How Bitcoin Works

More than a Bit Scary
While some enterprising folks have minted physical bitcoins, the vast majority of the currency remains exclusively digital.
While some enterprising folks have minted physical bitcoins, the vast majority of the currency remains exclusively digital.
Image courtesy of Bitcoin

Bitcoin is slowly gaining more legitimacy. But, there's the matter of people really trusting a currency. And that's where this new currency gets scary. Rampant speculation has turned the valuation of bitcoins into a neck-snapping roller coaster ride. In 2010, a unit of 1 bitcoin was worth just a few cents, but it rose steadily to around $30 in the middle of 2011. Near the end of that year, though, it zoomed violently down to only around $2.

But then bitcoin value made a remarkable recovery, rising to a sky-high $260 in early 2013. Then, once again, it crashed, dropping to just below $100. Those who bought low and sold high made a lot of dough; others lost mighty sums.

To many observers, this crash brought to mind the dot-com and housing bubbles. Some economists warn that the bitcoin system is a bubble just waiting to burst, perhaps again and again. They think it's a currency built only for suckers and speculators.

There's also the fact that online currency exchanges continue to be a hub for most Bitcoin transfers. The exchanges are necessary, of course, because they help you convert bitcoins to and from local currency. However, in a system that's supposed to be decentralized, these exchanges offer up a tasty target for government regulators and malicious computer hackers.

Hackers, for example, may not yet be able to exploit Bitcoin's elegant system in order to create fake coins or fraudulent transactions. But they can definitely attack the exchanges, which are as vulnerable as any other kind of Web site. In one widely publicized incident, hackers launched a DDoS (distributed denial-of-service) attack on the popular exchange Mt. Gox, rendering the site unreachable to just about everyone. Chaos ensued and bitcoin value plummeted.

The exchanges themselves are risky in another way, too. Many people store their bitcoins in their exchange accounts under the assumption that these sites are the safest storage method. But nearly half of bitcoin exchanges have folded, often taking every user's savings down in flames, too [source: ScienceDaily]. So if you do buy bitcoins, don't think of your exchange account as a good place to store your hoard.

Bitcoins are definitely a high-risk asset. And as you're about to see, there are other potential downsides to the Bitcoin system.