By this time next week the SEC will issue a decision on whether or not to recognize an ETF designed to replicate the performance of the digital currency, bitcoin. If approved, the ETF (COIN), would make it easier for people to invest in bitcoin, so now might be a good time to offer an explanation of the currency to the uninitiated, in as simple terms as possible.
A single bitcoin, a digital currency that exists as a computer record, is now worth more than one ounce of gold, a rare yellow metal which can be held in your hand, and the boost that could come from the ETF would probably ensure that that is the case for some time to come. For some, this might be a mystery: How can something that exists only in computers be worth more than a metal that has been a store of value for centuries?
Regular readers may be aware that I have written extensively on this subject in the past, but have recently stopped covering it. The reason for that is simple: I said what I had to say and felt I had no more to offer on the subject. I was then and still am a believer in bitcoin. It took me a while to come to grips with the concept because, like many, when I first heard of it, I couldn’t see how something “created out of nothing” could have any value.
That value existed only because people believed it did and it took me some time to understand that in many ways that was no different to the pieces of green paper that I had in my pocket. Dollars have value because people will accept them in exchange for goods and services, and in that respect bitcoin is no different. What is different is that as long as that confidence remains, bitcoin will increase in value over time whereas dollars will decrease.
To understand why, it is necessary to think more deeply about economic and monetary systems. Government-issued money came about as a way of dealing with economic growth. As the amount of goods and services produced and consumed increased, the old system of barter became impractical and was replaced by tokens, or currency.
The amount of goods and services produced in each country, known as its economy, has, with a few slips here and there, continued to grow, and in order to accommodate that growth, more currency has been issued. The number of dollars in circulation a century ago was simply not enough to cover the value of a growing economy, or so the prevailing logic suggested, meaning more dollars had to be created.
If the rate of issuance was too high, though, the currency lost value too quickly, so Central Banks were created to control the money supply. That system is by nature inflationary. As more dollars are released into the economy to allow for growth, each one becomes worth a little bit less and the number of dollars needed to purchase things goes up. For example, houses that were sold for a few thousand dollars a few decades ago are now priced in hundreds of thousands.
What the creator of Bitcoin, the mysterious Satoshi Nakamoto, did was turn that notion on its head. What if currency, like gold, was both limited and scarce in nature? If that was the case, then as an economy expanded, the currency would become more, not less valuable, and increasingly small amounts of it would be needed to pay for things. That could be handled easily enough by simply using smaller and smaller fractions of the base unit of currency rather than more units, making the whole unit more valuable in relative terms over time.
That is exactly what has happened with bitcoin. The original protocol that established the currency limited the total amount that could ever be issued to around 21 million and, by making them increasingly hard to create, ensured that the rate of supply would diminish over time. That meant that, assuming the idea gained ground and bitcoin were accepted as payment for other things, the value of one bitcoin was literally programmed to increase over time.
The original idea was based very much on the supply of gold, and the creation of bitcoin, using increasing amounts of computing power, is even known as “mining.”
It is, therefore, significant that one bitcoin is now worth more in dollar terms than one ounce of gold. It is not, though, particularly surprising, as bitcoin has one major advantage. It acts, like gold, as a hedge against inflation, but in the modern world it is easier to store and spend.
Therefore, it is little wonder that as the world emerges from recession and looks forward to more robust growth, and the prospect of inflation, bitcoin has risen rapidly in value. You may still not wish to hold some of your assets in virtual currency, but given the current circumstances you should at least understand it, and hopefully this explanation has helped with that.