Much has been said about Bitcoin in the last year, but many people around the world - Malta included - still struggle with understanding what it all means.
So what exactly is Bitcoin?
Bitcoin is a digital, global ‘currency’. It allows people to buy products and services online from vendors accepting it, effectively bypassing the conventional banking system. The mathematical field of cryptography is the basis for Bitcoin's security and value. Cryptography is the computerised encoding and decoding of information for secrecy’s sake.
Bitcoin was invented by an unknown person or group of people under the name Satoshi Nakamoto and released as free software in 2009. It first started trading for around €0.20c, and as at 29th December 2017, 1 bitcoin was worth around €12,000.
It is the first attempt at a decentralised digital currency, as the system works without a central bank or single administrator (unlike the USD, the Euro and any other currency). It aims to facilitate cross-border transactions by bypassing conventional channels like banks and other intermediaries which are often notoriously expensive, bureaucratic, and slow.
Another defining feature of this new type of currency is anonymity. In fact, its rise to fame was notoriously associated with the online black market. However nowadays it is much harder to anonymise, and its use has expanded to different legitimate businesses ranging from hotel accomodation to cars, furniture and pizza.
You can store your Bitcoin on downloadable applications linked to the Bitcoin network. These are called online wallets and they charge fees. Two examples of such e-wallets are Exodus and Mycelium. Exchanges are another type of agent which let you convert your Euro to Bitcoin and vice versa. Two popular exchanges are Coinbase and Bitstamp.
So how does it work?
Bitcoins are created by miners. Miners are people who have computers dedicated to solving a mathematical equation that has a definite set of solutions. The solutions get progressively harder to find and that is why it has a finite supply and a predictable rate of price inflation. Think of simultaneous equations you had to solve for your Maths O-level “solve for x”. Each solution found, also called a block, can be thought of as one bitcoin. No one has a list of solutions, but solutions can be checked by running them in the equation.
Theoretically, anyone can try to create new bitcoins on his laptop. However, to effectively and profitably mine it, high-end hardware (specifically designed to mine bitcoin) would be needed. This would also rack up the electricity bills, and generate a lot of heat from the processor working so hard. It is also a highly technical operation to setup and run. Therefore, mining is definitely not for everyone.
The crux of this new digital currency is how its value, the actual amount in circulation and the transactions are being tracked and logged. All of these operations fall under what is called Blockchain technology.
As new solutions - or blocks - are discovered, they are added at the end of this chain. Each new block in the chain is a new Bitcoin unit. To this chain, also called public ledger, a transaction log is appended every time a successful transfer happens from person A to person B.
The transaction log is nearly impossible to fake, because if you try to do something you're not technically able to (like transfer coins from an account which doesn't hold enough), your transaction is flagged by a disagreeing computer on the network as invalid. The transaction is passed around the global network until a consensus is reached. If more than 50% of the nodes think you should be able to make the transaction, then it is validated.
What are Alt coins?
The term is short for alternative coins. Bitcoin introduced the concept of blockchain technology, which matured over the years to become a stable system. However, this is not the only cryptocurrency around, there are literally hundreds of others trying to emulate its success by being different in one aspect or another. Their aim is to ultimately provide a better system or cater for certain industries or users better than bitcoin.
For example Litecoin is very similar to Bitcoin, but allows for faster transactions. Ethereum has the ability to set up ‘smart contracts’ in order to be able to do more than just sending currency from A to B (like Voting, keeping historical records). Ripple does not require mining and therefore is much more energy efficient, albeit being centralised rather than decentralised.
Being the first to market, Bitcoin is definitely the leader of the pack, and when it swings in value, it drags the rest of the coins with it. However being the first mover in the market made the bitcoin blockchain tech somewhat outdated and bureaucratic compared to the new entrants. This results in increasingly higher transactions fees and longer transaction times. Only time will tell which cryptocurrencies can emerge as a useful global currency.
Blockchain's Pros & Cons
The fact that a copy of this public ledger is found on each computer connected to the blockchain network, makes it practically unfalsifiable. Without a central point of failure it is able to withstand malicious attacks and attempts at manipulation by any single entity.
Politically this also means that the value of currency is not dictated by central banks which can use policies to create inflation or deflation at their own will.
The fact that there is no central authority administering the currency is a challenge to government control and makes regulatory intervention, when necessary, much more difficult. Because classic currencies have always been created and regulated by national governments, cryptocurrencies face a hurdle in widespread adoption by pre-existing financial institutions if their legal status remains unacknowledged.
Price inflation has still proven to be a problem with speculation fuelling the valuation of Bitcoins to astronomical heights this year. The fact that its rate of exchange varies so widely is making it increasingly difficult to serve an essential purpose of currency - that of being a means of exchange and store of value. Many prefer holding on to it in the hope that it will increase even more.
Conventional bank transactions can potentially take days to settle, especially outside of working hours. Blockchain can reduce transaction times to minutes and are processed 24/7. By eliminating third party intermediaries and overhead costs for exchanging assets, blockchains have the potential to greatly reduce transaction fees.
Lately, exchanges have been increasing their fees, which negates one of the technology’s original aims.
Another external cost of this decentralized computerized system is the disproportionate electricity consumption that keeps these machines going. PowerCompare.co.uk estimates that this year, Bitcoin mining alone used more electricity than what Ireland consumed as a country.
Any seller accepting Visa and Paypal knows about the cost of chargebacks, some of which are fraudulent and a great strain on business. Same with fraud from the consumer side.
However with blockchain technology, once the transaction is validated it cannot be reversed by a higher authority. Since we are trusting mathematics, not a third party or banking authority, cryptocurrencies reduce the amount of fraud. You do not need to trust the person - the systems talk to each other and if the transaction is viable, it will take place.
Enabling transactions with potential anonymity may have illegal connotations. Every country has its own laws which are the cornerstone of a democratic society and its well being. The potential of cryptocurrency to circumvent these and enabling illegal trade in goods and services should not be dismissed. (One can argue that cash has been doing this for centuries.)
“It’s a scam”
It's not a scam when the right channels are used. But just like any other popular phenomenon, the buzz around it may be used to lure in unsuspecting people. Phishing of this sort is common on Facebook ads linking to dubious websites to purchase Bitcoin.
“You missed out on the best investment of the century”
You may have heard of people who were early buyers of Bitcoin and have become, seemingly overnight, millionaires. Such lucky people are few and far between. You do not hear of the thousands of people who lost their early bitcoins due to some hard disk fault, misplaced laptop, had their Bitcoin stolen through malware or just straight up forgot about them and erased the data on their hardisk. It may be the talk of town in 2017, but it spent a good number of years as just a geek word.
Just like any other volatile instrument in the stock market, if you manage to get in at the right time and hold it for the right amount of time one can be profitable. If a person bought 1BTC in 2013 for €200 and sold it off in 2014 for €700 he would have made a return of 250%. Had he not cashed out early and held it till late this year, he would have turned his €200 into €16,000. But this volatility is highly unpredictable;in fact if he needed to cash out in 2015 instead he would have have made a loss. Therefore speaking in hindsight may be misleading about the whole journey which Bitcoin has gone through.
Why the recent buzz?
The breadth of cryptocurrencies available, the rate of new ones being launched and the potential of gains for early investors are peaking this year. Automated investment robots are being used widely to purchase and sell-off coins depending on how they are trending.
So much so that Long Island Ice Tea Corp, a beverage company, was up 500% one day after changing its name to Long Blockchain Corp, despite having no relation to blockchain in its business.
The number of cryptocurrencies available can be thought of as the modern day penny stocks of ‘Wolf of Wallstreet’ fame. Like shares of unknown startup companies trading for pennies, from which 1 out of 100 can make it big.
Bitcoin as an Investment
By definition, most people buy their shares when their value is in full swing and panic-sell if their investment dips 10%. In a matter of days, Bitcoin fell by 20-30% multiple times during 2017. Having your savings drop 30% instead of growing at a slow steady rate in savings account may cause sleepless nights for some and stopping losses would be the right call. The following month they may be up by 40% but that's game that you need to be willing to play.
One thing to keep in mind is that when dealing with such volatile investment, you are better off treating this activity as gambling and not investing. You should never put any amount that if lost would have you tossing and turning in bed. Also, due to the technical and unique nature of this product, if you generally spend 3-5 hours researching a company financials before investing in its shares or bonds, investments in crypto generally need much more research hours to truly understand what you are investing in.
One can argue that the huge rise in value experienced during the last few months is not being matched by an increase in adoption and usage of this technology. To put it simply, if the value of bitcoin tripled in the last quarter, we did not see any significant increases in shopping volume in this currency let alone tripling. The number of retailers accepting bitcoin as a means of payment is still insignificant. This signals that the price may be fuelled by pure speculation.
Of course this is just one opinion and everytime a bitcoin is sold, its because there is a buyer that believes that he can get to sell it at an even higher price.
PS. Since no cryptocurrency in recognized as an official currency in Malta, the tax treatment of capital gains from trading is still unclear.
So what does this all mean in the long run?
We have barely scratched the surface of a massive technical operation that is the blockchain. However it's a promising revolutionary concept, combining new technology with old cryptography science to overcome certain current banking limitations. It's a neat system that eliminates middlemen and has an unlimited number of applications.
How long did it take from the invention of the computer to everyone having one in their pocket? One can't expect Bitcoin to stabilize overnight. The price fluctuates now because there is a lot of speculation on its future uses.
One of these coins should be able to win this cryptocurrency war and establish itself as a reliable means of payment. Once it starts stabilising its exchange rate, it may then fulfill the potential of a full blown global currency. It could also be the case that the EU considers it a threat to its sovereignty and bans its use entirely. But for the moment, everyone can keep on speculating.
- Slight inaccuracies may result from simplifications.
- The author is neither an authority nor an investor in this technology.
- The opinions expressed in this article are solely the author's own and are not to be taken or relied upon as advice.