Bitcoin or Big con?

7th February 2018

In our recent Insights piece ‘The Hidden Risk of Cash’, we opened with the question: what do you picture when you hear the word ‘money’? Had we asked any Briton born since the time of King Offa in the 8th century their answer would probably have referred to pound sterling – the world’s oldest currency still used today.

But since 2009, a new type of currency has emerged; one that is decentralised, meaning it’s completely detached from banks, governments or any other single point of institutional control. From the long list of these burgeoning ‘cryptocurrencies’, Bitcoin was the first and now most recognised example.

 

What is Bitcoin?

In essence, it is a totally digital currency, born out of the distrust of banks following the 2007-08 financial crisis. As such, it has a number of fundamental differences to traditional, or ‘fiat’ (government issued) currencies. The ‘coins’ (or fractions thereof) are created, transferred and recorded in the ether of the internet – more specifically, via the core Bitcoin software which is run on tens of thousands of computers around the world.

 

How does it work?

When we buy things in a supermarket in the usual manner, we can be sure of two things: that the notes or coins we hand over are received by the shop and the items placed in the basket are the ones we will be taking home.

With digital assets it is much harder to reliably establish who owns what at any point in time, because non-physical things like documents or images can be easily copied.

Bitcoin’s anonymous inventor(s) – going by the name Satoshi Nakamoto – recognised that their idea for a new digital cash system would need to solve this duplication (or “double-spending”) problem without relying on a central body to oversee the process.

The answer was to create a unique type of public ledger for transactions and ownership. Each new transaction would be added to the lists of records, called ‘blocks’. When linked together, these blocks comprise the ‘blockchain’.

The revolutionary part of this technology was that the validity of each transaction was reached by consensus. In the case of Bitcoin, if any user tried to send more coins that they actually owned, the network of computers running the Bitcoin software would recognise the error and agree to reject the transaction. Conversely, valid transactions (as determined by consensus), would be added to the blockchain.

The network of computers that enable Bitcoin to exist are called ‘miners’. Nakamoto incentivised people to be part of this network by rewarding them with new coins for completing the mining calculations.

The difficulty of these calculations has been intentionally programmed to rise incrementally, resulting in a diminishing supply of new Bitcoins over time.

Despite there being a public record of every Bitcoin trade, cryptography anonymises every user of the system. In any one transaction, all that is visible to an outsider are the two strings of 34 alphanumeric characters representing the sender and recipient, as well as the number of Bitcoins being transferred.

 

‘Cryptography anonymises every user of the system.’

 

Users create an electronic Bitcoin ‘wallet’, which acts a bit like an email address, providing them with a place to store and receive coins.

 

How do you buy/sell it?

Today, most buying and selling takes place on the many Bitcoin exchanges. Here individuals can exchange their conventional currency for cryptocurrency and vice versa. The initial process can be surprisingly difficult and expensive. Popular services such as Coinbase have experienced regular outages and delays as they struggle to process record numbers of new accounts.

Buyers wishing to exchange smaller sums, or those simply searching for a more familiar transaction, may have visited one of a growing number of ‘Bitcoin ATMs’ dotted around the UK.  Requiring only a wallet address and a form of sterling payment, they sell at an above-market rate in return for their convenience.

 

What are Bitcoin’s proponents saying?

Bitcoin is the original fully-decentralised electronic payment system. For the first time in history, blockchain technology allows ‘money’ (in the form of a Bitcoin) to be sent electronically to anywhere in the world without relying on a third party. Many cryptocurrency supporters point to the 2007-08 financial crash as an example of where single points of control and oversight failed to prevent a global crisis.

And recently there have been many examples of centralised controls on access to capital and money. In 2015 for instance, the Greek government imposed strict capital controls on bank account holders. Cash withdrawals were limited to €60 per day and international transfers restricted. Bitcoin is quite simply immune to this type of intervention.

There are no limits or restrictions on the number of coins that can be sent in any one transaction. Equally, because the recipient is identified only by a string of letters and numbers, there aren’t any geographical restrictions on where coins can be sent either.

Unlike a traditional bank account, Bitcoin wallets can be opened by anyone in any location with an internet connection. There are no forms to fill out or identity checks to complete. It is thus referred to as a permission-less system.

 

‘Bitcoin wallets can be opened by anyone in any location with an internet connection.’

 

The scarcity of Bitcoins (there will only ever be 21 million in existence) means their value cannot be inflated away through increases in supply. This feature stands in contrast to the use of quantitative easing (a type of money printing) by central banks over the last decade.

In theory at least, Bitcoin transactions are designed to be low-cost and confirmed by the miners in minutes. Microsoft and Expedia are part of a modest but growing list of places accepting Bitcoin payments.

 

What are the critics saying?

One of the most popular Google searches of 2017 was “Should I invest in Bitcoin?” The question itself presents the interesting notion of whether Bitcoin is a currency or an investment.