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 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. Forex traders can also trade Bitcoins on Bitcoin exchanges.
There are several important differences between Bitcoin and traditional currencies (eg the US dollar):
- Bitcoin has no centralized authority or clearinghouse (eg government, central bank, MasterCard or Visa network). The peer-to-peer payment network is managed by users and miners around the world. 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 to approve Bitcoin transactions. They receive transaction fees and new Bitcoins generated from solving Bitcoin algorithms.
- There is a limited amount of Bitcoins in circulation. According to Blockchain, there were about 12.1 million in circulation on December 20, 2013. The difficulty to mine Bitcoins (solving algorithms) becomes more difficult as more Bitcoins are generated and the maximum amount in circulation is limited to 21 million The cap won’t be reached until about 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 Bitcoins themselves.
- The digital currency can be acquired through Bitcoin mining or Bitcoin exchanges.
- 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, as well as to transfer Bitcoins anonymously 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 in a failed 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 a Bitcoin FAQ.
I believe Bitcoin will gain more public acceptance because 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 anyone, which can be used to prevent fraud; the currency supply is limited to 21 million and the payment network is operated by users and miners rather than 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 grew from about $14 to a high of $1,200 this year before falling to $632 per BTC at the time of writing.
Bitcoin rallied this year as investors speculated that the currency would gain wider acceptance and increase in price. The coin fell 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, the Chinese central bank banned financial institutions and payment companies from handling bitcoin transactions.
Bitcoin will likely 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 affect the currency.
Therefore, I do not suggest investors to invest in Bitcoins unless they were purchased at less than $10 USD per BTC because this would allow a much larger margin of safety.
Otherwise, I think it’s 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 Bitcoins and has no plans to change his position in the next 72 hours.