Bitcoin For Dummies
December 13, 2017 .

You would have to be living under a rock if you haven’t heard of Bitcoin by now.  The second steepest graph I have ever seen is the bitcoin price.  The steepest is the number of people who are talking about it.

My last 3 Uber Drivers have talked about the merits of bitcoin, as has my Hairdresser and the Matchmaker who shares her office with me.

While the rank and file seem to be in love with the cryptocurrency, many so-called experts are predicting its demise – Jamie Dimon, the CEO  of one of the world’s largest investment bank, called people who buy bitcoin stupid.  So who is right?  The plebs or the elite?

In order to answer that question, let’ take a look at what Bitcoin is, and how it works.

The blockchain

To understand Bitcoin, we need to first understand another concept known as the blockchain. Usually, when an asset is transferred from one owner to another, there will be a central register which records who owns the asset.

For example, BHP keeps a register of who owns its shares.  If you own 1,000 BHP shares, it will be recorded in BHP’s share register.  If you buy another 500 shares then BHP will record that you now own 1,500.

Property is another example.  In NSW, the Land Registry Services office records who owns every property in the state.  Similar property registries exist in other states.  Other examples include bank accounts, cars, managed funds, superannuation, frequent flyer points.  The list goes on.

You may ask “What is wrong with a register?” Well – there are 3 issues:

  1. These registers are VERY expensive to maintain and ultimately you pay the cost
  2. The register can make a mistake
  3. Registers can be prone to fraud either internally or externally (i.e hacked)

Without getting too technical, a blockchain resolves these issues by having a network of computers which synchronise the tracking of ownership of each asset.   Each computer in the network is known as a miner.  The miners record every transaction (a block) in the list of historical transactions (the chain).  As long as 51% or more of the miners agree on the list of transactions, that list becomes the truth.  So it would take more than 50% of miners to collude in order to manipulate the system.  This creates a high level of security.

The problem with money

We use money for 2 reasons:  As a store of value and as a means of exchange.  Both of these are becoming increasingly problematic.

During the GFC, the global financial system nearly collapsed.  Governments were able to coordinate globally to rescue the system.  Their solution was to create more money.  As a result, anyone who had money has seen their share of the world’s wealth deteriorate.  And who wins out of this?  Governments, because they are the ones who created the extra money.  It’s a bit like trying to win a game of monopoly when your opponent pulls more money out of the bank every time you blink.

Have you ever wondered why you keep getting priced out of the property market?  You can thank the central banks.  Although, as an aside, if you would like to buy property then Plenty can probably help you get there.

Another problem with money is the transaction costs involved in making payments.  For example, it is expensive to convert from one currency to another.  In a world that is becoming increasingly global, the cost of converting currencies is creating larger and larger inefficiencies.  If you don’t believe me, try this:  Walk into a bank, give them $100 and ask them to swap into $US.  They will give you around $US71. Then hand them the $US71 and ask them to swap it back to Australian dollars.  How much do you think you will get back?  Probably less than $90.  Why do you think the banks make so much money?  Even when you pay by credit card the banks keep around 2% of the amount you pay.  You might not realise it, but ultimately the retailer is passing this cost onto you and other customers through higher prices.

If everyone used Bitcoin instead of our existing currencies and payment methods, it would solve both of these problems.

How Bitcoin works

You can think of Bitcoin as a new currency, however it isn’t issued by a government.  Therefore, no-one has the power to unilaterally issue more coins and de-value the currency in the process.  One of the strengths of Bitcoin is that there are a finite number of coins, and a strict set of rules on when and how new coins can be created.

As you have probably guessed by now, Bitcoin is based on the blockchain.  Every transaction is recorded by miners all around the world. There are no physical coins – everything is recorded digitally.

Why can’t you spend Bitcoin?

It is early days for Bitcoin (and other cryptocurrencies).  While the concept has been around for about a decade, most people still don’t own Bitcoins and most stores won’t accept them.  This is a chicken-and-egg situation.  Consumers don’t have a need to own coins until businesses will accept those coins.  Businesses won’t invest in the infrastructure to accept coins until Bitcoin is more widely adopted.

Like with any innovation, there will be early adopters and over time Bitcoin will become more generally accepted.

How mainstream will Bitcoin become?

This is the big unknown.

At one end of the spectrum, Bitcoin could become a mainstream method of payment across the world.  It probably won’t completely replace existing currencies because central banks won’t want to lose control of their monetary systems.

At the other end of the spectrum, governments could outlaw the use of Bitcoin and other crypto-currencies.  This is unlikely because crypto-currencies will still exist, they will just will go underground where governments have no visibility at all.

Only time will tell exactly how prevalent Bitcoin becomes.

Are there enough Bitcoins out there for it to become mainstream?

There are currently around 16.7m Bitcoins in circulation.  At a price of $16,000 each, that represents a total capitalisation of $267 billion.  While that sounds like a lot of money, Bitcoin would need a much larger capitalisation (in the trillions) in order to become a mainstream global method of payment.  With a finite number of coins, there is only one way for the capitalisation to grow, and that is for the price to increase.

To put really clearly:  If Bitcoin becomes a mainstream global method of payment then its price needs to increase significantly from where it is today, on top of the very large returns that have already been achieved.

So does that mean Bitcoin is guaranteed to increase further?

No, it doesn’t.  If it was guaranteed to go up further then I would sell my house and invest the proceeds in Bitcoin.  And I haven’t done that yet.

The above statement was predicated on a big IF.  Bitcoin may never become mainstream.  Whether it does or not is very hard to predict. In a decade, Bitcoin will either be mainstream (in which case the price will increase further), or it won’t (in which case the price will have crashed).

There is another important element to all of this.  While Bitcoin is all the rage, there are hundreds of other cryptocurrencies out there too.  Some are aiming for global domination while others are designed to be used for specific purposes.  It is possible that the ultimate globally adopted cryptocurrency hasn’t even been invented yet.

So what will happen to the Bitcoin price?

In the long term, it will depend on whether Bitcoin becomes widely adopted.  Don’t be surprised if this is the case.  But there are no guarantees.

It wasn’t my intention to provide a short term prediction for Bitcoin in this article.  And you should never base investment decisions based on past performance alone, in particular recent performance.  However, just this once, lets look at the 1 week Bitcoin chart:

1 Week Bitcoin Chart
1 Week Bitcoin Chart

If we now look at the 1 week Ethereum chart (another cryptocurrency)

Etherium 1 Week Chart
Etherium – 1 Week Chart

Based on these 2 charts alone, Bitcoin seems to have peaked whereas the momentum seems to have swung to Etherium and other cryptocurrencies.  The moral of the story is that if you buy Bitcoin today, you could be buying at a peak.  And whether you buy Bitcoin, Etherium or any other cryptocurrency, then only invest what you can afford to lose.

But rather than speculate on cryptocurrencies, go with a sure bet.  Get a free financial roadmap covering every aspect of your financial life from Plenty.

The information contained on this page is of a general nature and may not be appropriate for your personal circumstances. You should obtain personal financial advice before acting on this information.

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