The Digital Desires That Bank on Bitcoins

What’s a Bitcoin? A Bitcoin is a form of digital currency whose creator called it “a peer-to-peer, electronic cash system.” It is presently used where the parties to a transaction do not want to leave a digital trail, like credit card transactions, or any other trail for that matter. For this reason, the Bitcoin is presently mostly used for gambling, drug transactions, or speculation.

Background of the Bitcoin

On Wikipedia, one can find a detailed analysis of the creation of the Bitcoin, some historical timelines, and some of the caveats that one should be aware of before using this digital form of currency.

There are also many other articles and analyses available online describing this interesting creation of complex calculation and cryptographic protocol.

It’s newsworthy to note that some high-profile people have taken a serious interest in Bitcoins and have invested heavily in them. Remember the Winklevoss brothers? They are the wealthy twins who were able to successfully sue for a share of Facebook. They became more famous when their involvement with Facebook was portrayed in the movie “The Social Network.”

One of the Winklevoss brothers recently spoke about their investment in Bitcoins: “We have elected to put our money and faith in a mathematical framework that is free of politics and human error.”

As I see it, they are choosing to turn away from common currencies that are backed by the various countries that issued those currencies, and turn to a mathematically created currency that is based on a very complex model, one free of politics and government.

Flaws of the Bitcoin

It’s true that there is no electronic trail when dealing with Bitcoins. It’s sort of like delivering or receiving a bag of cash — no trails to be concerned with.

Yes, you can use Bitcoins to make online transactions where both parties agree to this form of currency. But presently, most online transactions are being done through credit cards and companies such as PayPal. In fact, online transactions are currently approaching 20 percent of total sales in the U.S. So in my estimation, there is no need for a newly created form of cash.

In any event, Bitcoins have their setbacks. On August 6, 2010, a major vulnerability was found in the Bitcoin protocol. Simply put, users could bypass Bitcoin’s restrictions for creating additional currency. Someone found this vulnerability a few days later, on August 15, and generated or created more that 184 billion Bitcoins that were sent to two addresses on the Bitcoin network.

Fortunately, this untoward event was rapidly spotted and the bug in the system was quickly addressed and fixed. However, the point is that it was exploited, and such exploitation can quickly affect the ever-changing value of the Bitcoin.

Gyrations in the Bitcoin’s Value

First off, let me state that most of us realize that all currencies fluctuate in value. For example, some countries are so economically hard-hit that they have to devaluate their currencies in order to sustain their country’s viability.

Also, most of us realize that currencies normally fluctuate on a day-to-day basis. Just take a look at the dollar versus the euro. This is a natural phenomenon based upon the everyday economic dynamics that affect countries and their currencies.

But how does Bitcoin’s value fluctuate? To answer that, I’m going to quote economist and Nobel Laureate Paul Krugman, from a recent statement about valuating the Bitcoin:

“It’s very peculiar, since Bitcoins are in a sense the ultimate fiat currency, with a value conjured out of thin air. Gold’s value comes in part because it has non-monetary uses, such as filling teeth and making jewelry; paper currencies have value because they’re backed by the power of the state, which defines them as legal tender and accepts them as payment for taxes. Bitcoins, however, derive their value, if any, purely from self-fulfilling prophecy, the belief that other people will accept them as payment.”

Bitcoin’s value is based upon perception, without regard to economics, unlike the way the currencies of most countries fluctuate. Since the countries of the world ultimately back their currencies, the economic and political fortunes of the various countries do in fact affect the perceived values of the various currencies. This is something that we can understand and deal with — we have been doing so for centuries.

What about the Bitcoin? How is it doing vis–vis fluctuations in its value? Not so well as far as I’m concerned. In early spring of this year the value of the Bitcoin gyrated like an out of control dervish. Its value at one point went up more than 300 percent, and then fell about 50 percent in a few short hours. Not a stable currency as far as I can tell.

As to other people accepting Bitcoins as payment, I read a CNN iReport dated April 16, 2013, that the country of Zimbabwe will make the Bitcoin its official currency. Please note that the CNN iReport producer states that the story has not been verified. As of this writing, I can’t find any valid independent verification of this story. I do note, however, that bitcoinmoney.com had a posting on its site that talked about Zimbabwe and said: “Why not imagine a situation where Bitcoin merges with M-pesa so you get mobile telephone money backed by a quasi-commodity standard like the Bitcoin? I think most Africans readily would accept that money.”

So, I’m not sure whether the story about Zimbabwe converting to Bitcoins was prompted by bitcoinmoney.com or not. Still, it’s all a very interesting phenomenon, created by mathematically gifted people coupled with modern-day technology.

As for me personally, I’m sticking with the dollar!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected]. Follow Theodore F. di Stefano on Twitter.

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