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Is Bitcoin Right for You?

Oct. 9, 2014
Personal Finance
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Bitcoin, the trendy digital currency, garnered some negative press in August when the U.S. Consumer Financial Protection Bureau warned about its potential pitfalls, like unpredictable exchange rates, hackers and scams.

Despite these concerns, the consumer bureau was quick to add that virtual currencies like bitcoin “offer the potential for innovation,” something that has captured the attention of casual consumers and big hedge funds alike.

Before dipping your toes into bitcoin’s often choppy waters, you should know that this particular form of digital money represents quite a double-edged sword. While some financial experts question its viability and safety, others are adamant that bitcoin is here to stay.

Here’s a look at how this disruptive technology works and what you risk losing – or stand to gain – by using it.

What is Bitcoin?

Although the system and software used to create and support the digital money is called Bitcoin, a unit of the currency is a bitcoin. If you’ve heard of bitcoins but haven’t actually seen any, it’s because the currency exists exclusively online. Some enterprises and individuals “mine” bitcoins using sophisticated computers to wring them out of a digital file called the blockchain. The process is complex and expensive, and there are easier ways to obtain the scrip. The system used to create bitcoins also caps the number that can exist at just under 21 million, easing inflation concerns among users and investors.

You can stash bitcoins away in a digital wallet before transferring a sum directly to another user or to a merchant that accepts them. Due to the lack of a middleman like a bank, transaction fees are typically much lower, which is among the online scrip’s most attractive features.

People interested in converting cash to bitcoins can do so on Bitcoin exchanges, where they can buy the virtual currency. Despite being relatively new, the number of exchanges is growing rapidly. Entire websites have made it their mission to direct users to the safest and most reliable online exchanges.

As straightforward and user-friendly as this currency might sound, it has several notable drawbacks.

Opinion: Why I Use Bitcoin

Bitcoin’s unpredictability

“The value of a bitcoin can fluctuate extraordinarily due to high volatility,” says Evan Hutchinson, a business consultant in Ames, Iowa. “Also, due to the large number of exchanges in the world with relatively little oversight, bitcoins are at risk of being lost or stolen.”

Volatility depicts how much the value of an asset changes over time. When looking at a Bitcoin price chart, you might think you’re looking at a seismogram from a strong earthquake. This virtual currency has been known to lose as much as 80 percent of its value in a matter of days, only to spring back quickly. For people who make purchases with the digital money, checkout time can be a shocking experience.

“Those who choose to use Bitcoin with little understanding of how the currency actually works can be in for a big surprise when they try and exchange the money back into local currency or use it to buy a product,” Hutchinson says. A 2014 Federal Reserve Bank of Boston study cites the “extreme volatility of Bitcoin’s price,” which creates significant exchange-rate risk.

While the fluctuating value of Bitcoin has scared many people away, optimistic investors cling to the idea that the digital money will ultimately find its footing. Their hope is that the technology behind Bitcoin will be fortified, making it safer to own and use, ultimately broadening its user base and improving its stability and long-term viability.

“While reasons differ, I find many early adopters use Bitcoin because they believe in the revolutionary nature of the underlying technology that makes Bitcoin possible,” says Scott Nichols, founder of Paybits, a Las Vegas-based company that helps people convert a portion of their income directly to Bitcoin.

The ease of making transactions is another draw for Bitcoin believers.

“What other currency can you send money so quickly and cheaply over the Internet and across borders?” asks Michael Flaxman, an avid Bitcoin user and co-founder of CoinSafe, a Seattle-based online service that helps merchants buy and sell bitcoins.

Indeed, while you might have to pay upwards of $45 every time you send money overseas using a traditional bank’s wire service, many Bitcoin exchanges offer similar transfers at a much lower cost, and direct transactions can be virtually free.

Flaxman isn’t alone in his enthusiasm: It’s estimated that over 5 million people currently use Bitcoin, up from about 765,000 only a year ago, according to Reuters.

Drawing the wrong crowd

Unfortunately, a fraction of those users engage in criminal transactions, and some may be intent on stealing bitcoins. Just last year, the world’s then-largest exchange for the virtual currency, Tokyo-based Mt. Gox, collapsed after hundreds of thousands of bitcoins went missing, sticking customers with millions in losses.

Despite the relentless hype surrounding the “revolutionary nature” of Bitcoin’s technology, it is still a very vulnerable system. Because you can exchange bitcoins relatively anonymously, the digital currency has attracted hackers who prey on exchanges that store large bitcoin reserves. It has been popular among those engaged in illicit commerce, too – transactions on the shuttered online black market Silk Road took place exclusively with Bitcoin.

Although records of every transaction using Bitcoin are permanently stored on a shared public transaction register, it’s difficult to track down Bitcoin thieves. The lack of government support certainly doesn’t help.

A lack of oversight

Because Bitcoin isn’t backed by the U.S. government or any of the world’s central banks, it’s lightly regulated, if at all. What’s more, any bitcoins you store in a digital wallet are uninsured, meaning you’ll probably eat any losses, regardless of how they occur.

Interestingly enough, the risks and lack of government backing haven’t scared off everyone. According to Nichols, Bitcoin’s independence may be one its biggest draws.

“The exact warning from CFPB that Bitcoin is not backed by a central government is exactly the reason many use Bitcoin today,” Nichols says, referring to the U.S. consumer agency.

While the lack of official oversight attracts users eager to make transactions outside of the regulatory eye, many are reluctant to embrace this new technology.

The bottom line: As with any decision involving your hard-earned dollars, you should think long and hard about the risks that come with an erratic online currency like Bitcoin. In the end, any gains may be vastly outweighed by the pain of losses.