The Smart Money: What are Bitcoins?

Posted Friday, January 24, 2014 in Analysis

The Smart Money: What are Bitcoins?

by Gina Hamilton

Perhaps you've heard by now that a couple of Maine candidates for office are accepting a currency called "bitcoins" for their campaigns.

What are bitcoins? How do people trade in them? And are they a good investment?

Bitcoin is a form of digital currency, used by people buying goods and services, mostly over the internet.  Not everyone accepts Bitcoin, yet, although there are new Bitcoin markets coming on line regularly.  In California, there are even gas stations where bitcoins are accepted, although clearly that's not the case everywhere.

Bitcoin is a form of cryptocurrency, which means that they use cryptography to be generated and traded.  People obtain them through a process of "mining" them by cracking parts of the code via their computers, and are rewarded with parts of bitcoins. It takes a fast PC to do this. People can also accept them by accepting them in trade.

The number of bitcoins is limited to 21 million bitcoins, hardwired into the encryption system.  Of that number, a little more than 12 million are currently in circulation, with a value in U.S. funds of $156 million.

Because the number of bitcoins has a natural limit, and because "lost" bitcoins are out of the system forever, the chances that bitcoins will rise in value is almost certain.  Some believe the value of a single bitcoin could rise as high as $100,000.

However, Bitcoin has a history of bubbles and busts.  And it also has a history of being used for things that aren't exactly, well, legal.  And every now and then, some country ... the latest is China ... decides they can't be used.

Just Sunday a Bitcoin exchange start-up founder, Charlie Shrem, and his customer, Robert Faiella, were arrested for money laundering.  They are accused of laundering funds for online customers of the drug bazaar Silk Road, which had been busted in 2013 before with 144,000 bitcoins, some $28.5 million worth.  The bitcoins in Sunday's arrests were also seized,30,000 of them, worth more than a million dollars.

China moved in December to restrict exchange of bitcoins for local currency, thus rendering bitcoins useless for most transactions in one of the largest markets in the world.  The value of bitcoins dropped like a stone after that, and panic selling occurred in China.  It has since regained some of its value.

And unlike other currencies, Bitcoin isn't protected in any way.  It is essentially a bearer bond.  If a hacker were able to hack into a holder's "wallet", he'd be able to walk away with the funds and no one could prevent it.  The aggrieved owner would have no recourse.  If a hacker hacks into a bank account, the bank eventually replaces the funds, and is compensated by a federal insurance program up to a certain amount.  If a hacker gets a credit card number, the credit card issuer makes it good.  

Not so with Bitcoin.  Part of its appeal is also its greatest liability - it isn't linked to your name, social security number, or bank account number.  It is almost anonymous, which is what made it so irresistible to drug dealers like Silk Road.  It has also been used by other illicit traders - money launderers, and the buying and selling of other illegal goods and services.  In fact, it is so irresistible that one of the world's great havens for illicit services, Thailand, made Bitcoin illegal. 

The up and down legality issues, and the frequent run-ins with law enforcement, make Bitcoin highly volatile as a currency, far more so than other world currencies except those in places where inflationary spirals are playing out.  Young people with very fast computers and forgiving internet networks may be able to mine bitcoins, but the majority of us aren't in that boat. The difficulty to come by and spend bitcoins, unless you accept them in trade and are in one of the isolated markets where bitcoins are used, makes them less of a natural alternative currency and more of a hedge, like gold.  But unlike gold, there is no "there there". Investors could easily lose everything if another large market restricts Bitcoin.   With gold, you at least have the value of the metal, no matter how debased it is.

Bitcoin may make it to $100,000 per coin, but there are a lot of uncertainties involved.  Nations may restrict the currency, law enforcement may seize large quantities in an illegal action, holders may dump the currency to avoid being tarred with the same brush as drug dealers, child porn salesmen, and gun runners. 

For now, Bitcoin is an interesting plaything, but it's not even close to being a potential retirement or college savings plan.

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