By Marcio Silveira, CFP, CFA, CAIA of Pavlov Financial Planning
What is Bitcoin? Bitcoin is the most popular cryptographic currency. It is money backed by a sophisticated computer code and not a precious metal like gold or a government like the US Dollar. Over the last year the public attention paid to Bitcoin and its value measured in US Dollars grew significantly.
How is it created?
The process of creating new Bitcoins is based a preset protocol of increasingly more difficult code puzzles. The process acquired the nickname of “mining” due to the similar nature of gold rushes of the past. Mining for Bitcoins substantial computational resources, which generally involve specialized hardware and huge amounts of electricity.
What are the benefits?
Enable financial transactions to be cleared without a single trusted third party. This reduces dramatically the transaction costs. A maximum number of 21 million Bitcoins will be ever created. This provides protection against debasing (inflation).
How is it regulated?
The main benefit of agility generates the fear that this ease of transfer could help the operations of international criminals and terrorists. It also threatens the business models of existing financial institutions. Different countries have different attitudes. Some big countries like China and India have already meaningfully restricted the use of it. The US allows it, but a number of rules regarding its use and exchange are evolving and tend to be more restrictive over time.
Over the long term, things are less clear but if Bitcoin becomes a meaningful and common way to pay for goods and services, the entire financial and economic system will be very different. The government will need to give up its role in setting monetary policy and this is a really monumental change that is hard to conceive today.
Is it safe?
There have been a few cases of theft from Bitcoin Wallet services. A recent incident involved a start-up called Flexcoin, which lost about $620,000 worth of Bitcoins to hackers. Since only the very techs savvy have direct access to the direct Bitcoin ledger and most regular people rely on these service providers, the risk of loss due to theft is real.
There has been enormous volatility in the Bitcoin price measured in US Dollars, especially over the last year. See the Graph here.
What to do? Should I invest in Bitcoins?
If you are tech savvy and very aggressive, go for it knowing that the losses can be very significant and permanent due to the highly speculative nature of it.
For the rest of us, stay away for now.