Posted by Peter Cohan @Forbes. Read it here:
I have been curious about Bitcoins — an unregulated electronic currency running on a computer network — ever since June 2011, when I first wrote about them after a hacker broke into Mt. Gox, a Bitcoin exchange, sending its price plummeting from $30 to pennies on the dollar.
After reading my post in which I compared the risk of Bitcoin to that of Cyprus, a Bitcoin trader contacted me and shared his views on their value as an investment. In a nutshell, this trader is bullish and plans to buy it on dips.
Kent Liu is getting a master’s degree in materials science from Cornell and on April 4, he explained to me how Bitcoins are minted and tracked and why he is so bullish on them.
Liu began trading Bitcoins earlier in 2013. He believes they will go up because Bitcoins operate on superior “fundamental properties” and thanks to all the media attention they are getting, more people will see things his way and demand will exceed supply — driving up Bitcoin prices.
Liu cleared up one widely reported mis-conception — so-called Bitcoin miners — who create new tranches of the electronic currency — do not create new Bitcoins by what is widely reported as solving a difficult math problem.
Rather, Bitcoins are created “by rolling a really big die until you get a really small number. It’s not hard, just takes a lot of tries.” Moreover, Liu says, “If you want to roll the die, anyone can create Bitcoins. Here is a link to software that Liu provided that he claims anyone can use to create Bitcoins if “they roll the die fast enough.”
Being a Bitcoin miner is a bigger job that involves keeping track of the ones you create. As Liu explained, a winning roll of the die yields a “block reward that is currently 25 Bitcoins.” Miners — who follow the procedures described here – are supposed to publish the number of Bitcoins they create.
Liu said the each Bitcoin miner has an incentive to account for new Bitcoins. According to Liu, “The new blocks are transmitted though the network and are numbered. So they form a chain and new blocks get added to the chain.” Moreover, Bitcoin “can only be created, they cannot be destroyed.”
Liu believes that public awareness will boost the price of Bitcoins. As he explained, “The fundamental properties of bitcoin make it a superior currency. However, a currency is only valuable as long as there are people that accept it. So short term value is very much based on how many people know it, which becomes more and more.”
Liu believes that Bitcoin is better than other currencies because it is hard to destroy, tough to fake, and easy to divide into small pieces. As he explained, “Ultimately, money is used as a means of exchange and store of value. To store value, it must be durable, and hard to counterfeit. This is why gold has been used for most of human history. Gold is inert. As for means of exchange, the money should be light and divisible.”
Liu is a fan of Bitcoin’s volatility because it gives him a chance to buy low and hold onto a pop. He thinks that its volatility is a result of the ease of manipulating a small market. According to Liu, “On Mt. Gox, there are typically 10 million buy orders and 50,000 Bitcoin sell orders on the book. So it’s not hard to have a million orders and cause major swings.”
In 2012, Liu believes that Bitcoin was far more risky — but he thinks that it is much safer now. As he explained, “[Last year]. the whole ecosystem was plagued with scams, hacks, thefts. Now, it’s not really the case.”
Unfortunately for Liu’s argument, the day before he shared his views with me, a service site, Instawallet, was hacked. Not surprisingly, this contributed to a plunge in the price of Bitcoin.
But Liu thinks these hacks are becoming the exception. According to Liu, “I think the ecosystem is getting to a point with a lot of reputable vendors. Scams become harder to pull off and not as profitable. Legitimate businesses are proving to be profitable, so scams naturally reduce.”
In order to spur the adoption of Bitcoin as a currency, Liu believes that services should arise to protect consumers. As he said, ”At some point, escrow services will start popping up, that will act as banks or PayPal in which chargeback is possible for buyer protection. I plan to start one actually.”
Liu believes that Bitoin’s value will grow as consumers become aware of it and retailers respond to consumer demand to use it as a currency. As Liu explained, Bitcoin will grow as a result of “awareness and acceptance. As more people become aware, some will buy Bitcoin, and some of those will start businesses and accept Bitcoin. The value of any currency ultimately comes from the fact that you can buy stuff with it. Otherwise, it’s just paper you can’t even write on.”
Liu declined to discuss his personal finances. Thus I am comfortable making a guess that he has not lost money on Bitcoins. He did, however, say that he prefers investing in Bitcoin to stocks “because no company can change the world.”
In my experience, the key to blowing up any finance-related bubble is the enthusiasm of a new generation that has never lost money with that financial instrument. For example:
- Oil and Gas loans. Back in the last 1970s, a generation of bankers eagerly lent out money to oil and gas driller in Texas and Oklahoma.
- S&Ls. In the early 1980s, newly deregulated Savings & Loans bought junk bonds and lent out too much money to home builders and buyers;
- Junk Bonds. In the mid-1980s, a new generation of traders bought companies using junk bonds;
- Dot-coms. In the late 1990s, a young generation of entrepreneurs started dot-com companies valued based on “eyeballs;” and
- Sub-prime mortgage backed securities. And in the mid-2000s, banks levered themselves up 50:1 to buy bundles of securities backed by sub prime mortgages.
These bubbles and their subsequent disastrous collapses depended heavily on people not learning from history. I hope all those Bitcoin traders who are following in Liu’s footsteps have the good fortune to get out before the masses get in.