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Bitcoin Users Are Going to Hate This Article

The Good, the Bad, and the Ugly of Bitcoin

Written by Joseph Cafariello
Posted June 5, 2014 at 2:39PM

If a coffee shop charged you $8 for a $3 cup of coffee, would you be upset? Would you have a little chat with the manager, or would you simply pay up with no questions asked?

Without realizing it, this is precisely what Bitcoin users are up against on a daily basis.

After a period of relative calm, Bitcoin’s wild price fluctuations are back. Just looking at Bitcoin’s price activity over the past 12 months would be enough to give an accountant a heart attack.

It moved from $200 to $1,200 in just 3.5 weeks in November of last year, then back down to $400 two weeks later in December, back up to $1,000 in January, a steady decline to $350 by April, and recently a nearly 100% ascent to $680, which has just started turning red once again at the right end of the graph below.

Bitcoin June 2014

Source: BitcoinCharts.com

If you used Bitcoin to purchase anything during these past six months, you are not going to like this article. I’m sorry to say, you’ve been paying $8 for a $3 cup of coffee.

But you wouldn’t be the only one who’s been duped. Investors purchasing shares in certain Bitcoin companies have been misled as well, prompting the Securities and Exchange Commission to issue alerts to investors.

What makes the Bitcoin landscape so difficult to navigate is that alongside the scams are some legitimate Bitcoin companies attracting serious investments from venture capital firms.

Here’s a quick look at the good, the bad, and the ugly of Bitcoin.

Bitcoin Stock Scams

The Bad: A number of scams offering shares in Bitcoin-based companies have caught the eye of the Securities and Exchange Commission. Earlier this week, two more Bitcoin-based Web businesses were fined by the SEC for selling shares of their companies’ stock illegally.

Erik Voorhees, the owner of both businesses, was fined $35,000 and ordered to return to investors the $15,843.98 they paid him for shares in his companies. The crime wasn’t that he accepted Bitcoin as payment for the shares; it was that the shares were not registered with the SEC.

Illegal sales of unregistered shares in Bitcoin businesses are more widespread than many realize, prompting the SEC to issue the following warning to investors:

“Investments involving Bitcoin may have an increased risk of fraud,” the alert cautions, “and the people behind these fraudulent schemes may lure investors by touting Bitcoin investment ‘opportunities’ promising unrealistically high returns.”

It’s not as if the sale of illegal shares has never been perpetrated in other businesses. Just because it happens a little more frequently among Bitcoin companies does not make the digital currency nor their companies inherently evil. In fact, some venture capitalists find them quite heavenly.

Venture Capital Loves Bitcoin

The Good: Bitcoin start-ups in the San Francisco area have already received more than $200 million in funding.

One major attraction is Bitcoin mining, where high-powered computers process trillions of calculations as they solve algorithms that reward the successful solution with a freshly minted Bitcoin — in digital format, of course.

Groups of miners organized as clubs and co-ops have been forming across the nation and around the world, pooling their computing power together into networks that can locate thousands of dollars worth of Bitcoin per day. You can see why venture capital firms are keen on funding such operations.

Other investor groups are delving into payment systems development, helping businesses get plugged into the Bitcoin revolution, equipping them with the systems and hardware they need to start accepting the e-currency as payment for their goods and services.

One such provider, Coinbase, has already received more than $30 million in private equity funding. BitPay is another, with a network of more than 30,000 merchants using its services.

As if that weren’t enough to keep entrepreneurs and venture firms busy, there is now a whole new use of the Bitcoin system for more than simply exchanging Bitcoins. The delivery system Bitcoin uses — called the “block-chain” — is, in the simplest of terms, a ledger in cyberspace that records all Bitcoin transactions in the world. It’s like a giant bulletin board that posts all Bitcoin transactions for anyone to see, using coded “keys” of letters and numbers instead of people’s names.

Companies such as Ethereum and Colored Coins among others are now adapting Bitcoin’s block-chain delivery and bulletin board system to allow parties to exchange other items besides Bitcoins, such as currencies, stocks, deeds and titles, baseball cards, gambling bets, even gold. A description of the items being exchanged along with their quantity and/or value can be stored inside the Bitcoin block-chain by altering certain segments of the transaction’s code.

Bitcoin may have given the world more than just a new digital currency — it's provided an entirely new means of managing barter and trade, both locally and internationally.

Its Strength is its Weakness

The Ugly: Bitcoin is a barter system in its purest form. Since the Bitcoin e-currency does not have a central bank that strengthens or weakens its value by adjusting dials and knobs like interest rates and printing presses, there is no one directly influencing its value.

But while this is readily cited as Bitcoin’s strength, it can also be its undoing, since the e-currency has no reserves to back its value and no agency or government to guarantee its acceptance. In order for two parties to know that they are getting a fair trade, there must be a way of linking a currency to another item of value — such as another currency or a commodity of value such as gold or crude oil.

Yet Bitcoin has no link to another item of value.

Though it can be converted into other currencies and even merchandise, there is nothing that “supports” the Bitcoin price, nothing that can be used as a reference in determining Bitcoin’s inherent value.

This is why its price is so volatile. No one really knows what Bitcoin is actually worth; it has no defined value at all. It just is what it is at the time. While this may seem perfectly ok and acceptable at first glance, the lack of any underlying base value might upset quite a few Bitcoin users if they took a moment to examine it more closely.

Take that $3 cup of coffee, for instance. At the current BTC price of $643, a $3 coffee would cost 0.0046656 BTC, or just under half of one percent of a Bitcoin. Is that a fair price to pay?

To determine if that’s a fair price, we need to make one other calculation: we need to consider the price of Bitcoin when you bought it, which is not an easy thing to keep track of since the Bitcoins sitting in your e-wallet were purchased at different times, perhaps going back many months.

If the Bitcoin sitting in your e-wallet was purchased in January at $1,000 per coin, that 0.0046656 BTC the coffee shop is charging you today is actually worth $4.66 of your $1,000 Bitcoin. As it turns out, you are paying 55% more for your coffee using the Bitcoin in your e-wallet than if you simply used the cash in your leather wallet.

It’s even worse if you bought a $3 coffee in April when 1 BTC was worth $350. A $3 coffee then would have cost you 0.0085714 BTC, almost twice as much as in the example above. If you paid for it using that $1,000 Bitcoin, you’d be paying $8.57 for a $3 cup of coffee.

Of course there are times when Bitcoin’s volatility works in your favor. If you purchased a Bitcoin in April for $350 and are using it to buy your coffee today, you’d be paying just $1.63 for a $3 cup, or almost half price.

The problem is that we have no idea what the future price of Bitcoin will be, and we can’t know if we should be buying Bitcoin now or later. If you load up on Bitcoin now in the high $600s and the price falls below $300 and stays there for the next year, you wouldn’t want to use your Bitcoin for that entire time, since doing so would cause you to pay double the price of the item you are buying. You would simply pay with the good 'ole American dollar after all.

Do you really want to carry around with you a little registry of when you purchased your Bitcoins and how much you paid for them to make certain you are not over-paying for your merchandise? There’s a lot more to this whole Bitcoin craze than most people think, isn’t there?

Trying to figure out the real value of anything bought or sold in BTC is an accountant’s worst nightmare, since one needs to compare the price at which BTC was bought with the price at which it is now being traded. Without a solid base of value backing Bitcoin, such price disparities will continue to plague its users and the merchants who accept it, as well as all the investors who are sinking their money into its businesses.

Joseph Cafariello

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