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What is Bitcoin?

It’s become impossible to talk about the markets in 2018 without mentioning bitcoin. But the digital currency’s worth and its uses seem to remain a mystery to many of the very investors whose fear of missing out is nudging them toward the bitcoin craze – sometimes at great cost.

There doesn’t seem to be a lot of middle ground when it comes to bitcoin: People are either crypto-evangelists, or they go out of their way to call the currency a scam.

So, what exactly is bitcoin?

Bitcoin is a digital currency that’s created as users solve cryptographic problems on a public, decentralized ledger called
“blockchain.” Bitcoins are awarded to “miners,” or the people on the blockchain who solve those complex computational problems and validate the network’s transactions. Once a problem is solved and that block is added to the blockchain, it should be impossible to tamper with.

Mined bitcoins can be exchanged for other currencies, products or services. You can also buy and sell the tokens through an online bitcoin exchange like Coinbase or QuadrigaCX, which matches buyers and sellers. Other options include using a bitcoin ATMs or trying your luck with an “initial coin offering,” where early-stage companies raise money directly from investors by selling digital tokens.

“Bitcoin is part of a broader set of what’s called `distributed trust technologies’ that are designed around creating trust in the system based on the technology rather than trusting the government or the central bank that actually backs the value of that paper (money),” said Marc-David Seidel, an associate professor at the University of British Columbia’s Sauder School of Business and director at the Maurice Young Centre for Entrepreneurship.

“When you’re using (a) $20 bill, you’re saying: ‘I trust Canada, I trust the Bank of Canada – it stands behind it, the government of Canada stands behind it, it’s worth it.’ When somebody purchases bitcoin or any other cryptocurrency, they’re trusting that the technology says that it’s worth it.”

Bitcoin is just one way to use underlying technologies such as blockchain. Other popular cryptocurrencies include Ethereum, Ripple, Stellar, Cardano and Iota.

Why is everyone so into it?

Blockchain technology has been around for nearly a decade, but interest in bitcoin rose significantly in 2017, when there was a massive surge in digital currency prices, sending the market capitalization of the overall cryptocurrecy universe somewhere around the $700 billion mark.

Experts have quoted everything from hype, to the move toward cashless payment systems, to its value as speculative instrument to explain bitcoin’s astronomical rise.

“There’s a general pattern in society that if something is highly volatile, people will speculate around it,” said Seidel.

“People get interested in figuring out how they can take advantage of that and make a profit (but when they) don’t understand something, they tend to over or under value it a lot more than the people who are true experts.”

Amid the ongoing debate around the value and possible dangers of investing in bitcoin, some countries have started putting up roadblocks: South Korea has threatened to shut down virtual currency exchanges and China said it plans to block domestic access to Chinese and offshore cryptocurrency platforms that allow centralized trading.

Is it a good idea?

Such obstacles reflect concerns around the safety of holding unregulated digital currencies, as well as the possibility of being hacked or losing access to bitcoins as a result of misplaced passwords.

Since digital currency transactions can’t be tracked, some users also worry about associating with money that may have been used in illegal activity such as tax evasion or money laundering.

There are also technological concerns. Bitcoin has limited processing power available because it takes time for miners to figure out the difficult cryptographic problems needed to confirm transactions. Those miners are paid fees for their work, and often tend to choose to process the transactions that offer the highest fees first – which can mean possibly paying a premium to get your transactions dealt with at peak times.

The specialized computer farms set up to solve the complex equations quickly also take a large amount of energy to run, raising questions about the carbon footprint of mining bitcoin.

Concerns have also been raised about investing in initial coin offerings, since these don’t have any intrinsic value. Their worth is really only based on interest and hype and can change at any time. As Canso Investment Counsel points out in its January 2018 newsletter “it is a little more than astounding to us that investors are essentially financing companies without gaining ownership of the companies’ stock, only ownership of their cryptocurrency.”

The corporate bond manager goes on to point out that Ripple, the second largest virtual currency, is a “profit maximizing company which intends to act as a financial transaction blockchain ledger for banks.”

Yet it’s the Ripple tokens that are soaring in value, the newsletter points out, not the Ripple equity that represents ownership in the company.

“Money is useful in that it acts as medium of exchange and store of value,” the fund notes. “In the case of Ripple, which is selling its services to banks as a transaction record-keeping system, the value of the token is simply speculative demand.”

Bitcoin proponents argue that since bitcoin is traded in multiple exchanges and accepted in multiple countries, investors can be assured to offset their holdings wherever they want. They also argue that holding and transferring bitcoin is made simple by the use of a wallet ID that holds your private key instead of cumbersome bank account details.

Supporters also point to the fact that the cryptocurrency has been seen as safe haven for countries like Venezuela, where people are buying bitcoins to protect themselves against a level of hyperinflation that has driven the value of their local currency to practically unusable levels.

But while experts like Seidel believe the underlying technology that powers cryptocurrencies will inevitably disrupt the financial services industries, what its digital currency will ultimately look like remains to be seen.

In the meantime, he encourages caution.

“There are perceived opportunities (in new technology, but) just as with highly volatile stocks, those opportunities are captured by people who understand it better,” he said.

“Those that are kind of naïve investors, realistically, should be thinking of investing in something they understand better.”

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