Cryptocurrency for Beginners: Part 1

byGotBackupGuy

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6 years ago

What is “currency?”

When we think of currency, we think of money, such as dollars, pesos, and yen. These are called government-backed currencies, or fiat currencies (currencies that have no inherent value--just the value that people ascribe to them). Their value lies in the fact that the respective governments recognize these currencies as a legal form of exchange, and also that they insist that taxes be paid in their currency. However, their value is generally limited to the borders of their own country.

With fiat currencies governments and their central banks decide how much of the currency is in circulation, and government actions affect the value of their national currencies. In the United States our currency used to be backed by “the gold standard.” For every $1 the government created, they had to have $1 in gold in reserve. You had a legal right to trade your paper dollars for gold at any time.

Gold is the least corruptible of metals and has been used as a way to exchange value for thousands of years. Gold is fungible (one ounce of gold in one place is as good as another ounce of gold someplace else), gold is verifiable (you can test if it is pure gold and it cannot be counterfeited), gold is divisible (a bar of gold can be sold in much smaller quantities), and gold is limited (some unknown fixed quantity on the planet), and finding new gold usually involves a lot of work). It is somewhat transportable.

The $USD is fungible (one dollar is as good as any other), it is verifiable (difficult, but not impossible to counterfeit), it is divisible (fractions of dollars can be traded, down to two decimal places). It is artificially limited by how much the government decides to print (as they print more and more money it dilutes the value of all the existing money; hence prices go up—this is inflation). Printing new money does not involve work, but only those with the authority to do so (the Central Bank) can do this. It is more transportable than gold, and most all money that is created now is never printed—only represented as digital information. The Central Bank can magically change the total number of dollars in circulation, thus influencing inflation.

Inflation has been about 3% per year over the past 100 years. This means that every dollar is losing 3% of its value every year. $1 100 years ago had the same buying power as $20 today. In other words, in 100 years the $USD has lost 95% of its value!!

World War 1 and the Great Depression (with runs on the banks) forced many countries off the gold standard, but the United States was able to keep its currency tied to gold (because it did not have such high war costs).

This led to the $USD being the strongest currency in the world, but during the Vietnam war France kept exchanging its store of $USD for gold so President Nixon took the USD off of the gold standard.

In 1976 the transformation was complete and the $USD has been purely a fiat currency since then. It has retained its status largely because it put in place a world trade in oil that required all oil buying and selling be done in dollars—so any country that wanted oil had to buy dollars, keeping the demand high.

As we moved into the digital age, several challenges arose.

Cryptographers thought about new ways money could be used in the digital age. One anonymous cryptographer, going by the name of Satoshi Nakamoto, created a new currency idea called “Bitcoin.”

Bitcoin is a new model for currency

Bitcoin is

• Fungible: all bitcoins have equal value.
  
• Divisible: down to 8 decimal places (0.00000001 BTC is lovingly called a satoshi)
  
• Transferrable: much easier to transfer than any fiat currency because no banks are involved—it travels directly from one person to another, anywhere in the world.
  
• No middle-man between me and the person I want to send money to.
• If I am paid in bitcoin, the transaction is final--nobody can reverse it.
• Verifiable: it cannot be counterfeited, plus every single transaction is verified by a network of computers and a record of every transaction is kept on a permanent, growing balance sheet called a blockchain.
  
• All transactions that have been verified and approved in the last 10 minutes are bundled together into a block.
• Each block of transactions is tied back to the block behind it, and then attached to the block in front of it (hence “block chain”).
• A network of computers races to be the first to solve a difficult problem that allows them to verify the block; whoever wins the race gets the new coins that are “mined.” The bitcoin network is by far the world's largest supercomputer, all devoted to maintaining the ledger and mining new coins.
• Limited: there will only be 21 million BTC ever created. New coins are mined every 10 minutes until all have been mined.
  
• It used to be that 100 coins were mined every 10 minutes and the problems were so easy that a home computer could solve them. The program adjusts the difficulty to maintain a solving time of about 10 minutes, so if more computing power is used to solve the problems faster, the problems simply get harder.
• As bitcoins started to have real-world value more and more people competed to mine them, resulting in the current situation of large “bitcoin farms,” or warehouses full of computers that simply work 24 hours/day trying to solve difficult problems and mine bitcoins.
• Following a predetermined schedule, the reward was cut in half to 50 coins, then cut again to 25 coins, then cut again to 12.5 coins (where it is currently). It will be cut in half again in June 2020.
• Nearly 80% of total bitcoins have already been mined. Currently the inflation rate is about 4% per year, but that will drop to around 2% and continue to decline.

Bitcoin gets its value because 1) it cannot be counterfeited, and 2) it cannot be printed or manipulated by any government, and 3) all the above bullet statements about how it is a near-perfect currency. The value is only what people are willing to pay for it, but as demand increases faster than supply price must go up. Hence, bitcoin is perceived as a store of value, and people who want to protect their assets long-term are turning to bitcoin instead of (or in addition to) gold.

Alchemists of old tried to convert lead into gold. It was not possible--gold is gold, and there is no substitute. Bitcoin, however, is just code, and that code can be replicated and changed. As we will see in an upcoming post, hundreds of other cryptocurrencies have been created from the bitcoin model--we will explore why they were created, why they have value, and why they are of interest to investors and traders.