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Tam Hunt: Is Bitcoin the Future of Money?

Six years ago, a programmer in Jacksonville, Fla., bought two Papa John's pizzas with 10,000 bitcoin. He traded his bitcoin with a friend who bought the pizzas. It was the first time anyone had used bitcoin to buy anything. At the time of the pizza purchase, that 10,000 bitcoin was worth about $25 — pretty standard pricing for two pizzas.

Ten thousand bitcoin is now worth about $7.5 million, making those two pizzas worth far more than their weight in gold. The global market cap of bitcoin is now more than $12 billion, with a “b.”

So what is Bitcoin, and how the heck did it get so valuable? And is Bitcoin the future of money more generally?

Bitcoin is a type of digital currency or, more accurately, a “cryptocurrency.” Digital currency is to normal money what email is to normal (snail) mail: It’s simply an electronic form of value exchange, but with a key advantage in that most digital currencies are intentionally not linked to any particular country or government.

The king of digital currency today is Bitcoin, created in 2009, shortly after the economic and banking system shocks known now as the Great Recession. Bitcoin was the brain baby of a mysterious person known as Satoshi Nakamoto — his real identity is still unknown. Satoshi posted his 2009 Bitcoin white paper, a document that described how Bitcoin would work, on a well-known cryptocurrency forum. The paper described the architecture and function of the new type of currency that he had invented.

There are now about 16 million bitcoin in circulation. Bitcoin is different than regular money in that there’s a limit to how many can be created: just 21 million. Ever. The idea behind this limit is that the value of this currency can’t inflate away. The dollar loses about 2 percent in value each year because of inflation, and this provides a strong incentive to invest rather than save. Bitcoin is the opposite: It’s designed to always increase in value so simply buying and holding may be a very good investment strategy.

There’s also a limit on how small each Bitcoin can be divided: into 100 million parts. This tiny part of a bitcoin (a particular bitcoin is small b, whereas Bitcoin the technology and platform is Bitcoin with a B) is called a satoshi, in honor of its mysterious creator.

Why buy or use Bitcoin?

Why would anyone use digital currencies? Well, the 2008-09 Great Recession is itself a big part of that answer. Normal money like the U.S. dollar is known as “fiat currency” because it is offered by fiat by the central government and its value is backed by the economic and military power of the state issuing it and the confidence that such power brings. Its value also comes from its ability to be used to pay taxes to the state.

Until 1971, the U.S. government used gold to back the value of money it issued, but President Nixon took the U.S. off the “gold standard” in favor of a new floating system of value in which the value of the dollar is determined mostly by market forces. The market that determines the dollar’s value is the international trading system, of both goods and services that are denominated in dollars but also the trading of dollars themselves for other currencies.

For example, China now holds up to $2 trillion of dollar-denominated assets in reserve in order to pay for goods and services denominated in dollars and as a store of value, out of a $3.5 trillion in total currency reserves. China keeps such a large amount of dollars because the dollar is the primary reserve currency in the world today and has been for some time.

Other reserve currencies include the British pound, the euro, the Japanese yen and, as of this year, the Chinese yuan/renminbi is also considered a reserve currency.

The dollar became the primary reserve currency because of our central role in the global economy, which was won by our large size (more than 25 percent of the global economy after World War II) and our military might that came from being on the right side in World War II, as well as from our continued military dominance in the wake of the collapse of the Soviet Union in 1991.

Since the United States went off the gold standard, the value of our currency has been determined entirely by social and economic acceptance. In other words, the value of the U.S. dollar is based entirely on confidence in the U.S. government and its economy, and on the trust that such confidence instills in the ability of the dollar to retain its value and its use as an exchange currency.

But the Great Recession shook a lot of people into the realization that nothing is written in stone, no economic foundation is entirely firm and even the dollar can of course lose value. Maybe even large amounts of its value. Let’s not forget that the stock markets lost more than half of their value in late 2008.

When the U.S. government agreed to the $700 billion (with a “b”) bailout of major U.S. banks in 2008, plus the Federal Reserve Bank’s trillions in additional support, it became quite obvious that our economic and currency system had some major flaws. This was not, of course, the only economic crisis we’d suffered. Rather, it was simply the latest and most severe since the Great Depression and by some measures it was even worse than the Great Depression.

Satoshi’s new form of money, Bitcoin, arrived in 2009 at an opportune time and many hobbyists, libertarians and electronic tinkerers leaped at the chance to experiment with a new type of currency that didn’t rely on any central bank or any central authority whatsoever for its value or its operation.

The magic ingredient in Bitcoin is the distribution of trust in a vast electronic network that moots the need for the “centralization of trust” that is the function of central banks like the Federal Reserve. Central banks issue money, control interest rates and act as a lender of last resort in fiat currency systems. The distribution of trust performs these roles in the Bitcoin ecosystem and this is made possible with Satoshi’s invention of the blockchain, the heart of Bitcoin.

The blockchain is an electronic record of all Bitcoin transactions that is stored on every node of the ever-increasing network of the Bitcoin ecocystem. Because it is completely distributed and constantly updated in real time, using very difficult cryptographic keys that require massive amounts of computing power, the blockchain, which is the complete ledger or record book of Bitcoin transactions, can never be shut down by any outside force. This fully decentralized system renders Bitcoin as a system practically immune from hackers.

Centralized businesses that are part of the Bitcoin ecosystem can still be hacked, however, and there have been prominent examples of such hacking, such as the Mt. Gox Bitcoin exchange before it folded in 2013, but these incidents do not reflect on the security of the blockchain itself.

In other words, the Bitcoin ecosystem is a way for any person or people using it to avoid the centralized power of central banks and of national governments entirely, in terms of these entities’ ability to affect the value and use of the Bitcoin currency. ABN Amro bank chief said it well in 2015: “What the Internet has done for information and the way we communicate, the blockchain will do for value and the way we look at trust. The financial world is going to flip upside-down.”

Billions of dollars have been invested in various blockchain technology solutions, and it is widely considered the biggest thing in “fin-tech” (financial technology) for decades.

Obviously, the decentralized nature and independence from government influence has appealed to libertarians and techno-optimists since Bitcoin’s creation.

Bitcoin’s growth trends are very positive

Despite its many detractors, its many growing pains and many very public hacking debacles, Bitcoin has continued to grow in all the ways that matter. Blockchain.info keeps stats on key aspects of Bitcoin, and here are some of the key trends:

» The number of bitcoin in circulation has grown from zero in the beginning of 2009 to 16 million now, with only 5 million more to mine (but this will take about a century to complete because mining becomes more and more difficult).

» The Bitcoin price grew from nothing to almost $1,200 at the end of 2013, plummeted to around $200 in 2014, and rose again to almost $800 in the past year.

» Bitcoin’s market capitalization has gyrated similarly, but is now about $12.5 billion and is enjoying a strong upward trend.

» The number of Bitcoin wallet users (required to buy and conduct business using bitcoin) has grown from zero in 2009 to more than 10 million now.

» The computing power around the world used to mine bitcoin has grown from nothing in 2009 to 2.25 million tera hash per second (hashing is a type of computing).

Even with these strong growth trends, Bitcoin still could go belly up and become merely an interesting historical footnote. Even though the Bitcoin network is fully distributed and in principle is all but unhackable, there are many ways that national governments could place major hurdles in its path. And if the United States and China, in particular, working together decided to kill Bitcoin they probably could. Or at the least they could render it a pale shadow of what it is today.

Nevertheless, the key idea behind Bitcoin is that it eventually can reach a point where it can’t be killed and can’t even be interfered with. Despite this dream of massive distribution of power and trust, and independence from national governments, Bitcoin has grown more centralized in terms of how it’s controlled.

One of the prominent early developers of Bitcoin, Mike Hearn, went public earlier this year with a cri de coeur against the direction that the Bitcoin community was moving. He continues to claim that Bitcoin is now controlled by just a handful of people because the large mining operations are now in the hands of a just a few people in China and the United States.

Despite some prominent critics and worries about the size of blocks for completing Bitcoin transactions, we’re still seeing Bitcoin grow in all of the important ways, as described above. While there certainly have been growing pains, it seems that Bitcoin may well continue to grow steadily and get past its current problems.

Other digital currencies?

Bitcoin is not, however, the only exciting digital currency. People are increasingly seeing Ethereum, a newer digital currency, as the future of money. Ethereum’s big advantage over Bitcoin is the degree to which the Ethereum network can support software and smart contracts in addition to the monetary functions that form the core of Bitcoin.

Most observers agree that the key innovation with respect to Bitcoin is the blockchain technology rather than Bitcoin itself. The blockchain is all about the distribution of trust. So even if Bitcoin itself doesn’t break through to the mainstream, it seems likely that some other currency based on the blockchain eventually will.

Will Bitcoin replace fiat currency?

Perhaps the most interesting question, however, is whether Bitcoin will live up to its biggest promise and actually replace fiat currency. How would this happen?

I looked last year at this possibility with respect to China’s currency. As with the success, or not, of fiat currency, the success of Bitcoin as a mainstream currency will be all about confidence. The difference is that Bitcoin’s ability to inspire confidence is all about the system of users, businesses and transaction networks, and not at all about state power and the ability to prop up the value of a nation’s fiat currency with the traditional toolbox available to nations like interest rates, printing money, quantitative easing, military power, etc.

So the ability of Bitcoin or other cryptocurrency to become mainstream is about the currency system itself and not about the power and economic viability of any particular nation. That’s not surprising since this type of libertarian internationalist dream was one of the motivating factors behind Bitcoin’s creation.

It seems to me that Bitcoin may become the mainstream currency in a small nation before a large nation — perhaps a nation like Estonia that is technology-friendly and forward-looking. (And let’s not ignore that the newly created country of Liberland has stated its intention to use Bitcoin as its sole currency, but with its founder banned from this attempt at country creation it doesn’t look like a particularly serious effort.)

Such a transition to Bitcoin may not be voluntary, as I discussed in relation to China in my previous piece. A country’s citizenry may incrementally decide to invest in Bitcoin, despite its government’s official policies, and to use it increasingly for transactions and, over time, bitcoin use may become widespread and begin to rival the official currency in terms of its popularity.

There will be a tipping point in any particular country with respect to the use of Bitcoin or other digital currency. Once a particular critical mass is reached it will likely become ubiquitous practically overnight because the bar to entry is very low in terms of becoming a Bitcoin user, and getting lower everyday as more and more user-friendly ways to use Bitcoin are invented. Once a majority of a nation’s transactions are conducted in Bitcoin, the official currency would probably plummet in value rapidly, despite any attempts by the government to shore it up. And that would further increase the degree to which Bitcoin becomes the preferred currency.

There are still ways, however, for governments to ensure against a Bitcoin “takeover,” it seems, including banning it outright, as some countries have already done, including Ecuador, Bolivia, Bangladesh and a few others. There were rumors that Russia had also banned Bitcoin in 2014, the first major economy to do so, but Russia’s tax agency has made it clear in 2016 that Bitcoin is not illegal in Russia.

It would actually be very difficult for a nation to ban Bitcoin because Bitcoin transactions are all done online and, by definition, as part of a highly distributed blockchain. That said, a country’s authorities could make it very difficult in various ways to conduct business in Bitcoin, including by placing fines or jail time on conducting transactions.

I anticipate that as Bitcoin and other digital currencies continue to grow rapidly we’ll see more and more nations attempt to regulate, control and even ban them.

I can’t offer any firm conclusions about the future of Bitcoin, ultimately — no one can — but my money is on it sticking around for many years and probably becoming ubiquitous. And, who knows, it may even replace fiat currency eventually.

Wait, I can offer one firm conclusion: I’m pretty sure we’ll be able to buy pizza with bitcoin for many years to come.

Disclaimer: Hunt owns a few bitcoin and ether.

— Tam Hunt is a lawyer and a writer based in Santa Barbara and Hilo, Hawaii.

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