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Introduced in January of 2009, by a developer using the pseudonym "Satoshi Nakamoto," Bitcoin, a digital currency allowing users to send money over the Internet without the need of a credit card or bank account, has gained extreme amounts of popularity and value as of late. Bitcoin crossed the $100 mark for the first time in its four-year lifespan in April and, due to a drop on news from China, closed most recently at a price of $881.00 per coin. The chart below shows the currency's change in value since its introduction in early 2009:

(click to enlarge)

(Source: Bitcoin Charts)

This recent run up in price begs the question: is there still money to be made from investing in Bitcoins, or has the ship already sailed?

Understanding Bitcoins

After reading the opinions of many analysts regarding Bitcoins, I feel many people do not actually have a legitimate grasp on how the currency works, which is crucial when deciding whether or not (and how) to invest.

Bitcoin first came into being after its (still) unknown creator, using the pseudonym Satoshi Nakamoto, published a research paper about the currency on the Cryptography Mailing List. Soon after, in January 2009, Nakamoto began mining (essentially creating - more on this later) the world's first Bitcoins, which eventually became known as the original "Genesis Block." In its most straightforward definition, Bitcoin is a cryptocurrency. This means it is a peer-to-peer, decentralized, digital currency that relies on cryptography for validation and generation.

Bitcoins are decentralized, meaning they are not issued by governments. This gives Bitcoin the advantage of being free of manipulation and interference, but also means it is less widely accepted, easier to lose and more volatile than fiat currencies.

Unlike other currencies, such as the Euro or USD, Bitcoins have no physical form. They are completely digital and use cryptography and a proof-of-work scheme to create and manage the currency. This system prevents the copying and spending of the same Bitcoin multiple times, known as double-spending.

Bitcoins have a public ledger, known as the blockchain, which records every transaction and keeps track of who owns each coin in circulation. Each time a transaction takes place, it is bundled with other recent transactions to form a "block," which is added to the blockchain and confirmed by computers on the peer-to-peer network. A block is solved about every ten minutes. Due to this process, transactions cannot be reversed; meaning, in the case of an online purchase, a new transaction from the merchant to the customer would have to take place if a refund were deemed necessary.

It is extremely important that any potential investor take into account that Bitcoins are limited in supply. Unlike most currencies, where the supply changes to keep the value the same, the ultimate supply of Bitcoins is set, causing the value to fluctuate instead. The total volume of Bitcoins is capped at 21 million. Currently, the total number of Bitcoins available is just over 12 million. Bitcoins are "mined," or generated each time a block is solved. For every 210,000 blocks solved, the number of Bitcoins yielded per block is cut in half. This makes the generation of new coins increasingly slow and difficult as they approach maximum volume, as seen in the chart below:

(click to enlarge)(Source: en.bitcoin.it)

Though the supply of Bitcoins is limited, a single coin can be divided all the way down to its eighth decimal place (0.00000001 BTC) to allow for precise transactions requiring no rounding, even when the price spikes. Given its ability to be split, each coin could reach a value of $100,000,000 and still maintain the ability to accurately reflect dollar amounts down to a penny.

Bitcoins can be bought using popular currencies and sold on an exchange. Currently, the most popular exchange is btcnCNY, while most transactions are made in USD. Bitcoins themselves can be thought of as codes added to the blockchain. Once someone buys or receives a Bitcoin, it is held in a secure, digital wallet. Wallets work by having two keys: one public, one private. The public key is given out to anyone who wishes to send you Bitcoins. Think of it in the instance of someone mailing you a check: the public key would be your address. The private key does the opposite of its public relative, allowing you to send coins from your wallet to another's. It's private because, if someone else were to get a hold of this key, they could send all of your Bitcoins to any wallet they wished and you would never be able to recover them.

Volatility

Bitcoin is currently worth in excess of $881 per coin. Twelve-months ago, they were just $13.50. This insanely large increase in price has continually left potential investors wondering whether the value can still climb higher. Just over a week ago, when the price was $730, analysts urged investors to stay away from hefty investments in the currency; and yet it continues to rise.

The biggest issues analysts have with Bitcoin is that it is too volatile. The more usage Bitcoin gets, the less volatile it will be. As its implementation becomes more diversified and widespread, individual incidents (like the government's shutdown of the Silk Road) should have less of an effect.

One reason, in my opinion, that the average consumer does not use Bitcoin has to do with how difficult it actually is to use. First, you need to set up your Bitcoin wallet and understand how the wallet works. Then, you need to go online to an exchange, purchase them, and spend them at a retailer who actually accepts them. In terms of practical usage alone, it's much easier to just enter a credit card number online or go to an ATM and get money that you can spend anywhere you want. Overall, there is not much incentive for your average consumer to use Bitcoin: but the same cannot be said for merchants.

Unlike credit cards, which typically charge fees of 3-5%, Bitcoin transactions usually cost retailers less than one cent per transaction. Companies like Coinbase, an easy to use wallet and exchange service, can make the adoption of Bitcoin by merchants far easier, especially since it allows them to cash in their coins easily and frequently, allowing them to avoid any of the currency's volatility while still benefiting from decreased transaction costs. If the amount of Bitcoins used in retail spend are to increase, it will have to be due to heightened adoption and incentives from merchants. It's clear Bitcoin is not completely ready for actual use by the average Joe for most legitimate purchases. The question for the potential investor is not "how soon will it be ready for retail?" but instead should be "what is driving current prices and are they fair?"

Pricing Bitcoins

Predicting what Bitcoins are worth is hard, if not impossible. They have no backing from a government or asset of monetary value and no physical value themselves. I'm of the opinion that the price of Bitcoin is directly related to the volume bought and sold each day, which is plotted in the chart below:

(click to enlarge)

(Source: Bitcoincharts.com)

The data does not present a particularly compelling argument in favor of my hypothesis. While the volume of Bitcoins traded each day is slightly related to the price, it is by no means a high enough correlation to indicate whether or not the currency is trading at a premium or a discount. The major flaw is that, using the graph above, each Bitcoin is assumed to be worth the same amount of money. If a coin were worth $1 instead of $1,000, the same transaction would require 1,000x the volume. Re-tooling the graph for volume based on USD shows us how the price of Bitcoins moves given the dollar amount traded daily:

(click to enlarge)

The results here are far more convincing. There is a strong correlation between the volume of money moving through Bitcoin exchanges and Bitcoin prices. Record spending on Bitcoins recently had led to record prices. Looking at the Bitcoin model, this makes perfect sense. The amount of Bitcoins increases each day, but as stated earlier, does so at a decreasing rate. Every four years, the production of Bitcoins is halved. So four years ago, when there was minimal cash flowing through Bitcoins, there were also 100% more Bitcoins being created each day.

When the amount of Bitcoins is increased at a faster rate than money invested, the price will be lower. Think of it this way: if investors use Bitcoins to move $5 million one day, and there are 50 Bitcoins, each one of those coins will be worth more than if investors move $5 million and there are 50 million available coins. It might seem overly simplistic, but it is important potential investors keep this in mind when looking towards Bitcoin's future. If the volume of money invested (measured in USD for simplicity) stays the same, the price will decrease at a decreasing rate. If the volume of money traded increases at a rate higher than current Bitcoin creation, prices should increase at an increasing rate. This assumption does not include the fact that public perception of the currency has a large impact on its price.

The amount of Bitcoins created each year is easy to calculate. About every 10 minutes, a block is solved, which releases 25 Bitcoins to whoever solved it. Given that there are just over 12 million coins currently in circulation, supply will increase 10.95% over the next 365 days. This is an average for the year, since a set amount of about 3,600 are created each day, meaning the increase in supply will continually fall percentage-wise each day.

What Drives Volume?

Since the supply of Bitcoins and the amount of money used through coins are the two major factors affecting price, and the supply increase is a known, set schedule; potential investors should be most worried about the cash flowing through the coins each day.

Getting an idea of who is actually using Bitcoins is difficult (but extremely important). A lot of the past and continual draw to the currency is due to its ability to be used anonymously when correct measures are taken, making the task of finding data on individual user groups almost impossible. The ledger for Bitcoin transactions is public, but it does not reveal any information about the people on either end of the transaction. One way to gain some insight is by taking some of the data released by Bitcoin exchanges.

(click to enlarge)

(Source: Bitcoin Charts)

The charts above show us that most of the Bitcoin traffic seems to come from China and the United States. 91% of transactions are done either in Chinese Yuan or US Dollars. Additionally, Chinese and US-based exchanges account for 82% of the buying and selling of Bitcoins by volume. Clearly, the two most important markets for Bitcoin volume are China and the United States.

Bitcoin interest is strong in China and has risen 30-fold over the past two months. Some of Bitcoin's appeal to Chinese investors is likely related to the Yuan, which can be considered anything but a respectable reserve currency. China does not allow its currency to float, so moves into Bitcoin may be seen as a lack of confidence in the Yuan. Since the beginning of November, purchases of Bitcoins in China have shot up. The graph below shows the volume of coins traded through China's largest Bitcoin exchange.

(click to enlarge)

(Source: Bitcoin Charts)

One reason for the sudden increase in volume in China is likely due to the government seemingly encouraging its citizens to invest in the digital currency. Shortly after the popular search engine Baidu (the 5th largest website in the world) announced that it would begin accepting Bitcoin, the Chinese government aired a half-hour documentary portraying the currency in a favorable light on the official state television network. Whether or not Chinese citizens buying Bitcoins is a just a short-term trend is still impossible to say. Bitbill, a Chinese version of BitPay which streamlines and simplifies the Bitcoin process for both buyers and sellers, now features China Telecom, a state owned telecommunications company. This again points to the fact that the government may indeed be promoting the digital currency to its citizens. However, in a turn of events on Thursday, the Chinese restricted banks from using Bitcoin as a currency. Though this is seemingly big news, Yi Gang stated in November that the currency was unlikely to be accepted by China's banks. Citizens can still buy and sell Bitcoins, meaning their status as an investment or commodity is not threatened. If the currency's use as an investment tool continues in China, the recent increase in volume should become more sustainable.

Another use of Bitcoin (which is frequently discussed) that would support higher volumes of trade in China is money laundering. China makes it very difficult for wealthy citizens to get their money out of the country, only allowing $3,200 to be moved out at a time, with a maximum of $50,000 annually. One common way rich Chinese citizens circumvent this issue is by laundering their money through the casinos in Macau. The process involves making a deposit with gambling promoters (junkets) in China, who get the money over the border and make it available for gambling in Macau. Macau's casinos deal with comparatively little oversight, so large quantities of chips can be bought and cashed quickly without question, allowing large amounts of money to be laundered. Recently, China has attempted to crack down on corruption and laundering.

Bitcoins can make the process of laundering much easier for China's elite. Rather than using junkets, one could simply purchase Bitcoins, transfer them to a wallet associated with an establishment outside China, and then sell them in the currency of their choice. Bitcoin exchanges in China are to be regulated soon, but there are many which operate outside of the country. This process has probably only become feasible in the past 12 months, since a high market cap would be necessary to keep these large transactions from influencing and destabilizing prices. It is difficult to say whether or not this has been done yet.

While Bitcoin use in the United States is high when compared to most other countries, the number of coins bought and sold each day has been relatively stable.

(click to enlarge)

Examining the graph above, we see Bitcoin use in the US may have increased slightly starting in October, but has stayed fairly consistent overall, especially when compared to China. Additionally, China has traded the highest volume of the currency since November, a trend not seen before. Both of these points solidify the notion that China has indeed had the largest influence on the recent and astronomical price increase.

How are Bitcoins Being Used?

It's apparent that most of the influence on the price of Bitcoins has come from China, with the US also being responsible for a small amount. The question of what these coins are actually being used for is crucial. Again, the anonymity of the currency makes answering this question very difficult.

BitPay is currently the largest Bitcoin payment processor - meaning they streamline and simplify the process of accepting and using the currency for merchants. Detailed in the graph below, BitPay's transaction numbers have been increasing:

(click to enlarge)

(Source: BitPay)

On Black Friday of last year, BitPay processed a mere 99 transactions; this year, that number increased to 6,296. Even though November was the company's biggest month by far, even on its largest day, it still only accounted for 6% of all Bitcoin transactions. Though the numbers are fairly insignificant, BitPay's increase in sales do show that Bitcoin is beginning to gain some traction as a method of legitimate payment, which is key for the currency's success. However, even though BitPay is just one of a few popular payment-processing companies, the number of Bitcoins used for legitimate online purchases seems troublingly low.

So what are the vast majority of Bitcoins being used for? Public sentiment seems to be that Bitcoins are frequently used to buy drugs and other illegal items on the Internet. Bitcoins are well suited for this job. They're fairly anonymous and the transactions cannot be reversed, meaning a cocaine dealer will never have to explain to American Express's (NYSE:AXP) fraud department that he in fact did ship the drugs requested.

During its time of operation, the Silk Road was far and away the largest online drug marketplace available. Not surprisingly, the site accepted Bitcoin as the only form of payment. An analysis of the Silk Road showed that, at the time of its shutdown, 70% of the 10,000 items for sale on the site were illicit drugs. Half of the available goods could be shipped worldwide. Given the site's domination of the online drug market and its global reach, the Silk Road's traffic should give a good indication of whether or not the drug trade does comprise a large majority of Bitcoin use. Thanks to the FBI report released after its closure of the Silk Road, there is a good amount of applicable data available concerning this anonymous site. Over its lifetime, the Silk Road collected 9.5 million Bitcoins in revenue; this is shocking considering there are currently only just over 12 million in circulation. Chances are, if you've bought a Bitcoin, it's traveled through the Silk Road. However, the FBI and a previously conducted study of the site both concluded that the Silk Road accounts for ~9% of all Bitcoin traffic at most.

Though it may seem conflicting that the Silk Road has had almost 80% of all Bitcoins in circulation pass through the site, but only made up an estimated 9% of currency's use, further trends in the site's usage offer a simple explanation. The prices of items on the Silk Road were pegged to the home currency of the seller, not Bitcoin. In January of 2012, one Bitcoin was worth only $5. That price did not increase to above $10 until July of the same year. Therefore, items on the site worth $100 would have cost 20 Bitcoins in January and 10 Bitcoins at the start of July 2012. Today, the same item would cost just 0.1 Bitcoins. If Bitcoin's value had remained at current levels through the Silk Road's entire operation, only 8% of all coins would have passed through the site.

As it turns out, gambling makes up the majority of all Bitcoin transactions. This past June, the leading Bitcoin betting site, Satoshi Dice, accounted for 51% of Bitcoin transactions made. This is just one site: competitors Bitzino and Just-Dice are also growing quickly. If you're betting on Bitcoin, you're betting on the growth of these sites, which was excellent in 2012. Satoshi Dice had an average monthly increase of 78% while Bitzino grew at a rate of 178% per month. These astronomical increases are likely to have continued throughout this year, since awareness in Bitcoin has grown so much.

Conclusions

If you're considering investing in Bitcoins, keep in mind you are betting that China's increased adoption of the cryptocurrency will continue for some time. Though Bitcoin may gain popularity in other countries, it is clear that the current increase in price is due to the huge volume China is purchasing. Speculation also plays a role; however, given the growth of the online gambling industry, I believe that with each passing month, these effects (though large) are at least slightly alleviated.

I believe that Bitcoins could settle in the high $2,000 range eventually if they are adopted by economically weaker countries as an alternative to leaving money in cash. However, this could take years during which we may see extreme highs and lows. If Bitcoin fails to be embraced by other countries, it will eventually die out, falling down to around $250, then slowly losing value each year. Bitcoin cannot become too widely adopted or else its authentication and payment system will suffer, since it is not capable of handing a high-volume of transactions. I believe this will be the limiting factor for the currency's price. Though this is disheartening for Bitcoin's future, right now the usage is very, very limited, so plenty of room for growth remains. Even if you are of the mind that Bitcoin is stupid and pointless, remember that lots of people buy stupid, pointless things every day.

Source: Breaking Down Bitcoin's Price