Until a couple of months ago, the world at large was - on the whole - blissfully unaware of the existence the bitcoin. In most cases, even the savvy among the trading and investment communities would not have been able to tell you much more about this subversive electronic currency than a Google search might have revealed.

Then along came the Cyprus chapter of the eurozone crisis which reached its crescendo in March/April of this year. With Cypriot bank depositors unable to access their accounts and facing the unappetising prospect of being forced to take swingeing haircuts, it seemed like investors were starting to think the unthinkable and invest in an untried electronic protocol in lieu of hard currency.

The prospect of failing banking systems usually drive up gold prices as the market seeks a hedge against financial uncertainty. But gold behaved counter intuitively during the Cyprus crisis, dropping to a 52-week low, however the value of bitcoin took off like a rocket. Between 1 January 2013 and 10 April, the counter’s dollar value rose from $13 to $266. This dizzying ascent, however, proved unsustainable and in the days following the peak, the cryptocurrency nose-dived to $50 before stabilising at around $100.

Stuff of science fiction

‘Bitcoin prices have been a lot more stable over the past couple of weeks,’ says David Jones, a market strategist at IG Index. ‘It currently trades in a range between $112 and $122.’ In technical terms, support seems to be around $110 with resistance up around the $125 mark.

You may believe that the bitcoin has had its 15 minutes of fame, or be of the opinion that this new virtual currency is here to stay as a real alternative to government controlled mediums of exchange. But that IG Index makes a market for the counter, albeit it only in the limited form of binary bets at present, suggests it could in time become a widely traded asset and it may be worth getting to grips with the basics. At first glance, the currency’s origins seem to have more in common with the science fiction of Philip K Dick or William Gibson than the macro-economic pedigrees of traditional fiat currencies. The first use of the term ‘bitcoin’ can be traced back to 2008 when a paper by the pseudonymous developer Satoshi Nakamoto was posted on the internet under the heading ‘Bitcoin: A Peer-to-Peer Electronic Cash System’.

Philosophically, the bitcoin is based on the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The currency was designed around an idea of money that uses cryptography to control its creation and transactions, rather than relying on central authorities as is the case for the majority of the world’s so-called fiat currencies.

The concept of cryptocurrency had been mooted before, most notably in 1998 by Wei Dai, a ‘cypherpunk’, but it wasn’t until 2009 that Satoshi brought the bitcoin network into existence with the release of the first open source bitcoin client and the issuance of the first bitcoins. The currency’s inscrutable developer left the project in 2010, having apparently moved on to other things and as such, the project’s motivation and origins remain shrouded in mystery.

But while bitcoin’s free-booting origins in the digital equivalent of the Wild West’s frontier seem anarchic, dangerous even, the currency itself follows relatively conventional rules which can be found on www.bitcoin.org. Each bitcoin is subdivided down to eight decimal places, thereby forming 100 million smaller units called satoshis. The currency can be transferred through a computer or smartphone without an intermediate financial institution and transactions are cheap and mostly free.

Bitcoin transactions are processed by servers known as bitcoin miners which communicate over an internet-based network and confirm transactions by adding them to a ledger which is updated and archived periodically using peer-to-peer file sharing technology.

As well as archiving transactions, each new ledger update creates some newly-minted bitcoins. These transactions are broadcast within seconds and verified within 10 to 60 minutes. The transactions are irreversible and double spending is prevented by the use of a block chain which is a shared transaction database. A full copy of the currency’s block chain contains every transaction ever executed in it. With this information, one can find out how much value belonged to each address at any point in history.

The number of new bitcoins created in each update will half every four years until the year 2140 when this number will round down to zero. After that time, no more bitcoins will be brought into circulation and the total number will have reached a hard limit of 21 million. To date, the total value of all bitcoins in circulation is over US$1.3 billion.

While the cypherpunks may agitate for the use of cryptography to foment revolution, there’s nothing remarkably controversial about bitcoin. However, the relative anonymity and virtual impossibility of tracing transactions has drawn unwelcome attention from law enforcement and financial regulators who are cottoning on to the currency’s potential as a tool for money laundering.

The concerns of the US law enforcement community prompted authorities in May to seize two accounts linked to Tokyo-based exchange Mt. Gox. While there are ‘exchanges’ worldwide that trade and offer services paid in the cryptocurrency, the world’s largest platform, Mt. Gox handled approximately 63% of the plant’s Bitcoin transactions as of April 2013.

The seizure warrant, obtained by the Department of Homeland Security, froze a Veridian Credit Union account held by an Iowa-based online payment processor, Dwolla Inc. in the name of Mutum Sigillum LLC, a Mt. Gox subsidiary incorporated in Delaware. Homeland Security maintains that Mutum Sigillum was operating as an unlicensed money transmitter, in violation of federal law.

However, regulatory scrutiny is not the only area of concern surrounding bitcoins. A cyber attack in 2010 saw over 184 billion bitcoins generated in a transaction before being sent to two addresses on the network. The transaction was quickly spotted and erased from the transaction log after the bug was fixed and an updated version of the bitcoin protocol introduced.

While this has so far been the only major security flaw found and exploited in the currency’s history, there is plenty of evidence that the system comes under regular attack from hackers. In April, the information security press reported that the Mt. Gox exchange battled a massive distributed denial of service (DdoS) attack

More recently, Symantec researchers revealed that hackers have turned to spoofing the Mt. Gox site and deceiving its customers into downloading malware such as the ‘Ponik’ Trojan, which is also able to steal passwords.

New currency is hard sell

The currency trading community is understandably sceptical about the bitcoin. Shares spoke to several market insiders who declined to comment on the bitcoin phenomenon, tacitly discounting it as a fad. But not everyone was so quick to dismiss the counter or the lessons to be learned from it.

Kathleen Brooks, a research director at FOREX.com says: ‘I don’t think it’s necessarily a fad, I think there is a legitimate reason to question central control of a currency, especially since the sovereign debt crisis in Europe has questioned the future of the euro, the world’s second most traded currency.

‘Whether or not it’s an elaborate scam, we shall have to wait and see. It’s only four years old, some call it a Ponzi scheme and Ponzi schemes can go on for years. As long as people continue to accept it as a mode of exchange then it will work as a currency, but as an investment I am not so sure.’

At the time of writing the bitcoin and US dollar cross was trading on a 0.07% bid/offer spread, quite competitive even if the pair had traded in a volatile $88 to $136 range over the previous 24 hours. Should this volatility attract traders or is the counter just too unstable? Again, Brooks offers some insight on the currency’s pros and cons.

‘Traders love volatility, so in theory the answer should be no (the price movements are not unmanageable), although it’s been a particularly rough ride for bitcoin in recent months. However, the bitcoin is a very young “currency” so as it grows in popularity, you have to expect some growing pains and unusual price action.

Brooks goes on to highlight some of the risks. ‘Bitcoin does have some specific risks - it is an electronic currency so it is at risk of being hacked. Also, some governments and officials don’t like the idea of bitcoin so it is at risk from government intervention to limit its use. As long as you understand the risks involved, trading a new currency could be fun.’

Because bitcoin is a frontier currency, its legitimacy (or lack thereof) - both in the eyes of law enforcement and the criminal fraternity - gives it a somewhat less than Gilt-edged status as a tradable security. This reasons Brooks, ‘could seriously limit the take up of bitcoin, as big corporations, banks won’t want to open themselves up to unknown legal challenges’.

The future for bitcoin would therefore appear rather uncertain but, as Brooks posits, the same could be said of the fledgling single currency back at the turn of the millennium. Some market insiders - while less than sanguine about bitcoin - do feel nevertheless that the phenomenon of cryptocurrencies is not going to go away anytime soon. ‘Bitcoin will be shortlived but something more superior and regulated will probably be the major winner,’ says one analyst.

Early evolutionary stages

Ian Bremmer, the founder and chief executive officer of Eurasia, the world’s largest risk consulting firm told CNN recently that he would be ‘very surprised if bitcoin is still around in 10 years’. He thought that bigger players would enter the field and improve upon the currency’s weaknesses. This sentiment was certainly echoed by analysts and experts in the foreign exchange market, in fact some give it much less than a decade.

‘There’s been a lot of bitcoin mania out there, particularly after the Cyprus crisis,’ says IG Index’s Jones. ‘But I think bitcoin has had its day in the sun, I’d be very surprised if we’re still talking about it a year from now.’