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.

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, etc.) — or whether Bitcoins have a long-term future at all. While Bitcoin defies easy categorization, we can break down its functionality and analyze how it compares to traditional currencies, commodities, and collectibles.

Bitcoin as currency

Currencies serve multiple functions in society, but primarily they are 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 fulfill 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. More sobering long term 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 us 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 Confederacy in the Civil War or 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 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.

It’s beyond the scope of this article to go into the technical or financial details of Bitcoin mining, but suffice it to say the easy money has been made.

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.

Next page: The rise of cryptocurrencies and the future of Bitcoin…