What Bitcoin Means For You

Posted by Simon Moore on September 26
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For the average investor, we think ignoring bitcoin is a perfectly acceptable strategy, but for those who are interested, we'll dig in a little more to how Bitcoin works.

How is Bitcoin different?

'Money' has been around for about as long as people have, whether it was a certain type of shells, a certain kind of rock, gold silver, or now, coins and banknotes. So innovation in currency isn't that new, we've had different currencies before even though most of the world is now on banknotes and coins it hasn't always been that way.

Bitcoin is similar in many ways to other forms of money, but also has a few differences. The main one is if you have a five pound note, it is backed by the Bank of England, that used to mean that they would exchange that five pound note for gold if you asked them to. They don't do that any more, but they do aim to keep the supply of notes limited so that the price is fairly stable. Basically, you have one very powerful organisation standing behind the pound.

Similarly, Bitcoin is limited, but not by a central bank, it's a lot more decentralised, there is a guarantee that only a fraction under 21 million Bitcoins will ever be produced, and the rate at which they are produced is slowing over time. This is important, because if Bitcoins were created at a faster rate than demand, their price would fall. Limited supply helps to make sure that doesn't happen.

 

The Blockchain

Bitcoin also uses an important technological innovation called the blockchain. With a banknote there are all sorts of tricks to make it hard to copy them such as serial numbers, transparency, plastics, detailed calligraphy, holograms, metallic threads, colour changing inks and patterns only visible under certain light. The goal is that if you look at any banknote in isolation you can tell if it's real or not.

Bitcoins protects against fraud a bit differently, the proof of ownership is due to a distributed ledger. It's a complicated concept, but its really the heart of how Bitcoin works. The key is using a really large network to store information.

Basically, when a transaction occurs in Bitcoin it is written into the "block" (a block is basically a digital record) and then that block is broadcast to every single party in the network.

That's the novel element. Rather than having one powerful bank (like the Bank of England) behind Blockchain, you have a very large network of computers. No single computer is impressive or powerful in isolation, but they become powerful when used together as a network.

So now, rather than try and forge a single banknote, you would need to try and overwrite information that is stored digitally in different places all over the world. Clearly, you could tamper with a handful of them to try and look like you had more money than you actually did, but that wouldn't work, the network would notice the error and be able to correct for it as the vast majority of machines tracking the transaction would make the difference obvious.

 

The Power Of The Network

So that's really the difference with Bitcoin, it uses the power of the network to make sure that records are accurate by storing them in many different places, rather than having something that can be checked just by looking at it (like a banknote) or something that relies on a few banks tracking the transactions (like the Bank of England).

So Bitcoin takes a different approach to keeping your money safe. It's about making so many copies of every transaction that it's virtually impossible to overwrite them enough of them that you will change the overall record, rather than having a single record of the transaction that's really well protected. Of course, that's not perfect, just like a banknote, your Bitcoin could be stolen if a hacker got access to all your details (which is why having a secure Bitcoin 'wallet' is crucial), but stealing a Bitcoin without access to your details is extremely difficult.

 

A Good Investment?

So, Bitcoin is definitely an interesting idea. Does that make it a good investment? Maybe. It's possible that over time Bitcoin becomes similar to gold in being a store of value that people trust. It's also possible that people find transacting in Bitcoin preferable to paying for things than pounds, dollars or yen. It's early days for Bitcoin.

To complicate things more there are about 900 different crypto-currencies, of which Bitcoin is just one, albeit the largest in value terms right now. So maybe crypto-currencies are the future, but a different one than Bitcoin ultimately dominates.

At the moment an investment in Bitcoin is probably better thought of as speculation - as we've seen it can rise or fall a lot even in a single month. For assets like shares, bonds and gold, we can look back over century to see how they have performed and how they might perform in future. Bitcoin doesn't have that track record yet, it's appears a sound technological idea, but good ideas aren't necessarily good investments.

Written by Simon Moore

He was previously CIO of FutureAdvisor, a US digital advisor. His most recent book Digital Wealth, explains automated investing. He studied economics at Oxford, and completed his MBA at the Kellogg School of Management.

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