Hey everyone, we’re going to continue with this Finance Fridays which is outside “The Philosophy“. We’ve talked about Taxable Accounts, Tax Efficiency, and Dividend Stocks. So as promised, I’m going to talk a little about Cryptocurrency (Bitcoin) today.

Stock Photo from: Pixabay

What is Cryptocurrency (Bitcoin)?

First things first, Cryptocurrency and Bitcoin aren’t the same thing, although people tend to use them interchangeably sometimes. Bitcoin is the “first” and “prototypical” cryptocurrency, but not the only one. I choose my title to include both because people tend to think of them as one and the same and search for both.

I will try to explain in the way I understand it.

This may be an oversimplification, but this is just how I understand it.

Cryptocurrency is a type of currency, like the US Dollar or the British Pound. However, it’s “crypto” meaning it doesn’t actually exist as a tangible object.

However, the US Dollar and British Pound are considered “centralized” currencies, meaning there are boards in place which can control supply and amount of units in print. For example, for America, the United States Federal Reserve System controls the supply of the US Dollar.

Cryptocurrency is a “decentralized” currency. There is no company or board or entity which can produce new units. No system is in place to set an official “asset value” on it.

Wait.. isn’t that kind of crazy?

Well yes. You are placing value on an item which does not have an official value. However, if you step back you’ll see it’s not as crazy as you may think. The United States Dollar used to have gold backing its value until around 1933. Then back in 1971 under Nixon, there was a cancellation of the direct conversion of the US Dollar into gold.

You might ask yourself “What backs the US Dollar then?”

The answer is: Nothing.

The only thing backing the US Dollar is the belief that it is worth something. Or as the US Treasury says:

“Federal Reserve notes are not redeemable in gold, silver or any other commodity, and receive no backing by anything This has been the case since 1933. The notes have no value for themselves, but for what they will buy. In another sense, because they are legal tender, Federal Reserve notes are “backed” by all the goods and services in the economy.”

So, in that sense, cryptocurrency and the US Dollar aren’t all that different.

It gets kind of difficult to understand here, so I will try to simplify:

In order to use digital cash, you need to make sure that each transaction only occurs once. This entity is called “double-spending“. Normally, this occurs through a central server. This central authority makes sure that “double-spending” does not occur.

However, in cryptocurrency with a decentralized network, how can you make everyone in the network agree. Not even one person in the network can be “off”. Everyone must agree otherwise the system breaks down. In other words, not just a consensus, but an absolute consensus – in other words, unequivocal agreement. This was the major problem.

How can you achieve absolute consensus without a central authority to make the absolute decision? It didn’t seem possible…

Where did Cryptocurrency come from?

No one knows whether it was created by an individual or a group. However, the name of its creator is “Satoshi Nakomoto“. We will refer to Satoshi as a “him”.

Satoshi Nakomoto created “bitcoin”, the first cryptocurrency and devised the first blockchain database. The idea of achieving absolute consensus without a central authority is from him.

The key part of Cryptocurrency (or any currency) is establishing “the record” of transactions. For example, you pay your Bank to do this for you in a normal centralized currency like the US Dollar. Also you pay your bank for taking care of your money for you.

However, for a decentralized currency, there is no central figure. Everyone in the ecosystem confirms the record of transactions. The single most important part is not the transaction itself, but the actual confirmation of the transaction. Once the transaction is confirmed, it it essentially written in stone (added to the blockchain).

That said, only a “miner” can confirm transactions. Every time a miner confirms a transaction, they receive payment, in cryptocurrency, such as Bitcoin.

Can I become a miner?

Sure. Nothing is technically stopping you from becoming a miner.

However, Satoshi, in his infinite wisdom, did not make it easy. He set a rule that in order to be a miner, you needed to provide a “hash” to connect the new block of the transaction to the blockchain. The creation of a hash can vary with different types of cryptocurrency. However, the prototypical cryptocurrency, Bitcoin, uses a SHA-256 Hash Algorithim. Not only that, since there is only a limited amount of Bitcoins available to mine every 10 minutes, the difficulty will increase depending on how many miners there are.

Long story short, you will need a ton of computing power in order to do this efficiently. Also, because of the amount of power needed, you will need to evaluate whether the cost of electricity is worth it or not. Most likely you will also need to join a “mining pool”, a group of miners (and you) who share their computing power when a block comes up. There are whole websites dedicating to coin mining, but I’m not going to go into it here. My TL;DR for mining is that it probably isn’t worth it unless you’re getting your electricity for cheap (or free).

I feel more confused than when I first started reading this…

That’s understandable.

The concepts become even more hazy as you go farther down the rabbit hole. For example, some currencies have their own sub-currencies. Some currencies can be bought relatively easily, like Bitcoin or Etherum, which are the two “major players” nowadays. However, some others can only be exchanged from Bitcoin, etc. Then certain cryptocurrencies have done a “hard fork” which invalidate certain prior transactions and create a divergence in the blockchain. For example, Ethereum had one recently in 2016 after a hack occurred.

And to be honest, this is all new stuff. There are few (if any) rules to this stuff right now. There is no central authority, and as of right now there is little (if any) government oversight. So then… people are just kind of making things up as they go along.

In my opinion Cryptocurrency is the highest stakes of gambling.

You are going to see all this stories about people who bought Bitcoin back in 2009 when it first came up, and all of the sudden those shares are worth a million dollars.

Like this guy who bought pizza with Bitcoin.

Or this dude, who is worth $25 million.

To be honest, I almost bought Bitcoin twice.

The first time was back in 2010-2011 as a poor resident eating ramen. I had just started learning about investing/retirement back then when a friend of mine mentioned it to me. I almost bought some of it back then, but didn’t…  because… why would I invest in something I didn’t understand?

The second time was back in 2013 when I was first year attending and didn’t have access to the company 401k yet. I thought maybe I should just throw like $10k at Bitcoin and see what happened since it was still around. It didn’t sound like a scam anymore. However, I opted to save that money since I wanted to buy a house.

I haven’t done the math, but I’m sure both of those bets would be worth a pretty penny right about now. However, I could have lost it all too.

Hindsight is always 20/20.

Everyone remembers what they “could have made”, but no one thinks about how much they “could have lost.”

What do you think?

I’m still learning, just like you guys. A colleague of mine finds this stuff intriguing, and he’s educated me a bit. In turn, I’ve read up on it a bit more to try to understand it and yet I still don’t have a great grasp of things. However,  there are now over 900 different types of cryptocurrency. At this point in time, all the different types are trying to find “their niche”.

In my (humble) opinion, I don’t think cryptocurrency is going anywhere, but I also don’t think there will be “one currency to rule them all”. I think we will see multiple currencies rise to the top over the next 5-10 years. The question is, which ones will they be? Also, which cryptocurrencies will cease to exist in the next 5-10 years.

This is high risk, high reward stuff.

When you break it down, it’s just like betting on horse racing:

Pick your horse and hope for the best… but once again, only gamble with what you are ok losing.

2010-2011 and 2013 still sit on the back of mind… maybe I should gamble? (Just a little?)

TL;DR

Cryptocurrency is interesting stuff, and I’m still a novice.

However, in my opinion, after all the high tech crypto talk, it all boils down to horse racing:

Pick your horse and hope for the best…

… but once again, only gamble with what you are ok losing.

2011 and 2013 still sit on the back of mind… maybe I should gamble again? (Just a little?)

I’ll talk about some “other horses” next week and may even discuss “my picks”.

Sensei’s note: I don’t own any cryptocurrency currently. However, I may “pick a horse” as part of a “Let’s Gamble” Finance Fridays segment.

I think it would be fun to buy some cryptocurrency and not touch it for 20 years. I would just update everyone on my blog every few months about where it is.

What do you guys think?

-Sensei

Agree? Disagree? Questions, Comments and Suggestions are welcome.

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