In Bitcoin We Trust?

By now you have probably heard of Bitcoin, but can you define it?

Most often, it is described as a non-government digital currency. Bitcoin is also sometimes called a cyber currency or, in a nod to its encrypted origins, a cryptocurrency. Those descriptions are accurate enough, but they miss the point. It’s like describing the U.S. dollar as a green piece of paper with pictures.

I have my ways of describing Bitcoin. I think of it as store credit without the store. A prepaid phone without the phone. Precious metal without the metal. Legal tender for no debts, public or private, unless the party to whom it is tendered wishes to accept it. An instrument backed by the full faith and credit only of its anonymous creators, in whom I, therefore, place no faith and to whom I give no credit except for ingenuity.

I wouldn’t touch a bitcoin with a 10-foot USB cable. But a fair number of people already have, and quite a few more soon may.

This is partly because entrepreneurs Cameron and Tyler Winklevoss, best known for their role in the origins of Facebook, are now seeking to use their technological savvy, and money, to bring Bitcoin into the mainstream.

The Winklevosses hope to start an exchange-traded fund for bitcoins. An ETF would make Bitcoin more widely available to investors without the technological know-how to purchase the digital currency directly. As of April, the Winklevosses are said to have held around 1 percent of all existing bitcoins.

Created in 2009 by an anonymous cryptographer, Bitcoin operates on the premise that anything, even intangible bits of code, can have value so long as enough people treat it as valuable. Bitcoins exist only as digital representations and are not pegged to traditional currency.

According to the Bitcoin website, “Bitcoin is designed around the idea of a new form of money that uses cryptography to control its creation and transactions, rather than to rely on central authorities.” (1) New bitcoins are “mined” by users who solve computer algorithms to discover virtual coins. Bitcoins’ purported creators have said that the ultimate supply of bitcoins will be capped at 21 million.

While Bitcoin promotes itself as “a very secure and inexpensive way to handle payments” (2), few businesses have moved to accept bitcoins. Of those that have, a sizable number operate in the black market.

Bitcoins are traded anonymously over the Internet without participation from established financial institutions. As of 2012, sales of drugs and other black-market goods accounted for an estimated 20 percent of exchanges from bitcoins to U.S. dollars on the main Bitcoin exchange, called Mt. Gox. The Drug Enforcement Agency recently conducted its first-ever Bitcoin seizure after reportedly tying a transaction on the anonymous Bitcoin-only marketplace Silk Road to selling prescription and illegal drugs.

Some Bitcoin users have also suggested that the currency can serve as a means to avoid taxes. That may be true, but only because bitcoins aid illegal tax evasion, not because they actually serve any role in genuine tax planning. Under federal tax law, no cash must change hands for a taxable transaction to occur. Barter and other non-cash exchanges are still fully taxable. There is no reason that transactions involving bitcoins would be treated differently.

Outside of the criminal element, Bitcoin’s main devotees are speculators with no intention of using bitcoins to buy anything. These investors are convinced that the limited supply of bitcoins will force their value to continue upward.

Bitcoin has indeed seen some significant spikes in value. But it has also experienced major losses, including an 80 percent decline over 24 hours in April. At the start of this month, bitcoins were down to around $90 from a high of $266 before the April crash. They were trading near $97 earlier this week, according to mtgox.com.

The Winklevosses would make Bitcoin investing more accessible by allowing smaller-scale investors to profit or lose, as the case may be, without the hassle of buying and storing electronic coins. Despite claims of security, Bitcoin storage has proved problematic. In 2011, an attack on the Mt. Gox exchange forced it to shut down temporarily and caused the price of bitcoins to fall briefly to nearly zero. Since Bitcoin transactions are all anonymous, there is little chance of tracking down the culprits if you suddenly find your electronic wallet empty. If the Winklevosses get regulatory approval, their ETF will help shield investors from the threat of personal theft. The ETF, however, would do nothing to address the problem of volatility caused by large-scale thefts elsewhere in the Bitcoin market.

While Bitcoin comes wrapped in a high-tech veneer, this newest of currencies has a surprising amount in common with one of the oldest currencies: gold. Bitcoin’s vocabulary, particularly the term “mining,” highlights this connection, and intentionally so. The mining process is designed to be difficult as a control on supply, mimicking the extraction of more conventional resources from the ground. Far from providing a sense of security, however, this rhetoric should serve as a word of caution.

Gold is an investment of last resort. It has little intrinsic value. It does not generate interest. But because its supply is finite, it is seen as being more stable than forms of money that can be printed at will.

The problem with gold is that it doesn’t do anything. Since gold coins have fallen out of use, most of the world’s gold now sits in the vaults of central banks and other financial institutions. As a result, gold has little connection to the real economy. That can seem reasonable when the real economy feels like a scary place. But as soon as other attractive investment options appear, gold loses its shine. That is what we have seen with the recent declines in gold prices.

In their push to bring Bitcoin to the mainstream, its promoters have accepted and, in some cases, sought increased regulation. Last month Mt. Gox registered itself as a money services business with the Treasury Department’s Financial Crimes Enforcement Network. It has also increased customer verification measures. The changes came in response to a March directive from Financial Crimes Enforcement Network clarifying the application of its rules to virtual currencies. The Winklevoss proposed ETF would bring a new level of accountability.

In the end, however, I expect Bitcoin to fade back into the shadows of the black market. Those who want a regulated, secure currency that they can use for legitimate business transactions will pick from one of the many currencies already sponsored by a national government equipped with ample resources, a real-world economy, and far more transparency and security than the Bitcoin world can offer.