Bitcoin 101: What You Should Know About Cryptocurrency

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By Mia Kitner

Bitcoin has made recent headlines, and by now we are all familiar with the term cryptocurrency. Cryptocurrencies are digitized currencies that are rising in popularity, and many wonder if the frenzy behind them is a bubble or not.

Fiat Money vs. Cryptocurrency

To understand what bitcoin or other cryptocurrencies are, we must first take a moment to understand the meaning of money. We value money for what it can do for us, yet we do this as automatically as we breathe.

For centuries, we have used various forms of currencies to trade and buy; currency is a medium of exchange, and usually, we refer to it as fiat money. Fiat money is simply the term we use for legal tender as declared by a government. In Latin, fiat means “it shall be.” However, money, as we know it today, was not always a piece of paper with intricate designs. At one point, it took the form of a feather, a stone, and even a shell.

Money’s value depended on its appearance or condition, and at times it was merely valued because of its beauty or practicality. However, the real value was ultimately based on its availability since the item was often difficult to acquire or produce.

Fast-forward some centuries, and money has taken a new form. The evolution is without a doubt an interesting one and perhaps one of the reasons why cryptocurrencies like bitcoin have become popular. Bitcoin and many of its competitors are digital and decentralized currencies secured by cryptography (digital signatures) and, in some cases, anonymous as well.

The main difference between cryptocurrencies and fiat money is that a government typically backs fiat money. Yet fiat money is not backed by any physical reserves (although it has been in the past), and this much it has in common with cryptocurrencies. Their value depends on the faith we place in them.

Sure, it is easier to put your trust in the government declaring a currency to be its legal tender, but why is the government backing fiat money? The central banks play a significant role since they are ultimately in control of regulating the supply of money by printing what they estimate the economy will need.

They also supervise other financial institutions and act as a “bank for banks” by providing financial services to them. In short, the central banks control the money supply. In the United States, the central bank is the Federal Reserve. It was created in 1913 with the goal of alleviating financial crises and banking panics.

Bitcoin shares a similar story in the sense that the surge in the popularity of cryptocurrencies came after the United States’ financial crisis of 2008. The crisis caused mistrust in the banking systems and led to some banks filing for bankruptcy. This, in turn, caused more discontent among many citizens. The financial crisis brought to light issues that come with storing your money through a centralized, government control system, and it helped propel the rise of cryptocurrencies.

A System of Mathematics

Created in 2009, Bitcoin became the first cryptocurrency created, and it started with a value of $0.0001. As of this writing, 1 BTC is about $13,880. The system behind bitcoin is based on mathematics rather than physical elements, like gold or silver, or trust in a government.

However, to understand how bitcoin’s value has increased dramatically in a relatively short time, we need to take a look at how bitcoin operates. We know that it is decentralized since no bank or government controls it. So who does control it, then? The answer is simple, yet complicated. Since there is no middleman, transactions occur peer to peer directly without a third party, and not one individual controls the network. Any time a transaction occurs, it is added to the ledger, which keeps growing, and it is the blockchain that powers the system.

Peers, or miners, verify each transaction through a series of events that involve complex mathematical equations requiring supercomputers to do the work. To send someone 1 bitcoin (or a fraction of one), the system will first verify that you have in fact that amount available in your account. It will then trace that back to its origin to ensure a secure transaction and prevent double-spending.

Unlike a traditional bank, whose ledger is private, bitcoin’s ledger is public, accessible by any computer running the software and connected to the network. It keeps a running tab of all users and their transactions (think of it as all the ledgers syncing with one another to stay up to date).

The network relies upon multiple users running the software 24/7 (the blockchain) and miners that keep it secure by performing useful services. They “mine” the coins, help keep the system running smoothly, and secure the network. “Mining” is the process of creating new bitcoins, and the miners also play a vital role in verifying the transactions. In exchange, they are rewarded for their work by receiving transaction fees (optional at the time), and through a fixed formula they also “mine” the new coins, or bring them into existence.

A Finite Supply

The supply of bitcoin is limited to 21 million coins, and those 21 million coins may be divided into sub-units up to 8 decimal places (the smallest available bitcoin at the time is 0.00000001 or 1 Satoshi, named after its founder). Fiat money, on the other hand, theoretically has an unlimited supply because an infinite amount of money can be printed.

The value of each bitcoin depends on the faith we put into it (the more users and wider acceptance, the higher its value) and the basic law of supply and demand. As demand increases and supply decreases, the value or price goes up, and vice versa. The current issue with this model is that due to its market cap at the moment its price is volatile, but the upside is that due to its limited supply and calculated creation, demand follows the level of inflation and sets the price.

This is not to say that cryptocurrencies are flawless. Price manipulation, the risk of declining value, and a competitor taking over are a few of the risks associated with cryptocurrencies, along with its volatility. Recent headlines have shown just how much the price of bitcoin and other cryptocurrencies can change in a week.

The Big Question

One of the biggest questions that this volatility brings up is “Is bitcoin a bubble?” We are all familiar with bubbles, the most recent one being the U.S. housing bubble that peaked in 2006. A bubble occurs when the price of an asset is significantly higher than its intrinsic value.

Bubbles are based on suspension of disbelief, our willingness to abandon logical thinking and believe that what we are experiencing is real. Many bubbles have five stages, starting with displacement or, as I would refer to it, the “falling in love” phase. Following this phase comes the boom stage when FOMO (fear of missing out) comes into play, and the demand drives the price up. Then comes the euphoria stage, when we seek for the proof that the valuation we are seeing is real.

The profit-taking phase comes next when some investors start to see signs of failure, and they try to take their profit. Lastly, panic sets in, and the bubble bursts. Prices drop as fast or faster than they rose, and many are left with losses and disappointment. But hindsight is always 20/20, and it’s not always easy to identify a bubble when you are caught up in it.

What Will Tomorrow Bring?

No one can predict the future, and we don’t know what the value of bitcoin or any other cryptocurrency will be tomorrow or if they will still exist in a year. The same can be said for any asset, commodity, and even currency.

What we know for sure is that bitcoin has grown since its creation in 2009 partly because there is a demand for it. While it is not illegal to own it or trade it, many people question its legitimacy. If you happen to have any gains, the IRS views bitcoin as property, so taxes are due on those gains.

Perhaps bitcoin may not be the currency of the future, but cryptocurrencies or digital currencies are valued by some already, and some think they are here to stay.

Think about your hotel rewards, credit card points, airline miles, and even your Starbucks or Dunkin’ Donuts rewards program. All those perks have value because we see a benefit to using them. These are all digital currencies; they allow us to obtain goods or services in exchange for virtual “payment.” Instead of dollars, we are paying with digital points, and akin to bitcoin, they are peer-to-peer. I move 125 “stars” from my Starbucks account to theirs, and I get to sip my venti Caramel Macchiato.

We value these digital currencies since we trust that they will be there when we decide to “cash in our points,” yet all we have is faith that the company will be there tomorrow to fulfill its promise.

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Northstar Financial Planners

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