Making Heads or Tails of Bitcoin

NEW YORK ( Real Money) --The digital currency revolution is here -- maybe. The seemingly overnight rise of bitcoin has spread across the Internet faster than the Harlem Shake or videos of cats playing the piano. Unlike these fleeting Internet memes, bitcoin may herald a new era in currency exchange, though some may wonder if it is just a scam.

Nobody knows for sure who created bitcoin. It consists of a digital string of numbers and letters earned by bitcoin "miners" in cyberspace on peer-to-peer servers. Its circulation is limited to 21 million units by way of open-source code; if circulation increases beyond 21 million, everyone will know. It isn't regulated and it isn't associated with any country. Some would say that is a problem, while others would argue that that is the point.

So, is bitcoin a scam? Possibly, but there is no unequivocal proof. And even if proof of a scam should emerge, it will already be too late for holders to get out. Does bitcoin have value? That's for the market to decide. Bitcoin is accepted as payment at some locations, therefore, it has value -- at least for now. Its future value, if any, is unknown.

Legit or not, bitcoin has several serious drawbacks to consider:
  • That 21-million-unit hard limit on circulation may sound fine, but bitcoin can be hacked and its parameters changed. You'd know about it, but that knowledge wouldn't prevent a loss. Even if bitcoin circulation remains within its current parameters, the potential supply of virtual currency is unlimited.
  • Its creator or creators may decide they no longer wish to adhere to previously stated policies. They are bound by no law or regulation. Either way, you'd be out of luck.
  • Bitcoin's biggest problem could be competition: If the concept proves successful, an unlimited number of knockoffs could appear. There is already a competing virtual currency called Ripple.

Though bitcoin is considered a joke by some, what it represents is not. It's a radical attempt at control in what is increasingly an out-of-control economic world. We accept the idea of central banks dumping billions into world economies on a daily basis; is that not a radical concept as well? For centuries, a virtual currency has been a response to economic policies that rendered real currencies valueless. This is just a partial list of currencies that abruptly lost their value:
  • Bolivian peso, 1985
  • Nicaraguan cordoba, 1987
  • Yugoslavian dinar, 1992
  • Russian ruble, 1992
  • Bosnian dinar, 1993
  • Brazilian cruzeiro, 1994
  • Zimbabwe dollar, 2008

It's doubtful that any of these countries intentionally wrecked their own currencies; just as liquidity can be added, it can also be withdrawn. Obviously, this is not as easy as it sounds, as has been proven by so many currency failures.

Can bitcoin even be considered a currency? That's debatable, but many of the reasons given why bitcoin is not a currency are actually invalid. First, let's blow up a few currency myths.

Myth: A currency is, by necessity, regulated by a central bank

Fact: For much of its history, the U.S. dollar wasn't regulated by a central bank. The first greenback rolled off the press in 1862; there was no central bank in the U.S. from 1836 to 1913.

Myth: A currency possesses intrinsic value because a government declares that it does.

Fact: If this were true, currencies would never collapse. For example, the Zimbabwe dollar has virtually no intrinsic value. If the Zimbabwe government could create value by decree, I'm sure they would.

To bitcoin supporters, let me say this: I get it. When respected economists back ludicrous concepts like the trillion-dollar coin, it's a warning sign. When Europe decides it's OK to raid Cyprus' savings accounts, it's time to hide your money. Unfortunately, bitcoin is the wrong place to hide.

I wouldn't invest in bitcoin. That doesn't mean that it won't rise in price; I just don't like the risks. Bitcoin trades like an illiquid tech stock, and while its opponents are celebrating its recent sharp decline, it is still trading considerably higher than it has been for most of its existence. Eventually, a virtually currency may indeed become a safe and legitimate currency -- but not yet. Bitcoin is merely a first attempt, but those who hold it must understand that they are guinea pigs in a grand experiment.

The Internet has revolutionized every facet of our lives: email replaced "snail" mail, and digital cameras killed the Polaroid. In both cases, a string of ones and zeros replaced paper. So is it any more outrageous to suggest that the Internet will also change the way we use currency? I don't think so, but that day hasn't yet arrived -- and bitcoin isn't the answer.
Ed Ponsi is the managing director of Barchetta Capital Management, an NFA-registered commodity trading advisory, and is also the president of FXEducator. An experienced professional trader, Ponsi has advised a variety of hedge funds and institutional traders. Ponsi has appeared on CNBC more than 50 times and has been profiled in magazines such as "Technical Analysis of Stocks and Commodities" and "The Traders Journal." He is the author of Selling America Short: The New World Order vs. the American Middle Class, released in Novermber 2011; Forex Patterns and Probabilities, a top-selling book on currency trading that has been translated for release in China; and The Ed Ponsi Forex Playbook, which was endorsed by Steve Hanke, professor of applied economics at The Johns Hopkins University.

If you liked this article you might like

A Big Move in the Yen May Be Coming

A Big Move in the Yen May Be Coming

What Is Chipotle Thinking?

What Is Chipotle Thinking?

Charting Coke, Kraft and Molson

Charting Coke, Kraft and Molson

Sector Rotation Points Toward Strength

Sector Rotation Points Toward Strength

The Return of the Two-Way Market

The Return of the Two-Way Market