A Bluffers' Guide To Bitcoin

This feature appeared in Shares Magazine on 13 June 2013. 


'Paypal for Wiseguys' or the birth of a new 'fiat' currency? Whatever is, Bitcoin’s certainly got governments worried.

Until a couple of months ago, the world at large was – on the whole – blissfully unaware of the existence of bitcoin. In most cases, even the savvy among the trading and investment communities would not have been able to tell you much more about this subversive electronic currency than a Google search might have revealed.

Then along came the Cyprus chapter of the eurozone crisis which reached its crescendo in March/April of this year. With Cypriot bank depositors unable to access their accounts and facing the unappetising prospect of being forced to take swingeing haircuts, it seemed like investors were starting to think the unthinkable and invest in an untried electronic protocol in lieu of hard currency. 

The prospect of failing banking systems usually drive up gold prices as investors seek a hedge against financial uncertainty.

As the price of gold slid and approached a 52-week low, however, Bitcoin seemed to take this as a fillip and for a few heady weeks at least, it took off like a rocket. Between 1 January 2013 and 10 April, the dollar value of Bitcoin rose from $13 to $266. This dizzying ascent however proved unsustainable and in the days following this peak, the cryptocurrency nose-dived to $50 before stabilising at around $100.

Bitcoin prices have been a lot more stable over the past couple of weeks,” says  David Jones, a market strategist at IG Index. “It currently trades in a range between $112 and $122,” he adds. In technical terms, support seems to be around $110 with resistance up around the $125 mark. Jones went on to tell Shares that IG Index currently only quotes a binary market in bitcoin.

So, if like David Jones at IG Index, you believe that bitcoin has had its 15 minutes of fame, there is nevertheless no denying that the rise of the cryptocurrency is very much a product of our time. That said we're still no closer to understanding what it is and how it works. So, what the hell is bitcoin anyway?

At first glance, the currency's origins seem to have more in common with the science fiction of Philip K Dick or William Gibson than the macro-economic pedigrees of traditional fiat currencies. The first use of the term 'Bitcoin' can be traced back to 2008 when a paper by the pseudonymous developer Satoshi Nakamoto was posted on the internet under the heading “Bitcoin: A Peer-to-Peer Electronic Cash System”.

Philosophically, bitcoin is essentially based on the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The currency was then designed around an idea of 'money' that uses cryptography to control its creation and transactions, rather than relying on central authorities as has been the precedent set for the majority of the world's so-called fiat currencies.

The concept of cryptocurrency had been mooted before, most notably in 1998 by Wei Dai on the cypherpunks mailing list but it wasn't until 2009 that Satoshi brought the bitcoin network into existence with the release of the first open source bitcoin client and the issuance of the first bitcoins. The currency's inscrutable developer left the project in 2010, having apparently moved on to other things and as such, the project's motivation and origins remain shrouded in mystery.

But while bitcoin's free-booting origins in the digital equivalent of the Wild West's frontier seem anarchic, dangerous even, the currency itself – while complex in its technical structure – follows relatively conventional rules which can be found on bitcoin.org.

Each bitcoin is subdivided down to eight decimal places, thereby forming 100 million smaller units called satoshis. The currency can be transferred through a computer or smartphone without an intermediate financial institution and transactions are cheap and mostly free.

Bitcoin transactions are processed by servers known as bitcoin miners which communicate over an internet-based network and confirm transactions by adding them to a ledger which is updated and archived periodically using peer-to-peer filesharing technology.

As well as archiving transactions, each new ledger update creates some newly-minted bitcoins. These transactions are broadcast within seconds and verified within 10 to 60 minutes. The transactions are irreversible and double spending is prevented by the use of a block chain which is a shared transaction database. A full copy of the currency's block chain contains every transaction ever executed in the currency. With this information, one can find out how much value belonged to each address at any point in history.

The number of new bitcoins created in each update will half every four years until the year 2140 when this number will round down to zero. After that time, no more bitcoins will be brought into circulation and the total number will have reached a hard limit of 21 million. To date, the total value of all bitcoins in circulation is over US$1.3 billion.

While novel and 'cypherpunk' in its origins, there's nothing remarkably controversial in the foregoing. However, the relative anonymity and virtual untraceability of bitcoin transactions has drawn unwelcome attention from law enforcement and financial regulators who are cottoning on to the currency's potential as a tool for money laundering.

The concerns of the US law enforcement community prompted authorities in May to seize two accounts linked to Tokyo-based exchange Mt. Gox. While there are 'exchanges' worldwide that trade and offer services paid in the cryptocurrency, the worlds largest exchange, Mt. Gox handled approximately 63% of the world's Bitcoin transactions as of April 2013.

The seizure warrant, obtained by the Department of Homeland Security, froze a Veridian Credit Union account held by an Iowa-based online payment processor, Dwolla Inc. in the name of Mutum Sigillum LLC, a Mt. Gox subsidiary incorporated in Delaware. Homeland Security maintain that  Mutum Sigillum was operating as an unlicensed money transmitter, in violation of federal law.

However, regulatory scrutiny is not the only area of concern surrounding bitcoin. A cyber attack in 2010 saw over 184 billion bitcoins generated in a transaction before being sent to two addresses on the network. The transaction was quickly spotted and erased from the transaction log after the bug was fixed and the network forked to an updated version of the Bitcoin protocol.

While this has so far been the only major security flaw found and exploited in the currency's history, there is plenty of evidence that the system comes under regular attack from hackers. In April, the information security press reported that the Mt. Gox exchange battled a massive DdoS (distributed denial of service) attack

More recently, Symantec researchers revealed that hackers have turned to spoofing the Mt. Gox site and deceiving its customers into downloading malware  such as the Ponik downloader Trojan, which is also able to steal passwords.

The currency trading community is understandably sceptical about bitcoin. Shares spoke to several market insiders who declined to comment on the bitcoin phenomenon, tacitly discounting it as a fashionable trope. But not everyone was so quick dismiss bitcoin or the lessons to be learned from it.

Kathleen Brooks, a research director at FOREX.com was reluctant to dismiss bitcoin out of hand. “I don’t think it’s necessarily a fad, I think there is a legitimate reason to question central control of a currency, especially since the sovereign debt crisis in Europe has questioned the future of the euro, the world’s second most traded currency,” she tells Shares. “Whether or not it’s an elaborate scam, we shall have to wait and see. It’s only 4 years old, some call it a Ponzi scheme and Ponzi schemes can go on for years. As long as people continue to accept it as a mode of exchange then it will work as a currency, but as an investment I am not so sure,” says Brooks.

As evidenced above, bitcoin currently trades in a range between $112 and $122 which is a significant spread and not lacking in volatility. Surely, this is something that should attract traders or is it just too volatile? Again, Brooks offers some insight on the pros and cons of trading this nascent currency.

“Traders love volatility, so in theory the answer should be no, although it’s been a particularly rough ride for bitcoin in recent months. However, bitcoin is a very young “currency” so as it grows in popularity you have to expect some growing pains and unusual price action. It’s worth remembering that when the euro first came into circulation it required a multilateral effort to prop it up,” she reminds. Brooks goes on to highlight some of the risks associated with this new counter.

“Bitcoin does have some specific risks – it is an electronic currency so it is at risk of being hacked. Also, some governments and officials don’t like the idea of bitcoin so it is at risk from government intervention to limit its use. As long as you understand the risks involved, trading a new currency could be fun,” she says.

Because bitcoin is a frontier currency, its legitimacy (or lack thereof) – both in the eyes of law enforcement and the criminal fraternity – means that its status as a conventional tradeable security is somewhat less than gilt-edged. This reasons Brooks, “could seriously limit the take up of bitcoin, as big corporation, banks etc won’t want to open themselves up to unknown legal challenges. Although I understand that all new technologies/ currencies etc come with untested legal problems, the fact that bitcoin is a unit of currency that stands outside the legal and regulatory framework is the biggest risk for me.”

The future for bitcoin would therefore appear rather uncertain but, as Brooks posits, the same could be said of the fledgling single currency back at the turn of the millennium. Some market insiders –   while less than sanguine about bitcoin – did feel nevertheless that the phenomenon of cryptocurrencies was not going to go away anytime soon. “Bitcoin will be shortlived but something more superior and regulated will probably be the major winner,” said one analyst.

Ian Bremmer, the founder and CEO of Eurasia Group, the world's largest risk consulting firm told CNN recently that he would be “very surprised if Bitcoin is still around in 10 years,”  He thought that bigger players would enter the field and improve upon Bitcoin's weaknesses. This sentiment was certainly echoed by analysts and experts in the foreign exchange market, in fact some give it much less than a decade. “There's been a lot of bitcoin mania out there, particularly after the Cyprus crisis,” says Jones. “But I think bitcoin has its day in the sun, I'd be very surprised if we're still talking about it a year from now,” Jones adds.