Would you invest in Bitcoin, the future of global currency?
Yes, there is no central authority or government regulating Bitcoin, but that is the very idea behind it.
A Bitcoin (virtual currency) coin is seen in an illustration picture taken at La Maison du Bitcoin in Paris, France, June 23, 2017. PHOTO: REUTERS
Mark Hanna, a student at New York University (NYU) in 2011, bought a few odd Bitcoins for a $1 each from some guy in Canada through PayPal. He only bought those novelty digital coins to purchase illicit drugs through Silk Road – an online black market – which had begun to use Bitcoin to hide its transactions from governmental oversight.
If Hanna had seen Bitcoin as a speculative asset instead, and somehow managed to hold on to his Bitcoin for six years, each one of his Bitcoin would have been worth $11,000 today – the new high reached by Bitcoin on Wednesday before it dipped 20%. This would have been a return on investment of almost 1,100,000% over six years if Hanna had staked out on Wednesday – not bad I’d say.
It was not just Hanna though. Most of the other people could not understand the idea of a digital currency as a store of value. The problem with Bitcoin is that it is much like what e-mail was in the 90s. People could not wrap their heads around the idea of online letters. Similarly, nowadays people ask how can a software code, based on a mathematical formula created by an unknown Satoshi Nakamoto, be assigned monetary value. How can currency exist only in the digital realm?
There is a simple answer to this. Look at your bank accounts. Do you think the Rs5,65,320 you have sitting in your checking account is safely enclosed in a secured vault, just like Golden Galleons are in the Gringotts Wizarding Bank in Harry Potter’s world?
Everyone knows the answer to this, of course. The Rs100 you deposit in your bank is used by the bank to create Rs97 of debt for someone, let’s call him Mr Asim. This Rs97 is digital currency, which doesn’t really exist. The bank simply relies on Asim’s promise to pay the money back.
When Asim spends the virtual Rs97 at a grocery store, the grocery store owner deposits the virtual Rs97 in Asim’s bank, which is used by the bank to loan out Rs94.09 to another person, and this cycle continues ad infinitum. Each of these people only have numbers showing that they hold this money in their account – much like Bitcoin. This money does not exist in any physical form.
The bank uses the original Rs100 and multiplies it to let’s say Rs3,333. This process of loaning out more money than the bank has as cash on hand is known as fractional reserve banking. Retail banks everywhere create money out of thin air, virtual money essentially, to lend to people and earn interest on it.
The only reason we still use banks is because we believe in the solvency of the banks and the viability of the economic system, which in one word means ‘trust’. In theory, after the collapse of the Gold system and the Bretton Woods system thereafter, there is nothing preventing any central bank from printing as much money as they desire, because money is not tied to anything.
Thus, the central banks also create money out of thin air. They can assign any value to any piece of paper, and it is the collective trust of people that maintains this value. Now, if we were to repose the same kind of trust on Bitcoin or any other digital currency, then it would be no different to a physical currency like the US dollar or the pound.
True, there is no central authority or government regulating Bitcoin, but that is the very idea behind Bitcoin. We do not need any third party to give value to the money we have (central banks) and to conduct our transactions for us (retail banks). The people as a collective can do this, and Bitcoin enables this. How Bitcoin enables this trust on a digital medium is through cryptographic proof, using Blockchain.
To give a simple example, Blockchain is to Bitcoin what internet is to e-mail. Blockchain is basically interplay of complex mathematical functions to create a secure and definitive record of who owns what and when. For Bitcoin, it is simply a record of every transaction that has ever occurred on the network.
Naysayers would say digital currencies like Bitcoin are not secure, and thus, cannot be used as a means of transaction or a store of value. That is a very valid concern because there have been a couple of major hacking cases such as the half a billion dollar theft from the Gox exchange in Tokyo and its subsequent collapse in 2014, and the $72 million theft from the Hong Kong exchange Bitifinex in 2016.
That being said, if a hacker is able to steal Bitcoin, it doesn’t mean that have been able to break the blockchain, rather it simply means that they have stolen money from an unsecure wallet or exchange, because the blockchain itself is impenetrable. If a hacker wanted to break into any block in the blockchain, they would not only have to gain access to that particular block, but to every single block in the entire history of blockchain, and on every single ledger in the network. Also, they would need to access all those millions of blocks simultaneously, which is virtually impossible to do.
It is easier to hack into a bank’s computing system holding sensitive information, than it is to hack into Bitcoin’s blockchain. In fact, credit cards are in a way more of a soft target for hackers than Bitcoin’s wallets. Even if a few are stolen, it doesn’t mean that the whole system is compromised. That’s like saying that if you forget your wallet on a bench in a park, and someone steals it, the Pakistani Rupee has been hacked.
Despite this, the Bitcoin community would need to come up with better safeguards to prevent the hacking of individual Bitcoin wallets and exchanges. This is because if one’s bank account or credit card is stolen from, one can complain to and get refunded by one’s bank, but what recourse do Bitcoin users have if their accounts are subject to theft?
Another major concern with digital currencies like Bitcoin is the possibility of multiple transactions. While with paper money, it is a central bank which gets to decide how much money is printed, with Bitcoin, it is individual miners who not only issue new Bitcoin, but also approve every transaction to ensure that it only takes place once.
When a digital transaction takes place, it is batched up with all other transactions that have occurred in the last 10 minutes, in a cryptographically protected block. Bitcoin miners then compete to approve the transactions by performing complex coded calculations. The first one to solve the coded problem receives new Bitcoin as reward.
You may also think that a digital currency can be easily copied, but it is way easier to counterfeit paper money or even create fake gold than to create fake copies of Bitcoin. This is because consumers’ wallets don’t contain any Bitcoin. Rather, they give an indication of the amount assigned to a particular address in the universal blockchain ledger. And as I said before, it is almost impossible to hack into the blockchain.
Many countries around the world suffer from massive inflation because they print money without abandon, Zimbabwe being a prime example. Wouldn’t it be better if this control was taken away from unscrupulous politicians, lobbyists and bankers, and given to a computer code which ensured that digital currency remained stable?
Bitcoin may perhaps be the answer to this. Bitcoin miners use special software to solve complex math problems and are given a certain number of Bitcoins in exchange. The software code behind Bitcoin has a built-in brake pedal, cutting the creation of Bitcoin in half every four years, and would ultimately limit the total number of Bitcoin to 21 million by 2140.
I don’t want you to see Bitcoin as a speculative bubble or a fad which celebrities have taken to, but an idea which democratises the creation and use of money, and eliminates banks and other third parties. Overtime, many of the glitches which prevent the large scale adoption of virtual money would be removed. Right now, it may be hard to use Bitcoins as a means of transaction because of its massive fluctuations. However, eventually the open market will determine what value to assign to Bitcoin and it will become a stable currency.
Bitcoin’s prices may go up and down, and itself may collapse. But I want you to understand the concept of a digital currency free from governmental control and all other third parties who try to exert control over your money in various ways.
In fact, free floating currencies, not based on gold, is by itself a very recent phenomenon, so if you think about it, the use of Bitcoin, or any other unregulated digital currency, is not really outside the realm of ordinary.
However, if you are not so enthused by the idea of digital currency, and merely want to ride the waves of the speculative bubble that Bitcoin has become, then do so at your own peril. No one really knows how far up Bitcoin will go, or if it will crash, or when would it.
If Hanna had seen Bitcoin as a speculative asset instead, and somehow managed to hold on to his Bitcoin for six years, each one of his Bitcoin would have been worth $11,000 today – the new high reached by Bitcoin on Wednesday before it dipped 20%. This would have been a return on investment of almost 1,100,000% over six years if Hanna had staked out on Wednesday – not bad I’d say.
It was not just Hanna though. Most of the other people could not understand the idea of a digital currency as a store of value. The problem with Bitcoin is that it is much like what e-mail was in the 90s. People could not wrap their heads around the idea of online letters. Similarly, nowadays people ask how can a software code, based on a mathematical formula created by an unknown Satoshi Nakamoto, be assigned monetary value. How can currency exist only in the digital realm?
There is a simple answer to this. Look at your bank accounts. Do you think the Rs5,65,320 you have sitting in your checking account is safely enclosed in a secured vault, just like Golden Galleons are in the Gringotts Wizarding Bank in Harry Potter’s world?
Everyone knows the answer to this, of course. The Rs100 you deposit in your bank is used by the bank to create Rs97 of debt for someone, let’s call him Mr Asim. This Rs97 is digital currency, which doesn’t really exist. The bank simply relies on Asim’s promise to pay the money back.
When Asim spends the virtual Rs97 at a grocery store, the grocery store owner deposits the virtual Rs97 in Asim’s bank, which is used by the bank to loan out Rs94.09 to another person, and this cycle continues ad infinitum. Each of these people only have numbers showing that they hold this money in their account – much like Bitcoin. This money does not exist in any physical form.
The bank uses the original Rs100 and multiplies it to let’s say Rs3,333. This process of loaning out more money than the bank has as cash on hand is known as fractional reserve banking. Retail banks everywhere create money out of thin air, virtual money essentially, to lend to people and earn interest on it.
The only reason we still use banks is because we believe in the solvency of the banks and the viability of the economic system, which in one word means ‘trust’. In theory, after the collapse of the Gold system and the Bretton Woods system thereafter, there is nothing preventing any central bank from printing as much money as they desire, because money is not tied to anything.
Thus, the central banks also create money out of thin air. They can assign any value to any piece of paper, and it is the collective trust of people that maintains this value. Now, if we were to repose the same kind of trust on Bitcoin or any other digital currency, then it would be no different to a physical currency like the US dollar or the pound.
True, there is no central authority or government regulating Bitcoin, but that is the very idea behind Bitcoin. We do not need any third party to give value to the money we have (central banks) and to conduct our transactions for us (retail banks). The people as a collective can do this, and Bitcoin enables this. How Bitcoin enables this trust on a digital medium is through cryptographic proof, using Blockchain.
To give a simple example, Blockchain is to Bitcoin what internet is to e-mail. Blockchain is basically interplay of complex mathematical functions to create a secure and definitive record of who owns what and when. For Bitcoin, it is simply a record of every transaction that has ever occurred on the network.
Naysayers would say digital currencies like Bitcoin are not secure, and thus, cannot be used as a means of transaction or a store of value. That is a very valid concern because there have been a couple of major hacking cases such as the half a billion dollar theft from the Gox exchange in Tokyo and its subsequent collapse in 2014, and the $72 million theft from the Hong Kong exchange Bitifinex in 2016.
That being said, if a hacker is able to steal Bitcoin, it doesn’t mean that have been able to break the blockchain, rather it simply means that they have stolen money from an unsecure wallet or exchange, because the blockchain itself is impenetrable. If a hacker wanted to break into any block in the blockchain, they would not only have to gain access to that particular block, but to every single block in the entire history of blockchain, and on every single ledger in the network. Also, they would need to access all those millions of blocks simultaneously, which is virtually impossible to do.
It is easier to hack into a bank’s computing system holding sensitive information, than it is to hack into Bitcoin’s blockchain. In fact, credit cards are in a way more of a soft target for hackers than Bitcoin’s wallets. Even if a few are stolen, it doesn’t mean that the whole system is compromised. That’s like saying that if you forget your wallet on a bench in a park, and someone steals it, the Pakistani Rupee has been hacked.
Despite this, the Bitcoin community would need to come up with better safeguards to prevent the hacking of individual Bitcoin wallets and exchanges. This is because if one’s bank account or credit card is stolen from, one can complain to and get refunded by one’s bank, but what recourse do Bitcoin users have if their accounts are subject to theft?
Another major concern with digital currencies like Bitcoin is the possibility of multiple transactions. While with paper money, it is a central bank which gets to decide how much money is printed, with Bitcoin, it is individual miners who not only issue new Bitcoin, but also approve every transaction to ensure that it only takes place once.
When a digital transaction takes place, it is batched up with all other transactions that have occurred in the last 10 minutes, in a cryptographically protected block. Bitcoin miners then compete to approve the transactions by performing complex coded calculations. The first one to solve the coded problem receives new Bitcoin as reward.
You may also think that a digital currency can be easily copied, but it is way easier to counterfeit paper money or even create fake gold than to create fake copies of Bitcoin. This is because consumers’ wallets don’t contain any Bitcoin. Rather, they give an indication of the amount assigned to a particular address in the universal blockchain ledger. And as I said before, it is almost impossible to hack into the blockchain.
Many countries around the world suffer from massive inflation because they print money without abandon, Zimbabwe being a prime example. Wouldn’t it be better if this control was taken away from unscrupulous politicians, lobbyists and bankers, and given to a computer code which ensured that digital currency remained stable?
Bitcoin may perhaps be the answer to this. Bitcoin miners use special software to solve complex math problems and are given a certain number of Bitcoins in exchange. The software code behind Bitcoin has a built-in brake pedal, cutting the creation of Bitcoin in half every four years, and would ultimately limit the total number of Bitcoin to 21 million by 2140.
I don’t want you to see Bitcoin as a speculative bubble or a fad which celebrities have taken to, but an idea which democratises the creation and use of money, and eliminates banks and other third parties. Overtime, many of the glitches which prevent the large scale adoption of virtual money would be removed. Right now, it may be hard to use Bitcoins as a means of transaction because of its massive fluctuations. However, eventually the open market will determine what value to assign to Bitcoin and it will become a stable currency.
Bitcoin’s prices may go up and down, and itself may collapse. But I want you to understand the concept of a digital currency free from governmental control and all other third parties who try to exert control over your money in various ways.
In fact, free floating currencies, not based on gold, is by itself a very recent phenomenon, so if you think about it, the use of Bitcoin, or any other unregulated digital currency, is not really outside the realm of ordinary.
However, if you are not so enthused by the idea of digital currency, and merely want to ride the waves of the speculative bubble that Bitcoin has become, then do so at your own peril. No one really knows how far up Bitcoin will go, or if it will crash, or when would it.