7 ways anyone can understand Bitcoin in 7 minutes or less

For the fifth time in the past month I have heard from a very intelligent and financially savvy individual that they “don’t understand bitcoin and don’t think it’s worth taking the time to understand it”. Such professionals are busy, and have a very good reason not to be distracted with some new thing that their lives are getting along just fine without, and perhaps they should be thankful for not being infected with the curiosity that makes it impossible for someone like me to trying to at least master the basics of a topic that even Bill Gross found worth mentioning

Like many concepts in finance, it actually is not that difficult or time-consuming to understand bitcoin, at least at a basic level, though of course some sources are better than others for learning about it. The challenge with most concepts in finance or technology is that they are best understood by actually using them, preferably regularly – everyone reading this understands web browsers and e-mail, probably better than they understand the JGBs, FX options, or anything else they don’t use every day. In other words, the points below may be nice food for thought, but there’s no substitute to actually getting and using your own bitcoins and deciding for yourself.

So each in less time than probably took to read the preface, here are 5 concepts on the road to understand bitcoin:

1. The underlying value of bitcoin is internet-based, which is much more than nothing. If someone offered you $1 to close your FaceBook account and never use FaceBook again, would you take it? What if someone offered you $1,000? $1,000,000? The point is that even though your FaceBook account was free, you may have invested a significant amount of your valuable time into your profile, and did so for the value you get out of connecting with friends and other opportunities that come to you through it. All currencies, including gold, only have value because others will accept them as payment for things you want, and your FaceBook profile’s value is exactly as great as the interaction you get from it. The biggest risk to bitcoin’s value is similar to the risk of the value of your Facebook profile – if, like from MySpace, everyone stops using bitcoin to switch to Litecoin or Ripples, bitcoin may become about as valuable as your MySpace profile.


2. The number of bitcoins is mathematically fixed, by definition, at around 21 million. One analogy is to say that a bitcoin is like a 5-letter .com domain name – there are about 21 million of those, the whole internet knows whether you have one or not, and like land or other real estate, their quantity is as fixed as the number of letters in the alphabet. The domain name analogy also explains the overall value (averaging out the value of apple.com and qZQiW.com) – the biggest risk to .com registrars is if .com as a whole goes out of fashion and everyone starts registering .biz domains instead (which we might all agree seems unlikely anytime soon). The more mathematical analogy I like is to say that a Bitcoin is like a prime number with 500,000 digits – there are an absolutely fixed number of them, and you will use a lot of computing power to find one that someone else hasn’t already found, which explains a bit about why mining is so hard.

3. Bitcoin’s best use now may be as a low-cost payment solution. PayPal and many credit cards charge around 3% for payments, which may be “small” for retail purchases with large profit margins, but is prohibitive for most financial transactions of any size. On the other hand, an international wire transfer costs around US$15-30, which may be an acceptable rounding error for larger transfers over about US$30,000, but is not cost effective for routine payments in the $100-$10,000 range. A big example of the scale of these costs’ adding up is in remittances to the Philippines, where remittances make up about 10-12% of the Philippines’ GDP of US$250bio, meaning a typical 2% remittance fee costs the Philippines around US$500-600 million annually. By contrast, sending any amount of bitcoin anywhere in the world is as easy and inexpensive as sending an e-mail – enter the amount and recipient’s public key in your password-protected wallet, and the software will confirm the transfer on a “blockchain” of servers, not too different than those that transmit your e-mails, in minutes if not seconds. In fact, the biggest cost in a bitcoin transfer these days is exchanging money into and out of bitcoin on each side, which at Coinbase’s current 1% charge would add up to the familiar 2%, but we would expect volume and competition to push down more quickly than with brick and mortar banks.

Paste recipient’s wallet key, enter amount, hit send –> money sent!

 

4. Bitcoin and other cryptocurrencies, by design, are nearly impossible to counterfeit. Around 3% of the UK’s £1 coins are estimated to be fakes, and it is likely that many of us have handled one of these works of kitchen metallurgy and passed it on in our shopping without ever bothering to notice. (http://www.royalmint.com/discover/uk-coins/counterfeit-one-pound-coins) In many currencies’ paper money, there is a technological race between anti-counterfeiting features and the better, faster, and cheaper color printers available to counterfeiters (which seem to be about 98% inkjets these days, at least in Canada). Statistic: the US reportedly spent $33 million to develop its 2003 series $20 bill.  With bitcoin on the other hand, it is about as difficult to counterfeit 1/1,000 of a bitcoin (a millicoin) as it is to counterfeit ฿1,000. Unlike with traditional coins or paper money, the recipient of bitcoin has immediate software confirmation that the bitcoin is in his wallet, and that the bitstack has confirmed the transfer. Trying to “counterfeit a bitcoin” would involve cracking its SHA 256-bit encryption key, which would use an amount of computing power that might be better used simply mining a new bitcoin. It would actually be far easier for a thief to try another trick like stealing a user’s password.

5. China may be the biggest user of Bitcoin in the next year or two. Speaking of counterfeiting and payment technologies, anyone who has ever visited mainland China might be shocked that the world’s second largest economy still has a fairly basic design on its highest denomination RMB100 note (US$15). These bills lack many holograms and other anti-counterfeiting features seen on Hong Kong’s $1,000 bill, but offer little alternatives: most of the Chinese consumer’s experience is still “cash only”. UnionPay has slowly grown as China’s answer to Visa and MasterCard, but electronic payments in China are still in their relative infancy, and it is not surprising that a technology like bitcoin, which does not require local banks to participate, has quickly made China the second largest destination of wallet software already. Unlike Thailand, I think even if China somehow decides to restrict, block, or ban bitcoins in the PRC, I believe they will very likely accompany it with their own home-grown cryptocurrency made in and for China (and export, though as much as Weibo may replace Twitter in China, few of us outside PRC borders are losing Twitter time to it). PandaCoin anyone?

As a bonus between points 5 and 6, for anyone who clicks on this link or the ad banner below to sign up for a Coinbase account and buys 1 bitcoin, I will be credited US$5 worth of bitcoin, which I will thankfully split with you if you are interested and contact me.

6. Bitcoin probably will get more legal and regulatory scrutiny, but that’s a good thing. BusinessWeek recently wrote why the shutdown of the black market website silk road was good, but in simple terms, when something is legally recognized and even taxed, many mainstream users feel far more comfortable with it.

7. If used as a payment technology, the absolute price of bitcoin doesn’t matter. Those who feel they “missed the boat” now that BTC has rallied from $3 to $130 per coin are more importantly missing the point: it is just as easy to transfer $1 of coin from my wallet to your wallet at $130 per coin as it was at $1.30 per coin or as it would be at $1,300,000 per coin. Since the currency is digital, it divides nicely into bitcents (฿/100), millicoins (฿/1,000), microcoins (฿/1,000,000), and if ever needed, satoshis (฿/100,000,000). So even someone wanting to transfer a few dollars should still be able to do so as easily as sending an e-mail.

Excellent diagram on how a bitcoin transaction works

 

I would like to know how many readers made it this far and how many found any of the points above taking longer than 7 minutes (which I always heard was how long it took to make a pilsner).

2 thoughts on “7 ways anyone can understand Bitcoin in 7 minutes or less

  1. It’s welcome that someone has taken the time to try to explain the inexplicable….I am still highly skeptical … my initial thoughts on these concepts are …

    #1 — more than nothing can still be very little indeed and the analogy you make does not make holding Bitcoins seem particularly attractive as a store of value

    #2 — The number of Bitcoins is fixed … so what … it does not explain where the value is supposed to have come from.

    #3 — I don’t find the cost angle that convincing, but I suppose it may be that the hurdles to the transfer are lower and that may be attractive.

    #4 — the “ease” of counterfeiting US dollars does not really hurt me as a user of US dollars so the difficulty of counterfeiting Bitcoins is at best a lack of a huge problem.

    #7 — I suppose this may be right if we are seeing the Bitcoin as ONLY the transfer medium. But once it has to be stored for value by either party, the volatility of the value surely is a major issue.

    1. Howard – thank you for the excellent point by point comment.

      Some answers that hopefully make the points even clearer:

      #1 — The reason I try and compare the value of a bitcoin to the value you place on your Facebook profile is to give some idea on how time and effort committed to something + a critical mass of others doing the same thing can give something value which is sometimes significant. Obviously if many goods and services you wanted to buy were all available for purchase in bitcoin, you would have a quick idea how much those bitcoins are worth to you for their value in letting you buy those goods. The Facebook profile analogy comes from the idea that your Facebook profile similarly only has value because you know your friends are logging on to look at it – if the world stopped using Facebook, or merchants stopped accepting bitcoins or dollars or gold or pounds sterling for that matter, each of those respective currencies would lack value.

      #2 — You’re right, first the value has to be explained in the “numerator” by point #1, basically the universe of everything you can buy with bitcoin (demand for bitcoin by anyone willing to supply you what you want in trade for it), and only then does the “denominator” of the fixed number matter. If the numerator is 0, the denominator doesn’t matter, but there is a community that gives the numerator value, and I believe they overemphasize the benefit of a fixed denominator. You and I may be quite comfortable with the growing M1 supplies of dollars, sterling, or yen, but gold bugs seem to like “currencies” that they claim central banks can’t “print”.

      #3 — The cost angle is what inspired my later article on how, even in 2013, it still seems surprisingly expensive to move small amounts of money across borders. I would have expected technology to have done better by now.

      #4 — Counterfeiting may not affect you much as a US dollar user in the US or UK, but it does make using dollars riskier and more difficult in places like Ecuador, Cambodia, and Burma. Counterfeiting is also a huge problem in China, and I find it funny how I am recommended to write down the serial numbers on notes I give as deposits so that I don’t get fakes back (though I’m maybe even more surprised a clever Chinese printer hasn’t gamed that already). I’ve noticed an odd relationship between the ease of counterfeiting a currency, the value of its top denomination bill, and the use of e-commerce in that currency — extreme example: Euros are relatively hard to counterfeit, the 500 EUR note is very valuable, but credit cards and electronic payments are widely used anyway, while Chinese RMB are relatively easy to counterfeit, the 100RMB note is worth less than 12 EUR, and the economy is still largely cash-only.

      #7 — I agree 100%, and that is my biggest problem with bitcoin. I would prefer a transfer technology as easy as bitcoin, but with a fixed exchange rate against USD, EUR, JPY, etc…

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