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Bitcoin: The Digital Currency

Bitcoin is a form of digital currency.  Created in 2009, it is the first example of a category of money or store of value referred to as cryptocurrency.

A software developer using the name Satoshi Takemoto devised bitcoin as an electronic payment system.  The idea was to create a currency independent of any central authority.  Unlike conventional currencies, bitcoin is unique in that it is decentralised.  No government or central banks controls the bitcoin network.

There are only 21 million bitcoins in existence.  However, these coins can be divided into smaller units.  The smallest unit is one hundred millionth of a bitcoin and this is referred to as a “satoshi”.  You buy bitcoins either through cryptocurrency exchanges or directly from others via bitcoin marketplaces.  Coinbase is regarded as the world’s best known exchange.  Be aware the exchanges do not offer the same capital protection as banks.

Bitcoin works on a peer-to-peer system.  Transactions can take place between users directly, without an intermediary.  These transactions are verified by computer network nodes and recorded in a public distributed ledger called a “blockchain”.  The transactions are verified and recorded by a network of nodes (or databases) on the internet.  Because each node stores its own copy, there is no need for a trusted central authority (bank).

Designated to work as a currency, bitcoin is touted as a low-cost medium of exchange with international currency transfers costing a fraction of what, say, a bank may charge.

To buy bitcoins – or units of bitcoin you do not need to buy a “whole coin” – you must first establish a bitcoin “wallet”.  As there is no physical currency, the value  is stored electronically.  The process of establishing a wallet in Australia is akin to opening a bank account and subject to conventional banking requirements verifying identity and the source of funds.  The ATO has stated that profits derived from bitcoin transactions are taxable.

Over the last five years, the price of bitcoin has soared from $US12 to over $US14000.  Since I last wrote on this subject in July 2017, valuations have surged six times.  Bitcoin enthusiasts see it as the currency of the future.  An alternative view is that it is just another example of a bubble in an investment market.

The recent volatility in the value of cryptocurrencies is a warning.  Here are a few reasons you should be very wary of bitcoin and cryptocurrencies.  The primary function of any currency, crypto or otherwise, is to be a reliable store of value to execute trade.  Cryptocurrencies are far from being a reliable store of value.  The market has had numerous 20 per cent–plus setbacks un value, meaning huge losses if someone transfers funds into bitcoin for a transaction, say to trade an asset, but it collapses in value before the transaction is completed.

Bitcoin produces no income or yield, it’s impossible to value and, unlike gold, it’s intangible.  The price could go to $100,000 but could fall to $10.  China has already moved quickly on this front.

I admit I personally struggle to fully understand how it works and one important lesson from the “dotcom” era and the global financial crisis is, if you don’t understand what you are investing in, you shouldn’t invest.

Even if you do understand how bitcoin works, the cryptocurrency market exhibits all the hallmarks of a classic speculative bubble.  I seriously doubt most investors are buying bitcoin for it’s primary function, currency exchange, but rather to speculate.

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