What You Need to Know About This New Kind of Currency

Bitcoins, a volatile and controversial new form of money that exists only online, have become a financial phenomenon. Billions of dollars worth of bitcoins are in circulation. The value of each has soared from as little as $13 in early 2013 to more than $1,200 at times, with ­plunges in value of several hundred dollars on some days.

They have been used to buy trips booked at CheapAir.com…a haircut in Reno, Nevada…a martial arts class membership in Atlanta…and a Subway sandwich in Allentown, Pennsylvania. But the wild gyrations in value…warnings of major risks from financial regulators in some countries…and questions about what exactly bitcoins are good for have confused consumers and investors.

Bottom Line/Personal asked Stanford University professor Susan Athey, PhD, a leading expert on Internet economics, to explain what bitcoins are and whether they can withstand the battles ahead…

UNDERSTANDING BITCOINS

What are bitcoins?

They are a form of electronic or “virtual” money held in online “wallets” that you can save, spend, sell and move from place to place as cheaply and easily as you would send an e-mail. You can access the global online bitcoin network through your personal computer, tablet or smartphone.

Where are the actual bitcoins kept?

There are no coins or bills that you can hold in your hand or put in a safe. Your “money” is in the form of strings of numbers kept safe in your encrypted virtual wallet. There is a bitcoin public ledger that tracks the ­anonymous transactions, but bitcoins are not backed by a physical asset such as gold or by any central bank. The currency maintains value only as long as enough people agree that it does.

What are bitcoins worth now?

Their value fluctuates continually against major world currencies. They were valued around $750 at the end of 2013.

How do I get bitcoins?

Web sites such as BitCoin.org can help you get started. Bitcoin exchanges such as BitStamp.net allow you to trade bitcoins for traditional currencies as well as move money in and out through wire transfers. CoinBase.com makes the system more user-friendly, hosting your bitcoin wallet and enabling transactions through Automatic Clearing House (ACH) transfers linked to your bank account.

Where do bitcoins come from?

Back in 2008, an anonymous Japanese computer programmer or group of programmers using the pseudonym ­”Satoshi Nakamoto” created the highly complex bitcoin software system and, in 2009, released it for free on the Internet. Nakamoto’s provocative idea was to create a decentralized system of currency not controlled by governments or dominated by major banks. Bitcoin software, which is designed to slowly release a total of 21 million bitcoins by the year 2140, runs on a network of thousands of computer servers. New bitcoins are awarded every day.

You can earn, or “mine,” new bitcoins by using your computer to solve very complex mathematical problems. (For more information, go to BitcoinMining.com.) Every single bitcoin (there currently are 12 million in circulation), transaction and digital wallet is tracked, and transactions are recorded on the public ledger shared by all the servers for anyone to see, although the individual wallets themselves are listed as anonymous numbers.

Who oversees bitcoins?

The system is designed to be self-­policing. Nobody can make a payment on your behalf, and due to the authenticated history of this virtual money, counterfeiting is virtually impossible. The Bitcoin Foundation (BitcoinFoundation.org), a nonprofit industry lobby group, informally oversees the network and its rules.

Why does anyone need another currency, especially one that is unregulated and volatile?

Our current system of buying and selling goods and services and transferring money is clumsy, expensive and inconvenient, often relying on big banks, credit card companies or a service such as Western Union as middlemen that don’t put our best interests first.

For example, if I want to send money from my Bank of America account to a friend, I am charged $25 for a wire and my friend has to wait for the funds to be available on the other end. With digital currency such as bitcoins, I could make that transaction directly and securely for free in minutes. There are no bank rules, holidays or imposed limits to deal with. I have more control over my money.

Aren’t there other digital currencies in circulation, too?

There are dozens, including ripples,* which allow you to send any type of currency, even US dollars, to another individual without using a bank or a credit card system…litecoins, which make it easier than bitcoin for individuals to earn or mine new coins…as well as bytecoinsfrankos­hobonickelsjunkcoins…and quarkcoins. But bitcoins have attracted the most interest and investments.

USING BITCOINS

Can I actually buy stuff with bitcoins?

So far, there are a few hundred online and real-world businesses in the US that accept bitcoins. A car dealership in California helped a customer convert bitcoins to cash to buy a $119,000 ­Tesla luxury car. Many businesses seem to be using them for promotional value. For instance, Virgin Galactic, British billionaire Sir Richard Branson’s company, accepts bitcoins in payment for future commercial space flights.

Until the volatile exchange rate for bitcoins stabilizes, I don’t expect them to be widely used in commerce. But eventually, merchants will have a significant incentive to accept them in order to avoid the 2%-to-3% transaction fees typically imposed by credit card processors.

For shoppers, paying in bitcoins is as easy as making debit or credit card purchases, and bitcoins also can be sent to friends, family and others, as long as they also have bitcoin accounts. You use a bitcoin digital-wallet app on your computer, tablet or smartphone to enter the recipient’s account number and payment amount, then hit “send.” In some stores, you can pay with bitcoins by using your smartphone to scan a QR code (a type of bar code). To make bitcoins easier to exchange, they also are subdivided into smaller units just like dollars and cents. For example, one bitcoin equals 100 million satoshi.

What happens if someone steals my bitcoins or I lose access to my wallet?

These are legitimate risks. There is a lack of redress if something goes wrong. If thieves obtain your smartphone or password for your wallet and private “key,” they will have access to your electronic money, and there is no ­government-mandated insurance to cover your loss or virtual currency laws that hold bitcoin exchanges responsible.

If you lose your cryptographic key—a long string of numbers that allows you or another person to access your digital wallet—there is no central authority to look it up for you or reset your key. And the bitcoin system is dependent on the Internet itself. If a wide-scale catastrophe shut down global electronic communications, you would have no way to access your money. Of course, you might also lose access to your regular bank accounts under those ­circumstances.

Are there other dangers?

Bitcoins can be used to transfer money directly from person to person without revealing your identity, and that kind of anonymity can be attractive for criminal enterprises. However, the fact that all transactions are recorded on a public ledger makes it less anonymous than cash. If the wallet addresses can be tied to individuals, then the transactions become a matter of public record.

INVESTING IN BITCOINS

Should I buy bitcoins as a long-term investment for my portfolio?

In the near-term, as digital currency spreads in popularity, bitcoins could continue to appreciate in fits and starts because bitcoin is the most established player among many digital currencies.

But I also expect the value of bitcoins to swing wildly for the foreseeable future as governments, corporations and consumers adapt to the new currency.

This volatility presents a major risk. For example, the value of bitcoins dropped by nearly 40% within one day in December. That happened after ­China’s largest bitcoin exchange said it would stop accepting deposits in renminbi, the ­Chinese currency. Also, China’s central bank reportedly ordered payment-­processing companies to halt transactions involving digital currencies, the latest in a series of warnings by authorities in several countries about the use of bitcoins. Most long-term investors will find bitcoins’ unpredictability hard to handle. It is impossible to gauge how ­bitcoins will fare many years from now.

*Athey sits on the advisory board for Ripple Labs, and she has a small stake in the company.