What Is Bitcoin?

Summary/TLDR

Bitcoin is a transactional protocol created by an anonymous programmer who went by the pseudonym Satoshi Nakamoto in 2008. It details how two private individuals may transact with one another without a third-party intermediary, effectively solving the notorious “double-spending” problem and revolutionizing the financial landscape. Bitcoin evangelists and skeptics alike often go too far in their praise or criticism of the protocol, which is still very novel. One thing, however, is certain – there has never been anything like Bitcoin in history. Dismissing it as a “fad” is likely a mistake, and not one that consumers should put up with if they want honest advice about whether Bitcoin can serve a role in their financial plan.

Introduction

On October 31, 2008, in the depths of the Great Recession, a whitepaper titled Bitcoin: A Peer-to-Peer Electronic Cash System was sent to a mailing list of programmers known as the “cypherpunks”. It was authored by Satoshi Nakamoto – an anonymous programmer whose identity remains unknown to this day. While Satoshi likely understood the groundbreaking nature of his discovery, there’s no way that he ever could have anticipated exactly how much he was about to change the world.

In the past fifteen years, Bitcoin has gone from a libertarian fad worth less than $0.01 per coin to an asset with a $1T+ market capitalization, boasting a seemingly impossible valuation of about $65,000 per coin today. The largest asset managers in the world have received SEC approval for Bitcoin funds, publicly traded companies are holding it on their balance sheet, presidential candidates have made it a part of their campaign, “Bitcoin conferences” are being held globally, and entire nation-states have declared it to be “legal tender” within their borders.

Regardless of your opinion on Bitcoin’s potential, one thing is certain: there has never been anything like it in history. Despite this fact, Bitcoin remains widely misunderstood by most – especially by members of the financial services industry. Even discussing Bitcoin is considered taboo in many financial advisory circles as compliance departments far-and-wide disallow their advisors from providing advice on it. In this post, I aim to demystify some of the very basics of Bitcoin for consumers of financial services.

Bitcoin, Simplified

For a moment, I want you to forget everything that you think you know about Bitcoin. Forget all the propagandistic tropes you’ve heard from its supporters and detractors alike and begin with an open mind. When discussing Bitcoin with clients, I’ve found that providing simple answers to the following questions is the best starting point: What is Bitcoin, and what problem does it solve?

What is Bitcoin?

Bitcoin is nothing more than a list of instructions – a protocol. This instruction manual is written in computer code and is open source, meaning that anyone can download a copy and see for themselves how it is written and even participate in its future development. The Bitcoin protocol specifies how two private parties can directly transact with one another without a third-party intermediary. Before Bitcoin, the only way to do this was to meet up in person and transact in cash.

To transact with other individuals using the Bitcoin protocol, Satoshi also created a digital currency native to the protocol: Bitcoins. Bitcoins come into existence through a process called mining, and their supply is capped at 21,000,000 (about 93% of which are already circulating). Finally, every Bitcoin is divisible into 100,000,000 units which are known as “Satoshis”.

What Problem Does Bitcoin Solve?

Through his invention of Bitcoin, Satoshi discovered how to solve something known as the “double spending” problem – one of the most notorious and costly problems in the history of finance. Anyone familiar with the idea of a “bounced check” is familiar with the double spending problem – how can you be sure that funds you’ve received as payment for a good or service haven’t already been spent? In the developed world, this problem is largely papered over by financial intermediaries such as banks or credit unions who reverse illegitimate transactions and try to prevent mistakes and dishonest behavior from occurring in the first place. They still haven’t solved the core issue, however. Ironically, these financial intermediaries, through the practice of fractional reserve banking, are arguably the largest “double spenders” in the world – but that’s a topic for another day…

Satoshi solved the double spending problem through something that has come to be known as the “Blockchain”, although Satoshi never used that term himself. The idea of a “blockchain”, or at least something like it, has been around at least since the 1990s and Satoshi heavily relied on the work done by those before him, as is evident by the citations in his whitepaper. What the blockchain is and how it works are beyond the scope of this post, but I might write one dedicated to it in the future.

Through the blockchain and the Bitcoin protocol, it is finally possible to directly transact with anyone else in the world. Furthermore, the Bitcoin network is operative 24/7 and is accessible to anyone with internet access. And finally, due to the nature of the code it is written in, Bitcoin cannot be counterfeited, and no more than the 21,000,000 coins scheduled to be mined will ever be in existence, meaning that it is deflationary in nature. This is all in direct contrast to our current system, which only operates 250 days out of the year for certain hours of the day, requires enormous sums to operate and monitor for fraud and counterfeit, is only readily accessible to those in developed nations, and which is inflationary by design.

Bitcoin certainly faces a lot of uncertainty in the future. What’s known as the “base layer” of the protocol is already regularly congested with transactions and requires a relatively hefty transaction fee to participate. Solutions for this issue are already in operation and are becoming adopted at an astounding rate, but the precise path forward still remains unknown. Furthermore, how and if the government can regulate it, and even their ability to do so, will undoubtedly be a hot topic in the coming years.

Bitcoin and Financial Services

Like the internet, Bitcoin has been widely dismissed in its early years as nothing but a “fad” or even a “scam” or “ponzi scheme” by most members of the financial services industry. I believe this criticism is mostly mindless in nature – it’s nothing but people who repeat what is told to them without taking the time to educate themselves and think on their own.

As in political discourse, these types of flippant insults are code for: “I don’t know what I’m talking about and don’t care to expend the energy required to learn.” They’re just “shortcuts” that prevent people from having to undertake the laborious task of educating themselves and exercising independent thinking. In other words, it’s a convenient way to justify one’s lack of self-responsibility.

Fortunately, the tide is beginning to turn as Bitcoin and other protocols like it are sweeping news headlines and consumers are demanding that their advisors be educated on it and similar topics. As mentioned above, the SEC approved 11 Bitcoin ETFs in January of this year, some of which are managed by behemoths like Blackrock, Fidelity, Invesco, and Franklin Templeton. Others, however, have dug their heels into the anti-Bitcoin camp, disallowing their clients from purchasing the new ETFs and even preventing their advisors from discussing or advising on the topic altogether!

At the end of the day, what a consumer of financial services needs is the following: a very basic understanding of Bitcoin and a non-partisan financial advisor who is educated at a deeper level and can help them understand whether it is a good fit for their portfolio.