Bitcoin (BTC) is a new type of digital currency with cryptographic keys and is decentralized for a network of computers used by users and miners around the world and 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 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 Bitcoin on Bitcoin exchanges.
There are several key differences between Bitcoin and traditional currencies (such as the US dollar):
- Bitcoin has no centralized authority or clearinghouse (such as a government, central bank, MasterCard or Visa network). The peer-to-peer payment network is operated by users and miners worldwide. Currency is transferred anonymously between users directly over the Internet without going through a clearing house. This means that 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 validate Bitcoin transactions. They are rewarded with transaction fees and new bitcoins from solving Bitcoin algorithms.
- There is a limited amount of bitcoins in circulation. According to Blockchain, there were approximately 12.1 million units in circulation as of December 20, 2013. The difficulty of mining bitcoins (solving the algorithms) gets harder as more bitcoins are produced, and the maximum amount in circulation is limited to 21 million. The limit will not be reached until about 2140. This makes Bitcoins more valuable as more people use them.
- A public ledger called the 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 obtained through Bitcoin mining or Bitcoin exchange.
- The digital currency is accepted by a limited number of merchants online and at some retailers.
- Bitcoin wallets (similar to PayPal accounts) are used to store Bitcoins, private keys and public addresses, as well as transfer Bitcoins between users anonymously.
- Bitcoins are not insured or protected by government agencies. Thus, if the secret keys are stolen by a hacker or lost on a failed hard drive or due to the shutdown of a Bitcoin exchange, they cannot be recovered. If the private keys are lost, the associated bitcoins cannot be recovered and will go out of circulation. Visit this link for frequently asked questions about Bitcoins.
I believe that Bitcoin will be more accepted by the public because users can remain anonymous when buying goods and services online, transaction fees are much lower than credit card payment networks; the public ledger is accessible to anyone and can be used to prevent fraud; the currency supply is capped at 21 million and the payment network is run by users and miners instead of a central authority.
However, I don’t think it is a great investment vehicle because it is 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 price. The currency fell 50% in December as BTC China (China’s largest Bitcoin operator) 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 handling bitcoin transactions.
Bitcoin will likely gain more public favor 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 they are bought at a price below 10 USD per BTC, as this greater margin of safety.
Otherwise, I believe it is better to invest in stocks with strong fundamentals as well as great business prospects and management teams, as the underlying companies have intrinsic values and are more predictable.
Disclosure: Victor Liang has no position in Bitcoins and has no plans to change his position in the next 72 hours.