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Ask The Experts: A Bit about Bitcoin

by John S Kiernan on February 18, 2014

bitcoinIn an era dominated by digital technology it should come as no surprise that someone has developed a digital currency. Paypal is a digital payment system but Bitcoin, developed in 2009, is an actual digital currency that, in the last several months, has generated excitement and interest – and yes, a little concern --  in the financial services industry.

Bitcoin uses crytography to create and transfer money. Any country's currency can be transformed into bitcoins so users can make payments. To use a bitcoin you need wallet software that runs on a computer or mobile device.

Like any other currency, bitcoins can be traded on currency exchanges. During the latter half of 2013 trading in bitcoins became quite volatile. Traders made a lot of money buying and selling bitcoins last year but some lost a lot of money as well.

Behind the excitement

So what's the appeal? We turned to some economic experts for answers?

“My guess is that Bitcoin has a ‘coolness’ factor that has attracted a strange collection of libertarians and other anti-government types – including people who want to conduct illegal transactions, and others who see it as a great speculative opportunity,” said David Parsley, an economics and finance professor at Vanderbilt University.

John C. Alexander, Jr., a professor of investments at Clemson University, is skeptical of the argument that Bitcoin represents a new currency. He sees it more as a new payment system.

“We have metrics relative to payment system valuation in the our public equity markets, such as Ebay, and in the past Paypal,” he said. “Despite these valuation metrics, ultimately the value of a Bitcoin transaction and the value of the Bitcoin equity is whatever the last person was willing to pay.”

Appealing anonymity

Nicolas Christin, assistant research professor in electrical and computer engineering at Carnegie Mellon University, believes the degree of anonymity provided by Bitcoin transactions is part of the appeal. He also sees some drawbacks to its use in normal, day-to-day transactions.

“The fact that Bitcoin payments take around ten minutes to be confirmed -- and basically one hour for being completely vetted -- is a real problem for quick, face-to-face transactions,” he said. “It is not unsolvable -- all you need is an escrow or insurance system built on top of the existing mechanisms to make this work well -- but this will add costs, and whether or not this will be a really practical solution compared to the alternatives remains to be seen.”

Parsley is also skeptical that Bitcoin has much practical value as a currency.

“Most people still tally in dollars, euros, yen etc.,” he said. “I don’t see that going away.”

Some governments and their institutions appear leery of the Bitcoin as well. Russia's central bank has expressed deep reservations about Bitcoin transactions, saying they may be useful to terrorists and run counter to the country's laws. In December 2013 the People's Bank of China stepped in to block merchants from accepting bitcoins and barred banks and payment processors from converting bitcoins into the Chinese currency.

Finally, law enforcement seems to have a concern with the anonymous nature of bitcoin transactions. The U.S. Justice Department recently announced the arrest of Charlie Schrem, CEO of Bitcoin payment processor BitInstant and vice chairman of the Bitcoin Foundation on money laundering charges in connection with the Silk Road anonymous black market for drugs.

Ask the experts

  • Bitcoin, the open source peer-to-peer payment network and digital currency, has captured the imagination of Wall Street. Why has it become so popular?
  • How practical is a digital currency? Do you think this is the way we'll pay for things in the future?
  • Some people who traded in Bitcoins have made a lot of money as its value has risen. Doesn't that suggest there are downside risks? Are there other reasons consumers should proceed cautiously?
  • Could Bitcoin find its niche as one of these systems?
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  • Amanda S. King Professor of Finance and Economics, College of Business Administration, Georgia Southern University
  • James L. Swofford Professor, University of South Alabama, Mitchell College of Business
  • John M. Veitch Professor and Associate Dean of Graduate Programs, University of San Francisco, School of Management
  • David Parsley E. Bronson Ingram Professor in Economics and Finance, Owen Graduate School of Management, Vanderbilt University
  • John C. Alexander, Jr. Breazeale Professor of Investments, Clemson University, College of Business and Behavioral Sciences
  • Nicolas Christin Assistant Research Professor in Electrical and Computer Engineering, Carnegie Mellon University, College of Engineering

Amanda S. King

Professor of Finance and Economics, College of Business Administration, Georgia Southern University
Amanda S. King
How practical is a digital currency? Do you think this is the way we'll pay for things in the future?

We use digital forms of traditional currencies today—you make a purchase with your debit card or pay your rent with online checking. Businesses use wire transfers and pay employees with direct deposit. No literal cash ever changes hand. Electronic orders are debiting and crediting accounts, so in many settings digital currency is practical. People have been speculating about when currency as we traditionally think of it, paper bills and coins, would disappear for quite some time now. It hasn’t happened yet. There are infrastructure issues (for example, how do you make sure all individuals can make and receive these electronic orders), and the way we think about money will have to change before traditional paper currency goes away completely. I think that digital and paper currency will coexist for the foreseeable future.

Some people who traded in Bitcoins have made a lot of money as its value has risen. Doesn't that suggest there are downside risks? Are there other reasons consumers should proceed cautiously?

As we have seen in dramatic ways over the past decade, values that rise have the potential to fall too! The value of Bitcoins is being determined in the market for Bitcoins. As the market fluctuates—there are more buyers or more sellers—value will fluctuate. This means that there is a risk of losing a lot of money as Bitcoin’s value declines as well as the potential to make a lot as its value rises.

Bitcoin describes itself as experimental, so certainly that suggests some additional level of risk. This is also an unregulated financial market meaning there are not the consumer protections we are accustomed to. These should lead consumers to proceed cautiously.

James L. Swofford

Professor, University of South Alabama, Mitchell College of Business
James L. Swofford
Bitcoin, the open source peer-to-peer payment network and digital currency, has captured the imagination of Wall Street. Why has it become so popular?

I suspect Bitcoin has become slightly popular because it is new and interesting. You say it is popular, but have you found a single person who has adopted Bitcoin and given up all governmental currencies? I suspect not.

Bitcoin does have several ready made group of "fans” including:

• Those who think a private money system is more stable than a government backed money system. Among these are those who follow the Austrian school of economics.

• Those who are generally suspicious government. According to the polls that is a growing number of people.

• Those who like privacy. Though, how private Bitcoin transactions are is unclear to me.

How practical is a digital currency? Do you think this is the way we'll pay for things in the future?

Very practical in fact government money is to a great extent digital now. That is what the debit card did and they are quite popular. What makes Bitcoin different is not its digital nature, but that it is a private money not a government money. Of course governments may tax Bitcoin out of existence as the US did to privately owned bank notes of the 19th century.

Some people who traded in Bitcoins have made a lot of money as its value has risen. Doesn't that suggest there are downside risks? Are there other reasons consumers should proceed cautiously?

Certainly if the value of something can rise, it can also fall. That Bitcoin value fluctuates undermines its role as a money. This is true of all monies whether private or government issued.

People will proceed cautiously with Bitcoin because people are naturally cautious. People proceeded with some caution when the euro was introduced and the euro and the old currencies circulated side by side for a period of time to build up the confidence in the public in the euro. The euro was introduced by a number of stable governments who the public knew the track record of. Bitcoin has only the track record of Bitcoin and the public has a short track record of "owners" of the Bitcoin market.

The above is what if it is to ever become widely used bitcoin will need to slowly develop a track record and build up public trust. Unlike gold, the producers could at anytime produce any amount more they want of Bitcoin.

John M. Veitch

Professor and Associate Dean of Graduate Programs, University of San Francisco, School of Management
John M. Veitch
Bitcoin, the open source peer-to-peer payment network and digital currency, has captured the imagination of Wall Street. Why has it become so popular?

Digital currency isn't supposed to capture the imagination. Money is supposed to be a solid means of payment and a stable store of value. The popularity of a currency has to do with its ability to hold its value in real terms, i.e. in terms of how much in the way of real goods and services one unit of that currency purchases over time.

Bitcoin fails spectacularly in this regard. Its value whipsaws around in ways that make it spectacularly bad money but a hugely attractive speculative investment. That's why segments of Wall Street like it - it is the ultimate speculative investment that can be talked up because it is so loosely anchored to anything of real value. It has become popular because it's the ultimate "penny stock" whose value is subject mostly to the vagaries of human greed and fear.

Go back two years to articles on Bitcoin and you will see that retailers were reluctant to use it because it was not widely accepted and its value fluctuated from day to day, putting them at risk of loss when they accepted it in payment.

How practical is a digital currency? Do you think this is the way we'll pay for things in the future?

Hate to say this but we already have a digital currency - it's called the US dollar and people seem to use it on their phone in front of me at Starbucks all the time. And the bonus is, that you pretty much know how many dollars it will take to buy a latte tomorrow. The same is not true about Bitcoin.

How practical is a currency that is not backed by a government and a central bank? Well that's a separate question. My answer would be that digital money, like fiat money, requires credible backing so that it will be accepted as a means of payment. Bitcoin fails this test. Long-term its not a viable currency, only a speculative vehicle that people will leave behind after they are exhausted by its inevitable boom and bust cycles.

Do criminals and people wanting to hide from government scrutiny like Bitcoin? Absolutely, as long as they can eventually shift it into a currency that they can use. So to the extent that there is honor among thieves, I suppose Bitcoin is viable in a limited way. Of course that assumes that governments are willing to let criminals and others hide their activities in this way. Do you think that's what will really happen? It certainly doesn't seem so given the recent arrests in the US and crackdowns on exchanges in China, but what do I know?

Some people who traded in Bitcoins have made a lot of money as its value has risen. Doesn't that suggest there are downside risks? Are there other reasons consumers should proceed cautiously?

The answer is of course yes, and many people have lost through Bitcoin's gyrations. As I argued above, consumers shouldn't proceed at all in my view as Bitcoin isn't any type of reasonable approximation to a currency.

It's like arguing that tulip bulbs were currency during the Tulipmania episode. Did tulip bulbs have value during the mania? Absolutely. Did some people make money from holding and then selling the bulbs during the mania? Yes some did, most however didn't. When the mania subsided, and the value of the bulbs fell to sustainable levels, were the losses to those who held the bulbs catastrophic? Absolutely.

So if you want to appear cool, take an amount of money you are willing to lose and speculate in Bitcoin. Its great cafe conversation over your latte.If you want to be able to buy a latte tomorrow, or the day after and the day after that, hold dollars - in your hand or on your phone.

David Parsley

E. Bronson Ingram Professor in Economics and Finance, Owen Graduate School of Management, Vanderbilt University
David Parsley
Bitcoin, the open source peer-to-peer payment network and digital currency, has captured the imagination of Wall Street. Why has it become so popular?

That’s a great question. My guess is that bitcoin has a ‘coolness’ factor that has attracted a strange collection of libertarians and other anti-government types – including people who want to conduct illegal transactions, and others who see it as a great speculative opportunity.

How practical is a digital currency? Do you think this is the way we'll pay for things in the future?

No. You have to think of what functions money is supposed to perform. First, is medium of exchange; on that account, as long as more and more people adopt it, it will be useful. However if legal restrictions are imposed, as China has, and others will surely follow, it will not be very useful – except, again, for crooks. Second, a currency is supposed to be a unit of account – that is, do we measure things in terms of it. Most people still tally in dollars, euros, yen etc. I don’t see that going away. Moreover, as a unit of account Bitcoin is particularly bad since the value fluctuates so much in terms of the underlying real goods and services. The third function of money is a store of value. Again, Bitcoin’s fluctuations pretty much negate that function since value rises and falls dramatically.

Some people who traded in bitcoins have made a lot of money as its value has risen.

Doesn't that suggest there are downside risks? Are there other reasons consumers should proceed cautiously?

Absolutely. With currency in a bank, for example, if the bank gets robbed, or the manager or clerk runs off with the money – your money is safe up to $250,000. Not so with bitcoins. Similarly, that’s one reason why we have banks – to keep our money safe. Bitcoins are stored electronically – and there have been many cases where they have been stolen. Who are you going to call? They are not insured and my guess is that you’d have a hard time of getting your local police to investigate. I see Bitcoin as just another bubble. Some people make a lot of money in Ponzi schemes too! But, of course some lose. Bitcoin is supposed to be unique. However, by its very success it will (and has) stimulated other e-currencies. Now, you may not be able to counterfeit bitcoins,but other e-currencies serve exactly the same function as Bitcoin. So, in effect bitcoins are just one e-currency. We have dollars, euros, yen, etc. We also have bitcoins, ripple, QQ coins, litecoin, etc. So, the supposed benefits are actually illusory.

Also, think about who are the players/traders in Bitcoin. The very lack of transparency is the problem. We had similar problems in financial markets before all the regulatory apparatus was set up requiring banks and firms to open their books to investors, auditor, and regulators. These basic consumer safety nets are not present in Bitcoin.

John C. Alexander, Jr.

Breazeale Professor of Investments, Clemson University, College of Business and Behavioral Sciences
John C. Alexander, Jr.
Some people who traded in Bitcoins have made a lot of money as its value has risen. Doesn't that suggest there are downside risks? Are there other reasons consumers should proceed cautiously?

Bitcoin is a fiat currency that represents a U.S. dollar, but it is not backed by any treasury or government. Because of that, in my mind its real value should be less than a dollar. Ultimately Bitcoin is just a payment system. We have metrics (PE, PS, etc.) relative to payment system valuation in the our public equity markets, such as Ebay, and in the past Paypal. Despite these valuation metrics, ultimately the value of a Bitcoin transaction and the value of the Bitcoin equity is whatever the last person was willing to pay.

Nicolas Christin

Assistant Research Professor in Electrical and Computer Engineering, Carnegie Mellon University, College of Engineering
Nicolas Christin
Bitcoin, the open source peer-to-peer payment network and digital currency, has captured the imagination of Wall Street. Why has it become so popular?

It's hard to tell. The decentralized nature of Bitcoin -- where you don't have central banks or mints -- has certainly played a role in its popularity. It may also have been at the right place, at the right time. There is an increasingly vigorous debate about online tracking, anonymity, and, essentially, control, and Bitcoin fits very well in this debate. (Even though the anonymity claims are actually very questionable.)

How practical is a digital currency? Do you think this is the way we'll pay for things in the future?

Digital payment systems have been around for a long time, and we already use them a lot -- PayPal is a good example of a successful digital payment system. Now, there is definitely a growing interest in digital wallets, particularly when integrated with mobile devices. Digital wallets have been very popular in Asia for a while now; public transit electronic passes there can often be used to purchase goods in stores or vending machines. We start seeing similar digital wallet technologies being deployed in the US. Google Wallet is probably one of the better known alternatives, but they're not the only one.

Could Bitcoin find its niche as one of these systems?

It is possible, although the fact that Bitcoin payments take around ten minutes to be confirmed -- and basically one hour for being completely vetted -- is a real problem for quick, face-to-face transactions. It is not unsolvable -- all you need is an escrow or insurance system built on top of the existing mechanisms to make this work well -- but this will add costs, and whether or not this will be a really practical solution compared to the alternatives remains to be seen.

Some people who traded in Bitcoins have made a lot of money as its value has risen. Doesn't that suggest there are downside risks? Are there other reasons consumers should proceed cautiously?

Bitcoin is still a highly volatile asset, as it's been for most of its relatively short life. The fact that it significantly appreciated in the past twelve months doesn't change anything to the fact that drops of 30% or more in a day occur once in a while. It was the case at $17/BTC, it's still the case at $500+/BTC.
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John Kiernan is Senior Writer & Editor at Evolution Finance. He graduated from the University of Maryland with a BA in Journalism, a minor in Sport Commerce & Culture,…
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