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Investing basics: What is Bitcoin?

Larissa Fernand  |  19 Feb 2021Text size  Decrease  Increase  |  
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Attempting an analogy to explain Bitcoin is precarious because there’s nothing quite like it. Even the best of them will be imperfect.

There are comparisons to fungus, with descriptions of antifragile and decentralised networks. Tulips bulbs and rai stones, indestructible piggy banks made of transparent plastic, and on and on. Let me attempt one with prison currency.

Prisoners need a proxy for currency as they are not allowed to possess cash. So how do they “pay” for laundry service, hygiene products, protection, a haircut, a book, chocolate or even alcohol? The medium of exchange must be durable, uniform and have a wide acceptance. That is how instant noodles and canned fish became prison currency. But cigarettes are top of the pecking order.

Notebooks are kept. Prisoner X will note down how many cigarettes he owes Prisoner Y, and Prisoner Y will make note of what Prisoner X owes him. That book documents all the transactions. To prevent fake entries, a third individual is selected as a witness. He signs the entry made in the books of Prisoner X and Prisoner Y.

Cigarettes or instant noodles or canned fish are Bitcoin. Notebooks are ledgers. The similar format in the notebooks is blockchain.

With that rather feeble attempt at an analogy, let’s dig deeper.

Is Bitcoin money?

There are 3 functions of money:

  • Money is a store of value. It can be used as a means of saving and allocating capital. It holds its value over time, despite inflation slowly eroding the purchasing power of money.
  • Money is a unit of account. It can measure value in transactions. It can be used to record debts and make calculations. It is divisible and countable. It can account for profits, losses, income, expenses, debt and wealth.
  • Money is a medium of exchange. It is accepted as a method of payment. When you go to the store, you can be confident that the cashier will accept your money, and not demand your shoes as a barter exchange.

Though increasing in popularity, Bitcoin is not universally accepted as a unit of account and a means of payment. Far from it. Countries can even ban it. As billionaire Mark Cuban summarised: Bitcoin would have to be so easy to use it’s a no-brainer. It would have to be completely friction-free and understandable by everybody first. So easy, in fact, that grandma could do it”.

Is Bitcoin like gold?

Gold and Bitcoin are both speculative; their prices are not determined by cash flow, revenue, earnings, interest payments or dividends. Though Bitcoin is sometimes referred to as “new gold”, the similarity ends there. Since gold exists in the physical realm it has to be stored someplace. It is universally acknowledged, and humanity has a long history with it. While gold is classified as a commodity, cryptocurrency has eluded categorisation.

What is Bitcoin?

  • Bitcoin is a cryptocurrency. There are thousands of cryptocurrencies, the most popular being Bitcoin.
  • A cryptocurrency is created and held electronically. Call it digital currency or virtual money. It can be used to buy goods and services online.
  • Cryptocurrencies are powered by blockchain—a decentralised technology that manages and records transactions spread across many computers. Each transaction is a “block” that is “chained” to the code, creating a permanent record of each transaction.

In other words, the cryptocurrency uses an online ledger with strong cryptography to secure online transactions.

Bitcoin was introduced to the world via a whitepaper authored under the pseudonym Satoshi Nakamoto. The creator’s gender, race, nationality, or whether it is an individual or a group, remains a tantalising mystery.

This was an attempt to create a currency backed by code rather than items of physical value like gold, or by trust in authorities or countries. What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.

What Bitcoin is not

It is not dependent on central banks that control money supply. It does not flow through the traditional banking system. It is not controlled by a monetary agency, institution or country. It is not paper money like the rupee, dollar, euro or yen. Oh wait, did we not already agree that it is not money either, as we currently comprehend it?

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is the editor of the Morningstar India website.

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