Bitcoin is a digital currency that operates over the internet as an alternative to traditional money. The Bitcoin network allows users to transfer bitcoins directly from peer-to-peer, without going through a bank or financial institution. It is completely decentralised, meaning there is no central bank to float the currency. As such, its value is based entirely on the forces of supply and demand.
The strength of these forces have been made starkly apparent by the bitcoin’s rapid rise in value over recent years and months. In September 2011, the bitcoin (BTC) was valued at $US7.61, by April 2013 it sat at $US135.19. Today it is worth around $US605.48 – however this is down from figures of $US900-1000 seen earlier this year.
Source: Coinbase – 12 February, 2014
How does it work?
To understand the Bitcoin system, punters often draw a comparison between the digital currency and gold. It is gold’s rarity that gives it value – if anyone could dig gold nuggets up out of their backyard, it wouldn’t have a particularly high market value. Similarly, there is a finite supply of bitcoins – 21 million to be precise. There are already about 12 million in circulation, with around 25 bitcoins generated every 10 minutes. This rate will decrease over time, until the supply is estimated to be completely exhausted. Estimates of when that could happen vary from 40 to 100 years. It is important to note, that Bitcoin is not the only digital currency in circulation – it is just the most popular and valuable.
Like gold, these bitcoins are ‘mined’. That is, uncovered by unlocking increasingly complicated algorithms online using sophisticated computers. The mining software can be downloaded for free on any computer, and once a bitcoin is ‘mined’, it can be traded on the market – which means you don’t necessarily have to be a tech-genius to own bitcoins, you just have to accept the currency as payment for your goods and services. Because bitcoins are not a tangible currency, they can be divided into infinite smaller units – so you can still buy a cup of coffee for a tiny portion of a bitcoin.
Transactions take place when one user sends money to another user’s Bitcoin Wallet address, which is usually a random sequence of 30-characters. This ‘wallet’ is not dissimilar from an internet banking account and is unlocked using a password. Again, this wallet can be downloaded for free online. Although there is no central regulator, all transactions are recorded on a public ledger called the Block Chain, which is shared by all Bitcoin users. These transactions can take place directly between users or via an exchange market, the largest of which is Mt. Gox [1].
There is speculation that the fast-growth of bitcoins – based entirely on market forces – is creating a bubble, which could lead to a total loss of valuation, if consumer sentiment shifts unfavourably. Whether or not this is the case is yet to be proven as the currency matures.
Our prediction
Society is becoming increasingly tech-savvy and technology increasingly accommodates for the digital currency. Plus, further swings in the traditional market, such as those experienced during the global financial crisis, might be enough to make Bitcoin a viable alternative.
Former Federal Reserve Chair Ben Bernanke [2] believes the currency has legs, writing in a letter tabled by the Senate Committee that virtual currencies, such as Bitcoin, “may hold long term promise, particularly if the innovations promote a faster, more secure and more efficient payment system.”
The Australian Taxation Office [3] has also acknowledged the growth of virtual currency, and is currently working on a draft tax determination on the following topic – Income tax: Is Bitcoin a ‘foreign currency’ for the purposes of Division 775 of the Income Tax Assessment Act 1997? – to clarify the ATO view.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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