It is the latest innovation to sweep the financial world and it wasn’t created by some investment bank. In fact, it’s not entirely clear who created it.
I’m talking about Bitcoin. And you would be completely forgiven if you aren’t exactly sure what it is.
So, What is Bitcoin?
Bitcoin is a peer-to-peer virtual currency exchanged digitally and directly between users. Some merchants have even begun to accept Bitcoins as payment. Since there is no institution or person that controls Bitcoin, it is considered a “decentralized” currency.
Instead of a central bank, Bitcoin relies on mutually agreed upon rules embedded in the software responsible for facilitating Bitcoin transactions.
The same way that a Town Clerk’s office would maintain records, each Bitcoin has a public ownership ledger – or “block chain” – that is accessible to all users. Because the ownership record involves a complex electronic address, it is possible to maintain anonymity while exchanging Bitcoins.
The transparency of a publicly viewable block chain ensures that a Bitcoin is only sold by its owner and that the buyer becomes the new owner of record.
Because the currency is decentralized, global and can be exchanged anonymously, it has already emerged as a favorite for e-criminals and money laundering.
And because it rose from $15 to $1,200 between January and November 2013, it has been a favorite for speculators as well.
How do you get Bitcoins?
First, you could accept Bitcoins as payment for goods or services that you are offering for sale.
Second, you could simply purchase Bitcoins through an online Bitcoin exchange. There are even Bitcoin exchanges offering to connect Bitcoin owners to Bitcoin buyers nearby. These services act as a neutral third-party and keep the Bitcoins in escrow while the two parties meet in person to exchange cash or services.
The fourth, and by far the most interesting way to acquire Bitcoins, is also the way in which Bitcoins enter circulation. You could “mine” for Bitcoins.
Yes, I said “mine for Bitcoins.”
How does the virtual currency work?
When the first Bitcoin block chain started in January 2009, there were only 50 virtual coins in circulation. Today there are 12,336,200.
Mining involves applying significant computational power to the Bitcoin network, which serves to verify past transactions and strengthen the Bitcoin network. Eventually, this processes releases new blocks of Bitcoins to the miner and new Bitcoins have entered circulation.
The process is meant to simulate real mining in the sense that it is labor intensive, takes a long time, and gets harder and harder over time because the easiest Bitcoin blocks are mined first.
The final blocks of Bitcoins will be mined in or around the year 2140. At that time there will be 20,999,999.9769 Bitcoins in circulation and no new blocks can be mined.
There are specific terms for Bitcoins in various denominations.
1 BTC = 1 Bitcoin
0.01 BTC = 1 cBTC or 1 Centibitcoin or Bitcent.
0.001 BTC = 1mBTC or 1 Millibitcoin or Millibit.
0.000 001 BTC = 1 μBTC = 1 Microbitcoin or Microbit.
The U.S. Dollar was backed by silver, gold and Treasury Notes at various points in history. But today the U.S. dollar is no longer backed by any hard asset.
Like the U.S. dollar, Bitcoin isn’t backed by any hard assets. But unlike the U.S. dollar and other world currencies, it isn’t controlled by a central bank that can expand the money supply for political or arbitrary reasons. The expansion of the Bitcoin supply is predictable and generally understood by the Bitcoin community.
Bitcoin advocates will say it has value because it can be used in exchange for goods and services, is somewhat scarce, and is accepted by individuals and merchants for payment. In reality, Bitcoin has value because speculators have piled into Bitcoin in hopes that it would rise…and its price has surged higher.
Regardless, the advantages of a digital, global and low-fee or fee-free currency are unmistakable.
What are some of Bitcoin’s risks?
For starters, it is subject to the laws of supply and demand. If Bitcoin users lose faith in the virtual currency and demand for Bitcoin suddenly drops, the value of Bitcoins will drop along with it.
I wrote more about Bitcoin’s risks yesterday in an article offering three compelling reasons to not invest in Bitcoin.
Additionally, there are competing virtual currencies. A shift from Bitcoin to other virtual currencies could result in the demise of Bitcoin the same way that Myspace and Friendster fell victim to Facebook (NYSE: FB).
And you can’t ignore the fact that many view Bitcoin as nothing more than a hi-tech money laundering scheme. Two executives of a popular Bitcoin exchange tied to the criminal marketplace Silk Road were arrested on charges related to money laundering only two weeks ago.
Just a few days ago prosecutors in Florida filed charges against heavy Bitcoin traders for use of an unapproved money transfer service in what will surely be a landmark court case.
The fact is, Bitcoin’s legal status is in question.
The Bottom Line
This technology is so new and unproven that long-term investors would be best served by avoiding Bitcoin altogether.
If you want to invest in the future of payments, take a look at this list of alternative Bitcoin investments that we published last week.
Whether Bitcoin is here to stay remains to be seen. Surely, its journey to the final mined block of Bitcoins in the year 2140 will have its ups and downs.
But hopefully the next time you hear someone ask, “What is Bitcoin?” you will have no trouble offering an intelligent answer.
The One Stock to Own in 2014 — The Year Mobile Takes Over
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