Monthly Archives: April 2013

Understanding Bitcoins: Bitcoin, Litecoin, Whatcoin? Oh My!

You’ve probably heard of Bitcoin by now, and at the time of this writing, meaning mid-April 2013, it’s currently experiencing a blossom that has caught everyone by surprise and made a lot of people very rich.

What you may not know, though, is that Bitcoin is just one of several emerging virtual currencies. Bitcoin is definitely the biggest, but it’s important to understand the other currencies too, especially if you plan on investing or mining coin.

In this article, part of the Understanding Bitcoin series, I’ll talk about each of the different cryptocurrencies and what distinguishes them from each other. I’ll focus mostly on the two largest, Bitcoin and Litecoin, and then give you a brief overview of some of the other cryptocurrencies out there.

Cryptocurrencies?

Let’s start with the basics. A cryptocurrency is a virtual currency that people use for various purchases. Currently, it’s used a lot of places online, but even offline brick-and-mortar stores are beginning to accept cryptocurrencies. This is especially true for Bitcoins.

There are already several cryptocurrencies in existence, each having slightly different characteristics and have uses in different scenarios. Which one will be used and which will die is a matter of great speculation, and as with all things that have a geeky nature, it’s often becoming a debate of passion. When I read these debates, I’m often reminded of Linux vs. Windows vs. Mac debates, or Android vs. iPhone, or similar debates where the underlying differences aren’t really that huge but people still get massively passionate about their particular favorite.

What most agree, though, is that digital currencies have a place in society now, and especially on the internet. With the democratic, global, and decentralized nature of cryptocoins, the ease of use for anyone, the inherent security and potential anonymity, as well as the technical abilities, cryptocurrencies are starting to look like a perfect model for internet heavy economies. Cryptocoins, although certainly not the only form of digital currency, seems to have the characteristics that users and society covets.

Cryptocurrencies work in much the same way as regular currencies and are in their simplest form nothing more. It’s money, and that’s really all you need to know. Whether the money is worth anything is up to society, if society adopts it as an accepted measure of value, then cryptocurrencies have value just like ‘hard’ (or fiat) currencies. Adoption is rising rapidly so there is evidence to support the idea that cryptocurrencies have merit and thus value.

On the flip-side, cryptocurrencies are extremely young and nobody really knows where they will go. The technology hasn’t been proven on a large scale and we know there are inherent problems that need to be resolved at some point. We do not know how governments around the world will react, although we do know that the US have declared digital money as just another foreign currency, giving it at least some credibility. We also have no way of determining value. Cryptocoins can take over online trade completely, and if so, even the current pricing is ridiculously low, or not exist at all in a year or two, in which case any value is overrated, even at one US cent per Bitcoin.

For the purposes of the rest of this article, I’m going to focus on two of the cryptocurrencies that derive from the open-source Bitcoin code. Bitcoin was the first of these currencies, but several other currencies have since appeared with different characteristics making them useful and beneficial in different situations. The other one is Litecoin.

Bitcoin (BTC)

Bitcoin was the first and remains by far the largest cryptocurrency. It is largest in market capitalization, acceptance by merchants, transactions, and mining power.

On the downside, Bitcoins’ size is starting to become a problem, or will shortly. For example, by design, a particular transaction block can be up to 1 Mb in size and must contain every transaction since the previous block was solved. This means that as more transactions happen, the block fills faster, and some transactions must wait until the next block, delaying transactions.

The mechanism designed to solve this is a voluntary transaction fee, which is added to the bonus of the block. As Bitcoin evolves and transactions increase, this voluntary transaction fee becomes the main revenue for mining operations, and if the market decides so, the fee will effectively be mandatory by giving low fee transactions less priority and slower transaction times, with a larger fee ensuring a faster transaction.

At the moment, mid-April 2013, BTC is seeing a rocket ride in terms of price. Be aware, though, that the actual value (as opposed to price) is still very undetermined and absolutely unknown. Anyone claiming to know is wrong at this point, whether they are warning against a bubble or hailing this as the most important thing on the planet.

Bitcoins have a fixed distribution rate and will end up with a maximum of 21 million coins. Most of those coins will be mined by 2032, though so after that (or even before) transaction fees will make up most of mining profitability. Bitcoins are mined using an SHA-256 based algorithm.

For Bitcoin based financial and investment services, there are currently both currency exchanges and stock markets, and other services from traditional financial markets are emerging. Still, because of the nature of Bitcoin, there is no government regulation or guarantees for these markets, so it is extremely risk to invest in BTC-based markets. The largest BTC/USD exchange by far is MTGox. Two other prominent currency markets are BTC-E and Vircurex, while MPEx (large, but expensive and somewhat difficult), BTC-T (smallest but easier), and Bitfunder corners the market on stock trades.

Litecoin (LTC)

Litecoin is the second largest cryptocurrency at this time, but is still much smaller than Bitcoin. Although the relative size varies in terms of market capitalization, at present the Litecoin economy is about 1/30 the size of Bitcoin.

Note: Numbers are based on sizes from http://dustcoin.com/mining

Litecoins have some different characteristics from Bitcoins. First, it is mined using a slightly different algorithm, called Scrypt, which is more resistant to massive mining rigs than the SHA-256 based currencies. That means that even personal computers, provided they have sufficiently powerful graphic card, can still participate in profitable mining.

Note: For a mining operations guide, read the previous post in this series on cryptocurrency mining.

Litecoins like Bitcoins are limited in total number of coins too, but its limit is 84 million coins. This really has nothing to do with its price or value, and because Litecoins are generated at a much faster rate, it evens out in the long run.

When I say that the Litecoin economy is much smaller, I mean much smaller, not just in market capitalization but also in adoption. Adoption is growing, though, but it looks like the community and merchants are waiting to see whether Bitcoins take off. Few merchants accept Litecoins yet, at least compared to Bitcoin, so its circulation is mostly based on person to person transactions and not so much for purchasing products or services.

On the plus side, Litecoins have a faster rate of block generation. Where Bitcoin blocks are designed to appear every 10 minutes, Litecoin blocks appear every 2.5 minutes. This has the benefit of giving potentially quicker and cheaper transactions, although it doesn’t necessarily mean that it will be quicker or cheaper.

Also, as the largest of the alternative cryptocurrencies, it may take a place as a backup currency in case Bitcoin transactions have issues like high fees, slow transactions, or even technical issues. Adding support for Litecoins once a merchant has support for Bitcoins is easier than trying to add other backup payment alternatives.

At the moment, Litecoin price is tied closely to the price of Bitcoins, so a rise in Bitcoin price often lead to a rise in Litecoin price. Litecoins are mined using a Scrypt-based algorithm.

Note: You can see an exchange rate for LTC to BTC or USD on BTC-E http://btc-e.com/. MTGox, the largest Bitcoin exchange in the world, is rumored to introduce Litecoin support soon.

Other Cryptocurrencies

Bitcoin and Litecoin combined make up more than 99% of the market at the moment, but that doesn’t mean they are the only currencies available. Other currencies exist, perhaps with more obscure characteristics, and right now, nobody knows whether these will survive or grow alongside their bigger brothers.

Namecoin is a much smaller currency, even compared to Litecoin, having about 0.3% of the market share. It’s designed to work with identities, currently mainly through an alternate DNS system that allows for completely anonymous domain name registrations. Very much a currency and system for privacy freaks bit can also be used to provide secure identification services. Namecoins utilize merged mining, meaning they are mined alongside regular Bitcoin mining at no extra cost to the miner.

PPCoin is a somewhat different cryptocurrency that implements an alternative method of minting coins and securing transactions, called Proof of Stake (BTC and LTC uses Proof of Work). There are several benefits to this, and the details go beyond the scope of this article, but feel free to read up on it on the PPCoin Github wiki.

Devcoin is a coin designed to support open source development, where mining generates revenue for open source projects. 90% of coin generation goes to open-source projects, the distribution of which is done through bounties administered by a democratic voting process. Anyone can apply and three random administrators vote on whether to approve the project, thus giving revenue to the project.

Novacoin is a bit of a controversial coin due to allegations of fraud in the introduction of the coin. The founder allegedly pre-minded a lot of coins before the introduction, many or all of which were used in a bribe and later destroyed (read more). It is the only alternative coin that uses Scrypt for mining (like Litecoins) so it may be an alternative to Litecoins, should Litecoins need one.

Terracoin is a relatively new coin that has seen some recent troubles due to its similarity to the Bitcoin code. In short, the profitability of mining rose drastically in a short time, making it practically worthless for normal miners to support. The developers have taken steps to correct the issue, which may help the coin survive.

Freicoin is another very interesting but obscure currency with some pretty remarkable characteristics. For one, it effectively implements negative interest, meaning you need to spend your money unless it loses its value gradually through Demurrage. The argument for this is that holding money is bad and circulation is good, encouraging investors to invest and banks to loan rather than hoard money.

Why, Oh Why?

With all these different types of coin in existence, it’s pretty clear there will be confusion for many people. The risk is huge like we saw with Terracoin, that technical issues and exploitation may kill smaller coins completely. New and innovative algorithms may stall this or prevent it completely, but it’s still a very immature technology and subject to malicious intent, like most other technologies.

However, it also shows that there is innovation in the way money works and should work and what society wants from its currencies. Cryptocurrencies is a great tool for encouraging innovation in monetary scenarios.

Even more, we have only seen the start of this innovation, perhaps at the level where the web was around 1997 when it too was four years old (Bitcoin is four years in 2013). Nobody knows yet whether this is a passing fad or whether the world is ready for new ways of using money, but if nothing else, Bitcoin and its smaller siblings have already had an effect on people’s minds.

I’m rooting for the future!

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Bitcoin Investment Complications

I have previously written about the dangers of investing in cryptocurrencies like Bitcoin. In short, DO NOT invest a single dime or cent you cannot easily afford to throw out the window while speeding down a highway, DO NOT see this as anything but a gamble, and most importantly, with the exception of this sentence, DO NOT listen to any advice I give when making financial decisions.

One reason why investing in Bitcoin, Litecoin, or other cryptocurrencies is complicated is that you need to think doubly about the effect that the price of a currency has. No only will you need to consider all the normal investment considerations, but you add what is often a completely opposite effect of your investment because of the exchange between currencies.

Even if you are a seasoned or even moderately experienced investor, you need to take into account a number of complications with cryptocurrency investments. Let me show you a few examples.

Currency Trade Complications

Let’s start with something that may seem simple, buying and selling cryptocurrencies at one of the virtual currency exchanges.

Most of the world still denominates value in fiat currencies (like US dollars, Euros, Yen, Pounds, and so on). You probably still pay your bills in such fiat currencies. That means that in addition to doing your regular investment planning, you need to calculate the effect that exchange rates have on your investment.

To make matters worse, if you hold a certain amount of currency units, whether that is US dollars, Bitcoins, Litecoins, or any other currency, you need to remember that when one currency goes up, the other currency of the exchange pair effectively goes down. In other words, if you hold your US dollars while the price of Bitcoin goes up, your relative value of US dollars goes down.

Currency speculators know this by heart, but for a novice, it may not be obvious that holding a ‘safe’ currency is almost as dangerous in terms of profit. If you trade, you double the risk and potential profit or loss.

Let’s start out with US$100, and a price of a Litecoin at $2 so you can buy 50 LTC for your money. You decide to hold on to your US dollars, thinking the price of Litecoin goes down. However, the price rises to $2.5 per Litecoin so you can now only buy LTC 40. Effectively, your dollar value measured in LTC has dropped 20% even if you did absolutely nothing. In relative purchasing power, you now have only $80 dollars.

Let’s further assume that the price drops back to $2 per LTC and you sell. You still have $80, right, so the loss hasn’t increased? Wrong! The only thing that changes is that you realized your loss, meaning you took the lost and made it ‘real’ by converting back to whatever value your had at the beginning.

RiseAndFallOfLitecoin

However, you have effectively lost double the amount you think. $100 initial value minus your current value of $80 is your realized loss of $20, right? You can now only buy 40 LTC which is 20% lower than initially.

Let’s say you didn’t buy LTC at all. You would no be left with no realized loss, and $100, which is obvious. If you didn’t buy at $2.5, but waited until the price dropped and purchased when the price fell back to $2, you would now have 50 LTC.

If, on the other hand, you had bought at the beginning and sold at $2.5, you would now be left with $125, and a price of $2 per LTC, meaning you can now purchase 62.5 LTC, or around 56% more than if you had failed to hit the top and bottom (or vice versa) completely. While the price of LTC was rising, your dollar value fell, and while the price of LTC was falling, your dollar value rose.

Even by not trading and just sitting still, you have ‘lost’ 20% profit, even if the price is now back exactly where it was when you began. If you trade and miss completely, your loss is 56%, even if the price rises and falls by only 20%.

Note: I know this can be said for any commodity, stock, or item that rises and falls in value, but it is even more obvious when you trade in currency because both are considered the same thing (money) and your loss becomes immediately visible.

Currency speculation is dangerous and complex, and it’s easy to get scared when you realize that even when you don’t buy in, you lose money. However, making mistakes may effectively double your losses, and unless you know very well how a currency will behave in a market (and frankly, nobody does with cryptocurrencies at this point), you’ll stand a high chance of risking such a loss.

Buying Stock

There’s also the psychological aspect of currency values. For example, let’s say you invest in a gaming company that pays our dividends in Bitcoin at an average rate of 0.5% per week and also charges their users in Bitcoin.

Lets now think that the exchange rate of US dollars to Bitcoin rises drastically (meaning Bitcoins become more expensive to buy with US dollars). What happens to your investment? Well, because dividends are paid in Bitcoin, you still reap the same amount of Bitcoins, but because each Bitcoin is more valuable, the dividend is worth more in terms of US dollar.

However, because the price rises, the cost for people playing the game also rises, meaning they will spend less in Bitcoin even if their spending in US dollar is the same. Suddenly a bet or purchase cost more in terms of US dollars and people will likely reduce their spending in Bitcoin. That means the rate of dividend will go down even if that dividend is worth more per coin than previously.

This complication is more difficult to understand than it may seem. The psychological effect that currency values have on people’s perception may completely throw normal investment ideas out the window.

Also, if you plan on investing in stocks denominated in cryptocurrencies, you need to realize that the cryptocurrency market is still very, very immature. There is by nature no government control and thus no government oversight of exchanges. Although there are a few reputable stock exchanges already, anyone can set up a new exchange without requiring any mandate or supervision from anyone.

Further, even the established and somewhat reputable exchanges have very few formal requirements for accepting new assets, and most of the requirements are based on community consensus which can be manipulated. You are essentially trusting the issuer of the asset that they will honor their commitments, and sadly, the short history of cryptostock exchanges have shown that you can’t always trust even those with the most honest of appearances. People have lost a lot of money and so may you.

Mining Operations

Lets say you consider investing in coin mining operations, and let’s say you have US$1,000.00 to invest and the current Bitcoin/USD exchange rate is 1 BTC = $100.

Note: Bitcoins, Litecoins, and other cryptocoins based on the Bitcoin code base, can be mined, or minted, by users using their own computers at home.

You may think that the US dollar price of a Bitcoin will rise, so you decide to buy mining equipment to get a piece of the action. You buy a new computer with a few suitable graphic cards, and start mining. Perhaps you mine a couple of Bitcoins over the course of a month.

It turns out, you were right about the price increase, and after the first month, the US dollar price for a Bitcoin has risen to $150. “Great,” you think, “I’ve gotten $300 free and that must have been a great investment”. You still have your new computer, valued at $1,000, and let’s assume it still holds its original value after just a month, and you have two free Bitcoins priced at $150 each for a total value of $1,300.

Not so fast, grasshopper. You have actually lost money on this operation.

Had you purchased BTC for $100, you could have gotten 10 of them, now valued $1,500. In other words, you ‘lost’ $150 on your investment because you paid for your computer in US dollars. Even if you sell the new machine for Bitcoins now, you would only get around 6.6 BTC ($1,000/$150) and even with your mining revenue of 2 BTC, you’d be down 1.4 BTC.

Ah,” you think, “I can just keep mining and the profit will skyrocket! One more month and I’ll be up 0.6 BTC

You may be right in thinking this, but you may also be forgetting that the difficulty of mining increases with time (or rather with effort) so your revenue goes down. In fact, for certain cryptocurrencies, the difficult has doubled, effectively halving revenue, within a week due to shifting and ever increasing effort for the network. What may seem like a great investment in April may be costing you more in electricity than you get back by June.

The Dangers of Investing in Cryptocurrencies

DO NOT under any circumstance take this as financial advice. I have no idea what I’m doing with regards to investing, I merely want to point out some of the dangers to you. DO EXPECT to throw money out the window unless you know very well what you are doing. ANY INVESTMENT is a dangerous game, especially for novices like me.

There, that should get the mood set.

In this article, I’ll focus on explaining to you some of the dangers of investing in cryptocurrencies. I’m doing this to warn you about the dangers involved, and maybe even scare you away from investing completely. This isn’t a beginners game and you will get burned if you approach it without proper preparation.

Investing Bits and Bytes? You’re Joking, Right?

You may be surprised that there is a thriving market for Bitcoin based investments. Even Litecoins now have dedicated stock and options markets. Why on earth would such a thing exist at all? It’s just numbers, right? Not real money?

Note: No, I’m not having the debate about the merits of Bitcoin, whether Litecoin has a place at all, cryptocurrencies in general, or other similar discussions now. My opinion is that there is a market need for cryptocurrencies, Bitcoin, Litecoin, or otherwise. Currently, Bitcoin and Litecoin are my favorites to lead this race, but don’t listen to me.

Well, as with all things subject to speculation, people will speculate, trying to make more of what they already have. Whether they speculate in the volatility of the market, or the long-term success of any particular cryptocurrency, these markets will pop up and as long as there are willing participants who believe they can benefit, they will thrive.

I would like to stress, though, that investing with and in cryptocurrencies is an extremely risky business. It is even more tricky and complicated than regular speculation because you also need to take into consideration the exchange rate between the various cryptocurrencies, and the exchange rate between cryptocurrencies and fiat currencies.

In other words, and make no mistake about this: DO NOT under any circumstance put money into cryptocurrency speculation that you are not completely comfortable considering lost the moment you buy in. Nobody understand this market, nobody knows where it is going, nobody has any relevant previous experience with cryptocurrency markets, much less with how stocks and options work.

So, Why Are You Investing?

Personally, I have a few Bitcoin and Litecoin investments, but like I explained, I consider these funds lost and have no hope of ever recovering them. I am using the investments to learn more about investing in general and about cryptocurrencies in particular. I have faith in cryptocurrencies as the future of commerce, and I want to learn as much as possible. I’m a learning junkie, in case you haven’t read anything I’ve written before.

At the time of this writing, I have yet to realize any losses on my investments, but I have also spent weeks and months learning and calculating, reading about investment strategies, how traditional markets work, how psychology plays into the game, and so on. I have spread my investments to balance any risks, and I’ve constructed an investment profile that matches my risk profile (which is ‘let it ride’, basically) with my expectations for the growth of cryptocurrencies.

I am a complete novice at this game; I expect to suffer heavy losses, perhaps even a complete loss, or, as it stands right now, even more than I have invested. I have spent considerable time learning, and that time may instead have been used for other, more profitable ventures.

I have, however, put in some of the legwork to understand as best I can how this game works, and it has taken considerable time. When I say I’ve worked weeks on this, I’m talking about 15-18 hour days, seven days a week. This probably makes me more informed than most first-time investors, but make no mistake; I am utterly incapable of making sound decisions, and I’m having to completely rethink what I’m doing on a daily basis. DO NOT take any of what I tell you as any kind of advice on what you should do, with one exception (two, counting the previous sentence): DO YOUR HOMEWORK.

Why is it So Complicated?

I’ll talk more about the complications of investing in cryptocurrencies in a later blog post, but be aware that investing in cryptocurrencies is more complex than regular investments. Rather than having an investment go up and down based on a single or few market conditions, you need to take the exchange rate into consideration, and that may move in any direction at any time.

Further, since Bitcoins and other cryptocurrencies are by nature decentralized and out of government control, you have no recourse if something goes wrong (recourse meaning your ability to get money back if you’re tricked or scammed). Plenty of people have lost plenty of money to scammers, but also to people who have had honest intentions but very little experience or just plain bad luck.

Also take into consideration that the cryptocurrencies’ exchange rates are extremely volatile at present. This is partially due to its size but also because it is a young market and nobody really knows what drives the exchange rate. Bitcoin Market Capitalizaion Snapshot from Blockchain.info

Many people lost large fortunes during April 2013 after what seems to have been a bubble in the Bitcoin/US Dollar exchange rate, even seasoned investors who thought they could ride the wave into the sky.

Finally, because the Bitcoin stock investment market is extremely young and small, but also due to its decentralized nature, it is to a large extent based on trust. You need to do far more investigations into the background of the issuers of stock denominated in cryptocurrencies than you would for a regular stock exchange, where you can trust somewhat in the exchange to do some of the due diligence for you.

The cryptostock market is definitely maturing in this area, but has a long way to go before its reputation and process for admissions is as strict as it would be for example for being traded on NASDAQ.

So, if I haven’t scared you off yet, I haven’t done a good job, but I would like to see that you’ve at least become more aware of the dangers inherent in investing in an unproven, highly speculative, and largely misunderstood market.

Be safe, and in the case of Bitcoin, Litecoin, or other cryptocoin investments, that may mean sitting on the bench for a while.

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