What are Bitcoins and should you invest in them?

Visitors to the Brooklyn Café in Glasgow are used to paying for their coffees and teas with cash and plastic but now they're being offered another way of paying: by Bitcoin.

But what is a Bitcoin? How would you pay for your sandwich with a Bitcoin? How do you acquire Bitcoins? And if you're an investor looking for new ways to use your cash, is Bitcoin something you should consider as an investment vehicle?

Bitcoin was invented in 2009 but only really started to appear on the radar in the past couple of years as the existence of the Silk Road website (which drove its growth) began to attract attention beyond the 'nerdosphere'.

Silk Road, which was shut down last year by the FBI, was an online marketplace on the 'darkweb' that sold, among other things, guns and drugs; Bitcoin was the only way of paying for goods, as it offered a secure means of payment combined with anonymity.

Bitcoin is a 'cryptocurrency' – a virtual currency that uses cryptography for security. Cryptocurrencies don't exist in any physical sense – you can't carry coins or notes in your pocket – and they are not linked to any single country, government or economy.

Bitcoins are produced by powerful computers that 'mine' the coins. A coin is produced when the mining computer solves a mathematical problem set by the Bitcoin software. That software was developed in 2009 by a mysterious developer or group of developers – nobody really knows – called Satoshi Nakamoto.

It's an ingenious algorithm that makes it progressively harder to mine Bitcoins as time goes on, and the software ensures there will never be more than 21 million Bitcoins in existence. At the time of writing, there are around 12.2 million coins and the rate at which they are produced will slow as they get more and more difficult to mine until the year 2140, when production will stop.

Bitcoin transactions are recorded in a public computerised ledger called the 'blockchain', which is maintained by the miners. Anybody can see the blockchain via websites such as blockchain.info, although the blockchain doesn't reveal who has carried out the transaction, and it's this combination of transparency and privacy that appeals so much to many of its users.

Buying Bitcoins

Anyone can use Bitcoins to pay for goods and services online – there are plenty of outlets other than underground illegal marketplaces that will take them, both online and in the real world. Users can buy Bitcoins in a number of ways, such as via one of the trading exchanges like Mt. Gox (mtgox.com) or via bank transfers and even by using SMS and mobile phone apps.

Your Bitcoins are held in a 'digital wallet', either on your own machine or via an online provider, and transferred to the wallet of your payee. When a customer settled his £42 bill at the Brooklyn Café in Glasgow in January, he used his mobile to scan a code in the café that initiated the transaction – which completed faster than a payment by credit card, according to café manager Jonny McDonald: "Our credit card machine takes around 45 seconds to process a payment, whereas a Bitcoin transaction takes just 10 seconds."

Setting up a digital wallet and an account with an exchange isn't particularly difficult but it's as well to make sure the computer you keep it on is very secure and backed up: if you lose your wallet – either by someone stealing it via malware on your computer or a computer failure – it is gone forever and you cannot get your Bitcoins back, as the unfortunate James Howells discovered at the end of last year.

He had stashed 7,500 Bitcoins in his digital wallet back in 2009 when they were worth only pennies, and later removed the hard drive containing the wallet from his computer and put it in a drawer, only to throw it away in a clear-out. He had forgotten about that hard drive until Bitcoin hit the headlines when Silk Road was shut down, and realised that the cryptocurrency had risen dramatically in value – it was around $1,200 at that time, making the contents of his wallet worth around $9 million (£5.5 million).

Looking for the hard drive that held the wallet, he soon discovered that he'd thrown away the drive and it was probably buried in a landfill in Newport, Wales. He was pictured mournfully standing in front of the landfill, saying: "I'm at the point where either I laugh about it or cry about it. I think I'm resigned to never being able to find it."

Bitcoin is by no means the only cryptocurrency: there are dozens, known as altcoins, and anyone can create one – even on behalf of a dog. Some, like Litecoin and Peercoin, are forks of Bitcoin: they use the same software protocol but differ in other ways: Peercoin has a more efficient mining process, for example.

Others are 'statement' cryptocurrencies, such as the Dogecoin, which uses the Doge internet meme as its mascot, and Coinye, a 'crytpocurrency for the masses' that has no connection with the rapper, Kanye West.

Why do people want to use Bitcoin?

Some small businesses like to accept payment in Bitcoins because they get paid straightaway, instead of having to wait for funds to clear via PayPal or other online payment methods.

Some consumers (and businesses) like them because there's no tax to pay on transactions while others see Bitcoin as something of a safe haven, similar to gold. Charlotte Watson, chief investment officer at Attivo Group, says the effect of quantitative easing, which has seen gold's price sink, has put a lot of people off the precious metal as a safe haven and they're looking for alternatives.

Tim Johnson, managing director of printer supplies company Inkfactory.com – which has started accepting Bitcoins as payment in the past few months – agrees and says lots of people see it as a store of wealth. "We have clients in southern Europe – Spain, Cyprus and Greece – who don't see Bitcoins as a currency but merely as a way to keep their money out of the banks and where they know they can get access to it."

Johnson says his company started taking Bitcoins for two reasons."We like to be early adopters of new technology. Earlier this year, we became the first company to use a 3D printer to make inkjet cartridges," he explains. But he says the other reason is to do with PR and branding."If people really start to use Bitcoins to pay for lots of things online and they see we've been doing it for a while, they'll be more likely to come to us to spend their Bitcoins."

Unlike 'real world' currencies, which are controlled by governments, Bitcoins aren't subject to laws that aim to tackle money-laundering.They can be bought and sold anonymously without trace – meaning they've become very popular with criminals.

Investment potential

The big question for many with Bitcoin and other cryptocurrencies is can they be used as investment vehicles – and, more pertinently, is that a good idea?

Certainly, there has been some high-profile enthusiasm for Bitcoin as an investment vehicle. Last year, the Winklevoss twins, Cameron and Tyler, who are best known for their legal scrap with Facebook founder Mark Zuckerberg, announced they were floating the Winklevoss Bitcoin Trust, "designed for investors seeking a cost-effective and convenient means to gain exposure to Bitcoins with minimal credit risk", according to their filing with the US Securities and Exchange Commission.

However, the Winklevii, as the twins are known, "are famous for being number two," says Steve Ruffley, the chief market strategist at InterTrader, the spreadbetting firm. Ruffley is unequivocal about the idea of investing in Bitcoin: "It's a categorical no," he says.

It was Bitcoin's meteoric rise in value – it peaked at around $1,200 last year before falling back – that encouraged buyers to pile in, hoping to capitalise on its apparently inexorable upwards trajectory. However, as Ruffley points out, by the time that had happened, the best days were already over for speculators: "Once you see a trend, you've already missed it," he says.

Bitcoin had a fillip towards the end of last year when an FBI letter revealed during a US Senate committee hearing that the law enforcement agency believes that cryptocurrencies offer "legitimate financial services", only to suffer a blow in December when China banned the use of Bitcoin in the country.

Those events underline the fact Bitcoin is extremely vulnerable to real-world events, and exemplify why many observers believe that the cryptocurrency is more like a speculative asset than a real currency.

Others are more enthusiastic about Bitcoin as an investment vehicle, and products exist for those keen to ignore advice of sceptics such as Ruffley: the Bitcoin Investment Trust, launched by SecondMarket, the online marketplace that specialises in illiquid assets, has, unsurprisingly, done well for its investors thus far; while eToro, the social investment network, has recently launched a product that gives its members exposure to Bitcoin.

Giles Russell, operations manager at CipherTrade, says: "The ordinary consumer should definitely be investigating cryptocurrencies but should do so with caution." He points out: "As with any high-risk investment there is high risk, not only from the exchange rate dropping but also in regards to legal matters in their respective countries. Cryptocurrencies should either be viewed as a very long-term strategy, or very high risk, and the consumer should not invest more than they can afford to lose."

He adds: "I'm one of the few people who makes his entire living via crypto-sources. It is possible to make money but you have to be very careful."

Paul Plewman, a director at Sable International FX, sounds another note of caution: "The truth is, we're still in the early days and while investors are looking on with interest, no one is quite sure what the future holds for the market."

However, you could note those comments are from people with a vested interest in encouraging people to invest in Bitcoin and other altcoin currencies via their products. Steve Ruffley remains deeply unconvinced. He points out nobody should invest in anything they don't understand, adding: "I understand how to trade the Standard & Poor's; I don't understand Bitcoin. I don't trade Bitcoin for the same reason I don't trade the Nikkei – I don't understand it. I wouldn't know how to control the risk."

A key reason to be wary of using Bitcoin as an investment vehicle is the lack of regulation, although the US Treasury in December warned businesses that dealt with Bitcoin they face the possibility of having to comply with money-laundering rules. Also in December, the European Banking Authority warned consumers there are no regulations that protect consumers in Europe, and added that it is assessing further "all relevant aspects associated with virtual currencies in order to identify whether virtual currencies can and should be regulated and supervised".

Libertarians insist regulation will kill Bitcoin but consumers might be more willing to jump in if regulation does come to pass. Until then, perhaps the words of Steve Ruffley should ring in the ears of anyone considering a punt: "You're off your head. The risks so outweigh the benefits that I don't see it as a viable investment for anybody. There are so many other ways to make your money work for you."

Where can I spend my Bitcoins?

You can't use them on the websites of big high street stores such as Amazon or eBay but there's a very long and varied list of small shops, restaurants and even investments that accept Bitcoins as payment.

The weird and wonderful places where you can spend your Bitcoins include:

  • Burger Bear, a street food burger vendor in east London. The first burger it sold for Bitcoins (BTC) in early December cost 0.0131 BTC, which was worth around £7.50 at the time.
  • The Pembury Tavern in Hackney, east London, allows customers to pay for food and drink in the cyber currency.
  • You can hire a designer dress at girlmeetsdress.com using Bitcoins.
  • Richard Branson has said you can spend your Bitcoins on a trip into space with Virgin Galactic.

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