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Bitcoins – Buyer Beware

It seems every time I pick up a magazine or watch a show on investing someone is touting Bitcoins. Even Congress and the White House have endorsed the benefits of an alternative currency system.

So what is a Bitcoin? It is an on-line digital currency supposedly created by a Japanese computer programmer under the pseudonym Satoshi Nakamoto (although no one has ever met this person). The idea of a Bitcoin is to replace government-issued currencies and the need to settle transactions through a central banking system. It is a virtual currency whose total issuance is controlled by a network of computers by a sophisticated algorithm. As opposed to a government that can continue to print money endlessly, thereby deflating its value, the network has a finite amount of coins or tokens that can be issued. The total supply of Bitcoins is theoretically limited to 21 million with approximately 11 million already issued.

So how did Bitcoins get created in the first place? To get a newly minted Bitcoin requires one to solve a complex equation whose answer is a 64 digit number. The people who attempt to solve this are known as “miners” as they are sort of mining for “gold” via an on-line network. Their reward for their work is currently 25 Bitcoins, but that amount will decrease over time and you will likely need a network of computers to be successful. The equation gets more and more complex over time with the amount of Bitcoins issued per year limited and decreasing each year with all issued by 2040. Of course you can buy a Bitcoin just like buying gold or common stock.

So what can I do with a Bitcoin? Bitcoins are becoming more widely accepted as a viable alternative to cash. You can actually buy goods and service by exchanging Bitcoins and a several networks have developed to exchange them. The underworld loves them as they do not have to launder a Bitcoin as they do with regular cash.

The value of Bitcoins, just like gold or shares of common stock, are determined by supply and demand. However the value of a Bitcoin is extremely volatile ranging from under $200 to over $1,300 in 2013 and now valued at around $750. On a daily basis the value often moves up or down by 10%. It often takes up to 50 minutes to process and settle a trade using Bitcoins.

So are Bitcoins safe and something I should own? In my opinion a strong NO to both. Unlike the good old US dollar, a Bitcoin is not backed by anything. It exists only in cyberspace in a network whose issuance is controlled by a complex algorithm written by an unknown person. While you may say that there is nothing backing the dollar, I beg to differ. There is an established government that for over 225 years has made good on its debts. While we are off the gold standard and there is no hard asset per se backing the dollar, the US government still owns vast holdings including about 30% of all the land in the country. There is NOTHING backing a Bitcoin. Some point to the controlled network making Bitcoins “tamper-proof” with a limited supply as benefits. However, the network supporting them was recently hacked causing a sharp drop in values and now I am seeing more and more articles on how to steal Bitcoins. I suspect this is simply a large scale Ponzi-style scheme developed in Russia or China and the developers are just waiting to flood the market with newly minted tokens. Supporters say that they are like gold but can be exchanged easier but they fail to point out the near 30% crash in gold prices in 2013 whose price was inflated by speculation. And unlike Bitcoins, gold is actually an industrial commodity that has some intrinsic value. A Bitcoin only has value if someone will pay more for it.

My advice is to sell off any Bitcoins you have and do not accept them in your business. If you are smart enough to be a miner – go ahead but don’t hold onto the tokens for too long.
As a student of history and finance this very much reminds me of the tulip mania in Holland in the 1600s and the dot-com bubble of the 1990s and both ended badly for investors.

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