Each bitcoin is a unique string of computer code. It has no physical existence. Bitcoins are created (or mined) by solving mathematical puzzles using computers. The coins are held in digital wallets, which means that strings of unique code (bitcoins) are each associated with digital wallets. Bitcoin wallets are free and can be downloaded anonymously. Every transaction ever made with every bitcoin, from the instant of mining, is recorded in an open transaction ledger, the blockchain. Every transaction can be independently verified by anybody who downloads a blockchain copy. The blockchain is constantly updated as new transactions are entered.
The creator of bitcoin, a mysterious person whose pen-name was ‘Satoshi Nakamoto’, developed an ingenious method of ensuring privacy. A transaction means a given bitcoin (or part of a bitcoin since it can be broken into fractions) moves from one wallet to another. Users check their individual copies of the blockchain to verify that the coin is in a given wallet and it is not being used in two transactions at the same time.
The transaction is, in itself, anonymous. A transaction is accepted as genuine only when a large majority of blockchain users agree the transaction is genuine. The verification process is time-consuming and it has led to a recent split in the underlying blockchain technology.
Bitcoin trading exchanges have know-your-customer guidelines of different stringency. It is possible to layer transactions with enough complexity to make it very hard to find entities. Bitcoins are accepted by some merchants but most don’t accept bitcoin as currency.
Bitcoin is a popular means of moving between fiat currencies, ironically because it’s not recognised as currency by most nations. During the Greek euro crisis for example, conversion of Greek euros was halted. But, the Greeks used euros to buy bitcoin, which they could then sell for dollars and yen. Similarly Mainland Chinese use bitcoin to transfer from yuan to other currencies.
Bitcoin have been among the fastest appreciating of assets. It may be useful to think of them as akin to virtual gold, or perhaps, to works of art. Apart from being a potential store of value that could beat inflation, another similarity to gold is that bitcoin is not interest-bearing. The technical underpinnings make it almost impossible to lend bitcoin for interest, without bringing other currencies into the picture.
There are risks of fraud, of course. Also, if you forget your wallet password, or the wallet is hacked, there is no recourse. But, every investor must deal with such risks. Those risks apart, the biggest fear with bitcoin is that it is still undergoing global regulatory scrutiny.
It is unclear whether the Reserve Bank of India and other central banks will let crypto currency trading run unchallenged for much longer. No government likes the thought of untraceable currency and bitcoin has been used in many crimes such as money-laundering and in the recent ransomware attacks. However, it is also unclear what governments can do to block crypto currencies. A currency gains value if users choose to give it value and use it in transactions and bitcoin clearly meets those criteria.
If you can stomach those risks, a small percentage of asset allocation to bitcoin seems like a reasonable gamble. The crypto currency could be a major gainer in an uncertain global environment. It is less cumbersome than gold and it seems to possess strong hedging characteristics.