You may have heard of a strange virtual currency called “Bitcoins” making headlines lately. And no wonder.
On Wednesday morning, Bitcoins were going for $260 for one unit, a 520 percent increase since mid-March. Investors were in a frenzy as people all over the world tried to get their hands on it; one family in Austin even sold a Porsche in exchange for 300 Bitcoins.
Then, suddenly, the price plummeted Wednesday afternoon, tumbling down to about $150.
What are Bitcoins anyway and why should we care??
Created in 2009, Bitcoins exist only online as digital signatures. Though most institutions don’t recognize bitcoins as valid currency – and they’re best known as the payment of choice for black or “grey” market websites, like the underground drug-dealing website Silk Road – recently more mainstream businesses, like a bar in New York City, have started accepting them.
How is Bitcoin different from normal currency? Most money is regulated by a central authority, which can control its value and manipulate rates, as we’ve seen with the Federal Reserve’s quantitative easing policy in the United States. Bitcoin, however, is decentralized, and there’s a finite supply of Bitcoins, never to exceed 21 million. As a result, many Bitcoin supporters tout it as a solution for inflation.
Meanwhile, some investors are treating Bitcoins like a commodity by buying them in the hopes they’ll appreciate, rather them using them as currency. But with the recent volatility, others are questioning whether anyone should take them seriously.
Here’s what you should know:
UNDERSTANDING THE BITCOIN RISE
There’s no authoritative answer to why Bitcoins appreciated so drastically, but the first big price jump coincided with the Cypriot crisis. Many people who were worried about the future of their own currencies fled to the online currency, and increased media coverage fueled the rise.
“Demand is driven by media attention,” says Reuben Grinberg, an associate in Davis Polk’s Financial Institutions Group, who has studied Bitcoins since he was at Yale Law School. “Every time there’s an article about Bitcoin, people say, ‘This is interesting, maybe I’ll buy some.’” The higher Bitcoin soared, the more it got covered in the media; the more media coverage there was, the higher it soared.
So then why did it plummet so suddenly, in the wake of a ton of press ranging from The New York Times to NPR? Many blamed it on a lack of confidence in the currency. But Matthew Yglesias at Slate claims it’s because Bitcoin’s structure is inherently problematic: Since supply is limited, as the price rises, people want to hoard the currency and not spend it, which makes it useless – causing the price to crash.
WHY REGULAR INVESTORS SHOULD BE WARY
John O’Meara, a certified financial planner and founder of Inner Harbor Advisors, an investment firm, says that even when Bitcoins were at their peak, he and his firm didn’t recommend buying in: “I would be shocked to hear of any mainstream advisor who could even consider recommending Bitcoins.”
Even before the crash, he predicted Bitcoin’s volatility. “It’s my experience that when a company goes from $20 to $250, it’s capable of going to $2,000 – but it’s also capable of going to $2. I don’t know what the value should be, because [Bitcoin has no history]. You’re talking about a completely new currency … No person in the world could give an accurate prediction of where Bitcoin is going.”
BITCOINS ARE NOT REGULATED OR PROTECTED
Bitcoins also represent a new concept and technology, so “essentially no regulation exists,” Christin says. For example, if you buy and sell Bitcoins at a profit, he asks, “Is that taxable? It’s probably capital gains, but it’s all very new.”
Grinberg adds, “No one knows how governments and agencies will deal with [Bitcoin]. There’s always the chance that one day you could wake up and a foreign or U.S. government could say you can’t use Bitcoins for certain purposes or trade them in certain ways.”
In March, the Financial Crimes Enforcement Network (FinCEN) issued a report with implications for Bitcoin. Regular Bitcoin users probably won’t be affected, but other purveyors, like exchanges where Bitcoins are traded for traditional currencies, could be regulated in the future. “Even after an official pronouncement like the one from FinCEN, a lot is still unclear,” Grinberg says.
SECURITY CHECK: YOU CAN’T HIDE IT IN A BANK …OR A MATTRESS
Another risk factor is security. “It’s so difficult to hold a coin securely,” Grinberg says. “Think of yourself in the Wild West prospecting for gold. How will you keep the gold secure? Maybe you keep it in a safe at home or with a local bank, but what if someone breaks in? Bitcoin is very similar.”
You have two options: You can store Bitcoins on your computer, or you can use a third-party service. Grinberg likens storing Bitcoins on your computer to holding cash under your mattress. “It’s inviting trouble,” he says – as people can steal your coins through malware or by physically gaining access to your machine. The basic security risk also adds to volatility: “Every time there’s a hiccup with security, the Bitcoin price seems to be affected,” Grinberg says.
“One of the first things we talk about with any prospective (financial planning) client is where their assets are stored,” says O’Meara. “What if something happened to us? How are our clients’ assets protected? I don’t even know where you’d start with Bitcoins.”
Yes, Bitcoins are a tool to combat inflation, but as Grinberg says, “If your main worry is inflation, there’s a good argument that instead of Bitcoins, you should be investing in something like gold, which, unlike Bitcoins, doesn’t have the same regulatory or security risks.”
INVESTING IN BITCOINS IS LIKE BETTING IN A CASINO
As the Bitcoin industry grows, new spin-off investments are likely to develop, such as the ability to place leveraged bets on Bitcoin via margin trades. Of course, if Bitcoin is risky, adding even more leverage to the equation will only make things riskier. “If you converted all your money to Bitcoins, I’d say you’re very, very brave. It’s basically the same as investing all your life savings in a Las Vegas casino,” Says Christin.
Does that mean it’s a terrible idea to buy Bitcoins, ever? No.
The same way you might have a stable, diversified retirement portfolio but reserve a small percentage of your net worth for playing the stock market, you might decide to dive into a speculative investment such as Bitcoin to see what happens (and to avoid the “what if” scenario if the digital currency does turn out to be the next big thing). The important takeaway, however, is that you shouldn’t abandon all of your time-tested investing principles with each new investing craze.
WHAT DOES THE FUTURE HOLD?
Despite its flash crash, Bitcoin could continue to thrive – and mature – as a financial instrument. Whether it remains in its current incarnation or another similar system replaces it, Christin thinks the concepts behind Bitcoin “are here to stay.” He sees a growing desire for more privacy of online activities.
Bitcoin helps consumers maintain privacy in online payments because it uses cryptography to authenticate the transaction and can’t be reversed. “It’s much better than credit card payments or wires,” Christin says.
Grinberg sees Bitcoin as a powerful tool for online services that cater to people around the globe, because it allows them to avoid “translating 50 different currencies into their home currency.” But compared to traditional internet commerce, he imagines that Bitcoin will represent a small share of the market for a long time.
He also notes that many invest in Bitcoin for ideological reasons. “Especially in the early days, a lot of people talking about Bitcoin on forums were deeply distrustful of the government, diehard libertarians,” Grinberg says. But over time the demographic has shifted. These days, more people are getting involved because they see it as a way of making the financial system more efficient, “similar to the way Google has made the Internet more efficient.”
What would it take for Bitcoin to become more mainstream? For one thing, more vendors would have to accept Bitcoins as payment, which would require a more stabilized Bitcoin price. Says Christin, “It’s pretty hard to exchange goods for money when the currency is subject to wide swings, especially since people have the tendency to hold on to Bitcoins [when their value is high].”
Another thing required for wider adoption would be more user-friendly exchanges. “Right now,” Christin says, “procuring Bitcoins is not difficult, but also not something an average person with very little technical background would find intuitive.”
Christin is on the fence about whether Bitcoin could one day change the monetary system as we know it. “I wouldn’t put it outside realm of possibility, but it’s still too early to tell.”