It’s been a while since we last discussed Bitcoin on the Stone Pine blog. However, we’ve received a steady increase in the amount of questions regarding the cryptocurrency, particularly so in the last few months. No one can deny that Bitcoin has become quite popular, and while we don’t recommend cryptocurrencies as an investment, it is worth discussing what exactly Bitcoin “is” and how it works as a method of payment.
One of the concepts behind Bitcoin that makes it popular is that it is a way to exchange money without a bank and without providing your identity for a transaction. (We think this sounds like a great premise for the final season of Ozark on Netflix!) While the anonymity of a financial transaction may be appealing for a variety of reasons, the question you may be asking is, “then how is the transaction secure and guaranteed?” Because certainly no one would use a form of payment that didn’t guarantee you’d be paid! This is where the Bitcoin “magic” happens.
When you pay someone with a check, or a credit card, or even a modern technology like Paypal or Venmo, a bank is verifying your transaction, and making sure the funds are available, transferred, and received. With Bitcoin, there is no bank but rather “miners” competing to audit and verify the transaction by creating a blockchain (a record of transactions maintained across several computers ensuring security, transparency, and decentralization). The miners are independent individuals or entities that are being compensated to verify and confirm each transaction. Essentially, the miners are the ledger book.
Now pause for a minute and think back to a time before any of us were alive… back to the beginning of the motor vehicle in the late 1800s. What an amazing new technology! You no longer need horses to travel. Instead, you can board your motorized coach alone and off you go! But it wasn’t that simple. A motor car was initially a very cumbersome and energy inefficient mode of transportation. For example, you had to start the car with a crank that could be difficult to operate, taking considerable force in an attempt to get the pistons moving to start the engine. This process could even result in personal injury. Once the spark plugs ignited the fuel and the engine started, there was risk of the crank handle being thrown backwards against the driver’s hand from the force of the pistons coming to life. That said, automobile technology has certainly seen vast improvements over the last 100+ years. (Thanks to Cadillac for getting rid of the crank!) It’s pretty incredible that motor vehicles are now started with a simple push of a button, let alone we are now transitioning from internal combustion to electric vehicles.
Crypto technology is in its infancy and currently on par with starting a car using a crank. The miners verify transactions using very complex mathematical calculations that can only be completed by large specialized computers. These computers use a massive amount of energy to make these computations. So much energy is required that Cambridge University recently estimated that Bitcoin alone uses as much energy as the entire country of Argentina!
There are many ways digital transactions can happen today utilizing less energy and lower costs. Currently, banks do it quickly and cheaply via credit cards, or ACH transactions, such as paying a bill online through your bank account. But what if you don’t want a bank account or your identity to be connected to the transaction? Another method that is currently being discussed is for governments to introduce a digital currency (think digital dollar, digital euro, or digital yen). In the case of a digital dollar, or Fed Dollar, the US Government doesn’t need a bank to guarantee the transaction because the government is the guarantee. This is just like how the government is the guarantee behind most bank holdings (through the FDIC). Who knows if anything is to come of national digital currencies, but interestingly, last week the US Secretary of the Treasury signaled interest in backing digital dollar research.
So why don’t we consider Bitcoin or other cryptocurrencies to be a good investment? Because it is a currency, not a company with products and services, profits and losses. Therefore, the future value is totally based on the collective thoughts of what other people think it should be worth – not on actual profits and growth. For the same reasons, we don’t view gold, silver, or a foreign currency as good investments either. Bitcoin happens to be even riskier than other currencies because it’s still not in widespread use, which means small issues or new innovations can create massive volatility.
As always, should you have any questions or want to discuss this topic further with us, please don’t hesitate to reach out!