Bitcoin Update: 5 Important Considerations

An article by New York Institute of Finance instructor Tracy Williams.

Let's not beat around the bush about Bitcoins, the digital currency that has stirred up the financial world in the past year.

Bitcoins are a virtual currency, now accepted by some merchants and commercial enterprises as a form of payment for services or products. Because Bitcoins have a fluctuating market value, many exploit price volatility and treat Bitcoins as an investment--similar to investors who purchase foreign currencies with hopes that volatile swings will result in handsome profits.

However, many participants are still not sure how Bitcoins came to be, who or what oversees the marketplace, and where all this is headed. For now, any purchase or investment in Bitcoins is a speculative investment. Uncertainty, volatility and mysterious origins offset any confidence conservative investors or cautious users for payments might have in its legitimacy. As we saw in late 2013 when governments in China and Russia intervened to discourage its use, Bitcoins are enveloped by the unknown. They trade as if the marketplace is still a testing ground. And investors run for the hills when they sense something odd or peculiar or simply just not right.

Confidence has roiled again in early 2014. The founder of one Bitcoin exchange was accused of illegal activity. Another major exchange, also under investigation, suspended activity after users experienced technical problems.

This is a marketplace where even the most active participants are not sure the founder is one person with a vision for a new revolutionary payment system or a horde of computer academicians out to amuse themselves. It’s a marketplace in its infancy. As of mid-Jan., 2014, this was a $10 billion market with less than a million Bitcoins (BTC) traded or transferred daily.

Time will tell whether they will become a reliable currency for the long term. Time will also tell whether this is a finance fad of the early 2010's or a landmark turning point in monetary history.

Transactions, trading and investing in Bitcoins are a global phenomenon. A curiosity for some. Vast opportunities for others. Just a year or so ago, the value of a Bitcoin was around $300. During the year, prices soared to $1,000, sank quickly to $500 last fall and then surged and stumbled again like laundry tumbling and churning in a dryer. (They were valued at about $780 in mid-Jan., 2014 and endured a rocky February, when they fell below $600.)

Some argue Bitcoins (or their off-shoots or similar virtual versions) are here to stay. Bitcoin activity will be propelled by those attracted to a system that knows no boundaries, is not directed by government bodies or political systems (at least not now), and allows for trades and payments in relative anonymity. Others like the permanence of transaction records. Some say Bitcoin payments can be a substitute for the risks of identity theft that come with credit cards. As with most financial trends or fads, this phenomenon is bound to stray in some direction--up or down, up and down, out of existence, or perhaps eventually into a nightmarish tangle of fraud, misrepresentation and legal quagmire.

For now, let's review five important facts about Bitcoin in early 2014:

1. The price movements and upward, secular trend in value have attracted speculative investors around the world.
Whether they believe in the system or are proponents of a politics-free, digital market for payments, they see opportunities to make money in the short term. If the price increased from $300 to $1,000, why wouldn't it increase to $2,000 over the next year or two--especially if popularity continues the current course?

Speculative investors may not care much for the algorithms and calculations that expedite transactions. They see trends in growing demand and popularity, not always sufficiently explained, and a grand opportunity for a windfall.

2. There appears to be a growing acceptance by some merchants and businesses to accept payment in Bitcoins (BTC).
Growing acceptance offers legitimacy and comfort to consumers who choose to participate in the system. VirginAtlantic, the airline, joined the group of merchants late last year that are willing to accept Bitcoin payments.

An increase in participating businesses helps boost liquidity in the system and encourages other participants to join. The growing number of participants may eventually lead to a cry for more transparency and oversight--which exists today, but in veiled ways.

3. A Bitcoin market depends on a class of participants called "miners," who act as transaction overseers, almost like "brokers" or "market-makers."
In financial markets, brokers or market-makers facilitate and process trades. Rewarded with commissions or marked-up profit spreads, they have incentives to keep a market alive, active, and liquid.

In the Bitcoin world, miners act vaguely in that role. They don’t skim commission fees or profit from mark-ups, but act as arrangers and are rewarded in a unique way for what they do. Like many financial markets, Bitcoin "miners" have sprouted everywhere in surprisingly large numbers, partly because of the lure of rewards and partly because mining Bitcoins could be considered less risky than in investing in them.

Note the wrinkle in miners' responsibilities. Miners secure, confirm, document and report Bitcoin transactions. They are compensated by being rewarded with a special new supply of Bitcoins, but only after they have successfully solved a math problem that requires enormous amounts of computer power.

Think of a financial broker being rewarded with an incremental new issue of a company's stock. Or think of the Federal Reserve rewarding big banks who confirm and expedite money transfers with new-money credits at the Fed. However, imagine being paid for the service only after solving a math problem that--by Bitcoin rules--will become more difficult to solve in the future.

Those who have access to such computing heft have opportunities to reap substantial rewards. Like market-makers and brokers in a financial market, they facilitate transactions without taking on significant amounts of investment risk. (Their initial investments are those in computer servers or in space that houses computers.)

Because of money-making opportunities, a cottage industry of miners (and related businesses) has surfaced in global corners everywhere--from California to Iceland. There are miners, but there are also companies that support miners by selling or leasing access to computers for mining purposes. There are investors (including private-equity firm Andressen Horowitz) that are now comfortable investing in "mining" operations (as well as in Bitcoin exchanges).

4. Bitcoin "money supply" is controlled, and growth is restricted, planned and charted, based on an initial algorithm.
Bitcoin supply is based not on economic policy or economic objectives, but on the complex math calculations miners are required to do with their high-power computers.

By design, the more successful miners are in finding solutions to the calculations, the more difficult the next series of calculations becomes. It becomes harder and harder to solve the problems to get the same reward. Miners will, therefore, invest in greater computing power to earn similar revenues. Today, miners are racing to grab revenues that might be near impossible to generate a few years from now.

Those calculations have less to do with how central bankers manage monetary supply, more to do with the calculating power of their computers. Governments and central bankers, we observe, manage monetary growth based on objectives they have regarding interest rates, inflation rates, and expected economic growth. "Money supply" is ultimately finite in the world of Bitcoins. Until supply reaches a determined maximum, it is now determined by activity, participants, and computer power.

5. While "mining" helps ensure the Bitcoin market is an orderly market, nobody yet knows what will happen in the worst of cases.
If there is a sudden crash in price --a sudden collapse or a widespread panic, who will oversee the marketplace? If there are crises or disruptions caused by technology, systems or deceitful miners, who will act to revive trading and transacting?

The system, which eased quietly into the global financial system within the past few years, will continue to attract participants--not because libertarians enjoy that governments have no part to play, but because of money-making opportunities.

A steady increase in legitimate participants may eventually force the system to provide a blueprint for how it will behave in worst-case scenarios.

Furthermore, crises, disruptions and crashes will have legal implications, which will require governments or courts to intervene in the end. New York State regulators have already taken a lead in trying to determine what regulation is necessary. Some participants have launched studies and proposals to improve the system. Academics have begun to research the system and map out necessary changes, improvements and even long-term possibilities.

For now governments and central bankers reside on the sideline. The system is decentralized and self-policing. But the greater the number of participants and the greater the likelihood for mishaps, then the greater the push for order and protocol that would boost confidence.

But will all that occur before the system's first panic crash, the shocking catastrophic plunge that will cause large numbers of participants to flee en masse with no intent to return?

Will the system, supported by a phalanx of miners around the world, find ways to keep itself honest, fair, and relevant? Or will it be replaced by another, better system—on the drawing board somewhere right now?

Let’s see what time tells, while Bitcoin prices continue to move uncomfortably and unpredictably along the way.

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