Tuesday, 23 April 2013

What are Bitcoins and should you invest in them?

I recently got sent an article about Bitcoins and the way in which they are going to revolutionise the way in which the financial system works.  There seems to be a lot of buzz about them at the moment and the following post will cover what they are and should you invest in them.

What are Bitcoins?

A Bitcoin is a decentralised virtual currency which means that it exists only online and is not regulated by any central bank.  There are a finite number of Bitcoin in the world.  They are currently generated by Bitcoin miners and there is an upper limit of 21 million Bitcoins which will be reached by 2040.

They have no fundamental value and are exchanged by users over a P2P network.  They are generated by a program on your computer which 'mines' Bitcoins but the amount generated decreases as more users join the network and as the number of Bitcoins approaches the upper maximum of 21 million.

They are untraceable and can be used in transactions with anyone else that will accept them.  This is the whole crux of 'what is a Bitcoin'.  In fact anything can be used as 'money' or a currency.  Something does not have value because a government says it has value.  It has value because people are willing to accept it in exchange of something else.  Thus as more places accept Bitcoin as currency, the more mainstream they will become.

The big questions around Bitcoin is whether it will become a lasting currency and one that is widely accepted.  There is plenty of speculation in them out there at the moment with the slightest hint of a problem causing crashes (see the chart below).  In my personal opinion the only reason that you would use Bitcoin instead of a mainstream currency is because you do not want your purchase tracked or otherwise traceable (e.g. if you are using it to buy illicit substances).  Otherwise why wouldn't you use a more stable currency (even one that is not your home currency).  However in the section below I have found more and more mainstream businesses that are willing to accept them as a method of payment so perhaps I will be left behind on this particular trend.

The video below is how the founders of Bitcoin pitch their product which obviously only highlights the benefits and none of the cons of Bitcoins.  It is interesting to see however, how they think about Bitcoins and the role they can play in the financial system:

Are Bitcoin a good investment?

At the moment Bitcoins are nothing more than pure speculation.  
There is no fundamental value underlying the currency other than the idea that the product is scarce and this scarcity along with the inability for a government or other agency to issue more currency (other than as specified above) gives it some sort of lasting value.

In this sense Bitcoins are a lot like gold.  There is a limited quantity and its value is largely based on people's perception of what it will be worth in the future.  The only difference is that gold has a floor under it because gold can and is used for other purposes such as jewellery.  Bitcoins have no alternative use which could provide a floor under the price if confidence in the product slumps.

If and when the currency stabilises (it is incredibly volatile at the moment based on speculation - the chart below is just the last month!) and is used widely for trade (see the section below) then as a medium of trade it will have an inherent value.  When it gets to this point, though, the potential for massive gains and losses will have largely evaporated.

I wouldn't invest in this product - I can see that Bitcoins will have value to some people who are sick of their currency being depreciated by governments looking to stimulate growth.  The lack of an underlying use for the product and thus a floor in the valuation is the biggest stumbling block for me and one that I can't reconcile.  I can just as easily see people moving onto another 'currency' like this and Bitcoins becoming pointless and irrelevant.

It is the inability to value this currency on fundamentals and the uncertainty around the longevity of the currency which is keeping me on the sidelines.

Can I actually use Bitcoins to buy anything?

This used to be one of the biggest criticisms of the Bitcoin market - it was purely built for 'investment' (read: speculation) and that you could not actually do anything in the real world with it.  Then people clicked onto the fact that the anonymous factor would make it perfect for things such as drugs and other illegal transactions.

However recently more and more vendors are starting to accept Bitcoins as currency.  For example a relatively new website that I came across - BitFash - allows you to
use Bitcoins to purchase clothing from stores such as Zara and Forever 21.  With major brands such as this starting to accept Bitcoins (though note you have to purchase through BitFash's website) it looks like Bitcoins will become more and more relevant.


Regardless of whether you buy them or not, whether you think the inventors and investors are crazy or onto the next big thing - Bitcoins are certainly an innovative and interesting exchange medium.  They go to the heart of 'what is money'.

If I were you I would stay away from speculating in them - how on earth can you determine the fundamental value of something that isn't real when you have no idea what the demand for it is going to be in the future?

Do you own any Bitcoin?  I would love to hear why and your experiences!

You May Also Be Interested In:
Alternative Investments: Initial Thoughts
Online Investment Forums: Friend or Foe?
When to buck the trend and ignore the share market
Investment Psychology: Follow your convictions

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