With news this morning of another Bitcoin crash, and recent bans of the currency by China and then Russia, we thought it was high time we took a closer look at the nascent cryptocurrency that has everyone up in (mostly confused) arms. What is Bitcoin? Why is it valuable? Will it ever be sensible to invest in them? We’ll answer those questions, and more, in this article.

While Bitcoin started as a response to the financial crisis and an attempt to circumvent the shortcomings of our global financial system, it has quickly turned into a growing economic force and a unique testbed for new ideas about money, value, and ways of buying and selling.

While Bitcoin news is often in the headlines, the system itself – loosely called a digital currency or cryptocurrency – is still not widely understood. More importantly to most of us, it hasn’t been clear when and how we might use Bitcoins – or one of its imitators (Litecoin, Dogecoin, and so forth) – or whether Bitcoins have a long-term future at all. While Bitcoin defies easy categorisation, we can break down its functionality and analyse how it compares to traditional currencies, commodities, and collectibles.

Bitcoin as currency

Currencies serve multiple functions in society, but they are primarily used as a medium of exchange and as a store of value. (They are also used as a unit of account, but for simplicity we’ll leave that aside in this case). In principle Bitcoin can fulfil both of those roles for its growing community. As long as businesses choose to accept Bitcoins in payment and there are exchanges to turn them into other currencies, Bitcoins will survive as a medium of exchange.

Currently Bitcoin acceptance continues to increase, although it is still not trivial to get started in the world of Bitcoins, and transactions take nearly an hour to settle. Taking a long term perspective, more sobering is the lack of any underlying foundation for the acceptance of Bitcoins. The US dollar, for example, is by law accepted as a means for settlement of debts in the US – especially money owed to the government. That may not sound too important, but every business needs to collect and pay various taxes, as do most individuals. That helps firmly root America in a dollar-based economy.

With Bitcoin, if everyone chose to stop accepting them tomorrow morning – perhaps because they lost faith or thought that the Bitcoin system had been co-opted or corrupted – then the remaining Bitcoins would have no worth except as collectors’ items. Bitcoin would be like the currency printed by the government of Zimbabwe. For now that seems highly unlikely, but long-term investors think in decades, and Bitcoin has only been around for a few years.

Currencies aren’t mined, commodities are

Until Bitcoin, traditional currencies are not directly mined. Materials that are mined and sold for later use or as collectibles are called commodities, and their value fluctuates with demand and supply. Some of them, like gold, have become popular enough as a way of storing value or hedging currency risk so that they act almost like a currency, but except in rare instances like the California gold rush, modern commodities aren’t spent directly – instead they are first converted back into a national currency. Intriguingly, early US coins contained an equal amount of gold or silver to their face value, making them a much closer analogy to the Bitcoin model than today’s “fiat” currencies that rely on law and trust for their value.

As a value store, Bitcoin suffers from its roots as a cyber-commodity. Its value fluctuates wildly up and down with the latest tech news or scare. Unlike a typical nation-backed currency, no one is actively managing the value of Bitcoins. The result is a market driven by speculation more than by savings. While, like gold or oil, speculative ups and downs may make Bitcoins a legitimate part of an investment portfolio, it doesn’t make it a safe place to store your savings.

While it is easy to pick theoretical holes in Bitcoin as a currency, clearly it is popular and growing, so it pays to look at what makes it valuable to purchasers. Perhaps the most succinct description of the utility of Bitcoins I’ve ever heard is that they are like “dollar bills with wings.” Because they are global and require no physical presence or large fees to exchange, Bitcoins go well beyond the advantages of a traditional currency to provide a worldwide financial framework, and in particular a mechanism for the low-cost exchange of value. (The Bitcoin price chart below shows its explosive growth in value, but also shows its volatility).

Unlike other international electronic transfer systems, Bitcoins are nearly fee-free. For example, the startup BitPesa believes it can save Kenyans $74 million (£45 million) a year in wire fees by switching their remittances to a Bitcoin-based system. Bitcoins also have the advantage of being hard to trace, like cash. The combination of these two benefits give Bitcoins and other similar cryptocurrencies a natural appeal for those who want to do business around the world without being constrained by the conventional banking system.

Copycat coins: Baseball cards for geeks?

The first commodity many American boys were introduced to was baseball cards. Sure, they were cool to look at, but they were also collected and traded in vast quantities. A finite supply was created each year, and the number portraying star players was strictly limited. The result was a market that spanned backyards and swap meets – extended today by the reach of the Internet.

Whither Bitcoin?

Bitcoin’s unique status as part currency, part commodity, and part collectible make it hard to value. Forecasts regarding the Bitcoin are all over the place, but one of the most thoughtful and detailed was completed by David Woo of Bank of America. He divides the value of Bitcoin into the three aspects we’ve discussed: Medium of exchange, mechanism for money transfer, and store of value, assigning a somewhat arbitrary ultimate value of $5 billion (£3.05 billion) to each. At $15 billion (£9.15 billion) in total spread across the current 12 million Bitcoins in circulation, each Bitcoin could be worth just over $1300 (£795) – a nice but not stratospheric premium over their current market value.

Woo’s forecast is probably as good as any if Bitcoin continues on its current course. However, risks to that peaceful future vision include increased government regulation (like that just put in place by China and Russia), future flaws in the underlying software system, or flight to some rival, yet to be introduced, alternative. In short, for those who need the features Bitcoin provides, they’re a great tool, but don’t expect to make a huge return by speculating on them, not in the way those who bought in early have thus far.

Image Credit: FamZoo