Monopoly Money…For Real?

By James Gallagher, Fall 2013 Student Intern

I pay for my food, coffee, and almost everything else I buy electronically.   I hand over a plastic card, the nice man or woman at the counter swipes my piece of plastic on a machine, I receive my goods, and magically money is taken out of my bank account.   If I got in my time machine (which I also paid for by credit card), went back to 1920 and described this type of transaction I would probably be locked in an insane asylum.

Now, I get online, log into my virtual wallet and make a donation to the Electronic Frontier Foundation.   I donate 25 Bitcoins.   Reread my last sentence again.   There should be at least two questions that pop into your head immediately.   The first is what is a Bitcoin and the second is how much is a Bitcoin worth?

What are Bitcoins?

Bitcoin is a completely electronic cryptocurrency that can be transferred from one person to another without a bank or other financial intermediary.  It was created by an anonymous person nicknamed Satoshi Nakomato and is a form of currency that does not have the backing of a government.   Instead of a government printing and circulating money, Bitcoins are “mined” in a digital universe.

Mining takes place when computers solve complicated mathematical equations.   If the computer solves the equation correctly then a batch of Bitcoins are unlocked.   However, there is a catch.   Each time an equation gets solved, the next equation gets more difficult.   The creator(s) of Bitcoin only supplied the universe with 21 million Bitcoins, a number derived from the mathematical equation that releases Bitcoins, which will all be in circulation by the year 2140.

I understand this is all a bit confusing.  Let me try and help a little.   Pretend that you are in a giant mine.  In 2008 someone tells you that there are 21 million pieces of a new, precious stone in the mine.   Every single piece is the exact same size, weight, look, and sparkle.   You say great and you start digging.   At first you find a lot of pieces because they are plentiful and easy to uncover.  However, as more people mine the stones, it gets tougher and tougher to retrieve a single piece.   Each month fewer pieces of stone are removed from the mine.  This same situation is happening in cyberspace but instead of mining for stones people are mining for Bitcoins.

What is a Bitcoin Worth?

Once you come out of the mine you have all these pieces of rock, you don’t know how much they are worth.  You start trading them for goods and services.   However, you get frustrated because one day a single stone is worth four Atlanta Falcons tickets and the next day it is only worth a happy meal at McDonalds.  This is exactly what is happening with Bitcoin.  A Bitcoin is worth what someone will pay for it, which has traditionally been very unpredictable. For example, in April 2013, a single Bitcoin was worth $266.   Two days later it was only worth $54.   As of October 30, 2013 Bitcoins are back to trading at $212.78.

One reason for this volatility is that there is nothing underlying the computer code that is a Bitcoin.   As seen above, a Bitcoin is worth only as much as someone is willing to pay for one.  Similar to the U.S. dollar, there is nothing physical that supports it and the value of the currency may become worthless if users lose confidence in the money’s ability to retain its value.

Unlike Bitcoin, however, the U.S. and other countries have central banks that manage their money supply so that economies remain stable.  These central banks can buy and sell treasury bills, change reserve requirements for banks, and alter discount rates, all for the purpose of either expanding or contracting a country’s money supply.  By adjusting the money supply, banks can help stabilize a country’s currency.  Unlike a government with a central bank, Bitcoin has nothing besides market forces to regulate the price of a Bitcoin, which, according to its creators, is exactly the point.

There are two major exchanges where Bitcoins are traded and exchanged for dollars, yen, pounds, and other currencies:  Mt.  Gox, a Japanese based exchange, and Bitstamp, based in Slovenia.

How Are Bitcoins Used?

How does a person actually use Bitcoins? The best way I have found to describe it is below.

bitcon

Found at: http://lsvp.com/2013/03/28/how-bitcoin-works/

Should You Invest?

Are Bitcoins a good investment?   The answer to that question is certainly your own, however, I will give you my two Bitcoins on it.  Bitcoin is an experiment.   It is an experiment to see if we as humans can rid ourselves of national governments controlling currencies.   Can humans manage finances without a central authority regulating them?  It is an interesting question but for now I think that is all it is.

Pros of Investing in Bitcoin

The largest benefit I see in Bitcoin is that investors could get in on the ground floor of a potential universal currency.  It is foreseeable that Bitcoin becomes a currency used in day-to-day life throughout the world, essentially doing away with exchange rates.  This would be similar to what the European Union did with the Euro, however, Bitcoin would be on a global scale.  If this does take place in the future, then the value of a single Bitcoin is going to skyrocket.  However, I do not foresee a global currency without heavy government regulation, and so I think the cons outweigh Bitcoins potential benefit.

Cons of Investing in Bitcoin

The largest downside to Bitcoin is its volatility.  As I mentioned earlier, the price for Bitcoins varies wildly and if you are looking for a safe investment option, Bitcoins are not the place to look. However, the volatility of this market may be attractive to some people who are trying to make money quickly.  If Bitcoins were purchased low and then sold after a spike in the market there is the potential for a significant gain.

What’s Next?

Bitcoin is a new and exciting form of purchasing goods.  However, just like U.S. dollars, the currency can purchase any type of service or product.  Look for a later post on how criminals are using Bitcoins to conduct business and what governments are doing about it.

Additional Information

If you want to learn more about Bitcoins and how they work, check out the following websites:

Bitcoin.org

WSJ articles

Bitcoin Trading Forecast