5 Facts You Should Read Before Buying Bitcoins

Nov.29.13 | About: Winklevoss Bitcoin (COIN)

Bitcoin, the infamous cryptocurrency made popular by tech-savvy libertarians and others suspicious of economic centralization, often sparks passionate arguments about the nature of government, money, and markets.

Some believe that Bitcoin is a threat to society by creating opportunity for terrorists and criminals. Others believe it's the salvation of the market from government and special interests, redeeming money from centralized political control.

The truth, like usual, is a little more nuanced. Once we cut through some of the myths and fallacies, we'll see that cryptocurrencies are imperfect-but-useful currencies that will likely exist alongside other forms of money for some time.

1. Bitcoin is not just an "electronic version" of gold

Saying that Bitcoin is an "electronic version" of gold is extremely dangerous, because, while there are similarities between the two assets, there are extreme differences.

Bitcoins can be tracked, can't be melted down, and require different logistics for moving than gold or other hard assets.

The economics are simply different. Understanding this is necessary to spot other derivative myths, like the idea that, "Litecoin is Bitcoin's silver."

The only real similarities are a limited supply of the money that is supposedly "deflationary." The assets are very different and should be treated very differently.

Considering gold and silver have non-monetary uses -- especially silver -- the comparisons of cryptocurrencies to precious metals likely does more harm than good to our ability to understand either.

2. Bitcoin's money-laundering risk is exaggerated

The risk of Bitcoins being used to launder money are greatly exaggerated. As time goes on, the NSA, CIA, and the world intelligence agencies will analyze every transaction on an extremely detailed level, mixing Bitcoins built-in database of all transactions with their already comprehensive data on people, habits, and finances.

Even modest regulatory proposals regarding cryptocurrencies will likely give governing bodies more than enough data to keep tabs on the vast majority of transactions in real time.

So far, this seems to be the direction we're headed, as anti-money laundering laws have already been applied to Bitcoins.

If anything, Bitcoins are a bad way to launder money, because it's hard to disappear into the sunset when your transactions exist to be analyzed by algorithms and financial detectives indefinitely.

As Wired reported on November 25th:

That public ledger makes it pretty tough for big-time criminals to launder money through the network. At least that's what researchers at the University of California and George Mason University found when they studied the Bitcoin network by developing sophisticated tools to track how money was moving around it.

The researchers argue that it's often possible, when paired with current law enforcement tools, to learn a lot of information about people who are moving Bitcoins. "Laundering money - moving around illicitly obtained Bitcoin at scale - seems very difficult," says Sarah Meiklejohn, the University of California, San Diego, graduate student who co-authored the study, which is set to be presented at a technical conference in October.

Because of this, if you're going to launder money, cryptocurrencies are a horrible way to go about it. Cash is king.

This is similar to what Jennifer Calvery, director of the Treasury Department's Financial Crimes Enforcement Network, said:

"Cash is probably still the best medium for money laundering."

3. Bitcoin has fundamental flaws

Some of these "problems" are intentionally part of the design, but the negative impacts still stand.

  • Irreversible. Bitcoins are irreversible. This means that combating fraud has a substantial obstacle to overcome. This isn't a game-ending issue, but it's definitely enough that it makes certain financial uses much more difficult and likely unprofitable, slowing use.
  • Not legal tender. Bitcoins aren't legal tender. This is absolutely part of the design and is one of the advantages, but the negative impacts are also massive. Legal tender laws exist for a reason, and they won't be going away anytime soon, if ever. Legal tender laws immediately make Bitcoins behave more like a commodity or investment asset than a stable currency, and will likely continue to do this indefinitely. The volatile aspect of the currency makes widespread use very difficult for many businesses that can't afford the risk.
  • Only money. The only purpose of Bitcoins is monetary use, which is a massive issue both in terms of trust of the currency and in terms of creating intrinsic value as a type of effective price floor. This means the risk of "zero" is astronomical compared to silver or some other commodity. Other fiat currencies don't have this problem because they're backed by the governments of the world -- the threat of force creates artificial demand.
  • It's deflationary. It's irrational to spend Bitcoins if dollars are available to be spent instead -- assuming that one believes Bitcoin demand will increase in the future. This is an application of Gresham's Law. Bad money chases good money out of circulation. This doesn't mean merchants won't be trying to sell their goods for Bitcoins. It simply means that most consumers won't be motivated to spend their Bitcoins. As this Wired article discusses, this is a widely understood problem.

4. Bitcoin won't replace the dollar anytime soon

The dollar will continue to get weaker as time goes on and as people look for more and more alternatives. This doesn't, however, mean that Bitcoins will somehow replace the dollar for decades, if ever.

Without the ability print their own money, the entire world financial system would be completely decentralized. While this might be wonderful according to certain ideologies, the entire world will conspire to stop it from happening anytime soon.

If the dollar -- or any major currency -- is replaced by deflationary money, then the economic consequences would be severe, whether justified or not.

Frankly, in such a doomsday scenario, I'd rather be holding gold than Bitcoins. It's more anonymous and puts security in a more local context that isn't open to hacker issues that most people aren't very familiar with.

5. Bitcoin is still a massive possible opportunity

None of this should be seen as a rejection of Bitcoins as a speculation.

Whether there are flaws or not, the possible payoff for the cryptocurrencies is simply staggering. If anything, the off-chance that the currencies become even medium-sized alternatives to fiat currencies is reason enough to put some money in the coins as a speculation.

Even accounting for the facts listed above, the truth looks strong for Bitcoins as an alternative to the political currencies that exist now, and I'll continue to regularly, and passively buy some as a hopeful-but-cautious speculation.

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.

Additional disclosure: I own Bitcoins, Litecoins, Gold, and Silver.