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 buy 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 main 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 transferred anonymously 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 approve Bitcoin transactions. They are rewarded with transaction fees and new bitcoins generated by solving bitcoin algorithms.
- There is a limited amount of bitcoins in circulation. According to Blockchain, there were about 12.1 million in circulation as of December 20, 2013. The difficulty of mining bitcoins (solving algorithms) gets harder as more bitcoins are generated, and the maximum amount in circulation is capped at 21 million. The limit will not be reached until approximately 2140. This makes bitcoins more valuable as more people use them.
- A public ledger called “Blockchain” records all Bitcoin transactions and shows the respective holdings 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 through bitcoin mining or bitcoin exchange.
- The digital currency is accepted by a limited number of merchants on the web and at some brick-and-mortar retailers.
- Bitcoin wallets (similar to PayPal accounts) are used to store bitcoins, private keys and public addresses, and to anonymously transfer bitcoins between users.
- Bitcoins are not insured and not protected by government agencies. Therefore, they cannot be recovered if the secret keys are stolen by a hacker or lost on a damaged hard drive or due to a Bitcoin exchange being shut down. If the secret keys were lost, the associated bitcoins could not be recovered and would be out of circulation. Visit this link for a Bitcoin FAQ.
I believe Bitcoin will gain more public acceptance because users can remain anonymous while buying 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 currency supply is limited to 21 million and the payment network is run 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 USD this year before falling to $632 per BTC at the time of writing.
Bitcoin has soared this year as investors speculated that the currency would gain wider acceptance and that it would rise in price. The currency crashed by 50% in December because BTC China (the largest Bitcoin operator in China) announced that 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 processing Bitcoin transactions.
Bitcoin is likely to gain more public acceptance over time, but its price is extremely volatile and very sensitive to news – such as government regulations and restrictions – that can negatively affect the currency.
This is why I do not suggest investors to invest in Bitcoins unless purchased at less than $10 USD per BTC because this would allow a much larger margin of safety.
Otherwise, I believe you are much better off investing in stocks that have strong fundamentals as well as great business prospects and management teams because the underlying companies have inherent 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.