Bitcoin is a digital currency, but it is unlike most others. While it lost more than half its value recently, the interest in it is growing. We examine how Bitcoin works and what makes it different.

Most so-called digital currencies are little more than vouchers, or IOUs. Their value is fixed in terms of real money.

Usually, such currencies are designed to have more limited application than real currency, such as being restricted to a customer loyalty scheme. Even when they are popular, have value, and are widely accepted (such as FNB’s eBucks), they are not true currencies at all. Without rands backing them, eBucks would be entirely worthless.

Bitcoin is different. It does not merely represent another currency. It is a true currency, created by people transacting in the open market, with a value all of its own. Much like a rand has a value in terms of dollars, bitcoins do have exchange rates, but they do not depend on that other currency in order to maintain their own intrinsic value.

To understand how they are created, and what qualifies them as a true currency, some history is required.

WHAT IS MONEY?

Since time immemorial, the market – all individuals who cooperatively produce goods and service and exchange them with each other – has created currencies to transact with a convenient medium of exchange, and store value in a conveniconvenient, durable form. Over time, precious metals became the currency of choice, since they most closely fulfilled the requirements of an idealised currency.

Those requirements are often forgotten, in today’s paper-money world, but the features of an ideal currency were stipulated more than 2000 years ago by Aristotle.

1. It must be durable. Its function as a medium of exchange means it must not wear easily, and its function as a store of value requires that it does not corrode or otherwise be destroyed by time.
2. It must be portable. That means it should contain a high amount of value in a small and light package.
3. It must be consistently divisible, or “fungible”. That is, a fraction of the currency must be worth that same fraction in value. A theoretically ideal currency would be infi nitely divisible.
4. It must have intrinsic value. Since value is an entirely subjective judgement, but is a function of scarcity, Aristotle should probably have said it must be scarce.

None of these criteria say anything about who ought to create or produce the currency. That is because it doesn’t really matter who creates it. All that matters is whether the market, by implicit consent, accepts the currency as trustworthy, conveniconvenient and able to retain (or improve) its value over time. If gold is inconvenient, silver or copper might substitute for smaller amounts. Some merchants agreed to accept bank notes backed by gold on deposit, or letters of credit backed by a promise by a trustworthy merchant or bank to pay gold in future. In this way, the market decided what would pass muster as currency, and dictated its acceptance by virtue of the trust individuals put in it.

Like the understanding of a “soundmoney” currency, however, the history of government control over the money supply and its debasement also goes back thousands of years.

DEBASING THE COINAGE

The Roman emperors infamously debased money by mixing lead in with the gold or silver they collected in taxes, before issuing new, alloyed coins.

Currency debasement, often described as an “invisible tax”, would collapse if anyone in the market issued sound money; that is, coinage that was not alloyed with lead. Therefore, kings and emperors issued decrees reserving to themselves a monopoly on minting coins, or licensing only hand-picked bankers for this purpose.

PRINTING MONEY

Today’s “quantitative easing” is just a fancy way of describing printing money, which is just a modern way of debasing the coinage. It decreases the value of each currency unit in terms of goods and services and, therefore, raises prices and erodes the value of both cash deposits – on which many pensioners survive – and debt, including government debt.

Prices are influenced by other things, too. For example, declining asset values cause price deflation, as do lower employment, lower wages, and lower consumer demand. These common features of an economic downturn mask the inflationary effect of printing money, so governments can hide behind the fact that debasing the coinage doesn’t always show up immediately and explicitly in the value of currencies. Printing money as a tool of monetary policy is why governments still insist that anyone other than the appointed central bank monopoly who prints money is a counterfeiter and a criminal.

The result of this “inflationary monetary policy” – remembering that inflation is an effect of increasing the amount of currency in circulation, or printing money – is that the sound basis for the currency has been entirely eroded. Modern currency is no longer backed by gold, but is issued solely by government say-so, or “fiat”.

A SOUND CYBER-CURRENCY ARISES

This brings us back to bitcoins. They are a currency created by powerful computers performing increasingly difficult work. They are scarce not only by virtue of being hard to generate (much like gold is hard to mine), but the Bitcoin algorithm guarantees that there will be a hard cap (of 21 million bitcoins) on the ultimate amount in circulation. Nobody, not even its pseudonymous creator, can print them at will, or debase them, in order to inflate prices and invisibly steal from existing bitcoin holders. (By convention, the capitalised noun “Bitcoin” denotes the algorithms, software ecosystem and network that manages the bitcoin currency.)

Bitcoins are strongly encrypted. Each new bitcoin, and each transaction involving bitcoins, is recorded by a large peer-to-peer network of computers, a majority of which have to agree to validate the exchange. In this way, a trust network is built up, and transactions can relatively easily be made between anyone with the necessary client software, without requiring any payment system or banking intermediaries.

While bitcoins can be lost or stolen if the encryption keys of an owner are compromised, they are impossible to create, copy or counterfeit without overwhelming a majority of nodes in the decentralised network comprising tens of thousands of computers worldwide. For this reason, attacks against the system – some of which have been successful – have focused on individual users and exchanges for purposes of theft, rather than on the trust network and integrity of the currency itself.

Monetary theorists will be interested to note that the trust network, by which all nodes verify and agree on a full transaction log of every bitcoin in circulation, is exactly the “work” that is required to “mine” bitcoins. In that way, the currency is backed not by a physical asset, such as gold or a basket of commodities, but by computing effort.

Being electronic, bitcoins clearly satisfy the portability criterion, as well as the durability requirement.

They can be denominated in fractions down to eight decimal places (a limit which could, in principle, be increased), so they satisfy the divisibility criterion too. And bitcoins have value, subjectively assigned by the implicit consent of their users, backed by the work required to administer the Bitcoin network, and safeguarded by the explicit scarcity baked into the system. Thus, bitcoins fulfi l all the criteria of a real, sound-money currency.

They are not denominated in any other currency, but their value rises and falls with market demand for goods and services priced in bitcoins. While this demand remains low, for reasons of trust and familiarity, their value will inevitably be volatile. However, unlike bank-issued scrip, they retain their value even when banks fail. Unlike government-issued paper money, they retain their value even when the sovereign goes bankrupt. The more widely they become accepted, the more stable their value will become.

They are a technological analogue to gold. They are sound money in much the same way, only with some improvements, thanks to their digital nature.

One day, perhaps when enough economies have collapsed under the weight of sovereign debt and hyperinflation caused by unrestrained money-printing, countries will seek to recover by issuing a new currency.

Many people who are afraid their governments will not only devalue the money in their pockets, but even confiscate their “legal tender” to pay sovereign debt, will likely turn to bitcoins as a safe, secure and free medium of exchange and a store of value. In some countries, like Argentina, Spain and Cyprus, they are already fairly common. It, or a competing currency much like it, looks set to become the gold of the 21st century.