A Short Guide to Understanding Bitcoin

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Bitcoins
Zcopley, Flickr.com

"Bitcoins" either sound like a futuristic, implantable, laser-guided and rocket-pack equipped form of money, or the latest coin-shaped chocolate snack. In reality, it's probably a bit of both. The bitcoin, a digital currency, started the year worth about $15. Less than four months later, one bitcoin now trades above $70. While this past performance may be enticing and a sign of its legitimacy as a future currency, the bitcoin market is full of risks -- risks that may make bitcoins worth as much as a foil-wrapped piece of sugar.

Bitcoin: A Crypto-Currency

Bitcoin is based around the idea of a currency created and transacted through cryptography instead of issued and tracked through a central bank. And to add to its mystique, the creator of bitcoin only goes by a pseudonym and has never been positively identified.

Instead of any legal authority, bitcoin transactions are verified through peer-to-peer interactions. If a user sends bitcoins to another user's "wallet" file, that transaction is verified through other users, and is written into the collective transaction log. And given the ease of transactions, any fees for transfers are minimal.

Instead of a mint, bitcoins are created through a process called "mining," where computers attempt to solve for a certain number, and once found, are rewarded with new bitcoins. The rewards decrease with time, however, and there will only ever be about 21 million bitcoins created, three-quarters of which by 2016, and all by 2140.

Even if you don't understand any of the above, the recent jump in valuation probably still has your interest. But there are plenty of reasons to continue to educate yourself before attempting to trade in bitcoins.

bitcoincharts.com


Glitches

Not having any legal regulation, bitcoin has attracted plenty of thieves through the websites that create trading markets:
  • In 2011, the third-largest trading site, Bitomat, lost its wallet file, which held 17,000 bitcoins worth more than $200,000 at the time.
  • In the same year, the exchange MyBitcoin lost 51% of its users' deposits, amounting to 78,000 bitcoins worth over $1 million at the time.
  • In 2012, Bitcoinica was hacked and lost $220,000 worth of customer funds. Two months later, it was hacked again and lost another $90,000. As Bitcoinica attempted to repay claims, the company was hacked a final time for another loss of $320,000.
  • In the fall of 2012, in what might have been the first Bitcoin Ponzi scheme, the creator of Bitcoin Savings and Trust promised returns to investors. The founder has since disappeared with 500,000 bitcoins.
Price Instability

The market forces behind the bitcoin are far from solid and predictable. There is a large demand from speculators while actual use of bitcoins for trading goods and services is small. Just last week, a young Canadian became the first to list his home in exchange for bitcoins, and most other places that accept bitcoins remain small online businesses. And as bitcoin's value continues to swing wildly, it makes it hard for businesses to accept bitcoins with confidence.

Meanwhile, established companies have taken notice of bitcoin. The popular blogging platform WordPress announced last November that it would accept bitcoins, while deriding eBay Inc.'s (EBAY) PayPal platform for blocking access from over 60 countries: "Some are blocked for political reasons, some because of higher fraud rates, and some for financial reasons. Whatever the reason, we don;t think an individual blogger from Haiti, Ethiopia, or Kenya should have diminished access to the blogosphere because of payment issues they can't control." If bitcoin ends up taking the role of PayPal in those blocked countries, future growth for eBay could be limited.

Other companies have been fighting to become the consumer's digital wallet. Visa Inc. (V) launched its V.me platform last November, which allows users to pay online without repeatedly entering in credit card and shipping information. Google Wallet breaks away from purely digital shopping, and allows users to use their phone, if it has near-field communication technology, to pay for goods in-store. Unfortunately, many phones -- like the iPhone -- have yet to come equipped with NFC, and less than 10% of retailers are estimated to use NFC.

Legality

As bitcoin has gained popularity, the U.S. Treasury's Financial Crimes Enforcement Network recently issued a statement clarifying that even virtual currencies like bitcoin are subject to regulation. As bitcoin can be exchanged between anonymous parties, it could be used for illicit activities with little trace. Bitcoin is already a popular currency on what's called Silk Road, a website accessible only through anonymous Internet connections that acts as a marketplace for many illegal substances.

In addition, bitcoin is the first major digital currency with no backing from a state nor physical presence. Unlike gold, which exists in physical form and has some actual applications, bitcoin is made up of data, and all value is solely what we perceive. If world governments decide to fight the currency, it could severely hurt any value bitcoin holds. If humans begin to change their mind on what these bits of data are worth, then it could also hurt bitcoin's value.

Worth Watching

Bitcoins are fascinating, for mathematicians, economists, traders, investors, politicians, regulators, and anarchists. And while watching the currency develop is entertaining, the experimental currency is no place for serious investing given the risk versus reward. Attempting to trade in established currencies is difficult enough.

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Fool contributor Dan Newman owns shares of eBay. The Motley Fool recommends eBay, Google and Visa. The Motley Fool owns shares of eBay and Google.


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