Virtual currencies have taken center stage in the media, with the currency bitcoin making a number of headlines so far this year:

In January, the Sacramento Kings of the NBA announced it would accept bitcoin as payment for tickets and merchandise from the team store.

In February, the bitcoin exchange Mt. Gox halted all withdrawals and announced it had lost almost 850,000 bitcoins, which had a total value of about $480 million at the time.

In March, the IRS ruled that bitcoins would be treated as property, not a currency, for tax purposes.

In July, computer company Dell announced it would accept bitcoins as payment through its website.

With public interest in virtual currencies piqued, the Federal Reserve Bank of St. Louis presented “Bitcoin and Beyond: The Possibilities and the Pitfalls of Virtual Currencies” as part of its Dialogue with the Fed series earlier this year. Dialogue with the Fed was started in the fall of 2011 to address key economic and financial issues of the day and to provide the public with the opportunity to ask questions of Fed experts.

In this session, David Andolfatto, a vice president and economist with the St. Louis Fed, discussed the rising popularity of virtual currencies, focusing specifically on bitcoin. He explained what bitcoins are and how they work, and he addressed some commonly asked questions about the currency.

What Is Bitcoin?

Andolfatto explained that he thinks of bitcoin as a computer program designed to do two things:

Create and manage a supply of digital currency units called bitcoins

Process payments between anonymous users by debiting and crediting digital accounts with these bitcoin units

Credit for developing this program is given to Satoshi Nakamoto, though many information technology industry watchers believe the name is likely a pseudonym for a programmer or a group of programmers. The bitcoin program is open source, meaning that the program is developed in a public, cooperative manner and anyone can read the program and work to fix bugs and make improvements.

How Bitcoin Works

To begin using bitcoins, Andolfatto explained that users must download a free virtual wallet, which is an encrypted computer file used to store bitcoins. This wallet can be stored anywhere a typical computer file can be stored, and users can have multiple wallets, just like having multiple banking accounts. A key difference according to Andolfatto is that all wallets are publicly observable, though the owner’s identity remains hidden. Andolfatto likened these wallets to a glass post office box. Anyone can see what is in there, but they don’t know who it belongs to and cannot access it without a key. Only the owner has the key to get into the box and take money out.

Andolfatto compared the potential for losing access to the wallet to carrying cash in a physical wallet. Losing the key to opening the wallet or losing the wallet itself (for example, storing it on a USB drive and losing the drive) means no longer having access to that account, which is a serious concern for people with wallets containing large sums in bitcoins. He said, “What if you lost your USB drive? What would you do? If the security key was in there with the USB drive, the person who found it could use your wallet and spend it. If the security key wasn’t there … that money is gone. It will never be used.”

Andolfatto explained that one way of guarding against this risk is to use an intermediary to store bitcoins, similar to how people who don’t want to carry large amounts of cash store their money in banks.

Transacting with Bitcoins

From a user perspective, Andolfatto explained that the experience of using bitcoins to buy something is no different from typical online banking. However, the processing of payments is handled quite differently. Volunteers called “miners” review individual transactions and approve or decline them.

Once approved, transactions are added to a public ledger called the blockchain. Andolfatto explained that this blockchain contains the historical record of all bitcoin transactions in the currency’s history. Andolfatto remarked, “For the system to work, participants must trust the integrity of the blockchain. It’s absolutely critical. The power to alter or fabricate the history of transactions is the power to steal.”

The blockchain does not, however, contain the identities of the transactors or a record of the items being purchased or sold. Andolfatto explained that it only shows the amount in bitcoins that have been transferred from a specific wallet to another specific wallet.

Is Bitcoin a “Bubble”?

To discuss whether bitcoin is experiencing a bubble, Andolfatto first provided a definition of a bubble as an object’s value having a liquidity premium. He said by this definition, bitcoin was indeed in a bubble, as it has no intrinsic value.

“If you think about decomposing the market price of any security into components—some measure of its intrinsic or fundamental value—and if you take a look at the difference between the market price, if it’s trading above its intrinsic value, we could ascribe the difference to a liquidity premium. That is to say, most assets are valued not only for their intrinsic use, but how easily they can be liquidated, how easily they can be passed along in future transactions. … Most assets, like I said though, have this property, at least a bit of a liquidity premium, even gold.”

Is Bitcoin a “Good Investment”?

Andolfatto began discussing whether bitcoin is a good investment by pointing out: “We have very good economic theory that tells us that asset price changes are difficult to forecast. A lot of people have lost a lot of money not listening to this theory.”

He said in his opinion it really depends on future outlooks for this product, like any new product. Investors considering bitcoin as an investment should ask a lot of questions:

How rapidly and extensively will it penetrate the market?

How might government regulations evolve over time?

How easy is it to replicate the product?

What sort of competing products might emerge now and in the future?

Is Bitcoin a “Good Money”?

Similar to how he discussed whether bitcoin was a bubble, Andolfatto discussed whether bitcoin was a “good money,” specifically, whether bitcoin as a medium of exchange would maintain a stable purchasing power over short periods of time. To demonstrate, he plotted the purchasing power of four currencies since 1990, normalizing the purchasing power of each currency to 100: the yen, the euro, the U.S. dollar and the Zimbabwean dollar.

As Figure 1 shows, the Zimbabwean dollar experienced hyperinflation until its purchasing power essentially fell to zero. The yen, dollar and euro, on the other hand, have remained relatively stable. Andolfatto said, “The striking thing about those lines, in my view, is that they’re relatively stable. They don’t exhibit wild fluctuations. Sure, there’s a 2 percent inflation in the United States, but it’s forecastable. It’s something you can predict, you can bet on.”

Figure 2 plots the purchasing power of bitcoin against that of the U.S. dollar over a much shorter time period (November 2013 through July 2014). Andolfatto concluded that the purchasing power of bitcoin has shown significant volatility over the short term.

Figure 1 Purchasing Power of Currencies Figure 2 Purchasing Power of Bitcoin and the US Dollar

Nominal Exchange Rate Indeterminacy

Andolfatto next turned to the issue of nominal exchange rate indeterminacy, or the inability to determine the exchange rate between two intrinsically worthless objects.

Andolfatto pointed out that there is nothing in economic theory that would explain the value of one intrinsically worthless object relative to another. He gave an example of casino chips, asking how consumers would determine the value of a red versus a blue chip if the values weren’t already fixed. He then applied the example to determining the exchange rate between two virtual currencies.

“The evidence is that exchange rates of fiat currencies are excessively volatile. And as I just alluded to, the problem is that there’s no fundamental economic force that pins down the relative price of two intrinsically worthless objects.”

Does Bitcoin Facilitate Illegal Trading?

Andolfatto explained that the identities of bitcoin wallet owners are disguised, “so in that sense, they’re very similar to using U.S. cash in facilitating illegal trades.” However, the blockchain’s public availability means transactions could still potentially be linked to users. For example, discovering a wallet on someone’s computer would then allow transaction history to be viewed.

“If I’m some government authority, you’re going to have some explaining to do. That’s not a property of a U.S. cash transaction.”

Can Bitcoin Be Regulated?

Andolfatto noted that some countries have banned the use of bitcoins and that banning currencies has been a common practice for countries aiming to protect their local currencies. However, the fact that bitcoin does not have a central authority makes regulating the currency challenging. “It’s like trying to slay the hydra. You cut off one head, and three other heads appear. I mean, it’s this distributed network out there in the world. How are you supposed to regulate something like that?”