Bitcoin 101: A Primer for Digital Currency

Smith School Experts Explain the Basics

SMITH BRAIN TRUST – Out of curiosity, the Smith School's Joe Rinaldi says he asked hundreds of Bitcoin buyers to describe the cryptocurrency, "and virtually 95 percent couldn't explain their investment."

Subsequently, Rinaldi, an adjunct finance professor at the University of Maryland's Robert H. Smith School of Business, and Smith School Master of Finance student Weijia (Lily) Tu and UMD economics student Michael James Huber have drafted the following primer for Bitcoin owners and potential buyers.

What is bitcoin? It is a digital form of currency with no government or central bank importantly standing behind it. The platform allows for a direct currency-to-Bitcoin exchange, or vice versa, without brokers. The transaction, through the blockchain ledger, bypasses traditional middlemen.

The model is a true disrupter since it eliminates the roughly 10 percent to 20 percent in fees that banks would otherwise charge to exchange currency. However, it carries risk as an algorithm that can be manipulated and hacked. It also has limited-to-no government oversight. The framework is now over 10 years old and difficult to update. More advanced cryptocurrencies have been launched, i.e., Etherum and Ripple. Both are growing faster than Bitcoin and could supplant it as the leading cryptocurrency.

How do I get started? Download the Bitcoin client software, or just get a standalone wallet. A wallet is defined as an online account that comes with the Bitcoin software, similar to Apple Pay. The account is maintained by the account holder. (The accountholder is entirely liable for any losses.)

How do I buy Bitcoin? The easiest way to buy Bitcoin is to go to an online exchange and place an order. It will automatically match the buyers and the sellers, very similarly to trading equities after 4 p.m. (after market). Some exchanges are said to be regulated (hard to verify) and other exchanges are more of an informal bulletin board. This suggests limited liquidity. The largest exchange is coinbase.com and the biggest risk is a catastrophic cyber hack where trillions disappear.

Why has the price of Bitcoin gone parabolic? In the past, many people used Bitcoin to exchange currency for illegal transactions, such as the illegal sale of military weapons, the sale of drugs, avoiding banking regulations, or avoiding a country's (i.e. China) self-imposed limit on the amount of capital that can leave the country. If Bitcoin popularity continues, the demand to buy Bitcoin will push the price up even further. Adding to the upward pressure on the value of Bitcoin is that speculators are simply buying Bitcoin and not exchanging into another currency, which is the main purpose of Bitcoin.

Is Bitcoin a bubble? Bitcoin is not a store of value like gold. It is simply a "digital" currency that will allow you to exchange a currency for another currency, while avoiding the regulated banking system and the fees associated with using banks. In this regard, it is a game changer, similar to PayPal and Apple Pay. It has great potential as a platform for exchanging currency, but not as an investment.

This Bitcoin run up in price is similar to the last great speculative mania, the tulip bulb bubble of the 17th century. The bottom will fall out when there's no one left to sell to. I suspect if Bitcoin continues to be used as an online speculative vehicle, the bubble may burst sooner rather than later.