Making Sense of Cryptocurrency

Before we launch in, I want to give a special shout-out to Money with Katie reader and friend who took it upon himself to aggregate a lot of the resources I used when writing this post – without Andrew Pinter, it’s no doubt that this article wouldn’t exist (at least, not for a lot longer). He rescued me from staring into the abyss wondering where to start, and his takes and influence are woven throughout. He’s a law student at Boston College who’s 50 shades of smarter than I am, so enjoy.

That’s a title I thought I’d never type. For a long time, I dismissed the hype around Bitcoin and cryptocurrency as a passing, speculative fad, borne out of a time of uncertainty and insecurity (global pandemic) where people were searching for a hedge against a failing economy on government life support. (To be fair, I’m still not wholly convinced it’s not, but only time will tell.)

It was easy to dismiss it for a while, since the majority of said hype was coming from Bryce Hall-equivalent Tik Tok stars and other 19-year-olds promising a get-rich-quick scheme to their followers.

It wasn’t until some of the smarter people I know started getting excited about it that I began to take it more seriously. Call me intellectually snobby, but I wasn’t about to take investing advice from Addison Rae’s boyfriend – and the general “meme” culture around crypto had me mostly writing it off.

The purpose of today’s post isn’t to give you the world’s most thorough run-down on the technical aspects of Bitcoin – if you’re looking for that, there’s an in-depth discussion with different “chapters” you can find here, from Coindesk.

Today’s post is intended to show you how I’m thinking about Bitcoin – why I was skeptical, what I’ve learned since then, and how I’m making sense of it. I’ll also share the broader questions I have about the technology, some of which I’ll answer today (and others I’ll just thrust out into the open and pray some overzealous crypto commenter will answer for me).

The big picture reason I was confused about Bitcoin

…because it begs the existential question: What is money?

What gives money value?

The dollar hasn’t been backed by gold since 1973, so it’s not like there’s some secret, underlying asset that gives the dollar some inherent value.

In a lot of ways, money is a collective delusion that we’ve all agreed on. The idea that one could just “invent” a new “money” didn’t make sense or fit into my framework of “things that can happen.”

Other reasons I was skeptical about cryptocurrency

Before we dive into how I’m making sense of it, I want to highlight reasons for my initial skepticism – so you know that I’m not close-minded, just paranoid and pessimistic. So much better, right?

Overly complicated explanations

For one thing, I judge someone’s understanding of complex things by how simply they can break it down. If you can explain something to me like I’m a fifth grader distracted by the high of a Scholastic Book Fair and still make it comprehensible, then that’s a pretty good sign you understand it.

It felt like every single explanation that people rattled off to me about cryptocurrency, blockchain, or Bitcoin was riddled with jargon, lofty language, and concepts that I wasn’t quite sure even they understood.

No long-standing history

I felt comfortable investing in the stock market because there’s a century of data behind it. Whether the sense of security I feel is false or not, it’s something with 100+ years of history backing it up – along with experts, industry, and more Suze Orman books than would fit in your local Half Price Books.

It felt like a relatively safe bet.

Cryptocurrency was invented in 2009, when I was a freshman in high school. And despite the fact that that time was plagued with me replacing the pink silicon cases on my Blackberry on a rotating three-month cadence and layering earth-toned Abercrombie polos – a lifetime ago – it’s really not a very long period of time for something to prove it’s got long-term value, especially when the growth chart looks like this:

We should note the counterpoint here – if this technology is in its infancy and destined for a truly valuable future, now’s a great time to get in. It could be Apple stock in the 1980s – or much bigger, which leads me to my third point of skepticism.

Distinct FOMO vibes

You can’t talk about cryptocurrency without talking about Bitcoin, the O.G. poster child of the movement (should we call it a movement? New wave of money? I don’t know). There are a defined number of Bitcoin that can exist – 21 million – and we’ve “mined” about 18.7 million of them as of the time of this writing (May 15, 2021). Here’s a real-time counter.

This creates the perfect breeding ground for a supply-and-demand bonanza – because what makes an asset valuable? Scarcity.

By that, I mean: People want something more if they know it’s scarce. That’s why “limited edition” brand drops are so popular for marketers; scarcity drives demand.

But the skeptical side of me saw that as a big FOMO inducer – people were talking about Bitcoin in the, “You better get in now or you’re going to miss the trip to the moon!” way, and it felt like a big circle jerk. If I own Bitcoin (read: I have some of the supply), it’s to my benefit if I pump up the demand by telling you that you need some, too. The more people want it, the more “valuable” it becomes.

It felt like a tech bro’s perfect MLM, and I was not into it. (Don’t worry, we’ll get to the “making sense” piece soon, but I wanted to be sure to explain all my initial hesitations in case you’ve got the same ones.)

The key example that shifted my perspective

By nature, I always analogize things. It helps me understand the world around me. And for the longest time, I had nothing to compare this to – until someone said, “How do you think people felt when they first heard about the Internet?”

Whoah.

I probably would’ve reacted the same way to the invention of the Internet as I am right now – “What do you mean it’s an interconnected network using standardized computer protocols? F*** you, I’m going back to the Book Fair,” I would’ve said.

It wouldn’t have made intuitive sense to me, and frankly, I still don’t understand how it works – I just know that it’s the reason I can blast my ridiculous musings to the world and somewhere, someway, you’re sitting in front of a computer on the other side of the country reading them, almost instantaneously.

Looking back, I probably would’ve been one of those people saying, “Yeah, but we have hundreds of years of proof that mail works! Why do we need this interconnected computer network? Dumb.”

And I would’ve been wrong.

But here’s the weird parallel between cryptocurrency and the Internet example

People have been saying that blockchain is “the next Internet,” which makes this comparison all the more appropriate.

But that calls to mind an even scarier parallel:

The dotcom bubble.

My understanding of the dotcom bubble was that everyone got too excited about the prospect of the Internet all at once, that confidence translated to a ton of money pouring into tech stocks, and then it all came crashing down in 2001 and 2002. Here’s how Investopedia describes it:

The dotcom bubble, also known as the Internet bubble, grew out of a combination of the presence of speculative or fad-based investing, the abundance of venture capital funding for startups, and the failure of dotcoms to turn a profit. Investors poured money into Internet startups during the 1990s hoping they would one day become profitable. Many investors and venture capitalists abandoned a cautious approach for fear of not being able to cash in on the growing use of the Internet.

While there are key differences between cryptocurrency and what happened in the late 90s to tech stocks, I can see parallels.

This chart is a perfect explanation for why people look at the dotcom bubble as “not wrong, just early.”

Were those people wrong about the importance of the Internet in the future? Well, no. But the amount of capital that flowed in – quickly and speculatively with really no underlying technology that could turn a profit, at the time – caused it to come crashing back down to Earth.

Before I published this piece, I shared it with the reader and friend who sent a lot of resources my way when I was learning about it. He’s a law student who’s taken legitimately accredited academic courses on blockchain and Bitcoin, and his enthusiasm for sharing it all with me rivals my enthusiasm for sharing all my hot 401(k) takes with you.

He noted an interesting difference between the conditions that propped up the dotcom bubble and the ones that we’re living in today: online forums like Reddit, Twitter, and even Robinhood that tend to democratize this type of information and spread it more quickly.

He posed an interesting question I want to float for the rest of you: Would the dotcom bubble have concluded differently if Reddit were around in 2000?

Now that that’s out of the way, let’s talk about blockchain

You can’t talk about Bitcoin without talking about blockchain, which is arguably the real shining star here – blockchain is the fancy name for the technology that enables cryptocurrency to exist, and it’s basically just a ledger (I think about it like a recordbook or journal, because of my #girlbrain) that records information.

When you or I send money to another person or place today, there’s a middleman in the process: the bank.

If I want to access my money or send it somewhere else, I have to consult my old friend J.P. Morgan Chase. Really, he holds the purse strings. I can’t really access it without him playing along nicely, and if he, for some reason, decides I’m blocked from my own account, I can’t really do anything about it besides beg and plead.

(It’s worth noting here that, if you buy your Bitcoin on an exchange like Coinbase, Gemini, or even a bank that’s beginning to offer the ability, you’re using a middleman again. The technology doesn’t require one, but if you’re using a third-party service or exchange to get it, you are reintroducing the very middleman that blockchain set out to eliminate. But this is capitalism, so welcome to the marketplace.)

The blockchain is special because it’s “decentralized,” which basically means there’s no one person in control. Banks are for-profit businesses with operating hours, fees, and incentives that don’t necessarily align with your own – by removing that step from the process of sending money between two individuals or places, you’re creating efficiency that isn’t bound by operating hours, bank fees, or other limitations that traditional banks have today.

How does the blockchain work?

The way I think about blockchain is like a record that can’t be changed, manipulated, or defrauded. It’s not instantaneous, though, which was an initial misconception I had. When you transact via the blockchain, that transaction is recorded chronologically in a block amongst all the others, then locked in place in a chronological chain that lists the transactions. And since it’s “decentralized,” meaning it doesn’t live in any one place, no one person or institution can control it.

Instead, all the computers on the network have to agree that a transaction is a legitimate. It’s like they all check their records simultaneously, say, “Yep, that one checks out,” and then the transaction goes through.

The computers are all incentivized to get it right, because they’re rewarded with more Bitcoin when they do.

(Does anyone else feel like they’re living in a sequel to Smart House that they never consented to? Damn.)

That’s why often times the blockchain is represented in pictures like tons of computers connected via dashed lines, with no hierarchy. No one machine/person/server controls the whole; the record-keeping happens simultaneously amongst them.

This decentralization is a huge selling point for the Bitcoin bull case, but in April, a flood in a remote part of China exposed a potential shortcoming: A coal mine used to power some of these fancy shmancy computers flooded, and was shut down temporarily as a result:

“Prior to the flood, most experts thought that Bitcoin miners operated in many parts of Xinjiang. But the shutdown exposed that almost all, if not 100% of production in the region, is flowing from Hutubi and three neighboring counties powered by coal from the Fengyuan mine.”

The report stated that the blackout stopped about one-third (35%) of all of Bitcoin’s global computing power. That’s a pretty big deal – it suggests that one-third of the “decentralized network” is in one place.

That aside, while conceptually I can grasp this blockchain concept, there are a few questions that came up for me:

1. Is a decentralized network inherently really valuable? Do we need decentralized record-keeping? What are the use cases for this?

   • In my post-draft discussion with Andrew, he told me that hospital records are a pretty good use case for this – which makes me think it’s beneficial in any sector or industry where record-keeping is fragmented, imperfect, or inefficient. So… all of them.

2. This seems like it has major implications for replacing the current financial system. Is that system too entrenched to be overthrown? Would the government ever allow that to happen? Could they stop it?

   • The answer is probably more complicated than this, but from my research, it sounds like the prevailing opinion is no, they couldn’t – they’d have to shut down the Internet in order to fully block it, though it’s possible they’ll start to tax the shit out of it. Instead, it’s more likely that they’ll play nice and try to find a way to control it instead.

3. How is this any different than cash? If I have $5, I can give it to someone else without any governing body in-between interfering. I can just hand it to them.

   • In thinking about this one further, I’d argue that it just takes the requirement for “physical proximity” out of the equation for a cash transaction. I can’t hand cash to someone in Africa.

For more about blockchain, this Medium article does a decent job of explaining it in greater depth.

So how does the blockchain relate to Bitcoin?

Where Bitcoin comes into the equation

Bitcoin, like other cryptocurrencies, is traded using this blockchain technology.

But instead of being produced by a central governing body (like the Federal Reserve creates U.S. dollars), Bitcoins are “created” by computers all over the world. I’m putting “created” in quotation marks because they’re technically “mined,” which is a confusing term since it connotes mining for gold. Was that intentional? Probably.

Once mined, a Bitcoin can be traded between two things called “wallets.” If you have a Bitcoin in your “wallet” and you send it to mine, I have a set of private “keys” that allow me to access it. You can think about the “keys” like a super long, complex, semi-anonymous username.

This is another place where the aforementioned tech-y coding piece comes in – but the important thing to note is that the entire network records every transaction.

If you send me a Bitcoin, you and I aren’t the only two with that record. The entire network – and everyone on it – stores and “sees” that transaction, too. When you go to send one, there’s a mechanism in place that checks the previous transactions to make sure that you have the Bitcoin to send in the first place. (This part doesn’t sound that different to me than traditional banking, except for the fact that it’s “decentralized” code doing the checking, vs. a bank or institution.)

This is, however, where the “safety” aspect comes in. The Bitcoin “protocol” – that method of keeping track of transactions in an unchangeable, chronological way – can’t be tampered with by coders (I don’t know why or how, so don’t ask – but that’s a big selling point).

Fraud and hacking that does occur tends to happen at the “wallet” level – as in, someone could “steal your keys” to that wallet, break in, and access your Bitcoin.

Why Bitcoin is different from traditional “money”

One of the key differences that jumped out to me is that it’s irreversible – today, I could rack up a bunch of spending on a credit card, claim it wasn’t me, ask for the money back, and get the purchases wiped out. The card company doesn’t pay the vendor, and the vendor is left out to dry – having given me goods in exchange for the promise of money, only to be thwarted by my nefarious ways when I later decided, Nope, I’m going to defraud this merchant.

You can’t take a Bitcoin back. Once the transaction happens, it’s gone and done. (And while, in this example, it’s used as a good thing, it’s a bit of a double-edged sword – Andrew pointed out that sketchy, offensive, or proprietary shit could also be locked into the blockchain in an irreversible way, which is not good.)

While this might not seem like that big of a deal at the individual level, “chargebacks” (or people reversing payment) are a not-insignificant source of inefficiency in the marketplace. Think about that example at scale: If you have a lot of people leaving the merchant out to dry (taking goods, promising to pay for them via credit card transaction, then defrauding the company later), that becomes a cost to the merchant. At scale, this can drive up the price of goods.

“This store accepts Bitcoin”

That said, it seemed odd to me that you’d ever pay for anything in Bitcoin – Bitcoin is theoretically an asset that’s going up in value. Paying for something in Bitcoin felt like the same thing as saying, “I’m going to pay for this transaction with one share of an S&P 500 ETF.”

Since the price of the asset is volatile and changing (unlike the value of $1 USD, which is the unit things like Bitcoin and an S&P 500 ETF are measured relative to), the price of any given object could then fluctuate day to day.

Why would I give you 1 Bitcoin for something today if I think in 6 months from now that same Bitcoin will be worth more? It would change the way I look at transactions. It’s like the guy who spent 10,000 Bitcoin on two Papa John’s pizzas in 2010. While that’s an extreme example, the same logic would apply in the future, I’d think.

It would create a perpetual system of being afraid to transact for fear of trading an asset that’s going up in value for something with a fixed value.

Think about it this way:

Pretend I can get a Tesla Model S for 1 Bitcoin. Today, a Bitcoin is worth $48,000.

Let’s say tomorrow it’s worth $50,000.

Does the price of the Model S vacillate between $48,000 and $50,000 from day to day? Or would Tesla charge slightly less than 1 Bitcoin the day it’s worth $50,000 since the “original” price was $48,000?

In other words, is the price tied to the dollar, or to the Bitcoin? (In practice today, it’s tied to the dollar – but if you believe Bitcoin will replace the dollar and we’ll no longer have dollars, then what is Bitcoin’s value measured relative to?)

And – more importantly – does anyone know where I can find a Model S for $48,000?

See why this gets weird?

That’s why I can see the argument that Bitcoin is a “store of value” – an asset that maintains or grows in value, assuming everyone continues to agree that it’s valuable – instead of a replacement for currency. Since the Bitcoin’s value is always related back to “how many dollars” it’s worth, there’s really no point that I can see in charging for things in Bitcoin instead of in USD.

The obvious big exception here is that some of the supposed biggest benefits of Bitcoin are for fraud and merchant protection (like the chargeback example), so in that case, I see this as a bit of an oddity that’ll have to be worked out.

Supply & demand of Bitcoin

Anyone who’s struggled through Economics 101 or seen one (1) Supreme drop knows that scarcity drives demand.

The fact that there are only 21 million Bitcoin “available” to exist is a key point that comes up with respect to its inherent value – it’s limited. You can’t make more (theoretically, at least – I don’t know why the inventor couldn’t just… code more, but remember? This isn’t a technical piece).

One concern I have about that structure stems from the massive wealth inequality we already see in the U.S. – in 2010, the top 0.1% of people in the United States controlled 20% of the country’s wealth.

The difference between traditional money and Bitcoin, though, is that Bitcoin is finite, and traditional money is not.

While there are critics who say the fact that they can always print more money is actually a shortcoming because it devalues the dollar, I guess I can see the counterpoint, too: If money were finite, the rich would continue to accumulate it at a rapid pace, and there wouldn’t be any left over for anyone else. It would be a zero sum game.

It’s intellectually sloppy of me to bring this up without a neat resolution, but I think the fact that we can create more dollars is actually a good thing (in moderation), not a bad one.

And while I don’t necessarily think this is an argument that would truly detract from some of the benefits of blockchain technology and the cryptocurrency traded on it, the laws of supply and demand would dictate that as supply shrinks (read: rich people get more of it, leaving less for everyone else), the demand would increase.

The value of each coin would become higher and higher as less is available on the market, thereby ballooning the value of the coins that the evil uber-rich (in this hypothetical) already accumulated, as people fight over the scraps.

I realize that’s a scary, post-apocalyptic picture, but it’s something I haven’t really heard anyone address or debunk yet.

While Bitcoin was originally intended to help address some of the inequality that was driven by the “too big to fail” banking system, now those very same banks are investing in it. They’re putting their big, bank-y weight into it, which… kind of defeats the purpose?

How I’m thinking about and making these decisions for myself

Regardless of whether or not I actually believe in the validity of this new technology, I’m looking at it the same way I’d approach any risk/reward situation by assessing the possible upside and downside.

For example, “regular” stock market investing is still a bit of a gamble. You know over the long, long run you’re likely to win the game, but you could take your fair share of Ls along the way. You won’t win every hand.

To me, though, despite scary forecasts and the potential to lose a lot of hands in a row, I always ask myself: Well, what’s the alternative? Not invest at all? The data points to the fact that it’s a good, easy, and cheap way to build wealth. I have yet to come across anything that brings more potential upside for less potential downside. The data is compelling enough to make me believe that I don’t really have a better option, with the exception of adding some rental property investing to the mix – but even then, I wouldn’t bet it all on real estate, either.

When it comes to Bitcoin, I have far fewer data points to work with. I have a conceptual understanding and a lot of smart people who swear it’s the next big thing, as well as the basic laws of supply and demand. I have about 6 months’ worth of rapid growth (November 2020 to May 2021).

But remember the takeaway about the dotcom bubble:

Many investors and venture capitalists abandoned a cautious approach for fear of not being able to cash in on the growing use of the Internet.

“Abandoned a cautious approach.”

Looking at this objectively, I would think that’s the key here: Move forward cautiously. Groundbreaking, I know.

The headline here for me: While I think there’s something to this technology, it’s still unclear to me whether everyone is flooding in right now because they’re all simultaneously seeing the value and it’s actually worth the price it’s selling for, or if everyone is just scared of inflation and the uncertain future we face globally.

Setting expectations realistically

Because here’s the thing: Even the most bullish Bitcoin investors aren’t going all in and abandoning all other investments (and some of the most famous faces of Bitcoin, like the Winklevoss twins, are reported to have bought it for as little as $10 per coin – that’s .0002% of its current value).

It probably goes without saying that someone who bought Bitcoin at even $100 per coin and saw a 47,000% return is likely to see more of an increase than someone who buys it today at its current price of $48,000.

In order for someone buying it at $48,000 to see 47,000% returns, the price of Bitcoin would have to rise to $23,040,000.

The most popular bull case I’ve seen for Bitcoin so far is on the Business Casual podcast interview with the aforementioned Harvard Dreamboat Twins: Bitcoin to $500,000.

If you’re wondering how they arrived at this figure like I was, it’s because they hypothesize that Bitcoin will replace gold.

Today, gold is considered a hedge against inflation and a store of value that people flee to when she gets dicey. The market cap of gold – think about this like the value of all the gold together – is $11 trillion. In order for Bitcoin to replace the full value of gold, each coin (21 million of them, remember?) would need to be worth roughly $500,000.

If you were to buy today at $48,000 and it did go to $500,000, that’s a 941% increase. Outstanding outcome, obviously, but it’s not 47,000%. Expecting a Winklevoss-style return just isn’t reasonable – at least, not in this dimension.

This may be controversial, but I think I’m comfortable categorically saying that if you can’t afford to buy “safe” (relatively speaking) index funds in traditional investment vehicles like your 401(k), a Roth IRA, or even a taxable brokerage account, you shouldn’t be buying Bitcoin.

And I don’t say that because I think there’s something wrong with the underlying technology or logic – I say that because the price chart shows that roughly 83% of its present value has been gained in the last six months (going from roughly $10,000 in October 2020 to $60,000 in the spring of 2021).

Even if you’re just looking at it as a game of chance, the chances that it could be overpriced right now are not zero – and if you aren’t comfortable going so far as to say the chances are “good,” the growth has been rapid and recent enough to admit that we don’t have enough historical data to say what’s happening next one way or the other.

Moving forward cautiously

Taking a cautious approach would suggest determining what percentage of my current investable assets each month could be feasibly risked on something that’s objectively more speculative than traditional stock market investing. Here’s my breakdown:

• $1,625 per month to the 401(k)

• $500 per month to the Roth IRA

• Between $3,000 and $8,000 per month to a taxable investing account, depending on income

That’s $5,125 to $10,125 per month going into the stock market.

Quick note about privilege here

I realize this is a privileged perspective – it’s easy for someone with $10,000 to invest every month to say, “Hey, don’t forego the traditional stuff. Do all that, too, and just dabble in Bitcoin.” If you’ve only got $500 to invest every month, it’s going to be a lot harder to take the slow-but-sure path for the next 30 years if you think there’s a rocketship to the moon that you’re missing out on.

But that’s the thing – it might not be. Despite all the evidence, it could still be a bubble. That’s where the true definition of “high risk, high reward” comes in: If you’re truly willing to risk everything for the potential payoff, you may be richly rewarded. But maybe not. Diversified, low-cost index investing in the stock market doesn’t really come with that same potential cliff; at least, not historically.

Combining belief with caution

Here’s where “personal belief in the technology and value” meets “caution.”

I’m convinced enough that there’s something there to invest in it, but not convinced enough to throw in the towel on my current strategy.

In a non-scientific method of decision-making, I’ve determined that I’m willing to risk 10% of my taxable investing contributions – between $300 and $800 per month – on this new technology.

Investing in Bitcoin is, in my mind, a little bit like investing in an individual stock (something that I don’t do).

That’s where the question of “downside” comes in – what becomes the worst case scenario? Obviously, a 100% loss – plus the opportunity cost of putting that money in the stock market, which is slightly harder to gauge for sure.

Let’s look at the average – $550 per month. That’s $6,600 per year.

If I invest $6,600 per year into Bitcoin instead of the stock market for 10 years, I could lose out on the stock market gains if Bitcoin doesn’t outperform the market in the long-term.

Using a conservative average rate of return in the market of 5%, that’s $83,909 in the market (about $17,909 of projected growth at 5% returns).

But my potential for loss isn’t just that $17,909 of opportunity cost growth – it’s the full $83,909, as Bitcoin could go to zero. While that’s admittedly very unlikely, it’s not impossible.

This whole analysis is made even more complex by the fact that some economists are predicting the USD will lose a lot of value over the coming years. It’s not clear to me (a) how valid that concern is, or (b) what that would mean for Bitcoin.

That said, the question I’m now asking myself is:

Am I willing to risk $83,000 over the next 10 years on this bet?

…and adjusting accordingly.

If the answer is no, then I lower the monthly contribution until the overall number becomes something easier to swallow. If the answer is, Yes, and more! Then the monthly contribution to Bitcoin goes up.