Over the last year, quite a few readers have written in asking me for my take on Bitcoin and, lately, other digital currency such as Litecoin. As I often do when I get many emails on the same topic, I thought I would sum up my take on the issue in a single post so that I can simply refer back to it in the future.
First of all…
What Is Bitcoin?
In simplest terms, Bitcoin is digital currency. You can essentially think of it as a new type of money with a few special features, which I’m going to explain in a simplified form.
For starters, Bitcoin is tied heavily to a network of computers all over the world. Anyone who wants to can run the Bitcoin app on their computer and become part of that network. Among other things, that app stores part or all of the Bitcoin transaction history.
What’s the transaction history? Whenever someone gives someone else a Bitcoin (or a fraction of a coin), they must share that transaction with the entire network. The other computers on the network can then store the record of that transaction.
Another important factor is that there is a very limited number of Bitcoins in existence. The entire system relies on a very brilliant mathematical system to verify that each Bitcoin in existence is unique and who the initial owner of that Bitcoin is.
When you own a Bitcoin (or a portion of one), it essentially exists as a small computer file. Since that file has real value, people who hold Bitcoins are wise to store them in a place that’s not connected to the internet for security purposes.
When Bitcoin first became popular, it was heavily used for payment for services and products on the black market, but as it has grown in popularity, it is now used and exchanged mostly legitimately. Think of it like a dollar bill – some dollar bills are indeed used for black market purposes, but they’re also used for normal shopping, too. Some businesses now accept Bitcoin for payment, such as Virgin Galactic.
There are several alternatives to Bitcoin that function in a very similar way: Litecoin, Namecoin, and Peercoin are among the most popular.
How Does One Invest in Bitcoin?
There are a number of currency traders out there who will exchange Bitcoins for dollars and vice versa, depending on whatever the current exchange rate between dollars and Bitcoins actually is.
That exchange rate is set by the free market. If someone out there is willing to pay $1,000 for a Bitcoin, then that’s the current value of a Bitcoin.
There are a lot of different brokers out there that engage in this buying and selling. To be quite honest, because Bitcoin is so new, it has a bit of a “wild West” feel out there. I have sold Bitcoins at only one place to this point: MtGox, because they’re the largest exchange at this point.
Should One Invest in Bitcoin?
I would only invest in Bitcoin as a purely speculative investment at this point, for several reasons.
For one, Bitcoin is incredibly volatile right now as speculators are having a field day in the market. People are buying them and hoarding them and then selling them quickly when they think the market is at a peak. The volatility is tremendous right now – you’re seeing daily 10% swings in value and monthly swings of 30% to 40% in value. That’s not something you want to have important personal savings invested in.
Another reason I would be wary is the lack of regulation of Bitcoin exchanges. Given the newness of Bitcoin, these services are largely unregulated. While I had a good experience with MtGox, that’s far from a guarantee that MtGox or any other exchange is legitimate.
Adding those two factors together, I would only invest in Bitcoin with money I was fully prepared to lose.
Over time, my guess is that either Bitcoin will become an established form of exchange for many transaction types and thus will become less volatile and be more regulated in terms of protecting people during exchanges, or it will fade away. Which will it be? Only time will tell.