Bitcoin users came to the stark realization that their digital savings were at risk when Mt. Gox, a prominent Bitcoin exchange platform, froze customer withdrawals on Feb. 7 because it received fraudulent requests for payments. Mt. Gox promptly released a statement blaming the Bitcoin software for the incident. The next day, another Bitcoin exchange was hacked, forcing the Bitcoin community to question the security of their savings. Bitcoin has been at the center of government scrutiny not only for its security issues, but also for its pseudonymity that facilitates underground markets. The risky nature of Bitcoin has made its exchange rates highly volatile. It should therefore be viewed as a financial asset, not a stable currency.
Bitcoin is unique because it is a peer-to-peer digital currency, which means that it does not require a third-party intermediary and is not owned by any company. Most Internet transactions involve a third party that controls the increase in one account and a corresponding decrease in another account. Without the intermediary, a user could duplicate electronic cash, a problem known as double spending. Bitcoin avoids double spending by using public key cryptography, meaning every user has a public key and a private key. Users validate the transactions using their private keys and each transaction is recorded on public domain using the public keys.
The growth in Bitcoin led to the creation of several online exchange platforms that allow users to exchange bitcoin for a variety of currencies. The first bitcoin was only worth a few cents and now one bitcoin is valued at roughly $558. However, these exchanges have faced crippling technological problems over the past several years. Mt. Gox’s recent fraud issue only highlights Bitcoin’s poor track record. Last year, the exchange stopped withdrawals because it could not handle a high volume and faced legal issues with its registration in the United States. Since governments do not regulate Bitcoin, it falls to a handful of exchanges with limited resources to prevent fraud. This fundamental problem with unregulated currencies creates risk.
Another risk with Bitcoin is that their demand is partially derived from black markets. Because only public keys are recorded, not individual identities, bitcoin are commonly used to exchange drugs, weapons and other illegal items on the Internet. However, if authorities ever manage to take down these illegal online marketplaces, bitcoin can lose value. One such example involved the Silk Road, an online marketplace that used Bitcoin to handle its drug trades. It was estimated that somewhere between five to nine percent of all bitcoins used were for drugs from Silk Road. The U.S. government eventually took down the Silk Road, which decreased demand for the currency.
Even though Bitcoin has opened up new possibilities for online exchange, it has serious obstacles to overcome before it is stable. The past few years have shown that bitcoin do not have a strong central authority to effectively stop fraud and that their demand is partially derived from illegal markets. These factors make Bitcoin an investment characterized by wild price fluctuations. The price volatility of Bitcoin is far too high to ever consider it as a store of value or unit of account, which is an integral functions of any currency. Investors should handle Bitcoin with precaution, not blind faith.
Adam Fazlibegu is a staff columnist. Adam’s Angle is published every Thursday. Email him at [email protected].