Rise of Bitcoin: Is the digital currency a solution or a menace? (+video)

Convenient and anonymous, alluring  and alarming, Bitcoin and other 'cryptocurrencies' come under closer  scrutiny. As officialdom tries to figure out if greater oversight is  needed, their use is multiplying.

 Los Angeles — Celine Sotelo "likes to be on the cutting edge," so  she was intrigued when a friend this summer touted the virtues of a new  kind of money called Bitcoin.  She downloaded the software that would allow her family-owned floral  shop/cafe to accept BTC, as Bitcoin is known. In August she posted a  sign, "Bitcoin accepted here," at her shop on Los Angeles's Westside.

She got her first taker in mid-November. She hopes it's the dawn of more  demand. But Ms. Sotelo says she is also a little worried because,  frankly, she doesn't fully understand Bitcoin yet.

"I used the phone app and pushed the right buttons, but I'm a little  freaked out," Sotelo says after the customer paid $59.95 to Le Petit  Jardin by sending her digital bitcoins via his cellphone. "I have no  idea if I got the money or not."

A lot of people, it seems, are both interested in Bitcoin and "a little  freaked out" by it. Bitcoin, after all, does not really exist, in the  physical sense. It is a digital currency, and buyers use their smart  phones to swap online credits with sellers of goods and services willing  to accept payment in Bitcoin.

With Bitcoin use exploding since its debut five years ago, officialdom  is taking notice – and starting to ask questions. On Nov. 18 Congress  held its first hearing on the subject to explore the "potential risks,  threats, and promises" of code-based currency operating largely outside  any governmental structure. Speculators have lately been snapping up  Bitcoin, betting that demand for it will push up the currency's value,  even as the Federal Bureau of Investigation has been probing the dark  side of Bitcoin transactions.

In the grand scope of all monetary transactions, "cryptocurrencies" such  as Bitcoin are used in a tiny fraction of transactions. Only about 600  online businesses worldwide accept Bitcoin, along with a scattered  number of brick-and-mortar establishments such as Le Petit Jardin.

But outlets for paying with Bitcoin are multiplying. You can now use  BTC to buy cupcakes in San Francisco and salmon in San Diego, rent digs  in Brazil or Ireland, and scoop up "enchanting gifts" in Lancashire,  England. The Federal Election Commission is discussing whether to allow  BTC for campaign donations.

Bitcoin is not the only virtual currency, but it is the best known.  Its notoriety is not all sweetness and light, however: In October, the  FBI shut down a black market website called Silk Road, where patrons  bought and sold illicit goods – such as cocaine, marijuana, child  pornography, and weapons – exclusively with Bitcoin. Copycat Bitcoin  sites with similar names have already sprung up, and analysts say they  are likely to keep doing so because Bitcoin offers an anonymity that is  especially attractive to lawbreakers.

Economist Kevin McIntyre at McDaniel College in Westminster, Md.,  likens the currency to the private money of Colonial times, which  continued in use through the 19th century. Before the federal government  began issuing cash, banks issued their own tender, backed by valuable  metals in their vaults. He calls Bitcoin "private money for the Digital  Age."

Virtual currency appeals to some people for financial reasons, says  Mr. McIntyre, a specialist in cryptocurrencies. "People are using them  as a speculative financial instrument – like investing in British pounds  or the euro. People buy them, hoping the value will go up," he says via  e-mail.

Other people seek out Bitcoin for reasons of political philosophy, he  says, noting that it is popular with the "tinfoil-hat-wearing, Ayn  Rand, libertarian, anarchist crowd" that distrusts central banks and  their control over money supply. Bitcoin users can remain anonymous.  While there is a record of each transaction, who is paying that amount  to whom is hidden by the coins' encryption, McIntyre adds.

BTC's popularity has also mushroomed outside the United States.  Giant search engine Baidu, otherwise known as the Google of China, now  takes Bitcoin as payment for select security services, joining other  online businesses such as Reddit, WordPress, and OkCupid. Chinese  state-run news media have suggested that the dollar may not be, in the  future, the reserve currency for the world.

Bitcoin enthusiasts say the virtual currency is getting an undeserved  bad rap, and they caution against a rush to regulation. At the Nov. 18  Senate hearing, a representative of the Bitcoin Foundation, which  promotes the currency's standardization and use, said efforts are under  way to stabilize its underlying code. He urged lawmakers to weigh the  benefits of any new regulation against Bitcoin's role in helping the US  remain a leader in innovative technology.

The entrepreneurial desire to break new ground ahead of the  mainstream culture is what is driving many early adopters. Take Matt  Younkle, founder and chief executive officer of Murfie.com, an online  music trading site.

Mr. Younkle knows Bitcoin is confusing to the average person on the  street, "but most of our customers are online," he says. "For people who  lead a digital lifestyle, this is a coming thing, and we want to be out  in front of that." BTC "gives the site a competitive advantage," he  says, "because it's the only online music site for trading CDs and other  accessories with Bitcoin."

Younkle uses a currency exchange, BitPay, to insulate himself from  fluctuations in the value of Bitcoin. It allows him each month to trade  in all his Bitcoin income for dollars. The transaction fees are much  smaller than what banks charge for credit-card transactions.

Three years ago Richard Kohl, another Bitcoin advocate, helped found  PikaPay, a service designed to make sending Bitcoin easy by using  Twitter.

Since the global economic crisis, he explains, some people,  especially those who are tech-savvy, have come to believe "that slightly  more separation between government and banking may be beneficial to  communities around the world." That belief is one of the things fueling  Bitcoin as "a popular underground revolution," Mr. Kohl adds.

Critics, however, point out the currency's instability, noting the  wild historical price swings. For instance, when the US Department of  Homeland Security in May shut down activity between a mobile payment  service, Dwolla, and the largest Bitcoin exchange, MtGox, Bitcoin prices  fell 75 percent. But just in the past few weeks, prices have climbed  back from below $200 to nearly $600 per bitcoin.

Not to worry, asserts Erik Voorhees, an early Bitcoin entrepreneur.

"This is a temporary affliction, because Bitcoin is still a small  market and is very new," he says. "As it matures, its price will  stabilize." Mr. Voorhees is reassured by the fact that bitcoins, unlike  dollars, cannot be "created out of thin air, with no limit" by the US  government.

Price instability is not the only concern of critics. Indeed, virtual  currencies have so many challenges that they may not be surmountable,  says Patrick Morris, chief executive officer of HAGIN Investment  Management in New York. The major problems with Bitcoin, he says, are  its attractiveness to black marketeers, money launderers, and dictators;  the absence of vested national interests to support the currency in a  crisis; and the risk that it could lose all its value and become extinct  overnight.

"History has not been kind to financial institutions or instruments  that attract a large number of illegal or questionable transactions," he  says. He cites the Bank of Credit and Commerce International, which,  much like virtual currency, had been set up to avoid regulatory  oversight. It collapsed in 1991 after regulators noticed it had become a  magnet for drug and arms dealers, and rogue political figures.

On the question of government support, every new financial instrument  faces the music eventually, Mr. Morris says. Bitcoin is a derivative  instrument. People with "real" currency – that is, government-issued  currency – buy bitcoins and are suddenly only liquid to the extent that  the Bitcoin market functions for the purchase of goods and services, he  says.

"There is no guaranteed 'exchange rate' for this currency against any  other in the world since it has no basis of value other than the  merchants or individuals who are willing to accept it," Morris says. If  Bitcoin security protocols were to suddenly and dramatically fail –  which he asserts they will – "that devalues the currency. How do you  exit it without facing potentially months or years of zero liquidity?"

The nature of the instrument almost guarantees that the market will  lock up at some point and that the Bitcoin millionaires will be wiped  out, Morris predicts. "The bad news, or the worst news, is that if  Bitcoin fails it is a 100 percent loss."

On the other hand, as with all technologies, Bitcoin should be  expected to evolve, says Daniel Castro, senior analyst at the  Washington-based Information Technology & Innovation Foundation.

"Bitcoin 2.0 might look different than what we have now," he says, "but  it is clear that the trend is toward more electronic transactions, not  fewer."

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