investing

Bitcoin: Virtual money or risky investment?

In an age when most of our money is little more than electrons in our banks' computers, it may feel like bitcoins and other virtual currencies aren't that different from the dollars you directly deposit into your account each week or the 401(k) account that holds your nest egg.

But bitcoins are different. It is an online currency that can be transferred through a computer or smartphone without an intermediate financial institution.

While it's true that many investors these days experience their portfolios primarily as numbers on a computer screen, owning a stock means you have a small piece of something that's at least partially tangible. That is, the company has offices, factories and other assets. Similarly, all those blips in your checking account can be withdrawn as cash and carried around in your wallet, and that cash is backed by the financial -- and literal -- firepower of the U.S. government.

On the other hand, bitcoins exist almost exclusively as entries on a giant virtual ledger stored on computers worldwide.

While the purely digital nature of bitcoins may make some uncomfortable, it does have a major upside: A user's bitcoins can't be frozen by an angry government, and the movement of bitcoins in and out of a country can't be prevented, says Jelena Mirkovic, a computer scientist and assistant professor at the University of Southern California's Information Sciences Institute.

Bitcoins are created or issued by a central bank. They are created by "miners," who solve one of a series of increasingly complex math problems through a combination of computing power and luck, Mirkovic says.

A miner who solves the problem gets to put his name next to a predetermined number of bitcoins on a ledger, which records all bitcoin transactions and is constantly shared and updated by a peer-to-peer network similar to the original version of the music-sharing service Napster. The number of bitcoins and the speed at which they can be created is mathematically limited, with successful mining that earns fewer and fewer bitcoins over time until the number reaches a little less than 21 million. That's when it stops.

"You're trying lots of different combinations to find the solution," Mirkovic says. "There is not a way to solve this quickly, so you have to just do a lot of trials in order to find the answer, and that's what controls the market. That's what guarantees that you can't just manufacture lots of coins."

An unconventional currency

When it comes to actually making day-to-day transactions, bitcoins aren't yet as useful as conventional currency, Mirkovic says. At the moment, only a handful of businesses, mostly online, accept bitcoins as payment, including blogging site WordPress and Reddit.

You know how if someone steals your debit card information and makes a bunch of purchases, you can report the theft and get your money back? That doesn't happen with bitcoins, which puts the onus for security squarely on users.

In order to make a bitcoin transaction, you need a "private key" that corresponds to the bitcoin address where your coins are held. That key consists of a code consisting of a long string of numbers and letters, which bitcoin users can keep on a slip of paper or in a file on their computer. Programs called "wallets" also can be used to keep track of a user's private keys.

Without that key, it's pretty much impossible for a thief to steal a user's bitcoins, Mirkovic says. But should someone manage to gain access to a bitcoin owner's hard drive though malware or other means and steal their private keys, they could use it to transfer that owner's bitcoins to themselves. Once done, such transactions, like all bitcoin transactions, are permanent and irreversible.

To prevent that, bitcoin users should consider storing their private keys on a separate computer than the one they use for day-to-day transactions and browsing so that they're out of reach of hackers, Mirkovic says.

Compared to more conventional investments such as stocks or bonds, the market for bitcoins is still in its infancy.

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