What is Bitcoin and should you invest in it?

A primer on cryptocurrencies

This is one of the most complicated and confusing and interesting topics I’ve covered. Bitcoin is an electronic asset (think: digital money or digital gold). It is almost nine years old. You can buy bitcoins with “real” money, just like you can buy gold or other currencies with your money. And if you bought a bitcoin today it would cost you three times as much as it would have cost you just three months ago.

So is bitcoin a bubble? Or is it the biggest financial innovation of our lifetime? Or both?

If you are like 98% of people, you don’t really know what bitcoin is. I didn’t. It’s super confusing. SoI decided to do a lot of reading and am beginning to get the hang of it now. This is an introduction. If you read to the end, you get an offer for $10 in free Bitcoin and the chance to give $10 in Bitcoin to the Weekend Reader too.

RECOMMENDED READINGS

1. When Bitcoin Grows Up

by John Lanchester in The London Review of Books (53 min)

If you don’t know anything about bitcoin and want to read just one article, read this one. Lanchester begins by asking and answering the question, What is Money? If that sounds trivial, it’s not. Money is harder to define than you might think. And the way you understand money influences the way you understand Bitcoin.

This article travels from the remote Island of Yap to the heights of Mt Gox in Japan to give you a tour of how wide bitcoin’s influence has spread. He explains a bit about what bitcoin is and how it works and what the problems with it are. A wonderful, and well-written primer you can devour in less than an hour.

Selection
We think of money as being the stuff in our wallets and purses, but most money isn’t that. It’s not notes and coins. In 2006, for instance, the total amount of money in the world in terms of value was $473 trillion. That’s a number so big it’s very difficult to get your head round: about £45,000 per head for all seven billion people on the planet.

Of that $473 trillion, less than a tenth, about $46 trillion, was cash in the form of banknotes and coins.More than 90 per cent of money isn’t money in a physical sense…What it is instead is entries on a ledger. It’s numbers on your bank balance, the electronic records of debits and credits that are created every time we spend money.

2.Bitcoin just surged past $2,000 for the first time

by Jon Russell and Fitz Tepper in TechCrunch (3 min)

This is a quick read, with less analysis, but I wanted to give you a sense of how Bitcoin is being covered as an investment vehicle, and this one had a little more balanced than some of the hater and booster pieces you’ll read.

I also include this piece because it was marveling at Bitcoin pushing past $2,000. The piece was published May 20. Today, three weeks later, Bitcoin was trading at $2,927. Three days later it was at $2200. Whoa, Nelly.

3. Bitcoin: A Peer-to-Peer Electronic Cash System

by Satoshi Nakamoto, found here (15 min)

On Halloween of 2008, a mysterious individual calling himself Satoshi Nakamoto introduced himself to the world. He published this paper and with it launched Bitcoin as an open source platform. Satoshi Nakamoto is a pseudonym. No one knows who it really is. Isn’t that just delicious?

He’s like the Wizard of Oz. Or Kaiser Soze.

This short paper is the thing that launched what is now a $110 billion market for cryptocurrency. Warning: if you are not technical, it turns into a difficult read. But it’s still interesting to take a look (at least for nerds like me).

Selection:
Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model…Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party. What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.

4. A Gentle Introduction to Bitcoin

by Antony Lewis in Bits on Blocks (19 min)

I have to say, this really is a helpful primer on bitcoin. If you read two pieces on bitcoin, make this your second. Lewis has done a nice job explaining what bitcoin is, why people use it, and has a very helpful description, with visuals, of how it works. His bits on explaining the bitcoin ledger and bitcoin “wallets” are particularly helpful.

Selection from the article:
Although people refer to bitcoin as a decentralised digital currency, I prefer to think of it as an electronic asset, to sidestep questions around which government backs it and who sets the interest rate, which are often a mental block in understanding bitcoin.

As an electronic asset, you can buy bitcoins, own them, and send them to someone else. Currently (Sep 2015) there are around 14 million bitcoins that have been created, increasing by 25 bitcoins every 10 minutes or so, with an agreed limit of 21 million, the last of which should be created a little before the year 2140.

5. Money, Blockchains, and Social Scalability

by Nick Szabo in Unenumerated (32 min)

Nick Szabo is one of the usual suspects to be the true Satoshi Nakamoto. From what I can tell he denies it and it hasn’t been proven. Regardless of whether that’s true, he is a person people listen to in this space because he invented bit gold as a precursor to bitcoin. And is an interesting thinker, trained both as a lawyer and a cryptographer.

In this post, Szabo introduces a new (at least to me) mental model of “social scalability” and explains how it is changed by blockchain. Social scalability is the ability of an institution to involve larger and larger groups of people. Szabo argues that the internet so far has been dominated by centralized networks — where Facebook and Uber and Ebay introduce people to each other online, but with the company as the central node. Blockchain technology like bitcoin is a radical shift toward decentralization that will enable a new level of social scalability in online payments and interaction.

Selection:
Without institutional and technological innovations of the past, participation in shared human endeavors would usually be limited to at most about 150 people — the famous “Dunbar number”…

Innovations in social scalability involve institutional and technological improvements that move function from mind to paper or mind to machine, lowering cognitive costs while increasing the value of information flowing between minds, reducing vulnerability, and/or searching for and discovering new and mutually beneficial participants.

Alfred North Whitehead said, “It is a profoundly erroneous truism, repeated by all copy-books and by eminent people when they are making speeches, that we should cultivate the habit of thinking what we are doing. The precise opposite is the case. Civilization advances by extending the number of important operations which we can perform without thinking about them.”

Friedrich Hayek added: “We make constant use of formulas, symbols, and rules whose meaning we do not understand and through the use of which we avail ourselves of the assistance of knowledge which individually we do not possess. We have developed these practices and institutions by building upon habits and institutions which have proved successful in their own sphere and which have in turn become the foundation of the civilization we have built up.”

6. The Quiet Master of Cryptocurrency

Interview with Nick Szabo and Naval Ravikant in The Tim Ferris Show (2 hours, 34 min)

Are you coming down the rabbit hole with me? This podcast is two and a half hours. Let me give you a few highlights.

First, if you don’t know Tim Ferris, he’s an unbelievable, curious, student of life and high-performance. You’ve probably seen one of his books (the first was The 4-Hour Workweek). I also went to college with him, and he was already a legend, teaching people to speed read in between classes. Tim has a terrific podcast I recommend to you.

In this episode he talks with Nick Szabo (See above) and Naval Ravikant, founder of Angellist and one of the most successful investors in Silicon Valley about bitcoin and cryptocurrency. Tim does a nice job of playing dumb, asking questions to get them to explain the basics, then later, lets the conversation roll to some fascinating, more technical topics and applications of blockchain technology.

A few highlights:

• Introductions and the story of how Nick and Naval met. [08:05]
• What is cryptocurrency? [10:47]
• What is cryptography? [12:56]
• What are the benefits of cryptocurrency? [15:44]
• What is a blockchain? [17:43]
• A brief history of currency. [18:51]
• What makes money — including cryptocurrency — valuable? [23:59]
• What is a smart contract? [30:45]
• “Wet” versus “dry” code. [31:44]
• What are ICOs (Initial Coin Offerings)? [41:56]
• What makes Bitcoin unique? [49:50]
• Computational inefficiency and social scalability. [1:00:04]
• What is Ethereum, and what are the pros and cons compared to Bitcoin? [1:12:53]
• What will it take for the more widespread use of Bitcoin (or other cryptocurrencies) among everyday consumers? [1:23:05]
• For which emergencies or possible future events (e.g. “The Singularity”) should we be prepared? [1:58:06]
• What makes certain cryptocurrencies appreciate in value over others? [2:04:50]
• Why Singularity and Simulation hypotheses are mutually exclusive. [2:12:31]

my postscript

The first thing to understand about Bitcoin is that it’s hard to understand. Don’t feel bad if you don’t get it at first. I’ve seen grown men reduced to stuttering fools in the face of trying to get how Bitcoin works. The designer Adam Greenfield calls bitcoin and blockchain “fundamentally difficult for otherwise intelligent and highly capable people to understand.”

The second thing to understand about Bitcoin is that it is money. But what does that mean? It’s not just money you can use in virtual worlds, video games and online gambling (though it is that too). It is also money that, increasingly, you can use in real life. Here’s an interesting series of posts about a woman who lived entirely off of Bitcoin for an entire week. She bought food with it, bought a beer with it. (Note that this was in San Francisco, which may be the only place you can currently live a week using nothing but Bitcoin.)

Let me explain what I mean by the word “money.” Most economists agree that money is three fundamental things:

First, money a medium of exchange. If you make boots for a living and you want to buy a taco, you have to give the taco maker something in exchange and the only thing you’ve got is boots. The problem is the taco maker may be satisfied with his sneakers and not interested in the boots you make. For an economic transaction to work, you’d have to want a bunch of tacos at the same time the taco maker wants your boots. This problem is known as the coincidence of wants. That would be a big coincidence and is unlikely. So you need a medium of exchange that you both value, i.e., money.

Second, money is a unit of account. You use money to measure the value of other goods and services and can compare the value of different goods using a common system. For example, the value of your boots versus the value of boots made by the woman living the next state over can be compared using dollars as a unit of account.

Third, money is a store of value. The boots you are making might retain their value if they are classics. Or if they are trendy, they might go out of style and lose their value. So boots may or may not be a good store of value. Money is a store of value also, in that it can be saved and traded and used later. Whether it is a good store of value depends on what money we’re talking about. The U.S. currency has historically been a better store of value than the Argentine currency. All money stores value, but some kinds do it better than others.

To fulfill these three roles as a means of exchange, a unit of account and a store of value, money often takes the shape of currency. A currency has five main properties. It should be:

1. Divisible: can be divided into smaller units of value
2. Fungible: one unit is interchangeable with another. All versions of the same denomination should have the same purchasing power.
3. Limited in supply / Scarce: If the government keeps printing money it fails as a store of value
4. Durable: can be used repeatedly
5. Portable: can be carried by individuals and transferred to others.

Strange money. The characteristics above could all be used to describe Yen, Euros, and Dollars. On the other hand, those characteristics also describe very different ideas of money. Salt, for instance. Ancient Roman soldiers used to be paid in salt (that’s where the latin root of “salary” comes from). Beads were used as money in many tribal cultures.

In modern times, you could even think of carnival tickets as a kind of money. Think about it. You buy $20 worth of tickets at the children’s carnival. You can use the tickets for rides, games or food. The tickets are divisible, fungible, limited, durable (somewhat) and portable. Within the carnival itself, they serve as a medium of exchange, a unit of account, and a store of value. By this definition, credit card points and airline miles are money too.

The strangest form of money I’ve ever heard of is on the Island of Yap in Micronesia. Milton Friedman wrote a famous paper about the Yapese called, “The Island of Stone Money.” John Lanchester summarizes it also in his article “When Bitcoin Grows Up.” The people of Yap had no metal on their island, so they resorted to stone to make their currency, called fei. Not just any stone. They sailed 250 miles to another island to quarry limestone (which also didn’t exist on Yap) and chisel it into circular forms 1 to 12 feet in diameter. Everyone on the island agreed how much a 1 foot stone was worth versus a 9 foot stone, just like Americans know the difference in value between a penny and a dime.

The person who quarried the stone would put it in front of his house to show he owned it. Because the stones were so big, they were impractical to move, meaning he didn’t need to worry about theft. On the other hand, when he wanted to buy something, it was also impractical to move the stone to the seller’s house. So if he bought something, he and the seller would agree to a price and tell the rest of the village that the stone now belonged to the seller, even though the stone didn’t move. The Yapese got in the habit of simply mentally agreeing who owned the coin. The same fei could change hands five or six or more times and never physically move.

That sounds funny, but that’s how a lot of money works today. Head to Home Depot to buy a sprinkler head. If you’re not paying in cash, you pull out your Visa and you go through a little ritual with a swipe and a signature and at the end of it, you’ve given no physical money to the clerk but you both agree you now own the sprinkler and you’ve both mentally transferred “money” from your account to Home Depot’s. Visa will sort out the details later.

In an Island the size of Yap, everyone knows everyone else, so it’s not too difficult to keep track of who owns which fei at the moment and if someone tries to lie about it, it won’t work. When you get to a city the size of New York, or a country the size of the U.S. or any society large enough that you begin to do business with strangers, this informal trust system doesn’t work. To re-establish trust, the government steps in to create money and enforce its acceptance as a medium of exchange. And businesses like banks and Visa step in to make the exchange easier. We’ve never had a modern economic system of money without the government being in the middle of it.
Until now.

Bitcoin is like money in that it is a medium of exchange, but it’s better than government-issued money because it can be transferred globally, instantaneously, to anyone (Visa and Paypal have restrictions on doing business with some countries, and exchange rates affect cash transfers of government money). It is a unit of account — you can measure the value of goods and services by how much it would cost to pay for them in bitcoin. It is also a store of value — it will hold value over time, but so far the value has been extremely volatile. It has lost 80% of its value more than once.

Bitcoin is an electronic asset that is a little like currency and a little like gold. Like a currency, bitcoin is durable (it’s digital so it doesn’t wear out, fungible (and bitcoin is like any other), divisible (it’s not physical, it’s just a number so it’s easy to divide), scarce (only 21 million will ever be created), and portable (in fact it’s the most portable currency because it isn’t physical at all!).

On the other hand, Bitcoin’s long-term value growth has been phenomenal. The first transaction made with Bitcoin was buying a pizza for 10,000 Bitcoin. Now a single Bitcoin is worth $3,000 dollars. In other words, if the pizza maker hung onto his Bitcoin, the proceeds from the sale of that pie would be worth $30 million.

Bitcoin is also a little like gold. First Gold is scarce — there’s a limited supply. Bitcoin is also scarce — only 21 million Bitcoins will ever be produced (according to Satoshi’s rules). Note, this is very different from US Dollars, which can be printed at will by the Federal Reserve and is the main reason gold values are often inversely correlated with dollar-denominated assets. If the government prints more money, that means dollars are worth less and gold will be worth more, thanks to simple supply and demand dynamics. Second, Gold is hard to counterfeit. So is bitcoin. Bitcoin may be impossible to counterfeit because of blockchain technology. More on that in a minute. Third, Both Gold and Bitcoin have to be “mined.” Again, more on that later. Fourth, like gold, Bitcoin isn’t controlled by any one central bank. That means both gold and Bitcoin are a hedge against fiat currencies. That’s a good investment if you are in a place like India where the government recently demonetized 86% of all currency in circulation.

So, wait, what is Bitcoin?
Bitcoin is a cryptocurrency based on blockchain technology. Bitcoin is the oldest and largest cryptocurrency but it’s not the only one. The last count I saw was over 700. And some of the others, like Ethereum, are multi-billion dollar networks in their own right.

Oh, cool…uhh…what is cryptocurrency? Cryptocurrency is “a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank.” It is digital, meaning the money is really code instead of physical coins. The transfer of funds and generation of funds is done by cryptographic techniques. The particular cryptographic technique is called blockchain.

Nice. Yeah. I love that one…Remind me what blockchain is again?

Go back and read the articles I recommended. I needed to read this stuff 5 or 6 times before I really got it. A quick summary is that Blockchain is a method for verifying transactions via a distributed ledger. Imagine an all-knowing accountant kept a magical spreadsheet that recorded every single transaction in an economy. In the economy of Bitcoin, that’s what happens. But it’s not just one accountant keeping a centralized ledger. Think of it more like a Google spreadsheet that is simultaneously updated by computers around the world. That’s what it is. And if you’re willing to invest the money, you could install the software that tracks and verifies the transactions on your own computer. If you do, you’ll get a copy of every transaction that’s ever happened in Bitcoin.

The way I’d summarize it, blockchains are defined by 4 attributes:

1. The keep a permanent record
2. They allow for anonymous transactions
3. They operate in a decentralized peer-to-peer network
4. They are secure

1. Permanence
Think of the difference between Etch-a-Sketch and a fly trapped in Amber. Yes, that’s what I want you to think about (Thanks to Naval Ravikant and others). With an Etch-a-Sketch, you draw something and, whenever you want, you can erase it by shaking the screen. That is what financial transactions are like with credit cards: they can be reversed and they can be erased.

You’re familiar with a fly in amber looks like, from Jurassic Park if nothing else. A fly lands on some tree sap and gets stuck. More sap flows and coats the insect. The sap hardens over time and the fly is stuck forever. Some insects have been preserved for thousands of years that way. Similarly, Bitcoin transactions are preserved forever in encrypted blocks of digital amber. So you have a permanent, perfect record of what happened.

This turns out to be useful for all sorts of purposes beyond simple monetary transfers. Imagine keeping records of refugee identities in the blockchain, to help them establish who they are and get credit. This is happening today. Imagine property ownership titles being kept in the permanent registry of a block chain. I have a friend in New York who just bought property in the city and had to parse through old legal titles from the turn of the 20th century. What a mess.

2. Anonymity
Because the transactions in blockchain are all encrypted, they allow for anonymity like no other financial system. Of course, this has led many bad actors to use Bitcoin for secure, but illicit activities — buying drugs, guns and other things on dark web networks like The Silk Road. But the promise of blockchain for the rest of us is that we might have a technology to reclaim our privacy from the corporations and governments that are watching and tracking an increasingly high percentage of our daily lives.

3. Peer-to-peer
Blockchain came out of a philosophy of techno-libertarianism that sought to put individuals, not institutions, in control. There is no central administrator designed in the system. The Bitcoin software is open source and is shared among computers across the world.

When I buy something with Bitcoin, “a payment instruction is sent to the network. The computers on the network validate the instruction and relay it to the other computers. After some time has passed, the payment gets included in one of the block updates and is added to The Bitcoin Blockchain file on all the computers across the network…The distribution of data works on a peer-to-peer basis, rather than client-server. Peer-to-peer is like a gossip network where everyone tells a few other people the news (about new transactions and new blocks), and eventually, the message gets to everyone in the network.” (from A Gentle Introduction to Bitcoin).

4. Secure
Blockchain networks are the most secure way possible today to store and transmit information (and in some cases the information is money). First, the information is all encrypted. When you buy bitcoin, the thing you get is a 64-character “key.” It’s like a password but it is encrypted and, if you lose it, you can never get it back (there are stories of people who threw away old laptops only to discover that their bitcoin keys were stored on there and they had no way of getting them back). Second, because the blockchain ledger isn’t stored in a single database, but is spread across computers all over the world, it isn’t so vulnerable to a hacking attack as centralized networks are.

Okay. I’ve taken all this time to explain what Bitcoin and blockchain are, and haven’t gotten to the key question: should you buy some?

Ahh! this post is already so long and it’s the end of the weekend. And there is so much more I want to share about blockchain and other applications for it — from smart contracts to the end of venture capital, to the end of Wall Street. I’ve read people suggesting that 50 years from now, blockchain is going to be studied like physics is today. The implications of cryptocurrency and blockchain growth are massive — for insurance, for churches, for recruiting and hiring in all businesses. This could be as big a disruption as the internet itself. I’ll get there in a future post. But it’s too much to share now.

But I have to say something! Well, I’m not a financial advisor, so this ain’t advice. I can just tell you that I decided to buy some today. There’s a chance it becomes worth nothing. I haven’t gotten to tell you about some of the serious problems with Bitcoin’s governance. It’s real. On the other hand, there’s a chance that Bitcoin and other cryptocurrencies continue to grow exponentially for years to come and that my small investment multiplies like nothing else and makes a tone of money.

I decided to invest in bitcoin as a way to learn about it. You don’t have to speculate on Bitcoin as an investment. You can just try it to use it to buy other things and learn about this radical technology. Kind of like when I first tried Snapchat. It was awkward and uncomfortable but “you can’t know what it’s like to pick up a cat by the tail by just reading.” Some things you only know by doing.

I picked an amount of money that I would care about (to incentivize me to pay attention) but that I would be okay losing (because this isn’t an asset class to park money you need to count on). The result so far? I was up 2.5% the first day and I expected there will be a serious market correction at some point. Within 72 hours it dropped nearly 30% in value. But I still think the long-term prospects are pretty interesting, so I may buy more. Or I may cool my jets.

Let me make you an offer: you can learn about bitcoin and support the Weekend Reader at the same time — in a single act. If you buy at least $100 worth of bitcoin at Coinbase through the link below, you will get $10 in free Bitcoin for your account and Coinbase will contribute $10 of Bitcoin to The Weekend Reader. Free money for you. Free money for me. Not too shabby.

I read a lot of reviews on Bitcoin platforms and used Coinbase myself because they have one of the best available. It took me less than 10 minutes to set it up. Please don’t invest anything that you can’t stand losing. But if you are interested, click and check it out.

The best way to learn is by doing. Here’s the link for the bonus:
https://www.coinbase.com/join/593d45bea1fa56869b1d510e

More to come on this topic in future weeks. We’ll take a breather next week for a different topic.

Until then,

Read widely. Read wisely.

about the weekend reader

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