10 Things You Don't Know About Bitcoin But Should

by: Mike Burns

1. It's a purely digital currency, backed by nothing.

Bitcoin is backed only by the faith of thousands, and growing, online devotees. There are not even shiny but low value coins or colorful papers to show your ownership of this currency. There is merely an account in a computer ledger. It has no backing, no promise to redeem it for so many grams of gold or bushels of wheat. Bitcoin articles like to say how this currency is not a fiat currency. But since it lacks any real backing, in this way it looks just like the U.S. dollar.

2. It's decentralized.

Bitcoin is decentralized in that each coin is listed on thousands of servers all over the world. If there is a discrepancy then the servers vote on which is the real coin. Your ownership is demonstrated by public key encryption, where only you have the password that unlocks and is able to use a given coin.

As a computer ledger it is easy to move it across borders. Try that with a suitcase of greenbacks or gold coins. You just need to remember your password and you have access to the account, much like a Swiss bank account from days of yore. But with Bitcoin you can access your account from anywhere in the world, from the privacy of your den.

Since it does not depend on the "full faith and credit" of central bankers like Ben Bernanke, the devotees believe that it will preserve its value. Indeed every paper currency that has ever existed eventually went to zero, or very nearly so. The U.S. dollar has lost 95% of its purchasing power in 100 years. Most other paper currencies have done much worse over this time period.

So you can choose to trade your faith in central bankers for your faith in a computer algorithm and founders not to inflate your value away. Since central bankers have always eventually failed to protect value, maybe it is worthwhile to trade the devil you know for the devil you don't.

3. There is a maximum of 21 million Bitcoins.

This cap can be seen as either an opportunity or a liability. The permanent scarcity (unlike dollars which are created by the billions every week), helps to insure that the value will not be inflated away. However the small number puts a severe restriction on using it for a real world currency.

But of course the cap on the supply of Bitcoins could be changed. If the founders stick to this promise then indeed the scarcity might make these a better long-term store of wealth than any of the world's reserve currencies: dollars, euros, GB pounds or Swiss francs. Greed has tempted many men. Do we know if these founders are immune?

4. Based on a computer algorithm.

Bitcoins are "mined" by using a computer to solve a very long and difficult mathematical problem, closely related to decrypting a secret text file. Usually many people pool their computers and resources because it takes so long to solve a problem and get the reward, currently a block of around 30 Bitcoins. The algorithm works to solve a problem using the brute-force method (i.e. guessing trillions upon trillions of possible combinations until finally the virtual safe is unlocked.)

Over time computers become faster so that the Bitcoin system requires longer and longer problems to be solved, and pays fewer coins. The system is set up such that all of the possible Bitcoins (21 million, see above) will finally be in circulation in about the year 2140, over a hundred years in the future.

5. The algorithm seems to be secure, but it got hacked once before.

Bitcoin (or more precisely mtgox.com, where most Bitcoins are traded) got hacked back in June, 2011. Overnight the value fell from $17.50 to mere pennies. You would have lost nearly all of your money had you invested and sold at the inopportune time. Defenders correctly point out that all of the bogus trades were rolled back and the hack was quickly fixed. But could it be hacked again? Really, this is unknown. It seems like not, since a lot of the world's cryptographic brains have tried to hack it and failed. Perhaps the NSA can break this encryption scheme, but they're not saying and we don't know. In the mathematical journals, it has not been proved if a hack exists, but those same brains have failed to prove that a hack does not exist. This is one red flag but perhaps not a deal-breaker. Given that many smart people have tried to break this type of encryption and failed, we can feel somewhat secure that it will not be broken any time soon.

6. Someone paid 10k coins for a pizza in the early days.

In the early days (2010) Bitcoins were far easier to mine and some of the early miners had many thousands of these coins. Computer geeks would mine them just to show them off to other geeks, much like World of Warcraft devotees showing off their latest rare suit of armor.

Here is an article describing how a guy paid 10,000 for a pizza, the first known transaction using Bitcoin to buy something in the real world. This amounts to about $1.4 million in today's dollars.

Do we know if the founders or the early adapters are sitting on tens or hundreds of thousands of coins? Hard to know. If so, they must be getting nervous give the recent run-up in price.

7. Recently it's gone through the familiar hockey-stick graph.

This should be enough to scare anyone who has lived through the dot.com and housing bubbles.

(Click to enlarge)

Maybe it will go to a million or maybe a penny. This is one more risk/opportunity for the gambler.

8. Bitcoin is first to market ... or is it?

If first to market is everything then the US dollar has a 225 year head start. Or if you just want to compare it to other cybercurrencies then the World of Warcraft gold piece was first to market in any meaningfully large way. Arguably the latter at least has some notional backing since you can use it to buy in-game weapons, armor and magic items.

Maybe we will see Google (NASDAQ:GOOG) or Microsoft (NASDAQ:MSFT) introduce a cyber currency. These behemoths have much more clout and might be able to crush the Bitcoin competitor or buy them out quickly.

9. It's traded online, anonymously.

The largest exchange for Bitcoins is mtgox.com which purports to handle 80% of all Bitcoin trades. However it seems to be rather thinly traded, about $8 million a day currently, which in the world of finance is about five orders of magnitude lower than the daily forex trading. The good news is that there is huge room for an upside in volume. The bad news is that this market is miniscule in the world of finance, and therefore cannot hope to compete with the dollar or Euro using the present incarnation of Bitcoin.

The low trading volume in anything usually leads to a wide differential between bid and ask, i.e. a high round-trip transaction cost. And it can lead to rapid fluctuations in price. Again this can be viewed as an opportunity or a risk, depending upon one's outlook.

10. It's accepted very few places, but growing rapidly.

Adherents to Bitcoin like to point out that it is not snooped on by any government. In this way it is much like an old Swiss bank account, but the latter has recently caved in to pressure from the U.S. government and others. Maybe Bitcoin is better in this way.

Bitcoin has been used to buy and sell drugs on illicit websites, which might be a bit of a black eye for this would-be world currency. But many things started out with seedy associations and rose above them. In the early days, a great deal of the internet bandwidth was used to transfer porn, for example.


Since Bitcoin is electronic and exists online it seems to be mostly outside of the scope of being snooped on by Big Brother. However the NSA could easily track all Bitcoin transactions and then lean on the perpetrators to reveal their income and bank accounts. This could be construed as a foreign account, since it does not exist solely in the United States. Note that having a foreign bank account is legal in the U.S. but the IRS can force you to reveal it and pay taxes.

So far it is not accepted many places but that is growing. Since online sales are still growing, Bitcoin could be positioned to ride this wave. Or it could be supplanted by a cybercurrency from another big online player such as Google, Microsoft or eBay (NASDAQ:EBAY).

There are many risks associated with holding or using Bitcoin. But there are many compelling reasons in its favor. It could be the next Google or the next dot.com bubble. I have tried to give you an overview of Bitcoin above so that you can consider the risks and rewards of investing in or using this new online currency. Do you feel lucky? Well do ya, punk?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.