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Cryptocurrency 101: How bitcoin works and is backed

March 24, 2021

Cryptocurrencies like bitcoin have had another surge in popularity over the past few months, leading to many questions: What is bitcoin backed by? Why is it worth so much? How do I buy it — and should I?

servers and laptop mining bitcoin On Feb. 21, 2021, bitcoin hit a high value of $57,489 per coin. The next day, Treasury Secretary Janet Yellen called it speculative, volatile and extremely inefficient. She said questions remain about its legitimacy and stability because of how it is used and how it is “mined.” (Late February brought a dip, after which the value began increasing again and briefly crossed the $60,000 mark in mid-March.)

The value of cryptocurrency is two-fold: the potential of its decentralized technology and investment speculation. But first, let’s start with the basics. Boiling this somewhat mysterious concept down to familiar building blocks will help us decide whether to invest in cryptocurrencies directly, indirectly, or not at all.

What is bitcoin and how does it work?

So, we know bitcoin is hot and controversial. But what IS it?

Bitcoin is the first cryptocurrency, created in 2009. There now are thousands of types of cryptocurrencies. These digital financial assets have no physical counterpart like cash or gold futures do. You can buy goods and services with cryptocurrency if the seller accepts it, but many people use them as an investment.

There is nothing particularly new about the concept of digital money. Think of credit card or Venmo transactions, where dollars move electronically with no physical cash involved.

Related: Explore the risks and value of cryptocurrency

What is bitcoin backed by?

The big difference with cryptocurrencies is that no central authority backs or regulates them. Millions of computers all over the world verify transactions, which are anonymous.

Here’s why this matters:

It's a Wonderful life run on bank scene Do you remember the “It’s a Wonderful Life” scene where Building & Loan customers all demanded their cash at once? While Old Man Potter’s actions were a catalyst, the key question was, “Who backs my money, and can I rely on that backer?” The Building and Loan customers asked for their money because they were concerned about its safety.

We no longer see such runs on U.S. commercial banks because of regulations started after the Great Depression. Money in a local bank — up to $250,000 — is backed by the U.S. government through FDIC insurance.

In addition, U.S. currency is backed by the U.S. economy. This means you can go to the U.S. government (through a bank or investment advisor) and exchange your dollars for a different form of value: a U.S. Treasury bond or note where the U.S. government will pay you interest and principal.

What can happen if there is no backer?

This “promise to pay” has value provided the backer is financially reliable, i.e., as long as the U.S. economy is strong enough to create a tax base that can repay U.S. government debt.

Think about the end of WWII, when a wheelbarrow full of German Reichsmarks could not buy a loaf of bread. Or consider how the Confederate dollar lost value at the end of the Civil War. In these cases, the government could not make good on any type of promise to pay.

With cryptocurrency, there is no authority to pay out if you were to try to exchange your digital assets for another form of value.

Central bank digital currencies are in early development, however. These will be cryptocurrencies that are produced by and backed by a government. China and South Korea are piloting the technology.

What’s the technology potential?

While cryptocurrencies do not have a backer, the decentralized blockchain technology that runs them is exciting. I would even say ingenious.

blockchain illustration It may well be a leap forward, which we all know can make a difference in the world. Think of the cost of a long-distance phone call 50 years ago versus today. Or think about the sophistication of instant messaging technology 20 years ago versus today.

Blockchain may be a better way to handle many large databases. There is opportunity in medical records, financial accounts, supply chains, election returns and more.

With cryptocurrency, blockchain has the potential to reduce transaction costs and delays. It also could act as a world currency — no need to exchange your dollars for euros, for example.

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