Rights & Money

Understanding Bitcoin

The concept of cryptocurrency may be perplexing, but digital money is here, and you’d better know what you’re doing before you invest


By Olev Edur

Photo: iStock/Tsokur.

Like tulips in the 1600s and dot-com companies in the 1990s, cryptocurrencies such as bitcoin seem to have become the latest investment rage. Since inception a mere decade ago with a market value measured in fractions of a penny, the bitcoin—essentially Internet-based money—has soared to thousands of dollars: at press time in March 2019, the market value of a single bitcoin was ranging between US$3,500 and US$4,000, after reaching almost US$20,000 in December 2017.

The first bitcoins were released in 2009, and the first bitcoin transaction reportedly took place in May 2010 when Floridian Laszlo Hanyecz bought two pizzas in Jacksonville for 10,000 coins.

Flash forward to March 2019, when coinmarketcap.com reported that the total capitalization of the global cybercurrency market had soared to almost US$140 billion and, according to a joint paper from the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada, more than 2,000 crypto-assets were being traded around the world. This dizzying ascent from nothing in just 10 years has made a lot of people rich and spawned thousands of imitations and variants; corporations and governments are reportedly taking notice and some are taking action, as well. The March paper from Canadian regulators proposed the creation of a regulatory framework to cover crypto-assets in Canada.

So what exactly are all these cryptocurrencies, and how can something with no real physical existence suddenly become so valuable? Is that growth likely to continue? Are they suitable for a retiree’s portfolio, or at least perhaps useful for certain otherwise awkward transactions such as sending money to relatives overseas? Or should you just stay away?


To appreciate the whole cybercurrency concept, you first need to understand its philosophical anarcho-capitalist, anti-authoritarian roots, which in this instance do make some sense. Bitcoin arose out of the desire for a currency that is independent of government manipulation (and regulation), free of institutional red tape (and fees), a secure, anonymous, and direct means for sending or receiving fixed value directly to or from anywhere in the world.

In the case of bitcoin (or indeed any crypto-asset), the value is market-driven and independent, as well as mathematically “secured” by blockchain (see box, below) and inflation-proof, because part of the idea is that only 21 million bitcoins will ever be created (by 2040). Cybercoin advocates point out that governments can and always do print more and more money to suit their fancies, creating inflation, which devalues the currency. They also suggest that as e-coin adoption spreads, market value will continue to boom and, for example, each bitcoin will eventually be worth millions of dollars.

As for intrinsic value, bitcoin is no less legitimate than a piece of inked paper or a polymer banknote whose value is established by government decree and accepted by all. The key is faith in the institution of government, or in the case of cybercurrency, faith in the inviolatility of the blockchain, in turn reflected by that soaring bitcoin market price.

You can refer to the accompanying boxes on blockchains and bitcoin mining (below) for quick synopses, but for more on the technology behind bitcoins and the seemingly arcane way they’re created, consider buying The Bitcoin Standard by Saifedean Ammous (Wiley, 2018); it provides a thorough explanation of what has been created so far and it’s fairly up-to-date. If you want more immediate news, check out cointelegraph.com; this site seems to have become the journal of record for the cybercurrency marketplace. And if you want a look at the other side of the coin, read David Gerard’s caustic—and in many places alarming—e-book Attack of the 50-Foot Blockchain.

The Flip Side

The rising value of cryptocurrency aside, there’s a darker side to the cybercurrency craze. For starters, it’s worth noting that while the cybercurrency market cap was $140 billion in March, it peaked in January 2018 at almost $800 billion, meaning that it’s down 82.5 per cent in the past 14 months. That in turn means that a lot of people got rich—but at the expense of lots more other people. And bitcoin’s unregulated, anarchic history—a mere decade long—continues to be littered with scams, thefts, and losses. Moreover, the $170-million-a-year Silk Road, launched in 2011 and dismantled in 2013, was part of the notorious dark web, where you can buy anything illegal from guns to drugs to slaves, and it was one of the few places that accepted bitcoin at the time.

More recent was the case in Canada of the cryptocurrency exchange QuadrigaCX, whose owner suddenly died this past January, taking with him the secret “keys” (passwords) to huge sums that are apparently lost forever. The company is now in the hands of Ernst & Young, a court-appointed monitor tasked with tracking down whatever remaining investors’ assets it can find. “This was the most-used cryptocurrency exchange in Canada,” says Benoit Vachon, a Montreal-based accountant (CPA, CMA). “Millions were lost.”

The latest warnings on cointelegraph and other cybernews sites revolve around ICOs (Initial Coin Offerings)—with everyone jumping on the bandwagon and creating their own blockchain-based currencies, absence of regulation has enabled a lot of fraud. And ICOs aren’t the only concern.

“Currently, the cryptocurrency market is not regulated enough to protect people from scams, so that is why scams are such a common thing among users of digital currencies,” reads a cointelegraph advisory page. “Since many people try to earn money by investing in new projects that are related to cryptocurrency, ICOs are one of the most popular ways to commit fraud. Besides that, some emerging cryptocoins use a financial pyramid system” and  “a digital cryptocurrency balance can be wiped out by a computer crash, a hack, and other unexpected events.”

A cointelegraph column by Selva Ozelli, an international attorney and CPA, contained a similar caution: “Despite information technology network security measures, blockchain platforms supporting the ICOs are vulnerable to computer viruses, physical or electronic break-ins, attacks, or other disruptions of a similar nature.”

Steel Door, Cardboard Frame

So how come these supposedly secure blockchain systems are always being scammed, stolen, or hacked, or the money just disappears?

The answer is that all those problems arise in the infrastructure that must be created to provide consumers with access to these blockchain-based currencies. Consumers must be able to buy and sell readily into an open market, so that requires exchanges, and they need storage facilities (“wallets”) for their coins—all of which may have vulnerabilities.

In his Attack book, David Gerard explains the situation more graphically: “Bitcoin’s cryptography is solid, but it’s a bit like putting a six-inch-thick steel vault door in a cardboard frame.”

With so much money now at stake, though, governments are beginning to take action. In 2017, the US Securities Exchange Commission (SEC) issued a landmark opinion concerning ICOs as possible securities subject to regulation; by March 2019, 28 countries had proposed or enacted ICO legislation, while China banned ICOs and closed all virtual currency exchanges.

“With the enactment of ICO regulations, institutional investors have become increasingly interested in investing in them,” one cointelegraph report states, adding, “[Many countries’] monetary authorities and regulators are looking to how to control, but not completely stifle, the growth in digital currencies. Due to the alternative nature of crypto coins, many regulators struggle to class it under the same policies as traditional investment assets.”

Where does all this leave retirees?

As an investor, you can certainly find any amount of feel-good bumph on the Internet, and it’s hard to deny the allure of four-digit returns. But tulips sounded great, too, until they didn’t. (Tulips prices famously soared in the Dutch Republic in the early 17th century and then crashed.)

“In theory [blockchain] is immutable, but we’ve seen a lot of events,” Vachon says. “There’s a lot of risk surrounding these cybercurrencies as an investment. We saw how bitcoin fell from $20,000 to $3,000 or $4,000. Then there was Quadriga. It’s still a largely unregulated environment. There are no rules.”

More outspoken cybercurrency skeptics cited in cointelegraph include the legendary investor Warren Buffett, who in 2017 called it “rat poison squared.”

And, while reports abound of corporations jumping onto the cybercurrency bandwagon, Vachon doesn’t see any great rush to the use of bitcoin. “This is all really new,” he says, adding, “We should see further developments in coming months.”

What about all those claims that eventually bitcoin will become universally adopted, in which case each coin will be worth millions of dollars?

The fly in this cyber-ointment is a technological limit: due to its decentralized nature, blockchain is cumbersome. In his book, David Gerard cites transaction-confirmation backlogs, delays of up to eight hours, and fees of up to hundreds of dollars.

“There is no way on earth that bitcoin could possible scale to being a general utility,” Gerard writes, noting that at its current size, the bitcoin blockchain can process “a maximum of seven transactions per second (TPS), worldwide. Compare with the systems bitcoin claims it can replace: PayPal, which ran 115,000 TPS by late 2014; Visa, whose average capacity was 56,000 TPS; even Western Union alone averaged 29 TPS in 2013.”

Similarly, cointelegraph reported on an outcry for scalable blockchain systems in 2017, which “led to a number of companies making attempts at solving the problem of scaling and gradually realizing that it’s not that simple. The first wave of projects triumphantly entering the market with a promise to solve specifically this issue have been, as predicted by experts, spectacularly missing their marks.”

Because of all the risks, Vachon strongly urges any would-be investor to discuss the matter with a professional advisor before diving in. If you insist on becoming involved, cointelegraph advises that you at least use a verified exchange or trading platform.

On the other hand, you might want to read and heed the FAQ (short version) at the beginning of Gerard’s Attack, attributed to one Christian Wagner:

“Q: Should I buy bitcoin?

“A: No.

“Q: But I keep seeing all this stuff in the news about them…

“A: No. Tech journalism is uniformly terrible; always remember this.

“Q: How does this work? It doesn’t make sense.

“A: No, it really doesn’t. It’s impossible to accurately explain bitcoin in anything other than mind-numbingly boring technical terms, so you should probably just not worry about it. Go do something useful instead.”


What Is a Blockchain?

Central to any cryptocurrency is the blockchain—an interactive, publicly networked, accounting/security system. It consists of a chain of interconnected blocks of data recording every transaction ever made with the currency. The data consists of amounts and electronic addresses that function as individual accounts. The data is all interlinked in such a way that the system is “immutable,” or tamper-proof.

“The blockchain technology is a decentralized digital ledger which keeps track of every transaction across a network and is incorruptible,” writes Montreal accountant Benoit Vachon in an article for CPA Canada’s website.

Addresses are available publicly and anyone can send coins to them, but each address also comes with a “key”: in order to access and spend or transfer the coins at that address, you must know the key. It’s generally recommended that keys be stored separately offline, or even printed so they can’t be hacked or lost.


“Mining” Bitcoin

The way in which bitcoins are created—there are to be a total of 21 million by 2040—defies any coherent explanation, although it seems to be working so far. The idea is that blocks are added
to the blockchain at a fixed rate to account for new coins, which are then given out. But to ensure they don’t go to anyone for free, debasing the coinage already in circulation, the system requires “proof
of work”—the cracking of new codes for creating each new block.

This code-breaking process, called mining, is extremely computer- and energy-intensive, consuming large amounts of electricity.

In the early years, bitcoin mining could be quite profitable, but the supply of new coins will continue dwindling (to zero 2040) while costs keep rising. In early 2019, cointelegraph.com reported that the last two months of 2018 were not financially beneficial for miners. “A sudden price downturn of around 50 per cent in the crypto markets in mid-November sparked temporary chaos, with warnings from China’s mining community in particular that network performance would soon suffer.”