Understanding Bitcoin

Most people at this point have heard of “Bitcoin” but few know what it is or why it is so popular.   The market value of bitcoin has grown at an astonishing rate, even faster than that of “Unicorn” stocks like Amazon.  

If you had invested $1000 in Bitcoin at the beginning of 2017, it would have been worth over $10,000 by the end of that year.

If you had invested that same $1000 in 2012, you would be a millionaire.

If you invested two years before that? Well, in that case you could be reading this article on your own private island.

Cryptocurrencies (of which Bitcoin is just one example) are collectively worth over $500 billion dollars in value and growing by the minute.

But what is going on here?  Why are cryptocurrencies valuable? How should we think about them going forward?  Is this a speculative bubble? Is this upward trend going to continue? My goal in this article is to answer these questions without scary technical jargon.  To do that, we are going to have to zoom way out to review some fundamentals.

 

What Makes Money Valuable?


A nickel ain’t worth a dime anymore. –Yogi Berra

 

Why do we have money in the first place?  What gives money its value? You can’t eat dollar bills, nor can you build shelter from quarters.  You can, however, exchange money for all the food and shelter you need so long as other people agree to accept it.  Money has inter-subjective value.  That is a fancy way to say that money only has value because enough people agree that it does.  

 

As a society, agreeing that money has value is really useful! In early civilization, small tribes would trade goods and services with each other.  The ability to trade means you can get really good at doing one thing and trade your work for the other things you need. This is called specialization, and it is far more efficient than trying to do everything yourself.

 

Tribes who trade efficiently would outcompete those that couldn’t.  When only dealing with a small group, money isn’t usually needed.  Barter and reciprocity work pretty well in small groups- you don’t typically need money to track favors and incentivize supporting your family.  As the tribe gets bigger, however, the ease of tracking who owes who what, or even what any given thing is worth becomes much more challenging.  

How many apples equate to a new shirt?

Can I trade a song for a new shoe?

This led to the adoption of more universal modes of exchange (i.e. money).  Different types of money got accepted in different cultures at different times, but the reasons money got adopted were the same across the world.

 

There are three principles that make money better than other forms of exchange.

 

  1. Storage-  easy to store and transport It generally retains (or increases) in value over time.
  2. Fungibility- easily exchanged for goods and services. It is easy to convert into things you actually need.
  3. Security- hard to counterfeit. It is easy to trust that the currency you are exchanging is legitimate.

 

The history of money is the history of getting better at the above three principles.  Let’s take a high level look at the progress money has made over the last two thousand years.

  1. Money started out as rare shells and precious metals.  These were hard to counterfeit and gradually got acceptance to exchange for goods and services, but were not very convenient to store and transport.
  2. Wealthy people choose to store large amounts of gold with trusted third parties, which became banks. Soon, private notes (paper) from those trusted individuals was used as money, verifying that the precious metals were stored and exchangeable.
  3. Government notes eventually surpassed private notes, still backed by precious metals, to allow for better consolidation and wider exchange.  
  4. Soon after that, paper money divorced from a connection to precious metal, and only trust in the entities creating and storing that money supported the network.
  5. Nowadays, our money has moved from paper to digital money, with over 90% of all money existing only on computer servers!  

 

Each one of the steps above represents a form of currency that is better than the previous on the three principles stated above.  Cryptocurrencies represent the next step in this chain.

 

Why are Cryptocurrencies Better than Today’s Money?

 

It is easy to understand how each step above increases the ease with which people store, exchange, and secure money.  The key trait that allow us to move from one form of money to the next is trust.  We trust that 3rd parties (most often banks and governments) will properly manage the flow of money and fairly track what money goes where.  Anyone who has followed current events knows that this trust is often misplaced.  From the housing market crash of 2008 to Enron all the way back to the great depression and beyond, we’ve seen banks, corporations and governments mismanage the flow of money in ways both incompetent and corrupt.  

 

So far, we have accepted these corruptions because it was the only way to gain access to a relatively stable and secure monetary system.  Cryptocurrency changes all that by giving us a way to secure a financial network WITHOUT any central authority.  Lets dig a bit deeper to show you how:

 

What is a CryptoCurrency?

Cryptocurrency is based on a new technology called the blockchain.  The blockchain is a peer-to-peer system for verifying transactions on a network.  What this means in plain English is that there doesn’t need to be any central banks or governments to ensure a trustworthy monetary system.  It does this through the use of cryptography.  This is where the “Crypto” in cryptocurrency comes from.  Cryptography is just a fancy word that means keeping things secret.

 

The most common form of cryptography is the password.  With a password, you and whoever you want to communicate with both have the same password or “key” you can use to communicate.  When I want to login to my bank, I enter the password, which the bank checks against its record. If they match, it allows me to access my accounts and send money. If, however, my password gets shared with anyone (say, if my bank is hacked), then I’m in big trouble- especially if I use that password for multiple sites!

 

Cryptocurrencies use a slightly different technology to help with this problem. For each cryptocurrency, you have both a public key and a private key.  The public key is like your bank account number or home address. You can share it with anyone and they will know how to send you money and where you will send money from.  The private key is like your password. Only you know it, but because of the way your private key is mathematically related to your public key, you can use it to “communicate” transactions without ever revealing your private key!

 

This link between public and private keys makes it safe to share a public key with an entire network. Because each transaction is then verified by that distributed network of computers, no middle man needs to get involved.

 

Cryptocurrencies represent a better form of money because it means trusting in the network instead of politicians and bankers.  By distributing work to a large network of computers, no one person or entity needs to be trusted to secure your money and ability to spend it. Just like the internet opened up information to be shared around the world, so too will cryptocurrencies allow trust to be distributed.

 

Now What?

Bitcoin was designed for use as a trustless currency, and its value in the ecosystem is very similar to that of gold traded on exchange markets.  Bitcoin’s value goes up because it is a limited resource (there will only ever be so much Bitcoin in the world due to the way it was created) and it will go up in value if more people want it- just like gold.

 

Cryptocurrencies, however, are quickly evolving to be far more than just money.  New cryptocurrencies like Ethereum (ETH) are not only used as currency, but actually have the power to form distributed applications and smart contracts.  

 

Smart contracts allow the distributed network to automate some pretty sophisticated processes that currently require expensive middle men to manage.  For example, holding money in escrow until a job is complete or ensuring timely payments from a trust fund.  All of this can be done without having to trust any third party with the use of this technology.

 

Distributed Applications (DAPPS) work just like the apps you have on your computer or “in the cloud” like Facebook, but instead of a central authority running everything from their servers, the application is distributed to hundreds of computers, each running a small and redundant piece of the total application.  Users can get paid in cryptocurrency for being a part of this network.  

 

This type of distributed network will radically change the way we interact with each other over the coming years.  Central authority will be eroded in exchange for distributed networks and this will mean lower costs to work together and exchange our goods and services than ever before.

 

To give you an idea, here are some blockchain projects that already exist or are in the works:

 

A coin that pays you for writing content and getting it upvoted- like Reddit with real money- (Steem – where I’ve reposted this article)

 

A coin that pays you for excess computer storage others can use- like AirBnB for computer storage- (Maidsafe coin)

 

A coin that pays music artists whenever their songs get listened to- like Spotify without the need for publishers- (Choon)

 

Should I Invest?

There are hundreds of cryptocurrencies that exist today and many more that will be created in the coming years.  It is impossible to predict with certainty which ones will succeed and which ones will fail.  If you correctly invested in Amazon in the 90s, you would be doing very well now, but your investments in Pets.com would not have turned out so well.  

I am not a professional investor and this article is not intended to be investment advice.  Cryptocurrencies will remain volatile and no one can predict how individual currencies will do in the short term.  With all that said, I believe in the long term on this technology and I will share my strategy:

 

Rule #1- Invest only what you are willing to lose!

 

Cryptocurrencies are a high risk investment.  Don’t put in money that is needed to pay the rent.  Keep it under 20% of your investment portfolio.  Be prepared to lose 100% of your investment before making the plunge into cryptocurrency investing.

 

Rule #2- Invest in a few of the top performers

 

Don’t put all your eggs in one basket.  I have about 60% of my investment in BitCoin, 20% in Ethereum, and 20% in other top 10 performing cryptocurrencies (you can see market performance at coinmarketcap.com).  Don’t invest heavily in the “hot new” cryptocoin or ICO (initial coin offering).  There are a lot of scams out there, so stick with the consistent performers until you know much more about the space.

 

Rule #3- Don’t try to time the market

 

Don’t fool yourself into thinking you can figure out when the market will go up and down.  Without tons of research and access to information before the public gets it, you have little chance of predicting short term fluctuations.  Even with research, odds are you will still make huge mistakes.  If you want to invest, add money slowly over time to reduce uncertainty and market timing. Make investing a habit and not an impulse decision! Set your rules ahead of time and follow them as best you can.  Don’t let emotions drive your investment decisions.

 

Let me reiterate- this is not investment advice and I am not a professional investor!  Investing is as much about personal psychology (risk tolerance, how you deal with loss, impulsivity, etc.) as it is about the market.  Pick a strategy that works for you.

 

How Do I Invest?

 

For US based investors, the easiest entry point by far is Coinbase.com.  Following this link will allow you to sign up with a $10 bonus on your first $100 investment. You can only invest in Bitcoin (BTC), Ethereum (ETH), and LiteCoin (LTC) on Coinbase for now, but that is a great place to start. Update: Coinbase recently added Bitcoin Cash (BCH) since the posting of this article

 

If you are looking to invest in more cryptocurrencies (also known as Altcoins) you will need to sign up on an exchange like bittrex.com.  Be warned, however, as most Altcoins are not well vetted and, just like in the early days of the internet, a lot of people are seeing this as a gold rush and launching or investing in new coins without proper research.

 

This is an exciting new technology and a great opportunity to get involved in something on the ground floor.  Cryptocurrencies are still in their infancy and it will be an exciting ride as the technology matures and we see what develops. Whether or not this trend of rapid growth continues, we will see positive changes over the next several decades as blockchain technology becomes more and more integrated into our lives.

 

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