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An Everyman's Guide To Understanding Cryptocurrencies

What are they exactly? Why consider owning them?
Friday, June 10, 2016, 5:51 PM

When an asset rises by almost 30% in a few weeks, it tends to attract attention.  Recently, that asset was bitcoin (BTC). The price of BTC in dollars rose from $454 on May 23 to $590 on June 6th.

When an asset doubles in a matter of a few months, it tends to attract attention.  The cryptocurrency Ether (part of the Ethereum platform) doubled from around $7 in April to roughly $14 in early June.

Are these cryptocurrencies mere fads? Or are they potentially game-changing alternatives to the conventional currencies such as the U.S. dollar, Chinese RMB, Japanese yen or European Union euro?

There’s no lack of skeptics and critics of bitcoin and other cryptocurrencies. For example, “National currencies aren’t as Centralized, and Bitcoin isn’t as Decentralized, as you think.” (Source)

There are plenty of defenders of cryptocurrencies as well, for example this response to the article above. 

The controversy is understandable; bitcoin has had a difficult adolescence. After soaring from $15 in early 2013 to over $1,000 in December 2013, the cryptocurrency crashed to $215 in early 2015 in the wake of the bankruptcy of a major exchange (Mt. Gox) that cost bitcoin investors $470 million in losses.

Yet despite concerns about security, criminal use and volatility, cryptocurrencies have proliferated at a dizzying pace, and new models such as the “smart contracts” of Ethereum have been developed.

So what are those of us who can’t follow the technical arguments supposed to make of all this? For that audience, here's my stab at making sense of the potential global role of cryptocurrencies.

Cryptocurrencies Are Digital Currencies That Are Not Issued by Governments

What’s a cryptocurrency? Wikipedia’s definition is “a medium of exchange using cryptography to secure the transactions and to control the creation of new units.” Cryptocurrencies exist only in the digital realm; there are no physical coins or paper notes.

Cryptocurrencies have no intrinsic value. They share this characteristic with fiat currencies issued by governments/central banks:

“Fiat money is currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. Fiat is the Latin word for “it shall be.” (Source)

Though major central banks own gold, the currency they issue is not “backed by gold,” i.e. it cannot be converted into gold upon demand.

The value of fiat currency is a function of supply and demand. There are many sources of demand for currency: governments demand taxes be paid in their fiat currency, for example, and this creates demand for the currency.

There is however only two sources of supply: the central banks of nation-states (or regional unions like the Eurozone) and private banks in fractional reserve money systems that enable banks to create new money via issuing new loans.

In a fractional reserve banking system, if a bank has $10 in cash deposits (i.e. in reserve), it can issue a new loan of $100. This loan is new money that was created out of thin air. When the loan is paid in full, this new money disappears from the system.

When central banks or states issue new currency in excess of what the economy is actually producing, the supply overwhelms demand and the currency’s value (i.e. purchasing power) falls accordingly. Venezuela offers a present-day example: the official exchange rate of the Venezuelan bolivar is 10 to the U.S. dollar (USD), but the “street”/black market value is closer to 1,000 to 1 USD. (My correspondents in Venezuela report that it is illegal to post the black-market exchange rate on a website.)

Governments typically restrict alternative currencies to protect their monopoly on money issuance: residents must use the government-sanctified currency or face prosecution and prison.

The U.S. government has declared bitcoin is a commodity (i.e. property) rather than a currency. Other nations have banned bitcoin (presumably out of recognition that it is an alternative currency outside their control.)

Why does bitcoin have any value at all? There are two basic reasons:

  1. The supply is limited.  The design of bitcoin limits the total number of bitcoins to 21 million. (If you really want to know why this is so, you’ll need to understand the blockchain and bitcoin mining, topics that are beyond the scope of this article.) At present, there are over 15.5 million bitcoins in circulation, roughly three-quarters of the eventual issuance of 21 million.
  2. There is demand for bitcoin precisely because it is outside the control of governments/central banks and cannot be devalued at will by governments/central banks.

Why Fiat Currencies Are Being Devalued

Why are most governments/central banks trying to devalue/depreciate their fiat currencies? After all, devaluing the currency reduces the purchasing power of everyone who holds the currency, meaning that the currency buys fewer goods and services. This loss of purchasing power makes everyone who must use the currency poorer.

Why do governments/central banks pursue a policy that makes their citizens poorer?

There are two primary reasons why governments seek to devalue their currency:

  1. To make the nation’s exports cheaper, i.e. more competitive, in the belief that expanding exports will make the overall economy grow, despite the fact that devaluing the currency makes imports more expensive, hurting everyone who buys imports.
  2. To make it easier for debtors to service their loans. As our currency loses its value, we experience that loss of purchasing power as inflation: the prices of goods and services rises as the purchasing power of the currency declines. Governments/central banks presume that wages will rise along with the prices of goods and services. This rise in wages will make it easier for debtors to service their debts, i.e. make their monthly payments. In a system that depends on the expansion of debt to fuel consumption, making it easier to service existing debt is of critical importance: if debt becomes more difficult to service, debt expansion slows and so does consumption. As consumption slows, the economy slides into recession.

As their currency is devalued (by intention or by unintended consequences), the great problem for many people will be transferring their remaining financial wealth out of depreciating currencies into a more stable currency or into assets in a more stable nation.

The Role of Cryptocurrencies in Capital Preservation

This is where cryptocurrencies have a role that could increase as global currencies are devalued: if you can shift financial wealth out of a currency that is losing purchasing power into a cryptocurrency that is holding its own or even gaining in purchasing power, it would be irrational not to do so.

What advantage do cryptocurrencies have over other stores of value such as gold, silver or cash? All of these traditional stores of value have advantages—portability and universal recognition that they are money—but they cannot be transported across the globe quite as easily as digital currencies.

Though it is a topic of hot debate, many observers believe it is technically difficult to the point of impossibility to stop people from buying, selling and sending cryptocurrencies because currencies such as bitcoin live in a network that is scattered around the globe—a network that can be accessed by anyone with a web browser.

While local exchanges could be shut down by governments, and businesses could be prohibited from accepting cryptocurrencies, stopping people from logging onto servers sited elsewhere is a bigger challenge. (Many governments have outlawed cryptocurrencies, though their success rate in stopping their citizenry from owning/using cryptocurrencies is unknown.)

The rise in daily transactions in bitcoin suggests an expanding base of users globally.

In Part 2: Will Cryptocurrencies Soar As The Global Economy Falters? we explore the potential demand for cryptocurrencies as a means of transferring and preserving capital, and the potential impact of these capital flows on valuations of cryptocurrencies.

As governments actively devalue their currencies (thereby making everyone using the currency poorer), their citizenry with financial capital are forced to seek ways to move their at-risk wealth into other currencies or assets. And as the stability and valuations of cryptocurrencies increase, the potential for a self-reinforcing feedback loop increases: as the value of cryptocurrency rises, it attracts more capital, which pushes prices higher, and so on.

Are we in the infancy of a global stampede into cryptocurrencies?

Click here to read Part 2 of this report (free executive summary, enrollment required for full access)

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17 Comments

jussaumm's picture
jussaumm
Status: Member (Offline)
Joined: Feb 16 2016
Posts: 14
Basic Question

The piece states, "In a fractional reserve banking system, if a bank has $10 in cash deposits (i.e. in reserve), it can issue a new loan of $100. This loan is new money that was created out of thin air. When the loan is paid in full, this new money disappears from the system."

With a loan repaid, does that total money act as a larger reserve to lend against or does it "disappear" as stated? For example, if a bank starts with $10 and lends $100. When the loan is repaid, does the bank have $100 as a reserve to now lend $1000?

Thank you. 

 
charleshughsmith's picture
charleshughsmith
Status: Platinum Member (Offline)
Joined: Aug 15 2010
Posts: 634
Steve Keen's explanation

Good question. I am relying on my understanding of Steve Keen's explanation, but Chris might have a better explanation than I can manage. As I understand it, the money disappears from the bank's ledger and from the money supply. If the bank retained some of the earnings from interest paid on the $100, it may have increased its assets/cash on hand as a result of interest paid on the loan, but the principal paid cancels out the loan.

jtwalsh's picture
jtwalsh
Status: Gold Member (Offline)
Joined: Oct 1 2008
Posts: 260
Out of the Dark

Charles:  Thanks for taking on this topic.  I have read about Bitcoin for several years now but have never been able to wrap my brain around the concept as to how it works. Your two postings have helped.

One question that may reveal my total ignorance in this subject, but here we go:  You gave examples of bitcoin's up and down prices over the last few years.  What is the mechanism for setting the price?  Is there a market, or some index, like the Dow, which would let anyone know the value of a bitcon in dollars, or euro's at any given time

JT

Grover's picture
Grover
Status: Platinum Member (Offline)
Joined: Feb 16 2011
Posts: 742
Am I rich?

A rich, eccentric uncle just died and willed me 1,000 bitcoins. Am I rich?

The wallet was encrypted, but the password died with him. Am I rich?

If/when the internet breaks down, will bitcoins be worth anything? I see bitcoins as a useful short term currency. If I were in some oppressed region of the world and wanted to get out of there, I would sell everything and buy bitcoins with the majority of my assets. Once in my new country, I would liquidate enough bitcoins to establish myself. Depending on the situation, I'd likely liquidate them all. Would I keep some for speculating? Who knows.

Why? I would create a complicated password that would be based on an easy to remember formula. I wouldn't write down either of these (because that paper can be stolen or lost.) I did that with some photos in a ZIP file once. Wish I could remember the "easy to remember" formula I used.

Grover

charleshughsmith's picture
charleshughsmith
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Posts: 634
bitcoin price

JT, there are websites with real-time prices--http://www.coindesk.com/price/ .  I've even seen sites that show the blocks being traded, so it is a 'real market' that's setting the price, as far as I can tell.

Grover, your point is very important. One link in part 2 is to a story that suggests up to 35% of all BTC in existence are lost due to things such as you mention--hard drives blew up, people forgot their password, etc. 

If you leave the bitcoin in your wallet, you can't lose the password, but then if the exchange gets hacked, your BTC maybe vulnerable. there is no ideal solution to security in either the digital or the material realms.

Nate's picture
Nate
Status: Platinum Member (Offline)
Joined: May 6 2009
Posts: 558
good quote

At Mauldin's 2016 Strategic Investment Conference, James Grant said "My favorite currency is gold. I'm going to give the digital currencies 2000 years prove themselves."

Makes sense to me.

 

 

JohnShippen's picture
JohnShippen
Status: Member (Offline)
Joined: Feb 16 2012
Posts: 16
Offline wallet

Trezor provide a storage device that enables you to cold store coins away from the Internet and risk of hacking. The likes of Xapo also provide very secure cold storage. 

Not having a modest position in BTC is nuts. It's a cheap call option of a revolutionary technology. 

 

 

reflector's picture
reflector
Status: Gold Member (Offline)
Joined: Aug 20 2011
Posts: 264
the halvening is coming

the bitcoin block reward halving (aka "the halvening") is less than 1 month away, expected to land on july 10:

http://www.bitcoinblockhalf.com/

basically this means that the supply of new bitcoins coming on to the market will get cut in half. some speculate that it will result in a jump in price. some will try to front-run that new market dynamic.

i've decided that the large potential upside outweighs the downside risk, especially with how bitcoin price has been rapidly trending higher last couple weeks.

 

 

reflector's picture
reflector
Status: Gold Member (Offline)
Joined: Aug 20 2011
Posts: 264
dup

.

 

 

charleshughsmith's picture
charleshughsmith
Status: Platinum Member (Offline)
Joined: Aug 15 2010
Posts: 634
a $70 jump since this was published...

OK so the price of BTC just jumped $70 since this was published...from $580 to $650. I just want to assure everyone I did not manipulate the price higher to make the essay appear prescient.

KugsCheese's picture
KugsCheese
Status: Diamond Member (Online)
Joined: Jan 2 2010
Posts: 1409
charleshughsmith wrote: JT,
charleshughsmith wrote:

JT, there are websites with real-time prices--http://www.coindesk.com/price/ .  I've even seen sites that show the blocks being traded, so it is a 'real market' that's setting the price, as far as I can tell.

Grover, your point is very important. One link in part 2 is to a story that suggests up to 35% of all BTC in existence are lost due to things such as you mention--hard drives blew up, people forgot their password, etc. 

If you leave the bitcoin in your wallet, you can't lose the password, but then if the exchange gets hacked, your BTC maybe vulnerable. there is no ideal solution to security in either the digital or the material realms.

Ah...use a password manager and keep copy of password in safety deposit box so estate manager can access in event of death etc.

charleshughsmith's picture
charleshughsmith
Status: Platinum Member (Offline)
Joined: Aug 15 2010
Posts: 634
excellent suggestion!

excellent suggestion, not jjust for BTC but for brokerage accts, bank accts etc. And don't forget the combination to the gold safe and the keys to the security deposit box...

tjh6030's picture
tjh6030
Status: Member (Offline)
Joined: Sep 17 2012
Posts: 1
In a fractional reserve

In a fractional reserve banking system, if a bank has $10 in cash deposits (i.e. in reserve); a de facto limited supply, it can issue extend a new line of credit (loan) of representing a value equivalent to $100 in cash deposits. This loan is new money credit that was created out of thin air by contractual agreement between the bank and its customer.  When the loan (contract) is paid in full with legal tender cash or satisfied as per the lawful contract, this new money the credit balance disappears  is reduced to zero from the system over time.

glddst's picture
glddst
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Posts: 7
lending debt money into existence

"Fractional reserve banking" is at best spin, since equity has been what banks must have to allegedly back deposits, since decades ago:

Just look at any bank's balance sheet (assuming they're a ballpark close to reality). (Not to mention  essentially negligible FDIC "reserves.")

Since the ancient debt money scheme for the confiscation of wealth ever automagically transfers wealth from the many to the few,

the wealthy and their bankster henchmen must spin the con to keep victim masses from noticing they're continually being fleeced

 – as US colonists well understood:

hence, it took the schemers over a century of propaganda (and engineered financial crises) to hoodwink Americans into the Federal Reserve. more below

Everyone is beholden to banksters, hence all one gets from web sites to economist theses is bankster spin.

(The public also has no idea equity is essentially vaporware the system overall has little interest in: it's the virtually free cost of doing business: Equity is also mostly if not entirely lent into existence.)

As the cannibalization of multiple banks and brokerages demonstrated a decade ago, from Lehman to MFGlobal: sharks are ever ready to gorge bank assets* and leave taxpayers and/or pawns holding the shredded bag.

                                                                       * = loans = "assets" to banksters/lenders

Every US dollar of debt money is simply leant into existence, including the paper Fed "Note" = loan in ones wallet – as Fed publications describe.

The financial system is nothing but a gigantic pile of debt obligations. Banks are nothing but repositories of debts = claims on borrowers' assets (secured or not).

Hence bankruptcy can only erase limited amounts of debt: Losses are essentially painless to banks since there was essentially no cost to make the loan, but amounts above bankruptcy limits justify collection and attorney fees, hence banks loan in proportion to net worth.

Colonists aware* debt money concentrates wealth** fought the most heated battle of the Constitutional Convention: Jeffersonians vs. debt money Hamiltonians.

                                            *see below                              **explained in link at top

The compromise set up the destruction of the former* greatest middle class society of all time

                    *shortly after WWII:

       per the Fed, 50% of US households now have ZERO net worth on average.

Welcome to the New Serfdom.

Hate of debt money British pounds is the unmentionable backstory to the Boston Tea Party: the tea tax had to be paid in pounds, the hated currency colonists shunned, hence they would have had to pay high exchange fees on top to pay the tax.

The modern version of debt money was perfected by Isaac Newton as head of Bank of England during US colonial times.

joe2baba's picture
joe2baba
Status: Martenson Brigade Member (Offline)
Joined: Jun 17 2008
Posts: 807
bitcoin

grover if the internet breaks down the least of your problems will be losing your cryptocurrency.

as for the safety of your bitcoins it is a simple matter of storing them offline as was mentioned by another poster. some exchanges like coinbase store them in "cold storage". "cold storage" means they are not accessible via the internet. you can use an "iron key" thumb drive or rather three and keep them in different places. one in a safety deposit box.

coins are stored in "wallets" on would not be careless with their wallet if it was loaded with cash, id's and credit cards. the same principle applies to any asset.

the exchange value for fiat can fluctuate wildly as has been the case for the last month. but there have also been times when it has been relatively stable.

i think it is prudent in these time to have a little bit of crypto but it is not for the faint of heart, nor is it for those looking for a passive investment. it takes due diligence, as does every investment.

developments are happening at breakneck speed so caution is advised with new tokens such as ethereum. peoples enthusiasm has outstripped the technology and a huge "theft" took place on a project called the dao. the problem was not with ethereum but with the project developed by slockit. but that is the subject for another time.......ciao

elliobl's picture
elliobl
Status: Member (Offline)
Joined: Mar 5 2012
Posts: 2
Absolutely agree

"Cheap call option of a revolutionary technology" is exactly why I bought some.  Bitcoin could collapse, or Bitcoin could grow to a larger market share than Visa.  No one knows.  I think it's a great speculative play though.

glddst's picture
glddst
Status: Member (Offline)
Joined: Apr 19 2015
Posts: 7
Fed keeps debt money system in balance

All money in the banking system, including whatever anyone has on deposit in a bank, originated via a loan.

The loan proceeds get deposited into someone's account. And so forth virtually ad infinitum.

Only if significant amounts were withdrawn as cash would banks have a problem staying balanced.

That's why bank runs are devastating.

And why the Federal Reserve has a monopoly on cash: the Fed limits paper dollar notes in circulation to a non-threatening, marginal amount.

Hence, if lots of folks flee to cash, the value will rise = prices will fall. That would threaten banks hugely, hence price collapses are what banks fear most.

What is spun as inflation is essential to the confiscation scheme explained in above link.

So-called deflation is thus its worst enemy.

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