Bitcoin for beginners

Over the holidays we’ve had the pleasure of catching up with our friends and family around the barbeque and having a chat about winners and losers in the markets for 2017. Instead of being excited about double-digit gains in residential property prices this year, everyone seemed to have something to say about bitcoin. But despite such a stellar rise in bitcoin prices in 2017 and a surge in popularity in Australia, it remains difficult to clearly articulate what it is about bitcoin that has made Aussies go bonkers for it. Whilst the team and I don’t profess to be experts on bitcoin (or other cryptocurrencies), we hope that these introductory notes will help some of our readers out during their next family barbeque or when chatting with their local “bitcoin billionaire” back at the office next week. Subscribe for our free newsletter

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Introduction

Bitcoin is the original member of the rapidly growing cryptocurrency family (which now has numbers in the thousands). These cryptocurrencies such as bitcoin are a special new type of currency that is 100% digital, meaning there aren’t any physical notes or coins that can be exchanged in real life, and the only way to send and receive bitcoins is via the internet. The downside of this is that the shiny gold bitcoin coins you see in the news are just for show and we aren’t able to buy or sell anything with physical bitcoins offline just yet. When bitcoin first hit the scene in 2009 it was bitcoin’s three special design features that helped it to catch on with the tech-savvy internet crowd, particularly in the wake of the GFC and throughout the Occupy Wall Street movement.

The rules of bitcoin – What makes bitcoin so special?

Bitcoin is fungible and divisible. Being fungible means that one unit of bitcoin is identical to any other unit of bitcoin and bitcoins are therefore interchangeable with one another.

You can divide bitcoins up into tiny pieces called “Satoshis” (named after the inventor of bitcoin, Satoshi Nakamoto). One Satoshi is worth one hundred millionth of a bitcoin. Bitcoin is built to be a decentralised currency system. The jobs of creating new bitcoins, transaction processing, and ledger maintenance are distributed amongst users and no central authority can control these functions.

This also means that transactions are irreversible as there is no authority who can step in when bitcoins are stolen or payments go wrong. Bitcoin transactions are private. Bitcoin transactions are linked to bitcoin addresses (like an email account) rather than real-world identities.

All bitcoin transactions are published to the bitcoin network, however only the sending and receiving bitcoin addresses are communicated and there is no link to the identity of the owners of the bitcoin address. So how do these features of bitcoin compare to the features of other currencies? By defining how more traditional currencies work, we can then evaluate if bitcoin is likely to succeed as a money system and we can start to think about what type of activity bitcoin is most suited to.

The purpose of currency – What is a currency meant to do?

Currencies should be a fungible unit of account. One unit of currency is identical to any other unit of currency and are therefore interchangeable.

You can use units of currency to measure the real value of things. Currencies should be useful as a medium of exchange. Used as an intermediary to facilitate the sale, trade or purchase of things.

Represents a standard of value which is accepted by all parties. Currencies should be a reliable store of value. Units of currency can be stored and retrieved whilst maintaining their value.

The future purchasing power can be predictably forecast and relied upon. So there are some similarities starting to show in the design of bitcoin and other currencies already. Both bitcoin and regular currencies are fungible units of account which are divisible to a usefully small unit. But it is the second and third rules of bitcoin that make it stand apart from the pack. Before we can fully compare the features of bitcoin to the universe of currencies available, we need to introduce two new currency types.

Fiat currency

Almost all currencies used today such as AUD, USD, and EUR, are a type of currency system known as fiat currencies. A fiat currency essentially represents a promise made by the issuer (usually a government) that the value of the currency won’t change much over time. This fiat currency is backed only by the confidence that the issuer will keep their promise, and that they will use their powers of taxation and legislation to protect the value of their issued currency. The issuer will normally write laws to encourage the adoption of the fiat currency, enforcing that the currency can be used to pay all debts both public and private and that taxes generally must be paid only by using this currency.

Commodity currency

Another type of currency that we will need to know about is a commodity currency (such as gold bullion or silver dollars). Commodity currencies are composed of a material that is a valuable input to the production of another good or service. These currencies are generally made of precious materials and they have value because there is confidence that the supply and demand of the commodity material will be stable over time. Commodity currency holders know that even if the issuer or type of coin becomes undesirable, by melting down the coins and selling the raw materials most of the value of the currency will be able to be recovered. So to understand what makes our digital currency bitcoin special, we will be comparing bitcoin’s features to those of fiat currencies (Australian dollars and Zimbabwean dollars) and a commodity currency (gold).

A tale of two fiats – Australian dollar (AUD)

Australian dollars are issued by the Reserve Bank of Australia (RBA) who has a mandate to protect the long-term purchasing power of the AUD by setting interest rates to keep price inflation within a target range. The RBA is also tasked with maintaining a stable rate of employment which can sometimes conflict with their interest rate-setting decisions. The RBA aims to control the rate of price increases in Australia to between 2 and 3 percent each year, however, the RBA can allow the inflation rate to diverge from the target range in order to balance their objectives of full employment and economic growth. Australian dollars are accepted widely in Australia and can be transacted physically using notes and coins or electronically via electronic payments infrastructures such as EFTPOS or Visa/Mastercard networks. There are currently short transaction delays for payments made between banks, however, enhancements are being made to Australia’s payments infrastructure in the form of a new payments platform which will improve transaction speed. The new payments platform is co-owned by 13 of Australia’s banking industry participants. Australian dollars can be deposited at banks within Australia and deposits up to $250,000 are guaranteed against loss by the Australian Government. Deposit accounts are paid interest to offset the decreases in purchasing power due to inflation and the RBA’s transparent inflation targeting policy makes the future value of our AUD mostly predictable. Is the AUD fungible – Yes. Is the AUD an effective medium of exchange – Yes, however only domestically. Can the AUD be used as a store of value – Yes, however, will lose purchasing power unless invested to earn interest.

A tale of two fiats – Zimbabwean dollar (ZWD)

Zimbabwean dollars were issued by the Reserve Bank of Zimbabwe between 1980 and 2009 and underwent three periods of “re-denomination” where the face value of existing banknotes in circulation was changed in an attempt to combat rampant hyperinflation. During the late 1990’s there was a period of massive currency instability in Zimbabwe brought on by failing economic reform, a significant increase in military expenditure and widespread government corruption. As Zimbabwe instituted land and economic reforms, the country experienced a significant fall in food exports and manufacturing output, which was coupled with a rise in unemployment and rampant money printing to finance involvement in the Second Congo War. These shortages in food and basic goods and an oversupply of freshly printed ZWD for military campaigns lead to a massive increase in the national rate of inflation. A lack of transparency about government spending and monetary policy meant that the public had little confidence in the long-term stability of the ZWD. As inflation rose to over 10,000% per year, the Reserve Bank of Zimbabwe began printing higher and higher denominated notes, with the Z$10 and Z$20 bills issued in the 1980’s soon dwarfed by the Z$100 trillion dollar notes of the 2000s. As Zimbabwean banks and computers began to struggle with data overflows from calculating enormous daily transactions, the Reserve Bank implemented a re-denomination in 2006, in which new money was printed and Z$1,000 in original circulating currency was deemed to be only worth Z$1 of the newly released, updated currency. Despite the government deeming inflation illegal, inflation remained so out of control that prices in stores needed to be updated many times a day so as to remain current. Continuing oversupply of ZWD and limited local interest in saving and holding ZWD (due to its near instant devaluation) saw re-denomination implemented again in 2008, ZW$10 billion was now worth ZW$1. It was only 6 months later when re-denomination was required for the third time in Zimbabwe’s history, with 1,000,000,000,000 of Zimbabwe’s third tranche of dollars now being exchanged for 1 new fourth dollar. Citizens had been using illegal foreign currency where possible to avoid having to deal in ZWD, and in 2009 the government gave up on its local currency completely and suspended trading in ZWD. The US dollar has since replaced the ZWD as the official currency of Zimbabwe. The promise that a fiat currency is reliant on, that the value of the currency will be protected by the issuer and not vary much over time, was broken. Is the ZWD fungible – Yes. Is the ZWD an effective medium of exchange – No, people actively sought to avoid transacting using ZWD. Can ZWD be used as an effective store of value – No, inflation was so bad that the purchasing power of ZWD could halve in a day. You can see that not all fiat currency is created equal, and the success and value of a fiat currency is reflective of the issuer’s ability to protect the long run purchasing power of their currency.

A commodity currency as old as time – Gold

Gold has been used as a currency for thousands of years and has deep cultural associations as a store of wealth. Found in nature, gold has excellent elemental properties that make it un-reactive, durable and malleable, perfect for minting coins! As there is a finite quantity of gold available on Earth, we can think of the Earth as the central bank that issues new gold (which is released via people mining it) and we can say that the gold supply will increase at the rate of global gold production. Changes in gold production will be linked to the discovery of new natural gold deposits and advances in mining technology to extract gold from lower quality ores. This means that there is no price or inflation targeting for gold, and the rate of production of new gold will not directly increase or decrease due to economic activity or the unemployment rate. Gold has become famous for its ability to maintain its purchasing power through extended periods of time which is somewhat due to this irreversible “central bank” policy. Many investors use gold as a way of hedging against inflation so that they can protect the value of their invested capital against increases in prices of goods and services. These days, transactions are very rarely settled with physical gold due to high transaction costs, low vendor acceptance, and the high cost of gold transport and security. It is also very difficult to cut or shape gold into small enough pieces to pay for everyday items, let alone poor merchants filing off and weighing out change for sales from their gold bars! The weight of gold can make it hard to transport overseas, but gold can be an efficient way of concealing wealth or transporting money between countries in a private and anonymous way. Gold can be stored in the Perth mint which is a government-guaranteed storage facility, however, the mint charges fees of 1% per year which can be expensive compared to storing other currencies, and you won’t earn any interest on your gold deposit. For gold, as with all commodity currencies, it is the supply and demand of the commodity material that drives confidence and trust in the value of the currency. Is gold fungible – Kind of, gold can be melted down and all elemental gold is identical. Is gold an effective medium of exchange – No, there is low merchant acceptance and high transaction costs. Can gold be used as a store of value – Yes, gold is an extremely popular currency for its ability to store value.

Back to bitcoin – A digital currency

Now we are getting to the good stuff! Important reminder Bitcoin is built to be a decentralised currency system. The jobs of creating new bitcoins, transaction processing, and ledger maintenance are distributed amongst users and no central authority can control these functions.

This also means that transactions are irreversible as there is no authority who can step in when bitcoins are stolen or payments go wrong. Bitcoin transactions are private. Bitcoin transactions are linked to bitcoin addresses (like an email account) rather than real-world identities.

All bitcoin transactions are published to the bitcoin network, however only the sending and receiving bitcoin addresses are communicated and there is no link to the identity of the owners of the bitcoin address. Bitcoin has completely done away with a central bank or a currency issuer, and instead transferred the role of currency production and the promise of maintaining purchasing power to the decentralised bitcoin network. Where a central bank produces new money for a fiat currency, and the Earth produces new gold for our commodity currency, new bitcoins are produced by the bitcoin network at a pre-programmed rate of production. The bitcoin source code has been written so that new bitcoins are produced at a mathematically defined rate until a hard cap is reached when there are 21 million bitcoins in the system. Currently, there are about 17 million bitcoins in supply and the rate of creation of new bitcoins represented around a 4% expansion rate in 2017. People have confidence in the rate of supply of new bitcoins, as the mathematical code is open source so it can be inspected, and the rate of production of bitcoins is unable to be changed. Like gold, the rate of production of new bitcoins is independent of local economic activity or the unemployment rate, and the amount of new bitcoins being created or printed is unable to be influenced or changed by the will of a government or central bank. Bitcoin’s source code also means that once the final bitcoin has been created, no more new bitcoins will be issued. Again like gold, proponents view this “central bank” inflexibility as a benefit versus fiat currencies, where central banks or governments can meddle in the rate of supply to suit their political or economic goals. The payments infrastructure of the banking industry has also been made redundant by bitcoin and replaced by the decentralised bitcoin network. This means you don’t need to have a bank account to have bitcoin, and you don’t need to pay any service fees in order to maintain your bitcoin wallet address. You also don’t need to receive permission or authentication to begin using bitcoin to request and accept payments on the bitcoin network, you simply need to set up a bitcoin wallet address which is just like an email address. So what is this bitcoin network which has so effectively replaced the RBA and Visa/Mastercard in one fell swoop? The bitcoin network The bitcoin network is a worldwide peer to peer network of computers that processes bitcoin payments and maintains an accurate copy of the global bitcoin ledger which is known as the blockchain. When a bitcoin user sends bitcoin from their address to someone else, a record of the transaction is broadcast to all users of the bitcoin network for processing. The bitcoin network now needs to validate that the transaction is legitimate and that there are enough funds in the sending bitcoin wallet to honour the payment. To do this, members of the bitcoin network known as bitcoin “miners” race each other to solve a complex cryptographic puzzle (hence “crypto” currency) before packaging up the current group of pending transactions into a “block” and announcing the combined solution to the bitcoin network. If the bitcoin network agrees that the solution is valid and other miners agree to accept the block and add it to the blockchain, a small reward will be paid in the form of bitcoin to the miner who submitted the completed block. The puzzles that miners solve are built in a way that they are hard to complete by the miner but easy to verify for the network, making the acceptance and addition of a valid block to the blockchain much less intensive than solving the crypto puzzle. So whats the point of making all the miners on the network compete to solve puzzles? This act of completing these difficult problems is known as “proof of work” and it is essential to ensure submitted blocks are genuine attempts at adding valid transactions to the blockchain. Because there is no way to trust that everyone in the bitcoin network is honest, there needs to be a way to stop miners from packaging up blocks of transactions (real or fake) that will benefit themselves and sending them to be added to the blockchain. To do this the bitcoin network makes it energy intensive to create a new block so that miners will be prevented from creating a large number of fraudulent blocks with the hope that one of them will be accepted and added to the blockchain. Therefore it is economical to try and produce as many valid and correct blocks as quickly as possible, incentivising the network to process valid transactions, then add them to the blockchain and move on to the next block. When people talk about the vast energy requirements of maintaining the Bitcoin network, they are talking about the energy used by the highly intensive computing tasks in solving the proof of work algorithms that are integral to the bitcoin payments system. Unfortunately, there is no tangible benefit from this computational work being done and economically speaking, the computation is almost 100% wasted effort (it only exists to ensure miners are trustworthy). The blockchain The blockchain is the distributed ledger of the bitcoin network and represents a history of every bitcoin transaction that has ever taken place. Bitcoin network participants maintain a copy of the blockchain and ensure it is kept up to date by comparing each other’s blockchain copy with one another and continuously updating their version of the blockchain to match the most complete/longest version of the chain. This gives the bitcoin network an easy way to form a consensus as to which copy of the blockchain is true and complete. Having a distributed blockchain ledger means that no individual network participant can cheat the bitcoin system by editing transaction records to suit themselves, as they would need to simultaneously edit every copy of the blockchain held by the bitcoin network such that their edits wouldn’t be overridden by another more complete copy of the blockchain. Bitcoin in practice The bitcoin network has been a victim of its own popularity, as the bitcoin network is currently drowning in transactions and processing times are reaching all-time highs (up to many days to complete a transaction). In order to have your transaction validated and approved by the bitcoin network ahead of others, you can pay an additional fee to the bitcoin miners to have the network prioritise your transaction. These transaction fees have become expensive, making smaller value transactions uneconomical. Some vendors have started to remove themselves from accepting bitcoin as a form of payment due to these issues, and the delays in transaction processing and expensive fees are impeding the success of bitcoin as a useful medium of exchange. Future updates to bitcoin technology may solve these issues, and there is a team of dedicated developers working to improve the bitcoin system. Bitcoin’s price volatility has also made it unusable as a long-term store of value, as recent price movements of up to 30% per day make it very difficult to feel confident that the purchasing power of your currency will be maintained in years to come. Is bitcoin fungible – Yes. Is bitcoin an effective medium of exchange – Maybe, bitcoin can be sent internationally theoretically instantly and with no fees. Practically, however, due to the large number of bitcoin transactions currently on the network, there is a delay in processing transactions (sometimes taking days) and transaction fees to incentivise swift payment processing by the bitcoin network can be expensive. Can bitcoin be used as a store of value – Maybe, the decentralised inflation policy is something that may be favourable for a currency to act as a store of value. The recent price volatility of bitcoin means that it is impossible to have certainty that you will be able to retreive your investment with retained purchasing power if storing it as bitcoin for an extended period of time.

Compare those currencies!

So what is bitcoin good at?

So bitcoin has some features which are similar to gold, in that the rate of currency production cannot be manipulated by governments or banks, and it has other similarities with fiat currencies in that it is easily fungible and can be used as a medium of exchange. Bitcoin sets itself apart from the currency competition by having market-leading privacy capabilities, a decentralised payments network and issuance function, and an ability to be transferred worldwide with theoretically minimal costs and no reliance on the banking or finance sector. This would make bitcoin incredibly useful if you were in Zimbabwe in 2009 and you needed to protect your wealth, as you could transfer your ZWD into bitcoin and not have to worry about government policy such as re-denomination that may impact the value of your ZWD. Bitcoin would also be very useful if privacy was one of your primary requirements due to the way it anonymises its transactions and bitcoin addresses. It would be fantastic for transferring funds cross-border undetected, or to store and hide wealth from governments or authorities who may have a claim to it. A downside is that some of the users that have rushed to bitcoin pre-2017 have been those seeking to use it as a way to facilitate the purchase of illegal goods. Bitcoin was the currency of choice of merchants operating on the famous dark-web site the Silk Road due to its anonymity and ability for payments to be hidden from governments and tax agencies. This lead to an earlier boom in bitcoin’s popularity before the Silk Road was shut down by law enforcement in 2013. The current difficulties in the bitcoin payments network make it unusable for making small transactions however these issues may be addressed with further updates to the bitcoin source code. So at present, bitcoin is not best suited for those who wish to make frequent, low-value transactions for goods and services. To be an effective store of wealth bitcoin needs to have price stability. Again bitcoin has been a victim of its own success as due to the large demand for bitcoin prices have risen violently through 2017, before falling just as spectacularly in the past week as currency speculators who were originally attracted to the currency have jumped ship. Price stability will need to improve before bitcoin could be considered as a currency which is effective as a store of value.

How do we value bitcoin?

Bitcoin is not a cash-generating asset so we can’t value bitcoin like we would normally value a small cap company. Instead, we need to look at the economic problems that bitcoin is able to solve and discuss which currencies bitcoin is likely to capture market share from. Then based on our assessment of how well bitcoin supersedes these currencies, we will be able to think about what is a fair price for bitcoin. Bitcoin is the best of our example currencies when it comes to privacy and international payments capability, it also ranks in line with gold in that it has a pre-set “central bank monetary policy” which is unable to be influenced by a government or private institution. As a store of wealth bitcoin is outperformed by gold and the Australian dollar due to the recent volatility in the price of bitcoin, and as a medium of exchange, the current technical issues prevent it from being as useful as the Australian dollar however it does outperform gold. It is fair to say that in time bitcoin could take market share from both gold (for its privacy and store of value benefits) and the Australian dollar (for its international transaction capability) however there are technological advancements required before this will happen. Bitcoin could have a genuine use case for countries struggling with the instability of their local fiat currency, and bitcoin could easily have taken currency market share from the Zimbabwean dollar had it existed a few years earlier. Bitcoin has also caught on with a new generation of individuals who have lost trust in governments and banks, wherein the past gold took the role as a safe haven currency during political instability, millennials and tech-savvy individuals are now turning to digital currencies as a way to protect their capital from ineffective governments and a reputationally damaged banking sector. So why the recent price rise? Our view at Little Hedge is that the recent increase in the price of bitcoin is not due to making inroads as a superior currency, but rather a massive inflow of speculative capital attempting to make short-term capital gains by chasing historic price increases. We don’t believe that growth in demand for these privacy and decentralisation features has been the main driver of this year’s price explosion, instead, it has been the attention of speculators who are plowing money into bitcoin in the hope that they will receive price appreciation. Bitcoin does have some very real economic benefits over other currencies of course, so in time there should be a long-term stable demand for it as a currency, therefore we feel that bitcoin is worth more than $0. However, in order to work out the true market value of bitcoin, we need to know what the true demand for these privacy and decentalisation features are. One indication that we can look at to try and identify the number of speculators versus genuine currency users is by analysing the number of transactions being passed through the bitcoin network and comparing the increase in bitcoin’s uptake as a medium of exchange versus the change in market cap over time. If bitcoin is being used by individuals with a real demand for its features need then we would expect there to be a large increase in transactions occurring along with the increases in market cap. However if the market cap of bitcoin is growing whilst transaction volumes are stagnant, then we can assume that a portion of the recent growth in the value of bitcoin is attributable to speculation (however some of this behaviour could be due to bitcoin being used as a long-term store of value, despite the recent price volatility).

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Chart 1 – Bitcoin market cap

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Chart 2 – Bitcoin daily transactions

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Chart 3 – Bitcoin unique wallet IDs

At face value, it would appear that the recent increase in price cannot be attributed to the growth of the network, and instead must be due to speculation. The market cap of bitcoin has increased more than 500% this year whilst transaction volumes and the number of wallet IDs on the blockchain is roughly unchanged other than seasonal movements, this gives us the opinion that we haven’t seen a large enough uptake in bitcoin usage this year to justify the increases in the bitcoin price. This year’s bitcoin-buyers could be forward-looking speculators, however, and they know that as adoption grows transaction volume and use will also increase, thus making their investment worthwhile as genuine users begin to join the bitcoin network. Again it is our view that the vast majority of recent bitcoin purchasers are chasing a speculative return on capital driven by past returns that bitcoin has been able to achieve.

How do I get involved?

So, now you want in? Whether it is that you are attracted to bitcoins privacy features or perhaps you are attracted to its decentralised network, fortunately, there are a number of Australian exchanges that you can use to buy bitcoin via EFT, BPAY or credit card such as Coinjar, Cointree, Independent Reserve, or BTC Markets. Alternatively, you could opt for an offshore exchange such as the popular Coinbase. Buying bitcoin in Australia is easy, however, most sites require you to present 100 points of ID… whilst this isn’t great if you were seeking out bitcoin for its privacy capabilities, these requirements for identification are due to Australia’s anti-money laundering laws which bitcoin exchanges must adhere to. Now that you have bought your bitcoin from your exchange of choice it is very important to keep it safe. Its recommended that you transfer your bitcoins to a private wallet not connected to a bitcoin exchange so that you can be in control of the private wallet keys used to authorise transactions. This way you will avoid falling victim to one of the sadly frequent bitcoin exchange hacks. You may opt for a hardware wallet such as those made by Trezor, or Ledger, or you could even make your own hardware offline wallet out of paper! Alternatively, a software wallet can be used such as breadwallet, Electrum or Mycelium, however, keep in mind that the closer your wallet is to the internet, the higher the chance that someone will be able to hack your device and steal your precious bitcoins! So now that you have your bitcoin safely stored in your wallet you may want to sell some of your bitcoins to take advantage of the 1,000% price rise they have experienced in the time it has taken to read this article. Selling bitcoin in Australia can be done via a number of sites including most of the exchanges listed above that are used for purchases and bitcoin can also be used to pay bills using BPAY in the Australia only site, Living Room of Satoshi (remember the creator of bitcoin Satoshi Nakamoto?). Some sites will charge transaction fees to buy and sell bitcoin, and other sites will offer lower/higher prices to account for their transaction costs and to earn a margin to maintain the business of running the exchange. It’s important to also keep in mind that there are situations in Australia where transactions related to bitcoin are taxed by the ATO.

Conclusion

Bitcoin isn’t for everyone, and there is an argument to be made that investing in bitcoin consequentially supports those facilitating and supporting criminal activities due to its history as the payment of choice for the dark-web. When friends have asked about if they should invest in bitcoin or not, our view has been that a currency isn’t something you should invest in, it is something that you either use to transact or speculate with. Speculate with only what you can afford to lose. We haven’t seen a market with this kind of frenzy in a very long time, and the experience of going through this wave of speculator-driven madness is probably worth the price of admission. So if Bitcoin technology is something that interests you, and you aren’t put off by the ethical considerations of supporting a currency that may be used in criminal activity, then there’s nothing wrong with buying a small amount of bitcoin (or any other cryptocurrency) just to be a part of the ride. It would be dangerous however to think of your crypto holdings as anything more than a bit of speculative fun, let alone an investment! We hope you have enjoyed this article and please let me know your thoughts in the comments below.