By Ryan Glover, CFP®
Learn more about Ryan on NerdWallet’s Ask an Advisor
A fundamental aspect of any sovereign economy is the right to mint and value a currency. In the United States, the Constitution lays this out clearly. Section 8 permits Congress the right to coin money, and Section 10 denies the states or anyone else that right. Creating a physical alternative to the U.S. dollar isn’t just difficult, it’s outright illegal.
Then came Bitcoin. What makes Bitcoin so unique (and legal) is that it is a digital currency and, thus, never minted. While its popularity has grown substantially in the past two years, the currency has actually been floating around since 2009, when it allegedly was created by clandestine developer Satoshi Nakamoto. Since that time, the currency has gone from little more than a theory to being worth as much as $1,200 per Bitcoin. At time of publication, it was trading just below $500.
Bitcoins are created through a process called “mining,” and they only exist in a computer file known as the blockchain, which is akin to a complex puzzle. After a computer works on the blockchain for a certain amount of time, a piece of the puzzle is solved, releasing 25 Bitcoins (rate halves in mid-2016) to the solver.
Seems easy, right? Buy a bunch of computers and get to mining! While this is how it worked early in Bitcoin’s existence, it isn’t quite that simple any longer. Part of the genius of Bitcoin is how elegant it is as a functioning monetary base. As more Bitcoins come into existence, the blockchain puzzle becomes progressively more difficult. The monetary base of Bitcoin was built to grow by 3% annually. This number was not chosen randomly: A 3% inflation rate is considered a healthy target for developed economies, and is near the figure targeted by central banks around the world.
As Bitcoin’s popularity has exploded in the past two years, the mining has grown exponentially more difficult and expensive. Whereas in 2009 it was possible to utilize a standard home PC for mining purposes, today it takes highly specialized kits to mine profitably. One has to remember, computers cost money and run on electricity. So, if you are running a non-specialized PC, it may cost $100 in electricity to mine $25 worth of Bitcoins. While some hobbyists still engage in such operations (I tried it myself), it is obviously far from a sound business.
To seriously mine Bitcoins it takes a minimum of a $5,000 investment. Companies like Butterfly Labs build specialized graphic cards designed specifically for blockchain hashing. These cards cost several thousand dollars and are typically back-ordered for months. To be in the “business” of Bitcoin mining requires an entire fleet of this equipment, which can easily cost $100,000 or more. To further complicate mining, this equipment typically is obsolete in six to 12 months, meaning further capital outlays are constantly needed to stay profitable. Entrepreneurs who have been successful at mining have significant capital, both intellectual and dollar denominated. Cheap access to power also helps—different parts of the country can have widely varying kilowatt costs.
If it is not profitable for the average person to mine Bitcoins any longer, then why has it exploded in popularity? The answer is twofold in my mind. First, and most importantly, central banks around the world have done very little to build confidence in paper currencies since the financial crisis in 2007. Furthermore, countries around the globe have taken on dramatic amounts of debt over the past seven years, resulting in an increase in the debt-to-GDP ratios of every developed market, and most of them have even doubled.
Open exchange rates have made fiat (paper) currencies viable since the removal of the gold standard in 1971. If one country practiced irresponsible monetary policies, the exchange rates punished them and devalued their currency. But what happens when everyone acts irresponsibly? Bitcoin is what happens.
The second reason Bitcoin has become so popular is that it has caught the attention of the investing community. The virtual currency has turned into a haven for speculators due to the extreme volatility of its exchange rate; at times it has doubled in the span of just a few weeks.
By design, there is a finite amount of Bitcoins that will ever be mined (20,999,839.77, to be exact). With a constrained supply, hedge funds have looked to corner the market on Bitcoin and have accumulated substantial holdings in the currency.
This environment is what has made Bitcoin a viable currency. It is in its infancy and there is still much that can go wrong. Two of its most recent hiccups were Mt. Gox (a large exchange and bank for Bitcoin) going bust, and a March 2014 IRS ruling that Bitcoin and other virtual currencies will be treated as property for IRS purposes, not currency.
While it is impossible to say whether Bitcoin is going to last, the idea behind it seems to be a lasting one. In fact, several major national businesses such as Dish Network, Overstock.com, and Zynga accept Bitcoin as a valid payment for goods. Don’t be surprised if the theory behind Bitcoin eventually ends up being the groundwork for a larger international digital currency.