While bitcoin usage could increase, be wary of the risks

“Bitcoin value hits a life-time high,”; “bitcoins are now more expensive than gold,”; “Winklevoss twins make a bid for an exchange-traded fund based on bitcoin.” Headlines such as these are making everyone sit up and take notice of the virtual currency that had faded into the oblivion two years ago.

Similar frenzy and excitement had prevailed in 2013 and 2014, followed by revelation of a series of scams and nefarious activities involving these currencies. Value of bitcoins had then crashed; bitcoin exchanges closed down and investors had forgotten about them.

Not much has changed with respect to the fundamentals of bitcoins over the last three years. They continue to remain highly unsuitable, both as a medium of exchange and as a store of value. Last week, bitcoins were in the news on hopes that the Winklevoss twins, who claim ownership of Facebook, will be able to list an exchange-traded fund (ETF) based on bitcoins. But the US Securities and Exchange Commission scotched these hopes firmly.

While bitcoin usage could increase in the years ahead, they carry multiple risks that investors need to be aware of.

Bitcoin basics

For those who joined the party late, bitcoins are virtual currencies created in 2008 by an anonymous person calling himself Satoshi Nakamoto.

He created a system wherein these currencies could be created (mined) by those who could solve some complex algorithmic equations.

Those who mined the currency also help maintain the open ledger or the block-chain. Every bitcoin transaction is recorded and verified in this ledger, thus preventing counterfeiting or double spending. The miners confirming the transactions are, in turn, rewarded with more bitcoins.

Using bitcoins is simple, if you are tech savvy. You have to first acquire a bitcoin wallet through one of the sites buying and selling bitcoins. Then you have to transfer funds from your bank to the wallet which can then be used to buy bitcoins. The bitcoins can be stored in the wallets, on your desk-top or mobile, or in the cloud until put to use.

Bitcoins can be used to buy products and services from various websites including Microsoft and Dell. The French e-commerce company allows you to buy clothes, fashion accessories and homeware with bitcoins. Air tickets can be booked on websites of Air Baltic and Air Lituanica, and CheapAir. Many gift cards can be purchased with bitcoins that can, in turn, be used on online retail stores such as Amazon, Walmart and Target.

So far so good. But if you thought that bitcoin is a substitute for your normal currency, think again.

Faulty price discovery

Bitcoin prices are discovered through trading that takes place in bitcoin exchanges that are spread across the world. Most of these exchanges are unregulated with very lax KYC compliance process. Wash trades, front-running and trading with insufficient funds is said to be common in many of these exchanges.

According to the website, Japanese exchange, coincheck, clocked the highest volume in the last 30 days, accounting for 25 per cent of global bitcoin transactions. Kraken exchange that operates in Canada, EU, Japan and the US and okcoin that is based in China are next in the list of top exchanges by transaction volume. The largest US bitcoin exchange, bitstamp, accounted for just 14 per cent of global volume.

In other words, the value of bitcoin is determined largely by unregulated pools of investors.

Lack of regulation

The biggest selling point for virtual currencies is that they are not regulated by anyone. The speed of money transfer and the lower cost of transaction are mainly because there is no supervising authority.

But with no regulator taking on the responsibility of overseeing the trading on bitcoin exchanges, instances of price manipulation are common. There is no central authority giving the rights to set up or trade on the bitcoin exchanges either.

Regulators, including the Reserve Bank of India, have issued cautionary notices to users, highlighting the risks they take in dealing with these currencies.

This causes a problem for bitcoin users too. If the user suffers a loss due to an exchange or the dealer deducting unfair transaction charges, he has no one to complain to. If the bitcoin wallet is hacked into or some bitcoins are lost, there is again no recompense.

This lack of regulation had resulted in websites dealing in narcotics and arms smuggling using bitcoins in the past.

Price volatility

If you thought that bitcoins could become a store of value, then the sharp price volatility seen in this currency is a deterrent to such aspirations. Check this out.

One bitcoin could be purchased for $5 in 2011. Between February and November 2013, the exchange rate rose from $20 to $1,000. By early 2015, the rate was at $200. In recent times too, volatility has been acute. On January 4, the high was $1,140. But a week later, prices were down more than 30 per cent.

The main reason for this volatility is that there is no underlying to which the value of the bitcoin can be pegged. Its price is based just on the demand and supply in numerous unregulated exchanges around the world.

The trading volume is quite shallow too. It’s reported that 50 per cent of the bitcoins is held by less than 1,000 people. Hoarding of bitcoins is also quite rampant.

Another problem is that only 21 million bitcoins can be mined in all. Over two-third is reported to be mined already.

As the number of bitcoins mined reaches the upper limit, the value is expected to shoot through the roof. Vendors facilitating transactions through this currency will then stand to lose.

The block-chain revolution

While it is best to be wary about bitcoins, the technology on which they are based — block-chains — is likely to grow popular in the days to come.

An open ledger where users enter information, verified by a set of people, can greatly increase transparency and cut down back-office costs. It’s already being put to use in the financial services industry and could grow in popularity in the days to come.

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