Riding the Cyprus bailout wave, Bitcoin catapulted into the financial spotlight this year, but the turbulent virtual currency still faces daunting regulatory, security and infrastructure challenges.
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As the debate over the future of this decentralized digital currency rages on, scary meltdowns, alarming cyber attacks and lingering skepticism have clouded its prospects.
Still, it’s clear that Bitcoin has captivated the minds of libertarians, economists and investors alike.
“We continue to believe that this phenomenon is the most provocative economic experiment since the invention of the euro and well worth watching,” Nicholas Colas, chief market strategist at ConvergEx, wrote in a recent note.
Founded in 2009 as an open-source software code, Bitcoin has exploded beyond $1 billion in value this year. Despite its young age, the cyber currency has benefited from growing doubt about the future of traditional currencies amid ultra-aggressive monetary policy and about the safety of bank deposits following the controversial “bail in” of depositors in Cyprus.
Bitcoin users can deposit local currency and then use those funds to buy Bitcoins at a rate that fluctuates with the market.
However, unlike traditional fiat currencies that are controlled by central bankers, Bitcoin is highly decentralized as its circulation expands at a predictable and limited rate. It also markets itself as untraceable, although that feature is coming under regulatory pressure amid concerns it could be used for nefarious purposes such as to finance terrorism.
Bitcoin’s value has skyrocketed, but it has also experienced more volatility than any reliable currency should ever experience.
Since trading at just $20 at the start of the year, Bitcoin rode a wave of enthusiasm beyond $260. However, a high-profile meltdown last month caused by heavy trading and a cyber attack wiped out nearly 80% of the currency’s value, prompting a 12-hour shutdown on one major exchange.
“Investing in Bitcoin has been a white-knuckle ride so far, and nothing in its near future points to a different trajectory,” Colas said.
Could the U.S. Ban Bitcoin?
The biggest obstacle facing Bitcoin in the medium term appears to be on the legal front.
So far the U.S. has said little about Bitcoin, with only the Treasury Department indicating rules that force money-service businesses to track transactions do indeed apply to virtual currencies.
"Bitcoin is to money what Amazon is to retail or Netflix is to video content."
Future regulation could severely restrict or even ban the use of Bitcoin in the U.S.
“National governments do not have a history of condoning unofficial currencies,” said Darrell Duffie, a finance professor at Stanford University. “If it were ever to become popular enough to begin acting like a serious alternative currency, I believe the authorities would step in.”
Duffie said Bitcoin could potentially fall under the Stamp Payments Act of 1862, which prohibits issuing notes for less than $1 that are intended to circulate as money.
“Previous case law has suggested that courts are willing to tolerate private currency so long as they do not attempt to replace the official currency. Bitcoin supporters envision Bitcoin as a global digital currency,” said Duffie.
Some feared Treasury was going to move to wipe out Bitcoin earlier this year.
“I did think there was a chance the U.S. would ban it. They chose the wiser choice: to regulate it,” said Daniel Friedberg, a financial-services attorney at Seattle law firm Graham & Dunn who has a Bitcoin client base.
Peter Dugas, director of government affairs at the law firm Clark Hill, said Bitcoin will continue to reside in a legal “gray area” until the U.S. issues further guidance.
As U.S. regulators remain bogged down with the implementation of the Dodd-Frank financial overhaul, it remains unclear whether the government will choose to regulate Bitcoin as a currency, a commodity or perhaps something in between.
While Bitcoin’s $1 billion outstanding is just a drop in the $4 trillion global currency market, Dugas said the “biggest concern” is whether the virtual currency is exploited for terrorism or money-laundering purposes.
“I can see [Bitcoin's] desire to remain faceless, but the realities of the global financial system are not such. There are entities out there that are going to use this for nefarious reasons,” said Dugas. “In my opinion, it would be smart for them to engage on that process early on to educate the regulators.”
Colas urged Bitcoin to convince global charities to use the virtual currency for donations and money transfers, giving regulators a reason to think twice about excessive regulation or a ban.
“That move alone would begin to remove the ‘Cokehead currency’ imprimatur which Bitcoin still struggles to overcome,” Colas said.
Will 'Smart Money' Now Embrace Bitcoin?
Some of Bitcoin’s security and legitimacy problems could be eased by future investment from venture-capital firms. An influx of cash could allow exchanges like Mt. Gox to upgrade their systems, limiting the number of scary meltdowns and cyber attacks.
VC cash could also be used to help finance service offerings for both individuals and businesses.
In recent weeks, Bitcoin startups like Coinsetter, which is devising a foreign exchange trading platform for the currency, have raised significant amounts of money from VC firms.
BitInstant, an online service that lets users convert dollars into Bitcoins, had been shunned by traditional investors in 2011, but is now in talks about a round of financing that would value the company in the “tens of millions,” according to tech blog Mashable.
Digital wallet startup Coinbase has also raised $600,000 from a number of VC firms, Mashable reported.
“Bitcoin is to money what Amazon (NASDAQ:AMZN) is to retail or Netflix (NASDAQ:NFLX) is to video content -- a much more efficient way to meet the needs of millions of people around the world," Colas said.
Competition in the Virtual Currency Space
It’s also possible that Bitcoin will be passed over by a new virtual currency just as previously popular currencies e-gold and Liberty dollar were.
One new virtual currency gaining attention is Ripple, which was created by OpenCoin and landed seed money from VC giant Andreessen Horowitz.
“I think virtual currency is here to stay. But I don’t know which of these virtual currencies will ultimately be the winner or if it will be Bitcoin,” said Friedberg.
Even some supporters of alternative currencies are skeptical about Bitcoin’s ability to thrive as a currency, especially given its lack of transparency.
“People are saying, 'We can’t trust the banks. Let’s go to the Internet.' In principle that’s a great idea, but Bitcoin may not be the best place to put your money,” said Jacqui Dunne, co-author of Rethinking Money: How New Currencies Turn Scarcity Into Prosperity.
Dunne believes Bitcoin, given its wild price swings, is more of a tool for speculation than a currency. “The trouble with Bitcoin is nobody knows what’s going on underneath the hood,” she said.
Given the looming legal challenges and persistent suspicion, it seems that the next few quarters will be critical in determining the future of Bitcoin.
“It could all still end in tears, either by regulation or mismanagement. But Bitcoin isn’t dead just yet, and it remains one of the most potentially disruptive forces in modern finance,” Colas said.