A beginner’s guide to bitcoin: what is bitcoin?
As a completely novel concept for many people, bitcoin can take a little effort to get to grips with. In the first of a short series on the cryptocurrency, Dominic Frisby explains just what it is, and why you should take notice of it.
If I only had a bitcoin for every time I’d heard someone say: “I don’t understand it”. Even after I explain bitcoin – and I’m pretty good at explaining stuff – many still shake their head and say “I still don’t get it”.
Often I think this is wilful ignorance; bitcoin does take some effort to get to grips with. The concept of a money system that is not state-issued is hard for many to wrap their heads around, and the tech can be a little baffling to non-techies, so the easy route for many is to say, “I don’t understand it” and walk away.
Don’t be one of those people. Simple explanations of bitcoin may leave you with more questions than answers. But that is all part of the process of coming to terms with the idea of a new system of money.
You don’t need to understand bitcoin to use it
I will explain the tech in simple terms below. But the first thing I would stress – and I am so keen to stress this that I am going to put it in bold italics – is this: you do not need to understand the tech in order to use it.
• Do you understand how hypertext transfer protocol works? No. And yet you still use the world wide web every day.
• Do you understand how simple mail transfer protocol works? No. And yet how often do you send emails?
• Do you understand the combustion engine? Or the science of antibiotics? Or nuclear fission? And yet you drive a car, take medicine and use electricity.
I will also say this: do you know how money – and I am talking about national currencies such as the pound, dollar or euro – really works? Do you know how it is created? Do you understand the difference between M1, M2 and M3 money supply? Do you understand interest rates? Most of us don’t (and even those who do, still don’t appear to understand how all of these things interact with each other). And yet we all use it.
So if you do not understand the tech – and in all probability you won’t – that does not mean you should not use bitcoin. Do not let that be your excuse. Nevertheless, here we explain, with devastating clarity, once and for all, what bitcoin is.
Bitcoin is a new system of money designed for the internet. Let’s shorten that to: bitcoin is money for the internet.
The internet is, essentially, a borderless medium. I’m in the UK. I can communicate with someone in the US, Australia, South America, Asia or Africa as instantly as though they were in my own country. I can send them messages, photos, videos, any kind of content, and they receive it instantly. Yet, until bitcoin, I couldn’t send them money with the same ease. I would have to go through Paypal, or a bank or a credit card company. There would be foreign exchange costs, money transfer costs, regulatory processes.
With bitcoin I can send money across the net, direct from person A to person B, just as I send messages. It might be tiny sums, but it could also be billions. (For example, only recently, I saw that somebody had transferred 14,892 bitcoins. That’s over half a billion dollars in value. I know that that value was transacted – the transaction was broadcast on the blockchain. But I have no idea who sent the money, or to which location it was sent. I rather suspect it was Elon Musk – but who knows? I also know that the cost of the transfer was a few dollars, and that the transfer was almost instantaneous).
How did bitcoin come about?
Bitcoin was invented in 2008 in reaction to all the money-printing policies that were adopted to bail out the banking system. Bitcoin’s creator, the (still) anonymous Satoshi Nakamoto, wanted to create a system of money that was apolitical and resistant to state actors. In other words, a politician or central banker couldn’t start printing this currency, even if they deemed the circumstances demanded it. Bitcoin’s inflation rate is set out in its code with full transparency.
Moreover, Nakamoto wanted to design a deflationary system of money. Central bankers and governments can create pounds or dollars when it suits them. Thus fiat money is an inherently inflationary system of money – the supply of money never stops growing.
Nakamoto wanted to code a system of money that is finite. There will only ever be 21 million bitcoins. By making it finite, by limiting supply, you make it desirable. Like gold, its rarity makes it precious.
Nakamoto designed bitcoin on an “open source” basis, meaning anyone could view the code and contribute. The result is the greatest digital collective ever known to man. Everybody who buys and uses bitcoin has contributed in some way, even just by mentioning it.
How is bitcoin’s price determined? That’s the next question that usually gets asked. The answer is: by the market. There are umpteen bitcoin exchanges around the world where bitcoin is traded for fiat money and other cryptocurrencies. Billions of dollars in value are traded every minute, rather like the foreign exchange markets, and the amalgamation of all these trades is the bitcoin price.
The market sets the price. If there are no buyers, the price will fall until buyers appear. If there are no sellers, the price will rise until sellers appear.
What is money anyway – and is bitcoin money?
At this point it is worth defining what money is, because this is another area where confusion arises. Money has several functions. First and probably foremost, money is a medium of exchange.
I give you money in exchange for your good or service. All sorts of things have been used as a medium of exchange over the years – shells, whales’ teeth, metal, paper, cigarettes, brandy. Today fiat money (money printed and controlled by governments, such as the pound, euro or dollar) is the most prevalently-used medium of exchange, but air miles, supermarket rewards points and gift cards are all other accepted media of exchange.
It’s unlikely I am ever going to go into my local corner shop and buy a pint of milk in bitcoin. Fiat money is much more convenient. But bitcoin still finds widespread use as a medium of exchange on the internet, as long as buyer and seller are both content to use it. It’s a preferable medium of exchange to fiat for cross-border payments, but for small, local payments in the physical world, fiat still prevails.
Money’s use as a standard of deferred payment, to use economists’ jargon, is closely tied to money’s role as a medium of exchange. You and I can agree a price now for a good or service, and the debt will be settled later.
Money is also a store of value. I pay you for a job you do today. You keep the money to be spent at some later date. Fiat has proved a rotten store of value. It has lost something like 99% of its purchasing power over the last hundred years. Look, for example, at how much less house fiat money buys you than it did 30 years ago. There may not be huge inflation in the price of phone calls, Primark clothes or bread, because these items are not in short supply. But there is huge inflation in the cost of housing, art, stocks and bonds, and school fees, for example.
Gold, because it is permanent and immutable, has proved a much better store of wealth over the very long run than fiat money. An ounce of gold buys you as much food, clothing or energy as it did a hundred or a thousand years ago. (Gold, however, is not a great medium of exchange).
Bitcoin, albeit volatile, has proved a wonderful store of value. Over the past three months, year, five or ten years it has beaten every other asset class hands down. Its purchasing power has increased every year. Indeed, Nakamoto designed bitcoin to be a form of digital gold – a digital store of value.
Finally, money is a measure of value – or, to use the parlance, a unit of account. You use money to measure the value of a good or a service. We still tend to think in terms of fiat money when measuring value. But it is a flawed measure because the value of £100 today is a lot less than it was 20 years ago. That’s why the use of “inflation-adjusted” pounds or dollars has become so commonplace.
Gold and, to an extent silver, are better historical measures. Their value is more consistent over time. We can look at the cost of wages or goods in Ancient Rome, for example, in gold and silver and compare them today. Until the 20th century, gold and silver were the standard. But ordinary people, brought up on fiat money, no longer think in terms of gold and silver, but their national currencies.
Bitcoin, except among its most ardent acolytes, has yet to find use as a widespread unit of account. The major exception to this is in the booming and rapidly growing crypto economy itself, in which bitcoin is the standard. We shall wait and see whether the bitcoin standard will come to replace fiat.
To conclude, the function of money is to exchange value; store value; and measure value. Bitcoin is fully-programmed, state-free money for the internet.
If you’d like to read more, Dominic has put together a downloadable Beginner’s Guide to Bitcoin for MoneyWeek subscribers, which includes a bonus section on other cryptocurrencies. If you’re not already a subscriber, sign up now to get the report plus your first six issues free.