In this April 3, 2013 photo, Mike Caldwell holds a 25 bitcoin token at his shop in Sandy, Utah.  Caldwell mints physical versions of bitcoins, cranking out homemade tokens with codes protected by tamper-proof holographic seals, a retro-futuristic kind of prepaid cash. With up to 70,000 transactions each day over the past month, bitcoins have been propelled from the world of Internet oddities to the cusp of mainstream use – according to a November 22, 2013 AP story by Rick Bowmer.

Since I have been asked about bitcoins by several people recently, it seems like time to talk about what they are, and importantly, what they are not.

In the simplest terms, bitcoins are an electronic currency that people can use to send payments to each other.  As such, they are a fiat currency just like the dollar, euro or yen – not backed by anything other than the confidence of the market for those currencies.

Problems with bitcoins are numerous. For example, what if the person on the other end of your deal isn’t interested in taking bitcoins in payment?  In that case you’ll need to trade your bitcoins for cash and where do you find someone local who will cash them for you without resorting to fire sale prices for your bitcoins?  Frankly, you would have the same problem if someone would not accept your euros, yen or gold.  Dollars have been legislated as legal tender, so U.S. merchants have to accept them. Not so with bitcoins.

Although 70,000 transactions a day sound like a lot, that is nothing compared to the number of cash and credit card transactions that happen every day around the world.  

And, many bitcoin transactions seem to be in dodgy enterprises that wish to avoid banking scrutiny of cash transactions.  Earlier this year, the FBI busted a drug dealer and in the process confiscated approximately 1.5% of all bitcoins in circulation.

The number of bitcoins in circulation is capped at 21 million creating a supply and demand dynamic that is pushing the cash price of bitcoins higher. This sounds good if you have an inflation phobia.  However, fixed money supplies such as the gold standard have been proven to greatly hinder growing economies.

If an economy or just a population is growing at 3% a year, the money supply needs to grow at 3% a year to avoid bottlenecks caused by cash shortages. The depressions of the 19th and early 20th centuries were made much deeper than recent ones by an inelastic money supply in a rapidly growing economy.

Bitcoin use also entails user fees, similar to credit card fees.  The fees are lower than traditional credit card fees, an advantage that may disappear as the formula governing fee payments creates smaller and smaller fees (in bitcoins) as the industry matures.  Processors will be forced to find other ways to charge fees or exit the business.

Bitcoins are supposedly protected by unreadable (except by the computer intended to read it) code, and a record of every bitcoin transaction is kept in a public online journal to avoid fraud and cheating.  This sounds great in a utopian sense, but as privacy concerns mount would you want every transaction you do publicly reported?

Bitcoins also need to be stored, just like cash.  Users maintain electronic files called “wallets” to store bitcoins.  But just like banks, cash in wallets can be stolen or pilfered or lost to hazards like a hard drive crash.  However, the bitcoin market is unregulated, so there is no protection if you happen to choose a bad online wallet service or have a computer error that destroys your wallet file.

Should you buy bitcoins? I’m certainly not recommending that. They can be used only for two things: payment for limited goods or services and currency speculation.  Currently few vendors accept bitcoins, so using them for payments is a bit iffy.  

Although some speculators have done well so far, speculating is, well, speculative.  Bitcoins have rebounded, but lost 90% of their value in two weeks (April 16-28) in mid 2013.  There is no way to be sure you will profit speculating in bitcoins. It is literally a gamble.

I don’t see how bitcoins can possibly work in the long run, but so far the market for bitcoins is functioning. I have to admit that it was hard to see the potential of early Internet technologies, too.  But over time, entrepreneurs took the basic structure of the Internet and built innovative and user-friendly services such as Google, Facebook and YouTube.  

Maybe bitcoins will morph into a more viable structure, but right now bitcoins are the Wild West of money.
 

The Fed’s “QE” economic stimulus program has held interest rates at artificially low levels for several years now.  When the Fed does withdraw stimulus most market watchers expect interest rates to rise.  

What is fascinating is that the bond market seems to be doing the Fed’s work, with interest rates already rising.  I track money supplies, unloaned bank reserves and Fed Funds rates, and from what I see the Fed has not changed anything, yet.  But the bond market is making a significant move anyway.  

The yield on 10-year Treasuries has doubled since last year.  As rates rise market values of bonds fall, often faster than interest is accumulated, creating outright losses for bondholders.  This is the headwind for the bond markets that I mention frequently in my writings.

The stock market continues to have periods of sideways action interspersed with a few hot days and then another boring week or two or three.  Just as the red lights were beginning to come on in my spreadsheets, the market rebounded strongly on Friday, erasing a week’s worth of small losses in one day.

The bond market is again drifting down as interest rates rise, and gold is flirting with new long-term lows.  European, Latin American and Emerging Market stock indices have also lost their mo-jo (a highly technical term, that one) with the US markets again leading the world over the last 6 weeks.  Right now US stocks are one of the few places in the financial markets that are showing any gains.

Could this be a case of the generals (US stock market) not realizing that the troops have deserted them?  Eventually the generals realize that they have no army and they turn and flee, too.  That is a possibility, but not something to act upon until we see the US market actually turn down in a meaningful way.
 

Two weeks ago I made a presentation to the regional gathering of Greater Phoenix Mensa where the talk turned into a lively discussion (lots of lively discussion and strong opinions in that group) on Bitcoins, a new electronic currency.   The discussion piqued my interest enough to include an article on Bitcoins later in this newsletter.

One thing about my business is that everyone is interested in money, and as you can see from the collection of monetary oddities at my office, there are a lot of ways money can manifest itself.  These include my Zimbabwean 100 trillion dollar bill, Russian bonds from the days of the Czar, and banknotes from the 1800’s when banks competed on the basis of whose notes looked better – they are works of art.

Bitcoins are the latest monetary oddity.  I’ll have to figure out how to hang one on my office wall!

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