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What the heck is Bitcoin?

April 29th, 2013 by ,    photos by

An introduction to digital currency - and why the Winklevoss twins say it's here to stay

 
 
 

Ever since we saw The Social Network we’ve been wondering what those gigantic twin vikings, Tyler and Cameron Winklevoss, have been up to. (We’ve also completely associated Jesse Eisenberg with Mark Zuckerberg and now imagine Zuck in every movie role that Jesse plays… but that’s not important right now.) We have finally learned what the Winklevii have been doing: they’ve been busy cornering the Bitcoin market.

According to some reports, the Winklevii have amassed about $11 million worth of Bitcoin (the value wildly fluctuates depending on the hour and the day) – or 1% of the total Bitcoin market. Cool, Bitcoin. It must be cool if the Winklevii are on it, right? By now, everybody has heard of it, but very few people understand it. So we are here to try and get to the bottom of this Bitcoin thing.

What exactly is it?

Is Bitcoin a currency? A commodity? A stock? A mere mathematical formula? Well, it’s a bit of a hybrid containing properties of all these things. At its base, Bitcoin is a mathematical algorithm that creates digital units that then serve as a form of currency. By currency, we mean that units may be bought, sold, or exchanged for goods and services. Because the currency does not pass through any central bank or financial institution, the price of those units is not dependent on foreign exchange rates, but rather, determined by how much people are willing to pay for it at any given time, just like a stock trading on a stock exchange.

Bitcoin can be obtained in two ways: (1) bought and sold between individuals; or, (2) virtually ‘mined’ with computer programs that crack an algorithmic code which then rewards you with freshly created units of Bitcoin. Like a stock, the value of Bitcoin will fluctuate throughout the day based on how many people are buying or selling it. Like a commodity, more Bitcoin can become available on the market through the mining process, but not forever.  The ability to mine more Bitcoin will end sometime around 2140, meaning there is a finite supply. Some say this will happen at around 21 million units (coins) – and there are around 11 million in circulation now.

Where did it come from?

The origins of Bitcoin are deliciously mysterious. An anonymous hacker who goes by the alias “Satoshi Nakamoto” created this digital peer-to-peer currency in 2009 as a way to get around having to use banks for financial transactions. Legend has it that Satoshi was frustrated by the 2008 global financial meltdown and the way central banks responded with actions that hurt investors – such as zero percent interest rates and increasing money supply.  About two years ago, Satoshi said he was moving on to different projects and has not been heard from since.

How do you buy it?

There are many Bitcoin networks and exchanges where you can buy Bitcoin online. Mt. Gox is a Japanese exchange that claims to handle 80% of all Bitcoin trades. Many networks and websites have been set up which allow the purchase of Bitcoins via bank transfers.  You can also buy Bitcoins locally by making a physical trade with someone, or find an individual online with whom you can do a direct swap using whatever form of payment upon which you mutually agree. Above all, remember this is an unregulated market. You must be super cautious and diligent about whoever you choose to transact with – trust that there are plenty of fraudulent organizations out there waiting to take your money.

Why do people like Bitcoin?

There are plenty of advantages to a digital, international, non-bank currency. For one thing, just imagine being able to have one form of money to use wherever you travel or whatever you buy online without having to be bothered with exchange rates and fees.  Second, if you’ve used PayPal, you appreciate the convenience and swiftness of digital payment systems. Third, retailers love the idea of Bitcoin in order to avoid the high merchant fees that credit card companies impose on them. Finally, unlike credit card transactions or PayPal that rely on financial institutions, Bitcoin transactions are entirely private – the exchange between transacting parties is instant, anonymous and irreversible.

What’s the downside?

A non-traceable currency is a catch-22. In this day and age of zero online privacy, many people are eager for a digital payment solution that will not be tracked, monitored and marked up with fees. However, when your transactions are not recorded, you have no recourse when your Bitcoin goes missing, your account gets hacked or your transaction is not fulfilled.

What’s the connection to drug dealers?

As you might guess, the anonymity of Bitcoin has made it extremely popular with criminals who find it the perfect way to launder money. Fortunately, this may be a short-lived phenomenon as the US Treasury Department Financial Crimes Enforcement Network has issued guidelines for companies dealing in virtual currencies.  It’s not quite regulation, but many are seeing it as a step in the right direction that will eventually give Bitcoin and other digital currencies greater respectability.

Can you protect your Bitcoin?

When it comes to Bitcoin, it's all about buyer beware. Going outside the banking world means saying good-bye to federally insured deposits and guaranteed transactions. Protecting your investment means taking matters into your own hands. The Winklevii have allegedly recorded the computer codes that are attached to their personal Bitcoin holdings from off the Bitcoin network computers, saved those codes on numerous mini flash drives, and stored the flash drives in safety deposit boxes at various banks in three different cities. (Yes, it’s just that simple?!) Whether or not this evidence will prove anything in the face of a massive hacker attack, remains to be seen.

Can you use Bitcoin to buy stuff?

Slowly but surely, some retailers, both online and on the ground, are beginning to accept Bitcoin in lieu of cash.  The Wall Street Journal recently interviewed the owners of a car dealership in Kansas and a cupcake bakery in San Francisco who have begun accepting Bitcoin as a form of payment. (Though with one coin of Bitcoin worth $80 - $260, you’d have to buy a lot of cupcakes…) One Alberta man recently offered to sell his house for Bitcoin.

Is it bad that Bitcoin is so volatile?

Volatile indeed. Bitcoin traded at around $50 in mid-March, jumped as high as $260 within a month, then a week later, plunged by 70%. The volatility makes it fun for speculators but tough on investors and consumers.

According to a report in The Atlantic, the fact that the supply of Bitcoin is limited creates a problem of hoarding. People want to buy up Bitcoin and hold onto it, rather than spend it. This contributes to price volatility.

For a system of currency to work, there must be a steady flow of circulation. If people are afraid they won’t have access to more of a currency, they use it sparingly rather than spending it freely. This shrinks supply of the currency, and therefore, people trying to buy the currency see the price shoot up. However, when those who own the currency see the price climb super high, they stop spending it altogether. It becomes too valuable to exchange for everyday goods and services – unless consumer prices change drastically in step with currency fluctuations - which is nearly impossible for business owners to manage. This is when the system stops working and people turn to other forms of currency.

Want an example?

Imagine one coin of Bitcoin is worth $10 today. You want to buy a car that, at the moment, costs 4,000 Bitcoins. But there is a chance that each unit of Bitcoin could be worth $100 in a couple days – or even later this afternoon! Would you still pay 4,000 Bitcoins for that car? No way. The prospect of being able to buy the car in the future for 400 Bitcoins would put you off buying it today. But then again, you can’t predict what the currency will actually do. As you can see, a volatile currency makes it very challenging for consumers to make decisions. A currency needs to be stable in order for consumers to trust it and use it.

Will Bitcoin last or is this a fad?

As one Winklevoss put it, “People say it’s a Ponzi scheme, it’s a bubble… At some point that narrative will shift to ‘virtual currencies are here to stay.’ We’re in the early days.” We think he is right about that. When you consider how often you shop online or via your mobile phone, and how increasingly the items you buy are coming from other countries (whether you shop eBay or global retailer websites) - one simple, digital, international currency seems not just logical, but inevitable.

Are there other digital currencies?

Bitcoin was not the first virtual currency to be invented and it certainly will not be the last.  OpenCoin is one example of a company that has launched a competing currency called Ripple. Some industry watchers have suggested that Bitcoin may go the way of Betamax or MySpace: a technology that works out the kinks among early adopting consumers, then gives way as a next generation product takes over the mainstream.

In fact, the Royal Canadian Mint has even tried to get in on the action. In 2012, the federal coin maker introduced MintChip – an online currency for small, cash-based transactions. At the same time, they launched a competition for software developers to create apps that would support MintChip. More than $50,000 in prizes has been granted to developers, but apparently the project is still in R&D mode.

Bottom line: Should you invest in Bitcoin?

One thing every analyst seems to agree on is that investing in Bitcoin at this stage is a gamble. One expert recently made this point crystal clear in an interview with The Atlantic: “Bitcoins are incredibly risky and volatile. The whole thing is one grand experiment. Don’t ever hold more money in Bitcoin than you can afford to lose and in general you should assume the whole thing will go to zero.”

While we believe there is a future for digital currency and we love the potential applications, for now, we’re going to leave this investment to the Winklevii.

 

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