Currency is the foundation of any economy. As a concept, currency has been around for millennia, and for good reason. Say I'm a shepherd, and you're an investment banker peddling non-investment grade foreign debt. Okay, that was a joke. I'm a shepherd and you grow wheat. You want to buy a sheep from me, but I don't want your grain. I am Novak Djokovic, shepherd - and for the uninformed, gluten-free - your grain is worthless to me. So we agree to initiate trade through a common currency. I sell you a sheep, and you give me some bronze coins, which I can then use to buy something else.
Over the years, currency has evolved from rough chunks of metal, to beautifully designed paper currency, to simply a dollar sign on a computer screen. You can be a perfectly functioning human being and carry nothing but a debit or credit card.
Billions of dollars of trade occur entirely online. Amazon, eBay and even clothing retailers like Gilt have proven that a physical storefront is no longer necessary to have a significant market presence. Enter Bitcoin, by way of a pseudonymously written 2008 paper - an entirely online currency, free of any sort of regulatory institution or central bank.
With the paper and accompanying software, so-called Satoshi Nakamoto outlined the idea for a currency that avoids many of the issues that faced past "e-currencies" by keeping track of every transaction made in a public ledger called the "blockchain." The blockchain prevents Bitcoins from being spent twice and allows buyers and sellers to safely keep track of their transactions.
That being said, Bitcoins quickly found their way into less than legal markets. The "Silk Road," an online black market that the FBI shut down in October, was one of the earliest adopters of the currency and popularized it beyond its early fringe community. Despite the benefits of the blockchain, authorities have had little success in linking Bitcoin accounts to their real-world owners.
But more recently, Bitcoin has earned the attention of both investors. The Winklevoss twins of (not) Facebook fame announced in September that they would be creating an investment fund based entirely on Bitcoins. Though Bitcoins are technically a currency, they behave nothing like it in financial markets. Currency exchange rates typically fluctuate extremely little - moves are often quoted in basis points, or hundredths of a percentage point.
Last week, the exchange rate for dollars to euros went from 1.3503 to 1.3479, a change of about 0.2 percent. In the same time frame, the exchange rate for dollars to Bitcoins went from around $550 to nearly $800 per Bitcoin - a change of more than 45 percent.
How is that possible? Without the intervention of a central bank, the price of a Bitcoin is based on a simple supply and demand function. As more and more stores and institutions begin to accept Bitcoins, people will be willing to pay more for them, driving the price up.
The supply side is more interesting - Bitcoins are produced by computers working on a complex algorithm. The rate at which Bitcoins are produced is constantly declining, and eventually no more Bitcoins will be produced.
You can buy just about anything with a dollar, and the government pumps in new dollars to increase the monetary base constantly. With Bitcoins, this relationship is skewed. Its value is entirely derived from the demand for itself, creating incredible risk - and reward - for users. Bitcoin's meteoric rise is bound to stall at some point, and I don't expect large companies to take on its inherent risk until its valuation settles down. I'll stick with cash 'til then.
