Bitcoin, New Virtual Currency, Or Digital ‘Tulip’ Bubble?

The Bitcoin frenzy has officially taken off in grand style this month, on the back of the Euro debacle in Cyprus and the stark realization that blind trust in the monetary authorities that regulate fiat currencies (including the Eurozone) can be rather costly to savers.

It is no coincidence that Bitcoin was created in 2008, in the midst of a massive world financial crisis and implemented the following year. In fact, the nature of Bitcoin is quite the opposite of putting your trust in the financial authorities: it is broadly speaking… everyone for himself. In the words of Satoshi Nakamoto, the pseudonym behind the project, Bitcoin is a virtual currency completely decentralized, without any trusted parties.

The Bitcoin project started with a strong ideological push against governments and public authorities, as a peer-to-peer service in the shape of an electronic payment system centred around a virtual currency outside the circuit of traditional central banks.

It is unknown who is behind its creation, maybe one or more IT geeks or hackers, as portrayed in an episodeof the populat American TV series ‘The Good Wife”. What we do know is that Bitcoin has achieved remarkable success, in terms of media coverage and record Google searches, when compared to other virtual currencies invented so far.

What sets Bitcoin apart from other popular virtual currencies, such as Facebook credits, QQ coins in China, or Linden dollars, in the game Second Life, is that it is not controlled by the companies that invented them and most importantly has a value outside its eco-system.

Bitcoin units are set with a fixed upper limit of 21 million units, which can be split in several decimals. There are about 11,8 million available to be purchased on the marketplace, with the rest being ‘mined’.
The ‘mining’ process takes place with the solution of complex algorithms, with a Bitcoin protocol controlling the process.

The protocol works in such a way that the more computing power around the world  is trying to ‘dig’ new bitcoins (imagine an army of computer geeks competing to solve complex equations), the more difficult the solution of those algorithms becomes. The opposite would happen if the number of Bitcoin diggers and their relative firepower were to decrease. Searching for new prime numbers is possibly a fair comparison to this process, in the sense that just like them, now only supercomputers or pool of IT and mathematics experts can manage to solve the problems that lead to the ‘discovery’ of new bitcoins.

Bitcoins are stored in an electronic wallet on your computer and this is when, in my opinion, arises the most important limitation in terms of its widespread usage. Bitcoins owners have already been targeted by hackers and their virtual wallet emptied. There is little or no chance of finding the culprits due to the anonymity, which is the distinctive feature of the whole system.

Truth to be told, some experts believe Bitcoin transfers are still more traceable than actual cash, but that is a rather difficult and complex task. Bitcoin has been used on a few websites for illegal activities such as money laundering, purchase of drugs, weapons and even hacking software, drawing an investigation from the FBI.

As things stand, there is no jurisdiction in the USA having a comprehensive policy on Bitcoin, partly because it is difficult to assess whether Bitcoin is a currency or a commodity. If there is no exchange of Bitcoin into US dollars, this activity should remain unregulated. Its dual nature currency/commodity explains why it has rapidly become a speculative phenomenon.

Venture capitalists and other investors (such as the Winklevoss brothers who have disclosed ownership of 1% of all Bitcoins)  are starting to become involved in Bitcoin and interest from the financial community is definitely growing.

In fact, the wild price gyrations and extreme price volatility have attracted many professional traders.

In my view, this indicates that, at least for the time being, the notion of Bitcoin as a currency is secondary.
Bitcoins can be traded at any time of the day any day of the week on a few exchanges, the most prominent being the Japanese-based Mt.Gox, originally a card collection exchange. Mt.Gox claims it is managing about 80% of all Bitcoin trades taking place around the world.

Last week, Mt.Gox trading systems suffered several hacking attacks and transactions were suspended, due to an inordinate rise in the number of users and volume of shares traded. Nonetheless,the  meteoric rise and fall in value for Bitcoin has happened before, like in 2011 going from $1 to about $30 and then back to low single digits. A year ago, Bitcoin was traded at about $13 and went as high as $260 a week ago, only to fall by some 70% and then to quickly rebound by 50%.

Any financial expert would tell you that these type of price swings are not typical of a currency, but are more indicative of a commodity (like the 16th century tulip-like) speculative bubble. Bitcoin representatives are telling everyone this unstable pricing is a natural consequence of its growth and that things will tend to adjust over the long run.

I believe that the concept of an independent electronic payment system is a valid proposition, so long as a sufficient number of merchants adopt it, under the assumption that it a cheaper and more efficient system to trade around the world. In the meantime, there are many questions that remain unanswered.

First of all, the security issues need to be addressed. The electronic wallet on your computer is not an efficient and sensible way to store value, at least no better than stashing cash under the mattress.

Secondly, I am quite confident that the authorities will get eventually a grip and attack this virtual currency ecosystem (the ECB itself has already made an official statement indicating that Bitcoin represents a challenge with negative effects on their authority in the markets). I think this is likely to happen, either because it threatens the official currency system or because of its use for illecit activities.

This intervention from the authorities could damage the users’ trust in Bitcoin and their confidence that it could also be a store of value. New forms of electronic payments are likely to appear in the future, but at this stage, I would not necessarily bet on Bitcoin becoming the new Amazon… and if you really like gambling, old fashioned betting is probably more fun than trading a virtual currency!