Bitcoin May Be The Currency Of The Future

Have you heard of Bitcoin? If you're a fan of the CBS legal drama The Good Wife, then you may have learned of it for the first time there. But if you're like most, you probably didn't know that Bitcoin existed or even what it is. You know of the dollar, the euro and the peso as ways to buy items and get paid for your service, but these fiat currencies as they are called may someday be replaced by a virtual currency that is only in digital form. So, how does it work? (To learn more, see Mobile Payments Could Replace Cash By 2016.)

See: An Introduction To Complementary Currencies

History
The mechanics behind digital currency appear complicated, but the major problem facing it is easy to understand. What would keep you from using it more than once? Assuming your digital currency was placed in your digital wallet, why couldn't you send it out to multiple people at the same time? With traditional currency, there is a physical exchange and unless you have exceptional resources that allow you to counterfeit, you can only use it once until you earn it back.

Because of that, digital currency has to be encrypted and just like with a credit card, there has to be some kind of clearing facility that keeps track of when a currency is used and who owns it. The early digital currencies were based around this idea, but having one central place seemed like a recipe for corruption to the creators. So they made the clearing house a process that happened on computers all over the world instead of just one place.

They also didn't want the value of the currency to be controlled by a central bank, the way traditional currencies are controlled. The bitcoin system releases a set amount on a certain schedule. In order to earn bitcoins, they have to be mined, much like gold but in a digital format. A complicated cryptographic puzzle has to be solved in order to activate the bitcoin, and the first person to solve it was the successful miner of the bitcoin block and now owns it.

Bitcoins started with pennies in value in April of 2010, but quickly rose thereafter. As the value rose, more bitcoin miners set up powerful systems to unlock the new bitcoin codes. As bitcoins gained popularity in 2011 the price rose beyond parity, and after Forbes ran a piece describing bitcoins, the exchange rate hit a peak of $29.57 to purchase one bitcoin. People who had held bitcoins from the beginning were millionaires in less than one year.

The Problems
As bitcoins rose in popularity, problems developed. This was not a mainstream currency with mainstream businesses adopting it. Who would want to accept payment in a currency without a guaranteed value? Next, people without advanced computer skills weren't interested in the hassle of mining or digital wallets, so the system has never reached beyond a relatively small amount of technologically savvy group of people.

Then, a series of online attacks sent the currency plummeting in value. Bitcoins were stolen from exchanges and in one instance, hundreds of thousands of dollars' worth of bitcoins were mistakenly deleted. The current value sits around $6, but with demand faltering and less merchants excited about this 21st century currency, some believe that bitcoins may have a shorter life than previously thought.

One of the ideas behind digital currency is to remove the market effects of traditional currency, but quite the opposite happened. As the popularity rose, currency speculators were able to manipulate the price making this currency even more volatile than commodities like gold and silver, and much more volatile than the dollar. (To learn more, see Volatility's Impact On Market Returns.)

There's also the problem of trustworthiness. Although traditional or fiat currencies may not be based on an underlying asset like gold, they have an implied value due to their universal adoption. Bitcoins aren't backed by a hard asset or a large government, so there is no guarantee that bitcoins will hold any value in the future.

The Bottom Line
Those who try to develop digital currency will face many of the same problems that have plagued paper currencies for generations. Because currency is not only a means to buy and sell but also an investment product, the currency may have to be regulated in some form. Although popular venture capitalist Fred Wilson believes that a digital currency not controlled by governments will make a large scale emergence in his lifetime, he still isn't sure if that's a good thing or not.