Digital money is clearly the techie infatuation of the moment. In the guise of 'bitcoins' it has been taken up by libertarians and most everyone who thinks that central banks are inherently incompetent. Just Google 'bitcoin' and scan the vast number of web sites explaining, discussing or dealing with the subject.
The vast bulk of most developed countries’ money supply is digital - it consists of electronic notations on financial
institutions’ computers. In the U.S.,
paper currency in circulation (excluding the $400 billion held outside the
country) makes up only 7% of the broadly defined money supply (M2).
What's Different? So, what’s different about bitcoins? These are created by private operators on request by those who wish to acquire them. They are “stored” on a computer (your own or the operators) or mobile phone 'ap.'
Bitcoins circulate via the internet totally outside the traditional banking system when used to acquire goods and services from entities willing to accept them. They intersect with the banking system only when someone wishes to buy or sell them in exchange for an official “legal tender” currency, such as the U.S. dollar or the Euro.
What is to prevent private operators from creating as many bitcoins as they can sell? The combination of an extremely complex mathematical/statistical formula and internet-based peer review of each operator’s activity provides a fairly robust control mechanism. The formula apparently is designed to permit no more than 21 million bitcoins from being created.
Virtues. What are the virtues of bitcoins? Proponents cite privacy (no bank record-keeping involved), ease of acquisition and use (all that is needed is internet access), no top down regulation, and security. However, all of these virtues have to be qualified, and one major short-coming will have to be overcome before bitcoins become something more than a techie fad.
Sending and receiving bitcoins requires internet addresses. Most countries’ intelligence agencies have the capability to trace such activity, even if they don’t know the precise details of the transaction. In addition to operational snafus, domestic internet systems are susceptible to politically motivated interruption on a countrywide basis, as we know from events in Syria and China.
At the moment, the bitcoin network and protocols are self-regulated in the sense that issues affecting their operation are resolved via a consensus of operators responsible for creating them. However, financial regulators in various countries are moving towards some degree of oversight and control, although it may be a lengthy process.
Security Issues. There are at least three important security issues that most bitcoin proponents pay little attention to: the inviolability of the algorithm used to create the currency and the competence and integrity of the middlemen who (1) operate the exchanges where bitcoins are traded against other currencies, (2) hold bitcoin balances for clients or (3) create bitcoin applications designed to facilitate transactions from your mobile phone or computer. One log of such problems, including losses for bitcoin holders, can be found on Wikipedia.
All forms of money attract counterfeiters and Ponzi-schemers, whether it’s fools’ gold or warehouse receipts. And any internet-centered money is going to attract hundreds of thousands of would-be scammers from around the world. If just one critical piece of the algorithm and protocols that undergird bitcoins is compromised, it is hard to see how that currency can survive.
The major short-coming of bitcoins is their inability to function as a credible 'store of value,' a core characteristic of widely-accepted forms of money. The only way to have a substantial amount of bitcoin held or used by people is to make them comfortable that someone will make them a reasonable price if they want to liquidate bitcoin for another currency or asset, such as gold.
Volatility. On May 10 bitcoins were trading at $120 on Mt. Gox, the largest bitcoin exchange. However, over the past 30 days, the value of a bitcoin has ranged from $50 to $266. Such a wide fluctuation tells us that there is scant liquidity in the market for anyone who wishes to buy or sell a large amount of bitcoin over a short period. That is confirmed by the fact that the average daily volume of U.S. dollar transactions at Mt. Gox in the same period was only $19 million.
In short, despite all the publicity and breathless promotion by some, it is hard to see bitcoins becoming a significant feature of the future monetary landscape.