BITCOIN – PART I
We’re going to write a lot about Bitcoin over the next few months, as it’s pretty topical. Just this weekend, in fact, China got mad with the cryptocurrency and is now working to shut down many of the exchanges it trades on in China. After this news came out, the price of a Bitcoin promptly fell 7%. So many questions, so little time.
OK, so what is Bitcoin?
There are so many different ways we have thought about attacking this question, but none of them are appropriate for a single 5-minute session. So instead, we are going to do this over multiple notes. By the end, you will know exactly what a Bitcoin is, why China is closing exchanges which allow you to trade bitcoins, and why them doing so has caused the price of a Bitcoin to fall.
First and foremost, it is really important you realise that Bitcoin is a completely made up currency that only exists on computers and the internet. And technically, it’s not even a currency at all. It’s an invention. It’s a piece of technology. And it’s the technology part which is super interesting. The Bitcoin itself, not so much.
But today we’re not going to discuss any of that. Today, we just want you to know what a currency is, and why it has value.
Have you played the game “if you were stuck on a desert island, and could only take ten things with you, what would you take”? Classic game. Good times. How many of you ever answered “cash” as one of your things? None right. Ever wondered why? It’s because money or cash actually has no inherent or intrinsic value. Zero. You can’t eat it, drink it, smoke it, sleep with it, wear it or live in it. It would be of literally no use to you on a deserted island.
Cash only has value because people believe that everyone else believes it has value. Sounds dumb, but it’s true. And because everyone else believes it has value, they are happy to receive it in exchange for providing goods and services.
The real question then is, why does everyone else believe it has value? Well that’s because it’s the only way you can pay your taxes to the government. That is why currency has value. In fact, that is the only reason currency has value. If the government suddenly announced it would only accept bananas as payment for taxes going forward, bananas would become the accepted form of exchange (and store) of value. It would be how you paid for your Uber, your toothbrush and your energy bill. That’s not a joke. That is exactly what would happen.
A bit of history
Back in the old days, when people rode dragons, rather than use currency, they would exchange goods and services for gold. Literally. The price of a good or service would be in terms of a weight of gold. The problem with that though was gold was hard to transport and more so difficult to break down into small, agreed sizes. This made it problematic to exchange. To solve this problem, over time, rather than exchange pieces of gold, people would exchange pieces of paper, which represented claims on gold. And you could trade these claims with the government, which would give you gold for your currency. Therefore, currency had value because it represented a claim on gold. Today currency has value because it is backed by the full faith of the government.
So in Summary
Currency is a way to store value. And currency has value because everyone else believes it has value because the government accepts it for the payment of taxes. Bitcoin, however, IS NOT accepted by the government for the payment of taxes…
At this point, you should be asking yourself, how then does Bitcoin have any value.
BITCOIN – PART II
Previously we said it’s the technology behind Bitcoin that you should be excited about, rather than with Bitcoin itself. So now, let’s go deep on the tech side of things. Quick caveat though. We are not tech-heads. In fact, we are far from it. Knowing that we should turn it off and on again is about the extent of our computer wizardry.
The Technology Behind Bitcoin
There are three key ingredients to Bitcoin’s structure. There’s the Blockchain, the Distributed Ledger and the Cryptography. We’ll discuss each one, but if you really want to get into the detail, we’d highly, highly recommend watching this video.
The Blockchain: In super simple terms, The Blockchain is a way of saying “the complete history of every transaction which has ever occurred in the order that it occurred”. For example, say there were just two people in the world who owned bitcoin, Matt and Damon. Matt pays Damon 50 bitcoins and then later Damon pays Matt 25 bitcoins. The Blockchain would look like this:
Matt has 50 bitcoins
Damon has 0 bitcoins
Matt pays 50 bitcoins to Damon
Damon pays 25 bitcoins to Matt
Now because you know both Matt and Damon’s starting balances and because the blockchain has every transaction which ever occurred, you can very easily work out their current balance. In the case above, Matt starts with 50, pays 50 and then receives 25. Meaning his current balance is 25.
It’s called blockchain because rather than adding transactions one by one, they get added in blocks, like links on a chain. Or blocks on a chain even. Hence the name “blockchain”. And that’s really it.
What gives blockchain its power though, is when it’s combined with a distributed ledger and cryptography.
Distributed ledger: So, a blockchain is just a ledger showing all historical transactions in the system. Importantly there isn’t just one copy of this ledger. There are thousands of them. And they are kept on of different people’s computers (called “miners”) all over the world.
When a new block of transactions occurs, all these miners/computers update each of their ledgers simultaneously. Importantly, anyone with a powerful enough computer can keep and maintain the ledger. Therefore, in geek-speak, the Blockchain is kept on a distributed ledger, distributed across many different computers.
The libertarians of the world love this by the way, as it means control of the ledger/blockchain is decentralized. It’s distributed “among the people” rather than owned by a single corporation of the government.
Cryptography: You know how your dollar-dollar-bills-yo have watermarks on them? This is to make it really hard for people to create counterfeit copies of them. To verify the notes are legitimate, people will put them into the light and check the watermark is as they expect. In a really rudimentary way, they are “decoding” the watermark with their eyes to verify it’s valid. Watermarks are really difficult to make (meaning they are hard to forge), but their validity is really easy to verify.
Cryptography is the computer-world version of the watermark. And when a new block of transactions gets added to the blockchain, a computerised watermark using cryptography is added to that block as well. This watermark uses a lot of mathematics and is extremely computer power intensive to generate. This is intentional, to make it extremely difficult to create and hence forge a block of transactions, just like with the watermark example above.
Once one of the computers within the distributed ledger generates the watermark, all other computers are able to verify whether it’s correct or not really simply by doing the computer equivalent of putting a note up against the light. Therefore, the cryptography used means the watermark is extremely difficult to generate, but super simple to verify.
Once verified, the new block of transactions gets added to the front of the blockchain on every single computer making up the distributed ledger.
So blockchain is just the term for the history of all transactions. These transactions are kept and maintained by heaps of computers all over the world (the distributed ledger). When new transactions occur, rather than being added one-by-one, they get added to the system in blocks. And each new block is assigned a unique watermark which is impossible to forge.
In summary, blockchain technology enables a historical, unalterable record, which is kept on thousands of people’s computers, of every single transaction that ever occurred in the system. It provides a full audit trail of everything, ever. And it can never, ever be changed. Therefore, the system has complete trust and forgery is near impossible.
BITCOIN – PART III
OK, so I get what bitcoin is now, but I still don’t understand why people are using it instead of actual money. The technology seems smart, but it’s still not a real currency, right?
It’s a great question and we’ll try and answer it in this part.
So? Why Bitcoin?
People interested in Bitcoin fall into one of four main groups: Libertarians, the Chinese, criminals, and those believing Bitcoin will lead to lower payment processing fees. There are also the speculators, but we won’t really discuss them here.
1: The Libertarians: Libertarians LOVE Bitcoin. They are anti-government and anti-centralised power, and Bitcoin ticks those boxes. Whereas Australian dollars are owned and controlled by Australia’s central bank (the RBA), Bitcoin is owned by the people sitting outside the government’s control. It is the underlying philosophy of the blockchain which draws libertarians to bitcoins as well as the other cryptocurrencies.
2. Lower payment processing fees: Merchants who accept Visa or Mastercard pay them a processing fee to VERIFY and AUTHENTICATE each of their transactions. A lot of times, you as the consumer will see this cost passed on to you via an additional “credit card surcharge”. This isn’t small either, usually between 1 and 3%. Fees for transactions with Bitcoin, however, are significantly lower.
As we discussed earlier, transactions get added to the blockchain in blocks after a “watermark” has been added to verify the blocks’ authenticity. This process is actually analogous to what Visa, Mastercard, PayPal and other payment processors do when they verify and authenticate transactions. However, processing a block of transactions with Bitcoin is a lot cheaper. Rather than paying 1-3% per transaction, Bitcoin transactions can cost less than 0.1%. That’s a big saving to the consumer and the merchant. And it is one of the reasons we believe the technology behind Bitcoin is so powerful. Bitcoin, however, not so much.
3. Criminals: Remember when you set-up your savings account with the bank? And how you had to provide your driving license, utility bill, passport and Medicare card? All of that was to prove you are who you say you are. Well, Bitcoin doesn’t require any of that. Setting up a Bitcoin account in some instances can be as simple as just providing an email address. Yep, an email address gets you a Bitcoin account and then you’re good to start moving money around as you see fit.
In this sense, Bitcoin provides you with anonymity – or for the pedants among you, pseudonymity. You have a unique identifier for your Bitcoin account (your pseudonym) and every transaction you’re involved with will include that. However, there is no link between you and your pseudonym. So you’re not quite anonymous, but pretty close to it.
Here’s the best example we can give that Bitcoin is the currency of crime. There was a website called Silk Road, which was recently shutdown. On it, you were able to buy all things illegal. Yep, you could get anything from Mary-Jane (that’s marijuana Mum) to heroin, cocaine, counterfeit watches and even hitmen (and women). How did people pay for this? They used Bitcoin. In fact, that was the only currency accepted. And why Bitcoin? Because of the anonymity protection provided by it. And when you’re dealing in crime, anonymity is key.
Do you remember the WannaCry attack? Essentially it was a computer virus which locked entire organisations (including FedEx, Nissan and the UK National Health Service) out of their computers. The only way to regain access to them was to pay the hackers a fee. And how did they accept their fee? Via Bitcoin of course.
4. The Chinese: Relax. We are not being Ray-Ray. It’s the truth. While we don’t have enough time to get into capital controls here, in short, China has put in place a number of restrictions, which prevents people from taking large amounts of Yuan (the Chinese currency) out of the country. People are always looking for ways to get around this, and Bitcoin provides the perfect vehicle to do so.
And that’s what’s happening. The Chinese exchange their Yuan for Bitcoin. They then exchange their Bitcoin for another currency, say USD. Boom. They have now moved their money out of China. Well, that was easy.
Estimates put the percentage of trading in Bitcoin which occurs in China upwards of 70%.
So Bitcoin is attractive to a number of different groups, all for very different reasons. We’re getting close now, but we’re not quite done. Here’s a chart for the next part…
BITCOIN – PART IV
The Netherlands in the early 1600’s was the setting for what is commonly agreed as the very first speculative bubble, the details of which should really blow your mind. Back then, a new product was imported into Holland, one the Dutch had never seen before. It was different, it was beautiful and it very quickly became the must-have item of the rich and famous. As demand for this thing increased, so too did its price. Noticing the price going up, “investors” started buying it too, in the hope of being able to sell it later at a profit. And with more demand came increased prices and with increased prices came increased demand. And so it continued and soon enough buyers were forking over the equivalent of ten times the YEARLY salary of a Dutchman for a single one of these things. The item of course was a tulip bulb. True story. The hype and speculation got so out of control, that a single tulip bulb was trading at 10 times the wage of an average person. Crazy stuff. On a completely unrelated note, back to Bitcoin…
In this part, we’ll talk about why we think Bitcoin is a massive bubble waiting to burst. But first it’s really important that we say the following:
No one knows anything for certain in finance. Investing is gambling. Educated gambling, but it’s gambling nonetheless. Never, ever listen to anyone who tells you that something is definitely going up, or definitely going down, as they cannot know it with 100% certainty. A key motivator of us writing this, is that the Finance industry is filled with so many pariahs who prey on the ill-informed and make money for no one but themselves. The purpose of The Daily is to shed some light on all things financial, to help you understand better what is going on, and to make better decisions yourself. We are not telling you what to or not to invest in, but we will tell you our opinions. And they could very easily be wrong.
On Bitcoin. We think the technology behind it is incredible. Game changing in fact. If you’re interested in how it can be applied in really clever ways, read this article by The Huffington Post. Bitcoin however, and all of the other copycat cryptocurrencies which have crept up over the last year, will most likely fall by the wayside. And in the next part, we’ll tell you why we think so.
For now, here’s an article which quotes Jamie Dimon who heads up the largest bank in the United States.
BITCOIN – PART V
There are three sections below. “The Summary is This” which is our traditional 5 minute yarn. After which we’ve also included “A Little Bit More” which has lot more detail if you want it. We wrote it, so we think it’s worth reading, but you do so at your own risk. Finally, there’s “Here’s a Story” at the end.
The Summary is This
The technology behind Bitcoin is so unbelievably clever it’s not funny. Over the next 5-10 years, you should expect a whole ecosystem of technologies to spawn, which are based on the blockchain concept. Further, we fully expect that governments over time will turn our currency into a digital one. We are already moving towards a cashless society, so putting our currency into the blockchain is a very logical next step. In fact, like one our readers pointed out, they have already hinted at it.
So the blockchain rocks. Woot Woot. Bitcoin does not. It’s getting a lot of airplay at the moment, because of the technology behind it and so it should. However, Bitcoin has no intrinsic value. And that is a super important thing that you must understand. Bitcoins cannot be eaten, drunk, worn, slept with or lived in. And the government will not accept them as a form of payment either. It only has value because a certain group of other people believe it has value, and we’ve discussed them previously: Libertarians, criminals, people who want lower processing fees, the Chinese who are trying to get money out of the country, and speculators.
However. China is closing down Bitcoin exchanges. Governments are getting better at tracking criminals who use bitcoins to launder money. The value of a Bitcoin fluctuates a lot and often which makes it difficult for businesses to accept it as a form of payment. There’s also the fact that the government needs to control the value of our currency so as to manage the economy, which may mean they will crack down on Bitcoin should it get too much use (just like what China is doing right now). When you combine all of that with the fact that Bitcoin has no intrinsic value whatsoever, you should at least start to question whether buying Bitcoins is really such a smart idea.
Having said all of that, in the short term, Bitcoin may very well go up. And if you like to gamble, throw some money in. But only a little bit and only what you can genuinely afford to lose. Because what you’ll be doing is speculating, not investing. For you to make money buying Bitcoin, you have to rely on the hope that other people are going to want to buy it after you and at a higher price than you paid. And maybe they will. Just like the Dutch did with tulips in 1600’s.
In the long run, we strongly believe that Bitcoin will fall to the wayside as governments themselves transform their own currencies into cryptographic ones. Will we be right? Only time will tell.
And that’s 5 minutes. Hope it helped.
A little bit more
Why businesses in general cannot adopt Bitcoin
Imagine you’re a business owner. And your business is selling cars. You have expenses, like wages, rent, tax and the purchasing of cars in the first place, all of which must be paid in Australian dollars. That’s not a problem, as all of your income from selling cars is in Australian dollars as well. In financial speak, we’d say you have no currency risk. It doesn’t matter whether the Australian dollar goes up or down, your income and expenses will remain unchanged. Sweet as bro. Enter Bitcoin.
The cost of a single Bitcoin frequently fluctuates in meaningful ways. During a week in August Bitcoin surged 20%. In July it jumped 15% in a single day. On Monday, it fell 8%. June last year it fell 25% in a week.
Anyway, back to your car business. Knowing that the value of a Bitcoin is inherently unstable, would you be willing to receive Bitcoin as payment for your vehicles? That’s a lot of “currency risk” you’d be taking on. The optimist in you would think, ‘what if it goes up, I could make a fortune’, which is fair. But what if it falls? You’ve bought the car for 20,000 Australian dollars and then sold it for 5 bitcoins, which at the time were worth 5,000 Australian dollars each. So you receive 5 bitcoins which are worth 25,000, therefore you’ve booked in a profit of 5,000. Or have you? You still have to sell those bitcoins so you can pay for all your other expenses which are paid in Australian dollars. What happens if the value of a Bitcoin falls 10% before you do? Your 5 Bitcoins are now worth 22,500 and your profit has halved. That sounds pretty risky to me.
And aside from not understanding what a Bitcoin is, this is one of the fundamental reasons the majority of businesses do not accept Bitcoin. Conceptually, businesses should love it. They really should. Like we’ve said previously, transacting in bitcoins substantially reduces transaction fees, which is great. But Bitcoin moves around way too much for any rationale business to start accepting it.
Should the government turn your currency into a blockchain currency though, this issue would be eliminated. The currency risk element would disappear and business adoption would be massive given the significant reduction in transaction fees. Long term, this will be bad news for companies like PayPal, Visa, Mastercard and American Express whose entire business model relies on collection these transaction fees.
Criminals love it, but it’s getting harder for them
Criminals LOVE bitcoin. Like we said previously, it is the perfect currency for crime. You trade under a pseudonym and setting up an account requires almost no identification. This makes it very hard for the authorities to find you. But not impossible. Remember, Bitcoin is not currency, it is a piece of technology. And that technology is essentially a historical ledger of every transaction which has ever occurred, in the order that it occurred. And that ledger is on thousands of computers all over the world and it is publicly available. Tech-heads are starting to work out how to harness that fact to glean more information off transactions and ultimately work out who is behind them. Don’t ask us how, but they can. At the same time though, the criminals are working on better ways to keep themselves anonymous. And they are still ahead of the authorities, but for how long, who knows.
The point being, Bitcoin is still great for funding criminal enterprises. However, it’s not as good as it used to be and it’s only going to get harder.
Here’s a story.
Jason and Bourne (yes, it can be a first name) both run highly successful cafes. And each loves to visit the others. Jason can’t go past Bourne’s famed avo-smash and Bourne is all over Jason’s Mocha-Choco-Lata-yaya. So much so, they are literally in each other’s places daily. One day Jason says to Bourne, ‘mate, money keeps going back and forth between us, why don’t we each just put 100 bucks into a shared account, and rather than me paying you and then you paying me every day, we’ll just track who owns what in a spreadsheet’. Bourne thinks about it for money, and says ‘dude, great idea. But you set it up. ‘Sweet as bro’ replied Jason, ‘we’ll start it from tomorrow’.
And so they did. Each put in 100 dollars and each was given 100 ‘units’ in return.
Every day Jason would go home and update his spreadsheet with entries like “Jason owes Bourne 15” and “Bourne owes Jason 11.5” and then send the spreadsheet back to Bourne to confirm. This went on for some time, until their friend Matt the mixologist caught wind and wanted in. Matt said ‘my brosephs, I want in’. ‘Why?’ asked Jason. ‘For the same reason man. You guys are drinking at my bar every day, and I’m eating at yours just as often. It just makes it easier for all of us and means we don’t have to keep transferring cash’. Matt’s point was a sold one and so Jason and Bourne brought him in. Matt paid 100 into the kitty and was promptly given 100 units.
And over the following months more and more people got involved with the spreadsheet and by the end of the year there was nearly 100 in the system. Each having paid 100 dollars for a 100 units. The spreadsheets were sent around daily to everyone for all to confirm they looked good. Things were working great.
Sadly though over this time, Matt’s business had fallen. Distraught, he needed a break and decided to close down his bar. So for him the spreadsheet was of little use anymore. He decided he would cash out. But no one within the system would buy his units from him. This was a problem.
The only way Matt could get money out of the system was when a new person asked to join. So Matt went looking. Actively. And successfully.
And Matt was clever. Rather than selling all his units, he only sold a portion of them, but at a higher price. Matt sold 50 of his units for 100 dollars. And so it began…
Going forward, rather than issue new units to people, everyone using the spreadsheet agreed that for someone new to enter, they would have to buy existing units from someone else in the system.
At first things started slowly. 1 unit cost 2 dollars (rather than 1 when the spreadsheet was first created). But now the existing holders of units realised they could make money by selling their units for a higher price, they started to market their spreadsheet hard. “The spreadsheet is the greatest thing every made“. “It is revolutionary they would say“. “It makes you run higher and jump faster“. “Spreadsheets are the new superfood”. They took out full page adverts in their local paper and radio ads during the ‘love hour’ evangelising the spreadsheet and the units themselves.
And the marketing worked. People wanted in. And the more people wanted in, the higher the price would go. First to 3 dollars, then 10, then 100! At 100 dollars, one of the national newspapers took notice and wrote an article about a new potential investment opportunity, one which has already gone up by a factor of 100 in just 6 months.
A factor of 100?! In 6 months? Now the speculators got interested. If it can go up 10 times in just six months, imagine what could happen in a year. And so the money flowed in. 200 dollars a unit, 500 dollars a unit. 1000 dollars a unit! Everyone was making money. So copycat spreadsheets started popping up all over the place. The best thing since sliced bread they would say.
Meanwhile, Jason, Bourne and Matt were long gone. They have closed down their shops, sold all their units, bought boats and now just giggle at the price rise.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.