BITCOIN - IS IT THE NEW MONEY?
By Mary Lynne Dahl, CFP®
February 23, 2015
Cyber currency comes in many versions, about 15 of which are actively being used worldwide today. The best known of these is “bitcoin”. So, what is bitcoin, who is using it and what is it for?
Bitcoin was created in 2008 by a mysterious person or persons going by the name of Satoshi Nakamoto, who is reportedly a software engineer who wanted to create a currency that did not rely on any government central bank or authority, would be able to transfer payment electronically, immediately, anywhere in the world, at little or no cost.The software designed by Satoshi Nakamoto, who some claim is not a person at all, but a computer, is what is called “open source”, without copyright, meaning that anyone can obtain it, use it and modify it, which some programmers using it have done. It is, essentially, public property, open to anyone; hence the term “open source”.
Bitcoin is form of digital currency that has succeeded in doing what it was designed to do. In the simplest terms, it is a way to buy and sell using an electronic form of payment. Unlike traditional money, it is not based on gold, silver or any government-backed promise of value. Instead, it is based on mathematics, using a complex formula on a worldwide network of computers. Unlike dollars, euros, yen or other currencies, bitcoin does not use printed currency or coins. It is produced by a community of people called “miners” who work to earn bitcoin using a network of computer servers that solve math problems that are the “work” of those miners. Anyone can become a bitcoin miner to earn bitcoin, but it is also possible to purchase bitcoins without becoming a miner.
A bit , first used in 1946, is a “binary digit”, which is the smallest unit of data in computer code, either 0 or 1. It is used to store data and execute instructions, which makes it ideal for creation of a digital currency such as bitcoin or other cyber currencies.
A key aspect of bitcoin, and other cyber currencies, is that they operate “peer to peer”, referred to as P2P. This means that it is private, not public. P2P is a system of transfer of value or payment between 2 people, without an intermediary. There are no banks involved, no government oversight, no regulations to control, restrict, guarantee the safety of the transaction or record the transaction. It is private, between the 2 people only. This form of private money is not actually new; historically private money was the norm for centuries in many groups of people all over the world. Governments printed fiat money in paper and coin in order to establish order and control over their own economies, thereby making private money less useful. However, this fiat money issued by governments also enables those governments to track, tax and manipulate the money that is printed by that government.
What can you do with bitcoin? Well, you can store it or spend it. There are online stores and merchants who accept bitcoin as payment for their goods and services, and there are also a few brick and mortar stores that accept bitcoin as payment. Bitcoin is also used online as payment for auctions, gambling, charitable donations and as a way to tip. Bitcoin is becoming accepted enough that anyone can pay with bitcoin using PayPal to process the transaction, making bitcoin payment even more routine.
One of the interesting facts about bitcoin is that there will be a limited supply. Reportedly, only 21 million bitcoin will ever be issued. The reason for this is apparently to limit the ability of anyone to manipulate the supply of this kind of money. As of this writing (Feb.19, 2015), the number of bitcoin produced is reported to be 13.856 million. The same source of information says that it takes approximately 8 minutes and 10 seconds to solve the math problem that earns bitcoin for the successful bitcoin miner, as of the same date.
The software is designed to make the problem harder and harder to solve as time goes by.
This finite supply has not proven to reduce the risks associated with buying and selling bitcoin. In fact, bitcoin values plunged as much as 61% in one day in 2013 and 80% in a single day in 2014. It is impossible at the present time to estimate the average value of bitcoin, as the market for it is very volatile, unregulated and subject to excessive swings in value on very short notice. The price of a bitcoin as of this writing (Feb 19, 2015) fluctuated between $235 and $243 USD. Because of the currency exchange rate, bitcoin in Canada as of the same date sold for about 23% more than in the US. For more information about prices of bitcoin on an ongoing, daily, basis go to: www.coindesk.com/price.
Another interesting fact about bitcoin is the complex system of earning them, keeping track of the transactions, proving them as being legitimate, called “proof of work”, using them as payment and limiting the number that will ever exist. This system is based on a computerized logarithm that each miner accesses by setting up his or her bitcoin account, and then uses to earn bitcoin. Earning bitcoin is very difficult, and is the result of the miner being given a math problem to solve upon accessing his or her bitcoin account. To do this requires very sophisticated computing capabilities and can be expensive as well as mathematically very challenging. For this reason, some miners join in pools with other miners to maximize their chances of being able to be the first to solve the problem, which is sent out to all miners simultaneously. The first miner to solve the problem earns 25 bitcoin, making the effort somewhat of a contest among the miners. Further explanation of bitcoin mining becomes very complicated, so interested readers should research this subject online and be capable of understanding some very technical computer language that details and explains the logarithms used to operate the network system efficiently.
Because bitcoin is a mathematical form of currency, based on a logarithmic formula, proponents of it claim that it cannot be used to “double spend” it, meaning that the math formula prevents duplication of each unit of bitcoin, but this does not reduce the other risks associated with cyber currencies. What are those risks?
Because it is private, largely anonymous, not easily tracked and not backed by any government, bitcoin and other cyber currencies offer complete privacy of the transaction, which makes it attractive to people who fear confiscation of their money by their government or wish to avoid paying taxes on income produced by earning bitcoin or selling goods and services paid for with bitcoin. However, governments all over the world are looking at ways to regulate bitcoin and achieve some degree of control over it, sooner or later. In addition, bitcoin is attractive to criminals, for obvious reasons. It is an ideal way to launder money and transact the sale of drugs or other illegal goods and services. Other risks are that since
In 2010 a Japanese company called Mt. Gox began to act as an exchange for people wanting to trade bitcoin and other currencies as an investment. Problems quickly became obvious and in 2013 Mt. Gox had to enter into a form of bankruptcy under Japanese laws that ended up uncovering a loss of about 825,000 bitcoin, owned by individuals and the company, which was equal at the time to about $450,000 USD. Investigations determined that the missing bitcoin had been stolen or somehow “lost” by unknown means, and although about 200,000 were later “found”, the reasons for the theft has never been explained nor has the case been solved. .
Another risk with bitcoin is that once you spend them on a purchase, for example, you cannot get them back by reversing the transaction. All transactions are final with bitcoin. If you buy something, send the bitcoin to pay for it, receive the item purchased and it is not as promised, the only way to get a refund is if the seller starts a new bitcoin transaction to send you the amount back voluntarily. If he or she does not do this, you have no alternative to get your bitcoin back, as transactions cannot be reversed, period.
And, because bitcoin appeals to criminals as well as law-abiding folks, government regulators fear that a pool of bitcoin miners could commit fraud or theft by forming bitcoin “companies” and then declaring bankruptcy, as was reported by a Federal Trade Commission complaint against a bitcoin mining company called Cointerra, which sold computer equipment to miners.CNN has done a special investigative program called “Inside Man”which aired on Feb. 19, 2015, hosted by Morgan Spurlock. The program delves into the world of bitcoin mining, bitcoin as a form of money and the future of bitcoin. The program can be replayed on CNN online and there are comments on Facebook and Twitter resulting from the airing of the program.
So, bitcoin has some interesting, positive and negative characteristics, some benefits and serious risks. Is it worth investing in? I strongly suggest it is not, but it may eventually become a real, accepted form of payment for goods and services. In the meanwhile, governments will seek ways to track it, identify the users of it, tax it and prevent it from being used for criminal activities, so bitcoin and other cyber currencies will remain a topic of intense interest on all levels. Is it the new money?
Only time will tell.
©2013 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only.
Mary Lynne Dahl©2014