Reply To: Bitcoin: does anyone get it??

[keith]

Just skip to the end, if you don’t have time for this long post.

Bitcoin is often called a “cryptocurrency”, but in that word, the “crypto” bit doesn’t mean that it’s anonymous or hidden. Bitcoin transactions can be tracked and traced more easily than usual cash transactions, but less easily than traditional bank transactions.

In one way, Bitcoin is no different to any other fiat currency (including the Pound Sterling, the Euro, the US Dollar, and just about every other currency in the developed world). The money is worth whatever people are prepared to agree on it being worth. In another way, it is like a fiat currency in that new Bitcoin is being created, just as more Pounds Sterling, Euros, and US Dollars are being created.

Bitcoin is different, in that it is not issued by any central bank, and there are no physical tokens such as metal coins and paper notes to represent it.

It’s created by using a computer, or a specially designed computing device, to do some particularly time-consuming calculations involving prime numbers with a lot of digits

I’ll not try to explain exactly how new Bitcoin is created, because

I don’t exactly understand all the maths behind it
it’s not really that important to know how it works unless you’re prepared to put in the time and money to build such a device

For all intents and purposes, you can think of Bitcoin as being just another currency, but one that has a very volatile exchange rate compared to bank-issued currency.

I have a bank account in the US, in US Dollars, another in the UK in Pounds Sterling, and another here in France in Euros. Most of the time, I use the Euro account, because I live in France. But if I want to give $50 to one of my nephews in the US for a birthday present, I just go online to my US bank, make the transfer to his account with a little message “Happy Birthday”, and that’s it. It’s all virtual and online. With exchange rate variations, that might be the equivalent of a little more than €50 one year, a bit less than €50 another year.

If both my nephew and I each had a Bitcoin wallet, which acts a bit like an online bank account, I could do the same: transfer a fraction of a Bitcoin to him. So really, you can think of Bitcoin as being the currency of a “Bitworld” that only exists online (or, to use a word that’s a bit out-of-fashion these days, in “cyberspace”).

The problem of the exchange rate volatility comes into play when you try to convert Bitcoin into a traditional (or “meatspace”) currency. Here, you have to go through an exchange, a bit like the old days of rolling up to Thomas Cook’s currency exchange window to buy Pesetas or Drachmas before going on holiday to Spain or Greece. There were times when the exchange rate of those two currencies compared to the pound were quite volatile, so if you went each year, you’d notice the difference in what you got for a hundred quid.

If you have a few tens of thousands of pounds spare, you could gamble on currency exchanges: you buy £20,000 worth of US Dollars when there are $2 to the pound, so you get $40,000, and you hope to sell those dollars for pounds when there is $1 to the pound, ending up with £40,000… In reality, though I’ve seen in my lifetime both $1 to the pound and $2 to the pound, it’s rare for a meatspace currency to fluctuate so much in such a short space of time that such trading is profitable… you need to start playing with much bigger sums for it to be worthwhile.

Bitcoin, on the other hand, is in a what’s commonly termed a bubble. I think most of us are familiar with the term; there’s been a lot of discussion of property bubbles, especially housing bubbles, in Ireland, the UK and Spain, over the last decade. People buy anything and everything, convinced that the value will increase rapidly so as to be able to sell at a profit. This behaviour pushes up the price, which people read as a sign that prices will go up even further in the future: it becomes a feedback loop (or vicious cycle) where higher prices encourage the behaviour that leads to higher prices…

I pointed out above, that to create new Bitcoin requires time and some special, costly gear. People are generally impatient and stingy, so they have been using meatspace currency to buy Bitcoin with the same mentality, with the same result: Bitcoin has been getting more and more expensive to buy.

But just like any market, there will be, from time to time, some big investor who thinks “that’s it, I’ve my investment in that stuff has reached the target I set, I’m going to cash out now”… This has happened in meatspace currencies, too. So the big investor puts up for sale a big quantity of Bitcoin at a price around or slightly lower than the general rate, and some other investor buys it. And that signal that one big investor has cashed out can be read as other investors as a sign “ah, maybe he knows something I don’t, he’s cashed out, maybe it’s time for me to cash out, too”. And that becomes a negative feedback loop, as people see trades for lower and lower prices and there’s a risk that so, everybody is trying to dump Bitcoin while the price is falling. Everybody is thinking “I hope I manage to sell for more than I paid”.

Next, there is another problem with Bitcoin exchanges, particularly with people not knowing how they work, who owns them, and there not being clear laws and regulations. Once again, technology has created a situation that the law is still trying to catch up with. Several big Bitcoin exchanges have either been the victims of attacks that have syphoned off the equivalent of millions of dollars’ worth of Bitcoin, or the exchanges have disappeared taking people’s Bitcoins with them. Mount Gox is a good example. If you can’t be confident that your exchange is going to honour its contract, and hand over your meatspace currency in exchange for Bitcoin, why risk buying any Bitcoin? And if you already have Bitcoin and you see an exchange go belly-up, you’re likely to want to cash out before the other exchanges do the same. This again destroys the impression of Bitcoin being a safe bet that’s bound to make a profit…

Finally, there’s a problem linked to what I mentioned above, about law still trying to catch up with technology. Some countries have decided that Bitcoin is a Good Thing, and are trying to enact rules and regulations to govern exchanges and even to allow direct purchase of goods and services using Bitcoin rather than national currency. Other countries have decided that it is Evil and must be Banned. Others are still hesitating and in the absence of clear guidance, nobody knows what’s allowed and what’s forbidden, including judges and police…

Wikipedia has a good summary of the situation around the world.

In the end, though, you don’t need to know everything about how electrons flow through semiconductors in order to use your computer or listen to the radio. You don’t need to know everything about fuel injection, compression ratios and gearboxes to drive a car.

The same is true for Bitcoin and other cryptocurrencies. You just need to know enough to not get your fingers burnt. And don’t gamble with money that you can’t afford to lose.

tl;dr It’s like ordinary money, but different.