A Bit of Clarity on What Bitcoin Is (and Isn’t)

“Our wretched species is so made that those who walk on the well-trodden path always throw stones at those who are showing a new road.”

-Voltaire

Today I want to give you just a quick look ahead at a fascinating topic we’ll delve more deeply throughout the next week…

I find it hard to fathom the many life-changing innovations that have occurred in my lifetime. As I look back, there is a definite theme to the introduction of these advances: lasting innovation is rarely embraced on the first try.

One of the earliest innovations that I can remember happened when I was a young boy and color TV became prevalent.

It took more than a dozen years (from the first color broadcast of the Rose Parade in 1954 until the mid-1960s) for color to be widely accepted, and 18 years from that first broadcast for the sale of color TVs to outpace black-and-white sets.

By the time I was in college, the first IBM/Microsoft OS personal computers were introduced. Again, it took more than 10 years for sales to move into the home in significant numbers, and that was thanks to the new widespread availability of Internet access.

I could list more – cell phones, HD TV, etc. For each of them, even in this age of rapid technological advancement, it has taken at least a decade to move from first commercial use to widespread use.

This brings us to transactional technology. Credit cards were the last widespread innovation in commerce transactions. They were a rarity until the 1970s (with the original bank card, or “open-loop” card, introduced in 1966 as the BankAmericard).

Thinking back on this, I watch all of the Sturm und Drang over Bitcoin with great amusement – and interest. I’m not a Bitcoin fanboy, nor do I believe it is a worthless endeavor.

After doing a good deal of research on Bitcoin, here’s where I’ve landed: Whether it flops or becomes a household name, I see Bitcoin as a necessary and ultimately useful step in the innovation cycle.

But in order to profit from it, you have to understand what it is and where it’s headed…

Even though there are many other “coins” out there, Bitcoin is by far the largest. So for this primer, I’ll talk about the basics of Bitcoin and its protocol, leaving the distinctions from other coins for a later article.

(As a readability note – the current capitalization protocol for Bitcoin is to capitalize the “B” when talking about Bitcoin as a protocol and to use a small “b” when it’s referenced as a currency.)

A Bit of Clarity on What Bitcoin Is (and Isn’t)

Since there is a lot of misunderstanding about what Bitcoin is, I’d like to take a shot at making a very brief primer on the key aspects of this phenomenon as I understand them. Please bear in mind these are the important aspects from my viewpoint. I believe these to be the most important things about Bitcoin:

  • Bitcoin is known by many synonyms: digital currency, virtual currency, cybercurrency – and you can replace the word “currency” with “cash” (more on whether Bitcoin qualifies as a “currency” a little later in the series).
  • It was designed as a low-cost way to exchange money using the Internet.
  • At the simplest level, Bitcoin is merely a universally shared ledger of who owns how many.
  • This central ledger is kept by every computer on the Bitcoin open-source peer-to-peer network and is tracked chronologically and permanently by a public record called the blockchain.
  • Add some very sophisticated algorithm-based security and Bitcoin is basically just a secure way for a group of connected computers to maintain a ledger.
  • This form of fiat currency is not regulated by any central bank.
  • The peer-to-peer network is run by a complex process known as mining, where computers are run on the peer-to-peer network to maintain the security of transactions and the validity of the ledger. Miners are paid in bitcoins according to an algorithm that decreases the payment as more bitcoins are added to the system.
  • Inside this system, anyone may transfer bitcoins to anyone else.
  • The transactions are completely transparent, but the privacy (identity) of the people on both ends of the transaction can be maintained simply through pseudonyms.
  • Bitcoin users have digital wallets that contain their bitcoins and their private keys. This part of the cryptography is sophisticated enough that hackers cannot guess private keys. The combination of the private key and your bitcoin holdings inside your wallet make a cryptographic signature that is unique, secure, and allows the network miners to verify transactions.
  • There is no third party to a transaction – only a peer network that verifies and records each transaction. So there are currently no (or at least very low) transaction costs.
  • The ultimate number of bitcoins is capped (as is the rate of additional bitcoins added leading up to the ultimate cap) – so theoretically, they can’t be deflated by more units being added to the system.
  • Bitcoin exchanges have developed to trade bitcoins for traditional currency (dollars, euros, etc.).

If you want to know the basics of the security algorithms and all the (admittedly pretty cool, as well as integral to the existence of the concept) stuff that is under the Bitcoin hood, feel free dig into the original whitepaper at Bitcoin.org.

But much like the billion-plus people in the world who drive cars without knowing how an internal combustion engine works, we’ll stay at the application level of the digital currency as we look to see its usefulness and what role it is playing in a bigger trend.

A Juicily Divisive Topic

Bitcoin is, quite frankly, a “bit” confusing. I’ve basically run into three types of people when I talk about it:

  • The big supporters. There are a few handfuls of these folks out there. They either love the peer-to-peer concept, the code, the math and algorithms, or are philosophically aligned with a decentralized currency.
  • There are the big detractors – mostly the people Voltaire was talking about in the opening quote who are guarding the status quo, or those who like to throw rocks at any innovative idea.
  • By far the biggest group is the “we don’t know and we don’t care” group. This is the same group that could care less about cell phones in the early 1990s because “who needs one of those?” or those who thought HD TVs were for the wealthy few in the early 2000s.

Clearly, you can tell from these thoughts that I think that digital currency is going to stay with us in some way, shape, or form. And more than that, I believe it will be the future of commerce and transactional activities of the future.

My best guess is that Bitcoin won’t be the ultimate winner, but much like VHS (and Betamax) technology paved the way for today’s DVRs, it is an important step along the way.

But for the everyday investor who isn’t a Silicon Valley wizard, the first step is understanding it properly.

Over the next several issues, we’re going to look at what’s going on in the Bitcoin world, then talk about whether we should care as traders and investors (and how we can give this knowledge a profitable twist, of course).

— D.R. Barton, Jr.

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Source: Money Morning