Why digital money is here to stay

Bitcoin is a big word these days. Some, like computer programmer and businessman, John McAfee, are predicting the digital coins will eventually hit a price of $1 million each. Others have reported (Atlantic) that cryptocurrencies in general could be Ponzi schemes. Despite divisive opinions, it’s clear that Bitcoin is moving beyond the digital space and becoming part of our day-to-day conversation.

Bitcoin’s current popularity comes from it hitting over US$19,000 (Fortune) in the middle of December, a 19-fold increase since the start of 2017.

Governments have also grown concerned about it. Just a few years ago, some countries like Iceland (Forbes) were expressing their intention to forbid the use of cryptocurrencies altogether. South Korea and China seem to be implementing a crackdown right now (Bitsonline). Some, like Russia, have decided it would be impractical to enforce such bans and decided to regulate them instead (Coindesk). Though it’s important to mention that they may not be targeting the use of cryptocurrencies per se, but an emerging capital raising method known as initial coin offerings (ICOs), similar to the stock market, but currently unregulated.

Now, there seems to be an increasing number of countries getting ready to enter the cryptocurrency market. Venezuela announced the petro and Russia announced the CryptoRuble (Financial Times). The Washington Post reported that the rising value of Bitcoin has observers predicting the U.S. may release a ‘FedCoin’ at some point.

As with most financial matters, nobody knows for certain what Bitcoin’s future will be. So it’s time to give the whole topic a closer look.

Digital money was already here

It’s important to note that cryptocurrencies didn’t introduce the concept of digital money. Most money in circulation today is digital and it’s been that way for at least a couple of decades. It may come in forms like plain cash in bank accounts or financial instruments like bonds, but it all exists as numbers in the computers of private banks. Such computers are audited by government agencies to make sure nobody cheats.

Paper money and metal coins are also issued by governments, but they make up just a tiny fraction of all money in circulation today (How Stuff Works). The usage of credit cards is so widespread in certain parts of the world now that actual cash is becoming a thing of the past.

If the traditional banking system, which comprises regular bank accounts, wire transfers, credit and debit card processing, is the first generation of digital money, then cryptocurrencies like Bitcoin represent the second generation.

Cryptocurrencies may not have introduced the concept digital money, but they have curtailed government control.

From blockchain to cryptocurrencies

The amount of attention blockchain – a decentralized ledger –  is attracting these days gives the impression that mathematics is finally catching up as a popular topic. For example, blockchain solves the Byzantine Generals’ Problem, which is part of a branch of mathematics called Game Theory. But in reality, this is a practical matter.

Centralized banking systems require all transactions to be validated by single authority, ensuring that digital money, which is easy to replicate by nature, can only be spent once. In contrast, distributed banking systems face a problem known as double spending: the possibility that, by taking advantage of the time gap required to synchronize the network, someone may spend money more than once.

Blockchain – the technology behind Bitcoin – was the first practical solution to this problem. It is a specific kind of distributed database devised to operate inside a network with no central authority. As its name implies, it’s composed of interlinked blocks of information, each containing data – in the case of Bitcoin, a transaction – that can’t be altered once set. The chain itself is built collectively but independently by the nodes (computers) in the network. (Investopedia)

Blockchain is the equivalent of monetary democracy in the digital world, since it is based on the principle that the opinion of the majority is the truth. The inevitable discrepancies between nodes in a decentralized system are solved by the majority principle, with nodes always preferring to build upon the most popular chain, quickly leaving minority chains behind.

A cryptocurrency is a specific form of digital money that uses cryptography for protection. Bitcoin uses a mechanism called proof of work to make it difficult for the nodes to launch brute-force attacks on the network. Cryptography in general is a highly asymmetric process, making an encrypted block easy to decode with the proper key and extremely difficult without. Since all blocks are required by the network to comply with a specific signature, it is necessary to add random information to the block and test it by the method of trial and error, until it meets the requirement. Keys are shared with the blocks, making it trivial for the rest of the nodes to check the validity of the block, but non-trivial for a rogue node to fake it.

It’s important to mention here that not all digital currencies use cryptography for protection. Competing technologies such as The Tangle don’t use it and thus aren’t technically cryptocurrencies.

Bitcoin and other in practice

According to some estimations (Blockchain.info), there are nearly 17 million bitcoins in circulation. At US$16,000 each, the cryptocurrency market has grown to at least about US$300 billion so far and already manages more wealth than some nations.

But Bitcoin still isn’t as practical as the paper bills and metal coins we all carry around in our pockets.

As impressive as this growth sounds, Bitcoin and other cryptocurrencies are still a failure when it comes to day-to-day usage. Sure, there are people who pay for drinks with actual bitcoins, but most transactions are done through intermediaries or brokers, meaning one of the parties (or both) receive the payment in a regular currency.

Also, despite its reputation as a haven for criminals, Bitcoin is far from anonymous. In the end, blockchain is a public resource and therefore transparent. Accounts don’t have an individual’s name on it, but this is mostly a disadvantage: your crypto-coins may be safe when it comes to street mugging, but they can and have been stolen from the other side of the planet a few times already. If that happens, it’s nearly impossible to report the theft to the police.

Right now, the Bitcoin network has almost stalled (Medium), making the time it takes to validate a transaction ridiculously high. It can go on for days sometimes. Fees are also outrageous. Among other things, this prompted the launch of a fork called BitcoinCash.

At the core of the issue is that Bitcoin isn’t as decentralized or peer-to-peer as some people claim (Bitcoin Magazine). It still depends on a single authority, which is now the consensus between the majority of the nodes in the network. In the end, you can’t really validate a transaction on your own.

Why cryptocurrency prices fluctuate so wildly

The digital part of cryptocurrencies might be high tech, but the process of rapid appreciation (deflation) most of them is experiencing can be explain by old-school money theory.

Traditional economies revolve around a single, government controlled currency. Almost all currencies exhibit sustained inflation. Together, these two properties uphold the policy of price stability. Supposing that you want a bike and it costs $100, the best you can expect tomorrow is that it will still cost $100. If you wait a year, it’s to be expected that it’ll cost more, say, $105. That’s why, if you really want the bike, there is no rational reason to delay its purchase.

Now, when a second currency enters a traditional economy (let’s call the original A and this new one B), the process of exchange between A and B provides contrast to notice the minor and natural fluctuations in the purchasing power that were previously hidden. This invites people to gamble.

A notable exception is the Swiss franc, the only currency in the world with nearly zero inflation. The main reason why people opens bank accounts in Switzerland isn’t anonymity; it’s because, like gold, the Swiss franc has proven to retain its value over time.

Speculation is quite inevitable when multiple currencies co-exist, but as long as they are exchanged for real goods and services (such as bikes), their value is kept in check. Gold has many advocates because it’s an element and thus its value is easy to quantify: 100g of gold is worth twice as much as 50g. On the other hand, the value of complex goods such as bikes is more difficult to quantify and compare.

By contrast, the problem with Bitcoin et al. is that very little of it is used to purchase real goods and services. Nowadays, most cryptocurrencies go back and forth in the market in the form of currency exchanges. As long as Bitcoin keeps receiving more capital that is stored and not exchanged for anything else, its price will keep going up.

The thing is, most people expect to spend their own money at some point; and when that happens, Bitcoin’s price will have to adjust accordingly, as in our bike example. Whether this happens smoothly or suddenly all depends on the net percentage of its users who hoard it for speculation purposes. If 90% are in it just for the quick gains (which seems to be the case, since most of it goes back and forth in the market in the form of currency exchange), be sure that the bubble will burst and its price will collapse to just about zero.

Critics tend to argue that Bitcoin et al. isn’t backed up by anything, but actually, none of the traditional, government issued currencies in the world is backed up by anything either. The proper term for this is fiat currency. Since money lost parity with tangible wealth, such as gold or silver, all currencies risk a process called hyperinflation. During the 1920s, the Weimar Republic (Germany) printed so many Marks that they began to be used as wallpaper.

However, if only 50 percent of its users are really committed to it, meaning they won’t buy or sell just based on exchange rates, the bubble will contract to its natural balance and stay there. The aggressive “investors” will lose interest, considering Bitcoin just another other asset in their portfolio.

Cryptocurrency future

No one knows what will happen to “private” cryptocurrencies like Bitcoin in the long term, but with governments preparing to launch their own digital currencies, they’re definitely here to stay.

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