Bitcoin: What is it, where can you use it and is it worth investing?

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Bitcoin had an incredible 2017 after increasing in value more 20 times from below $1,000 dollars to a peak of just under $20,000.

Such phenomenal returns have caused many to ask how they can get in on the action while others to suggest it’s a dangerous bubble waiting to burst.

So what exactly is bitcoin and why is it attracting so much attention?

Bitcoin is a digital currency created in 2009 by a mysterious figure using the alias Satoshi Nakamoto. It can be used to buy or sell items from people and companies that accept bitcoin as payment, but it differs in several key ways from traditional currencies.

Most obviously, bitcoin doesn’t exist as a physical currency. There are no actual coins or notes. It exists only online.

“Real-world” currencies, like the dollar, are managed by a central bank such as the US Federal Reserve or the Bank of England, which manage the money supply to keep prices steady. They can print more money or withdraw some from circulation if they think it’s needed, as well as using other monetary policy controls such as adjusting interest rates.

Bitcoin has no central bank and isn’t linked to or regulated by any state. The supply of the cryptocurrency is decentralised – it can only be increased by a process known as “mining”. For each bitcoin transaction, a computer owned by a bitcoin “miner” must solve a difficult mathematical problem. The miner then receives a fraction of a bitcoin as a reward.

A record of each transaction, using anonymised strings of numbers to identify it, is stored on a huge public ledger known as a blockchain. This acts to ensure the integrity of the currency.

“The system can act as a payment network that has no down time, it’s operating 24/7, it doesn’t care where and to whom you send money,” says Michael Rauchs, a cryptocurrency and blockchain expert at the Judge Business School at the University of Cambridge.

Like all assets or currencies, bitcoin's price is determined by the amount that people are willing to pay for it. Whether that is the “right” valuation, and whether bitcoin is truly worth that amount or not, is largely down to opinion.

JPMorgan boss Jamie Dimon recently labelled bitcoin a fraud, and said its astronomic rise in value is a text-book financial bubble comparable to the Dutch “tulip mania” of the 17th century, which saw speculators push up the price of one bulb to ten times the annual salary of a skilled worker – before quickly losing almost all of that value.

Speculation has fuelled bitcoin’s rapid ascent in recent weeks, Rauchs says, but there have been signs that the cryptocurrency is moving from the fringes of the internet to the mainstream. He points to more than 100 hedge funds specialising in cryptocurrencies that have started recently, triggering the current price surge.

CME Group, which owns the Chicago Mercantile Exchange, where trillions of dollars of derivatives contracts for global commodities are traded each year, now offers bitcoin futures. Some analysts say this is a sign that bigger financial players are now ready to enter the market.

The number of people using the cryptocurrency has also risen from around three to six million in April, to between 10 and 20 million people at the end of 2017, although exact figures are very difficult to establish, Rauchs says.

It’s impossible to say with any certainty, but anyone investing in bitcoin should be aware that it’s a risky thing to trade.

Bitcoin slumped from $1,150 to below $500 in late 2013, after widespread media coverage prompted many people to buy it for the first time, fuelling a bubble that then burst. Bitcoin didn’t pass its previous high for almost four years.

However, if the cryptocurrency was to move into the mainstream and become a recognised medium of exchange around the world, its value would likely increase dramatically. But that scenario is far from being a certainty.

Regulators are not particularly concerned by bitcoin and other cryptocurrencies like ethereum at present. Bank of England Deputy Governor John Cunliffe has said bitcoin is not big enough to pose a threat to the global economy. But if they saw bitcoin as unsafe and began to crack down on it, this could hurt its value.

The number of companies accepting bitcoin payments has increased over the last few years. Microsoft and travel website Expedia both take bitcoin, and Icelandic singer Bjork is also accepting bitcoin payments for her latest album. Retailers in Japan can now accept bitcoin payments thanks to a new law passed last year, and small businesses can accept bitcoin payments through simple plugins that add to WordPress websites.

The currency has also found favour in countries experiencing political turmoil like Zimbabwe and Venezuela.

Bitcoin has a reputation for being used by criminals, particularly people selling drugs on the dark web. On marketplaces such as the now-defunct Silk Road and its more modern imitators, cryptocurrencies such as bitcoin have been the only method of payment, largely because they are theoretically untraceable.

Transactions can be tracked, giving a higher level of security than handing over money to the average street dealer, but identities (generally) can’t. Bitcoin is still used to buy drugs online, but its use has spread far beyond that.

Hundreds of articles speculating on how high bitcoin could go now seem to be published each week. Hedge fund manager Mike Novogratz told CNBC it could quadruple to $40,000 by the end of 2018. A piece on the investing website Motley Fool in May questioned whether it could go to $1m.

But according to Rauchs, the current frenzy is bitcoin’s fifth bubble. “After all of the previous four it crashed and remained low for some time before bouncing back,” he says.

“It has been going crazy... and that is not backed by any fundamentals. It’s really a self-fulfilling prophecy, driven by fear of missing out.”

This is partly down to the economic environment, Rauchs says. “We’ve had low or even negative interest rates for some time and stock and bond markets are already at all-time highs, while bitcoin is giving these incredible returns.”

Despite this, Rauchs still believes the outlook for bitcoin and blockchain technology is strong. “I would put it in the same category of revolutionary new technologies like the internet,” he says.

“These world-changing systems tend to be accompanied by bubbles in their early stages. What’s happening now is completely normal.”

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