The five-year-old digital phenomenon known as Bitcoin has received a lot of attention. If you’re unclear on what all the fuss is about, here’s a brief introduction to what it is, how it works, and some of the potential pitfalls it presents.
Bitcoin isn’t a company but a virtual currency supported by a peer-to-peer computer-based electronic cash system first outlined in 2009. Unlike printed currency or coins that are minted, Bitcoin is created by “mining”–using complex software to solve complicated mathematical computations. Solving a problem creates a so-called “block,” and the computer that solved it is rewarded with a set number of digital bitcoins, each of which is a set of one public and one private cryptographic key. (The units are generally “bitcoins,” while the general system is “Bitcoin.”) The number of solutions that can be discovered globally per hour (and thus the number of “blocks” created and bitcoins mined) is limited by the system’s software code. The total number of bitcoins available to be mined eventually is said to be limited to 21 million. Most users acquire them either by buying them with physical currencies such as dollars or accepting them as payment for goods and services.
Advocates argue that the advantages of the system are: (1) It’s not controlled by any government’s central bank, (2) a global virtual currency facilitates global commercial transactions, (3) every block and Bitcoin transaction is recorded, and (4) though transactions are recorded, the payer and payee are anonymous, much like a cash transaction. (However, that anonymity has attracted charges that its chief use so far has been for illegal activities such as money laundering; in October 2013, the FBI shut down the Silk Road Bitcoin exchange and seized its assets.)
How does a Bitcoin payment work?
Just as a physical wallet holds paper money and change, a digital wallet stores the private software keys that are bitcoins. It makes or receives payments by communicating with the network of other Bitcoin wallets. Some merchants and services, especially those that focus on online or international sales, are starting to explore Bitcoin transactions. Physical bitcoins, which have a software key embedded in them, have begun to be minted. However, acceptance of bitcoins as payment is entirely at a seller’s discretion; there is no guarantee you’ll be able to spend them where you want to or get the value you expect. Also, as outlined below, problems at some exchanges have sometimes impeded access to Bitcoin funds.
Speculating in Bitcoin
Bitcoin’s usage as a currency is a ripple compared to the tidal waves of investment speculation it has fueled. “Investing” in bitcoins simply means acquiring them through one of the methods outlined above. However, to say that Bitcoin as an investment is volatile is an understatement. Over Bitcoin’s five-year history, its value has fluctuated wildly as both speculation and confidence in it as a currency have ebbed and surged. In April 2013, after rising from $90 to $260 over two weeks, a bitcoin’s value plummeted to $130 in just six hours;* since then, it has undergone multiple double-digit price swings.** Despite its lack of connection to any central bank, Bitcoin also has been vulnerable to actions by individual governments. After China cracked down on virtual currency transactions by financial institutions in 2013 and halted deposits of yuan at exchanges there, Bitcoin’s worth in dollars was cut by more than half.**
That volatility has led to problems for people trying to make payments in bitcoins. It’s hard to use a currency when you’re not sure whether the amount in your virtual wallet is worth enough to buy a Range Rover or a tank of gas. Complicating the issue is the fact that the value can vary on different Bitcoin exchanges.
However, volatility is only one of the problems that have created havoc in the Bitcoin universe. The cybercurrency has been subject to cyberattacks that have halted trading briefly on several exchanges. At one point, one of the largest abruptly declared bankruptcy and announced that nearly half a billion dollars’ worth of bitcoins held there had vanished. And federal seizure of the Silk Road exchange’s assets created problems accessing those funds. Worse than not knowing how much your bitcoins will buy is not knowing whether they’re available to buy anything at all.
The Wild West rides again
So far, regulatory oversight of Bitcoin has been spotty. The currency is not backed by either a government or any physical asset such as gold. Major exchanges are located around the world, and the decentralized nature of the system makes it more challenging for governmental regulators to get a handle on it. If you’re considering exploring virtual currency, either for transactions or as a speculative investment, you should become more familiar with it rather than simply relying on this discussion. And because of the issues outlined above, you should be prepared for dramatic price swings and only use money that you aren’t relying on for something else.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2014