Bitcoin, a currency or a commodity?

Bitcoin, a currency or a commodity?

BitCoin is a decentralized digital currency that can be exchanged for goods and services in lieu of traditional payment options like credit cards, bank-to-bank transfers and cash.

BitCoin is based on unique cryptographically signed blocks called BitCoins that can be traded between parties like currency.  By taking advantage of public/private key cryptography, BitCoin transactions have been designed to provide both secure and anonymous online transactions. The currency has no central authority and can be exchanged peer to peer or through intermediary agencies. In the words of Matthew O’Brien, associate editor of business and economics at The Atlantic, BitCoins are “anonymous digital gold.

BitCoins are created through “mining” – using computers to solve complex mathematic equations. It can take years with a normal computer to create a single BitCoin using this method.  In addition to the difficulties surrounding creating BitCoins, the BitCoin system is expected to reach its limit of 21 Million Bitcoins by 2040.  Since the available quantity of BitCoins is fixed, BitCoin has no central bank to issue additional currency and the network for exchanging BitCoins is growing there is substantial inflationary pressure on the currency, creating price instability.

Matthew O’Brien from the Atlantic argues that rather than being a currency, BitCoin is in fact the ultimate dotcom stock. In May 2011, one BitCoin was worth $7.50. In the past few weeks, prices have skyrocketed from $65 to $266, then collapsed and rebounded until trading halted. (see below)

Because of its volatility and the lack a central bank, O’Brien also argues that BitCoins are a commodity rather than a currency, as he believes that a currency needs a relatively stable value to function as a medium of exchange.

The structural deficits within the BitCoin system are primarily a result of its intended nature as a currency.  By prioritizing anonymity, political independence and predictable behavior many of the traditional control structures that maintain a currency (such as a central bank) were not possible.  BitCoin behavior is entirely managed by the code that underlies the system.

While it’s debatable if BitCoin would benefit from a central bank, by eliminating many of the structural institutions included within traditional currencies BitCoin has created advantages that are not available from any other online payment medium: low transaction cost, low barriers to entry and most importantly, anonymity.

Timothy B. Lee of Forbes argues that these advantages are significant enough for people to see BitCoin’s volatility as a manageable risk, especially in those areas that are underserved or restricted by traditional payment methods.  BitCoins have found a home in and will likely continue to serve as currency for a range of niche markets including online gambling, international transactions and the sale of illegal goods.

How BitCoin is going to be used in the future and what will happen with its value is unknown.  BitCoin has the hallmarks of a potentially disruptive technology. As an increasing number of use cases develop, it becomes more probable that BitCoins will find an indispensible use case that enters the public consciousness and catapults the platform into the mainstream.  Until then, BitCoin is certainly worth keeping our eyes on.

Where do you think BitCoin is headed? What does the future hold for this decentralized from of currency?