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Bitcoins for the Uninitiated: An Introduction


January 31, 2014 22:54 EDT

What are the shortcomings of investing in Bitcoin?

Let’s start at the beginning: What, you might ask, is a “Bitcoin”?

A Bitcoin is a cyber monetary unit used in a revolutionary financial system known as Bitcoin, applicable to real-world transactions.

The notion of a cyber monetary unit might not be surprising to you. After all, virtual currencies have been popular in online gaming environments for some time. Some, like World of Warcraft, have created entire virtual economies that function much like our own, creating exchange values between online and offline currencies through secondary markets like eBay.

What’s different about Bitcoin is the second proposition that is noted above: the potential interpenetration of Bitcoin between virtual and actual worlds. The Bitcoin itself is virtual. It moves in a virtual environment. However, it can be used for tangible goods and services. You might use bitcoins to purchase groceries, gasoline, clothing, services, or even a university education.

The Bitcoin website provides a basic introduction:

Bitcoin uses peer-to-peer technology to operate with no central authority or banks; managing transactions and the issuing of bitcoins is carried out collectively by the network. Bitcoin is open-source; its design is public, nobody owns or controls Bitcoin and everyone can take part. Through many of its unique properties, Bitcoin allows exciting uses that could not be covered by any previous payment system.”

Key Points to Note

First, the currency is purely intangible and transactions take place within a decentralized, virtual marketplace that operates on a user to user platform. This structure produces some interesting implications: Bitcoin is free from government regulation, can be used anywhere in the world by anyone, and transactions are anonymous. As a result, bitcoins have gained a relatively small but strong user base.

Second, the currency is not added into the market like more orthodox financial systems. Instead of creating money like the Federal Reserve, bitcoins are introduced into the market by computational competitions held for Bitcoin users or “miners,” and the winner receives a prize in the form of bitcoins. The amount awarded to miners is cut in half every four years, keeping the potential amount of bitcoins in circulation limited to 21 million, as there are 12 million in circulation now and the current award amount is 25 bitcoins. The value of a Bitcoin is roughly over $750, meaning that a miner wins roughly $18,750 per competition. While the mining competitions may be the best way to earn bitcoins for computer geeks, the average person is better off buying them for cash.

Finally, what is perhaps most remarkable about Bitcoin is the rapid increase in value that’s taken place since its inception. A single bitcoin has gone from being valued under $1 in 2009, to over $750 in just four years. This phenomenon has made for very happy investors, perhaps the most famous of which are the Winklevoss twins who are among the biggest stakeholders and actively lobby on its behalf.

On the Fence?

The rapid growth of Bitcoin, however, has many skeptics believing that it is a bubble waiting to burst and will devalue just as quickly. Phil Sanderson of IDG Ventures argues: “The risks of an unregulated security that can also be hacked are too great for any mainstream investor.”

This is a legitimate concern, however, the past four years of Bitcoin have defied logic and it may continue to do so. Despite the closure of the Silk Road, one of the most active Bitcoin market places, companies accepting bitcoins remain small in number but are growing constantly. There are plenty of websites and even a few ATMs that will exchange bitcoins for cash, and recently, a Subway restaurant owner in Philadelphia made news for joining the Bitcoin movement and accepting the digital currency.

Regardless, however, don’t expect to see Bitcoin go mainstream anytime soon. It seems too misunderstood and volatile to gain widespread confidence from stakeholders for the time being. Though investors, users, and business owners alike have found several useful ways of bitcoins, for the rest of us, there are just too many implications, too many puzzles still unresolved.

In fact, some countries have already taken early action against the use of Bitcoin and other digital currencies. Chinese officials have forbidden financial institutions operating within China to deal with the currency in any respect, causing Bitcoin Internet exchange rates to reduce significantly. Their reason? The currency does not hold any “real meaning,” nor does it hold the same legal status as other currencies do.

As Hao Hong, in charge of Chinese research at Bocom International Holdings Co, stated: “The concern is that it interferes with normal monetary policy operation… it is difficult to regulate and could be used for money laundering.”

While China has taken a first, bold step in standing against the Bitcoin craze for the time being, you can expect other countries to follow suit in either support of Bitcoin usage or vehemently against the currency. Either way, policy makers and regulators will need to take that stance soon, as bitcoin is only increasing its profile despite taking a hit in China.

And the Verdict is…?

In sum, investing in bitcoins ought only to be appealing to risk takers and for a few reasons. Bitcoins are intriguing because they’re anonymous, have undergone incredible spikes in valuation, and are decentralized and unregulated by government, giving investors confidence that no exterior force will alter the system.

These qualities alone would make any investor starry-eyed, if not for Bitcoin’s massive shortcomings. The dangers of investing in Bitcoin is that it is not easily forecasted. No one knew it would spike as it did, and no one can say with confidence that it won’t dip dramatically. Also, Bitcoin’s recent success has inspired many others to follow its formula, giving way to the creation of many alternatives such as Anoncoin, Zerocoin, and Litecoin.

These factors demonstrate how the field is just too young and investors are too inexperienced to predict longevity in any one cyber economy, not to mention, Bitcoin. While cryptocurrency is a promising contender, we have yet to see if it will really be a player to watch out for.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

Image: Copyright © Shutterstock. All Rights Reserved


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