How Bitcoin Works: Part 2 - Spending Cryptocurrency

published by:
KENT GROFF, CFP®
March 30, 2021
How Bitcoin Works

How Bitcoin Works: Part 2 - Spending Cryptocurrency

In part 1 of our three-part series, we introduced cryptocurrency in general. Next, let’s explore the challenges and opportunities that exist for those hoping to earn, store, and spend their bitcoin or similar cryptoassets.

The Crypto-Possibilities

As described in part 1, cryptocurrency is typically driven “by and for the people” in peer-to-peer exchanges. In theory, this permits it to flow more quickly and cheaply, with fewer fees and administrative hurdles. Ideally, cryptocurrency offers the potential to:

·        Push Past Boundaries: Successful cryptocurrencies and the blockchain technologies behind them could offer a faster, cheaper, or at least additional way to conduct domestic and international commerce alike.

·        Democratize Currency Exchange: Cryptocurrency as a means of exchange may particularly appeal to those who are not big fans of government oversight or who live in a country that lacks dependable currency of its own.

·        Make Money More “Programmable”: By optimizing different blockchains for different purposes, it may be possible to “program” a cryptocurrency to adhere to specific rules or conditions during an exchange. For example, this in-depth report describes how a cryptocurrency could be programmed to act as a digital trust, contract, or escrow reserve, which could only be unlocked when certain conditions were met.

The Crypto-Challenges

On the flip side of the coin, many of the same qualities that appeal to cryptocurrency holders can also create challenges, even for established currencies like Bitcoin.

·        Competition: What if a competitor invents a better mousetrap, and the cryptocurrency you’re using falls out of favor? With no central authority in charge of safeguarding your ownership or preserving the worth of your cryptocurrency, its purchasing power may or may not endure. As one chief investment officer observed in a January 2021 Financial Advisor piece, “There is little in our view to stop a cryptocurrency’s price from going to zero when a better designed version is launched or if regulatory changes stifle sentiment.” 

·        Theft: Recent evidence suggests bitcoin theft decreased dramatically in 2020 … or at least became harder to detect. Either way, cryptocurrency remains an appealing target for cyberthieves with long histories of finding new nefarious strategies, even as older ones are shut down. Granted, the same thing can happen to your legal tender. Still, there is typically more government protection and insurance coverage in place for more regulated accounts.

·        Loss: Your cryptocurrency “wallet” is typically secured through a password that you – and only you – know; consequences are dire if you lose that password (or if a thief does get ahold of it). Best case, you may be able to pay a professional 10%–20% to recover your coins. Worst case, your coins may be gone for good. A January 2021 BBC piece reported, “Currently, about $140bn worth of Bitcoin is lost or left in wallets that cannot be accessed.

·        Supply and Demand: A government can seek to stabilize its currency’s spending power by adding to or pulling back on supply as demand rises or falls. In contrast, Bitcoin’s supply is fixed and finite. With a maximum set at 21 million bitcoin, approximately 18.6 million are already in circulation as of January 2021, with no mechanism for reducing that supply when demand declines. Time will tell whether this model remains a sustainable way to store value.

·        Government Regulation: Speaking of governments, since cryptocurrency was uncharted (unregulated) territory until quite recently, the rules of engagement are still largely under construction. As such, your cryptocurrency could suddenly become more or less appealing to hold, trade, or exchange, depending on countries’ rapidly evolving reporting requirements, taxable ramifications, judicial findings, and other regulatory acts. 

·        Energy Consumption: Last but not least, cryptocurrency mining centers worldwide are using enormous amounts of electricity. In December 2020, MarketWatch reported bitcoin production alone was annually “gobbling up the energy of a country of more than 200 million people.” The same report notes that most production is coming out of coal-fueled China, where “bitcoin production is likely to be particularly dirty.” Iran recently shut down most of its bitcoin processing centers. The country faced rolling blackouts and toxic smog in Tehran. In short, many cryptocurrencies aren’t exactly “green” money.

Given the challenges, no wonder one tweet from a celebrity can still send a bitcoin’s spending power sinking or skyrocketing overnight. You don’t generally see that from a dollar bill!

Still, many believe cryptocurrency is here to stay. Are they right? Will cryptocurrency prevail and ultimately become a widely accepted means of exchange? If so, which ones will sink? Which will swim? Under what circumstances?

We wouldn’t bet your life’s savings on any particular outcome – which brings us to our next topic of conversation: Does cryptocurrency belong in your evidence-based investment portfolio? Our short answer is no – at the very least, not yet. In part 3, we’ll explain why.

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