Already proclaimed dead, the virtual currency Bitcoin has staged a comeback, posting a record high of $272.50 Wednesday. It rose almost fourfold since its closing low of $69.50 in July, but doubts remain.
Some view it as an alternative currency that will preserve its purchasing power long term, while being easier and cheaper to trade than gold. Others like it because they think it’s anonymous and can be used as an untraceable payment. It is these factors that propelled the currency to its last peak of $266 in April.
After Bitcoin’s sudden crash in April and May, mostly due to uncertainties regarding the currency’s legal status, it crawled back up as more and more legitimate businesses started accepting it.
So how does it work? Is it a bubble? Could it replace normal money in the future?
Encrypted Data
Bitcoin is both simple and complex. Launched in 2009 by a programmer using the pseudonym Satoshi Nakamoto, a bitcoin is basically money, a medium of exchange. At the same time, the electronic money is basically encrypted data.
Unlike bank deposits, however, which are also electronic, it does not depend on a counterparty, for example, a bank. It is the equivalent of a paper dollar bill in electronic form, freely transferable for goods and services, and exchangeable for other currencies.
The tricky part is how Bitcoin becomes this kind of electronic money. The initial programmers only included a few fixed rules: The total number of bitcoins will reach an absolutely limited number of 21 million by 2140, issued in fixed increments over time. The current supply stands at just below 12 million, and it is worth around $3.2 billion.
The programmers set up the system so it would self-regulate in a decentralized way. At this moment, 25 bitcoins are created automatically by the peer-to-peer system every 10 minutes. It is how these bitcoins are distributed that creates the automatically self-regulating system.
New Bitcoins
In order to verify that a bitcoin was transferred correctly from one electronic wallet to another, and has not been spent twice, extensive computer calculations are needed. Special servers and their users, called “miners,” carry out this verification work and receive bitcoins as payment.
Any computer with open-source software installed can connect to the Bitcoin network, making the system decentralized. It merely has to follow the calculation specifications set by the original programmers. As transactions are posted, miners start the verification process.
The output is a complete transaction log called “blockchain,” which follows a chronological order. For processing 10 minutes worth of transactions miners get 25 bitcoins.
The more common way of obtaining bitcoins, however, is by exchanging it for dollars, euros, or yen, on one of the different Bitcoin exchanges, such as Mt. Gox. It can then be spent with different merchants or it can be used for private party transactions. According to the trade publication American Banker, more than 1,000 merchants signed up to accept bitcoins as payment in 2012 alone.
Transactions Not Anonymous
Contrary to popular opinion, however, bitcoin transactions are not anonymous. In fact, every transaction is posted on the public ledger. This is necessary so the servers can carry out the verification work. If the user’s IP address is known, law enforcement agencies can verify identities through the Internet Service Provider (ISP).
“When they claim that bitcoins are anonymous or untraceable, in fact the opposite is true,” Jeff Garzick, founder of Bitcoin Watch, told CBS.
Traders will also leave an electronic trace when they wire money to their accounts on one of the exchanges.
At the same time, customers’ names will be protected until a prosecutor requests the ISP to connect an IP address to an identity. This guarantees a fair amount of privacy, as normal users will only see IP addresses on the public ledger.
Is It a Bubble?
Bitcoin started its parabolic rise just as depositors in Cyprus found out in March that parts of their deposits would be confiscated to fund a bank bailout. Bitcoin seems to provide a solution to this dilemma by providing a currency that is transferable electronically, but doesn’t depend on a bank or any other institution.
Like gold and cash, the bearer can exchange it for goods and services with whoever is willing to accept it as a form of payment, meaning that no bank is necessary.
However, Patrick Korda writes on mises.org that this is also its biggest weakness: “[Austrian school economist] Carl Menger made the point that money, a general medium of exchange, has always tended to be the most ‘saleable’ (that is, marketable or liquid) commodity of the time.”
Technology Dependent
According to Menger, a lot has to change for Bitcoin to be the most salable good: “Until the majority of the 7 billion or so people that inhabit this planet have either a smartphone or frequent access to the Internet, a digital currency is out of the question.”
Since Bitcoin is inherently dependent on technology, it cannot—at least not for the foreseeable future—replace cash and gold, which are accepted worldwide, irrespective of a connection to the Internet. Taking a $100 bill or an ounce of gold to New York City or sub-Saharan Africa requires no power or Internet, and both can be exchanged for goods and services.
In addition, Bitcoin is a very illiquid market, trading only $3.7 million on average per day during the last month on the most liquid exchange (Mt. Gox).
This does not mean, however, that the Bitcoin phenomenon cannot grow as an alternative to bank deposits and cash. Its unique attributes of being 100 percent electronic, independent from banks and central banks, reasonably private, limited in supply, as well as decentralized, will support its growth in technologically developed economies.
