Bitcoins, Bubbles, And Beanie Babies

Yesterday the U.S. Department of Justice announced the arrest of two individuals affiliated with “bitcoin” exchanges. The two men are charged with using the bitcoin exchanges — which allow people to trade bitcoins for currency like U.S. dollars — to obtain bitcoins that could then be sold to users of another on-line exchange, called Silk Road, where the bitcoins could be used to buy drugs anonymously, in violation of the Bank Secrecy Act.

Bitcoins are a kind of token to which some people have assigned value. Each bitcoin is represented by a supposedly unique online registration number, created when a computer solves a difficult mathematical problem with a 64-digit solution. There are supposed to be a finite number of such 64-digit solutions and therefore a finite number of bitcoins, which is why bitcoin investors believe they will only appreciate in value. Users receive bitcoins at unregistered, anonymous addresses, which means the bitcoins themselves can be used to conduct anonymous transactions, as a kind of on-line currency. And, as the announcement yesterday reflects, bitcoins can be traded for real money.

I don’t pretend to fully understand bitcoins and how they are supposed to work — but I wonder how many people who have them and use them really do, either. It’s hard to understand how real value could be created simply because a random computer solves a complex math problem, and I expect that many bitcoin investors don’t have the mathematical and computer capabilities to really understand whether bitcoins are truly unique and just how limited their supply really is. And the anonymity of bitcoins means there is plenty of opportunity for mischief in how they may be used.

People who trade in bitcoins and are banking on their appreciation in value are taking a lot on faith. Of course, at a certain level you can argue that every form of currency involves a similar act of faith, but at least there are public, functioning markets for U.S. dollars, Treasury bills, stocks, and bonds and they are backed by functioning, publicly known entities. Bitcoins remind me of subprime mortgage bundles, or for that matter Beanie Babies. For a time, each of them was a hot commodity. Everyone seemed to be buying them and the word on the street was that their value was only going up. Then one day the frenzy ended, people stopped buying, and the investors were left with pieces of paper or a pile of children’s toys — and a big hole in their balance sheets and bank accounts.

Maybe bitcoins will be different . . . or maybe they won’t.

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