With up to 70,000 transactions each day over the past month, bitcoins have been propelled from the world of Internet oddities to the cusp of mainstream use – according to a November 22, 2013 AP story by Rick Bowmer.
Since I have been asked about bitcoins by several people recently, it seems like time to talk about what they are, and importantly, what they are not.
In the simplest terms, bitcoins are an electronic currency that people can use to send payments to each other. As such, they are a fiat currency just like the dollar, euro or yen – not backed by anything other than the confidence of the market for those currencies.
Problems with bitcoins are numerous. For example, what if the person on the other end of your deal isn’t interested in taking bitcoins in payment? In that case you’ll need to trade your bitcoins for cash and where do you find someone local who will cash them for you without resorting to fire sale prices for your bitcoins? Frankly, you would have the same problem if someone would not accept your euros, yen or gold. Dollars have been legislated as legal tender, so U.S. merchants have to accept them. Not so with bitcoins.
Although 70,000 transactions a day sound like a lot, that is nothing compared to the number of cash and credit card transactions that happen every day around the world.
And, many bitcoin transactions seem to be in dodgy enterprises that wish to avoid banking scrutiny of cash transactions. Earlier this year, the FBI busted a drug dealer and in the process confiscated approximately 1.5% of all bitcoins in circulation.
The number of bitcoins in circulation is capped at 21 million creating a supply and demand dynamic that is pushing the cash price of bitcoins higher. This sounds good if you have an inflation phobia. However, fixed money supplies such as the gold standard have been proven to greatly hinder growing economies.
If an economy or just a population is growing at 3% a year, the money supply needs to grow at 3% a year to avoid bottlenecks caused by cash shortages. The depressions of the 19th and early 20th centuries were made much deeper than recent ones by an inelastic money supply in a rapidly growing economy.
Bitcoin use also entails user fees, similar to credit card fees. The fees are lower than traditional credit card fees, an advantage that may disappear as the formula governing fee payments creates smaller and smaller fees (in bitcoins) as the industry matures. Processors will be forced to find other ways to charge fees or exit the business.
Bitcoins are supposedly protected by unreadable (except by the computer intended to read it) code, and a record of every bitcoin transaction is kept in a public online journal to avoid fraud and cheating. This sounds great in a utopian sense, but as privacy concerns mount would you want every transaction you do publicly reported?
Bitcoins also need to be stored, just like cash. Users maintain electronic files called “wallets” to store bitcoins. But just like banks, cash in wallets can be stolen or pilfered or lost to hazards like a hard drive crash. However, the bitcoin market is unregulated, so there is no protection if you happen to choose a bad online wallet service or have a computer error that destroys your wallet file.
Should you buy bitcoins? I’m certainly not recommending that. They can be used only for two things: payment for limited goods or services and currency speculation. Currently few vendors accept bitcoins, so using them for payments is a bit iffy.
Although some speculators have done well so far, speculating is, well, speculative. Bitcoins have rebounded, but lost 90% of their value in two weeks (April 16-28) in mid 2013. There is no way to be sure you will profit speculating in bitcoins. It is literally a gamble.
I don’t see how bitcoins can possibly work in the long run, but so far the market for bitcoins is functioning. I have to admit that it was hard to see the potential of early Internet technologies, too. But over time, entrepreneurs took the basic structure of the Internet and built innovative and user-friendly services such as Google, Facebook and YouTube.
Maybe bitcoins will morph into a more viable structure, but right now bitcoins are the Wild West of money.
Will Hepburn is the President and Chief Investment Officer of Hepburn Capital Management, LLC, in Prescott, Arizona. He specializes in developing, implementing and teaching innovative investment strategies that Adapt to Changing Markets®.
Will began helping clients make smart decisions with their money in 1977. He practiced as a Certified Financial Planner from 1994-2006, and currently focuses exclusively on investment management.
His academic record includes a major in business and economics at Ottawa University where he studied under Dr. Wayne Angell, a former Federal Reserve Board Governor prior to transferring to the Institute of Computer Technology in Chicago where he graduated first in his class. He has also completed a number of post-graduate level courses with the College for Financial Planning in Denver.
Will is also a college instructor. He taught classes on investments and estate planning at Yavapai College in Prescott, AZ for 20 years. His articles on financial topics have been published nationally and his ideas have been included in best-selling books such as Rich Dad, Poor Dad, by Robert Kiyosaki and leading investment newsletters such as Dow Theory Letters and John Mauldin’s Thoughts from the Front Line. In addition, he frequently gives expert interviews to national media, including InvestmentNews, Kiplingers, Forbes, Fortune, CNNMoney and The Wall Street Journal. Will is a past-president and currently on the Board of the National Association of Active Investment Managers (NAAIM).