If you haven’t heard it’s not due to a lack of press coverage; bitcoins are a hot topic. And yet, even with its skyrocketing popularity many can’t help but wonder how this thing really works. The writing on the wall seems clear; I mean we’re talking about e-money right?

Well kinda sorta not really.

Reports infused with familiar concepts like currency, security, trading exchange, bubble and “just like cash” unfortunately lend a false understanding of this tool. To truly wrap one’s head around this new “pseudonymous” electronic medium one must contend with decades of an indoctrinated fiat money standard and its relative macro-economic principles. Welcome to my Saturday trying to sell this Kool Aid, over a few beers and bourbon, to a couple of finance veterans.

Never mind the fact that we spent a prime weekend night indoors debating the state of bitcoins in our economy and its prospects as an investment asset— those are grievances of an “older” man for a different day. The takeaways from the evening interestingly enough ended as a mish-mash of arguments based on an incomplete image of a new system characterized by labels that incorrectly set the foundation for factual debate on the subject.

Bitcoins are fucking confusing

Bitcoins come from one of two places. They are either mined by special machines connected to the bitcoin network (process + verify transactions) or are purchased on a market exchange. Like cash, ownership is singular, transactions, absent of a 3rd party, are final and transfers between parties guaranteed and secure.

These processes are the result of a tremendous computer science breakthrough in cryptography. Andreessen Horowitz summarizes it best in one of the better articles about the potential of bitcoins:

“Bitcoin is the first practical solution of the Byzantine Generals Problem that poses the question of how to establish trust between otherwise unrelated parties over an untrusted network like the Internet.
Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer.”

All of this sounds great except for this whole Mt. Gox thing people keep talking about.

Half A Billion Worth of Bitcoins Disappear

The jury is still out and we don’t know the root of this massive blunder that has left thousands of users (pardon my french) essentially holding their dick in their hands. Official word from Mt. Gox is that coins were stolen. Though, I’m convinced the makeup is instead rather a  strong cocktail made up of 1 part fraud, 2 parts negligence, 1 part cover-up and a splash of the alleged transaction malleability. This isn’t the first fuck up (see here, here, here…) but we are dealing with a new technology poised to endure some growing pains not-withstanding traditional macro-economic interpretations.

What’s My Money?

Unlike fiat currencies that derive their value from federal law and regulation, bitcoins are transparently self controlled and their value is the result of two notions. The present use of the system in terms of volume of transactions and  speculation of future use of the system.

Contrary to popular belief, bitcoins do not have an deflation problem. Though the traditional fundamentals make sense here. According to economists, given the coins’ finite supply (presently around 12 million BTC and poised to steadily reach around 21 million by 2140) users are incentivized to horde the currency and delay purchases until a later date when BTC value increase (deflation 101). Although this makes sense,  the BTC system, in rudimentary terms, is a tool that allows for transactions to take place relative to an actual fiat currency. [Remember? Bitcoins don’t have an arbitrary value to begin but rather volume of transactions are a key aspect where BTC derive its value allowing people to use them for trade.] In the end, national currencies remain central while the bitcoin ecosystem acts as a more efficient middleman replacing transactional functions of traditional banks.

Lets be clear that as is, the BTC system lacks may key elements (insurance, legal accountability of exchanges) for it to earn critical mass public trust and adoption. But, as more people use the system  it becomes more stable, less volatile, and its efficiencies become more apparent.

Like the many ground breaking technologies of the past decade and a half, bitcoins are simply a more efficient way of transferring value. They accomplish this feat much faster and at a fraction of what the banks costs. Certainly the lack of customer assurance, trustworthy mediators, independent audits and technical complications, that I didn’t even touch, are hurdles. Fortunately, these issues are all solvable and so long as the rate of adoption increases  the incentize is there to do so. To quit amidst the turmoil would be foolish when the upside is just too good not to fight for.