Bitcoin (BTC) is a new type of digital currency – with cryptographic keys – that is decentralized to a network of computers used by users and miners around the world and is not controlled by a single organization or government. It is the first digital cryptocurrency to gain public attention and is being accepted by a growing number of merchants. Like other currencies, users can use the digital currency to purchase goods and services online, as well as in some physical stores that accept it as a form of payment. Currency traders can also trade Bitcoins on Bitcoin exchanges.
There are several major differences between Bitcoin and traditional currencies (eg the US dollar):
- Bitcoin has no centralized authority or clearing house (eg, government, central bank, MasterCard or Visa network). The peer-to-peer payment network is operated by users and miners worldwide. Currency is anonymously transferred directly between users over the Internet without going through a clearinghouse. This means transaction fees are much lower.
- Bitcoin is created through a process called “Bitcoin mining”. Miners around the world use mining software and computers to solve complex bitcoin algorithms and to approve Bitcoin transactions. They are rewarded with transaction fees and new Bitcoins generated by solving Bitcoin algorithms.
- There is a limited amount of Bitcoin in circulation. According to Blockchain, there were about 12.1 million in circulation as of December 20, 2013. Bitcoin mining difficulty (solving algorithms) gets harder the more Bitcoins are generated, and the maximum amount in circulation is capped at 21 million. The limit will not be reached until about 2140. This makes Bitcoins more valuable the more people use them.
- A public ledger called ‘Blockchain’ records all Bitcoin transactions and shows the ownership of each Bitcoin owner. Anyone can access the public ledger to verify transactions. This makes the digital currency more transparent and predictable. More importantly, transparency prevents fraud and double spending of the same Bitcoins.
- The digital currency can be acquired by mining Bitcoins or exchanging Bitcoins.
- Digital currency is accepted by a limited number of merchants on the web and in some physical merchants.
- Bitcoin wallets (similar to PayPal accounts) are used to store Bitcoins, private keys and public addresses as well as anonymously transfer Bitcoins between users.
- Bitcoins are not secured and are not protected by government agencies. Therefore, they cannot be recovered if the secret keys are stolen by a hacker or lost due to a broken hard drive or due to the shutdown of a Bitcoin exchange. If the secret keys are lost, the associated Bitcoins cannot be recovered and would be out of circulation. Visit this link for Bitcoin FAQ.
I believe Bitcoin will gain more public acceptance as users can remain anonymous while purchasing goods and services online, transaction fees are much lower than credit card payment networks; the public ledger is accessible to everyone, which can be used to prevent fraud; the supply of the currency is limited to 21 million, and the payment network is managed by users and miners instead of a central authority.
However, I don’t think it’s a great investment vehicle because it’s extremely volatile and not very stable. For example, the price of bitcoin rose from around $14 to a peak of $1,200 this year before falling to $632 per BTC at the time of writing.
Bitcoin has rallied this year as investors speculated that the currency would gain wider acceptance and rise in value. The currency fell 50% in December as BTC China (China’s largest Bitcoin operator) announced it could no longer accept new deposits due to government regulations. And according to Bloomberg, China’s central bank has banned financial institutions and payment companies from handling bitcoin transactions.
Bitcoin is likely to gain more public acceptance over time, but its price is extremely volatile and highly sensitive to news — such as government regulations and restrictions — that could negatively impact the currency.
Therefore, I do not suggest investors to invest in bitcoins unless purchased for less than $10 per BTC as this would allow a much larger margin of safety.
Otherwise, I believe it is much better to invest in stocks that have strong fundamentals as well as great business prospects and management teams because the underlying companies have intrinsic values and are more predictable.
Disclosure: Victor Liang has no positions in Bitcoin and has no plans to change his position in the next 72 hours.