The story of Bitcoin grows curiouser and curiouser, to borrow a phrase from Lewis Carroll’s novel, Alice’s Adventures in Wonderland. Bitcoin is a digital currency created in 2008–09 by a programmer, or a group of programmers, known only as Satoshi Nakamoto. It is an ingenious decentralized virtual currency and payment network.

Bitcoins are created by a computer algorithm, and payments are made via encrypted transactions over a worldwide network of computers that also keeps a public transaction ledger and log known as the “blockchain” so as to prevent double-spending of the same Bitcoin. It is important to note that the amount of created Bitcoin is capped at 21 million units, with about 12 million currently in circulation. The remainder is to be created through a mathematical code-breaking computer process referred to as “mining.” It will be done at a steady rate (estimated to top out around 2040) to act as a mechanism for compensating those that maintain the payment network.

As with any new innovation, there has been much early experimentation and creativity in establishing the usefulness of this cryptocurrency, as well in highlighting its problems.

The September 2013 arrest in the U.S. of “Dread Pirate Roberts” (a pseudonym taken from The Princess Bride), the accused operator of the Silk Road website, used for purchasing illegal drugs and other criminality, highlights the attractiveness of using Bitcoin for criminal transactions, as there is relative anonymity with such transactions.

At the same time, it was reported that the Silk Road website had only accounted for about four percent of the Bitcoin trade, so the arrest did little to dampen the growth of Bitcoin as a legitimate payment currency. The number of establishments willing to accept Bitcoin payments appears to be growing rapidly, for legitimate commerce as well as for vendor promotional purposes, and the number of organizations and systems being created to facilitate Bitcoin transactions is also growing, including Bitcoin exchanges, ATMs, electronic wallet providers, and mobile apps. There are also Bitcoin investment vehicles being proposed, including a plan for a Bitcoin exchange-traded fund (ETF) put forth by the Winklevoss twins (known for their Facebook-related lawsuit chronicled in the movie The Social Network). BitPay, an electronic payment processing system for the Bitcoin, announced in December that it processed over US$100 million in Bitcoin transactions in 2013 and increased its merchant base to over 15,500 approved merchants in over 200 countries. Its volume of Bitcoin transactions had also tripled since October.

Bitcoin’s multiple features and advantages attract a diverse set of legitimate users. Transactions are relatively cost-efficient, unlike online payment transaction processes involving third parties that directly (such as PayPal) or indirectly (such as credit cards) increase the ultimate cost to the consumer. Bitcoin also appeals to those with a growing distrust of central authorities that control and manipulate the supply and trade of currencies, as well as to those who are looking for alternative vehicles for storing their wealth. Bitcoin is also fully convertible to various traditional currencies and is not linked to any specific proprietary payment processing platform, allowing most investors to move in and out of Bitcoin positions relatively easily.

As well, there is the rapid upward price trend that has very handsomely rewarded many early investors in Bitcoin while also triggering many media comparisons to the Dutch “tulip mania” financial bubble of the 1630s. During 2013, the value of one Bitcoin rose from less than US$15 to over US$1,200, before dropping about 50 percent and then recovering slightly in volatile trading during December.

However, while Bitcoin is certainly riding the growing shift towards electronic commerce, anyone considering going down the Bitcoin rabbit hole should be fully cognizant of the dangers, including the real potential for theft by electronic wallet hackers and losses due to the failure of organizations facilitating Bitcoin transactions. Moreover, there are no special regulatory or consumer protection safety nets afforded Bitcoin users.

At the same time, the rapid rise of Bitcoin is attracting increasing attention from various governments and regulators. The U.S. Senate Committee on Homeland Security & Governmental Affairs held hearings on Bitcoin in November, with no strong view emerging on whether tighter regulation of the Bitcoin trade was necessary. Of course, Bitcoin exchanges in the U.S. are already expected to register with the Financial Crimes Enforcement Network (FinCEN) of the U.S. Department of the Treasury and must implement anti-money laundering and know your customer (KYC) policies. However, many jurisdictions do not have similar requirements—including Canada, because Bitcoin is not covered by the legislation administered by the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC). This is leading to some concerns that more criminals globally will utilize the mobility of the internet and the relative anonymity of Bitcoin transactions for illegal activities and to launder money.

To date, governmental authorities have generally been content to leave the Bitcoin marketplace to develop and experiment on its own, knowing that any significant problems that develop in the near term with the fledgling digital currency would be little more than a tempest in a teapot for the financial system as a whole. As the U.S. Department of the Treasury pointed out during the U.S Senate Committee hearings, Bitcoin transactions amounted to only about US$8 billion in the first 10 months of 2013, while Bank of America processed wire transfers worth US$244 trillion, and PayPal conducted US$145 billion of transactions during 2012.

However, with more time and growth in the Bitcoin marketplace, much more government involvement can be expected in addressing criminal and anti-money laundering concerns, clarifying applicable capital gains and sales taxes, reinforcing national currency restrictions, and to better protect investors from fraud and theft. The Chinese government has already banned its financial institutions from trading Bitcoin and has asked third-party payment services to stop handling Bitcoin transactions. Such moves have led to significant Bitcoin price declines, given that the Chinese yuan is the second-largest currency used in Bitcoin exchanges after the U.S. dollar.

In fact, until the issues and uncertainties around Bitcoin become better resolved, the growth of Bitcoin will continue to face significant headwinds. In December, Bloomberg reported that many U.S. banks are reluctant to service Bitcoin exchanges and payment processors, and Global News reported that most of the big six Canadian banks have frozen or shut down accounts owned by Canadian companies that trade and convert Bitcoin to other currencies.

The key questions for many are when and how the Bitcoin story will end— and will Bitcoin ever replace traditional currencies? Few think so, given Bitcoin’s inherent supply restrictions, cybersecurity concerns, and significant price fluctuations that limit its credibility as a stable and suitable vehicle for storing wealth. Perhaps the best strategy for maximizing the benefits and limiting the risks is to use Bitcoin as a cost-effective transactional currency, limiting the holding of it to little more than the time it takes convert fiat currency to Bitcoin and transact it through the payment network.

However, Bitcoin has surprised many with its rapid growth and resiliency. Bitcoin continues to expand, and we still don’t know how far and deep the rabbit hole will go. However, even if it amounts to just a virtual daydream in the annals of modern currency, its legacy may be much more enduring: challenging the status quo with alternative possibilities and realities, and sprouting further ideas for the development of effective and efficient currency and payment systems more suitable for the advancing global high-tech age. To borrow and expand on a line from Alice’s Adventures in Wonderland once again, we can’t go back to yesterday because we were different people then.

Author’s note:
There have been a number of important developments with bitcoin since this article was written. The goal of the article was not to foresee such developments but instead provide context for better understanding the future unfolding of the bitcoin phenomenon.