Bitcoin for Dummies

Posted: March 7, 2014 in Economics & Politics
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What is a Bitcoin?

Bitcoin is a worldwide digital currency that was created in 2009 by an entity using the alias – Satoshi Nakamoto. It is a peer to peer, decentralized, non-regulated currency. Bitcoin is not controlled by banks, governments or other authoritative entity. The supply of Bitcoins is regulated by a process called mining, which makes this digital currency resistant to dramatic inflation (supposedly). Bitcoins can be stored digital wallets, or in cloud servers. In short, Bitcoins are mediums of exchanges much like any other “real” currencies. The US Government maintains the circulation of Dollars, but there is no central agency that controls Bitcoin. Owners of Bitcoins are able to maintain anonymity, which is very appealing to a certain percentage of each population. Owners of Bitcoins are able to avoid taxes when paying for transactions over the internet. Bitcoin is the first mainstream peer to peer cyber currency, much like Napster was the first mainstream peer to peer file sharing software.

Physical Bitcoin - Storage device for encrypted digital key

Physical Bitcoin – Storage device for encrypted digital key

How are Bitcoins created?

Much like gold is excavated from a mine, Bitcoins are excavated by digging through data. It takes computers with brute processing abilities to mine for Bitcoins. Individuals such as you and I, are incentivized (mining rewards) to contribute our computing resources and joining as “nodes” on the Bitcoin network. Every single time any transaction happens in the Bitcoin network, it needs to flow through every user’s software. It is almost like blood cells flowing through your veins. This increases the integrity of each transaction and hopes to battle fraud and hacking attempts. Mining is more akin to rolling dice than solving problems. To understand mining, one needs to understand what a hash function is. Put simple, a hash function takes an input and creates an output based on a criterion. The output is consistent every time you perform the function on a given input. It is very difficult to determine an input, given only the output. For example, the square root of 3 is: 1.73205080756887729352744634150. Now take the digits from the 6th place from the decimal all the way to the 10th place: 08075. The square root of 3 is the input (1.73205080756887729352744634150) and output is 08075 (6th place from the decimal all the way to the 10th place). Pretty simple right? Input – Output. Now imagine, given the output of 08075, that I have asked you to provide me with the correct (unknown) input. You would need to try out billions upon billions of inputs; this is what is referred to as mining. An excruciatingly difficult task, which must be solved with the processing power of computers. The process of mining is regulated by Bitcoin software. Every single time a user “cracks the code”, they are awarded with 25 Bitcoins. This is how the supply of Bitcoins is regulated in cyberspace. The algorithm built into the mining software adjusts itself accordingly in order to stay on pace for 21 million Bitcoins by 2140. 

Who’s mining?

Whenever there is serious money to be made, there will be serious competition. Mining requires massive electrical and computational resources, so naturally, the affluent and tech savvy will be the first to “strike gold”. However, your average Joe is able to engage in a strategy called pooling. Pooling simply means linking up with a bunch of “friends” via network in order to create a massive processing force (imagine 100,000 computers in a warehouse). The aforementioned “shared” processing force is able to compete with the few supercomputers that the affluent have working towards mining. Whenever a pooled community strikes gold, the dividend is shared among the pool members. The process of mining is cumbersome and can be as random as winning a mini-lottery. It’s all about which computer gets lucky and deciphers a code first. Darwin’s theory is applicable in cyberspace as well as real space.

Supercomputers used for mining Bitcoins.

Supercomputers used for mining Bitcoins.

What are Bitcoins worth?

The price of Bitcoins started at around $0.05 per Bitcoin in 2008 to as high as $1,116 in late 2013. The price of a Bitcoin is currently about $690. Bitcoin pricing has been pretty volatile lately. The cyber-currency is not insured by agencies such as the FDIC and has proved to be quite volatile as of late. Similar to financial instruments, there are institutions that allow consumers to buy Bitcoins at fair market values (for a fee). Unlike financial instruments (stocks, bonds), Bitcoins intrinsic value is derived purely from speculation. Traditional financial instruments are valued by their collateral (a company or country).   The real question is: Are you willing to invest your resources into an unregulated, decentralized, uninsured, volatile, cyber currency?

Bitcoin values from Jan. 1 2013 through Mar. 3 2014, via Coinbase.

Bitcoin values from Jan. 1 2013 through Mar. 3 2014, via Coinbase.


The present and future of Bitcoins

Mt Gox, an online exchange for people to buy and sell their virtual money, filed for bankruptcy in a Tokyo district court last week. Mt Gox was a poorly run venture that has been hacked for Bitcoins since 2011. The most recent hack caused the company to lose about $500 million worth of Bitcoins. After Mt Gox crashed on Feb 24, the value of Bitcoin fell to $440 after reaching highs above $1,000 in November. A wild 50% decrease in about 3 months.

Flexcoin, a provider of “cold storage” for client Bitcoins, announced last Tuesday that it has closed on the aftermath of being hacked of some $600,000 worth of the cyber currency. On Wednesday, Flexcoin announced, “Flexcoin does not have the resources, assets, or otherwise to come back from this loss, we are closing our doors immediately.” This sucks for anyone who was using Flexcoin as a virtual bank instead of stuffing their Bitcoins (hard drive) under their mattress. Remember, Bitcoins are not insured.

Supporters of Bitcoin say that the anonymous, decentralized Bitcoin is a way to evade large banks, payment processors and governments that make billions of dollars each year as financial intermediaries among consumers. The Winklevoss Twins (guys that fought Mark Zuckerberg over Facebook), are heavily vested in Bitcoins and are attempting to create an ETF (exchange traded fund) for Bitcoins. An ETF would be taxed and riddled with many fees. This is an excellent way to get rich from fees that are derived from people trading a digital currency that has no intrinsic value. 

I believe that the price of Bitcoins are heavily inflated and lack any collateral whatsoever. I also believe that the Bitcoin is a scheme that has been orchestrated by a group of individuals who are attempting a “get rich quick scheme” and succeeding. Bitcoins have a market capitalization of $8.5 billion dollars so far. Consumers who are leveraging themselves heavily on Bitcoins are rolling the dice.  When the housing bubble burst in 2008, there were a handful of individuals that were rolling on the floor laughing with very large sums of money. The rest of us suffered the consequences of a crippled economic system, foreclosures, unemployment, ect. The individuals that created the Bitcoin are waiting for their turn to roll on the floor laughing. Stay tuned.


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