#Bitcoin: The $1bn Virtual Economy

Dave Baxter investigates what the virtual independent currency has to offer in the modern economic climate.

bitcoin_casascius_holograph

Investors are cautiously watching virtual currency Bitcoin after it was hit by a round of dramatic spikes and falls in the same day.

There has been major fallout for existing currencies and commodities recently because of uncertainty in Europe, particularly in April, after Cyprus was plunged into economic turmoil.

This has brought big dividends for Bitcoin, as investors hunt for alternatives to traditional currencies and commodities. But its greatest high was both dramatic and fleeting.

The economic crisis in Cyprus has done a lot to shake investor confidence. The Cypriot economy was downgraded to junk status by international ratings agencies in March because of fears that the country’s banks were too exposed to Greek debt.

This made the country’s borrowing more expensive, with Cyprus needing a bailout from the European Commission, the European Central Bank and the International Monetary Fund.

Though it got the money – around €10 billion – Cyprus had to take aggressive measures to stop a run on its banks. They were closed for a number of days, and limits were placed on how much money account-holders could withdraw.

In Europe, this knocked confidence in currencies. Gold and silver – which usually act as havens for frightened investors – should have enjoyed highs, but Cyprus had sold its excess gold and other factors such as slowing production in China also made an impact. Because of this, both slumped in value.

Bitcoin then enjoyed the biggest high in its entire history. The digital currency spiked at $266 on April 10, though it fell down to $105 a few hours later, partly because of technical problems encountered by MtGox, one of the exchanges that trades it. By the end of that day Bitcoin’s value had risen back to about $130.

Two months earlier, a Bitcoin had been worth just $20.

But the currency is still prone to volatility. MtGox, one of the main exchanges selling Bitcoins, admitted that the April 10 fall was in part because increased demand caused its trade engine to freeze.

And as the currency enjoys a higher profile, MtGox and other Bitcoin-related exchanges have been targeted by attacks, causing concerns about the currency’s security and stability.

What is Bitcoin?

Bitcoin is a decentralised digital currency. This means that unlike conventional currencies like Sterling, it isn’t issued by a central bank and there is no central authority which oversees or controls it.

Instead, is it underpinned by a peer-to-peer computer network made of its users’ machines. This is similar to the networks underpinning systems such as chat service Skype and file-sharing system BitTorrent.

Bitcoins are generated by a complicated number-crunching procedure known as “mining”, which is done by the computers in the network. They can be sold or transferred, and are available to buy on some exchanges.

Where does it come from?

All people know is that Bitcoin was launched in 2009 by a person – or a group – with the pseudonym Satoshi Nakamoto. This figure has since disappeared.

As Bitcoin’s website states: “Towards the end of 2010 Satoshi left the project, saying he had moved on to other things.

“The creator of Bitcoin never revealed his identity and simply left his invention to the world.

“The origin and the motivation behind Bitcoin are still today a great source of mystery.”

Bitcoin doesn’t have official representatives as such, but in 2012 the Bitcoin Foundation was created to “standardise, protect and promote” the currency.

How do I get, and use, Bitcoin?

Bitcoins, or fractions of Bitcoins, can be traded for conventional currency on a number of currencies including MtGox. They can also be transferred online from one user of the Bitcoin network to another person using Bitcoin software.

A number of Bitcoin transactions are free, though some have small fees.

Bitcoin can also be used to pay for some internet services, such as online gambling, and its digital wallet, which can be downloaded to a smart phone, can be used to pay for a limited number of services.

On April 21, MtGox was taken down for around four hours by what it described in a release as a “strong” Distributed Denial of Service (DDoS) attack.

A few days earlier BitFloor, another exchange, had announced that it was stopping all trading operations indefinitely because of “circumstances outside of our control.”

And though the reason for the closure is unclear, BitFloor had been hacked in the past. In September last year, around $250,000 in Bitcoins was stolen after a hacker gained access to some of the BitFloor servers.

And Instawallet, a service for storing Bitcoins, suspended its activities in early April after being “fraudulently accessed.”

As Robert Courtneidge, global head of cards and payments at legal firm Locke Lord, says, Bitcoin may be growing in size and popularity but it remains unpredictable.

“There’s over $8 billion of Bitcoins, which is the size of the economy of a small country,” he says.

“But it’s still very volatile. If someone gambles on a horse race and it comes in at 100/1, the Bitcoins can alter in price before the bookie has paid out.

“It’s had issues with the DDoS attacks, and that has really hit its value.

“It has a completely anarchic life. But some would say that’s the point, and the appeal is that it’s not governed by any country.”

Michael Rolph, director of Anthemis Group, a company focusing on new developments in financial services, says security will be vital to Bitcoin’s future survival.

“Bitcoin’s interesting, but it all depends on how secure it is.

“If people don’t trust it because there’s been an attack on service it won’t work. So it’s hard to tell whether it will be here in the long term.”

At the same time, Bitcoin may have to deal with an increasing amount of regulation.

In America, government body the Financial Crimes Enforcement Network clarified the definitions around some of its regulations to include virtual currencies such as Bitcoin.

And in May, the Commodity Futures Trading Commission revealed that it was considering regulating it.

Courtneidge says: “In the US, you will be required to be a money service business and you will need your customer and terrorism and financial checks.

“But they can’t regulate Bitcoin per se, because that would add validation to the currency itself.”

For the time being, Bitcoin will continue to grow in popularity. MtGox claims it has already enjoyed a boost this year, with 60,000 new accounts opened in March, 75,000 more in just the first few days of April, and now around 20,000 new accounts opening every day.

With Bitcoin worth around $130 toward the end of May, things were looking steadier. But highs and lows could be on the horizon.