Bitcoins 101

Understanding this New Digital Currency

Bitcoins 101
January 21, 2014

What are Bitcoins? Depending on whom you ask, the answers will vary from a new form of virtual currency to a massive online accounting ledger. Some even consider Bitcoins a conspiracy to bring down the international monetary system, but those fears seem exaggerated. What is true is that the distinctive nature of Bitcoins, as compared to traditional sovereign currency, makes them hard to characterize or evaluate.

Simply explained, Bitcoin is a decentralized commerce system where all transactions are logged into the "Blockchain" (essentially a huge, transparent, third-party accounting ledger). Bitcoins are the unit of measure — or virtual currency — for these transactions. The transactions are recorded in the Blockchain by a sizable network of individual computer users, known as miners, who deduct from one account and add to another in an immediate, irreversible logging process.

As a reward for their efforts, the miners are also the creators of new Bitcoins. They solve cryptographic puzzles of increasing difficulty and are rewarded with new Bitcoins when they succeed. Eventually the puzzles become virtually unsolvable, thus "capping" the supply of Bitcoins.

The program is designed to cut the new issues of Bitcoins in half at regular intervals, creating an asymptotic supply curve peaking at around 21 million Bitcoins. As of the end of 2013, slightly over 12 million Bitcoins have been "mined" into existence. The intent is to mimic gold or other precious metals in their scarcity and recycling patterns (thus the name "miners").

A small, but growing, number of merchants already accept Bitcoins as payment, and a judge in Texas recently declared Bitcoin to be a form of currency. But is it? Despite this judge’s ruling, the technical answer is no, for Bitcoin has no backing by a sovereign government. Nevertheless, Bitcoin is clearly a form of payment that is becoming increasingly acceptable.

It has interesting parallels to currency, but some major differences. For example, there is no central bank or governmental authority to back Bitcoin — or adjust its supply — as occurs with the money supply of sovereign nations. Thus, Bitcoin is more analogous to precious metals than to traditional currency. Just like gold or silver, the value of Bitcoin is determined by marketplace perception of its value.

Like cash, Bitcoins can be stored in your "wallet" — an application for computers and smartphones that allow you encrypted digital storage with a private key. Not surprisingly, it is extremely important that you back up your wallet! Lost Bitcoins are gone forever — there is no central authority to retrieve or unlock them. Lost Bitcoins still exist in the ledger, but are effectively "orphaned" and unavailable for use.

This brings up another interesting point — with an eventually decreasing supply (as new Bitcoins cease and existing Bitcoins are periodically lost), will the effect be deflationary or inflationary, or large enough to even matter? Bitcoins do have the added feature of being divisible up to eight decimal points, so it seems more likely that it will be inflationary in the beginning and relatively stable at maturity — as long as it is continually accepted.

The decentralized and anonymous nature of Bitcoins makes them attractive to criminal enterprises, so an emerging challenge is how to regulate this virtual currency. Transactions themselves cannot be altered, but there are steps where governments can (and will) intervene. For example, the Singapore government is now regulating how merchants must handle reporting of capital gains, earnings, and even sales tax on Bitcoin transactions. How other governments — especially the US and European nations — approach regulation is likely to have a drastic impact on Bitcoin acceptance and value.

That is why Bitcoins are such an investment wild card today; it is simply impossible to predict what events might affect their value. This uncertainty is reflected in the wild fluctuation of Bitcoin pricing (in USD) over the past three months alone. In early November, Bitcoins sold for around $200, then shot up to $1,200 in December, only to plunge back to roughly $800 at the time of this writing (January 16, 2014). Clearly, Bitcoins are not investments for the faint-hearted!

To be fair, though, Bitcoins have their advocates among the investment elite. Chris Dixon, partner in the successful Silicon Valley venture capital firm Andressen Horowitz, believes Bitcoins are an absolute bargain today for two reasons. First, he predicts they will become the primary form of online payment. Second, because Bitcoin volume will eventually cap at 21 million (due to the software system that drives and mints the virtual currency), their scarcity will drive prices far higher. He predicts a single Bitcoin may eventually sell for $100,000! (He did not forecast when it would reach this value.)

Clearly, no one can predict where Bitcoins are headed. If they interest you, it is possible to purchase them through exchanges listed on the Bitcoin website, or from individuals. Additional investment vehicles may be available soon — papers have been filed with the SEC to allow a fund for investor speculation on Bitcoin pricing.

So in the end, what type of investment is Bitcoins? Is the better analogy currency, gold, stocks, baseball cards, or Dutch Tulip bulbs that were a choice investment in the early 1600’s until the speculative bubble burst? Most professionals suggest treating it as a lottery ticket — an all-or-nothing venture that may be worth a small amount of your discretionary funds for long-term speculation.

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