mimic the economic properties of gold, in that there is a finite amount of it (the more you mine, the less there is available). As scarcity and use increases, the value goes up. Additionally, the price of gold tracks inflation because mining it, refining it, and delivering it requires labor and goods. As the price of labor and goods increases over time, so does the price of gold.

The parties involved in the creation and delivery of Bitcoins are called "Miners."

The Bitcoin Currency System operates on a cleverly designed computer program which is open source, or available to anyone. Miners earn Bitcoins by solving mathematical problems generated by the Bitcoin currency program. The mathematical problems are generated by the program when authentication, processing, or other services are required to service transactions. By doing this, the system harnesses or utilizes the Miners computer power; and anyone can be a Miner.

From the outset, Miners have been primarily computer enthusiasts. However, the software is designed to create increasingly difficult problems to solve, and the number of Bitcoins paid to Miners as remuneration decreases as more Bitcoins are created. As the Bitcoin Currency System matures, enthusiasts will no longer have the computing power or resources to do the work required, and larger organizations will take over. The increasing difficulty (and therefore the cost) to create new Bitcoins will eliminate smaller Miners, as has been the case within the literal gold-mining system.

The program was designed so that each Miner contributes their computers' processing power towards maintaining the infrastructure needed to support and authenticate the currency network. As more processing power is contributed to the system, the software automatically increases the difficulty of the math problem, thereby creating scarcity of the newly created Bitcoins. There is a limit to the total number of Bitcoins that can ever be created, and the arbitrary cap is set at 21 million. Once this number is reached (or approached), those parties contributing their computer power will be rewarded through transactional fees ultimately paid by users (like a credit card processing fee) rather than though mining.

At one point in our history the most important currencies in the world were tied to gold, and money was issued based on the amount of gold held by the government. Over the past 100 years, however, most countries drifted off of the gold standard and simply issued money based on decisions made by politicians and other government officials. So when they needed money, they issued it, often resulting in massive devaluation of these currencies, not unlike what we've seen in third world countries or throughout our own Great Depression. Predating even the gold standard was the barter system, where currency was established through items traded for other items. That system ensured absolute adherence to the value of the currency being traded -- a goat is a goat, and should be traded as such.

The Bitcoin Currency System closely resembles such a pure system. Despite common criticisms of the Bitcoin Currency System relating to a lack of transparency, there is in fact nearly absolute transparency. The value of a Bitcoin is determined by supply and demand, and more Bitcoins cannot simply be issued because a country or a party needs more of them. The increase in the number of Bitcoins is purely organic, and if the cost of the computing power necessary to generate a Bitcoin exceeds the trading value of a Bitcoin, then no more will be mined. Just like gold, no one will pay $1,000 an ounce to extract and deliver Bitcoins when trading at $800 an ounce. The result is Bitcoin being worth exactly what it should be worth, and not shrouded in mystery, which has become the norm for most major currencies.

Not surprisingly, governments do not like the Bitcoin Currency System because it threatens their respective currency. One reason for this relates to the fact that holders of Bitcoins currently have anonymity. Those who own Bitcoins are anonymous, and regulators point to the inherent risk of using said anonymity to evade taxes. Nevertheless, this is not actually a legitimate concern. The holder of Bitcoins has no more anonymity than a person holding cash in his pocket or at his house. In fact, Bitcoins actually afford less anonymity to holders (compared to holders of cash) because no computer record of cash exists, but ownership of Bitcoins is digitally recorded in the Bitcoin ledgers. And as is the case with Swiss bank accounts, the IRS can require disclosure and could ultimately determine individual ownership by using the same powers it has used to break down other anonymous walls. Lots of people contend that the Bitcoin Currency System lacks transparency, and part of this sentiment stems from an inability to distinguish transparency versus anonymity -- two obviously different issues. In actuality, the Bitcoin Currency System has both transparency and anonymity.

What are the Risks?

Like anything new, the Bitcoin Currency System will have objectors and abusers. For instance, the Bitcoin Currency System took a major hit last October after the drug trafficking website, Silk Road, (where purchases were made with Bitcoins) was taken down. However, for the sake of argument, no one would earnestly suggest that cash should be abolished because drug traffickers use it.

The Bitcoin Currency System experienced an even greater hit again in February when a leading Bitcoin exchange, MtGox, went offline and disappeared for nearly three weeks. Bitcoin reversed most of the losses stemming from those issues, which were in fact attributed to stabilization of the collective computing power. Due to a reliance on computers for all of our economic transactions today, this is an inherent risk of any currency -- decentralized or not. The same risk applies even to PayPal, or having your password or other identification information hijacked.

These are simply the risks of the computer age, which encompasses the true risk of the Bitcoin Currency System, as opposed to transparency. There is no less transparency in owning a Bitcoin than owning a dollar. The dollars you have in your hand (or under your mattress) all have serial numbers and are unique. Whether or not you report those dollars as your own has no impact on the value of the dollar, nor does it mean that those dollars are the product of tax evasion. Citing an anonymously published report, an article in The Guardian recently claimed that "Bitcoin prices were being manipulated in late 2013 by a pair of autonomous computer programs running on Bitcoin exchange MtGox." Additionally, The Guardian reported that "Bitcoin's value went from around $200 at the start of November, 2013 to a peak of $1,132 by the start of December -- at which point the price collapsed." But why should that be considered remarkable?

Because Bitcoins still represent a small currency, and they are not widely accepted, their value will be susceptible to wide swings until and if the currency matures. So users, and those serving the capacity of an exchange, inevitably take on enormous risk by accepting such a volatile currency.

However, the most noteworthy disadvantage facing Bitcoin is a dearth of availability in retailers and vendors that accept it as currency. Currently only a select few companies accept Bitcoin -- Overstock.com being one of the most visible, with Dish Network and others announcing that they will accept the currency beginning in the third quarter of this year. That said, Overstock.com and Dish Network are the exception rather than the rule among retailers, as the Bitcoin Currency System continues to be regarded as simply not liquid enough to accept with confidence, and therefore extremely volatile. If all retailers suddenly decided not to accept Bitcoin, it could suddenly be rendered worthless. With Bitcoin, although at times the market seems to indicate the consensus that it is being properly controlled and valued, it remains deregulated. Hence, it's not yet considered meaningful, which is why you don't see it accepted by more retailers.

Value swings and liquidity are not the only issues facing investors of Bitcoin. By virtue of being involved with an unregulated currency, one is immediately made a target by governments, and will likely face attacks. For instance, in an effort to dissuade usage of Bitcoin -- despite the fact that it is and obviously legitimate currency -- the IRS decided to treat and tax Bitcoins as assets. This penalizes holders of Bitcoins for merely spending their money -- and such an example could be just beginning of a trend. The Bitcoin Currency System is not established enough to defend against arbitrary policies on the part of governments. Consequently, it will remain susceptible, at least until it becomes formidable.

Considering the risks, how is Bitcoin currently considered valuable within the market?

The answer lies in the erosion and instability of the American dollar and other world currencies. The current policy of the U.S. is to simply print money at will, whenever it is needed. This is a reckless policy which has caused the value of the current American dollar to plummet when compared to that of the 1990s. Additionally, interest rates remain artificially low.

If treated judiciously, the government would have raised interest rates to increase the value of its currency. If one is in desperate need of money, the natural order of things is to pay a premium at a higher interest rate, or actually produce more. But that has not been common practice in recent years. America's choice to print money and sell it cheaply has resulted in the dollar losing much of its credibility. If managed properly, we would have inevitably experienced pain by paying the just price for our mistakes, but the long term the value of our currency would have remained intact. Unfortunately, we have essentially ignored the system that is the basis for our currency's value. And like much of the world today, short-term relief trumps permanent cures.

Previously a large portion of the world economy was tied to the American dollar. When the euro was created it actually provided an opportunity for greater potential in the American dollar. Initially, there was a great deal of uncertainty and instability with the euro, and the American dollar should have become the primary world currency. But that opportunity was missed by recklessly printing money. There is no doubt that in the last decade we have endangered the US currency and removed it as a pillar of economic stability. Now, the value of the American dollar is very much faith-based, much like the peso. The policy of irresponsibly printing money has led to the dollar's erosion, allowing not only foreign currencies to challenge it, but creating the opportunity (and in fact the need) for seemingly incorruptible currencies such as Bitcoin to exist. Much of Bitcoin's value is directly correlated to a lack of faith in the American dollar.

So what does the future hold for Bitcoin and similar currencies that will inevitably be created?

Given that the number of Bitcoins is finite, it has an advantage over currencies like the American dollar. Certainly if Bitcoins were being printed any time based on the subjective decisions of policymakers, they would instantly be considered worthless by the market. In the future, a finite currency that offers clearly defined parameters will likely be a game changer. Given the aforementioned instability in world currencies, there is a definite need for something like the Bitcoin Currency System. Though still facing challenges, the concept is here to stay -- if not Bitcoin, then it will be something else in a similar vein.

There are countless advantages to a Bitcoin-type system once it becomes widely accepted. One would instantly become isolated from banking risk. You could walk into any country without having to struggle with currency exchanges. If you reside in a country that restricts the transfer of money outside of their borders, you would be immune to such parameters. Trapped currencies would be a thing of the past, and governments would be forced to operate their economies responsibly in order to compete. When properly analyzed, the benefits of a Bitcoin-type currency system far outweigh the cons.

For those whose money is tied up in unstable nation-based currencies (which is, essentially, everyone), Bitcoin is a definite option. And with the present-day world economy built on a number of different currencies -- no longer relying so heavily on the American dollar -- a huge opportunity exists for global corporations to create currency that can legitimately rival that of world nations.

The vast amount of American currency throughout the world means that any movement in value will have a relatively small impact (at least initially) on the world economy. But with Bitcoin, the value can fluctuate dramatically until it grows. That's why a currency developed by a large global corporation -- like American Express -- could be a true possibility for the future, with real staying power. Although the risk remains quite high and the initial release would be uncertain, the concept of a large global corporation creating a regulated currency that has the backing of its assets and accordingly provides transparency could inevitably become a reality. If they disclose the means by which they developed such a currency, along with the basis for its value and regulation, it will alleviate much of the disadvantages that come with the Bitcoin Currency System.

However, if Bitcoin is allowed to grow without competition (a legitimate consideration given the appeal of not being tied to a company with a pre-existing agenda,) it is conceivable that Bitcoins will remain the decentralized currency of choice. Time will tell, and the narrative will no doubt be intriguing.