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updated 5/26/2011 10:18:48 AM ET 2011-05-26T14:18:48

 

A new form of digital currency is gaining attention worldwide, partly because its creators have openly announced their intentions to revolutionize (and completely sidestep) current economic models and currencies.

If that sounds a little ambitious (and possibly less-than-legal) to you, you're not alone.

"One should be quite skeptical with any new payment system," Ward Hanson, policy forum director for the Stanford Institute for Economic Policy Research, told TechNewsDaily.

Here's a look at what the digital currency called BitCoin is and what it could mean for consumers.

What is a BitCoin?

BitCoin is a virtual currency; it only exists in bits and bytes. Even though the money in your bank account is simply represented as a number, the guarantee from the government (via the FDIC) is that those numbers can be converted to actual dollar bills at any time. BitCoins, on the other hand, will never have a physical analog.

BitCoins can be earned by either converting dollars to BitCoins (at the time of publication, BitCoins cost around $7 for a single BitCoin), or by "BitCoin mining." Mining involves downloading an app that uses the processing power of your computer to power BitCoin transactions around the world. You earn BitCoins for sharing your computer, and the more processing power available for the BitCoin app, the more you earn.

What's the benefit?

BitCoins are the currency of a completely new economy that functions much like any other, except that BitCoins are much less regulated. This makes them extremely easy to use. They can be exchanged for goods and services, they can be given from person to person without any middleman and they can be accessed through a simple Internet interface. Many businesses, including small business owners and freelancers, already accept BitCoins.

The total number of BitCoins are capped at 21 million, meaning that owners don't have to worry about runaway inflation from millions of people buying and earning. They are also untaxed and transactions are basically free.

What are the problems?

BitCoin and any other virtual currency start at a huge disadvantage. It's easy to make coupons for a grocery store or tokens for an arcade, which are payment systems of their own, because they are confined to a single business and usually can't be transferred back into dollars.

But BitCoin is trying to create a substitute for firmly established, global currencies. There may simply be no need for it.

"Any successful payment system will have to solve a problem, whether that's insufficient markets or an unmet need in the market. I haven't seen that kind of need," Hanson said.

Furthermore, you can bet all 21 million BitCoins in existence that the IRS and other regulatory bodies worldwide won't be happy about an untaxed economy springing up under their noses. There are larger legal issues as well. If BitCoin does become successful, it could run up against antiterrorism laws that require transactions worth more than $10,000 to be carefully documented.

But more importantly, the unregulated nature of BitCoins have the potential to make it quite volatile.

"Any time you're trying to create a virtual currency, you have more risk than when it's guaranteed by a sovereign state that can levy a tax," Hanson said.

BitCoin's decentralized system doesn't inspire much confidence because there isn't a governing body and, as Hanson pointed out, "Their website is less than transparent."

Demand for BitCoins drives pricing more than demand for goods and services, which is backward. For instance, the dollar exchange rate of a BitCoin will skyrocket if many people start using BitCoins because there are only 21 million in existence. If the entire American population wanted BitCoins, less than ten percent would be able to own a single BitCoin. This means those who get in early will benefit the most because demand could cause the value of a single BitCoin to skyrocket.

Exchange rates will continue to be a problem for BitCoin because there are already well established currencies in place and rates will vary. If Ben's Burger Bin offers to sell a Combo Pack Deluxe for one BitCoin, what happens when demand doubles the dollar value of a BitCoin?

The semi-lawless BitCoin economy makes it perfect for paying a friend for work or products, but it also makes it possible to make less traceable transactions. Already, there are several sites where BitCoins are being used for illegal actions, including selling illegal drugs. Users on the BitCoin forums praise the currency because it is " easy to conceal … and harder to detect."

Another problem with BitCoins is the same problem that has plagued digital currencies (there have been many, and they have all failed): usability. The concept behind legal tender such as the dollar is that it must be accepted for goods and services, but only a fraction of businesses accept BitCoins at the moment. The number is growing, but it's unlikely that you would be able to use BitCoins for most transactions. Friends or freelance workers may also balk when offered to be paid in BitCoins.

What will happen?

It's difficult to predict exactly how things will end up, although the historical precedent doesn't lean in BitCoin's favor. Virtual currencies can and do flourish, but only within a single business or market (think airline miles and Farm Cash in FarmVille). Taking a virtual currency to a global scale creates myriad hurdles.

"Payment systems in general are very hard to create. Over the last 50 years we've had PayPal, credit cards and not much else succeed. And there's a good reason for that. Unless you really solve a problem you are fighting an uphill battle. I don't see what BitCoin is solving," said Hanson.

Already the loose rules have lead to BitCoin scamming, and a significant portion of people seeking the currency only seem interested in reselling BitCoins straight to others or trading them in for dollars. It's unclear how long governments will ignore this. The entire BitCoin network is so decentralized, though, thanks to the BitCoin processing app, that it would be extremely hard to stop BitCoin use. There is no central business to take down or regulating body to remove.

However, if such a thing is declared illegal or BitCoin's manufactured economy fails, you can bet that a lot of BitCoin owners are going to be wondering how many physical dollars they can get for their virtual money.

© 2012 TechNewsDaily

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