How Does Cryptocurrency Work? A Study in Bitcoin

Thinking of joining the Bitcoin bandwagon? Here's why a virtual currency can be worth real money.

Cryptocurrency is one of the hottest buzzwords in fintech, and has been for years. While Many people have talked about the technological wonder that is Bitcoin, but few answer the simplest question: how can a Bitcoin, which is just a string of code, be worth anything?

In this article, we’ll explore the notion of how Bitcoin is theoretically worth money, and how it works in a more practical sense.

How Can Bitcoin Be Worth Money?

Money, or a currency, can be understood in two main ways:

First, money is a medium of exchange. That is, I have to be able to give you Bitcoin in exchange for, say,  a can of Coke, or a haircut.

Second, money is a store of value. This is actually problematic for all forms of money, not just Bitcoin – but generally speaking, Bitcoin can act as a store of value.

You know, for example, that a Singapore issued ten-dollar note is going to store more or less S$10 of value, whether you keep it for one week or one month. The same is true with Bitcoin. However, Bitcoin is admittedly more volatile, as its value can increase or decrease quickly.

(Some people would point out that this is true for all forms of money, including the Singapore dollar. Currency fluctuations happen all the time – the most extreme case in recent history is the massive devaluation of the Venezuelan bolivar in 2018. That’s why these people prefer to invest in assets like gold, which they see as a more stable store of value).

It should be noted that throughout history, people have used all sorts of things as money. Cowrie shells, blocks of salt, copper, blankets, bags of tea leaves, cows and fish... all of these things have been used as money at some point.

The current incarnation of money – which is changing from bits of paper to digital ones-and-zeroes online – is just the most practically accepted form.

So long as people agree that something has value, and they agree to use it as a medium of exchange or store of value, it can function as money.

Bitcoin As Commodity, Versus Bitcoin As Money

One immediate problem is that, right now, Bitcoin acts more like a commodity than money. For example, many people buy Bitcoin in the hopes that its value will go up, at which point they can sell it for US dollars, Singapore dollars, or some other form of money.

This is not the original intention of Bitcoin. When Bitcoin is used this way, it acts more like a  commodity - such as gold or oil - than it does money.

Many Bitcoin advocates would rather this stop - they want to see Bitcoin being used in everyday transactions. That is, you can use it to pay for taxi rides, for a coffee, or for getting your nails done. However, the practical reality is that - as long as Bitcoin operates as a volatile commodity - this is tough to make into a reality.

Consider this: if you own Bitcoin, would you spend 0.1 Bitcoin (it can be divided into fractions) to buy a smartphone? Many Bitcoin owners might answer no. Because 0.1 Bitcoin may be worth S$1,000 today, but it could be worth S$10,000 in three months.

Consider the famous Bitcoin pizzas: in 2010, two pizzas were bought for 10,000 Bitcoins. Today, those pizzas would have the equivalent of US$100 million. Nobody wants to be the next fool to spend millions on a pizza, right? So with that in mind, many people who own Bitcoin are hesitant to spend it on consumer goods, as they keep thinking its value may rise by 10 or 100 times.

This gets in the way of Bitcoin being adopted as an “everyday currency”.

The other reason, of course, is on the seller’s end. Bitcoin values can drop as quickly as they rise. Many businesses are hesitant to accept a currency that’s highly volatile. Most businesses wouldn’t want to accept, say, the Venezuelan Bolivar or the New Iraqi Dinar. They’re worried that the currency could quickly plummet in value, or become worthless.

Nonetheless, Bitcoin can be said to operate as money, because it has found some traction as a currency. In Japan, for example, some 260,000 stores accept it as currency. Most recently, major retailers such as Whole Foods, Nordstrom, and Lowe's have begun accepting cryptocurrencies as payment, signalling that crypto may soon break through to mainstream retail.

Note that either way – as a currency or a commodity – Bitcoin is still worth serious money. A Bitcoin investor may not even believe in its future as a transaction currency; but that same investor may believe it can be resold for a tidy profit, perhaps later in the year.

That's not to say, however, that Bitcoin has not seen its own share of controversy. As always, due your due diligence before committing to any investment product.

Read these next:

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