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Ask the Experts: A Bit about Bitcoin

by John S Kiernan (Click Here for the original article)

In 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 cryptography 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?
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.

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