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Bitcoin Decoded (Readers, Use Caution)

The price swings and variable government response to Bitcoin highlight both the promises and risks of a currency not controlled by any government. Unlike a fiat currency system, which is backed by a government guarantee, Bitcoin is a “hard” currency, designed to act like gold or silver.

For those unfamiliar with the currency, we start with a primer on the two key aspects of Bitcoin: how they’re made and how they’re recorded.

1.  How Bitcoins are Made.

A bitcoin is a unique string of data, created (or “mined”) by solving a computer algorithm of increasing computational difficulty. This algorithm is tied to transactions on the Bitcoin blockchain, which is the shared digital ledger of every bitcoin transaction. Solving the algorithm accomplishes two things simultaneously: it creates new bitcoins for the miner while extending and verifying the record of bitcoin transactions for everyone. This dual result serves as a relatively efficient money transfer service (NB: transactions take about an hour to receive payment confirmation, so for payment processing they’re not as fast as your credit card).

2.  How Bitcoins are Recorded.

Once created, a Bitcoin is kept safe without any involvement by financial institutions using a system based on public key encryption. A Bitcoin owner first generates a pair of cryptographic keys. One is public and shared, and the other is private and secret. Anything encrypted with the public key can only be decrypted with the private key, so Bitcoins are safely encrypted only as long as the owner’s private key stays secret. To send a Bitcoin, the owner attaches it to the recipient’s public key, and signs the transaction with their private key. The transaction is then published to the Bitcoin blockchain, publicly recorded and verified. It is irreversible at that point.

This protocol effectively prevents double spending, but only if the Bitcoin is sent digitally and recorded in the blockchain. If it is transferred on paper or some other physical form, there is always a risk that the sender could still use it.

For Some, Bitcoin May Have Unique Benefits.

The power of the Bitcoin system lies in its ability to accurately process and record money transfers without needing a third-party intermediary such as a bank. Particularly in international transactions, bypassing a bank in a purchase or sale can drastically cut lag-time and fees. This is a huge benefit for those engaging in international money transfers, such as workers who send remittances overseas to their families.  Lower fees may be a benefit for smaller businesses burdened by credit card fees; we’ve already seen over 20,000 businesses accept Bitcoin as a means of payment.

Finally, for people in countries with high inflation rates and capital controls, Bitcoin may also become a way to exchange their currency while avoiding government oversight. It is attractive for anyone looking for an alternative to their home country’s fiat currency.

But on the Whole, Use Caution.

Bitcoin’s manifest benefits as a unit of exchange – no central authority, no physical assets, semi-anonymous transactions – are also what makes it so volatile as an investment. Without any defined value or connection to an established currency, the price of a bitcoin fluctuates wildly in cycles of fear and excitement. And without any third party guarantor, there is a very real risk of theft or fraud for any Bitcoin holder. Add to that a constant risk of regulation by world governments, and holding bitcoins long-term starts to seem like a pretty risky proposition.  (It’s why large retailers are staying out of the game).

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If you find yourself in the unlikely position of having to transact in Bitcoin, you can avoid some volatility by rapidly converting them back to fiat currency through one of the bigger exchanges.  But note: holding a Bitcoin in a third-party account at an exchange is not FDIC protected, and the exchanges are vulnerable to fraud, hacking and failure – a study of Bitcoin exchanges found that nearly 50% closed over a three-year period. And finally, if you do use Bitcoins, be sure to pay your taxes afterwards. Bitcoin transactions are only SEMI-anonymous. Remember: everything is being recorded in the blockchain.

Photo credit: Zach Copley

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

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