Bitcoin-What’s the hype all about?

Hello readers, welcome back to my blog.

In this post I thought I would explore the idea of Cryptocurrencies, in particular Bitcoin. With its market price soaring past £10,000, something that many people did not even think would happen, it has certainly got everyone talking about it and wondering whether to invest in it. I’m not just talking about the economists who analyse and process the data from six computer screens whilst monitoring other currencies/commodities but everyday people who are looking to make a quick and effortless profit from their smartphones in the comfort of their own home or office. Its volatile nature however is what makes this quite a risky investment. That said you can yield some big profits if you buy at the right time and are not too risk seeking or risk averse. Although it is actually relatively straightforward to purchase Bitcoin via your smartphone using a coin wallet such as Coinbase, the mechanism behind it is actually rather complex and there is a lot of technical jargon that comes with it from ‘miners’ to ‘blockchain’ to ‘hash rate’.

In this post I will firstly outline what Bitcoin is, briefly summarise how it works, explain how it is different to conventional currencies and explain why it is suddenly growing in popularity. I hope this post clarifies some of the questions you may have about Bitcoin and if you have any further questions, please post them in the comments below. It is an interesting and topical issue which has the potential to replace traditional currencies  (aka Fiat currencies) whereby the central banks control the money supply. Already certain business are starting to accept payments in bitcoin and it was recently reported that people in central London have sold houses in the currency, therefore there is clearly potential. Others however argue its just a ‘craze’ or hype and that people will not be as confident in it due to the growing uncertainty about cybersecurity. Its recent crash last week proved that at some stage the bubble would start to bust, although could it rise again, and more importantly how high will it go this time round.

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Bitcoin was invented by Satoshi Nakamoto (the unknown inventor/ inventors of Bitcoin), who wanted to invent a peer to peer electronic cash system, in essence a decentralised cash system. Previous attempts at this had failed in the past until the invention of Bitcoin. It was created in 2009 and is now classified as a ‘cryptocurrency’. Numerous other cryptocurrencies such as Litecoin and Ethereum have been introduced although Bitcoin is by far the most successful one. [1]

A currency needs a payment network (accounts, balances and a record of transactions) as well as a central server or authority that verifies this network. In conventional currencies ( Fiat Currencies), this role is provided by the central banks such as the Bank of England. The challenge in a decentralised system is that every single transaction needs to be verified as if there are any discrepancies the whole systems will collapse. The game changing innovative feature of Bitcoin was that Satoshi Nakamoto  invented a system that could verify every single transaction in a decentralised system.

A brief summary of this is as follows:

  1. Cryptocurrencies are entries in a database that cannot be changed without fulfilling specific conditions.
  2. Bitcoin transactions are sent from and to electronic bitcoin wallets, and are digitally signed for security. Everyone on the network knows about a transaction, and the history of a transaction can be traced back to the point where the bitcoins were produced.
  3. The transaction is known almost immediately by the whole network. But a specific transaction gets confirmed after a certain amount of time. Confirmation is a critical concept in cryptocurrencies.  An unconfirmed transaction is pending and can be forged. Confirmation usually only takes a few minutes. Once a transaction is confirmed, it cannot ever be reversed, it is part of the so-called blockchain (database).
  4. Only miners can confirm transactions. This is essentially their job in a cryptocurrency-network. After a transaction is confirmed by a miner, it is added to the database and It has become part of the blockchain. For this job, the miners get rewarded with a token of the cryptocurrency.
  5. Anyone can be a miner, a decentralized network has no authority to delegate this task. Satoshi set the rule that the miners need to invest some work of their computers to qualify for this task.[3]

Bitcoin mining is legal and is accomplished by running complex computer programmes in order to validate Bitcoin transactions and provide the requisite security for the public ledger of the Bitcoin network.[4]

The Bitcoin network compensates Bitcoin miners for their effort by releasing bitcoin to those who contribute the needed computational power. The more computing power you contributed then the greater your share of the reward. In the initial stages of Bitcoin mining could be done on a personal computer. Today that’s no longer possible. Specialised computer hardware is now needed for Bitcoin mining. Mining with anything less will consume more in electricity than you are likely to earn.

Like traditional currencies, such as Sterling, Bitcoin has value relative to other currencies and physical goods. Whole Bitcoin units can be subdivided into decimals representing smaller units of value.The smallest Bitcoin unit is the Satoshi, or 0.00000001 Bitcoin. Bitcoin can be used to purchase goods from an increasing number of companies that accept Bitcoin payments. It can be exchanged with other private users for services performed or to settle debts. It can be swapped for other currencies, both traditional and virtual, on electronic exchanges similar to Forex exchanges. And, as it is untraceable, it can be used in illicit activity, such as the purchase of illegal drugs on the “dark web”.[5]

Recently there has been a surge in the value of Bitcoin the current valuation on the day of writing this is 1 Bitcoin is worth £10314.49. though there have been several large fluctuations in the price.[6]

Bitcoin was initially thought off as a niche product but the rest of the financial world is starting to take notice. A blog by Nieplet in the LSE Business Review [7], succinctly summarises the potential effect of Bticoin on Central Banks, he writes

‘Crypto currencies offer limited benefits for users who do not have overwhelming privacy needs. Their usefulness as money suffers from limited liquidity, which creates exchange rate volatility. As long as the number of people using crypto currencies is small, the incentive for others to adopt them too remains limited. But strong network effects may quickly disrupt the payments system once a critical mass of users coordinate on, and adopt a specific crypto currency.’ Central banks increasingly are under pressure to keep ‘their’ currencies attractive. They should let the general public access electronic central bank money, not just financial institutions (Niepelt 2015). To do this, they should embrace the blockchain.’

Why the sudden hype?

The latest spike was driven by the news that the Chicago Mercantile Exchange will trade futures in Bitcoin; a derivatives contract based on a notional currency. If more people trade in Bitcoin  that means more demand, and thus the price should go up. But what is the appeal of Bitcoin? There are three main reasons: the limited nature of supply (new coins can only be created through complex calculations, and the total is limited to 21m); fears about the long-term value of fiat currencies in an era of quantitative easing; and the appeal of anonymity. Perhaps is is time to reassess our relationship with money. Crypto currencies and Bitcoin may be the start of this revolution, if its volatility can somehow be ironed out. However, currencies need to have a steady price if they are to be a medium of exchange. Buyers do not want to exchange a token that might jump sharply in price the next day; sellers do not want to receive a token that might plunge in price. People are buying Bitcoin because they expect other people to buy it from them at a higher price; the definition of the “greater fool theory“. [8]

If you’re reading this from an investors point of view, my advice would be to play it safe and invest only what you can afford to loose. Although it has the potential to make you a millionaire overnight, it is extremely volatile and a crash like the one we recently saw is always a possibility if not a certainty. Its just a question of time.

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References:

[1] https://www.chapman.edu/research/institutes-and-centers/economic-science-institute/_files/ifree-papers-and-photos/koeppel-april2017.pdf

[2] https://blockgeeks.com/guides/what-is-cryptocurrency/

[3] https://www.coindesk.com/information/how-do-bitcoin-transactions-work/

[4] https://www.bitcoinmining.com/getting-started/

[5] https://www.moneycrashers.com/bitcoin-history-how-it-works-pros-cons/

[6] http://www.xe.com/currencycharts/?from=XBT&to=GBP&view=1Y

[7] http://blogs.lse.ac.uk/businessreview/2016/10/21/bitcoin-may-have-implications-for-monetary-policy/

[8] https://www.economist.com/blogs/buttonwood/2017/11/greater-fool-theory-0

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