Will Bitcoin Replace the Dollar?

In the not-too-distant future, you could find yourself buying goods and services with this new digital currency

Will Bitcoin Replace the Dollar?

Dollars, euros, pounds, rubles, rupees, pesos and leks: These are all currencies issued by some of the world’s governments.

Actually, there are 182 currencies recognized by the United Nations. Nation-states have always minted currencies (usually in the form of paper banknotes and/or metal coins, although ancient Rome paid its solders in salt). Each nation’s central bank — such as the Federal Reserve of the United States — formulates and executes its country’s monetary policy. They do this by supervising and regulating banks, assisting the federal government’s financing operations, and serving as the banker for their governments.

At least that’s how it’s worked for centuries.

Today, however, new currencies are being created digitally. With no governmental backing, they exist only online, for use by anyone anywhere in the world. One has attracted far more attention than the rest.

It’s called bitcoin.

But is it a legitimate medium of exchange or merely a speculative fad?

Indeed, in a December 2013 survey by Bloomberg, only a few knew what it was. More than half of those polled said they had no idea what bitcoin is, 6% said they thought bitcoin was a video game and the rest thought it was an iPhone app.

You should become familiar with bitcoin. Why? Because, at least prior to a March 25 IRS ruling, more and more merchants were accepting bitcoins as payment for goods and services and investors were pouring money into bitcoin-related ventures.

What effect the IRS ruling will have on that remains to be seen, but meanwhile here’s what you need to know about bitcoin’s history and development:

What is bitcoin?

Bitcoin is a decentralized digital currency. Decentralized means it was not created by any government. Digital means it exists only online. As a currency, it can be used as a medium of exchange for the purchase of goods and services — just as you do with dollars.

Bitcoins are the unit of currency of the bitcoin system. In the United States, we use a dollar; its symbol is $. The dollar is divisible to two decimal points — or $1.00. Bitcoins, by contrast, are referred to as BTC, and the currency is divisible to eight decimal places; thus 0.00000001 BTC is the smallest denomination that can be used in a transaction. You could say that bitcoins are like an electronic form of cash.

What is a bitcoin worth in dollars?

Unlike other currencies, no government’s central bank sets the value of a bitcoin. Therefore, its value is simply whatever people say it is. If people believe a single bitcoin is worth five U.S. dollars, then that’s what it’s worth. If people believe it is worth $500, then it is worth $500.

If that sounds strange, realize that this is the same way people value gold; in 2012, people said gold was worth $1,900 per ounce; they say it is worth about $1,100 per ounce at this writing. Like gold, bitcoins are worth only what people are willing to pay or receive for them.

Who accepts bitcoins?

One of the challenges for early owners of bitcoins was finding a place to spend them — but that’s rapidly changing. Today, more and more businesses are accepting them, including:

  • The NBA’s Sacramento Kings, which lets you pay for tickets, team merchandise and even concessions at home games
  • Overstock.com, a major online retailer
  • Two Las Vegas hotel-casinos, the D and the Golden Gate, the city’s oldest, accept bitcoin for rooms, gift shops and restaurants — but not yet on the casino floors (although the owner of both of properties says wagering in bitcoin will happen soon)
  • BitCoinShop.us, a website listing goods for sale on Amazon, eBay and other retailers that accept bitcoins
  • CheapAir.com, an online travel agency based in Los Angeles
  • The photo-sharing website Reddit
  • Pizzaforcoins.com, which arranges deliveries from Domino’s and other pizzerias
  • A bar in midtown Manhattan
  • The dating website OKCupid
  • A Subway sandwich shop in Allentown, Pa.
  • An ATM in Vancouver
  • The University of Nicosia, in the capital of Cyprus, accepts bitcoin for tuition payments

Perhaps the biggest growth potential for the use of bitcoins is apps on mobile devices. That’s because bitcoins themselves are software, and apps on wireless devices are a highly efficient way to pay for goods and services. Many merchants like bitcoin transactions because the fees cost them less than credit card transactions do.

At the end of 2013, Bitcoin Wallet, which stores and pays bitcoins, said it was adding more than 5,000 users a day, up from about 500 a day at the beginning of the year. Another service, BitPay, allows thousands of brick-and-mortar merchants to complete bitcoin transactions in stores via mobile devices.

How did bitcoin originate?

In 2008, bitcoin was devised by software programmers (or perhaps a group of programmers — nobody knows for sure) using the pseudonym “Satoshi Nakamoto.” The real identity of the creator(s) is unknown. Newsweek said it identified the founder, but he has strongly denied the allegation.

The first 50 bitcoins were issued on Jan. 3, 2009.

Why was bitcoin created?

Bitcoin was invented to create a way for individuals to engage in financial transactions anonymously, with no government intervention or role. By creating a fixed amount of the currency (more on that later), bitcoins are meant to be immune from inflation, which ravages every currency in the world. Some people believe bitcoin is meant to undermine the influence nation-states have on people by virtue of their control over monetary supply. Others argue that bitcoin is simply a way to facilitate electronic commerce.

How are bitcoins created?

Since bitcoin is a digital currency, it is created online, through a process called “mining.”

Think about mining for gold: You dig a hole in the ground looking for the metal. Likewise, Satoshi Nakamoto hid bitcoins on the Internet; you can find them by writing an algorithm that solves a certain mathematical problem. But each time a block of bitcoins is found, the math problem gets harder to solve — just as you must dig deeper into the ground to find the next batch of gold.

About every four years, half as many bitcoins will be created as were created during the previous four years. Because 10.5 million bitcoins were created from January 2009 through the end of 2012, 5.25 million will be eligible for mining during years 4 through 8, then 2.625 million bitcoins in years 8 through 12, and so on. Thus, the total number of bitcoins will never exceed 21 million.

Near the end of 2013, there were roughly 12 million bitcoins in existence.

Is mining difficult?

Mining is akin to picking a lottery number. To improve the odds of finding the right number, some miners use specially built computers with advanced calculating capabilities. One operation is located in Iceland — chosen because it offers cheap geothermal and hydroelectric energy and free arctic air to cool the computers — and deploys 100 computers (worth $20,000 each) to mine bitcoins around the clock. It’s unlikely that you can effectively compete in the search for bitcoins using a laptop you bought at Best Buy.

Currently, according to Michael Taylor, a professor at the University of California-San Diego, all the computers mining bitcoins have 4,500 times the capacity of the U.S. government’s most powerful supercomputer, the IBM Sequoia. The tremendous effort to find bitcoins has led to criticism that bitcoin mining is wasteful to society.

Is mining the only way to get bitcoins?

No. Again, think about gold. Sure, you can mine for it. Or you can buy gold, gold coins or gold jewelry from a dealer. Likewise, most people who collect bitcoins buy them.

There are many places where you can do this — all online, of course. What had been the largest bitcoin exchange, Tokyo-based Mt. Gox, shut down and filed for bankruptcy in February, citing huge losses it attributed to hackers. Others include Bitstamp, BTC-e, Coinbase, Coinsetter and CoinLab. All charge about 1% to convert dollars into and out of bitcoin. They also store your virtual currency in a “digital wallet” and pay merchants for goods and services with it.

Ironically, physical bitcoins (a contradiction in terms because the whole point was to create a digital currency) are becoming available. One is the Titan bitcoin, produced in California. These have a digital value attached to them, much like gift cards.

Where do I store my bitcoins?

Once bitcoins are placed in your digital wallet (only your computer’s IP address is associated with it), you have an encrypted “private key” to access them. If you lose that key (or if the computer holding the wallet crashes and you’ve not made a backup of your data), then you’ve lost your bitcoins. It’s the same as having money in your wallet — and then losing that wallet.

Are bitcoins legitimate?

Yes – but.

The anonymous and untraceable nature of virtual currencies — there are now more than 80 of them, including peercoin, namecoin, worldcoin, hobonickels, gridcoin, bbqcoin, litecoin, alphacoin and fastcoin — make them appealing to money launderers and other criminals.

In May 2013, the Department of Homeland Security seized an account tied to Mt. Gox. The warrant alleged that the company and a subsidiary were conducting transactions as part of an “unlicensed money service business” and failed to register with FinCEN, the Treasury Department’s Financial Crimes Enforcement Network.

Then, in October 2013, the FBI shut down Silk Road, an online black market that allowed visitors to anonymously buy illegal drugs. Other sites reportedly use anonymous digital currencies to pay for prostitution and even murder for hire. Digital currencies can also be used by people who simply want to keep their activities secret — such as cheating husbands paying for hotel rooms with digital currencies so their wives can’t detect the transactions. Gambling activities and alcohol usage are easily hidden with these currencies too.

For these reasons, most banks are not yet willing to serve companies selling bitcoin services. There is simply too much legal uncertainty.

And it’s not because legislators and regulators aren’t paying attention. Senate hearings in December 2013 noted that bitcoin provides as much opportunity for good as for harm. Officials from the Department of Justice testified that “virtual currency systems offer legitimate financial services and have the potential to promote more efficient global commerce.” As for crime worries, the U.S. Secret Service, which investigates counterfeit currencies, and FinCEN detailed successful investigations into criminals using bitcoins and other currencies — reducing fears that government agencies cannot catch criminals using digital currency.

Even though federal agencies consider bitcoin legitimate and possibly even helpful for the economy, legitimate users are still finding it challenging to use.

In addition to the risk of flat-out losing your bitcoins, their value is quite unstable. Earlier we mentioned that the value of a bitcoin is, like gold, whatever people believe it to be. A year ago, on Jan. 1, 2013, few people were aware of bitcoins and even fewer involved with them. As a result, the value of one bitcoin back then was equal to $13. But awareness and popularity have grown much faster than the supply of bitcoins themselves — so much so that by Dec. 4, 2013, the price of a bitcoin reached $1,132 — a thousand-fold increase in less than a year, making millionaires of the earliest participants. But two weeks later, the Chinese government declared that businesses in that country are prohibited from using or accepting bitcoins, and their value immediately plunged more than 40%.

Indeed, according to an analysis of bitcoin prices performed for The Wall Street Journal, bitcoin values between late 2010 and late 2013 were 7.5 times more volatile than gold.

What’s it really worth? Economist Brian Wesbury, writing in The Wall Street Journal, noted that the current U.S. money supply (known as M2) is about $11 trillion. If all 21 million bitcoins are mined and become an accepted currency (a big if ), each bitcoin theoretically would be worth $524,000. But because all the companies that currently accept bitcoins make up less than one-hundredth of one percent of all spending, or GDP, bitcoins are really worth just $52.50.

So which is it — half a million or 50 bucks? You could ask the same question about a lottery ticket: Is it worthless, or is it worth millions?

This uncertainly and speculation make bitcoins highly unstable. It begs the question: How many bitcoins is a hamburger worth? If a restaurateur is willing to accept bitcoin, he must have a reasonable basis for determining the value of a bitcoin. These wild fluctuations in price undermine the ability of bitcoins to serve as legitimate currency.

As a result, there is more focus currently on bitcoin as a get-rich-quick scheme than as a legitimate currency. This makes it of more interest to gamblers than investors or businesses.

The tax implications

The U.S. government has decided to treat bitcoins as property, applying the rules used for taxing any other investment, as well as barter transactions.

The IRS handed down that ruling on March 25, ending months of speculation by bitcoin users. The ruling now provides certainty for them — as well as potential income tax liability.

Under the ruling, if you purchase a $3 cup of coffee with bitcoins, the $3 will count as income for the coffee shop — a fact that is routine and thus not noteworthy. But if you had bought the bitcoins for $1, you’ll now be treated as though you have a $2 capital gain. The tax you’ll owe will depend on how long you owned the bitcoins before using them to buy the coffee.

The IRS will require the filing of Form 1099 for those using bitcoins. The ruling covers past and future transactions and tax returns, the IRS said, adding that it may offer relief from penalties to those who engaged in bitcoin transactions before March 25 and can show reasonable cause for any underpayments or failure to file. So, plan on keeping good records if you engage in transactions using bitcoins.

What the rise of bitcoin means to you

Using bitcoins conveniently and anonymously to make online purchases with a mobile device is one thing, but will bitcoin truly become a major alternative currency, perhaps even replace existing currencies? What would be the impact on nation-states if that were to occur? How should all this affect your long-term investment decisions?

Or will bitcoin fade over time, like eight-track cassette players or pets.com, the 1998 start-up that raised $85 million in venture capital before going broke eight months later?

For now, these questions have no answers. But it will be fascinating to watch the answers emerge. We will continue to monitor and report on developments for you.

Originally published in Inside Personal Finance April 2014

 

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