Bitcoins: Deciphering Their Value

During past inflationary periods, investors dedicated small portions of their portfolios to art, stamp and coin collecting as a way to preserve value. Alternative investments such as these have always been a key inflation strategy to preserve wealth. That said, they represent high risk and should only contain amounts that investors can afford to lose.

Predicting the value of these investments involves a sensibility about future cultural tastes, preferences or idiosyncrasies that even the world’s top art, stamp and coin appraisers sometimes have difficulty divining, much less the average investor.

Within this context, we review the advent of the digital, decentralized currency known as Bitcoin. There’s sufficient momentum in the emergence of digital currency to justify watching Bitcoin closely as a potential alternative investment, if the market matures to where it’s more easily accessible and becomes more liquid.

At the very least, companies accepting Bitcoin for payment could make good plays on this trend, especially those in the Internet space.



In the meantime, Bitcoin has garnered global attention with its highly volatile price gyrations and increased adoption.

Supporters claim that digital currency has the potential to be “Gold 2.0,” the world’s next reserve currency or the ultimate payment system, while detractors say it’s a speculative, bubble market with no intrinsic value that’s only good for illicit activities. Further, detractors say that Bitcoin is a market controlled by speculators and could collapse at any moment.

For those new to the subject, Phil Springer, chief investment strategist of Personal Finance, developed a Bitcoin primer, in his Nov. 27 Mind Over Markets article, “Bitcoin: A Joke or the Real Thing?”

Springer! ’s healthy skepticism is shared by your correspondent. But in following various global discussions on the subject—and discussing it myself with an early investor—there are disruptive features to Bitcoin and crypto currencies in general that seem compelling. And while Bitcoin itself may be just the first of various iterations before a dominant design emerges and eventually falls under regulation, the idea of digital currencies is here to stay.

The reason crypto currencies are gaining attention today—particularly Bitcoin—is the fact that they represent a massive technological breakthrough in digital money. Cryptographers have long dreamed of developing a decentralized digital currency and previous attempts had failed. The main issue was how to address the problem of tracking double spending, which is resolved in the real world with a central monetary authority.

“If a digital dollar is just information, free from the corporeal strictures of paper and metal, what’s to prevent people from copying and pasting it as easily as a chunk of text, ‘spending’ it as many times as they want? The conventional answer involved using a central clearinghouse to keep a real-time ledger of all transactions—ensuring that, if someone spends his last digital dollar, he can’t then spend it again. The ledger prevents fraud, but it also requires a trusted third party to administer it,” was how Wired magazine described the problem, in a 2011 expose titled: “The Rise and Fall of Bitcoin.”

The Power of Distributed Currency

Bitcoin did away with the third party by publicly distributing the ledger, what Satoshi Nakamoto, Bitcoin’s designer, or some believe a pseudonym for the design team, called the “block chain.”

“Users willing to devote CPU power to running a special piece of software would be called miners and would form a network to maintain the block chain collectively. In the process, they! would al! so generate new currency. Transactions would be broadcast to the network, and computers running the software would compete to solve irreversible cryptographic puzzles that contain data from several transactions,” according to the aforementioned Wired article.

Furthermore, Bitcoin values are artificially set, partly through complicated mathematical algorithms and partly by what people think they should be worth at any time. The algorithm limits the total number of Bitcoins ever mined to 21 million units, an amount expected to occur by 2140. This fact has caught the attention of those seeking inflation hedges because the money supply is preset at a steady, predetermined rate, which makes it a deflationary currency. And in fact, Bitcoin has been sought out by people in countries experiencing inflation seeking wealth preservation, such as in Argentina.

But one of the main challenges of Nakamoto’s design is achieving price stability so that Bitcoin could really be a medium of exchange or store of value. The price of a Bitcoin has gyrated between $14 and $1,200 in the span of a year. The most recent decline was on the news that the Chinese government in early December announced it would bar financial institutions from transacting with Bitcoin—one of the first overt moves by a central bank to bar adoption, and perhaps tacit recognition of the technology’s potential to disrupt world currencies.

However, another interpretation is that in allowing Bitcoin transactions among people and businesses, China has actually legitimized the currency (at least more so than US dollars), where the greenback can’t be owned or exchanged for the renminbi by citizens.

Meanwhile, other countries and institutions have taken a more enlightened view. The German government and the International Monetary Fund have said they regard Bitcoin as a “private currency,” and Fed chairman Ben Bernanke said virtual currencies “may hold long-term promise.”

Th! e Threat ! from Central Banks

Central banks around the world may seek to contain Bitcoin as a payment system. China in its announcement specifically challenges the legitimacy of Bitcoin as a currency in its move to bar financial institutions or accounts, but nonetheless will allow Bitcoin as a payment system.

In fact, adoption is your correspondent’s chief concern. The barring of access using traditional bank accounts is obviously a major barrier. Moreover, Bitcoin clone currencies are vying for the top spot. But some argue that Bitcoin has achieved critical mass or momentum in large-scale adoption to keep competitors at bay.

Bitcoin’s capitalization, valued by Bank of America (NYSE: BAC) recently at $15 billion, has already surpassed the money supply level of several small nations put together. Adoption by people in various countries (China represents 65 percent of market trades) and the expansion as a payment system to retail outlets (70,000 online shops via Shopify now can add Bitcoins as payment methods) could eventually stabilize the price with greater adoption.

The greater acceptance of Bitcoin as a payment system would prevent central banks from creating exchange rate incentives or other punitive measures that would prevent currency conversion between Bitcoin and a home country currency.

According to Torsten Hoffmann, entrepreneur and Bitcoin investor, “I don’t think governments will be able to control Bitcoin or create incentives to limit its use. The market today is already quite liquid, but the traditional banking system lobbying against it or preventing exchanges from having bank accounts make it difficult to get money in and out of Bitcoins.

“Remember, ultimately no government can control your software on the PC, or your password that you have written down somewhere. It is impossible to really stop, even though there may be some ways to block access via the exchanges, i.e. the places where you trade paper money for Bitcoins. So the! weakness! in the system is moving in and out, that’s the point of failure. But given its international use, and more and more ecommerce companies accepting Bitcoin, this won’t be a huge problem after 2015,” argues Hoffmann.

Further, Hoffmann does not believe that Bitcoins represent any major threat to central banks. “Probably more dollars are traded every second than Bitcoins in four years. I don’t have data, but I assume that the value of Walmart and Amazon gift cards or some air mile loyalty programs are larger than the value of Bitcoins. These also offer a certain store of value, and can be considered private money, which are used to transact value,” he says.

Meanwhile, for many in the Bitcoin world, the core issue is ease of adoption and not security. Bitcoin proponents argue that while Bitcoins in digital wallets can be stolen if they are entrusted to a shady third party or not properly secured, the system itself is extremely secure.

To trick the Bitcoin network (for 10 minutes) you need the computing power of the top 500 supercomputers times 256, according to Hoffmann and other experts. With respect to illicit activities, Bitcoin proponents argue that there’s nothing special here. Just as with cold hard cash, the money can be traced when directed through bank accounts and can even be confiscated like cash by authorities—simply by hauling away the hard drives.

The Internet’s Coin of the Realm

Some critics of Bitcoin have said that one issue as a store of value is the stratospheric appreciation that’s possible. Because the currency appreciates with more users, the cost of buying Bitcoins could become prohibitively expensive. But a Bitcoin can be subdivided into eight decimal places, allowing the currency to still be accessible to late adopters, although early adopters would be rewarded.

At the very least, Bitcoin has the potential to disrupt established payment system processors such as Western Union (NYSE: ! WU), and ! to the other extreme, change the global financial system as we know it.

While Bitcoins themselves in their present state of development aren’t suitable as an investment or inflation hedge, there are ways for investors to play this trend via established companies. Internet companies that accept Bitcoins as a system of payment are your best bets.