Here's What You Should Know About Bitcoin

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Many people heard of the virtual currency bitcoin for the first time recently when U.S. authorities shut down Silk Road, an online marketplace for illicit goods. Bitcoin was the currency used to order everything from heroin to fake IDs on Silk Road — but the online-only currency is also used by law-abiding citizens who embrace it for a number of reasons, ideological, practical and profit-motivated.

Buying and using this digital currency doesn't make you a law-breaker — but is it a good idea? Here's a look at what bitcoin really is, and the pros and cons of using it. (See also: Should You Choose Debit or Credit at Checkout?)

What Is Bitcoin?

Bitcoin is a form of money that you can buy online using dollars or other national currencies, then spend at merchants who accept it, or save as an investment. There aren't any official bitcoin bills or coins; bitcoin holdings exist digitally and are stored on your computer or held for you by an online company.

Bitcoins are released into the economy when computers "mine" them by solving increasingly difficult mathematical problems. There are a finite number of bitcoins — and once they are all mined, no more can be created, since there is no central bank or federal reserve to manipulate the bitcoin supply. (See also: How Banks Increase the Money Supply With “Quantitative Easing”)

This system, an open source software protocol, was created by an anonymous person or group known as Satoshi Nakamoto, as an alternative to national currencies. Bitcoin is decentralized, not under the control of any one government, and is embraced by libertarians, voluntaryists, and anarchists as a way to effect transactions without government involvement. However, that doesn't mean it's immune to government regulation. U.S. authorities, for instance, are requiring companies that transmit bitcoins to register as money services businesses.

Another way that bitcoin is different from other forms of currency is that it can be transmitted online from person to person without going through any bank or clearinghouse. Because of this, fees for exchanging or transferring bitcoins are very low.

When the first bitcoins were released in 2009, the published exchange rate was just $1 for 1,300 bitcoins, but as more and more people became interested, the price climbed to a high of $31. Then, the value crashed to a low of $2. Further price gyrations have ensued, even as more bitcoins have been released and more and more people have acquired and used them.

Now, there is more than $1.5 billion worth of bitcoin in circulation. The value hit a record high of $266 in April 2013, and currently trades at around $137, making many early investors into millionaires.

Why Buy Bitcoin?

This all may sound like a crazy system that only hard-core computer geeks would try — or worse, some kind of fraudulent scheme. And it's true that many of the people I have met while writing about bitcoin are computer programmers. But bitcoin does have advantages that could appeal to anyone — if the downsides aren't too much for you.

Advantages

Bitcoin users point to a number of advantages bitcoin has over regular currencies.

Tiny Fees

If you want to send money to family overseas through Western Union or other companies, fees can amount to 9% or more of the amount you're sending. But you can use an online wallet to transfer bitcoin to another person's online wallet for just a few cents.

Privacy

Depending on what wallet app you use, you can transfer bitcoin without sharing as much identifying information as credit cards or bank accounts require. Some people call bitcoin anonymous, but because bitcoin transactions can be viewed publicly, it is sometimes possible to figure out who people are on the system.

Potential Investment

Many bitcoin enthusiasts just hold onto their bitcoins, because they believe that the value of the currency will keep going up. Remember that there is a limited number of bitcoins in the system — so the theory is that if the crypto-currency's popularity continues to grow, the price will keep growing as well. Some people make money by day trading bitcoins — buying when the price dips in the hopes that it will bounce back again.

Merchant Advantages

If you operate an online retail business, chances are you pay about 2.5% of everything you take in to credit card companies. Some merchants have started taking bitcoins just to avoid those fees. Other merchants chafe at credit card company rules — especially the fact that credit cards can force merchants to issue a refund even if they don't think the customer deserves one. With bitcoin transactions, only the merchant can decide to issue a refund. (See also: How to Get a Refund on Non-Refundable Goods)

Liberty

A lot of people who collect and spend bitcoins like the fact that it is not a government-issued currency. If you feel like the government has too much influence over your life, using bitcoin can be a small way of rebelling.

Disadvantages

Before you jump in, keep in mind that bitcoin is still relatively new and that it has a lot of challenges.

Volatility

The price of bitcoin moves around so much that the few people who get paid in bitcoins have their salaries pegged to the dollar or other national currencies. Bitcoin Foundation chief scientist Gavin Andresen warns, "don't invest your life savings in bitcoin unless you're willing to lose your life savings, because it is highly volatile and risky."

Legal Uncertainty

This is a biggee. As governments grapple with how to regulate this new virtual currency, they have frozen and seized accounts at companies such as bitcoin exchange Mt. Gox. If something like this happens to a company that's storing your bitcoins, you could have trouble accessing them.

Theft Risk

Hackers can steal bitcoins from your smartphone or computer if you're not using adequate security measures — a crime that experts say is probably growing. Even bitcoin companies have been robbed. And good luck explaining to the local police that someone cleaned out your bitcoin wallet. (See also: More Scams Everyone Should Know About)

Limited Places to Spend

This is probably the biggest reason that most people don't have any bitcoins. Compared to the number of merchants that accept dollars — every business in America, since it's legal tender — the number that accept bitcoins is tiny. You can't pay utility bills or taxes in bitcoins. You can order pizza, but paying your rent in bitcoins can be challenging. Bitcoin enthusiasts I have interviewed spend a lot of time convincing merchants to start accepting the virtual currency.

Do you own bitcoin? Have you considered buying bitcoin?