Finance / Seven questions you need to ask about bitcoin

Seven questions you need to ask about bitcoin

With bitcoin now worth 800 per cent above its initial valuation, is the superhero cryptocurrency in danger of becoming a supervillain?

What is bitcoin? 

A currency, a system – and the next big thing everywhere, according to most news outlets.

It’s officially a “cryptocurrency”, but that term suggests bitcoin is merely a unit of money. But it needs greater definition. Bitcoin is also a payment system in itself, that includes the blockchain – a publicly distributed ledger – and a peer-to-peer financial network.

At bitcoin’s birth in 2008, a person or persons known as “Satoshi Nakamoto” published a white paper which introduced the system to the world as an alternative currency. It was intended to serve the greater good, with its ideas about independence from governments and central banks and isolation from fraudulent financial shenanigans, and self-governing citizens free of the shackles of state interference and corruption: a decentralised but functioning power structure.

At bitcoin’s birth in 2008, a person or persons known as “Satoshi Nakamoto” published a white paper which introduced the system to the world as an alternative currency. It was intended to serve the greater good, with its ideas about independence from governments and central banks and isolation from fraudulent financial shenanigans, and self-governing citizens free of the shackles of state interference and corruption: a decentralised but functioning power structure.

It proponents hail it as revolutionary and rebellious; its opponents see it as uncontrolled and open to abuse. As does anything that threatens the status quo, bitcoin has attracted a loud and extensive commentariat. It can often be hard to separate the real information from the white noise, which is why you’re already reading this guide (which is, of course, the former) to how it will affect you.

We are already using digital payments when transferring pounds, euros or dollars. What makes bitcoin any different? 

There are many distinguishing features of bitcoin, but here we’re focusing on three: difference in money creation, the peer-to-peer transactions and the safeguards of the system.

For a user-friendly explanation, let’s simplify a few complex ideas and tell you a little story about how money is created.

Traditionally the banking system is the engine for money creation. Let’s say that Greedyland, a sovereign nation state, has a rule that every bank must keep 10 per cent of the deposits in the bank. If the citizens of Greedyland deposit 1,000

grissinis (the national currency of Greedyland), then the bank must keep at least 100 grissinis in their vaults, so that their customers always have access to their cash. But the banks are free to lend the leftover 900 grissinis to property buyers, businesses, or even to other banks.

Let’s say the yearly interest rate on each of these loans is 5 per cent – so when the debtors pay their loan back in a year, they pay 945 Grissinis (900 plus 5 per cent). Et voila – the initial 1,000 grissinis has swollen to 1,045 Grissinis (100 plus 945) in 12 months. Money has been created.

Simultaneously, the property buyers have renovated their flats (employing builders, plumbers and painters), the businesses have produced new car tyres and fur coats, and the other banks have helped other businesses. Not only money is created, but also additional economic value. When new values are created, we need new money to pay for them – and when new money is born, we produce more goods and services.

So how does that work with bitcoins?

How are new bitcoins created?

Let’s imagine that Mr Hammond wants to buy a red suitcase from Mr Bannon.

The price of the suitcase is one bitcoin – fairly expensive, as in sterling the price tag is £5,633.50 (on the day of publication). Mr Hammond finds Mr Bannon on an online marketplace, PanamaSwap.disorg.uk. He buys the the red suitcase, but now somebody needs to check whether his bitcoins are real.

What does real actually mean? A banknote in Greedyland, the UK, US or France would be real if it was issued by the central bank, the Royal Mint, the Federal Reserve, or whatever relevant authority, using watermarks, special paper and other authentication devices to verify its authenticity.

Bitcoin is not a banknote with a watermark, but a file in an e-wallet. We can trust Mr Hammond, but some other bitcoin holders will try their luck to copy their files and try to become rich dishonestly.

So the best way to safeguard the value of the bitcoin is to keep a record of every token and every transaction in a ledger, and every time a transaction is initiated, we can record and validate all tokens involved and all relevant details.

But with all the Hammonds, Bannons, suitcases and bitcoins in circulation in the world, you may think that level of safeguarding needs supernatural powers – taking a snapshot of the current status of the whole bitcoin universe in every millisecond sounds like a work for magicians. This is where bitcoin miners come in, and for their efforts they earn (well, create) new bitcoins.

What makes the ledger and bitcoin miners special? 

The ledger is called the blockchain.

Blockchain is the robust, continuously updated shared record where every transaction and bitcoin is followed from millisecond to millisecond. Shoes, cocktails, cookbooks, accounting services, fortune-telling and plumbing are sold and bought from Manila to Kuala Lumpur around the clock, without any schedule or structure. The blockchain follows them all.

Blockchain is the robust, continuously updated shared record where every transaction and bitcoin is followed from millisecond to millisecond. Shoes, cocktails, cookbooks, accounting services, fortune-telling and plumbing are sold and bought from Manila to Kuala Lumpur around the clock, without any schedule or structure. The blockchain follows them all.

As there are tens of thousands of miners contributing to the blockchain, it has to be the smartest spreadsheet shared in the cloud. There is no room for failure.

The computations miners run demand whole farms of high-capacity computer hardware and software. Visit one of these farms, and you will learn a lot about global warming.

Does no banks mean no central bank?

Exactly. This is a peer-to-peer system – the money goes from buyer to vendor without intermediaries. If you argued that paying with cash instead of a bank transfer was the same, as there was no intermediary, you would be wrong. The banknote itself, issued by the central bank of your country, means that there is an intermediary present – the authority who has recorded and verified the value of the cash that you exchange.

Is bitcoin affected by inflation?         

Whenever new money is created theoretically there is inflation.

Imagine that in 2017, Greedyland has produced exactly 100 items and its citizens can buy one of each with the 1,000 grissinis they have. The average value of each item is 10 grissini.

In 2018, through the banking system, 100 more grissinis are created, so the citizens have 1,100 grissinis – but the country is still producing 100 items. This means that the average price has climbed to 11 grissinis – the money is worth less

and the consumers must spend more of it to get the same products and services.

Of course, the reality is far more complicated, but when governments and central banks set their inflation target and base rates they try to control not only the prices but also the productivity of the economy. A healthy level of inflation signals growing output and more money.

I heard that criminals, drug and human traffickers and terrorists use bitcoin. Should I keep my distance?

Criminals are also using euros, pounds sterling, dollars and other national currencies. Many countries accept bitcoin as a legal currency. The Japanese government is preparing to introduce bitcoin as an official currency alongside the yen. Goldman Sachs, meanwhile, plans to start a new bitcoin trading option on Wall Street, the first of its kind.

Whether you should use bitcoin or not is a question only you can answer. If you do, according to Jamie Dimon, CEO of JPMorgan, you are “stupid” – he sees perilous patterns and insidious forces behind it. CNBC has run a survey with almost 100 CFOs who have expressed their doubts about the reliability of bitcoin. Some of them think the obdurate rise in its value, to almost 800 per cent of its initial USD exchange rate in 2008, represents a bubble.

Others are more optimistic and think that bitcoin is still finding its real value. Exchange rates fluctuate, they say, so just act responsibly.

Ultimately, the decision on whether to use bitcoin or not does not require more or less professional argument than any other financial and trade decision, where you still need to think about exchange rates, volatility, due diligence and compliance with regulations.

Ultimately, the decision on whether to use bitcoin or not does not require more or less professional argument than any other financial and trade decision, where you still need to think about exchange rates, volatility, due diligence and compliance with regulations.

Bitcoin is not the only cryptocurrency either – many others such as Mastercoin, Ethereum and Karmacoin have entered the fray. India and Sweden are thinking about issuing their own national versions, and Russian president Vladimir Putin has invested $37billion in an ICO, the initial currency offering of new digital currencies.

Business Reporter cannot give advice either way, only make its readers aware of the risks – you may lose all your investment in using bitcoins, digital currencies or engaging in any market operations and speculation. So be careful…


Originally published in Business Reporter Online: June 2018

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