currency experience includes counseling the Chicago Federal Reserve as part of its academic advisory council. “But for investors, the more pertinent question is whether they should even buy it.”
Nevertheless, Chowdhury is cautious. Calling Bitcoin a “tail-risk option” for investors, he equates investing in the currency to buying a lottery ticket — it only pays off if a highly unlikely event occurs.
According to research Chowdhury published in early 2014, Bitcoin’s strength has been predicated on three supposed qualities: It’s anonymous, difficult to hack and requires no financial middlemen, such as banks.
“Taking a tiny risk won’t damage a portfolio if Bitcoin goes bust, but will have a sizable impact if it takes off,” he says.
The problem: It’s not regulated. “No nation owns it, and no one can control it,” he says, adding that during the past few years Bitcoin and similar virtual currencies have been used to transfer illegal funds, particularly for drug trafficking. Valuation is also problematic. When Bitcoin currency hit the market, its value against the U.S. dollar was nearly 1-to-1. At its peak, the ratio was 1-to-1,200. (It hovers at about 1-to-380 today.) For all its hitches, however, Bitcoin’s popularity and momentum are very real. In the first study to apply academic research to Bitcoin’s investment prospects, Chowdhury uses an econometric test called mean-variance spanning. In that paper, “Is Bitcoin the ‘Paris Hilton’ of the Currency World?,” he writes: “The momentum behind Bitcoin is coming from around the world, as amateur investors, venture capitalists and technology enthusiasts pump money into businesses that are trying to figure out how to use Bitcoin to buy and sell goods.” His analysis further shows that Bitcoin’s low transaction costs relative to credit and debit cards are attractive to a growing number of merchants.
Is Bitcoin irreparable? Chowdhury doesn’t think so, suggesting that simply regulating the currency would solve a lot of problems. “We need to set up a new regulatory body or assign an existing body, such as the Federal Reserve, to regulate Bitcoin,” he says, pointing out that the majority of Bitcoin transactions have occurred in the United States. “The disadvantage there, however, is the way Bitcoin was created. There was no regulatory agency in mind.” Despite Chowdhury’s cautious optimism, Bitcoin remains fraught with volatility, misuse, regulatory issues and all the trappings of a passing fad. It seems like a currency on life support. “Will Bitcoin die?” Chowdhury wonders aloud. “It’s possible. But given the developments we see in emerging technologies, we will see some sort of digital currencies take hold. We need to be ready for that.” Chowdhury will surely keep an eye on Bitcoin and its inevitable mimickers and successors. After all, there’s conflict — tension — to study.
How Bitcoin works Mining
Wallets
Making a purchase
Verification
Bitcoins enter circulation through a process called “mining.” A miner’s computer solves complex equations for the Bitcoin network. If it successfully solves an equation, the miner receives bitcoins, which come in the form of a long string of numbers and letters known as an “address.”
The miner stores bitcoins in a virtual “wallet,” which saves the addresses on a hard drive or the Internet. Wallets can hold multiple bitcoin addresses that each hold a balance of bitcoins.
Say a bitcoin owner wants to use coins to purchase a muffin. The muffin retailer gives the owner a bitcoin address, to which the muffin buyer sends the bitcoin or fraction of a bitcoin.
The bitcoin-mining community verifies the transaction and stores it in a public ledger, making the transaction irreversible. In return for processing transactions, miners can be rewarded with bitcoins.
Source: Adapted from a U.S. Government Accountability Office report and first published in Investments & Wealth Monitor, March/April 2014, “Digital Currency and the Financial System: The Case of Bitcoin,” Dr. Abdur Chowdhury and Barry K. Mendelson
Read “The Case of Bitcoin” working paper: go.mu.edu/bitcoin-paper. heads or tails
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