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Bitcoins: sound investment or foolish enterprise?

| May 16, 2014 | Bitcoin, Investing

This article originally appeared as a column for the Cleveland Jewish News.

In December 2013, a California Lamborghini dealership made national news when it sold a Tesla Model S to a Florida buyer. The car’s value of about $103,000, while certainly unaffordable to the average car buyer, is not what made headlines though. What garnered such attention was the method of payment. The final price tag was, in fact, 91.4 Bitcoins.

Bitcoins have only begun to capture the attention of tech-savvy investors. After all, at the beginning of 2013 Bitcoins were valued in the low-double digits. But by November 2013, they were trading for as much as $1,242 per coin, an almost inconceivable level of growth.

Is it any wonder that many are willing to take a risk on what could be the most lucrative investment in their portfolios? You’re probably reading this and wondering, “How do I get in on this?”

Before you run out – or log in, as the case may be – it couldn’t be more important to do your homework, though. After all, Bitcoin values are extremely volatile and as of this writing are trading at only about $460 per coin. For so risky an investment, it certainly pays to have an understanding of the Bitcoin market so that you can make sound decisions.

First, though, what is a Bitcoin?

A Bitcoin is a specific type of virtual currency. It is not the only such virtual currency, though it is probably the most widely known. The European Central Bank has defined a virtual currency as “a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community.”

The U.S. Department of Treasury has defined it more stringently as “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency.” Bitcoins, in particular, are obtained by mining them (essentially by getting them in exchange for offering up the use of your computing power for purposes of processing other Bitcoin transactions), or by trading other more customary types of currency, services or goods for them. Then, you can spend them on other goods and services.

While that may sound OK, the concerns with Bitcoins are many. First, well-established currencies like dollars, shekels and euros are backed by something. That “something” may be gold, or silver, or at least the full faith and credit of the issuing authority.

Bitcoins are not backed by anything. They are not issued by any government authority, they are not legal tender and they are subject to virtually no regulation. While they are ostensibly self-regulated by their creator to the extent that only a certain number will exist, the number in circulation at any given time is not controlled in the same way as a traditional currency. Thus, there is little protection against market bubbles (and the burst that inevitably follows.) And, while the bank account that contains money is insured by the Federal Deposit Insurance Corp., a Bitcoin account is not protected.

Since Bitcoins exist online, they are can be hacked. In fact, a major Bitcoin exchange shut down after purportedly losing $350 million in Bitcoins. Theft and fraud are big concerns. And, since they may be used anonymously, many lawmakers are concerned that they are too easy to use for anonymous illegal transactions through dubious websites such as the Silk Road.

As is often the case with new technology, governments are seeking to keep up with appropriate laws. Some nations have already begun regulating Bitcoin use within their borders, although enforcement of such laws may be challenging. Most recently, the Internal Revenue Service has determined that Bitcoins constitute “property,” more like a stock share, rather than “currency,” meaning they will most generally be taxed on the gains realized on them.

What happens, though, if you want to use them for their practical application, as currency? They may be used on a number of websites and even in some other brick and mortar locations. But, their value fluctuates widely making it somewhat difficult to determine the appropriate Bitcoin purchase price.

Are they more trouble than they are worth as currency? Are they too volatile to be a reasonable investment? Many believe so. Many others believe in them. Ultimately those are going to be personal decisions. However, if you are considering obtaining, using, or keeping Bitcoins for any purpose it is important to understand what, exactly, is being purchased – a challenge in and of itself given the very small number of individuals who actually understand the algorithms that drive them – so that you make the decision to invest in this most unusual enterprise with your eyes wide open.

*Andrew Zashin writes about law for the Cleveland Jewish News. He is a co-managing partner with Zashin & Rich, with offices in Cleveland and Columbus.