Explained: How Bitcoin works and why it's crashing

KnCMiner, a Stockholm based Bitcoin mining hardware manufacturer, sold USD $8 million dollars worth of Bitcoin (BTC) mining equipment in one day , as customers clamored to gain a cutting edge advantage in the Bitcoin mining game.

The hardware-processing unit called Neptune - a USD $12,995 hardware unit that can potentially earn 2.13 BTC (USD$2608) profit per day - won’t even be available until 2014.

On the other side of the world, ASCIMINER - a Hong Kong based company - has set up one the most energy efficient (PUE of 1.02) systems to power and cool 92 circuit boards in 1 meter tall submerged containers in order to maintain a 24/7 dedicated Bitcoin mining operations.

And everywhere else, thousands of individual “hobbyists” are dedicating the power of their “pooled” hardware processors , 256 times more powerfulthan the top 500 supercomputers in the world combined, all for Bitcoin mining.

From Stockholm to Hong Kong, everyone has caught Bitcoin fever.

Very similar to the Gold Rush of early America, Bitcoin has captured the imagination of persons in every facet of society without even gold to motivate them - from a Vancouver based coffee shop owner who accepts payments in Bitcoin, to Richard Branson who is selling Virgin Galactic tickets in the most high tech currency every imagined. Bitcoin users can even pay for an education from the University of Nicosia in Cyprus.

A course in economics perhaps.

Bitcoin, the dominant digital currency, has all the underdog heroics going for it. Its unregulated nature, its supposedly inflation proof attributes, its efficiency and its low costs of transaction. Its everything you could imagine a perfect currency to be. Almost.

The fundamental problem with Bitcoin is that it may not really be worth anything.

What Is A Currency Anyway?

Prior to 1971, all the currencies of the world were valued based on gold. Any citizen could walk in to the central bank of their country and exchange the paper for equivalent value of gold. But after the Bretton Woods conference , the United States abolished that principle and most countries followed suit.

And money, or currency became all about trust .

Currencies by their nature work because of the collective faith in their value. Every country or region has collectively decided, through governments and institutions, to acknowledge the value backing the special pieces of paper that they call money.

As long as most people agreed in the collective value the paper had, everything was normal. However, when people lost faith in the currency, economies would collapse - like in the case of Greece .

In cases of catastrophe, countries are said to have a “soft currency” - one that is hypersensitive and fluctuates rapidly due to non-tangible factors like rumours, news, political situations and economic changes. Soft currencies are inherently unstable and an indicator of an unstable or inefficient or corrupt establishments, in the form of governments, banks, politicians or even technology networks.

Bitcoin is one such soft currency.

As struggling economies across the world attempt to grow and develop in international trade, their success has been rewarded with a higher valuation of their currency or those high and mighty economies that have made mistakes or been reckless, have seen their currency fall .

Bitcoin on the other hand has grown nearly 890 percent in the last year or 256,000 percent in the last three years .

I’ll repeat - 256, 000 percent growth.

It was traded at nearly half a penny in 2010 and its currently trading at USD $1280 now. Of course, it hasn’t been a steady growth, but one marred by plummets and spikes rivaling a terrifying mega rollercoaster.

All this growth is backed by nothing. There is no value - no participation in the production of resources like oil or minerals, no creation of services like the BPO sector or handicrafts, in other words there is no trade of created value that underlies the utility of the currency for most of the people. Trade is of the Bitcoin itself against traditional currencies within a small group. And this inherent flaw makes it susceptible to erasure.

“It (Bitcoin currency) has to have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is,” said Alan Greenspan, the former Chairman of the United States Federal Reserve. “I haven’t been able to do it. Maybe somebody else can."

“Show Me The Money!”

We know children ascribe value to things that most adults would not - toys, pens, comic books, blankets, coins (not for money reasons), almost anything. As they grow older, their obsessions mature and they find communities that reinforce that worldview. In the case of children, it can be trading cards of cricketers or wrestlers or Pokemon and for adults it can be fine wines, antique books or high-end consumer technology.

“We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first,” said Charles Mackay, in his book Extraordinary Popular Delusions and the Madness of Crowds .

In fact, a Pokemon playing card sold online for USD $100,000 because of its perceived rarity and high value. But most people wouldn’t sell someone a house or a car or an education or a litre of milk in exchange of that card. They wouldn’t see the utility value of it.

Bitcoin, despite its technological finesse, mathematical elegance and hardcore community of followers, is very similar to a rare Pokemon trading card you get free with chewing gums. Its value is only to those who buy in to the obsession. On the other hand, everyone likes cash - Indian, American, Greek or Brazilian - if you can feel it you can deal it.

And even as digital transactions become more common, the supporting infrastructure reaches even the most remote places and everyone is educated in the technology of digital currency, the human element can never be replaced - the ability to hold someone accountable for the irregularities of fate - from the stock market to currency rate dips.

In that respect Bitcoin is a failure, and that’s because it isn’t real.

Not in the way that matters anyway.