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“Our wretched species is so made that those who walk on the well-trodden path always throw stones at those who are showing a new road.”
                                                      —Voltaire
I find it hard to fathom the many life-changing innovations that have occurred in my lifetime.  As I look back, there is a definite theme to the introduction of these advances: lasting innovation rarely happens on the first try.
One of the earliest innovations that I can remember happened when I was a young boy and color TV became prevalent.  It took more than a dozen years (from the first color broadcast of the Rose Parade in 1954 until the mid-1960s) for color to be widely accepted, and 18 years for the sale of color TVs to outpace black-and-white sets.
By the time I graduated college, the first IBM / Microsoft OS personal computers were just introduced.  Again, it took more than 10 years for sales to move into the home in significant numbers thanks to the new widespread availability of Internet access.
I could list more — cell phones, HD TV, etc. For each of them, even in this age of rapid technological advancement, it has taken at least a decade from first commercial use to widespread use. 
This brings us to transactional technology.  Credit cards were the last widespread innovation in commerce transactions.  They were a rarity until the 1970’s (with the original bank card, or “open-loop” card, introduced in 1966 as the BankAmericard).
Thinking back on this, I watch all of the Sturm und Drang over Bitcoin with great amusement — and interest.  I’m not a Bitcoin fan-boy; nor do I believe it is a worthless endeavor.  After doing a good deal of research on Bitcoin, here’s where I’ve landed: whether it flops or becomes a household name, I see Bitcoin as a necessary and ultimately useful step in the innovation cycle.  Let’s look at a few things going on in the Bitcoin world, and then talk about whether we should care as traders and investors.  (As a readability note — the current capitalization protocol for Bitcoin is to capitalize the “B” when talking about Bitcoin as a protocol and to use a small “b” when bitcoin is referenced as a currency.)
Bitcoin Basics
Since there is a lot of misunderstanding about what Bitcoin is, I’d like to take a shot at making a very brief primer on the key aspects of this phenomenon as I understand them.  Please bear in mind these are the important aspects from my viewpoint — if I missed anything that you hold near and dear to your heart, please let me know using the email address at the end of the article.  With that being said, I believe these to be the most important things about Bitcoin:

• Bitcoin is known by many synonyms: digital currency, virtual currency, cybercurrency — and you can replace the word “currency” with “cash” (more on whether Bitcoin qualifies as a “currency” a little later in the article).
  
• It was designed as a low-cost way to exchange money using the Internet.
  
• At the simplest level, Bitcoin is merely a universally-shared ledger of who owns how many.
  
• This central ledger is kept by every computer on the Bitcoin open-source peer-to-peer network and is tracked chronologically and permanently by a public record called the block chain.
  
• Add some very sophisticated algorithm-based security, and Bitcoin is basically just a secure way for a group of connected computers to maintain a ledger.
  
• This form of fiat currency is not regulated by any central bank.
  
• The peer-to-peer network is run by a complex process known as mining, where computers are run on the peer-to-peer network to maintain the security of transactions and the validity of the ledger.  Miners are paid in bitcoins according to an algorithm that decreases the payment as more bitcoins are added to the system.
  
• Inside this system, anyone may transfer bitcoins to anyone else.
  
• The transactions are completely transparent, but the privacy (identity) of the people on both ends of the transaction can be maintained simply through pseudonyms. 
  
• Bitcoin users have digital wallets that contain their bitcoins and their private keys.  This part of the cryptography is sophisticated enough that hackers cannot guess private keys.  The combination of the private key and your bitcoin holdings inside your wallet make a cryptographic signature that is unique, secure and allows the network miners to verify transactions.
  
• There is no 3rd party to a transaction — only a peer network that verifies and records each transaction.  So there are currently no (or at least very low) transaction costs.
  
• The ultimate number of bitcoins is capped (as is the rate of additional bitcoins adding leading up to the ultimate cap) — so theoretically, they can’t be deflated by more units being added to the system.
  
• Bitcoin exchanges have developed to trade bitcoins for traditional currency (dollars, euros, etc.).
  

If you want to know the basics of the security algorithms and all the (admittedly pretty cool, as well as integral to the existence of the concept) stuff that is under the Bitcoin hood, feel free dig into the original whitepaper, which can be found at [You must be registered and logged in to see this link.] .  But much like the billion-plus people in the world who drive cars without knowing how an internal combustion engine works, we’ll stay at the application level of the digital currency as we look to see its usefulness and what role it is playing in a bigger trend. 
A Juicily Divisive Topic
I’ve basically run into three types of people when I talk about Bitcoin:

• The big supporters.  There are a few handfuls of these folks out there.  They either love the peer-to-peer concept, the code, the math and algorithms, or are philosophically aligned with a decentralized currency.
  
• There are the big detractors — mostly the people Voltaire was talking about in the opening quote who are guarding the status quo, or who like to throw rocks at any innovative idea.
  
• By far the biggest group is the “we don’t know and we don’t care” group.  This is the same group that could care less about cell phones in the early 1990s because “who needs one of those?” or those who thought HD TVs were for the wealthy few in the early 2000s.
  

Clearly, you can tell from those thoughts that I think that digital currency is going to stay with us in some way, shape, or form.  And more than that, I believe it will be the future of commerce and transactional activities of the future.  My best guess is that Bitcoin won’t be the ultimate winner, but much like VHS (and Betamax) technology paved the way for today’s DVRs, it is an important step along the way.
Since I’m into lists today, let me take a swing at listing the pros and cons of the Bitcoin currency as it stands.
What the haters are saying

• Bitcoin is not a currency because it doesn’t meet one or more of the characteristics of the definition. 
  
  
  
  • Classic economics says that money is
    
    
    
    • A medium of exchange
      
    • A unit of accounting
      
    • A store of value
      
    
    
    
  
  
  

Bitcoin has been widely employed as a medium of exchange, and this doesn’t seem to be slowing.  However, Buffet famously said in a CNBC interview that Bitcoin “is not a currency” because “it is not a durable means of exchange.”   He followed that up with saying he “wouldn’t be surprised if it [Bitcoin] wasn’t around in the next 10–20 years”.
Far be it from me to disagree with the Oracle of Omaha.  However, our time horizons may differ a bit here.  I would add that in the near term, Bitcoin has proven quite robust, surviving the failure of its largest third-party exchange (mtgox.com) and a host of associated negative press, etc.  On the other hand, I would not like to have a large portion of my wealth locked into Bitcoin with no chance to cash out until 20 years elapsed.  So I’ll call this one a near-term draw, long-term negative for Bitcoin.

• Bitcoin owners have suffered through security breaches and have lost money.
  

That’s true — though the biggest problems have been outside the actual Bitcoin infrastructure.  Bankrupt Bitcoin exchange mtgox.com claims that between 700,000 and 800,000 client bitcoins have been stolen from their ledger.  However, this was not due to Bitcoin security, but rather the exchanges. Still, the losses have been from the Bitcoin ecosystem, even if they weren’t through the Bitcoin algorithms.
On the other hand, it’s a good thing there has never been widespread credit card fraud…oh, wait.  Even good corporate citizens like Target show that almost all forms of transactions have vulnerabilities. Bottom line — I think that Bitcoin will be judged by history as contributing a revolutionary leap in transaction security, whether it survives or not.

• The wide speculative price swings make it tough to value.
  

Fair enough.  But I’m not too keen on the price stability of Argentinian pesos, either. Because transaction costs are so low, merchants can immediately turn any purchase into dollars or euros or whatever and carry almost no volatility risk. Bottom line — this will continue to be a theoretical problem more than a practical one, and will wane as the currency matures.

• Bitcoins have no intrinsic value
  

On this one I have to disagree.  I believe the sophistication and efficacy of the security algorithms, combined with the vast network of peer-to-peer computing power that enforces those algorithms, create an infrastructure that does lend intrinsic value to bitcoins.  The ability to transact securely and instantly with low or no fees alone lends intrinsic value to the system. However, one could argue that this is a tenuous trust and that tactics like mass collusion could undermine this foundation.  So far, it looks like the internal security features have worked in a very robust way. 

• The privacy features mean that law enforcement agencies can’t track illegal activity.
  

This is a tough one to overcome, but not entirely true.  Bitcoin has been an alleged component of drug trafficking and money laundering cases.  But as Marc Andreesen said in his excellent New York Times article last month, Bitcoin is pseudonymous, not anonymous.  It can be tracked, but not as easily as bank transactions.
Perhaps worst still, the Russian and Israeli central banks have issued warnings specifically about Bitcoin being used for terrorist funding.  Unless the world’s crime enforcement agencies are sandbagging on this issue, it will still be an important one for Bitcoin and other digital currency ventures to address.

• The same privacy features make taxation enforcement difficult to impossible.
  

If the last bullet about drug trafficking, money laundering and terrorist funding wasn’t enough to get most government’s undies in a bundle, this one sure will. The bottom line for me is that the privacy issue will be the Achilles heel of Bitcoin.   Governments can’t support or even stand aside and watch any transaction platform that can’t be taxed or policed for rule of law violations.
And now, some equal time for the Bitcoin positives

• Low transaction friction
  
  
  
  • Almost instantaneous
    
  • Low to no transaction fees
    
  
  
  

Bottom line: these are Bitcoin’s strongest edges, and why digital currency as a concept will eventually be a global commerce winner.  Imagine a vendor of low-priced items, who might make about a 5% margin, being able to double his or her margins just by eliminating the current 2.5% (or more) fee that banks and credit card companies collectively charge to move money digitally.  This is the real holy grail of digital currency. Bitcoin could also become an amazing tool to help the world’s poor by helping them send money and make financial transactions that are prohibited under current transactional structures.

• Anonymity / privacy
  

Governments or courts can’t seize what they can’t find.  Anti-government activists really like this part. Aside from conspiracy theories and end of the world scenarios, it’s tough to say these privacy pros outweigh the cons of facilitating illegal activities, terrorism and tax avoidance. Bottom line — the winners in the digital currency game will find a way to satisfy societal needs to limit illegal activities and facilitate reasonable taxation enforcement.  Any virtual currency that flunks this test will be a niche player at best.

• Security
  

Since each Bitcoin transaction can be unique (eventually, all of them will be done this way), a bitcoin is almost exactly like cash — the owner owns it, and the giver cannot get it back by asking a bank or a credit card company to do a chargeback. This eliminates fraud at the personal level.  The most someone with ill intent can do is steal one transaction, not a string of future ones like they can in credit card fraud. On a crypto-coolness level, Bitcoin has developed a security protocol that makes bitcoin transactions a major innovation in the ability to transfer property to another user of the Internet in a safe and secure manner.

• Inflation hedge
  

Since only a limited number of bitcoins will be made, this will theoretically avoid the problem of overprinting. With limited supply, if demand escalates faster, bitcoins could conceivably appreciate significantly over time.
When I look at all the pros and cons, I conclude that Bitcoin, if it keeps to its current mandate, will be remembered as a hugely innovative step on the journey to the mass use and acceptance of digital currency.   The leaps made in cryptography alone are very valuable intellectual property.  There may be a way for Bitcoin to morph and make itself acceptable to central bankers and governments, and also reconcile a finite supply in an expanding global economy.  But lacking that, it will be a grand experiment along the way to something bigger. 
With the conceptual issues realized, Bitcoin does have some major advantages to dominate in the digital currency race.  For example, Bitcoin already has a well-established platform and network.  If this first-mover advantage grows, challengers will have an increasingly difficult time overcoming the existing network’s inertia.
Bitcoin and Its Relationship to Investing and Trading
Let’s address the obvious question of using bitcoin as a vehicle for speculation.  With the volatility in this market, it certainly has the characteristics that one could use for speculation.  There is also adequate liquidity.  However, the exchanges are the current weak link, as mtgox.com has shown (as recently as the end of last year, mtgox.com was the main exchange, reported to be handling 70% of all Bitcoin transactions).  So if you choose to speculate in bitcoins, do so using the caution and position size you would with any other unregulated speculative instrument.
A longer-term play would be to uncover some of the companies that will likely win in the coming move to digital currency.  We’ll dig deeper into that concept in a future article.
I’d love to hear your thoughts and feedback — just send an email to drbarton “at” vantharp.com.  Until next week…
Great Trading,
D. R.
About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".

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