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Monday, April 8, 2013

Bubble or No, This Virtual Currency Is a Lot of Coin in Any Realm

Bubble or No, This Virtual Currency Is a Lot of Coin in Any Realm

WHEN he was a Yale Law School student, Reuben Grinberg wrote one of the first academic papers about Bitcoin, a novel virtual currency that uses sophisticated cryptography to validate and secure transactions that exist only online.

Bitbills are physical representations of the virtual currency known as bitcoins.

When Mr. Grinberg, now a lawyer in the financial institutions group of the Manhattan law firm Davis Polk & Wardwell, first learned about bitcoins, they were selling for 10 cents. Now, after the latest price surge that began in January, the cost of a bitcoin on an exchange that converts them to dollars is something like $140, and the collective value of all bitcoins has passed a billion dollars.

That is a lot of coin in any form, and the billion-dollar milestone has turned the once-obscure online currency into a media sensation. Had Mr. Grinberg invested just $100 back then, today his investment would be worth ...

Ah, but that way madness lies. “People are buying bitcoins because the price is going up,” he said in an interview. “That is the classic indicator of a bubble.”

The question of whether the increase represents real value or is simply evidence of a bubble is at the heart of the current media frenzy. Bitcoin began in January 2009, a project introduced by a programmer or group of programmers who worked under the name Satoshi Nakamoto.

The project represented a breakthrough in using software code to authenticate and protect transactions without resorting to a centralized bank or government treasury. In that way, Bitcoin became a peer-to-peer system. That comes in pretty handy for people who do not want their transactions monitored.

In conversations about the project with scholars who study it, the word that comes up as often as “bubble” is “genius.”

For one thing, though bitcoins are software code, you can’t simply copy them like a music file. The process of creating the coins â€" “mining” them in the project’s allusion to something tangible like gold or silver â€" involves computer work that, crucially, verifies Bitcoin transactions.

“It is the most successful digital currency already right now,” said Nicolas Christin, the associate director of the Information Networking Institute at Carnegie Mellon University. “Even if bitcoins become worth nothing, it has succeeded more than any academic proposals for a digital currency,” he said in an interview from Okinawa, Japan, where he was attending a conference on financial cryptography that included a number of papers on bitcoins.

People buy the coins for cold hard cash on exchanges. Completing those purchases, as well as cashing out, typically involves re-entering the world of traditional financial transactions, with fees and loss of anonymity.

But Bitcoin’s managers say the currency has proved so secure that despite the fact that exchanges and virtual wallets, where people keep their bitcoins, have been hacked, the coins themselves have not been forged.

So why the sudden run-up in value Some point to the recent crisis over Cypriot banks, which made a currency beyond the control of governments more tempting. And as with a run-up in anything tradable â€" tulip bulbs, dot-com shares â€" there is also the hypnotic logic that says the price went up today, so that means it will go up tomorrow.

Some observers and investors also make the case that bitcoins are in fact undervalued. Their argument goes like this. The total value of the world’s economic activity is enormous. There are certain transactions that are ideal for bitcoins because the currency is relatively anonymous and does not need to be processed by a financial organization or a government.

If bitcoins become the dominant currency in some small niche of the world economy â€" that is, those people who do not want their transactions easily tracked or who want to send money back home from abroad â€" then they will become quite valuable indeed. This outcome has been neatly summarized by the financial blogger Felix Salmon as making bitcoins an “uncomfortable combination of commodity and currency.”

The price increase becomes a question of supply and demand. Unlike other currencies that can adjust the money supply depending on economic conditions, bitcoins have a supply that is fixed. The amount of new coins that can be minted was plotted at the outset with a finite number of coins at the end, roughly 21 million in the next century. Today, the rate is 25 new coins every 10 minutes; for the first four years, it was twice as many, 50 every 10 minutes.

The slowdown in the rate new coins are added, which was programmed into bitcoins, may also help account for the spike in prices.

So far, excluding investors and day traders, the main use of the currency appears to be illicit activity. There are the online gambling sites that use bitcoins. And the anonymous online marketplace Silk Road, which accepts only bitcoins, is “overwhelmingly used as a market for controlled substances and narcotics,” according to a paper on Silk Road written by Mr. Christin of Carnegie Mellon.

A version of this article appeared in print on April 8, 2013, on page B3 of the New York edition with the headline: Bubble or No, This Virtual Currency Is a Lot of Coin in Any Realm.