[Guest post by FF over at Feeling Financial]
Bitcoin, while not exactly new, is still making waves as an alternative currency and investment. Never one to find myself on the leading edge of internet happenings, I finally got around to researching what the buzz is all about. Hopefully you find this to be a helpful overview of Bitcoin.
(Fair warning: this post gets a little long. Ideally it’s brief enough to cover the most important points, but I really wanted to include enough detail to help you figure out if you want to start using it.)
What is Bitcoin?
Bitcoin is a virtual currency, which means it exists only online. It was invented by Satoshi Nakamoto, a person (or group of people – it’s not exactly clear) who wanted an alternative to the existing currencies out there.
That may sound strange or even scary, but think about how other currencies “exist” for a moment: for the most part, any currency only has value because we all agree that it has value. A dollar bill is basically worthless (unless you’re fixing a bike tire), but you can give it to somebody else in exchange for something because they think it’s worth a dollar. If people believe something has value (whether it’s a piece of paper or a piece of data), then it has value.
Bitcoin is also a peer to peer (P2P) system. You make electronic payments directly to whoever you’re paying – not through a bank or any other third party. This is different from using a credit card to buy something, and it’s even different from popular online services you might use to repay a friend for last night’s beer money: with those methods, you pay the bank, and the bank eventually sends money to its final destination.
How Do You Use Bitcoin?
To use Bitcoin, you need bitcoins – the units that make up the currency. The easiest way to do that is to get a Bitcoin wallet and buy coins with plain-old money (like US Dollars). But you can also get bitcoins by having your computer solve complex math problems and “mine” coins. Although letting your computer create money sounds great, don’t quit your day job just yet – you need a fancy computer to pull it off and it gets harder every day.
Once you have some coin in your wallet, you’re ready to go. You can buy or sell using the currency, or you can just hold onto your bitcoins as an investment. If you want to use your money outside of the Bitcoin economy, you’ll need to use an exchange to convert back to a traditional currency.
There are a lot of places to use Bitcoin, but most of them are online. You can see a partial list here and you can also keep your eyes peeled for local businesses that accept Bitcoin. Using bitcoins for everyday spending is probably easiest if you live in a large city.
Why Do People Use Bitcoin?
So, what’s the deal with this new currency? Bitcoin appeals to people for a number of different reasons:
Anonymity and privacy: Bitcoin payments allow you to send and receive money more or less anonymously. With a credit card (not to mention a check), employees at a financial institution can easily see where your money goes. And whoever you pay knows who you are. What’s to stop them from keeping a permanent record of your transactions, and what if you don’t want that? With Bitcoin, it’s different because your “address” is not linked to your personal information. However, from what I can tell it takes some effort to remain completely anonymous - even with Bitcoin.
Bending the rules: Bitcoin can be handy for a number of illegal activities, although most users aren’t in it to dodge the cops. Probably the most popular example is the ability to buy drugs online. We’re not talking about filling prescriptions, but rather recreational drugs and substances you’d otherwise have to “know a guy” to find locally. But it goes beyond just buying a little weed: need to rent a botnet for a cyber-attack? That can be arranged, as can the purchase of firearms and explosives. There’s a market for everything – you just have to know where to find it. There are even reports of sites that offer to kill somebody for the right price, but who knows if anybody would actually follow through.
Of course, these markets attract attention from law enforcement agencies, but less than you might think. One of the most popular markets, Silk Road (which was basically an eBay for drugs), was shut down earlier this year after facilitating sales worth many many millions of dollars since 2011. Money launderers are also attracted to Bitcoin, but they might find that it’s not as great as it sounds for their needs (if working with large sums of money, they can be caught integrating laundered money back into the system).
Ideological reasons: Bitcoin is a virtual, open-source currency. That means anybody who wants to use it can do so, and anybody can see exactly how the system works (if you can read code, that is). No person or entity is in charge – everybody is – so the wisdom of the crowds should eventually prevail when it comes to valuing the currency and making the rules. What’s more, Bitcoin is not created or controlled by any government. If you’re not a fan of government spending and economic tinkering, you might find that appealing. Plus, nobody can freeze or seize your assets if they don’t like what you’re doing. Finally, the traditional banking system does not have its hands in the Bitcoin economy, so you’re probably not helping anybody get a bonus when you use Bitcoin.
Low transaction costs and ease of transfer: transferring money with Bitcoin is cheap and easy. You don’t pay bank fees, and you don’t have to jump through hoops to get money overseas. All you need for a Bitcoin payment is your payee’s “address,” which is basically a random number, and making a payment is about as easy as sending an email. Most payments are free, but you might pay a fee in certain situations (if you want the transaction confirmed more quickly, for example). Likewise, you don’t have to wait several days for your bank to “clear” funds (why does it take so long?), because Bitcoin transfers are more or less instant. Businesses can also benefit from these features when customers pay with bitcoins.
Investment: Bitcoin can be used as an investment. If you think bitcoins will gain value faster than dollars or anything else you might invest in, you could buy bitcoins and hope for gains. However, Bitcoin has been quite volatile, so it should be considered a high-risk investment.
The Risks of Bitcoin
Although Bitcoin has some attractive features, there are risks of buying and using bitcoins. That doesn’t mean Bitcoin is bad, but you should be aware of the following before you fund a Bitcoin account:
Market value: the value of your bitcoins could go up or down quickly, so your Bitcoin account is probably not the best place to leave cash sitting around if you really need the money. Proponents of Bitcoin say that market risk should decrease as more and more people use the currency, but it’s anybody’s guess when that will happen.
How volatile is it? Take a look at the past year. Bitcoin hovered around 13 or 14 at the beginning of the year (if it helps to think of it this way, it’s like you could have bought a share of stock for $14 – except you’d get one bitcoin instead).
In the spring, things got hectic. After Bitcoin more than tripled, even J. Money was wondering why he wasn’t in on this Bitcoin thing. He never told me how much he considered investing, but he’s probably fortunate to have invested nothing (he mentioned that it crashed shortly after). (EDITOR’S NOTE: I was planning on picking up $500 worth the day before one of its major crashes – real glad I was lazy and never pulled the trigger! :))
Bitcoin’s highest closing price was 230 on 4/9. After getting up to 266 the next day, it closed at 165, and it closed at 124.9 on 4/11. Assuming you invested $1,000 at 230, you would have lost about $283 after one day, and you’d only be worth about $543 after two days. The price continued to plunge to a closing price of 68.36 on 4/16. Easy come, easy go. If you have the stomach for that kind of ride, you might still be ahead (depending on when you got in), as Bitcoin is currently trading around 130 – but that’s a very hot tamale!
Different rules: this could be a good thing or a bad thing depending on your perspective, but you’ll have to live without familiar “referees,” and the rules are different from what you might be accustomed to. If there are disputes about itcoin payments, who do you go to? Granted, you have to follow certain laws no matter what currency you use – so it’s irrelevant in some cases – but some things are different. For example, you can’t just reverse the charges like a credit card payment if somebody fails to deliver. If your bitcoins are stolen, you can’t just call the bank and get the money replaced. Bitcoin transfers are like wire transfers: once the money is gone, it’s gone.
Anonymity? Bitcoin is designed to provide anonymity, but complete anonymity requires at least a little attention to detail, and might even be impossible. The mechanics behind how Bitcoin is (or isn’t) private are way over my head, so I’ll just say that you’ll want to take precautions if anonymity is important to you. Use a new address whenever you can.
The unknown: this is uncharted territory, and you need to be okay with that if you’re going to venture in. We don’t know what we don’t know. Regulatory uncertainty is one example: what will governments do about Bitcoin? They can’t shut it down, but they can make it cumbersome to use the currency or cash out. They’re already doing it. And how do you know which services are best to use if you want to convert back to US Dollars? I’m sure you could figure it out with a little research, but it’s kind of important to get a good deal and work with trustworthy people. Also, if an exchange goes belly-up – or if your computer dies and you don’t have your wallet backed up – while you have money there, your bitcoins are gone for good (that’s a new concept for most of us). Finally, the anonymity provided by Bitcoin is a wonderful thing in countless situations, but governments are clearly unhappy about its use in black markets and with money launderers.
Should You Use Bitcoin?
Given the risks and benefits, I think the decision is both personal and financial. It could make sense if you’re willing and able to take the risk of holding a volatile currency, and you might be especially willing to take some risks if the privacy or ideological features are important to you – I can appreciate that. A lot of really smart people are passionate about Bitcoin, and they’re making it better every day.
For me, I don’t think Bitcoin makes sense right now. The benefits just aren’t compelling enough to overcome my discomfort with the unknowns. I also don’t see much opportunity to actually use the currency (the list of places to spend bitcoins is impressive, but I don’t use any of those companies and I don’t see myself going to the trouble to find out about them).
Things could always change for as Bitcoin evolves – Rome wasn’t built in a day either – but for now I’ll stick with my old-fashioned money.
What do you think? Anyone currently using or investing in Bitcoin? Did I leave anything out?
FF writes about personal finance at Feeling Financial. The goal there is to cover all of the important stuff, while recognizing the role that behavior (driven by thoughts and feelings) plays in financial outcomes. Follow Feeling Financial on Twitter and Facebook.