In an age when most of our money is little more than electrons in our banks' computers, it may feel like bitcoins and other virtual currencies aren't that different from the dollars you directly deposit into your account each week or the 401(k) account that holds your nest egg.
Continue Reading Below
But bitcoins are different. It is an online currency that can be transferred through a computer or smartphone without an intermediate financial institution.
While it's true that many investors these days experience their portfolios primarily as numbers on a computer screen, owning a stock means you have a small piece of something that's at least partially tangible. That is, the company has offices, factories and other assets. Similarly, all those blips in your checking account can be withdrawn as cash and carried around in your wallet, and that cash is backed by the financial -- and literal -- firepower of the U.S. government.
On the other hand, bitcoins exist almost exclusively as entries on a giant virtual ledger stored on computers worldwide.
While the purely digital nature of bitcoins may make some uncomfortable, it does have a major upside: A user's bitcoins can't be frozen by an angry government, and the movement of bitcoins in and out of a country can't be prevented, says Jelena Mirkovic, a computer scientist and assistant professor at the University of Southern California's Information Sciences Institute.
Bitcoins are created or issued by a central bank. They are created by "miners," who solve one of a series of increasingly complex math problems through a combination of computing power and luck, Mirkovic says.
A miner who solves the problem gets to put his name next to a predetermined number of bitcoins on a ledger, which records all bitcoin transactions and is constantly shared and updated by a peer-to-peer network similar to the original version of the music-sharing service Napster. The number of bitcoins and the speed at which they can be created is mathematically limited, with successful mining that earns fewer and fewer bitcoins over time until the number reaches a little less than 21 million. That's when it stops.
"You're trying lots of different combinations to find the solution," Mirkovic says. "There is not a way to solve this quickly, so you have to just do a lot of trials in order to find the answer, and that's what controls the market. That's what guarantees that you can't just manufacture lots of coins."
An unconventional currency
When it comes to actually making day-to-day transactions, bitcoins aren't yet as useful as conventional currency, Mirkovic says. At the moment, only a handful of businesses, mostly online, accept bitcoins as payment, including blogging site WordPress and Reddit.
You know how if someone steals your debit card information and makes a bunch of purchases, you can report the theft and get your money back? That doesn't happen with bitcoins, which puts the onus for security squarely on users.
In order to make a bitcoin transaction, you need a "private key" that corresponds to the bitcoin address where your coins are held. That key consists of a code consisting of a long string of numbers and letters, which bitcoin users can keep on a slip of paper or in a file on their computer. Programs called "wallets" also can be used to keep track of a user's private keys.
Without that key, it's pretty much impossible for a thief to steal a user's bitcoins, Mirkovic says. But should someone manage to gain access to a bitcoin owner's hard drive though malware or other means and steal their private keys, they could use it to transfer that owner's bitcoins to themselves. Once done, such transactions, like all bitcoin transactions, are permanent and irreversible.
To prevent that, bitcoin users should consider storing their private keys on a separate computer than the one they use for day-to-day transactions and browsing so that they're out of reach of hackers, Mirkovic says.
Compared to more conventional investments such as stocks or bonds, the market for bitcoins is still in its infancy.
But that hasn't stopped some investors from jumping into bitcoins, hoping they'll be the next big thing, says Joel Redmond, a senior financial planner for KeyBank in Syracuse, N.Y.
"There's always going to be a group of people who want to speculate and that want to make money off of volatility, essentially," he says. "Anything that trades with the swings like the swings it's had, there's opportunity to make money there. But the problem is, you have to know what low is to be able to buy low."
Digital gold mined from Mt.Gox
Lack of any real fundamental value and relatively small market size make the price fluctuations of bitcoins extremely volatile and unpredictable, Redmond says.
"With those price movements, it's not difficult to get whipsawed," Redmond says.
For example, the closing price of bitcoins started the year at $13.28, rose as high as $230 in April and fell back down to around $136 in mid-September.
Some investors are attracted by the inherent supply limitations, looking to hold bitcoins as a store of value the same way they might use gold, Redmond says.
"They're only setting up a fixed supply of the coins, and that's a good thing," Redmond says. "I've seen people keeping it as a store and letting it appreciate -- almost like a collectible or like some kind of rare artifact or work of art -- rather than trying to trade it back and forth."
That strategy may make sense when you consider that liquidity can be an issue. Because bitcoins aren't traded on a centralized exchange, buyers and sellers must use private exchanges to buy and sell them via wire transfers, and those transfers usually take a while to transact. Bitcoin exchanges also have had a tendency to freeze up under heavy trading, as the world's largest bitcoin exchange, Mt.Gox, repeatedly has done.
"There's no centralized clearing floor. There's no centralized exchange, there's no central bank regulating it," Redmond says.
Investing in bitcoins may eventually get easier. Venture capitalists Cameron and Tyler Winklevoss, who famously contested Mark Zuckerburg's ownership of Facebook, this year filed papers with the Securities and Exchange Commission to start an exchange-traded fund for bitcoins. Should it be approved, the Winklevoss Bitcoin Trust would allow investors to buy and sell shares representing partial ownership of the trust's bitcoins in the same they would a stock.
Regulation of 'money transmitters'
New regulatory scrutiny is another potential wild card for bitcoin users and investors.
Earlier this year, the Financial Crime Enforcement Network, an agency of the U.S. Treasury, released guidance saying it considers any company that converts bitcoins into real currencies to be "money transmission services," meaning they're subject to stringent laws designed to prevent money laundering.
"Someone who uses a bitcoin for his own purposes, that person would not be regulated," says Kevin Levy, an attorney with the law firm Gunster. "But when you start to move money on behalf of a third party -- you take bitcoins and exchange them for some other currency -- now you become a money transmitter."
While the FinCen guidance is aimed at exchanges such as Coinbase and Mt.Gox rather than users, the availability and cost of those exchanges ultimately affects how easy and cost-effective it is to invest in bitcoins.
"The cost to operate a bitcoin platform or be an exchanger or administrator of bitcoin, that cost will go up and probably go up exponentially if you fall under this regulatory regime," says Andres A. Fernandez, a co-leader of the banking and financial services group at Gunster.
"When there's regulation put in place, people pause, and that usually has an effect," Levy says. "Any little issue causes huge fluctuations."
Copyright 2013, Bankrate Inc.