Bitcoins – what are they?
A Bitcoin is an electronic store of value, accepted at a growing number of retail outlets, mainly online.
If you have a Bitcoin account, known as a Bitcoin Wallet, you can receive Bitcoins as payment, or use them to purchase goods and services. There also exist a number of Bitcoin exchanges where Bitcoin may be exchanged for dollars, but Bitcoin does not have legal tender status in any jurisdiction.
Essentially Bitcoin is a virtual currency that can be used in the purchase or sale of real goods and services in the same way that vouchers are accepted across a number of participating retail outlets.
Extending this voucher analogy a little further, it’s important to note that retailers outside the participating voucher scheme cannot be forced to accept the vouchers as payment. It is this last part that makes Bitcoin virtually a currency rather than a virtual currency; it’s more like a voucher than the official currency of the internet.
That said, it has all the necessary characteristics of real money (durability, portability, fungibility, scarcity, divisibility, and recognisability) but these characteristics are based on mathematics (explained below) rather than relying on physical properties (gold) or trust in central authorities (US dollar).
Bitcoin is often described as a crypto-currency because of the process of Bitcoin creation (mining) which is effectively the production of solutions to mathematical puzzles which are similar in nature to cryptographic problems – code breaking. Under this process, new Bitcoins are created as these problems are solved, but the number of Bitcoins created for each solution effectively falls over time.
Anyone can go Bitcoin mining, all that is needed are the algorithms and hardware. The number of Bitcoins that can be mined is limited, with roughly half the allowed limit of Bitcoin creation already in existence today. This finite supply limit is part of the credibility of the Bitcoin currency.
Indeed it is for this reason that Bitcoin proponents argue that it is the future of commerce – the value of a Bitcoin isn’t tied to any central bank or government policy – clearly an argument that has found resonance in the post credit crunch world of Quantitative Easing.
This attraction of Bitcoin existing outside the main financial system and away from Central Banks and their expansionary monetary policy and extensive regulation also makes Bitcoin a target for fraud and money laundering.
We’ve already seen two high profile Bitcoin exchanges close in the past month (Mt. Gox and the smaller FlexCoin) as thieves stole hundreds of millions of dollars’ worth of Bitcoin from exchange servers. Such events clearly undermine the credibility of the Bitcoin ecosystem, but are not without parallel in the traditional banking world.
The major difference, at the moment at least, is the much lower level of capitalisation and governance throughout the Bitcoin ecosystem. Both this lower level of regulation and capitalisation makes Bitcoin more vulnerable and therefore more volatile as a store of value, but this could all change if it became more mainstream.
And in my opinion, there’s the catch. To become more mainstream, more regulation will be required, and that will make Bitcoin transactions both more expensive and less attractive to current investors.
Should I expect to see Bitcoins in my portfolio?
The quick answer to that question is no – or at least no, not yet. That’s because Bitcoin is too volatile as a commodity, and not accepted widely enough as a medium of exchange.
With no intrinsic value (as with gold or dollars) and no income or dividend, it’s impossible to value Bitcoins on an absolute basis – they are merely worth what they can be exchanged for, and that’s arbitrary at best given the small scale of both demand and supply.
Bitcoins started life less than 5 years ago with a face value of a dollar, and then peaked at over $100 towards the end of last year. It is this volatility that has made Bitcoin more attractive to fringe financial investors rather than consumers for transactional commerce.
If an economy had adopted Bitcoin as its official currency, it’s terms of trade would have been impossible to manage, sapping both internal and external demand. For Bitcoin to be successful as a medium of exchange, it needs exchange rate stability, and that’s something it has yet to achieve.
Success as a medium of exchange partly depends on the Bitcoin infrastructure and the
extent to which it can attract and retain confidence as a store of value, but it also depends on competition. Ask the question: “What if Visa, PayPal, Vodafone or Facebook were to issue a crypto-currency?” – that could be really disruptive for Bitcoin.
Partly because these potential competitors would have the resources to offer an infrastructure with a higher level of capitalisation, which in turn would add to the credibility of their ecosystem.
The more mainstream Bitcoin becomes, however, the less likely it gets competed away. The problem at the moment is that half of the Bitcoin in existence are held by fewer than 1,000 individuals, according to Rob Wile of Business Insider. On that basis, it’s a long way from the mainstream.
When we consider demand, we immediately note that consumers in many emerging markets for instance, are more likely to have a mobile phone than a bank account. That makes the concept of crypto-currencies very attractive, particularly to phone companies and social network providers as an entry point into the lucrative world of transaction processing and payment solutions.
A joint venture, PayBook, FacePal, or FoneBook for example, could provide the level of user trust, network, technology and captitalisation to leapfrog any incumbent.
So while there are many factors at play for Bitcoin, it seems likely that the concept of crypto-currencies are here to stay. So if we’re not sure about the success of Bitcoin, but we believe that crypto-currencies are likely to have a future, then an alternative would be to bet against the incumbents.
The problem here is that the returns to payment solutions companies are so profitable that they are difficult to short, or underweight. So while crypto currencies may eventually threaten the dominance of traditional payment solutions companies, it’s still too early to do anything other than buy a basket of crypto-currencies.
That may also sound a little premature to many, but it’s interesting to note that whilst few governments have welcomed Bitcoin, few have ignored it either.
Capital gains accrued in Bitcoin are still liable to tax. Indeed the UK’s recent move to reclassify Bitcoin from a voucher (liable for VAT) to a commodity (which is not) signifies its growing importance as a potential technological disrupter. In short, the UK has become more Bitcoin friendly.
If the Bitcoin infrastructure could be wrestled from the current enthusiasts so that it attracts the investment of professionals – it would be much more likely to succeed.
Given the pace of its current technological proliferation, it could be sooner than many expect. After all, the switch from gold-backed currencies to fiat money happened pretty much overnight with the collapse of Bretton Woods in the mid 1970’s.
Story credit: David Francis