Bitcoin has been making waves in the market as of late. The all-digital currency has challenged the very foundations of the world’s financial system and has raised the question: Can a currency exist that isn’t backed by precious metals or national governments? While the currency is still in its infancy, it maintains the potential to continue to grow and evolve. Still, potential investors and miners should be aware that there is a high amount of risk in the currency.
The first thing you need to understand is that Bitcoin is not backed by any government, treasury, or central clearing house. Its value does not derive from gold or any other precious metal. Throughout history and up until 1971 most national currencies were backed by Gold or another commodity. After the end of the Bretton-Woods agreement, however, most currencies were allowed to float in the free market, with buyers and sellers determining the actual value of the currency. National currencies are backed by the full faith of their respective national governments, and often act as a sort of referendum on a given nation and its fiscal health. For example, an economically vibrant country with sound fiscal policies generally enjoys a currency that is high in value.
Bitcoin is backed by no one except the faith of buyers and sellers in the market. There is no central bank to monitor and adjust currency developments and no leading authority to oversee the currency’s development and evolution. In a certain sense, Bitcoins derive their value from labor and electricity costs. In order to create a Bitcoin, a “miner” must use advanced computer hardware to solve complex equations. When the equation is completed, new Bitcoins are made. This creates a sort of inherent value in Bitcoin.
Still, only a small number of businesses (at the time of writing this article, about 1000) accept Bitcoins as payment. There are numerous Bitcoin exchanges, however, that allow users to exchange coins for money. By-and-large these exchanges have proven to be stable and Bitcoins have been largely liquid, meaning you can exchange them for cash. Recent days have seen the value of Bitcoins swing wildly, however, surging to over $250 dollars before plummeting back below $100 dollars. Under these wild swings, several exchanges were forced to close down.
If all of the Bitcoin exchanges were to close down and the currency became illiquid, any investors left holding Bitcoins would lose all of their money. Even if Bitcoin remains convertible with other currencies, the wild price swings could hurt a lot of investors. While Bitcoin is a very interesting concept, it would be foolhardy at the moment to invest money into the currency that you cannot afford to lose.
People and companies looking to mine Bitcoins should also be weary of the potential risks. Initially, mining was very cheap and anyone with a PC could create Bitcoins. Over time, however, the difficulty of solving equations has increased, requiring more powerful equipment and larger amounts of electricity. Now, mining equipment can cost upwards of $20,000 dollars and electricity bills for running the equipment can add up very quickly.
If Bitcoin collapses, all of the equipment will become largely useless and miners will still have to pay down their electricity bills. Any potential miner looking to get into the market should weigh the costs and risks very closely. If investors are looking to get involved in mining, the best method might be to spread risk among a pool of investors. That way, should the market head south, losses to individual investors will remain limited.
The old saying goes, that you shouldn’t put all of your eggs in one basket. The same is true of Bitcoin. Investing a small amount of money that you can afford to lose might eventually generate you substantial profits. On the other hand, if you invest a lot of money, you could stand to lose your life’s savings in the long run. Also, you should be aware that eventually a government or organization may feel threatened by Bitcoin and decide to bring it down. If the U.S. Treasury, for example, decided to invest large sums in theBitcoin to drive prices up before suddenly withdrawing and flooding the market by selling off the coins, it could potentially bring the entire currency down. While this may seem like a speculative conspiracy theory, it remains a real world risk.
In short, invest with caution!