Bitcoin Goes Boom

The D Las Vegas is advertising it now accepts Bitcoin. Will other businesses follow suit? Source: Ethan Miller/Getty Images.

Bitcoin. If you've peeked at the financial news lately, you probably know it's a newish digital currency beloved by speculators and tech geeks alike. You might also have read $460 million worth of the stuff just went missing, leaving its owners out in the cold. Yet even with this and other well-documented problems, Bitcoin believers seem unfazed. But lest you think that's a signal of Bitcoin's viability, a word of caution: Even setting aside recent developments, there isn't much evidence Bitcoin is ready for primetime. Its technology has potential, but its volatile exchange rate, low liquidity and security flaws make it less than ideal as a store of value or medium of exchange for goods and services.

For the uninitiated, Bitcoins (BTC) are created out of thin air by a computer algorithm, which releases them at pre-set levels-currently 25 BTC every 10 minutes, though the algorithm cuts the amount released in half every four years. Individuals compete for these new Bitcoins by "mining" them-using powerful computers to solve complex math puzzles. About 12 million BTC are currently in circulation, and the supply will reach its ceiling of 21 million BTC by 2140. This ceiling aside, it puts in practice the monetary system Milton Friedman idealized: Replacing the Fed with a computer system that increases the money supply by a stable, predictable amount each week.

Mining Bitcoins isn't the only way to acquire them. Folks can also purchase them on exchanges for a nominal transaction fee. Currently over a dozen exist, with BTC China the biggest by volume, accounting for about one-third of all transactions. The price varies depending on each exchange's perceived "safety net." People can also transfer Bitcoins off an exchange, in private transactions. Once people obtain Bitcoins, they can store them in virtual wallets-existing in the cloud or on a desktop computer. Many argue desktop wallets are safer since they aren't vulnerable to online hacking.

Because of Bitcoin's well-publicized rise, many owners have opted to hold on to them as an investment, speculating on future gains. But Bitcoin is first and foremost a currency, and folks do use it to purchase goods and services. Where they can, that is-while a growing number of businesses do accept them, many larger, well-known businesses don't, despite the rise in point-of-sales services and mobile payment apps. So, what's the catch?

While it's technologically easy for businesses to accept Bitcoin-and cheaper, as Bitcoin allows merchants to bypass credit and debit card transaction fees-convenience and cost aren't everything. Businesses still have several reasons to be wary. For one, Bitcoin's exchange rate is über volatile. Last year, a single Bitcoin spiked from about $100 to more than $1,200, then dropped to about $600. It was back near $950 on January 30, but now it's between $130 and $577, depending on the exchange. As you can imagine, goods and services are nigh-on-impossible to price in Bitcoin-or, at least, to advertise in Bitcoin-denominated pricing.

Plus, businesses who accept Bitcoin as payment-and don't immediately convert it to dollars-face significant risk. Pretend you own a car lot and sell a hundred autos for 50 BTC each. These 5,000 BTC might rise, letting you get even more bang for your buck ... err, bit. But they could also tank, leaving you with slim profits-a loss, even-and precious little to invest. This makes long-term business planning a bit thorny. Can businesses rely on those BTC to pay for new employees and inventory six months from now? What about R&D? These questions are a large reason why most merchants who "accept" Bitcoin use programs that convert it to dollars first. In the end, it makes Bitcoin more useful as a cheap transaction mechanism-an alternate point-of-sale system.

Then, there is the little matter of hacking schemes. Bitcoins are stolen frequently, and those stolen Bitcoins are lost forever thanks to the system's irreversible transaction policy. An attack on Bitcoin Internet Payment System (BIPS), which offers free online wallets, cost users 1,295 BTC in 2013. Another hit online wallet service Inputs.io in 2013, costing users 4,100 BTC. A Chinese exchange, GBL, disappeared last October along with $4.1 million in Bitcoins, and a Czech exchange, Bitcash.cz, announced the theft of 4,000 Bitcoin wallets last November. And, in the biggest heist of all, Tokyo-based Bitcoin exchange Mt. Gox filed for bankruptcy last week after revealing the roughly 850,000 Bitcoins stored there-750,000 of which belonged to individuals-were stolen by hackers, causing losses of about $460 million. (No tough ironic twist considering Mt. Gox's original founder was Jed McCaleb, a known hacker himself.)

Partly as a result, many governments are warning citizens off it or just plain banning it, further limiting its effectiveness as an exchange mechanism. The US and UK remain flexible-the Department of Justice deemed it a "legal means of exchange" while the UK scrapped VAT on Bitcoin transactions-but lawmakers seemed keen on a crackdown in Mt. Gox's wake. The Commodity Futures Trading Commission (CFTC) is considering whether it can regulate Bitcoin exchanges with a US presence, and Japan is doing the same. China's central bank went even further, banning banks from transacting in Bitcoin-citing its use in money laundering. Russia and Vietnam banned Bitcoin outright, and France and Malaysia issued strong warnings. While warnings don't suddenly lead to regulation or bans, they illustrate the uncertainty facing the currency. Adherents today may prove to be early adopters of a wave of crypto-currencies or they may just be people who got caught up in a fad that never touches the mainstream much. (After all, Mt. Gox's name came from such a niche trading game-the name is an acronym for Magic: The Gathering Online Exchange.)

To get beyond the niche, lower volatility is crucial. Much of the volatility, it seems to me, is tied to two factors: lack of rate uniformity across exchanges (see Greenback Period, United States) and sheer lack of actual deep, liquid markets. As of December, 29% of Bitcoins in circulation were owned by 47 people. 51% by less than a thousand. Absent those folks buying or selling, the market is likely to be quite illiquid and volatile. Stability in a market requires depth, and Bitcoin has next to none. In this way, its unregulated ecosystem is a big drawback. Adherents love that the currency is free from central bank meddling and official price controls-it's a true market-based currency. But it also lacks a key plank supporting most viable currencies: deposit insurance. If you hold money in FDIC-insured bank, your hard-earned cash (at least the first $250,000) is protected from theft. Most developed economies have similar systems, which is what allows their currencies to be stable stores of value. The FDIC and SIPC can't insure Bitcoin deposits. Nor can any other national regulator. Bitcoin bigwigs could create an independent, privately funded insurer, but this seems a ways off (and isn't guaranteed).

With so much still up in the air-and so many security risks-for now, Bitcoin seems a long way from being a viable currency. Speculators with nerves of steel might stick with it as an ultra-volatile commodity-style investment, and some businesses might continue using it as a cheap point-of-sales mechanism, but there doesn't seem to be much reason to go about your daily business in the virtual currency.