The obsession with Bitcoin is bonkers. But, a ten-fold return in only a year’s time has a way of grabbing attention.
Back in 2009, Bitcoin was invented by a still-unidentified person named Satoshi Nakamoto who wrote a short paper describing a new “peer-to-peer electronic cash system.” Mr. Nakamoto simply described an idea, published some basic software and registered a website. He then abruptly handed it over to his fellow enthusiasts and mysteriously stepped back into the shadows. It’s an origin story fit for a superhero.
At its heart, Bitcoin is just a secure, electronic ledger of transactions using a completely made-up and purely digital currency. There are no banks and no middlemen involved. There is simply a collective of non-owner stewards running the system.
Imagine I’m Mr. Nakamoto and I created the first 1,000 Bitcoins out of thin air. And, let’s further imagine I convince you that each of my Bitcoins is worth $0.10. With my new $100 in Bitcoin “wealth”, you kindly agree to sell me ten delicious pizzas. You then quickly turn around and convince your neighbor to accept your 1,000 Bitcoins in exchange for a $110 used bike. And, your neighbor then spends her 1,000 Bitcoins to buy a $120 painting from a local artist.
To make this transaction history official, this very first “block” of Bitcoin transactions needs to get securely recorded somewhere. After all, we need to have a record of the changing ownership of every Bitcoin in existence.
Remember, unlike carrying around traditional bills or coins or gold, Bitcoin is a purely digital thing. In the absence of something tangible to convincingly demonstrate true ownership, the entire system depends on the existence of a trusted ledger. To ensure the Bitcoin ledger’s security and legitimacy, Nakamoto’s moment of genius was arguably his creation of the “blockchain.”
Now, to permanently cement the addition of each new block of Bitcoin transactions to the official ledger – the process of “chaining” one block of transactions to the next block – Nakamoto’s system calls on millions of computers to solve a mathematical puzzle. The fastest computer to solve the puzzle is declared the winner. This winner then gets to officially add the newest block of transactions to the old ledger. The previous version of the ledger is destroyed and the brand new, official ledger is immediately distributed across the globe and is stored on an untold number of independent computers. This process is repeated every ten minutes with each new added block of transactions.
Like mining for gold, in return for their successful effort, the winner is awarded some newly-created Bitcoin. By its very design, a declining number of new Bitcoins will be awarded to the winning “miner” until exactly 21 million of them are in circulation. Supposedly, this limit will be reached in about 100 years.
In the face of newly-printed paper currencies, you can clearly see that promised scarcity is Bitcoin’s primary allure. While unlikely, perhaps Bitcoin will someday supplant the historic role of gold. But, there’s only one major problem, you cannot use Bitcoin to pay your taxes. That’s the ultimate definition of legitimacy. It seems only US dollars will truly satisfy Uncle Sam. Given this, I think I’ll stick with old-fashioned dollars and marvel at Bitcoin’s wild ride!
Jason P. Tank, CFA is both the owner of Front Street Wealth Management, a purely fee-only advisory firm and the founder of the Money Series, a non-profit program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com