On the Heels of a 1,000,000% Gain…

11/03/2011 3:39 pm EST

Focus: GLOBAL

No, there's not the slightest touch of hyperbole to that headline. Rather, it's the completely accurate, if exceedingly brief, tale of Bitcoin's short life. Far from dead, however, the digital currency continues to hold promise, and its trajectory bears more than a passing glance, says Mike Pienciak of The Motley Fool.

When I first wrote about Bitcoin in June, it had recently gone parabolic, first crossing the $1 mark, and then rapidly shooting up to the $9 range (if you don't know a Bitcoin from a Malaysian ringgit, see below).

The ascent, however, was still in the middle innings. Not two weeks later, the Bitcoin was trading at more than $30, having appreciated 10,000-fold since dollar-denominated trading began in 2010.

What Is a Bitcoin?
Bitcoin is essentially a cryptography-based peer-to-peer currency that functions independent of any central bank.

The creation of cryptographer Satoshi Nakamoto, and currently administered by Gavin Andresen, the Bitcoin system is designed to function as a genuine alternative to the dollar and other modern-day currencies. The value of these currencies are increasingly linked to the decisions of individual human personalities—think a certain bearded, balding former Princeton professor.

The Bitcoin system attempts to improve upon its paper peers by using a distributed network to generate new Bitcoins, and doing so at a predictable rate that slows over time.

So far, however, those controls have led to anything but stable currency value. Instead, the Bitcoin has rocketed from $0.003 in April 2010 to around $3 recently, with the monster move above $1—to $30 and back—coming only in the last few months.

Clearly, such wild appreciation—not to mention the daily up-and-down volatility—created a pricing challenge for participating merchants, which, in case you were wondering, include purveyors of Alpaca socks and blue canary nightlights.

Along with the appreciation of gold and silver in recent years, the simple existence of Bitcoin was yet another wheezing canary in the coal mine regarding the fate of many paper currencies. Bitcoin's large-scale success, should it materialize, would indicate a whole new level of public distrust for gaping government deficits and central bank tactics that seemingly bounce us from one bubble to another.

This Is Now
Then, of course, the inevitable occurred. Exuberance gave way to sanity and profit taking, and the Bitcoin first plummeted, then fell more gradually, eventually finding its way back down to the current trading range of $2 to $3.

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Was a bubble phenomenon in the cards for Bitcoin from the get-go? In mid-2010, lead core Bitcoin developer Gavin Andresen cautioned:

  • Bitcoin will get mentioned someplace with lots of readers;
  • A bunch of those readers will like the idea and try to buy Bitcoins;
  • Their price will rise, which will draw even more people to "invest," which will drive the price up even more...
  • Until people decide that the price isn't going to rise any more, and everybody rushes to sell before the price drops.

I predict there will be between one and five Bitcoin bubbles (price will double or more and then crash back down below the starting price) in the next four years. Rendering Bitcoin susceptible to bubble dynamics is its immediate appeal as a genuine, if fledgling, fiat-money alternative; its relatively illiquid trading market acts as a double whammy.

Consider that daily volume above $1 million represents a heavy day, and that total volume in the past year amounts to roughly $75 million. As an alternative to holding one's wealth in greenbacks, Bitcoin is on the map, but just barely. As such, it's a speculator's dream.

But what about the long-term prospects? In an e-mail, Andresen relayed that he remains upbeat on Bitcoin's future.

Furthermore, he mentioned "dozens" of development-stage projects, including secure "Bitcoin wallets" for cellphones. Although he doesn't see such ventures as critical to Bitcoin's success, they could, in my view, provide a notable boost.

As for potential legal issues, which have been cited elsewhere in the media as Bitcoin's eventual death knell, Andresen is likewise optimistic.

"New technologies are always ahead of the law," he quips, adding, "Bitcoin doesn't fit neatly into any of the categories our legal system has created for 'things that act as money,'...I wouldn't be at all surprised to see Bitcoin first really take off somewhere else in the world, where the financial system is more open to innovation."

Of course, price stability is the real key to Bitcoin's future. And here, even Andresen was surprised by the magnitude of the recent run-up. Moreover, he sees continued volatility across the next few years. For now, many may be put off by Bitcoin.

And for good reason. Even though the stock market routinely swings a couple of percentage points in either direction on a day-to-day basis, it's pretty much unchanged since Bitcoin's June peak. That beats a roughly 90% loss.

Going forward, Bitcoin projects such as those cited above, which aim to expand the marketplace, should help smooth the price volatility.

Ultimately, however, Bitcoin cannot succeed until the market begins to view it according to its design—as a legitimate currency with predictable supply growth—and not a get-rich-quick investment. If you want to bet on when that will happen, there's likely someone out there who's eager to accept your wager—in Bitcoins.

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