Observations: Can Bitcoin Break Out?

November 12, 2013

Techies around the world were all atwitter last week—not just about Twitter's initial public offering, but also about a new record value of $395 for the digital currency bitcoin.

Bitcoin prices have spiked before. Earlier this year, the virtual currency hit a high of $230 after bank depositors in Cyprus were hit with taxes to bail out failing banks before crashing to $50. With one prominent blogger predicting last week that the value of a bitcoin could hit $1 million, the frenzy is starting to look like a modern-day tulip mania.

It's too soon to tell if the bitcoin is a passing technological fancy or could one day become a viable currency. So far the cyberscrip, which changes hands with no names attached, has been popular with techies, libertarians, and underworld types looking to elude governments.

Open-source sensation

Fueled by the cooperative spirit of the open-source computer movement, bitcoins took off after the 2008 financial crisis. The currency's creator, who uses the pseudonym Satoshi Nakamoto, envisioned a means of exchange immune to the political or economic fortunes of any single country.

Bitcoins are backed neither by hard assets nor by governmental promises, like most conventional currencies. Buyers of bitcoins join a virtual network that collectively monitors itself. Each time a bitcoin is bought or sold, the transaction is added to a universal ledger, creating an audit trail visible to those on the network.

Here's the part techies love: Before a transaction can be recorded, a difficult math problem must be solved that requires pricey supercomputing time. The first programmer (a "miner" in bitcoin parlance) to answer the tricky question, which is essential to the validation process, broadcasts it to the other network members, who in turn verify it and post the bitcoin transaction. The winning team receives new bitcoins as a reward.

Monetary home brewing

However, this laborious, time-consuming process of confirming bitcoin's anonymous transactions—the ledger updates every 10 minutes—makes it unlikely that the virtual currency will ever be more than the monetary equivalent of home brewing: a niche hobby with limited mass appeal.

Currently, about 11.8 million bitcoin units exist in the virtual world, with a total value of $4.6 billion at the current dollar exchange rate. Trades take place online, and bitcoins are also accepted as payment by some online businesses such as the U.S. dating site OKCupid and the Chinese search engine Baidu.

Some adherents of the libertarian economic school see bitcoin as a realization of the belief that money can and should be managed by the private sector, rather than by governments as it is almost universally today. Most mainstream economists disagree: Chicago Fed economist François Velde recently called the bitcoin network an "automaton" that can't offer the stable store of value necessary for any successful currency.

China showing support

There's no doubt that bitcoin values are volatile, and thus ill-suited for ordinary commerce. Last week's spike in bitcoin prices is the latest twist in a lurid international tale featuring dealers in a range of black-market goods from drugs to body parts, with the FBI in pursuit.

Supporting players include the Chinese government, which has been promoting the digital currency on state-run TV. China renewed calls during last month's debt-ceiling standoff in Washington for nations to dethrone the dollar as the world's leading reserve currency. Bitcoin is hardly ready for reserve-currency status, but the Chinese support is telling.

The bitcoin thriller also includes a cameo appearance by Cameron and Tyler Winklevoss, famous as early investors in Facebook. The Winklevoss twins hold a bitcoin stake now worth about $46 million and have filed with the U.S. government to set up an exchange to trade the virtual currency. Cameron Winklevoss told a conference in New York Tuesday that he sees the capitalization of bitcoin hitting $400 billion.

Regulation looms

The most successful bitcoin exchange to date is called Mt. Gox, based in Japan. But Mt. Gox ran afoul of U.S. authorities for transmitting money without a license and had $5 million of its assets seized earlier this year. That forced Mt. Gox to temporarily suspend U.S. dollar withdrawals this summer, providing an opening for other bitcoin exchanges. Mt. Gox has since filed with the U.S. Treasury to formally become a currency exchange.

Regulatory issues aren't the only obstacle confronting bitcoin. Researchers at Cornell last week outlined a doomsday scenario under which a small group of programmers could take over the network and manipulate transactions to their own benefit. The researchers proposed a number of changes to bitcoin's operations to prevent such a takeover.

Even if those reforms aren't adopted, governments may force change. Last week's runup in the value of bitcoin was accompanied by reports from regional Fed banks predicting the cyberscrip will soon face increasing regulatory supervision. The U.S. Senate has also begun to ask how the government oversees virtual currencies.

This summer, Fed Chairwoman-designate Janet Yellen told a conference in Shanghai that bitcoin is subject to the same U.S. regulations as PayPal and other online payment systems. She may elaborate further during her Senate confirmation hearings Thursday.

Monica Gagnier is an Economics Writer at Moody's Analytics.

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