After a century of paying bills through the mail, an increasing number of Americans have made the switch to online bill payment systems.
Banks love the system because it reduces their transaction costs, but they now have a new competitor: Bitcoin.
Satellite TV provider Dish Networks (Nasdaq: DISH) has just announced plans to start accepting bitcoin. Overstock.com (Nasdaq: OSTK) and Virgin America also initiated a bitcoin payment option in the past year, and other major corporations may soon follow. That means you're likely to start hearing a lot more about this virtual currency.
For non-techies like me, two quick questions arose: How does bitcoin actually work? And is it a good idea, or just a flavor of the month? To find out, I did a little digging.
Controversial, But Gaining Acceptance
Bitcoin was launched in 2009 as an alternative to traditional payment systems. While digital payment systems such as PayPal conduct transactions in hard currencies (such as the dollar), bitcoin is an entirely new form of currency.
The methodology underpinning bitcoin is both brilliant and absurdly complex. Here's a quick primer:
Bitcoins are created as rewards for its use as a payment, though an increasing number of transactions must be conducted to receive rewards as the base of bitcoins in circulation grows. The amount of bitcoins in circulation is tracked by a universally accessible global ledger (known as the "block chain.")
The virtual currency saw huge spikes in its value in its early years, thanks in large part to a scarcity of bitcoins in circulation. Bitcoins reached a peak value of $1,000 last year and are now worth roughly $600. As the supply of bitcoins increases -- it stands at an estimated 12.8 million in circulation today -- prices are expected to stabilize. They should eventually settle at a fixed price, when the arbitrary cap of 21 million bitcoins has been reached (which is expected to happen in about 25 years).
Why were bitcoins created? There are three main reasons.
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Bitcoins reached a peak value of $1,000 last year and are now worth roughly $600. As the supply of bitcoins increases -- it stands at an estimated 12.8 million in circulation today -- prices are expected to stabilize.
First, to create an alternative to the almighty dollar, which is still the currency of choice for many inter-country financial transactions.
Second, as a way to generate profits for its early active supporters, though such profits are getting harder to come by.
Third, as a vehicle to conduct illicit transactions that are harder to track by government agencies. For example, a major drug ring that used bitcoins as its currency was broken up last year.
That leads to the questions: Why would consumers and businesses embrace such a risky currency?
The primary answer lies in transaction fees. Credit card processors such as Visa (NYSE: V) and MasterCard (NYSE: MA) charge up to 2% or 3% per transaction, which can take a big bite out of profit margins.
Second, despite the seemingly risky nature of this new currency, it has proven to be quite secure. The complexity of the system makes it (almost) impossible to steal bitcoins or issue false transactions. That doesn't mean that fraud doesn't happen: Uninformed consumers still fall prey to Web scammers, but those who follow the rules are safeguarded from such hucksters.
But a solid technology doesn't make for a solid currency. Bitcoin exchanges are operated by non-financial institutions, which means that you can forget about that $250,000 account protection from the FDIC (Federal Deposit Insurance Corp.) if a financial institution fails.
Japan-based Mt. Gox, which handled 70% of all bitcoin transactions, was seized by creditors earlier this year, wiping out hundreds of millions of dollars in bitcoins. Mt. Gox had a series of problems in prior years, leading to lost funds, yet ardent supporters of bitcoin remained undeterred.
Let's rephrase that earlier question: Why would Dish Networks embrace this currency in light of such risks? The company likely sees the move as a way to lure customers, especially those who are forward-thinking about new technologies. If Dish reports that bitcoin has succeeded in that mission, it could create a swell of new bitcoin announcements.
And as bitcoin moves into the mainstream for bill payments, it is also going to start popping up in financial spheres. And if that happens, you should steer clear. As it stands, financial regulation is the only thing that stands between investors and thieves.
So when the Financial Industry Regulatory Authority (FINRA) suggests you avoid bitcoin, you should listen. FINRA is currently focused on companies that promise to profit from the growth in bitcoin, but the day is coming when someone will offer you a chance to buy shares of Apple (Nasdaq: AAPL) or IBM (NYSE: IBM) using bitcoin.
Risks to Consider: The risks here are too numerous to mention, but they start with a still-volatile value for this currency, which has ricocheted higher and lower in the past year.
Action to Take -- At the risk of sounding like a neo-Luddite, bitcoin is an answer to a question that most people aren't asking. To be sure, the onerous credit card fees charged by Visa and MasterCard are a real drag for businesses and consumers alike. That sets the stage for new payment systems that avoid those transaction networks and link consumers directly to businesses with lower fee schedules. But such systems will still be based on the U.S. dollar, which is directly backed by the U.S. government, and not any dubious organizations with names like Mt. Gox.
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