By Philip Baczewski, executive director, University Information Technology
Feb. 15, 2018 – Bitcoin has been in the news recently. The big news is that after a meteoric rise in value during the end of 2017, Bitcoin values have dropped substantially in value since the middle of December 2017. So, those Bitcoin billionaires may now be measly Bitcoin multimillionaires.
The Bitcoin Story
Bitcoin is the first of what are now several or more cryptocurrencies. These are inventions of the internet that exist only as electronic records on computers that may physically reside anywhere over the globe. While Bitcoin is often portrayed online by what appears to be a physical coin, if someone offers to sell you a similar-looking Bitcoin you can put in your pocket, it's best to decline politely.
Some have recently contended that these cryptocurrencies will eventually drop to zero in value. However, it's clear from a recent U.S. Senate hearing that the U.S. Securities and Exchange Commission as well as the Commodity Futures Trading Commission are anticipating that cryptocurrencies will be around for a while and in need of future regulation. There's even a Bitcoin Futures Market for those who are particularly clairvoyant or have unwanted money they need to lose.
You might still have a lot of questions about Bitcoin and similar cryptocurrencies, so here is a brief primer on this new technology.
Q. What makes Bitcoin work?
A. Bitcoin works as a currency because a lot of people trust the idea behind its creation and are participating in the Bitcoin economy. What makes Bitcoin work as a technology is a concept called Blockchain. Blockchain is a method of storing a sequence of information, such as economic transactions, in a way that provides an ongoing record. These records are stored in "pieces" that are spread out over an extremely large number of computers on the internet. Blockchain uses public-key encryption to enable each new block (transaction) to point to the previous one, providing a chain back to the original transaction. A public key (one that can be shared with others) points to the virtual location of a block, while the private key allows access to the actual information stored in a block. Transactions occur over a distributed network, which is a collection and interaction of the many computers that are processing Blockchain records.
Q. How are Bitcoins created and spent?
A. Bitcoins are created and traded for goods or currency via a process called Bitcoin Mining. Mining involves using specialized software and hardware to solve a complex calculation which requires significant computing power. Multiple "miners" can work on a particular transaction, and the one who is first to come up with the solution gets credit for processing the transaction and is also rewarded with some fraction of Bitcoin for their effort. This competitive mining process is meant to ensure that the Bitcoin information is maximally distributed within the Bitcoin network. A transaction can be the creation of a Bitcoin or the transfer of Bitcoins in an economic transaction. However, Bitcoin was designed to have a limited supply, so eventually, the "mine" will be tapped out. However, mining may still be profitable if transaction fees increase or if new computer hardware makes mining less computationally "expensive."
Q. Where would I keep my Bitcoins?
A. In your Bitcoin wallet, of course. A cryptocurrency wallet is a specialized piece of software that stores the public and private encryption keys and can interact with the Blockchain records to support sending and receiving digital currency. The software can run on a desktop, smartphone, or cloud system with local or online storage of keys (sometimes on a USB thumb drive.) Your Bitcoin wallet is as valuable as your real one and has to be similarly safeguarded. Reported Bitcoin thefts have been due to hacks of systems that store the Bitcoin keys and not hacks of the Bitcoin infrastructure itself.
Q. Should I buy some Bitcoins?
A. Are you sure I can't interest you in some Tulip bulbs? While the recent volatility in the Bitcoin market may portend a market bubble waiting to burst, as long as Bitcoin and similar currencies have a functional value, then it would seem they would maintain an economic value as well. For most non-Billionaires of any type, the functional utility would be to be the ability to make economic transactions outside of government currency standards or as a source of funds that is readily available across different national borders.
A Shiny Digital Wrapper
As with currency and markets in general, it seems that the value of cryptocurrencies will ultimately depend upon human behavior. Tulip bulbs still have utility and value, but not as a surrogate currency. Bitcoin's innovation and novelty may have caused an "artificial" rise in its value and perhaps the recent drop we've seen is a market correction. If you were early to the Bitcoin market, then you probably timed things right. It still works to buy low and sell high and to not get blinded by the shiny wrapper.
Editor's Note: See also, "How cryptocurrencies work," August 2017, Benchmarks Online.