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Bitcoin: Know the risks before you buy

As Bitcoin hit a record high of $19,000 for each coin, the cofounder of the Bitcoin.com website warned that Bitcoin is "the riskiest investment you can make". 

Here are some of the things you should consider before you jump on board.

What is Bitcoin? 

  • Cryptocurrency is a digital form of money that you can use to pay for some transactions online. Bitcoin is the most popular of the so-called "cryptocurrencies".
  • As with "real" currencies (like the US dollar), you can own one, 10, or millions of Bitcoins. Unlike real currencies, cryptocurrencies only exist online and are not backed by any government or central bank.
  • Cryptocurrencies depend on complex computer software to verify, validate and secure transactions between people exchanging this virtual money online. 
  • Created in 2009. The software running Bitcoin was first released in 2009, together with the website Bitcoin.org, by a programmer self-identified as Satoshi Nakamoto. He announced Bitcoin as "a Peer-to-Peer Electronic Cash System".
  • Taxes. In March 2014, the US government agency responsible for tax collection (IRS) stated that all virtual currencies, including Bitcoins, would be taxed as property rather than currency. 
  • South Korea is reportedly also looking to tax the money made from trading in cryptocurrencies. The government will also ban minors from opening accounts on virtual coin exchanges.

How does it work?

  • Blockchain: The financial system to validate Bitcoin transactions is known as the Blockchain, and depends on a decentralised network of computers connected over the internet.
  • Like peer-to-peer (P2P) networks where unidentified people upload and download music and films, the blockchain depends on a growing community of people and institutions online. 
  • Those peers run the Bitcoin software to verify Bitcoin transactions, independent of any bank or treasury.
  • Every time people exchange Bitcoins online, the whole network gets updated with the new information, creating new "blocks", i.e. long chains of data for computers to solve.
  • Mining farms: As with printing new bank notes, new Bitcoins are created by solving "blocks" of mathematical equations that are created each time Bitcoins are exchanged online.
  • Bitcoin software can crunch all those equations automatically, but it requires a lot of computing power to do so. For this, large data centres known as "mining farms", have been set up, with many of the largest farms located in Russia and China.
  • Blockchain.info counts 16 million Bitcoins in circulation, while there can only be up to 21 million Bitcoins. This limit is set in the Bitcoin algorithm.

Where can you buy it?

  • Bitcoin exchanges. Bitcoins can be purchased through exchange operators dedicated to cryptocurrencies, as well as traditional operators such as the Chicago Mercantile Exchange (CME) and the Swissquote Bank, among others.
  • In those public exchanges, Bitcoin is traded under the XBT and BTC symbols. Bitcoin Cash (BCH) is another cryptocurrency with its own price.
  • CME's Bitcoin Reference Rate (BCC) is a spot price index used by CME, and is based on the daily Bitcoin price on specialised exchanges such as Bitstamp, GDAX, itBit and Kraken.
  • Costs more than gold. At December's peak rates, one Bitcoin costs as much as $18,000. For this much, you could also buy over 400 grams of gold, at current rates.
  • In 2010, you could buy one Bitcoin for less than $0.10. If you had invested $100 then, it would be worth millions today.

How safe an investment is Bitcoin?

Investing in Bitcoin would mean investing in the complex algorithms on which it is based, and on the future of the peer-to-peer network that operates it. 

A look at the terms and conditions that an investor in Bitcoin would have to accept to buy Bitcoin from a Swiss-based exchange operator. Here are some of the risks that you would be accepting as an investor in Bitcoin:

  • Price volatility. The value of cryptocurrencies may change significantly even in a single day, which would mean a capital loss of your investment.
  • For example, last week the price of Bitcoin fell by 26 percent. If you had bought a Bitcoin on December 19, you would have paid $18,936 for each coin. But if you wanted to sell it on December 23, buyers on the market were not willing to pay more than $14,048 - a loss of $4,888 for each coin.
  • In 2013, the price of Bitcoins had fallen by 61 percent in a single day. On April 10 the exchange for Bitcoin had fallen from $266 to $140 for each coin.
  • Cryptocurrencies lack the historical track record of other currencies or commodities, such as gold, that could guide whether current levels of volatility are typical or atypical.
  • Hacking risk. On December 19, a South Korean cryptocurrency exchange said it would file for bankruptcy after it was hacked for the second time this year. 
  • Over 70 million dollars' worth of Bitcoins has reportedly been lost by several cryptocurrency exchanges and miners, highlighting concerns about the security of such currencies.
  • "Hard fork" splits. Since the value and support for the currency depend entirely on the community using it, disagreement between the stakeholders may result in the splitting of the network to support new competing cryptocurrencies, known as "hard fork".
  • For example, Bitcoin Cash (BCH) is a hard fork from the original Bitcoin. Effectively, BCH is now a different cryptocurrency from the original Bitcoin, inviting stakeholders to sell their "old" Bitcoins and invest in this new one. 
  • The cofounder of the Bitcoin.com website, Emil Oldenburg, reportedly "sold all my Bitcoins recently and switched to Bitcoin cash". 
  • Early stage technology. With advances in technology, cryptocurrencies are likely to undergo significant changes in the future. How the existing cryptocurrencies will cope, or benefit, from those changes is to be determined.
  • There is also the risk of alternative technologies that could supersede existing cryptocurrencies and make them obsolete.

Where you can use it

  • Online stores that accept Bitcoin. In 2014, Overstock became the first major online retailer to accept Bitcoin payments. Monoprix and Newegg also accept Bitcoin online payments.
  • For travel. Latvian airlines AirBaltic and Air Lituanica accept Bitcoin payments for some of their flights.
  • California-based online travel booking website CheapAir.com claims to have completed more than $1.5m in Bitcoin sales on flights, hotel bookings and Amtrak railway bookings.

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