Cryptocurrency Primer - What is Bitcoin, and how does it differ from other currencies?

I thought we would go a little old school and start from the beginning and get to the basics of what cryptocurrency is and is not. Enjoy

Central banks issue traditional currencies like dollars, pounds, and yen and reside primarily in the banking system. Cryptocurrencies, conversely, are digital currencies created and issued by private entities and are largely independent of the traditional monetary infrastructure. They are decentralized, transparent, and immutable, which means that no person, entity, or government can control them nor take the system down.

Cryptocurrencies are unique because they are created and tracked by a technology called blockchain, an online distributed ledger system. What a distributed ledger refers to is that they contain a list of cryptocurrency owners and a description of each owner's holding. Cryptocurrencies exist on a network of computers in which each computer maintains its copy of the list. Every time there's a transaction, each computer in the network has to update its copy of who owns which units of the cryptocurrency. This feature helps maintain the network's security and enables it to exist outside the banking system.

Bitcoin is probably the most successful and well-known cryptocurrency to date, but it wasn't the first. There were many attempts to create a digital currency, but all failed to achieve bitcoin's success. Before bitcoin, other companies like PayPal successfully moved us toward a digital currency. They created ways to pay each other over the Internet without going through a bank. But PayPal and other systems are still dependent on the banking system but use a more streamlined way to utilize the existing payment system.

Cryptocurrencies differ because they are entirely independent of the banking system or other traditional financial institutions or governments. The creation of blockchain technology and bitcoin came out as a response and answer to the world financial crisis in 2009 by a synonymous person or persons called Satoshi Nakamoto. It was a watershed moment because this cryptocurrency could operate securely and entirely outside the established payment system built on the banks.

It could also operate anonymously. Combined with other features, this made it the perfect currency in its early days to use on the so-called dark web, a part of the Internet where illegal transactions and goods and services flourished. Eventually, the mainstream economy recognized the potential value of a currency and payment system independent of banks. For one thing, the currency's safety didn't depend on the health of the banks, and its value would be isolated from the decisions of the central bankers who controlled traditional currencies. We have seen this recently as this March when multiple banks failed and had to be taken over by the government, which we ended up paying for through taxes.

The distributed ledger technology, blockchain, gives bitcoin and all cryptocurrencies its utility since it is a general type of computer software and can be copied, modified, and customized by anyone with sufficient programming skills. Consequently, there's been an explosion in cryptocurrencies that utilize this technology.

You might've heard of Ethereum, the second largest cryptocurrency, Ripple XRP, or any others that have appeared in recent years. Each utilizes blockchain technology differently and has different rules governing its creation and usage. For example, Bitcoin is limited to 21 million total units, while other currencies didn't set any limits for the amount that could be issued. And yes, even central banks worldwide are considering using blockchain technology for traditional currencies called Central Bank Digital Currencies or CBDCs. Still, they should be closely watched as governments creating currencies using blockchain technology would be able to exert even more control over our money than they do now.

Another cryptocurrency type called Stable Coins could replace the government's equivalent of a dollar. Stable Coins, even though they are digital, are usually backed by hard assets such as dollars, Gold, or even government bonds; therefore, their NAV stays at one dollar. This type of cryptocurrency is helpful as a savings vehicle since its price is not volatile like bitcoin and other cryptocurrencies.

Even if we set security issues aside, digital currencies still portend potential problems. The first arises because cryptocurrencies may be the prime vehicle for speculation. The wall street journal has quoted the cryptocurrency consultant Tom Dyson as saying, "The world has never seen a more perfect speculative asset than Bitcoin." One of the main reasons he said this is that it's hard, if not impossible, to know the correct value of a cryptocurrency. In the bitcoin example, the price can spike as high as $20 a more, making it impractical to spend on most transactions. And yet spending a currency and adding up the prices of the goods and services it can buy is one of the best ways to establish value. If people don't spend the new currencies, it will be difficult to gauge their true worth or what financial professionals call their intrinsic value.

Bitcoin today is mainly held as a store of value like Gold and is not used for transactions. Other speculative assets have additional uses beyond serving as a medium of exchange that helps pin down their intrinsic value. For example, Gold is another asset that could be used to make purchases, but it also has high transaction fees that make this impractical. Still, Gold is in high demand in the electronics industry, as well as for jewelry, and it's these uses that give Gold an intrinsic value that we can use as a lower bound for its market price. There has yet to be a similar use among most cryptocurrencies that would help set their intrinsic value, so their price is balanced between high and low extremes. This became quite apparent when bitcoin's price spiked above $20,000 one day in December 2017, only to fall by half a few weeks later and then keep falling. An even greater crash occurred in the value of the cryptocurrency Ethereum in June 2017. Within seconds Ethereum's price crashed from about $319 a unit to 10 cents due to a large order that triggered a selloff. Some people feel that cryptocurrencies have a gold rush mentality similar to the .com boom and bust of the late 1990s. Some say 2022 was the shakeout in this space in which the weaker, less-than-genuine players folded. Although bad actors such as FTX, Alameda Research, and Three Arrows Capital did lose a lot of people a lot of money when they folded, this is not unlike what happened in the past in traditional finance.

This boom, bust cycle can get really out of hand when people apply leverage or borrow to make other risky investments. Money has three distinct functions. The first two are the medium of exchange and store value. But the third function, the unit of account function, can create the most significant bust cycles. The phrase, unit of account refers to the fact that we use the money to keep a tally of our assets and liabilities just as an accountant would, but this description hides its real power, which is to create debts or to make loans. If people accept cryptocurrencies as means of payment or stores of value or both, they'll almost certainly be willing to borrow and lend in these currencies. This means that issuers of cryptocurrencies could start making cryptocurrency loans. Lending, as we know, is a crucial way that currencies expand and grow, and as loans expand the supply of credit, it pumps up aggregate demand and economic activity. But as we've seen several times in history, the faster the amount of credit grows, the more danger there is that the lending becomes reckless and sets the financial system up for a crisis later. This is exactly what we saw with FTX and the above-mentioned failed businesses. Even though lending in the crypto industry requires over-collateralized loans, where you have to have twice as much collateral as the value of the loan, companies acquired too much crypto debt. When the volatile cryptocurrency price crashed, these companies couldn't withstand the margin calls and went bankrupt.

In the traditional banking system, central banks and regulators can question the rate of growth and lending and try to reign it in. But in a completely private and independent currency system, the only restriction will be the self-restraint of the lenders. While credit is expanding, the lenders will rake in the profits and won't be interested in ending the party until it all comes crashing down. This happened in the 2009 financial crisis spurred by a housing lending frenzy and again in crypto with FTX and partners.

Could this happen again? Well, unfortunately, we've seen it many times in history. But here is the thing: innovation doesn't cause trouble on its own. Instead, cryptocurrencies and other technologically driven products provide new ways for people to engage in behaviors that have always caused financial disasters– stealing, speculating, and excessive borrowing. Unfortunately, it's the nature of humans and money. Crashes and crises are a normal part of economic activity. Technology may reduce or even prevent some financial disasters by improving the information available to investors and regulators. Still, it also creates new ways for people to push the financial system beyond its limits. The human desire to pursue big payoffs will always be the driving force behind financial innovation – And financial disasters.

The balance we need to strike is between allowing people to chase these big payoffs through experimentation and innovation while limiting the damage from the recurring crashes and crises that result from it. The crypto industry wants new regulations and laws for a new digital financial system. It has asked the SEC to work together to create new financial and securities regulations and laws so that we don’t have to rely on laws created in the 1930s. As in the past, it can be painful, but technology always pushes us forward, as there is no putting the cat back in the bag.

The key is education and knowledge, and patience. Hopefully, this newsletter and my Youtube channel Crypto For The Rest Of Us, can help educate you on not only the perils of crypto but the absolute joy you can have and the profit you can make. Not financial advice, of course.

Until Next Time, J. Scott