How does the virtual currency tick?
This article is about the virtual currency Bitcoin. In order to understand how it came to the emergence of Bitcoin, we need first to look closer at our current monetary system. In the next step, we will deal with the technology behind Bitcoin. After understanding this, we will deal with the Bitcoin-Trading and the current situation.
What is money?
Under money is meant any recognized exchange and cash. That, in the monetary constitution of a country as legal tender defined money is called currency. In the Federal Republic of Germany, this was formerly the German mark and now is the Euro.
There is a fundamental distinction between two forms of money:
- Cash (banknotes and coins) and
- Paper money or deposit money (payment claims of a non-bank to a bank).
In addition, it is still important to know that money has to fulfill simultaneously three functions:
- It is a unit and thus serves as a measure of value (keyword: purchasing power).
- It serves as a store of purchasing power (keyword: saving).
- It has a function as a means of payment (keyword: buy).
Money is created in our two-tier banking system through central banks and commercial banks. In a first step, the central bank issues so-called base-money by lending to commercial banks money or asset values such as purchases securities (open market policy). In turn, the central bank credits the accounts of the commercial banks. In our minimum-reserve-system, commercial banks then produce further book-money based on these base-money-balances. Any expansion of money by the commercial banks is prevented that they have, for every euro of their customer deposits, to maintain a certain percentage in the Central-Bank in the form of reserves. This so-called minimum-reserve-ratio is currently by the ECB at one percent. So that, in the entire banking-system can be generated as book-money maximum 100-times the amount of base money.
Our currency is uncovered (fiat-money) and is ultimately secured only by the power of government. Although there is also the capital stock of the country and the tax-revenues, but that at the end is again “controlled” by the government. Euro is becoming real money with all the corresponding functions (arithmetic unit, a store of value, means of payment function) only through the general acceptance of the various trading partners. The fact remains that: Without the protection by the state and the guarantee by the central bank and without acceptance of our trading partners, euro banknotes would be in principle nothing more than printed paper. The converse conclusion may be that the euro and any other Fiat-Money-currency such as the US dollar could not exist without trust. Through the new financial crisis in 2007/2008, the public confidence in the banking system and the Fiat-Money-Currencies was strongly shaken. This was true, especially, but not only, for the euro. Perhaps you remember how once the Chancellor Merkel and her then finance-minister Peer Steinbrück had to appear before the cameras in order to guarantee the savings of the Germans. Without this government guarantee, there was at that time a danger that large parts of the population would have lifted their money from bank accounts, so it would come to a so-called “bank run”. This would bring a collapse of the banking system. As we have initially learned that banks must hold only a reserve in the amount of one percent of its customer deposits as collateral. The cash would therefore never be enough to actually pay out a large proportion of bank deposits.
Bitcoin in response to the financial crisis
As a result of the financial crisis, a search for alternative currencies began. The inventors created then – hidden behind the synonym “Satoshi Nakamoto” – the virtual currency Bitcoin. The aim was to take advantage of the conventional currencies, but not their disadvantages. Therefore, the Bitcoin was designed as a decentralized network (no central bank). At the same time a quite clever ceiling on the amount of Bitcoins has been set. This limit is achieved when the number of newly created (“mined”) Bitcoins is halved after achieving a certain quantity. And here is how it works: In a first step, based on certain algorithms an amount of around 10.5 million Bitcoins could be “mined”. In the course of time it becomes constantly more difficult to “mine” Bitcoins (because the algorithms for this purpose become costlier) and so the amount of newly generated Bitcoins is further reduced. Through this process, there is ultimately a maximum of 21 million Bitcoins or as mathematicians would put it: The maximum amount producible Bitcoins converges to (the limit) 21 million. It is criticized in this context that the initiators of Bitcoin probably hold large amounts of generated bitcoins from the early day and the price could collapse if they were thrown on the market. The author believes that this is unlikely to happen since the seller would be destroyed by such a “fire sale”.
The management of currency: Block Chain
So now we know how money creation works by Bitcoin. It would be interesting if transactions in that currency could be carried out. But how does the management function, which is of course in our financial system object of the banks? Users may carry out transactions using Bitcoin and each transaction is recorded. If it is not so, the whole system would be doomed. Without such a record of a transaction, it could not be determined who has transferred to whom how many Bitcoins and who owns how many Bitcoins. Can you think of this in the real world as if you would always write the current owner to each bill (but based on his account number, not by his real name, as Bitcoins are basically anonymous). It is only noted how many Bitcoins are transferred on which “account”. Transactions that take place within a certain time window are then gathered into a block. These blocks are documented in a public register, which consists of a long chain of blocks and is called Block-Chain. You can easily see this block chain at www.blockchain.info. If you know the correct “account number”, you can even see there using the search function the current account balance. Thanks to this database called block chain, there is therefore always a proof about who owns what Bitcoins. In principle it would be possible for a hacker to manipulate subsequently the Block chain. However, such manipulation is difficult both from a technical point of view as well as from “price/performance ratio”. Each block, as soon as he is finished (if the maximum number on transactions in a given period is reached), is converted into an arbitrary series of letters and numbers. This series is called hash. This hash is stored together with the block in the block chain. Since no one knows the specific formula for converting the transaction data in a hash, it is almost impossible for hackers to manipulate the block chain. Especially, the hash of the previous block flows also in the calculation of the current hash. The hash is thus virtually a tamper-proof seal. The actual Bitcoin-Mining is nothing but the sealing of a block by generating a hash. And the one, who creates first such a seal, gets Bitcoins as a reward. This incentive is given the high cost of electricity for the mining absolutely justified.
The value of a Bitcoin
No state or Fed, but the for years-proven still not hacked Block-Chain, promotes and protects the confidence in Bitcoin. The current value of Bitcoin is result of the acceptance and confidence of its users. There is always a current market rate for the Bitcoin against other currencies. Bitcoin is the most convertible currency in the world. Figure 1 shows the price development of Bitcoin. Initially, the acceptance and confidence in the Bitcoin were very low. In 2009 you had – at one of the first transactions at all –to pay even 10,000 Bitcoins for a pizza. Today the acceptance and confidence are significantly higher, so 10,000 Bitcoins currently are worth around four million dollars. As long as the acceptance and confidence in Bitcoin rise, the value of the bit coin will rise. More users by a limited quantity to 21 million pieces, means a rising demand for a limited commodity. So it is not entirely wrong when Bitcoin (instead of money) is called virtual gold. Therefore, Bitcoins are “mined” (compared to the gold mine) and not created.
Fight against Bitcoin
Because the acceptance, confidence and the value of Bitcoin were initially very low, central bankers and politicians allowed the emergence of Bitcoin. They did not take seriously this new virtual currency. In addition, a ban due to the decentralized structure of the Bitcoin network would have been difficult. This has now changed. After all, the market capitalization of Bitcoin already amounts to around six billion dollars. There are already, for example, efforts in Russia to ban Bitcoin. The ECB has denigrated the Bitcoin as a pyramid scheme and some politicians attack Bitcoin because of its anonymity which may be favored by crime and terrorism. In this way, they would like at least to regulate and control the virtual currency if they cannot even stop and defeat it.
Banks want to adapt the block chain
The banks as intermediaries by Bitcoin see their business model threatened. Therefore, they try to adapt the block chain since this concept has been proven over the last few years. So they also want in the future to manage transactions in the known state currencies through a block chain and thus to reduce costs. But if the “normal” currencies were managed via a type of block chain, the user would not have the benefits of a virtual currency but have the disadvantages of Fiat-Money-System.
Since the Bitcoin is the freest convertible currency in the world, it is very suitable for traders. However, the share price is highly volatile due to a comparatively low market depth so that only experienced traders should dare to deal with the virtual currency. This applies all the more since in Germany different CFD-brokers like FXCM, IG or Plus500 offer trading with Bitcoin. Given the already high volatility, one should remain more conservative in the use of CFDs in Bitcoin-Trading and not to use too high leverage. If somebody wants to trade Bitcoin directly, he can use the platform of www.Bitcoin.de and of Fidor-Bank. The Bank is cooperating in matters Bitcoin-Trading both www.Bitcoin.de and with the US-Bitcoin-Exchange www.Kraken.com. However, the trade is also possible on foreign exchanges like Bitcoin www.BTC-e.com, Bitstamp, Coinbase, www.Kraken.com or www.Poloniex.com. Be careful when choosing your Bitcoin-Exchange because after MtGox, the Bitcoin-Exchange also skids (slid).
Cryptsy into bankruptcy
Considering that in the Bitcoin-Trading generally do not incur transaction costs, the spreads are slightly higher than the established currencies – but are kept at manageable levels. The smaller a Bitcoin-Exchange, the higher usually the spreads. At the latest once the largest Bitcoin-Exchange in the world, MtGox, slid into insolvency, we know that size does not protect against a failure.
The Bitcoin is and remains speculative. One should not necessarily build his retirement on him. The more speculative is therefore the Bitcoin trading. You should be absolutely aware of this.
Sascha Huber worked around seven years for sharewise GmbH and was from 2010 to 2014 editor of sharewise’s stock-market-briefs. Recently he was active as Research Assistant for Stephan Heibel and its “Heibel-Ticker Stock-Market-Brief. On the side, he manages six listed Wikifolio-Certificates.