Bitcoin: Seven reasons to be wary

Of all the virtual currencies out there, BitCoin is the most interesting from a technical perspective - and the least interesting from the business point of view. BitCoin is a peer-to-peer virtual currency that uses cryptography to control the creation and transfer of money.

Farm Cash vs. Hard Cash

Unlike all other currencies, BitCoin is completely independent. "It is company or organization agnostic," says Ajay Vinze, a professor at the W. P. Carey School of Business at Arizona State University, who is studying BitCoin.

All other currencies are either based on some standard of value, or are backed by an issuing entity such as a government or corporations. Gold, for example, is a metal which has both practical and decorative uses, though many gold coins also have additional value as historical artifacts.

Many BitCoin enthusiasts are attracted by BitCoin's independence, and the fact that its value comes directly from its network of users. But aside from its status as a technical marvel, it has little practical benefit for business users or consumers.

Here are seven reasons why.

1. Nobody has to accept it.

Traditional government-backed currencies have local monopolies on things like paying taxes or utility bills. Merchants may decide to accept live chickens as payment, but they usually have no choice about whether or not to accept their national currency. Companies that issue virtual currencies typically offer goods or services in return.

"You want it to have inherent value, you want it to have someone backing it up and exchange it to other forms if you choose," Vinze says.

Now, this isn't a guarantee. Governments fall. Companies go bankrupt - or may simply decide to discontinue their virtual currencies.If a currency is only as strong as its backers, BitCoin isn't backed by anyone.

2. No critical mass.

For a currency to have any practical value, it has to have a critical mass of buyers and sellers.

"Technically BitCoin has no reason why it shouldn't be successful, but it certainly has no following that you would want," Vinze says.

3. No switching costs.

Say you are a U.S. business that accepts U.S. currency, and you decide to stop accepting it, and, say, accept only live chickens. You will lose all potential customers who don't have access to live chickens. You will have problems paying suppliers and employees. And you won't be able to pay taxes - in the U.S., even barter-only transactions are taxable. These are all high switching costs.

If you are a player of a popular online game, and decide to stop using their in-world currency, your game experience will suffer significantly, and you may have to stop playing the game altogether. This is a switching cost.

If you decide to sell off your existing BitCoins and stop using them, there are no switching costs. All your existing suppliers and employees will happily take other forms of payment. Your only loss would be the marketing value of accepting BitCoin, which is likely more than offset by the additional costs of processing BitCoin payments.

And if a newer, cooler virtual currency comes along, that has even more buzz surrounding it, there is no downside at all to leaving BitCoin.

4. There's nobody to police it.

If someone breaks into your bank and steals your money, the bank would cover the loss, or it will be covered by FDIC deposit insurance. If someone points a gun at you and takes your wallet, you can call the police and have them arrested. You might get your money back, and they'll go to jail. Maybe not the first time they rob someone, but eventually.

If a thief steals virtual currency from a company in order to defraud the company, there might be legal repercussions as well. In addition, companies carefully police their virtual currencies, banning hackers from their platforms and constantly improving security measures. And if their users suffer from a virtual theft, a company might make good on the loss in order to maintain good customer relations.

If your BitCoin money is stolen, there is nobody to turn to for redress. If someone steals your laptop - or hacks into it -- they get all the BitCoins stored there. If you keep your BitCoins with an online exchange, and it is hacked, there is no government-mandated insurance to cover your loss, and nothing protecting your account against the exchange closing down.

There are no jails for BitCoin crooks.

This may change if governments start passing laws treating virtual currencies like real money, and forcing virtual currency exchanges to get financial services licenses, audits, and deposit insurance. Until then, nobody should be keeping more money in BitCoin than they can afford to lose.

In fact, last year a BitCoin user woke up to find his haul of virtual currency had been plundered.

A user with the handle allinvain found 25,000 BitCoins had been stolen.

5. There's no real need for it.

What actual purpose does BitCoin serve that isn't already being met by other payment channels? Companies already have wire transfers, checks, prepaid cards, credit card payments, PayPal, Google Checkout, Western Union, and, of course, cash.

BitCoin offers completely anonymous payments, which can be useful for tax avoidance, money laundering, gambling, and other illegal activities.

A company that does a large amount of business in BitCoin, beyond what could be accounted for with the marketing coolness factor, would thus draw attention from regulators - same as a company that does a lot of its business in cash, which has the same benefit of anonymity.

6. It's volatile.

According to Vinze, BitCoin has fluctuated greatly during its short history, up to a high of around $30, and down to its current value of around $5.

This is a significantly higher volatility than almost any national currency. For example, the Euro has vacillated between $1.20 and $1.60 over the past five years.

The fact that BitCoin has survived despite these fluctuations is a sign of its resilience, Vinze says.

But it's also bad news for companies that want to do business in it, since these fluctuations make it difficult to set prices.

7. BitCoin is unfair.

Traditional, government-backed currencies are created when banks loan out money for new homes, business expansion, or to pay for college educations - actions which increase the money supply but also grow the economy. Virtual currencies backed by companies or organizations are issued to reward players for in-game performance or to reward customers for purchases, or are sold directly to users.

BitCoins are created when users run complex algorithms on their computers, with fewer and fewer BitCoins generated as times goes on.

"Anyone who got into BitCoin at the very beginning can be theoretically rich with very little effort," says Benjamin Joffe, head of digital strategy consultancy Plus Eight Star. "In addition, some people might be able to create wealth out of thin air, out of other people's efforts, by way of botnet networks."

Read more about software in Network World's Software section.

Register now for the ARN Security Forum 2013 on June 4 at the Sydney Mint

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