Betting on Bitcoins
Virtual currencies used to exchange goods on the Internet have been around for over a decade, but bitcoin is the one digital currency that’s proving its legitimacy in the real world with a current $1.5 billion evaluation and a possible ETF in the works thanks to venture capitalist twins, Cameron and Tyler Winklevoss.
In the early days, you could buy a bitcoin for a tenth of a nickel, but these days it will cost you $135 to buy one. While bitcoin’s performance has been impressive year-to-date, there are risks associated with potential returns just like any other investment. Speculation is still high and regulation is pending, so consider the following pros and cons if you’re thinking of riding the bitcoin boom.
Decentralization: Like gold, bitcoins are not tied to a government so they can’t be printed or manipulated by monetary policies. Since there’s only a finite amount of bitcoins—21 million by 2041 to be exact—they retain their value regardless of quantitative easing or interest rate policies.
Additionally, bitcoins are “minted” through preset intervals determined by an algorithm so that the supply grows at a regular, predictable rate without the interference of financial regulators like a central bank. Unsurprisingly, interest in bitcoins has come from countries that have had troubled economies including Argentina with its volatile currency woes and Zimbabwe with its hyperinflation challenges.
No Third Parties: Bitcoins are not tied to any banking system and do not require a clearinghouse to settle transactions so there are virtually no fees or limits on how much you can send or accept. Bitcoins can be directly transferred person to person anywhere in the world within a matter of minutes through an online wallet service or a Bitcoin Wallet application that can be downloaded on a phone or computer. Bitcoins can also be converted into dollars, euros, yen, rupees and other currencies.
Unlike banking transactions, bitcoins are transparent since every single transaction is verified and recorded in a real-time public ledger called the block chain. The block chain is maintained by a network of users who run it through a free Bitcoin mining software that solves complex cryptographic sequences to process and verify transactions and “mines” for new coins that are released into the system. Through this process, transactions are transparent but remain secure and anonymous.
Strong Encryption: With military-level cryptography, bitcoins are hard to counterfeit. Every transaction requires a unique signature, or private key, that is verified by a miner and is permanently stored on the network. Through this process, every bitcoin has an associated history attached to it that makes it difficult to replicate or counterfeit.
Technological Vulnerabilities: As with physical money, you can easily lose virtual money. If you forget your password, don’t backup your hard drive or accidentally override and erase your Bitcoin wallet, you can easily lose all your bitcoins.
Bitcoins can also be stolen through malware, viruses and attacks. Owners of online wallet services have also disappeared with people’s bitcoins. To safeguard against these attacks as well as human error, you’ll need to set up and maintain a system of online and offline backups — which can be a hassle in and of itself.
Volatility: Bitcoins are not pegged to any currency which can cause it to fluctuate wildly. Since its inception in 2009, it has traded for less than a penny and reached a high of $220 last April. Additionally, the rates between the bigger exchanges and a local exchange can be vastly different.
Fraud: The anonymity of using bitcoins has also provided a way for criminal activity such as the buying of illegal goods or money laundering. And while regulation can be good for Bitcoin in order to prevent fraudulent activities, there’s no telling if governments will try to abolish virtual currencies altogether. Just last month the Treasury Department’s Financial Crimes Enforcement Network, FinCEN, informed Bitcoin that it must adhere to U.S. financial rules.
Proceed With Caution
The most common ways to get bitcoins are to accept them as payment, mine for them which can require a lot of time and computing power, or purchase them directly which can be expensive. If you do decide to invest in them, be aware it can take a lot of time and resources, and you may want to start off with money you can afford to lose since the FDIC won’t guarantee virtual currencies even if the risks are just as real as the returns.
Hannah Kim is a financial writer at NerdWallet, a site dedicated to helping consumers learn how to manage their money, whether it’s to help them find the best credit card for their needs, or find the right online brokerage account.