What is Bitcoin, exactly?

By Chris Chen CFP | Financial Planning

Dec 16

What is Bitcoin, exactly?

BitcoinWhat is Bitcoin?

Bitcoin is a cryptographic protocol operating on a peer-to peer network created in 2009. This protocol is utilized in the form of a currency, allowing for direct transactions between individuals. Simply put, and as implied above, Bitcoin is an anonymous digital currency, which circumvents financial intermediaries in transactions.

Bitcoin can be considered in 4 parts:

1. How are Bitcoins created ? Bitcoins are created through a process called “mining”. The fundamental basis Bitcoin is founded upon is an algorithm, which regulates the speed at which Bitcoin can be “mined” and the manner in which it is used or transferred. In terms of speed, essentially, a computer program, accessible to anyone, works to solve an equation. Once it solves the equation, that person is awarded a certain amount of Bitcoins. The time it takes to solve an equation get progressively harder leading to diminishing returns, as the cap of 21 million Bitcoins gets closer (i.e. there is no additional money supply).

2. How does Bitcoin work? Bitcoins have two encryption keys: one public and one private. The public one has a similar role to an account number and the private one has a similar function to a PIN. Anyone can see the public one and the private one is stored in a “wallet” on the user’s computer or mobile device. These wallets store multiple Bitcoin addresses, created at the users’ discretion. To undertake a transaction, the user would simply give (whether directly or through a Bitcoin client) their private key, which can then be verified versus the public key to confirm the legitimacy of the transaction. Transactions are recorded in a public ledger in what are called “block chains”.

3. Why do people use Bitcoin? Bitcoin is used for its comparative advantages over other forms of currency and transaction methods. It is worth noting that one major attraction to Bitcoin, the anonymity factor, has drawn criticism from certain sectors (i.e. the US government). Websites, most infamously Silk Road (which was closed by the FBI in October 2013), use Bitcoin as a safe currency when dealing with illegal transactions (e.g. drugs, arms). Concern is that as Bitcoin becomes more liquid and volumes start increasing, it will become a target for money-launderers. Other comparative advantages which stand out are simply the fact that it is digital – giving it greater flexibility of usage – and that it is not subject to conventional political pressure or externalities. This second point derives from Bitcoin’s decentralisation, making market influences by a central bank (e.g. printing money) or a government (e.g. Cyprus’ proposed tax on bank deposits) irrelevant. Furthermore, the greatest attraction, at least from the financial side, is that Bitcoin is essentially frictionless; the digital currency has virtually no transaction fees, making cross-border transactions a main driver of future growth and monetisation.

Today, Bitcoin has limited usage. There are a number of services allowing individuals to obtain Bitcoins, through an intermediary or directly on the market (BTC China is the largest one at present, with c. 48% of Bitcoin activity). While large retailers do not accept Bitcoin, there are several services for the purchase of gift cards (e.g. Gyft), for example, providing an indirect method of accessing the retail market. Other website and small-scale retail also provide goods and services.

4. Every Bitcoin has two sides. Bitcoin suffers from a number of problems, many of which mirror the currency’s positives. The largest worry people have and the largest hurdle for Bitcoin and digital currencies in general is the lack of regulation and consumer protection. Simply put, what people don’t know, they don’t trust. While government and central bank action is certainly debatable, these institutions provide the authority to back a currency. Similarly, fees for companies such as MasterCard are used to insure users. The result of the lack of regulation, among other reasons, is a volatile and illiquid currency. Consumer confidence would go a long way to solving many of Bitcoin’s problems, with regulation, a potential platform, market penetration and less speculation key factors in controlling this.

From a technical perspective, digital currencies and especially Bitcoin have encountered difficulties of scalability and monetisation, with deflation a potential concern given the technical limit of 21 million Bitcoins. While perhaps simply growing pains, the currency has not gained any meaningful traction concerning scale and monetisation.  While the number of transactions have been increasing on absolute levels, normalised compounded monthly growth rates have been about 10%, compared to a previous rate of 13.6% (since the start of 2012).

(This guest blog was contributed by Patrick Chen, a graduate student in Finance at the Institut des Etudes Politiques, in Paris, France.  Insight Financial Strategists LLC does not provide Bitcoin advice or services.  This is published as an interesting topical topic ).

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About the Author

Chris Chen CFP CDFA is a Wealth Strategist with Insight Financial Strategists LLC in the Boston area. He specializes in retirement planning and divorce financial planning

Chris Chen CFP December 21, 2013

I should add that we cannot accept payments in Bitcoin, unfortunately.

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