Is it Time to Buy Bitcoins?

Last month, the Department of Homeland Security seized bank accounts belonging to Mt. Gox, the world’s largest Bitcoin exchange.

The crime? Japan-based Mt. Gox and its U.S. subsidiary had failed to register with the Federal government as a currency exchanger or money transmitter, as required by U.S. law. Mt. Gox’s website, which allows users to exchange dollars and other currency for Bitcoins and vice versa, is still up and running, although many U.S.-based users now have trouble sending dollars to and from the site (because Mt. Gox’s account with a service customers used for those transactions has been seized).

It seems pretty clear to me that Mt. Gox was in the wrong here, and that the Feds were simply trying to enforce the law, not target or weaken Bitcoin. But, the incident does underline the immaturity of many elements of the Bitcoin system.

For those who are unfamiliar, here’s how I described Bitcoins when I first wrote about them in my Investment of the Week e-letter in July 2011: “Bitcoins are an unregulated, digital currency.

“What’s attractive to many of the currency’s users and investors is its decentralization: Bitcoins are not issued, governed, regulated or authorized by any central authority.

“Instead, the currency system works as an online peer-to-peer network, with the peers being everyone who uses Bitcoins. Tasks that would normally be performed by a central bank are either distributed among the network or managed by set algorithms.”

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At the time, one of our Investment Digest contributors had just recommended buying Bitcoins as a defensive holding, alongside cash, gold and silver, so I took a look at them as an investment. I concluded that you might buy a few as a speculation, but that the market was still immature, and recommended “keeping your retirement savings denominated in a currency with a slightly longer—and less volatile—history for now.”

I also wrote: “Thanks to their rapidly growing popularity and awareness, Bitcoins have appreciated in value by about 200,000% in the past year alone. A year ago, you could buy a Bitcoin on one of the online Bitcoin exchanges (Mt. Gox and TradeHill are the big ones) for about $0.06. Today, Bitcoins trade hands for somewhere between $16 and $17.”

And today, almost two years later, one Bitcoin is worth about $120! That’s an excellent return.

But, I’m sticking by everything I wrote two years ago. Here’s a chart of Bitcoin’s ascent from $17 to $120:

Bitcoins chart

The huge spike in interest this spring was prompted by the idea that Cyprus might levy a one-time tax on domestic bank accounts. Bitcoin-to-dollar exchange rates soared as high as $230 per Bitcoin as fears about the integrity of fiat currencies swirled.

A few speculators probably did quite well for themselves. But, as a “safer” alternative to national currencies, I still don’t think Bitcoin is ready for prime time (if it will ever be).

Because while it’s true that Bitcoin is free from manipulation by governments and central banks, a digital-only cryptocurrency comes with its own drawbacks.

The most obvious challenge—and so far the biggest bugaboo for Bitcoin—is ensuring the security of the system for buying, selling, converting, spending and storing the currency. In addition to its trouble with regulators last week, Mt. Gox—where 60% to 80% of Bitcoins change hands—experienced a serious security breach in June 2011, in which usernames, email addresses and encoded passwords were leaked, and fraudulent trading temporarily drove the value of a Bitcoin down to one cent.

Also in 2011, a Poland-based Bitcoin exchange lost access to its own Bitcoin “wallet,” making all its funds inaccessible. In March 2012, a security breach at the web host Linode led to the theft of around 50,000 Bitcoins.

And one of the most vulnerable pieces of the Bitcoin infrastructure, so far, has proven to be Bitcoin “wallet” services that store unique strings of code proving which Bitcoins you own. This information has to be stored somewhere, whether in a file on your computer, on a physical piece of paper in your home safe, or on the system of a third-party wallet service. The latter option most resembles the bank accounts we’re familiar with, but unfortunately many wallet service providers have been plagued with security issues.

In the latest incident, just last month, a wallet service called Instawallet shut down, saying its “database was fraudulently accessed.” The company is taking claims from wallet account holders and says it will refund balances under 50 Bitcoins. In another memorable event, a company called MyBitcoin abruptly became inaccessible in July 2011 and either lost or absconded with the majority of its users’ deposits.

Bitcoin proponents point out that all of these incidents were related to, and the fault of, third-party companies built up around the Bitcoin system. For comparison, it’s like if several banks failed and the New York Stock Exchange faced a “flash crash,” security breach and Federal investigation. None of those incidents mean the dollar is an inherently unsafe place to store your wealth.

But, at the same time, having reliable, secure systems for spending and storing our dollars is an integral part of what makes the currency function. It might not be Bitcoin’s fault that the system built around it has security issues, but it still makes it harder to use and trust the currency.

Plus, there’s the exchange rate, which is still quite volatile.

At this point, I think of Bitcoins more like a speculative but high-potential small-cap stock than an alternative store of value. I might buy a few if the price drops to the low double digits again—in fact, one of our Digest contributors, Unconventional Wealth Editor Aaron Gentzler, recently wrote:

“I view Bitcoins as a responsible speculation at $30. This means, at that price, you might choose to buy with $500 or so. You get great upside with tightly limited downside. At $31-$50, I see it as a ‘lottery ticket’ speculation. This means, in that price range, you might choose to buy with $500 you’re prepared to never see again.”

I think his risk assessment is pretty sound, but would mention one final factor: in the years since the introduction of Bitcoin, numerous alternative cryptocurrencies have been introduced, some tied to Bitcoin, some wholly independent. So while I suspect decentralized digital currency is here to stay (in some capacity), Bitcoin may not turn out to be the winner in the end. Even if you manage not to lose your Bitcoins to a sham wallet service or security breach, there is a chance the currency may become worthless.

Nevertheless, I think the digital currency revolution is firmly here, and look forward to seeing where it takes us. And watching the industry mature will only be more interesting with a few Bitcoins riding on the outcome.


Timothy Lutts

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