Money makes the world go round
Let’s start with a little recap of the money cycle. Basically, you go to work, earn money which gets transferred to your bank. You can then spend that money as you see fit. You can use your credit card or cash to pay for goods and services. You can also invest it, by buying stocks or other securities, which you hope will increase in value in the future.
The fact that a loaf of bread, for example, costs as much as it does, is based on hundreds of factors ranging from the price of wheat on the global market, the availability of bread in a particular area and the purchasing power of the money you are using to buy that bread. Not to be underestimated is the fact that bakers and shops selling the bread also increase the price to factor in their profits.
Everything else around us is regulated by similar rules. Basically the more there is of a given item, the less it costs. That is why diamonds are expensive, and only kind words are free!
|A step above: Money is strongly dependent on the decisions of countries’ central banks, which control the availability of a particular currency. They have a number of instruments available to them which allow countries to control the inflation in the economy. These instruments include controlling the availability of money in circulation (the more money there is, the less valuable it is), as well as adjusting interest rates. If rates are low, people keep less money in banks and spend more. They also take out loans, in turn pumping money into the economy. These small tweaks by central banks (which should not be confused with commercial banks) are all aimed to keep the money flow stable and healthy.|
A new development
At the end of the last decade, as the Western world was observing an increase in banking greed with an imminent global financial collapse, some people started thinking of a way to avoid the repetition of such a situation in the future.
One proposal seemed to gain more popularity than others. It suggested a new currency, totally independent of central banks. A virtual currency which could also be exchanged for real goods and services.
This currency, called Bitcoin, also aimed to solve some of the problems inherent with an antiquated banking system which relied heavily on bureaucracy and a profit-driven system. The currency would be completely decentralized – there would be no single institution which would decide on the future course of the system, sets the price, or issues more or less of a set maximum number of coins.
|A step above: Apart from the name of the currency, Bitcoin is also the name of the structure underpinning the system. Bitcoin is based on thousands of interconnected computers all keeping a database of the transactions within the ecosystem. These machines all keep a log on the flow of currency between one user and another. The proposal by Satoshi Nakamoto says that there will be a total of 21 million Bitcoins which will ever be produced. New Bitcoins are “mined” every ten minutes on average by these computers which work on solving very difficult problems. The number of Bitcoin on the market is growing, but the growth is at such a slow pace (just over 12 Bitcoins every ten minutes added to the pool of some 18 million already in circulation) that the price does not drop against other currencies due to overinflation. Similar to gold, you can mine it, there are costs to mine it, and in 2140 its block reward will drop below 1 satoshi finishing the incentive to mine it. It is limited, similar to gold, making it a store of value, also similar to gold, in a digital form.|
How it works
Simply put, Bitcoin is a currency that can be used to buy things, both virtual and digital. Over the decade it has been around, hundreds of thousands of companies have started accepting it as a form of payment. You can buy hamburgers, plane tickets and pay a DJ performing at your birthday party.
Any just like you go to work to earn money, computers work to earn Bitcoin. They compute difficult equations to “mine” Bitcoin, which the owner can keep, spend, or sell to others.
Unlike other currencies, which are largely only accepted in one country – unlike the US dollar and the Euro – Bitcoin is a truly universal currency. Users of Bitcoin do not need to exchange money when making transactions in other countries, thus saving time and money.
Thanks to the fact that all these connected computers are keeping track of the transactions, the system virtually eliminates problems which are common in traditional financial systems, namely counterfeiting, fraud and other “creative” accounting practices.
Bitcoin can be used as a currency in itself – someone can accept 0.5 Bitcoin for their services, for example – or can be exchanged for local currencies just before payment. The value of Bitcoin – just like the value of other securities, like gold and crude oil, wheat and coffee – is dependent on the exchange rate against the US dollar and any other currencies at any given time.
Take the example of Saudi Arabia, which is sitting on millions upon millions of barrels of oil. If the price of oil on the international markets were to drop to $0.01 per barrel, countries like Saudi Arabia would immediately go bankrupt.
A similar fate is with people keeping Bitcoin in their “wallets”. The Bitcoin itself does not have value in itself, but as long as there are people who are willing to buy it for its market value at the time of exchange, it can be used to buy things.
|A step above: Users keep their Bitcoin in digital “wallets” which are protected by a unique password. They can make transfers to other wallets. Unlike bank transfers, these transactions carry very low fees and are almost immediate, even to users on the other side of the globe. These wallets can be set up by anyone with an internet connection and usually require no identification. The other benefits of Bitcoin include the fact that coins cannot be counterfeit. Each coin can be tracked on the Blockchain – the decentralized database network which keeps track of every Bitcoin transaction. This database cannot be corrupted because thousands of miners all keep a separate copy.|
What’s the point?
Bitcoin and other cryptocurrencies are difficult to understand because they share elements from many other areas. They are like money (because you can use them to buy things), they are like commodities (because people speculate on them by buying and selling to make a profit), and they are also a tool for better financial opportunities.
The market for Bitcoin can be a dangerous one though. Although the price of Bitcoin has increased thousands fold over its lifetime, ultimately its value is dependent on how widely it is accepted and used in the world as a whole.