By Erik W. Laymon, MBA
Originally Published: 12/20/2017
Definition of Bitcoin
Bitcoin is a digital currency that is sometimes referred to as digital gold. Indeed, it shares many features of gold, which is partially why Bitcoin is in demand:
- Scarcity. There is a finite amount of Bitcoin, just as there is a finite amount of gold. The main difference is, we know there is only 21 million bitcoin available in the network, but we do not know how much gold there is accessible to us currently. Just as gold lives in the ground (and outer space), Bitcoin resides within the Blockchain. It is from this Blockchain that bitcoin is “mined” by participants on the network, and released over time. Based on the current rate of adoption and rate of increase of computational power, the entire blockchain will be mined by the year 2140.
- Divisibility. A Bitcoin can be subdivided to eight decimal places just as an ounce of gold can be reduced to tiny ingots or flecks of dust. This allows for bitcoin to be utilized under heavy deflationary effects. The smallest unit of bitcoin is BTC 0.00000001, which at the time of this writing, is worth $0.0005.
- Transparency. Bitcoin transaction data is publicly viewable on the blockchain, which means all transactions for all time, are independently verifiable, and due to the highly sophisticated cryptography, this ledger is also unalterable. This is akin to gold at the atomic level, being independently verified for purity and unalterable without evidence of tampering.
- Autonomy. No trusted intermediary or authority is required to transfer bitcoin to someone else, just as with gold.
How Bitcoin Works
What makes Bitcoin a truly compelling technology is the underlying software called the Blockchain. Understanding the Bitcoin value proposition requires understanding what the Blockchain accomplishes.
The Blockchain is a revolutionary new accounting system that was created for Bitcoin. It can be described as a digital triple bookkeeping system. Classical double entry bookkeeping mitigates fraud by recording each transaction twice: once as a debit and once as a credit. Fraud is further mitigated when independent third-parties perform an audit to justify those double entries.
With Blockchain’s triple entry bookkeeping system, there is the debit, the credit, and the receipt. The receipt is the function of a highly complex, automated mathematical process that validates debits and credits on the digital ledger. Triple bookkeeping obviates the need for trusted third-party auditors by substituting human audits (along with human error and corruption) with mathematical laws. The Blockchain is self-auditing, and is also self-correcting. The receipt process invalidates any transactions that corrupt the integrity of the ledger.
It is important to note that this triple bookkeeping system is what makes Bitcoin and related cryptocurrencies so revolutionary.
In order for this receipt system to work, the Blockchain must be fully transparent, decentralized and open-source:
- Transparent transactions. The public can explore the Blockchain and see every Bitcoin transaction both past and present. While the public does not see who the owners of those addresses are, they can see the sending and receiving addresses. Owners of those addresses may voluntarily declare themselves to the public if they wish, which is why Bitcoin has a reputation for being private.
- Decentralized network. The Blockchain is a globally networked accounting system. Participating computers may serve as a “node” and dedicate computing power to validate transactions and essentially issue those receipts. This is called “mining.” Every node contains a complete copy of the Blockchain and hence a complete record of every Bitcoin transaction, which is necessary for validating and reconciling transactions.
- Open Source software. Bitcoin is not the intellectual property of any one person, group, or corporation. There is no patent either. The code was released into the public commons, along with a White Paper by an anonymous individual using the pseudonym, “Satoshi Nakamoto.” Because this software is open-source, given its disruptive nature, it is quite possibly the most highly scrutinized program in the history of the world. Experts have been determined the software to be safe.
Possible Advantages of Bitcoin
Bitcoin was designed to become a cash alternative, allowing two parties to transfer value from anywhere in the world, without the need for intermediaries such as governments or banks. Bitcoin is particularly useful and popular in countries where governments and banks are corrupt. In the developed world where governments and banks are more trustworthy, Blockchain technology is being studied for augmenting or replacing classical double bookkeeping systems.
The New York Stock Exchange and Depositary institutions are experimenting with the Blockchain as a means to record stock transactions and transfers of ownership. Deed Recorder offices and Title agencies are contemplating the same.
The government of Estonia is releasing its own officially-sanctioned cryptocurrency called Estcoin as part of the country’s digital residency program. Furthermore, the Blockchain can be used to track money movements within the Federal Government and the many States, ensuring full transparency and complete accountability. These are just a few of the many emergent use-cases of a technology that the world has only just begun to understand.
Possible Disadvantages of Bitcoin
Although there are many compelling reasons to be excited about the technology, there are equally compelling reasons to be skeptical of this technology as an investor:
- Bitcoin is not a security. In other words, it is not a securitized asset in a way that legally represents ownership share of a company (stock) or an issue of company debt (bond). It may be likened to a commodity, such as gold, but even gold is considered to be highly speculative. Unlike gold or any commodity, this is digital technology with a relatively recent history and unknown origin. It may even require its own asset class. Consequently, nobody can justifiably evaluate this and quite rationally, one should neither trust claims that the trending price increase will continue, nor should one trust claims that this “asset” is in a bubble either.
- The Blockchain is antiquated. Several years ago, it was the only technology of its kind, but today there are several thousand competing digital currencies, many of which have improved upon the Blockchain concept, and are competing directly against Bitcoin for “market share.” Other digital currencies are not trying to become a payment system, but a communications network for the internet of things.
- Bitcoin is not scaling well. Transactions that once took seconds when the network was smaller, now take hours (and in rare instances days), frustrating many early adopters who wanted this to be an instant (or near-instant) payment system. Bitcoin is vulnerable to competitors offering different scaling solutions such as Ethereum, Stellar Lumens, Bitcoin Cash, and Litecoin.
- Bitcoin’s price is volatile. The technology is still undergoing a “violent” price-discovery phase. Intraday swings resemble a penny stock, with daily volatility averaging 23.5 times the S&P 500. This is due in-part to the preponderance of numerous, unregulated 24/7 exchanges on which Bitcoin is traded, but even more pronounced is the presence of market manipulators on these exchanges. Wealthy investors, companies, sovereign nations and criminal enterprises are suspected (and in some cases known) to be “pumping and dumping,” which means Bitcoin’s market price is not a fair valuation of true market sentiment.
- Bitcoin’s regulatory future is unknown. In fact, regulators are themselves unsure what to do, and some US Government agencies perceive this to be a threat. Current IRS regulations and Know-Your-Customer/Anti-Money Laundering laws regarding Bitcoin and cryptocurrency “money transmitter” businesses are incomplete, confusing, and often contradictory. At this time, Bitcoin is taxed like an asset (subject to capital gains as barter), yet regulated like a currency.
- Bitcoin has an unsavory reputation. Without question, Bitcoin has enabled money laundering for criminal operations including tax evasion or financing terrorism. It is also the currency of choice for criminals lurking within “the dark web,” a hidden global network where contraband is bought and sold. Even though there is nothing morally or legally wrong with Bitcoin or Blockchain technology, its reputation has alienated many would-be investors from wanting to take part.
- Bitcoin requires technological know-how. “Be your own bank,” is a popular catchphrase for Bitcoin, but this means individuals bear all the risks that are part and parcel of being one’s own bank. Newcomers to Bitcoin will have to learn how to download, encrypt, and operate a “wallet.” They will have to learn how to properly store their “private keys” and guard themselves against scams and hacks or losing those keys. They will have to understand that there is no reversing transactions.
The utility of Bitcoin and related digital currencies has only been eclipsed by the trending price. In the midst of this excitement, extreme caution must be exercised. This is a technology, not a security. This technology is disruptive, which means it is also by nature subject to disruption. Prices are highly speculative and subject to unmitigated manipulation. Associated with Bitcoin is a somewhat unsavory reputation due to its ubiquity on the dark web.
***This article is intended strictly for educational purposes only and is not a recommendation for or against cryptocurrency.***
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