Are crypto-currencies the future of money?

The creditors of the collapsed Mt Gox have agreed to support a group of US investors who are trying to re-establish the Bitcoin exchange.

Despite these problems, can crypto-currencies, such as Bitcoin revolutionise the way we pay for goods and services in the digital age?

After all, money is anything that can perform three basic functions: a medium of exchange to be used in the purchase and sale of goods and services; a unit of account to measure the value of goods and services; and a store of value that can be saved and spent at a future point in time.

Bitcoin was founded in 2009 although nobody knows by whom, only that he, she or they took the pseudonym Satoshi Nakamoto.

Since then a plethora of other crypto-currencies have since sprung up, including Ripple and Litecoin.

Each Bitcoin, like other forms of crypto-currencies, is simply a long string of computer code protected by a personal key which provides both ownership and security.

All Bitcoins in circulation and their transactions histories are recorded in a giant ledger known as the blockchain. This prevents each Bitcoin from being spent twice.

The crypto-currency is a very simple way of transferring value from one person to another. Once the personal key code has been entered the Bitcoin value can be transferred to another address.

No middleman is required to verify the transaction so they are quick, secure and cheap to use.

A decentralised currency

Bitcoin is described as a decentralised money system because the ultimate supply of coins is fixed and not controlled by a central bank.

Instead the coins are created by computers which perform number crunching exercises akin to trying to crack a password by running through every possible permutation one at a time.

Each time a password is cracked new Bitcoins are added to the blockchain.

This process is designed to mimic the behaviour of mining for precious metals. The value of Bitcoins is derived from the value of difficulty and proof of work requirements needed to produce them.

So far Bitcoin miners are only just over half way towards the cap of 21 million and it is expected new coins will continue to be mined up to 2030.

The supply cap means that the eventual value of Bitcoin cannot be eroded through inflation and this might explain the popularity of the currency in countries where the central bank lacks credibility.

Boom and bust

So, if Bitcoin is an efficient medium of exchange and an effective long run store of value, what's holding it back?

Firstly, a currency becomes a useful medium of exchange if it is widely accepted by a large number of merchants. Although Bitcoins can be used in a variety of transactions, it is still generally thought of as money for computer geeks rather than the ordinary citizen.

At present the commercial use of Bitcoin is small, especially compared to the rampant speculative trading in the currency. Since 2009 Bitcoin prices have been 7 times more volatile than the price of gold and 8 times more volatile than the S&P 500 stock exchange.

If you happened to buy a Bitcoin at the start of 2013 it would have cost you $13. At the start of November the value had increased to $211 and then one month later to a peak of $1231. It goes to show that there is a lot of real money to be made trading in a virtual currency.

Part of the problem is that nobody really knows what the fair price or intrinsic value of a Bitcoin should be so there is little to quell speculation.

Various companies have been looking to cash in on the growing popularity of crypto currencies

Regulation

By mid December the value of Bitcoin had plummeted to less than $500. Up until that point Bitcoin and its rivals had been relatively freely traded in China, but it was clear that the authorities had felt it had become a speculative investment rather than a medium of exchange and clamped down.

Declaring it not to be a currency, the Chinese state stopped financial institutions from dealing with Bitcoin exchanges making it almost impossible to buy and sell Bitcoin using the yuan.

The Chinese were also concerned about the potential for the currency to be used in black market activities and money laundering through a process known as bitwashing.

It is clear that regulators around the world are unsure about what to make of Bitcoin and are still in the process of making up their mind if and how it and other crypto-currencies should be regulated.

Theft

Despite the December wobble Bitcoin prices were back above £1000 by the New Year.

But by late February the price had crashed once again to below $260 when it was announced that Mt Gox, a major Bitcoin exchange, had lost 850,000 Bitcoins valued at $600 million and subsequently filed for bankruptcy in Japan and the US.

Possession of the key is everything as it allows the currency to be permanently transferred somewhere else.

Lose the key, whether through hardware failure, software failure, amnesia or theft and you lose the value.

A TV reporter found out the hard way when he flashed Bitcoin gift certificates on air only for a viewer to scan the code with his smart phone and make off with the value.

Bitcoin transactions are irreversible and lack a practical system of resolving disputes, so it is almost impossible to recoup Bitcoin value once it has been transferred elsewhere.

The future?

Given its recent problems there are doubts as to whether Bitcoin and its contemporaries can become fully-fledged currencies.

It is unlikely that the credit card faces an imminent threat to its dominant position in online payments.

However, even if Bitcoin itself does not become the internet of money, its technology could provide the platform for future online payments systems.

One possibility is that these might be developed through the major banks, and JP Morgan has recently filed a patent for an online payments system with Bitcoin characteristics.

But with the development and adoption of all internet-based technologies, we can only wait and see whether it takes off or not.