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A very wise investor once said: “Price is what you pay, value is what you get”. The foundation of success in investing in any asset class results from the investor’s understanding of its value and how it is derived.
Understanding and investing in Cryptocurrencies like Bitcoin can be daunting to anyone who isn’t a techie or running a business on the deep web. There are many properties of cryptocurrencies that are unique and could pave the wave towards disruption in the financial industry. The key to understanding this exciting new asset class is first truly understanding money.
This begs the question—what is money? And where does it derive its value?
The term “money” is defined by Merriam Webster as “something generally accepted as a medium of exchange, a measure of value, or a means of payment”. And the system in which money is used is called currency.
There are 180 current currencies worldwide, as recognized by the United Nations. The most dominant among these are the European euro, the Japanese yen and the U.S dollar. Although it is not as valuable as it used to be, the U.S dollar remains the reserve currency of the world.
Now as the reserve currency, the U.S dollar formerly derived its value from gold. However, in an attempt to combat heavy deflation during the Great Depression, President Roosevelt depegged the dollar from gold to stimulate the economy. At the time the additional money the United States was printing to finance its spending was backed by National debt.
As other countries became weary of this they began to convert dollar reserves into gold. This made the run on gold was so extensive that President Nixon decided to officially remove the dollar from the gold standard in 1971.
Currently the US Dollar, as the reserve currency of the world, is backed by the full faith and credit of the US Government. Although the dollar is basically backed by nothing in physical terms, this does not mean it has no value.
The intrinsic value of any currency, regardless of what it’s backed by, is the agreement and faith by its users on its value as the means of trade.
During the financial meltdown of Wall Street and the entire US financial industry, this faith was shaken. So can we really trust central banks to maintain sound monetary policy that ensures our money doesn’t dramatically lose value? In the midst of this crisis, someone by the name Satoshi Nakamoto introduced a radical new currency to the world. A currency with no central bank or authority, secured through encryption in which monetary policy is written in software code. A currency that can be transacted without a trusted third party like Visa or Paypal.
So where do cryptocurrencies derive their value
As their name implies, cryptocurrencies are based on cryptography, a fancy term for the study, writing and solving of codes. The first ever among these is Bitcoin, which was introduced in 2008 when a white paper was released detailing a currency that had the capacity to be both decentralized and self-governed. This white paper is still available and accessible to anyone on the bitcoin website.
The technology behind Bitcoin explained- Warning: Put your tech hats on!
So there are 3 basic technologies that are integral to Bitcoin. They are peer-to-peer (P2P) networking, hashing and signature algorithms. The most crucial among these is P2P.
Peer-to-peer (P2P) networking is a type of network where each computer can act as both a client and a server at the same time. This is contrary from most web functions, which have a client-server model, where a centralized server communicates to its many clients. Think of how Google is one server communicating websites with content, videos and files to all of us as its clients.
With P2P instead of websites being communicated, it is a ledger, otherwise known as a blockchain. The blockchain is a public ledger of all Bitcoin transactions that have ever been executed. This ledger is decentralized, meaning people can download it from all others who own it. Every node(peer) hosts a full copy of the blockchain(ledger). The innovation behind this type of network is that since every node on the network has a fully copy of the history of transactions, this means if an attacker tried to add a false entry in the ledger, they would not only have to modify their copy but also everyone else’s copy.
Because of the way the network is set up, it is virtually impossible to counterfeit a bitcoin.
How Bitcoin actually works
Bitcoins aren’t actually coins of any kind. They are entirely virtual. The “coins” are implied in transactions which transfer value from sender to recipient.
Every user within the network owns keys which allow them to prove ownership of transactions in the network, unlocking the value to spend it and transfer it to a new recipient.
The keys are stored in a digital wallet on each user’s computer. Possession of the key that unlocks a transaction is the only prerequisite to spending bitcoins, putting the control entirely in the hands of each user.
So how are new bitcoins created?
Since no federal authority exists that can “print” out new Bitcoins, Bitcoins are created through a process called mining. Considering that they derive their value from cryptography, mining involves looking for a solution to a difficult code problem. Given the peer-to-peer nature of the system, anyone can operate as a miner, using their computer’s processing power to attempt to find solutions to this problem.
On average every 10 minutes a new solution is found by a miner who can then validate the transactions of the past 10 minutes and is rewarded with brand new Bitcoins. It almost sounds like a game doesn’t it?
The beauty of Bitcoin mining is that it decentralizes the currency-issuance and clearing functions. This evens out the playing field, leaving no room for devaluation/inflation of the currency due to an oversupply from a single authority deciding to print more of it.
Now how does Bitcoin work as a form of investment?
If you have been paying careful attention, you may realize that Bitcoin sounds more as a means of remittance than it does a form of investment. The investment value of Bitcoin, as with the trading of fiat currencies, lies in its exchange rate relative to another currency.
Therefore, should the price of the Bitcoin go up after a period of time, relative to the dollar or any other currency, then you have by definition realized a return on your investment.
Some avid users of the Bitcoin network have gone as far as transferring a significant portion of their savings into Bitcoins, attesting this to their understanding of and trust in the network due to its transparency and decentralized nature. However, this may not be a wise decision for beginners. After all, it was the wise investor who also said:
“Buy an investment the way you would buy a house. Understand and like it such that you’d be content to own it in the absence of any market.”