The rise of Bitcoin: Why bytes are worth more than gold – for now

Bitcoin certainly doesn’t glitter, but that isn’t stopping it from catching the eye of traders around the world.

Worth less than a tenth of a cent in 2009, the value of a single bitcoin reached a high of about $1,293 on Friday, surpassing the value of an ounce of gold for the first time. The surge of interest hinges on optimism that the Securities and Exchange Commission will approve the first US bitcoin exchange-traded fund this coming week, lending an unprecedented level of credibility to the crypotocurrency.

"There's one catalyst at the moment and that is the expectation that the Winklevoss Trust will be approved on the 11th of March. That's the only game in town," Daniel Masters, portfolio manager of Jersey-based Global Advisors Bitcoin Investment Program, told Reuters.

Cameron and Tyler Winklevoss filed an application with the SEC for a bitcoin "exchange-traded fund" four years ago. Approval would lend a certain level of liquidity to the cryptocurrency, and with it, a new degree of credibility that investors expect to drive further interest in Bitcoin.

But this week's historic level of interest could quickly disappear if the SEC opts not to approve the Winklevoss's application, because, unlike traditional currencies, Bitcoin isn't tied to any tangible value marker. And while Bitcoin surpassing the value of gold makes for good headlines, comparing troy ounces of gold to bitcoin makes about as much sense as comparing apples to oranges.

“We’re a long way from bitcoin establishing its properties as anything that could be considered to be a reasonably stable store of value,” John Butler, head of wealth services for GoldMoney, told Bloomberg in an interview. “The fact that it’s passing through gold is just arbitrary.”

The small total value of the entire Bitcoin market, along with other characteristics, makes the value of the currency prone to dramatic leaps and falls, sometimes more than 20 percent in a matter of hours.

“One bitcoin eclipsing one ounce of gold is an interesting psychological signal, but it itself is more of a curiosity than a harbinger of anything to come,” writes Andrew Hinkes, an attorney with expertise in virtual currencies, in an email to The Christian Science Monitor. “Bitcoin is significantly more volatile in its pricing than gold, but is also significantly more useful for transactional purposes than gold... It is rare that you can engage in day to day transactions using gold.”

Represented as 0s and 1s, bitcoin couldn’t differ more from the weighty yellow metal, but as carriers of value they both share some important similarities. Any currency has to have two features: rarity and owner confidence.

In the case of gold, rarity is a natural characteristic of the material itself, which leads owners to trust that there will always be a market should they decide to sell. Aspiring alchemists all failed at producing gold and no one expects a giant deposit to suddenly double the supply, so confidence is high.

Bitcoin, however, is at some level just a digitally printed list. But while the US government regulates money, and punishes counterfeiters, no analogous entity controls Bitcoin. How does it maintain its scarcity, and entice users to trust the system’s integrity?

An innovation known as the “blockchain” lies at the heart of bitcoin. This list, which Mr. Hinkes says measured more than 60 gigabytes as of January, tells the story of the currency from its very first transaction. Every purchase, every sale, and every trade all end up in this ever growing ledger.

Buying something using Bitcoin involves adding a line to this universal ledger, but what’s to stop a digital alchemist from trying to cheat the system by falsifying the blockchain? There is no official document locked up behind firewalls in some fortified server, waiting to be hacked. Rather, it’s a public document open for all to see and edit.

Its security lies precisely in this openness. Copies of the blockchain exist on every bitcoin-mining computer worldwide, and for a hacker to give themselves free bitcoins, or use a bitcoin twice, they’d have to commandeer enough computing power to overwhelm more than half of that international network and trick a majority into accepting their counterfeit version.

What’s more, every block of transactions is mathematically linked to the previous block, so changing a single character anywhere in the list would have a cascading effect that would make the hacking attempt obvious.

The scarcity springs from the same source. The distributed network of computers is constantly trying to add new transactions to the list to keep the bitcoin economy humming, but doing so involves checking the validity of the whole blockchain, a computationally intensive task akin to repeatedly trying to guess a password. The computer (or batch of computers) that succeeds in solving the puzzle gets a bitcoin reward, but as the system grows that task gets harder. The reward also halves periodically.

Many refer to this process of puzzle solving to add transactions to the ledger as “mining,” and the people who do it as “miners.”

A rigorous mathematical framework based on the science of encryption and code breaking underlies the whole system, ensuring a controlled influx of new currency expected to continue for over a century before reaching the cap of nearly 21 million bitcoins, after which small transaction fees will incentivize miners to keep maintaining the transaction list.  

"Bitcoin has been linked to gold as a store of value and a flight to safety – the truth is that bitcoin is its own asset class in its own right and does fairly well in times of uncertainty – however it is also subject to its own internal forces too, such as its governance or lack of to be more accurate," Charles Hayter, the founder of digital currency comparison website CryptoCompare, told CNBC via email. 

But that’s not to say the system isn’t without its risks. Multiple security breaches have resulted in the loss of millions of dollars of Bitcoin value. Access to the impenetrable blockchain depends on a unique code called a private key that identifies each user. If this code is lost or stolen, any bitcoins associated with it are lost forever.

Hinkes previously suggested that the cryptocurrency equivalent of Federal Deposit Insurance Corporation (FDIC) or future regulation could help lend an air of credibility to the new technology.

“[Insurance] is an important frontier to be resolved in order for the industry to offer up custodial exchanges as something consumers can rely upon,” Hinkes told The Christian Science Monitor in August.

Regulators have struggled to settle on uniform treatment of the technology in the past, but Friday’s milestone suggests that the technology could take off especially with any extension of credibility from the federal government. But some worry that if the SEC approval doesn't come through, the value will crash.

After its previous peak of $1,137 in 2013, the currency fell 53 percent in a matter of weeks.