Recently, the value of bitcoin jumped to more than $7,500, up significantly from its value of $700 in November 2016. While bitcoin has been out for a number of years now, it and other cryptocurrencies have only recently gained greater awareness in people’s minds. This leaves many to wonder: what are bitcoins, why are they so valuable and what can you do with them?
Bitcoin is a decentralized currency that was launched in 2009. Bitcoin was also the first cryptocurrency to gain global acceptance. It allows users to send payments to one another similarly to other payment platforms. However, it differs in a few key ways. Bitcoin is completely open in that it has no association with any financial institution or government and therefore is outside regulatory control. In addition to being a payment system, bitcoin is also a currency. But, because it is not affiliated with any country’s economy, it is not backed by a central bank. Instead, a network of peer-to-peer computer networks underpins bitcoin, similar to how Skype, the audio/visual chat service, works.
The fact that bitcoin isn’t backed by any economy, central bank or tied to a physical representation of value, like gold, leads many to wonder why anyone would use it as a currency. The value of bitcoin though lies in how it is mathematically generated or “mined.” Every day, hundreds of computers attempt to solve a computational puzzle requiring an extreme amount of computer power. Once a bitcoin miner solves the puzzle, it adds a block to a blockchain.
The validity of a bitcoin is in the logic required to generate its blockchain. This blockchain acts like a public ledger in that each transaction is produced from an algorithm that leaves a “hash” (representing a large amount of data in a numerical representation) virtually impossible to counterfeit. These hashes are then downloaded with the currency and validate the transaction. This is similar to how bank transactions are recorded using traditional payment systems like ACH or Fedwire.
Blockchain transactions act as records in a ledger that appear in chronological order just like a bank statement. Each block becomes progressively more difficult to mine over time, capping the number of bitcoins in circulation to around 21 million units. This makes the currency’s value based on scarcity rather than the financial backing of an issuer.
The ease of use and anonymity of bitcoin are also factors in its current value. A limitation to using bitcoin is its fungibility, meaning one bitcoin doesn’t necessarily translate into something equal to one bitcoin in value. For example, one ounce of gold still retains its value, no matter what form it is in. However, this issue is being addressed by the growing number of merchants that accept bitcoin, as well as by some international banks that will convert bitcoins into hard currency, such as dollars or euros.
To date, almost 100 merchants and servicers accept bitcoin, including Overstock.com, Microsoft, Expedia.com, Dell, Whole Foods, Bloomberg.com, and Dish Network. Small businesses as well can take bitcoin using QR codes. A user simply scans a label with a smartphone and a bitcoin wallet app, and then sends the payment directly to the retailer. Bitcoins are also notoriously used in many illicit transactions, with the most well-known being ransomware. It’s popular with criminals and other actors mainly because it is accepted currency by an increasing number of retailers and some international banks. Additionally, the ownership of bitcoin can be concealed using what are called mixers and tumblers. Many criminals attempt to use these processes to launder money or hide their location.
A bitcoin mixer combines your coins with the coins of others. Everyone simply sends their coins to a central address, and then the mixer sends a transaction back to each user from the key controlling the central address. When stolen coins mix with “clean” coins, they become difficult to track.
Coin tumblers swap coins between users. A tumbler will mix coins, and then send transactions with various amounts to keys it controls, attempting to simulate other network transactions. Sending a bitcoin to a tumbler may result in you receiving multiple, smaller transactions in return over a short time. The bitcoins returned to you will have been combined, split and transacted many, many times.
Despite their appeal to the criminal underworld and other issues, bitcoin and similar cryptocurrencies—some 1,150 are tracked globally and include such names as Ethereum, Monero and OmiseGO, among others—are new forms of payment that are slowly, but surely, playing a greater role in global finance and commerce.
Cryptocurrencies are mysterious and controversial. However, bitcoin and other cryptocurrencies are also here to stay, and the financial services sector will need to monitor their use and development. It is not outside the realm of possibility that your credit union will see bitcoins or other cryptocurrencies very soon, if you haven’t already.