What is Bitcoin, how does it work, and why am I not a billionaire?

A boy asked his Bitcoin-investing father for $10. His father said, “Twelve thousand dollars? Son, what do you need two dollars and fifty-seven cents for?” If you don’t get the joke, don’t worry—make it to the end of this article and I promise that you will. To its critics, Bitcoin and other cryptocurrencies—including Ethereum, Dogecoin and many others—are a pipe dream at best, a Ponzi scheme at worst. To its advocates, they’re the wave of the future, the ideal alternatives to precious metals in the rocky economic times and runaway inflation they are convinced lay ahead.
These aren’t just any critics and advocates. The most successful and credentialed economists and financial entrepreneurs on the planet are at complete loggerheads over the subject. So if you’re flummoxed by the idea of cryptocurrency as “digital gold,” don’t beat yourself up over it—you’re in excellent company.

I feel a good first step to understanding cryptocurrency is to break down the word itself. Crypto = encoded. Currency = a proxy for money. That’s clear enough, right? Oh, sure. As Groucho Marx said in Duck Soup, “Clear? Hah! Why a four-year-old child could understand this…run out and find me a four-year-old child, I can’t make head or tail of it.”

Fair warning: I don’t profess to be an expert by any means; in fact, I approached this assignment in the most basic way, by asking: if I had $10,000 lying around in a shoebox, would I invest it in Bitcoin? Please ask yourself the same question, as we embark on a journey into the world of cryptocurrency and its alternatives. What follows may seem painfully obvious to those who make their living in the banking and financial sectors, but for the rest of us knuckle-draggers, it’s important that we devote a few paragraphs to picking this question apart.
What Is Currency, Anyway?

Okay, so let’s look at the second part first. What does a “proxy for money” mean? Very early on in human history, people realized that it was far more efficient to trade goods and services using a universally valued and quantifiable medium of exchange, rather than direct barter. For 3,000 or so years, the preferred commodities have been gold or silver, usually in the form of small bars or coins. The problem for everyday people was assuming the burden and risk of carrying around these precious metals. Six hundred years ago, in Renaissance Italy—thanks in no small part to the Medicis and double-entry bookkeeping—“modern” banks and paper currency were invented. A bank or government treasury would hold gold and silver as a safe deposit, either for a fee or as a loan in exchange for interest paid, and issue receipt certificates (we call them bills) in denominations small enough to be used in daily commerce. They were redeemable on demand at the bank for the corresponding amount of physical gold and silver.

During the 20th century—as world war led to depression, to another world war, to inflation, etc.—the bond between gold and silver and paper currency was stretched to the limit and finally severed. If you are in your 60s or 70s, you may remember dollar bills used to be called Silver Certificates, and that until 1965, the dimes, quarters and half-dollars you received in change when you broke a dollar bill were partially made of silver. In August 1971, the Nixon administration “temporarily” suspended the convertibility of dollars to gold. That gold window is still closed, which makes the U.S. dollar a fiat currency.

Well there’s an interesting word. Fiat is Latin for “Let it Be (by decree)”—meaning that the bills in your wallet have value only because our government orders it so. We call dollars “legal tender” because coins or bank notes, by law, must be accepted when offered as payment “for all debts, public and private.”

Fiat currency has two main drawbacks: First, a government-authorized central bank issues and controls it; second, it is not limited by quantity. Our central bank (the Federal Reserve) can create as much as it wants, whenever it wants, and inflate the supply. What’s the problem with this? The fundamental rule of supply and demand says the more dollars that are created, the less value each one has. For example, a U.S. dollar in 2021 has less purchasing power for goods and services than a nickel in 1913.

Something else to understand about 2021 dollars: unlike that 1913 nickel, they are mostly digital. Today, we mainly use debit and credit cards, services like PayPal, Venmo, or various types of wire transfers. Once computers were available to keep track of how and where money moved, the transition away from paper and coins was fairly simple, since a centralized issuing authority and banking system already existed. The primary hurdle was not figuring out how to create a digital file that represents a dollar, but how to prevent someone from using that same dollar more than once (aka double-spending). Banks solved this problem by keeping centralized ledgers on their computer servers that record and confirm the transactions made by their account holders. We trust our banks. Our banks trust their servers. But digital transactions are still centralized, and predicated upon that fiat value of the U.S. dollar.

Now For the Crypto Part
Ask yourself this: What if you could enter into transactions with anyone, anywhere on earth, without using U.S. dollars—without worrying about the government and the Federal Reserve inflating away the value of your currency, and without a central authority keeping an eye on who is sending or receiving money? Many attempts had been made to realize this possibility, but none succeeded in eliminating the aforementioned risk of double-spending.

That all changed on October 31, 2008, when a document was published online—by an anonymous person (or persons) named Satoshi Nakamoto—entitled: Bitcoin: A Peer-to-Peer Electronic Cash System. It laid out the blueprint for creating an alternative digital currency using a transparent, decentralized ledger “…allowing any two willing parties to transact directly with each other without the need for a trusted third party.”

Why was this such a big deal? Bitcoin was the first digital “currency” not issued by government fiat or controlled by a central bank. Think about what the world was like before the internet, and how centralized information was. You could read newspapers like the New York Times or Washington Post, watch the evening news on the three major networks, pick up a copy of Time or Newsweek, or go to a bookstore or library and get “old information.” The internet decentralized news and information. Advocates of Bitcoin call it “the internet of currency.”

Bitcoin is called a cryptocurrency because of the encryption technology used in every single transaction, called a blockchain. Every single time that a transaction occurs, an enormous group (currently 80,000 or so) of individual server operators (called “miners”) compete to be the first to unlock its cryptography, in order to verify that the transaction is legitimate and that the same unit of Bitcoin is not being used more than once. Once a certain number of transactions are verified, they are grouped together in a “block,” which is then added to the “chain” of already existing “blocks.” Every block added to the chain creates a more unbreakable and trustworthy chain of transactions. The “miners” who decrypt, verify and record the transactions in the blockchain earn new Bitcoins as compensation for their work, which are then introduced into circulation. The Bitcoin blockchain is programmed so that only 21 million Bitcoins will ever exist—a predictably scarce, finite supply. At present, 19 or so million have been created in the manner just described, hence the nickname “digital gold”.

As you might have heard, the “mining” computers consume a jaw-dropping amount of energy, which has some potentially dire implications for crypto’s future, but let’s leave that to another time because it is just as interesting as (and even more complex than) the subject matter at hand.

If you feel more than a little bit lost at this point, take a deep breath and hang in there. Elon Musk likes to say that he’s one of the smartest people on the planet, but admits that he doesn’t “really understand” Bitcoin. Still and yet, he’s reportedly dumped billions into it.

Musk certainly understands the security advantages of cryptocurrency, and appreciates its transparency. Banks are not transparent; they keep a proprietary ledger on a central server, and only they can see and control what’s going on. Bitcoin’s blockchain is both transparent and totally anonymous. If you are a holder of Bitcoin, you can see all of the transactions and balances, but can’t identify any fellow Bitcoin holders. Every server in the Bitcoin network holds a duplicate, continually updated copy of the blockchain, which makes hacking or destroying the network virtually impossible, since “bad actors” would have to hack or destroy more than half (51 percent) of the servers simultaneously.

So What Exactly Is a Bitcoin?

Is Bitcoin a currency? An asset? Both? Neither? When I ask myself these questions, I think of Dr. McCoy in Star Trek: “Dammit, Jim, I’m a doctor, not a cryptocurrency Guru.” For starters, there are no physical Bitcoins. When you own Bitcoin, it means that you own access to your specific account record in the blockchain and can send or receive Bitcoin from other accounts. The more crucial question is: What’s it worth? Simple answer: The value of Bitcoin is entirely reliant on the number of people who decide what it is. In this way, it’s similar to gold. But remember—gold is a tangible hard asset, and Bitcoin is a digital asset.

Bitcoin has three major advantages to the current government fiat system. First, it gives you complete control over your currency. You and you alone have access to your account. No government or bank can freeze or confiscate your holdings. Second, Bitcoin eliminates third-party fiduciary intermediaries, so it’s potentially cheaper to use than traditional methods of transaction. Third, and this is perhaps the best advantage, it opens up global commerce to 2.5 billion people who don’t have access to the existing banking regime. The “underbanked”—the poorest, most disadvantaged and unfortunate of our fellow human beings—can buy, sell, or pay for goods and services because their bank is on a smartphone in their pocket. Stop and think for a moment about the potential of such a global blossoming of human capital.

More and more merchants are accepting Bitcoin and other cryptocurrency as payment, as are airlines, hotels and restaurants. Still, the world has taken only the first steps to global commercial acceptance.

Who’s on Board with Cryptocurrency?

Not everyone. At least not yet. Some financial professionals, including Peter Schiff and Michael Burry (portrayed by Christian Bale in The Big Short), see Bitcoin and other crypto assets as a “greater fool” game of hot potato or musical chairs. What if, suddenly, people all cash in their positions? Businesses might no longer accept it as payment, and its value could plummet to zero. Perhaps the important hedge against this happening is that Bitcoin is not issued or controlled by a central authority or government. Governments can theoretically make their currencies worthless by fiat, but they can’t make Bitcoin worthless by fiat. Also, there is no danger that the value of Bitcoin can be inflated or deflated by the creation of more Bitcoins, as there is that fixed number I mentioned earlier. Their value is determined by their holders and users, not a central authority. Another way to think of it is that the value of dollars is set by the government and the Fed from the inside out. By contrast, the value of Bitcoin is set by its holders and users from the outside in.

Where does the U.S. government (or any other government for that matter) stand on Bitcoin and other cryptocurrency? Let’s just say that Washington has serious concerns. Because there is a finite amount of Bitcoin, it may become more appealing to investors who traditionally put their money into Treasury bonds to look at Bitcoin as a safe haven. Even before the COVID-19 pandemic, our economy and that of other nations were becoming more and more dependent on government spending of trillions of freshly printed fiat currency to prop up their gross domestic products, in traditional Keynesian fashion.

Do you believe that our government will be able to service its soaring debt in the future? A lot of people have their doubts. If investors who currently keep their money in dollars and treasury bonds turn to cryptocurrency like Bitcoin, it will make it harder for the government to issue more debt, because someone actually has to buy it. You probably don’t hear much about this problem unless you’re an Econ nerd. The problem that you do hear about is that since the government cannot monitor or verify cryptocurrency transactions, they enable illicit and criminal activities like money laundering, drug dealing and terrorism—unquestionably very real problems with no immediate solutions. However, it’s not as if dollars aren’t being laundered or used by drug cartels or terrorists, too. Of course, there are many reasons (other than nefarious ones) why people might not want the government insinuating itself in their business. Libertarians, for example, believe that the government by definition is badly motivated (Google “Welfare and Warfare State”) and hold strong moral objections to its knowing how or with whom they transact business.

The truth of the matter is that, any time that people act entrepreneurially and seemingly under the radar of government, it tends to raise suspicions. But institutional investors and advocates of Bitcoin aren’t outlaws. They are simply placing their bets on a rival to the government’s primary asset, which is the full faith and credit of its currency, because the value of Bitcoin goes up when confidence in the dollar as a store of value drops. Bottom line? If you sense that your government is going to continue inflating its currency, then cryptocurrency is a possible hedge.

As mentioned earlier, Elon Musk (actually, Tesla) has invested billions in Bitcoin. So has Michael Saylor, the longest-sitting tech CEO in the country. The takeaway is that they believe more in Bitcoin as a repository of value than the U.S. dollar or Treasury bonds. The more new Musks and Saylors there are who follow suit, the more confidence will be generated in Bitcoin’s value. Its success or failure depends entirely on public perception, which is why so many remain so skeptical. However, as long as people are uncomfortable with the way their governments are handling money, diversifying into crypto assets is likely to remain an appealing option.

Will I be dumping my liquid assets into Bitcoin anytime soon? The short answer is Not yet. I would be more inclined to invest in gold, silver and durable commodities like grains and farmland. Bitcoin is way too volatile for my taste and bank account. Any investment that doubles in a year, as Bitcoin has, is tempting to be sure. But I don’t think I could stomach a one-day drop in value of 30%, which has also happened. The prospect of becoming a high-flying crypto-millionaire may be appealing, but the prospect of living under a highway overpass, however remote, isn’t worth the risk. As the old adage goes: Only invest what you are prepared to lose. EDGE

Editor’s Note: To say that the cryptocurrency world changes every day is an understatement. As this story went to press, the Government of El Salvador declared Bitcoin to be legal tender. Five other Central American and Caribbean Nations might follow their lead this summer. And, without revealing exactly how, the FBI announced that it managed to claw back most or all of the ransomware Bitcoins paid to hackers of the Colonial Pipeline, raising fascinating questions about just how secure and anonymous cryptocurrency may actually be.