With all the recent hysteria over bitcoins and cryptocurrency, I decided to drag my reluctant butt off the couch and wade into understanding the space.
This post is the first in a series of three where I’ve come to the sector completely fresh and tried to make sense of it.
The second post will explore how paying for things with a cryptocurrency compares to what we use today, such as Visa and cash. We’ll also take at look at the limitations of current cryptocurrency protocols, where things are headed, and how illegal transaction volumes in bitcoins and cryptocurrencies compare to the existing global black market economy.
The third post will explore my views on valuing cryptocurrencies, as an ex-currency trader and career financial analyst.
If you want a layman’s view on what a bitcoin or cryptocurrency is, or why someone might actually pay for one, then this is for you.
Common bitcoin definitions are unhelpful
Google ‘what is a bitcoin’. Go on, do it now.
Here’s the first definition, from Wikipedia:
Bitcoin is a cryptocurrency and worldwide payment system; it is the first decentralized digital currency, as the system works without a central repository or single administrator.
So this tells me (and everyone in the world who googles ‘what is a bitcoin’ or ‘what is bitcoin’ for the first time) that bitcoin is a thing called a cryptocurrency, as well as a decentralized digital currency.
So here we arrive at issue number 1 – what, actually, is a bitcoin? This doesn’t tell me!
In my view, when someone’s asking “what is a bitcoin?”, they’re coming from a place of knowing what their current form of currency is – ie, a gold coin is a round disk made from gold, or (if you live in Australia) a $10 note is a 137 × 65 × 0.1294mm piece of plastic. People what to know what is bitcoin is.
So perhaps a better question is, what is a bitcoin made from?
In recent centuries gone by, gold has been the primary store of value. Gold (and other base metals) have been used in commerce in the Ancient Near East since the Bronze Age, but gold coins didn’t properly emerge until the 6th century BC, in Anatolia.
As we said above, the thing about a gold coin is, you know what it is. It has a readily identifiable colour and weight. If you’re out on the high seas trying to sell your bootleg pirate haul, you could bite down on what your customer is trying to pay you with to check he (or she) isn’t ripping you off. You’re comfortable it’s worth something because, well, it’s gold!
So let’s go back to square one and have a crack at defining what a gold coin is, before we start on bitcoin. I’d say something like:
A gold coin is a round shaped disc made of gold. It can be exchanged for things or used as a store of value.
I’m sure you could do better than that, but generally speaking you’re pretty comfortable with that definition, right? Great.
Now let’s define gold – I’ll outsource to the dictionary for this one:
A yellow precious metal, the chemical element of atomic number 79, used in jewellery and decoration and to guarantee the value of currencies.
There’s that word again – value. Did you think about it much when you read either my crack at defining what a gold coin is, or the dictionary’s go at defining gold?
Or did you just gloss over it because we all just know gold has value?
Ok, let’s park that there for a minute and return to the original problem – what is a bitcoin (made from)?
Here’s my attempt at a definition in the same context as where I defined a gold coin above:
A bitcoin is a digital file made from 1s and 0s. It can be exchanged for things or used as a store of value.
That feels annoying, doesn’t it? I mean, on the one hand it tells me what a bitcoin is, as opposed to the more obtuse “…it’s a decentralised cryptocurrency…”.
On the other hand you’re probably now wondering why anyone would exchange cash for something that, in reality, is not too far off from a text file.
And perhaps more importantly, you’re probably wondering why would anyone would be willing to accept a digital file as payment for goods or services rendered?
To answer this, we need to understand why bitcoin has value.
Why does bitcoin – or anything – have ‘value’?
Why is something either worthy of exchange for something else, or as a store that you can use to preserve ‘value’?
In the context of money and paying for things, the first thing to note is, we as humans don’t actually agree on how the concept of money evolved, or came to be, in our history.
You read right – we actually have no clue where this whole ‘money’ thing first came from.
We don’t know if:
- Money was invented specifically to replace barter.
- Money evolved out of early ‘gift’ societies, which relied on elaborate credit systems (and therefore money originally evolved out of debt – there’s a thought!).
- Someone, somewhere, just one day went from saying “I owe you” to “I owe you one unit of X, which you can exchange for all this other stuff, so it’s cool”.
Helpfully, we can’t remember, and apparently no one wrote it down somewhere.
As we can’t remember where the concept of money came from, this might suggest that on a long enough timeline, the object itself to which we assign monetary value (like a coin) becomes arbitrary – as long as we all ‘agree’ it has ‘value’.
It also tells us that the reason for using whatever we’re using to transact as the medium of exchange today is likely divorced from the reason for why we invented money in the first place…otherwise we would probably remember why we, as humans, invented money.
Therefore the value of the medium of exchange today is not intrinsic (definition: ‘belonging naturally; essential’), but rather some benefit gained fromusing that particular medium for exchange, instead of another.
If we take a look at the evolution of how people have paid for stuff over the last couple of thousand years, we can broadly summarise it as the following:
TABLE 1: The evolution of how people have paid for stuff
If you paid careful attention, you’ll note that so far, for the majority of recorded history, humans have transacted in things other than gold coins, or coins in general. Basically, sheep were in pretty high demand for about five millenia. Then at some point, we decided coins were better, and then eventually, that gold coins were the best. Why?
For many millennia, not just gold but also other base metals, shells and commodities were employed as currency. Some suggest the use of shaped gold can be traced back to the fourth millennium BCE (4000 – 3000 BCE), where the Egyptians used gold bars of a set weight as a medium of exchange. Earlier, Mesopotamia did this with bars of silver.
Reconsidering TABLE 1, we can say that the medium of exchange for one unit of value has trended to the convenient over time.
Put another way, it’s easier to carry around coins than sheep!
Here’s some of the things that, over time, drove the trend to the convenient of carrying coins around as the standard unit of monetary value globally, versus the sheep (or many other forms of cattle or crop) used for the first (approximately) five millennia:
TABLE 2: Sheep as a medium of exchange versus gold
Cryptocurrencies in general and bitcoin in particular as the first cryptocurrency, in my view, is just the latest iteration of this trend to the convenient. But what is so convenient about cryptocurrencies that people want to exchange ‘real’ money for them?
Money that is worth something as money, and as a commodity
What we think of as the first ‘money’ today was what we now refer to as ‘commodity money’.
Commodity money, as the name suggests, is money whose value comes from a commodity of which a particular quantity underpins the ‘value’ of the representative medium of exchange (ie. the coin).
The first societies to trade in commodity money used the things that had the most utility and scope for re-use and re-trading on which to base their monetary units.
For example, the shekel was a unit of weight and currency first noted c.3,000 BCE which referred to a specific weight of barley, and equivalent amounts of silver, bronze and copper, amongst other things. Those things most desired were the easiest to assign monetary value to for direct exchange.
Once humans had their basic needs covered – ready food cultivation, long-lasting shelters, easily accessible water – we were able to multiply at a faster rate, the division of labour was able to increase, and we got into this positive feedback loop of being able to solve harder and harder problems.
This lead to the development of things like long distance communication, the physical separation of skilled labourers, and ultimately the need for indirect mediums of exchange and, importantly, a medium of exchange that could be common to communities separated by distance, language and culture.
In today’s increasingly global, decentralised economy, we still don’t have a widely accepted medium of exchange that is common to all communities. Sure, the US dollar underpins a significant proportion of global trade, but even that is changing as, for example, the Chinese economy emerges, and the Yuan gains more prominence.
Even with each country having its own currency, and those currencies being interchangeable, it’s still a pain in the proverbial to:
- Send money offshore.
- Open a bank account overseas.
- Get all the information together that you need to transact with someone on the other side of the world.
- Feel entirely comfortable sending $10,000 (or any other amount) offshore to someone you’ve never met.
Amongst other things.
Remember the ‘trend to the convenient’ we discussed before? We can reframe this argument in terms of ‘enough’…are the features of a medium of exchange that we value (there’s that word again) as a society today enough to meet our desires and needs in a transactional currency layer today?
If we go back to 5,000 BCE when we transitioned from sheep as the primary medium of exchange to commodity money, we didn’t transition because all of a sudden sheep weren’t portable any more. They just weren’t portable enough anymore. Our division of labour and mobility as a human race had increased enough that we needed a medium of exchange that was more liquid, durable, available, easy to secure and easy to move around. Our needs became more refined, and we transitioned mediums of exchange to accomodate how we lived and transacted.
With bitcoin specifically and cryptocurrencies in general, I would argue this transition is happening again. If we were to reframe TABLE 2 above for the modern day, it might look like the following:
TABLE 3: Standard currencies as a medium of exchange versus cryptocurrencies
So this leads us to the main point on why bitcoin has value:
Bitcoin has value because it facilitates the trend to the convenient.
And the same can be said for cryptocurrencies in general.
You could also argue that the support we’re seeing for cryptocurrency adoption from the ‘average’ person reflects a desire for greater control over their hard-earned savings.
For example, when Cyprus was bailed out by the Eurogroup, European Commission (EC), European Central Bank (ECB) and International Monetary Fund (IMF) in March 2013, bank accounts were frozen and a one-time ‘bank deposit levy’ was applied to people’s savings accounts. In other words, the banks in effect said “…we’re stopping you from accessing your money, and on top of that we’re taking some of it”. This is much harder for a government to do if your savings sit outside the ‘system’ in a cryptocurrency cold storage wallet (an offline device or medium for storing your bitcoins or other crytocurrency).
Cryptocurrencies also allow you to carry sums of money across international borders without approval from a central authority, and without limits on how much you carry. They allow you to access services and purchase goods without an intermediary arbitrating the transaction (more on this in Part 2), to access goods and services that might be legal in one country but not another, and in the not-to-distant future to undertake complex transactions without reliance on a third party, such as selling your home or issuing a new bond.
Summary and Part 2
We should be changing the discussion around definitions of a bitcoin. For those new to bitcoins and cryptocurrency, definitions based on words like ‘decentralised’ and ‘crypto’ muddy the waters and do nothing to debase the current market hysteria, in my view. If anything, the opaqueness of the descriptions lend themselves to further FOMO (fear of missing out), in so much as someone might say “…well I don’t quite get it, but it’s going up so someone must!”.
Bringing it back to first principles, what a bitcoin actually ‘is’ is a digital file, a set of 1s and 0s, that people see value in. They see value in it because it facilitates the trend to the convenient in transactions. It helps them to transact in ways, and for things, that the current monetary system either can’t, or prohibits transacting for and in for various reasons.
In my view, the extent to which cryptocurrencies facilitate the trend to the convenient in transactions means they’re here to stay. In Part 2 of ‘From Sheep to Bitcoins – Understanding Cryptocurrency Hysteria’ we’ll explore where this needs to go to rival current payment networks like Visa and Mastercard.