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Bitcoin new form of currency for the digital age

(Russ Ball/Albuquerque Journal)

(Russ Ball/Albuquerque Journal)

ALBUQUERQUE, N.M. — The truth about a currency, says Jeff Klingelhofer, is that if someone accepts it as payment, it is a currency – whether it is a dollar, a clam shell, a euro or a collection of zeroes and ones stored on a computer.

“If people will accept dirty socks, dirty socks it shall be,” said Klingelhofer, an associate portfolio manager with Thornburg Investment Management in Santa Fe. “There is nothing valuable about the U.S. dollar except the faith that it will be an acceptable currency.”

By that definition, the bitcoin, which was invented in 2008 by an anonymous programmer or group of programmers who did nothing more than write some open-source software, is a currency.

There are about $12 billion worth of bitcoins in circulation, there are vendors who accept bitcoins as payment, there are bitcoin currency exchanges, and there are speculators in search of profit who trade bitcoins.

“Bitcoin obviously qualifies as a currency at this point,” Klingelhofer said. “The question is its viability going forward.”

Bitcoin will remain a currency only so long as human beings accept it for payment of goods and services, he said, and only so long as governments are willing to tolerate its existence. In other words, bitcoin will be a currency as long as people have confidence that it is a currency.

That’s no slam dunk.

Chinese authorities realized citizens were getting around restrictions on moving its yuan out of the country by buying bitcoins. Last month, the government forbade financial firms from dealing with bitcoin exchanges, which cut off the supply of Chinese currency with which to purchase bitcoins. The price of a bitcoin fell from $1,200 to less than $500.

In Europe, Norway has announced it would not recognize bitcoins as legal tender, and Denmark is coming up with consumer protection regulations.

Confidence is key

Confidence in bitcoin could be eroded by users as well.

For one thing, the bitcoin has a reputation as the currency of choice for bad guys. The FBI recently confiscated 144,000 bitcoins from the computer of a San Francisco man accused of being behind the Silk Road website. Silk Road, which accepted only bitcoins in payment, is charged with selling illegal drugs, arms, forged documents and other illicit items.

For another, there are signs of a speculative bubble in bitcoins. According to The Economist, most bitcoin owners don’t spend the currency. They are holding it in hopes its value will rise – and rise it certainly has.

New Liberty Standard, a website that traded in currencies, declared in October 2009 that 1,300 bitcoins were worth $1. These days one bitcoin trades for around $600.

But bubbles can burst. When they do, they can be messy, as mortgage speculators learned in 2008.

On the other hand, Federal Reserve Chairman Ben Bernanke told Congress virtual currencies like bitcoin might one day become a worthy way of facilitating international trade, and Germany finds it an acceptable form of payment for some things.

Mining bitcoin

Bitcoins can be purchased or they can be obtained through a process known as mining. Essentially, this involves getting your computer to solve a cryptology problem found on the bitcoin website.

You obtain software from the website that will allow your computer to find a sequence of data that the bitcoin website will recognize as a correct pattern. When this algorithm is solved, the website will issue you 25 bitcoins.

The system is programmed to issue only 21 million coins ever – there are about 12.1 million in circulation today – so as fewer bitcoins become available, it becomes harder and more time-consuming for a computer to crack the code required to obtain bitcoins.

Organizations have sprung up to create pools of computers so more resources can be put on cracking the code. The bitcoins that are issued are then shared among the owners of the computers.

Why bitcoins?

The question remains: Why bitcoins? Who would want them and how did they become part of the online landscape?

Thornburg’s Klingelhofer says bitcoin is a sign of the times.

“Bitcoin is a product of people’s concerns,” he said.

Bitcoin founder Satoshi Nakamoto – believed to be either a person or a group of people – posted a paper online during the worst of the global financial panic unleashed by the September 2008 Lehman Bros. failure.

Monetary authorities undertook unprecedented steps to save the economy, including the printing of money at a previously unheard of rate. Confidence in commercial banks plummeted.

Since then, some governments have shown little skill in managing their economies. Cyprus confiscated some of its citizens’ bank holdings to cover its own debts. Even the International Monetary Fund has proposed an across-the-board tax on wealth.

As a result, bitcoin holds a lot of appeal to people who don’t trust banks or government, Klingelhofer said.

How it works

Bitcoin transactions are anonymous. There is no government regulation of the market or the currency of any sort.

If there is a way for a government to confiscate bitcoins, it isn’t obvious how it would do so. Since there will never be more than 21 million bitcoins, the value of the currency can’t be debased by a central bank’s printing press.

Transactions using bitcoins are fast and cheap. They occur when the buyer’s and seller’s computers exchange them.

No bank slows things down and drives up fees by executing bank transfers, letters of credit and exchanging dollars into euros. And no bank is in a position to report to the authorities any transactions that smell of money laundering or drug dealing.

Bitcoin isn’t the only alternative currency in the world. A new book by an Irish journalist and a former official of Belgium’s central bank identifies 4,000 of them.

They include such mundane currencies as frequent flier miles, which can be redeemed for restaurant meals and magazines and which are bought and sold by individuals.

Klingelhofer can only guess why bitcoin became prominent among them. Somehow, bitcoin achieved what he called the “critical mass” necessary to keep the attention of markets and traders. Maybe it’s simply because it was the first electronic currency of its kind, he said.

Caution advised

However bitcoin got here, Klingelhofer, who holds no bitcoin positions either on his own or on behalf of Thornburg clients, sees lots of reasons for consumers and investors to be careful.

Bitcoin is very volatile, and most of that volatility has involved rapid growth in value. People who buy bitcoins today in anticipation of that growth continuing “have to subscribe to the idea bitcoin will continue to be an acceptable means of exchange and people will demand it going forward,” Klingelhofer said.

“I can’t go to Home Depot and pay with bitcoins,” he said. “There are very few places where I can go to pay in bitcoins.”

A business operator who accepts bitcoins probably has to pay rent, utilities and wages in dollars, euros, yuan or some other government-issued currency.

“If I have very little faith I can exchange bitcoins into enough currency to cover expenses, I’m hard-pressed to hold it for a very long period of time,” Klingelhofer said. “Every bitcoin I get I’m going to exchange immediately to U.S. dollars because that’s how I’m expected to pay my bills.”

That kind of thinking could reduce demand for bitcoin and shake confidence in its worth.

And even if most governments have kept hands off bitcoin so far, that doesn’t mean they won’t take action eventually – through taxation or regulation – that could destroy confidence in bitcoin or limit people’s ability to use it.

Since the code used to create bitcoin is open source, any software expert can look at how the bitcoin network and website work. To Klingelhofer, that suggests some day some hacker will figure out how to steal from the system.

“At some point, growth in bitcoin prices will likely stop,” he said. “Where that is is anybody’s guess.”