What is Bitcoin?
Bitcoin is a digital currency created using Blockchain technology. In order to truly understand Bitcoin, we need to first understand Blockchain. Blockchain is a technology aimed at solving the problem of getting anonymous parties to trust each other without using a middleman.
The Blockchain method addresses the trust problem by creating a digital distributed ledger where new entries to the ledger are tightly controlled. New ledger entries are called “blocks” and each block contains the details of a fixed number of verified transactions (~ 2,500 per block in the case of Bitcoin). Blocks are then connected to each other forming a continuous “chain” of information. Hence the name Blockchain. The below illustration demonstrates how the blocks are connected to create a continuous digital ledger of every Bitcoin transaction.
Each block has four main components:
1) The hashcode of the block appearing immediately before the current block
2) The data itself - in the case of Bitcoin a list of transactions
3) The proof of work
4) The hashcode of the current block
The key to the whole system is the “proof of work” (item 3 above). This is a special number that generates the current block’s hashcode (item 4 above) so that it begins with a specific number of zeros. In other words, items 1, 2 and 3 above are used as inputs to create a unique item 4. This special number is very difficult to find and takes powerful computers a long time to calculate.
When you hear the phrase “Bitcoin mining” that simply means using a computer to calculate the proof of work. Miners are essential to the system since new blocks of verified transactions cannot be added to the digital ledger without a proof of work. Miners are compensated for maintaining the Blockchain by receiving newly created Bitcoins (block rewards) and a commission each time they solve the proof of work necessary to connect a new block to the chain.
Finally, since there is no centralized master ledger (i.e. every miner maintains a separate copy of the ledger), there needs to be a method to determine the most "correct" / up to date ledger. The agreed upon method for Blockchain is simply to choose the ledger with the longest block length at that moment. In other words, the most correct / up to date ledger is the one that has the most “work” put into it.
The First Problem with Bitcoin
Bitcoin has no inherent value unlike gold or other commodities. In the case of gold, it can be used as both a material to create jewelry and as a store of value due to its rarity. Bitcoin has no other purpose than as a store of value and its rarity is questionable due to the ease of creating new digital currencies. Furthermore, Bitcoin’s digital existence exposes it to the primary drawback of all digital programs and devices, obsolescence. All technology eventually becomes obsolete and is ultimately replaced with better, faster generations of new technology.
Bitcoin is already showing its limitations due to the recent explosion in transaction volume. What was once a quick, cheap payment method is now slow and quite costly (~$25 / transaction at the time of writing). Putting the slowness into perspective, Bitcoin transactions are fundamentally limited to approximately 4 transactions per second compared to Visa which can handle 24,000 transactions per second.
You may be wondering, how does an increase in transaction volume increase Bitcoin transaction costs? The answer is simple. Remember that new blocks of transactions cannot be added to the Blockchain ledger without a proof of work generated by a miner? Miners have full discretion on which transactions to bundle together in the next block they attempt to add to the Blockchain. Therefore, miners are more likely to choose transactions that offer to pay the miner a higher fee.
The Second Problem with Bitcoin
Bitcoin cannot truly be used as a currency due to its volatility and virtually non-existent population of merchants directly accepting Bitcoin as payment. The value of Bitcoin is so volatile because it has no inherent value. This results in Bitcoin’s value being driven by nothing more than the price the next person in line is willing to pay. What happens when individuals start to cash out their Bitcoin leaving no one left to buy? A brief look back into history’s Tulip Bulb craze reminds us that mass speculation is the precursor to a bubble. Learn from the past and don’t invest your life savings in flowers or in this case a digital currency with no clear use.
Putting Bitcoin’s volatility aside, it cannot function as a currency due to the simple fact that virtually no merchants directly accept Bitcoin. Many believe as time passes more merchants will begin to accept Bitcoin but that is simply unrealistic. Transaction fees are just too high at approximately $25 / transaction at the time of writing and transfers are too slow due to Bitcoin’s limitation of approximately 4 transactions per second. Putting the transaction fees into perspective, the major credit cards charge merchants about 1.5% to process a transaction. That means a merchant would need to sell ~$1,700 worth of goods per transaction in order for Bitcoin to be the preferred cheaper payment method. Said differently, how many people spend $1,700 per merchant in their day to day activities?
The End of Bitcoin
Bitcoin is proving to be an amazing beta test of the digital currency concept. However, the massive appreciation of Bitcoin’s price has sealed its own fate by causing the creation of Bitcoin futures at an unprecedented speed. Remember, a futures contract is simply an agreement to exchange goods at a predetermined price sometime in the future.
Let’s say you are a large Bitcoin holder from Bitcoin’s early days and you have decided to cash out. However, if you start to sell your Bitcoin, every transaction is visible to everyone on the Bitcoin network. That means other large Bitcoin holders may notice your activity and also decide to cash out potentially starting a crash. How do you get around this problem? Simple, by entering into futures contracts to sell your Bitcoin at a predetermined price sometime in the future. That way nobody else on the Bitcoin network will be aware of your activity and thus temporarily delaying the domino effect leading to a crash until you fully cash out.
Don't get caught up in the Bitcoin craze. If you were fortunate enough to make a nice profit so far, remember that it is not real until you cash out. When that time comes, The DIY Investor will be here to provide you with simple investing resources.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.