Besides the common label of Bitcoin* as a “scam”, we’ve heard the other epithets: “fake money,” “pyramid scheme,” “bubble,” “racket,” “Ponzi scheme,” and so on. When a new financial instrument appears, it’s natural to be skeptical of its legitimacy, particularly when its valuation sees a volatile and exponential rise over a short time. This attitude is often encountered by the characters in my new novel, Satoshi No No.
To the uninitiated, Bitcoin – and cryptocurrency in general – might appear even more dubious than the average money making scheme. Its fully digital nature, obscure mathematical underpinnings, and association with criminal enterprise all conspire to make Bitcoin a tough sell to the casual observer. But take the time to understand Bitcoin and, even if you don’t embrace it, you’ll understand why it has survived and thrived.
No central authority
It’s hard to scam people when there is no one controlling the scam. Unlike a traditional MLM or Ponzi/pyramid scheme, there is no hierarchy in Bitcoin, no individual or group enshrined at the top. The structure of Bitcoin, its network protocol and mathematical model, guarantees that any entity who wants to subvert it must contribute more than 50% of the world’s CPU resources to running it. This computational barrier is nearly insurmountable in a world with data centres on every continent; and game theory predicts that if anyone ever attempted it, the rest of the Bitcoin community would simply fork their own blockchain and exclude the bad actor.
It’s true that, compared with fiat currency like the US dollar, bitcoin’s lack of a central “bank” to control its supply makes it volatile. But this lack of central regulation is a feature, not a bug, of the design. Central banks around the world have often failed spectacularly at their job of moderating economic volatility. Of course, we need strong central banks to maintain the financial stability of traditional fiat currency. But Bitcoin can be thought of as a safety net or hedge against irrational exuberance by fiat currency regulators. And lack of central regulation allows bitcoin payments to circumvent unfair or oppressive regimes.
More fundamentally, there are numerous widely accepted commodities that have no intrinsic value and no central authority to control their supply or vouch for their authenticity. For example, we know that famous paintings have no practical utility, can easily be forged (the forgeries often unknowingly exhibited for decades), and have no central arbiter of worth, but we still assign them value. Bitcoin can be thought of as commodity just as much as a currency, and its value is, of course, entirely dependent on the collective opinion of anyone who can buy it.
Digital money is real money
The United States in 2018 had about $1 trillion in physical cash compared with about $14 trillion across all personal chequing, savings, and other liquid deposit accounts. This difference had grown as salaries, investments, and large purchases were increasingly paid by check, direct deposit, credit card, or other intangible means. So even before bitcoin came along, most money was effectively digital. Bank account balances, stock and bond ownership, all of it is digital. And every year, billions of digital dollars are fraudulently stolen, misplaced, or forged. But that’s still real money.
Bitcoin is also digital, but because it’s stored on a global blockchain rather than a collection of for-profit banks, it’s harder to steal or forge. You can guess or crack someone’s wallet password, if they choose to keep their bitcoin in an online wallet and don’t take basic steps to protect it. But you can’t break into a vault somewhere and take it. And you can’t counterfeit it.
Do the math
Intuitively, the first question many have after they understand that bitcoin is digital and has no central authority is, “Why can’t I just copy my bitcoin the same way I copy an MP3 of a song, and spend it as many times as I want?” The answer, basically: “Because math.”
Bitcoin is built on several important mathematical concepts that also underpin secure online communications and e-commerce: hashing, public key cryptography, and peer-to-peer networking. Without going deep into the math behind these concepts, it’s enough to say that they are solidly established and have withstood decades of careful analysis and persistent attack.
Bitcoin operates as a decentralized network of independent nodes. All nodes run software speaking a common protocol and playing by common rules. Every transaction — every coin sent or received — is broadcast to the entire network. The user behind each node’s wallet is identified, not by name, nor by a government-issued social security number or by a bank account number, but by a cryptographic public key — a long string of random numbers. The user has a private key that corresponds to their public key, which they use to digitally sign each transaction.
Each node has an equal opportunity to monitor the public ledger of all transactions — called the blockchain — and verify that no other node had falsified a transaction, fraudulently invented new coins, or “double-spent” a coin or fraction of a coin. Thus the only way to defraud the network is to control more than 50% of its nodes — or, more precisely, 50% of all nodes’ CPU power — and as previously explained, that’s not a feasible strategy.
The protocol dictates that coins are earned by spending CPU power to “mine”, or verify blockchain transactions in a process called “proof of work”. The miners’ proof of work involves using a mathematical formula called a one-way cryptographic hash to process millions of variations of each transaction to zero it out. Hashes are easy to confirm but hard to guess. This protocol leaves it essentially up to random chance which miner would “win” the next coin by verifying a transaction — except, of course, that those who devote more CPU and electrical power to the network are more likely to win. But in a zero-trust environment, democracy by wattage is the most fair way to play.
Other cryptocurrencies
If we accept that Bitcoin is not a scam, what about other cryptocurrencies, such as Ethereum? Most cryptocurrencies have similar features and goals, so it’s fundamentally inefficient for many of them to co-exist. A market striving for compatibility is going to eventually eliminate most cryptocurrencies. As an analogy, there are only a handful of top-level credit card payment networks: Visa, MasterCard, and a few others. With cryptocurrency there’s even less room for alternatives to proliferate successfully long term, because there is no cartel controlling the transaction fees, and therefore no one for a newcomer to displace; or more accurately, newcomers are continually displacing the incumbents.
There are some technical reasons that Ethereum is probably superior to Bitcoin, particularly its flexibility in storing smart contracts on the blockchain, and its higher openness to reduction of transaction fees. I believe that Bitcoin and Ethereum will remain the two most important cryptocurrencies for decades.
That said, we should be extremely cautious about the myriad new cryptocurrencies springing up in the last few years. Many of these are, as discussed above, redundant; and some are just as fraudulent as pump-and-dump penny stocks.
OK, so what?
If we accept that Bitcoin and Ethereum are not scams, what should we do? I don’t think we should go out and horde great quantities of them. Nor do I think we should make them a large part of our investment or savings portfolios, because unlike a stock or bond, cryptocurrency is not a growth or income-based instrument. I subscribe to the couch potato philosophy of investment. But I do see a small place for cryptocurrency, perhaps 5%-10% of a typical portfolio, to aid in diversification. (Up till now, cryptocurrency has often moved in value roughly in line with the stock market, but I believe that once more people understand it, they’ll see it as a hedge against traditional markets.) And if someone is rich enough to branch out from broad index investing and into individual company stocks, I could see it being profitable to increase that crypto share up to 20%.
* In keeping with https://bitcoin.org/en/vocabulary, I will try to capitalize Bitcoin when describing the entire project, its protocol, or community; I’ll use a lowercase “b” when describing bitcoin simply as a currency.