Ditching the Dollar: The Real Deal on the Bitcoin

Ditching the Dollar: The Real Deal on the Bitcoin

More than 80 alternative currencies exist in the United States alone.

From BerkShares in western Massachusetts to Bridgetown Bucks in Portland, Ore., cities and regions across the country print dollar alternatives to promote homegrown trade.

But one alternative currency—that's completely digital and worldwide—has taken the main stage in the aftermath of the recent financial panic in Cyprus.

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Hello, bitcoin!

And despite the fact that the bitcoin lost half of its value in April, thanks to better-than-expected economic news and a stock market rally, the digital currency remains more popular than ever—popping up in all sorts of places:

  • An ATM that converts bitcoins into cash was unveiled in San Diego on May 1. And another group of entrepreneurs plans to offer a bitcoin ATM in Boston.
  • Growing ranks of merchants—from a San Francisco cupcake shop to gift card website Gyft—accept bitcoins as payments.
  • Venture capitalists have plowed millions of dollars into start-ups that deal with bitcoins. On May 8, Fred Wilson's Union Square Ventures announced a $5 million investment in San Francisco-based Coinbase, which makes a virtual wallet for bitcoins, and converts them into traditional currencies.

You can spend bitcoins at any merchant that accepts them using your mobile device. You can transfer bitcoins from your virtual wallet to other bitcoin users. You also can cash in your bitcoins at online exchanges for other currencies.

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But the rapid rise of bitcoin may leave you wondering what to do with this virtual money—and whether you should invest in it or, for that matter, even use it.

A Bit About the Bitcoin's Back Story

Bitcoin's origin is shrouded in mystery. The first coins were created in January 2009 using a protocol published by a hacker or group of hackers going by the pseudonym "Satoshi Nakamoto."

Computers produce the digital currency using a free, open-source program called a bitcoin miner. It requires a lot of processing power to mine bitcoins, and people who run bitcoin miners often work in groups to split the costs and share the rewards. They produce the currency at a predetermined rate, which limits the supply.

There are more than 11 million bitcoins in circulation today. Only around 21 million will be made, in total, due to a hard limit built into the bitcoin code. But you have plenty of time before that happens: Bitcoin watchers don't expect the currency to hit that maximum until 2140 because the code cuts the number of new bitcoins that can be mined in half every four years.

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A big part of bitcoin's appeal: No central authority regulates the currency; funds are transferred from person to person online instead of a bank or clearing house, keeping transfer fees very low.

From February 1 to April 10, bitcoin's value surged 1,230%, from $20 to $266.

Since some fear that unprecedented action by central banks worldwide will lead to the long-term devaluation of major currencies—such as the dollar and euro—people have turned to the bitcoin as a way to hedge against bad central banking policy.

Thus far, bitcoin's production has run smoothly, but the currency has experienced extreme swings in value. From February 1 to April 10, bitcoin's value surged 1,230%, from $20 to $266. In less than a day, the value then plunged to $184, and by the end of April, a bitcoin was worth $140. Today's value: $121.

Cyber criminals have been behind some of the currency's price volatility. On April 21, the largest bitcoin exchange—Mt. Gox in Tokyo—was victim to a cyberattack that prevented users from converting bitcoins into major currencies for about four hours.

The response from exchange officials at the time: "While these attacks are a nuisance and a disservice to all bitcoin holders and enthusiasts, they are also part of the growing pains of this incredible new technology."

Banking on Bitcoins

Despite the risks, some people appear to be making a small fortune from bitcoin.

Tyler and Cameron Winklevoss—the twins made famous in the movie "The Social Network"—claim that they own 1% of all bitcoins in circulation, which is now worth about $12 million. "At some point, that narrative will shift to 'virtual currencies are here to stay.' We’re in the early days," Cameron Winklevoss told The New York Times.

So how can ordinary investors get in on the action?

You first need to create a virtual wallet to use bitcoins, which you can do for free on some websites, such as Blockchain.info and Coinbase. Once you've done this, you can receive and send bitcoin payments directly.

If you don't have any bitcoins, you can buy them on an exchange, such as Coinbase. Fees for buying bitcoins typically range from 0.25% to 1% per transaction, depending on the size of the transaction and the exchange you use. So it can be pricey if you buy bitcoins in small lots.

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"It's an interesting experiment," says Axel Merk, manager of the Merk Hard Currency Fund. "People want an alternative to currencies that are manipulated by central banks." According to Merk, more than 60 investors have inquired about his fund investing in bitcoins, but he has no plans to do so because he thinks that there are better and more stable opportunities in currency markets.

He's not alone in his thinking: Since the size of the bitcoin market is so small, there's hardly any interest from mutual funds to own the virtual currency. For some perspective, Bitcoin's total market capitalization only amounts to $1.2 billion. That's only 0.03% of the nearly $4 trillion—yes, trillion—that changes hands on currency markets each day.

A Closer Look at This Hot Currency

All the bitcoin buzz has, however, attracted scrutiny from regulators.

The Department of Treasury issued rules in March to make bitcoin and other virtual currencies subject to the same level of regulation as other forms of currency in an effort to more closely watch transactions because the digital currency has been used to purchase drugs and other illegal items and services online.

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The Commodity Futures Trading Commission is also examining whether bitcoin falls under its jurisdiction. "It’s not monopoly money we’re talking about here—real people can have real risk in these instruments, and we need to ensure that we protect markets and consumers, even if what at first blush appears to be ‘out-there’ transactions," Bart Chilton, a commissioner at the Commodity Futures Trading Commission, told the Financial Times.

The Department of Homeland Security seized funds from Mt. Gox, which processes about two-thirds of bitcoin currency conversions, on May 14, saying that the exchange failed to register itself as a money transmitting business in the U.S.

There are also practical concerns for the average consumer. Just ask Forbes writer Kashmir Hill, who used nothing but bitcoins to pay for things over the course of a week in San Francisco. "I sometimes had to live on the fringes to get by," she wrote. "It’s hard to convince someone who has never heard of bitcoin before to accept it as payment. You can choose to walk away from the person who won’t accept bitcoin, but that is hard to do when the person is your landlord."

Bottom line: Bitcoin needs to prove that it's more than an Internet novelty before it's worth the risk for most people to use the virtual currency regularly.

The same goes for investors. Due to its tight supply and volatility, bitcoin probably won't play a significant role in any portfolio—unless you're one of those early Winklevoss-like investors who are now sitting on a stash of cyber-coins.

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