What is Bitcoin?

It is next to impossible to avoid hearing or reading about bitcoin. Within the past decade, it has gone from being a fringe idea proposed in a paper written by a mysterious author, to being a mainstream technology that some people are treating as a new asset class. Bitcoin is now getting attention from the media, individual investors, and even large financial institutions.

As bitcoin continues to surge in both popularity and price, investors will naturally wonder if they should own some. This is an important question to ask, but to frame the decision about owning bitcoin, we first need to know what Bitcoin is.

In this episode of Common Sense Investing, I’m going to tell you a thing or two about bitcoin.

Bitcoin is a cryptocurrency.

Cryptocurrencies are a relatively new technology that has emerged within the past decade. Unlike traditional currencies, cryptocurrencies do not rely on a central issuing body or sovereign government. Instead they rely on blockchain technology. The blockchain is an open, distributed ledger that records transactions in a way that is public, verifiable, and permanent. While there are now countless different cryptocoins available, Bitcoin was the first, and it continues to be, by far, the largest cryptocurrency by market capitalization.

You can buy bitcoins using traditional currencies, or you can mine them. Mining means receiving newly created bitcoins in return for using your computer power to compile recent transactions into new blocks of the blockchain by solving a complex mathematical puzzle. There is a finite supply of bitcoin, with a total of 21,000,000 that can be mined. More than 16,000,000 of those are currently in existence.

For a long time, cryptocurrencies were pretty obscure, and mostly popular within a very niche crowd. More recently,  the sharp increase in the market value of bitcoin and other cryptocurrencies like Ripple, Litecoin, and Ethereum has contributed to intense attention from the media and investors.

Being such a new technology, it is challenging to draw evidence-based conclusions about what bitcoin is. We can try to work around this issue by finding things with longer histories that bitcoin might share characteristics with. On his blog, Aswath Damodaran, a professor of finance at NYU, explains that things can fall into one of four groups: a cash flow generating asset, a commodity, a currency, or a collectible.

Damodaran goes on to explain that Bitcoin is not an asset, since it does not generate cash flows. It is not a commodity, because, at least for now, it is not raw material that can be used in the production of something useful. This leaves currency or collectible, and of the two it is most likely that bitcoin could be classified as a currency.

A successful currency needs to be three things: a unit of account, a medium of exchange, and a store of value.

As a unit of account, bitcoin is as good as anything. As a medium of exchange, bitcoin is still far being accepted as mainstream for transactions, and where it is accepted transaction costs are high. Bitcoin has struggled as a store of value due to its significant price volatility. While bitcoin has room to improve as a currency, we might be able to look at it through this lens.

There is one other currency in particular that draws comparisons to Bitcoin: gold. Gold would be considered a currency, not a commodity, because its value comes from its currency-like functions, not its use as a raw material to produce something useful. Like Bitcoin, the amount of gold that can exist is finite. As a currency, gold also has high transaction costs, and a volatile price. It seems like Bitcoin could be a digital substitute for gold.

But not everyone agrees.

In a Medium post, Adam Ludwin from Chain, a company that builds cryptographic ledgers, explains that he views bitcoin not as a currency, but as a new asset class altogether. He does not think that cryptocurrencies should draw comparisons to traditional currencies because their use case is so much different. Ludwin explains that in much the same way that that stocks and bonds serve public companies, cryptocurrencies serve decentralized applications.

A decentralized application is service that no single entity operates due to its utilization of the blockchain. Ludwin explains that, in general, a decentralized application allows you to do something you can already do (like make payments, in the case of bitcoin) but without the need for a trusted central party. The growth and acceptance of decentralized applications could mean enormous growth in the value of the cryptocurrencies that serve them.

Damodaran believes that bitcoin can take one of 3 paths in the future:

It could become the global digital currency, in which case it’s high price could be justified.

It could become like gold for millennials, a seemingly safe place for those who have lost faith in centralized authority. In this case, the price would fluctuate, much like gold does.

Lastly, it could prove to be a 21st century tulip bulb, a comparison to a speculative asset that soared in the 1600s before collapsing completely.

I have just told you that bitcoin can draw comparisons to traditional currencies like gold, but it could also end up being a whole new asset class if decentralized applications take off. Interesting, right? I know I haven’t answered what you’re really wondering. Should you invest? I will be talking about that in my next video.