This is an open letter to anyone who studies personal finance, investing, and the markets. I can’t hold back any longer about cryptocurrencies and would like to address a number of things I see all over the internet about the space.
There is a lot of information and misinformation out there, and I want to shed light on the technology and highlight why I believe it is here to stay.
My goal here is to talk about what could be possible in a few years with digital currency, provide some explanation and the philosophy of what many of these projects are looking to do, and clear the air on a lot of controversy.
And no, this isn’t going to be an article where I say, “What is Blockchain, What is Bitcoin, Where can I buy it, here’s my Coinbase link, blah blah blah” – nothing against that, and bloggers who have done this are completely okay to use their reach to get some free bitcoin (I think it’s both of us get $10 if you spend $100), but that’s not going to be me.
To make this clear up front, I’m going to be talking about cryptocurrencies which are looking to be payment solutions and stores of value. This is not an investment pitch. I’m not an investment adviser, a lawyer, or a certified financial planner. This is not advice. I’m hoping to provide a lot of information here. With all investments and things regarding money, it’s crucial you do your due diligence, realize that your financial situation is unique to you, and do the necessary research and learning before taking action. Personal finance is personal.
What is Cryptocurrency?
This article is focused on cryptocurrency. I came across an excellent site the other day called Decryptionary – a site providing definitions for cryptocurrency terms.
From Decryptionary, the definition of cryptocurrency is as follows:
Crypto- is short for “cryptography”, a computer technology used for securing and hiding information among other things.
Currency means “money currently in use”.
Cryptocurrency is an electronic money created with technology controlling its creation and protecting transactions, while hiding the identities of its users.
Instead of trusting a bank with your money, users send money directly to each other while simultaneously recording their transactions. With so many records being maintained, transactions become efficient, permanent, secure and transparent.
The first cryptocurrency was bitcoin.
Wait, how are cryptocurrencies secure and transparent? Aren’t hacks happening all over the world?
Let’s take a step back – I think we are already going a little bit too fast.
Let’s talk about banking, and how money was recorded and transferred through history.
What is a bank and what is a bank’s purpose?
Way back, thousands of years ago, people wanted to go on pilgrimages and didn’t want to take all of their money with them. People wanted to store their money with someone they trusted while they were away.
The first banks were created to store peoples’ money and goods. Back then, a bank’s purpose was to be a safe storage place for an individual’s or businesses’ assets.
Over time, banks added many features and other capabilities. The ability to make loans, the ability to invest, and the list goes on and on.
At first, your money was your money – the banks were just holding it.
Now, when you deposit your money in the bank, you are technically loaning your money to the bank. Then, the bank takes your money and loans it out.
This is how banks make money: they pay interest at X% and collect interest at X+Y% (Y is a number based on your credit score and how risky of a borrower you are). Credit cards are the highest risk product for a bank, that’s why the interest rates are 20%+, whereas a mortgage is relatively lower.
If you are struggling with your finances, what are you going to stop paying first, your credit card or your mortgage? You need a place to live, I’d choose to stop paying the credit card first.
I’m getting off topic.
Money Out of Thin Air?
So back to banking. I deposit $1,000 at the bank. The bank, by law, is allowed to make loans and (depending on a number of factors) hold only about 10% of this outstanding amount in loans. A bank is allowed to take my $1,000 and loan $10,000. Where did the $9,000 come from?
I’m keeping it simple here, there are a lot more complexities (of course).
But my point here, is that banks are allowed to be levered 10 times on their investments.
For more information, please read here Capital Requirements, Fractional Reserve Banking, and here Capital Adequacy Ratio.
The Great Recession of 2007-2009
Back in 2007, the housing bubble popped. (I’m not going to get into those details – it’s a story that’s been told 1000s of times. My favorite storyteller for this story is Michael Lewis and his book, The Big Short.)Many banks failed. They were investing in risky products, and due to the massive leverage (which at the time, was more like 20 times, vs. the 10 I mentioned in the last section), they could not pay to keep their doors open and had to shut down.
Luckily, many governments guarantee the amount in your bank account, otherwise thousands of people would have lost their hard earned cash.
Why did this happen? Some people think it was the relaxation of regulatory guidance, others think banksters are natural crooks, and others think it was the perfect alignment of a number of people across the industry being incentivized to push risky products.
At the end of the day, many people were hurt by the Great Recession.
There were a few people who were sick of the banking system and wanted to create an alternative financial system. These people were sick of the Federal Reserve and big banks manipulating the money supply. They wanted to get the power back in the hands of the people.
That’s when Bitcoin was created.
The Creation of Bitcoin in 2009
In January 2009, the bitcoin network came into existence.
What is bitcoin? Decryptionary defines it as the following:
Bitcoin is the first digital cash created in 2009. It was made by an unknown person or group who went by the name, Satoshi Nakamoto.
Bitcoin is unique because it does not rely on government/bank created money. In addition, transactions occur directly between pseudonymous people (their real names are not known), meaning there are no banks or middlemen.
Each transaction is recorded on a digital record kept by many people across the world known as the “blockchain”. Because there are so many copies being simultaneously maintained, the banking data is very safe and virtually impossible to manipulate.
Okay fine… I guess I have to define blockchain after all.
What is Blockchain?
Again, I’ll reference Decryptionary – they have some really good stuff.
Blockchain is technology for creating permanent, secure digital recordings that don’t rely on any single person or group. Blockchains can record any information, though the first example was created to record bitcoin transactions.
Imagine the blockchain as a book of records. Each page in that book, is a block, and can record anything. Blocks are created one after the other, chained to each other creating what we know as the blockchain.
Multiple blockchain records are maintained simultaneously by a large group of unrelated individuals and their computers, making it cloud storage on steroids. Updates are seen immediately and manipulation is extremely difficult/impossible.
That’s better than I could have answered that 🙂
Diving into Cryptocurrency as a Form of Payment
Okay, so I’m still a little confused on what Bitcoin is and what the blockchain is – so I think an example of how all of this is working together would be good.
We should first define one more thing – a wallet. A wallet is just like it sounds – it’s a place where you can store your cryptocurrencies. There are many types of cryptocurrency wallets – essentially, for simplicity, you can think of them as a digital file that holds your crypto coins. These wallets can be software on your computer or phone, a flash drive, and you can even print out a piece of paper and have that be your wallet!
Your wallet is made up of a private address and a public address. The private address should be kept secret at all costs.
One thing to note, these coins are (theoretically) infinitely divisible. For example, you can have 0.0001 bitcoin, or 128.0123 bitcoin.
On to our example with how this all works.
A Transaction on the Blockchain
Billy and Bonnie are working together on a project. Billy has some bitcoin (or my personal fav, Litecoin), and wants to pay Bonnie for her work.
In Billy’s wallet, he has 3.2 bitcoin. He wants to send Bonnie 1 bitcoin as payment. These wallets have a public address, something similar to this: 17CtAf5VR1t9tJCuQJjUF2LUbjQ9hdSkTU (this is a random address I found on the internet, don’t send bitcoins here… it’s not mine.)
Billy types in Bonnie’s address, and then clicks send 1 bitcoin. A short time after, Bonnie receives the 1 bitcoin in her wallet. Billy now only has 2.2 bitcoin. The transaction is shown as completed in the public blockchain.
The transactions are transparent, through this public blockchain, and secure because of the encrypted data.
To understand the concept of the blockchain a little more, transactions which happened around the same time as Billy and Bonnie’s transaction might have been grouped together and completed in the same “block” or in the same batch. (It’s like putting cookies in the oven, yes, you might have a really big cookie and a really small cookie, but both can get cooked at the same time.)
The bitcoin blockchain is public and all transactions in history can be viewed and seen. As of writing, there were over 500,000 blocks on the bitcoin blockchain, so theoretically, you could go back to 2009 and see the first transaction.
Going way back to the top: how are cryptocurrencies secure and transparent? Aren’t hacks happening all over the world?
Yes, hacks are happening all over the world. These hacks are on the wallets, not the transactions or the blockchain.
As discussed in the previous section, the transactions are secured by the encryption in place, and the blockchain is completely public and there are records of it in many servers and places. To manipulate the blockchain would require manipulating it in thousands of locations.
But yes, there are hacks – since the digital currency is stored on a person’s computer, phone, or flash drive, there is always the potential for a hack. In addition, there is no governing body which will guarantee your coins, so there’s an additional risk with holding these coins.
While this is unfortunate, at the end of the day, I think it puts more power into the hands of the people.
These wallets are just like your purse or your wallet – if you lose the cash in your wallet, you aren’t getting it back.
That’s why it’s incredibly important to keep your private addresses safe, keep your anti-virus software up to date, and take care when making any transactions.
An Attempt to Address Common Comments from the Everyday Person
I’ve provided a fairly basic, but comprehensive view, of the cryptocurrency space. Now, I’d like to attempt to address common comments and concerns I hear and read in different places.
First, there’s so much hate on the cryptocurrency space. It’s wild… It’s a ponzi, it’s a bubble, it’s all fake, it’s all bogus, blah blah blah. I’m going to address and talk about the following six criticisms:
- Cryptocurrencies are the biggest bubble in the history of the world
- These cryptocurrencies have no value
- Cryptocurrencies are only for terrorists and people who want to hide their money
- It’s a huge ponzi scheme
- Cryptocurrencies are unsecure and not safe
- The technology is not developed enough for me to use it
It’s a Bubble!
Back to the comment, “IT’S THE BIGGEST BUBBLE, BIGGER THAN TULIPS!!!!??!!!!”
First, there are many goals of different cryptocurrency projects. What I’m focusing on in this article is the payments and store of value projects (Bitcoin, Litecoin, etc.) Since we are talking about these as digital currency, then it’s appropriate to compare these to the size of other stores of value.
I want to share with you a few numbers.
The cryptocurrency market capitalization is $400 billion dollars. It’s globally accessible, and has experienced tremendous growth as many of you know.
Compared to many other asset classes in the world, it’s incredibly small: (this picture was published June 30, 2017)
The total cash in the world is $7.6 trillion (#2). The total gold in the world is $7.7 trillion (#3).
This is where it gets scary though. Remember when we were talking about banks and their loans? There is over $200 trillion in outstanding debt in the world. Even worse, there is over $544 trillion in outstanding derivatives in the world. (At this point in the article, I’m about 95% tin foil hat, but I’m going to refrain from going that last 5%… let’s just say, I think the world’s biggest bubble is the global debt load, but I’ll leave it for the reader to complete the exercise.)
As a global store of value, or a global currency, there is still plenty of room to grow.
Look at Amazon or Google! Their market capitalization are up 1000s of times in the last 20 years. The same can happen here.
Cryptocurrencies don’t have any intrinsic value
Let me ask you something. The US Dollar isn’t backed by gold. It isn’t backed by anything (okay, I guess it’s back by the full faith of the government, but who knows what that is worth).
Why is the dollar worth anything?
Because people have determined it’s valuable. If I walk down to the coffee shop and look to pay with a 5 dollar bill, the cashier will take it no questions asked.
It boils down to the belief that others value it.
Many people argue, cryptocurrencies are made-up and have no value. Sure, it’s just software – it’s potentially worthless, as nothing backs something like bitcoin or Litecoin.
I’d disagree on this point: many people do believe these digital assets are, in fact, valuable. It’s the same thing with real estate for example: why are California houses more expensive than Minnesota houses?
It’s basic economics, these currencies are filling a need and now people are realizing this and they want to buy more of it to use.
I’m not talking about using these as an investment vehicle.
I’m talking about using these for payments around the world. Take for example Litecoin. Every day now, there are hundreds of merchants starting to accept Litecoin because it’s faster and cheaper than using credit card processing.
Another use case is sending money across borders. Let’s say I have family in another country. An international bank wire might take a week to send. With cryptocurrencies, I can send it today, and it will get there instantly.
People want this and are willing to pay for it. That’s why there is value.
Cryptocurrencies is only for terrorists and people who want to hide their money
Yes, it is true that these currencies are being used for bad things. It’s true that you can be anonymous on this network, make transactions, and no one will know who you are.
Where I disagree with this point, is that there are now thousands of merchants accepting these digital currencies as payment all around the world – for everyday purchases and transactions.
Your mom and pop store is most likely not a terrorist front – and they might start accepting cryptos in the near future.
It’s a Huge Ponzi Scheme
First, a definition:
A Ponzi scheme is a fraudulent investment operation where the operator generates returns for older investors through revenue paid by new investors, rather than from legitimate business activities or profit of financial trading.
I go back and forth on this. I see it from both sides. Yes, it’s being marketed as a get rich quick scheme – and many of the early adopters are very wealthy.
That being said, could you say capitalism is a Ponzi scheme?
Could you say the stock market is a Ponzi scheme? At the end of the day, the early investors of the stock market are wealthy today as well… just providing some food for thought.
Cryptocurrencies are unsecure and not safe
We talked about this in an earlier section – the transactions are secure and safe, but you need to be careful with your wallet and addresses.
It’s Not Developed Enough for me to use it
I would agree with this. The application of this blockchain technology towards payments is only 9 years old.
In the last 9 years, there have been many changes to the code. There are thousands of developers working on all sorts of cryptocurrency and blockchain projects all over the world.
Every month, there is another news announcement about a certain tweak or enhancement to the code to make it better.
Yes, right now there are some of issues with the implementation and the code.
That being said, there are armies of developers and programmers working towards the goal of a global currency.
I’m hopeful that in 3-5 years, these coins and technology will be more mainstream.
Some Other Great Resources to Check Out
Your learning and understanding shouldn’t end here.
For additional reading, I’d suggest checking out Reddit, Coindesk, and CoinMarketCap.
For podcast listeners, I’d suggest checking out Crypto 101. There’s a number of other podcasts I’ve listended to in the space, but some are a little bit more entertainment driven.
One of the articles that inspired me to write this post was published earlier this week by a fellow personal finance blogger, Mama Fish Saves: Everything You Need to Know About Cryptocurrency.
A fantastic article which provides a counterpoint to my article was written a few weeks ago by Mr. Money Moustache: Why Bitcoin is Stupid. While I agree with some of his points, I disagree we should completely shun technological change and growth.
Dismissing something which is potentially the future of the financial world is a little short sighted.
The technology is still primitive, and yes, there is a lot of electricity that goes into mining (one thing I’d have to ask though, how much energy and resources have been put into the creation of coins and dollar bills?)
That also being said, I doubt he bought any and actually saw the potential – I looked through the comments and couldn’t find anything, so if your reading this Mr. Money Mustache, I apologize for overlooking this point.
Cryptocurrencies as an Investment Vehicle
As an investment vehicle, there are quite a few cryptocurrencies which are risky, scammy, and have little potential. Please do your own research and figure out what is best for your financial situation. There have been a number of actual Ponzi schemes and scams that have contributed to people losing thousands of dollars in the cryptocurrency space – if it’s promising 1% a day in returns, it’s probably a scam.
My point is, there’s still a lot of growth in the space. Cryptocurrencies, as a whole, have been around 9 years. Where was the internet at 9 years old? What about cars at 9 years old? Where was the printing press at 9 years old?
I’m still learning a lot about this stuff, and just wanted to provide you an overview of what the philosophy of the technology is, what it’s goal is, how it’s affecting every day people and businesses, and some more resources for you to check out.
I could be completely wrong. I could be completely right. Maybe it’s the biggest Ponzi in the world. Maybe it’s the future. We will have to see.
Looking back 20 years, did you think the internet would be on our person at every hour of the day (with our newest cell phone)? Who’s to say that these currencies can’t overhaul the current financial system – into a system where money cannot be printed and created out of thin air, all transactions are made publicly, and money can flow around the world instantly and without restriction?
I don’t know. When I was growing up in the late 90’s and 00’s, globalization was a big deal. I’m white, and in my kindergarten class, there were only 5 non-Caucasian students. My youngest sister is 14 years younger than I am. Now, over 50% of her class is non-Caucasian students.
The world is integrated more than it ever has before. I’m working with a web developer in India right now. I have a virtual assistant in South Africa. I chat with people all over the world on this blog.
Just 2 years ago, so many members of the media and many people scolded Donald Trump for his pro-isolation thoughts on the United States with regards to immigration and trade.
Why can’t we have an open mind about the financial system? Why can’t money flow around the world freely, just like people can?
Thousands of merchants are accepting these things as payment all around the world. Cryptocurrencies are probably not going away no matter what CNBC or Bloomberg says.
Here’s my point: do your own research and keep an open mind. Living with an abundance mindset, and being open minded is so crucial for success in this world. Why not in the financial sector?
Feel free to ask any questions or bash me in the comments.
I couldn’t hold back any longer on cryptocurrencies. I had to get this out and I appreciate you reading.