Economists Question Bitcoin Stability Despite Meteoric Rise In Value

Watch the video “Bitcoin Risk: An Empirical Study

Peter Suciu for — Your Universe Online

The bank failures that resulted from the 1929 stock market crash took many people´s life savings with it, and some say the same thing could happen — a albeit on a much smaller scale at least — to those who invest heavily in Bitcoins.

According to a new study from Southern Methodist University in Dallas and Carnegie Mellon University in Pittsburgh, the virtual cyber currency known as Bitcoin could have as much as a 45 percent chance of failing. This could occur if an exchange center that held the currency — much as a bank holds real money — closed, losing customers their Bitcoins and any hard money paid for them.

Bitcoin received a boost in interest this week when PayPal president David Marcus noted that the online payment center would consider making Bitcoin a funding instrument. Many still believe that the sophisticated cyber currency still holds promise for becoming a major international medium of exchange.

Moreover the SMU-CMU study also found that currency exchanges that buy and sell a higher volume of Bitcoins are less likely to shut down. That´s the good news. The bad news is that these transactions are more likely to suffer a security breach.

The encrypted digital currency has been in the spotlight this week, as 87 percent of the nation´s top economists think that the Bitcoin only has “limited usefulness,” reported TechCrunch. This is according to a recent University of Chicago Initiative on Global Markets (IGM) poll of the 38 of the world´s top economists.

“A bitcoin’s value derives solely from the belief that others will want to use it for trade, which implies that its purchasing power is likely to fluctuate over time to a degree that will limit its usefulness,” the IGM findings noted — a general statement that, though intended to downplay the stability of Bitcoin, is actually true of all forms of currency.

Bitcoin exchanges work two ways. In the first, purchasers can go through an online exchange and pay for the virtual currency with hard currency, typically with a credit card. The exchange then transfers the purchased Bitcoins to the buyer´s account. The second way is for Bitcoins to be purchased from local dealers, where the parties meet in person and the buyer pays in cash.

As of now, the Bitcoin´s market capitalization has reached more than $1 billion — which is one reason why it has become a frequent target of fraudsters and traditional economists. Part of the reason is that it is encrypted virtual money created by computer programmers and not actually backed by any country or government — a feature that many Bitcoin users actually believe to be an advantage as it tends to make the currency immune to the inflationary tendencies of central banks and politicians.

The SMU/CMU study, which was led by Tyler W. Moore of the Lyle School of Engineering at SMU and Nicolas Christin of the Information Networking Institute and Carnegie Mellon CyLab at CMU, identified 40 Bitcoin exchanges worldwide that convert the cyber money into hard currency. Of those, 18 have already gone out of business, with nine of the 40 having experienced security breaches from hackers or other criminal activity. Of those nine, five were forced to close shop, while another 13 closed for other reasons besides a security breach. Of the exchanges that closed five did not reimburse their customers.

“The risk of losing funds stored at exchanges is real but uncertain,” Moore and Christian noted in the study, titled “Beware the Middleman: Empirical Analysis of Bitcoin-Exchange Risk.” The study was presented at the 17th Annual International Financial Cryptography and Data Security Conference held in Okinawa, Japan, April 1-5.

Customers might believe that Bitcoins could be secure, and instead of ℠cashing out´ and exchanging the money back into a hard currency, customers may see this as an alternative savings account. According to the study´s authors, however, this could be a risky proposition.

“Customers are at risk of losing their Bitcoins if the exchange suddenly closes,” Moore said. “Believe it or not, many people — if not most — choose to leave the Bitcoins in the exchange account, thinking that their Bitcoins are better protected there and with faster access to convert back to hard currencies.”

One reason for Bitcoin´s success has been its meteoric rise this year despite early startup problems and hosts of naysaying critics.

Bitcoin´s trading value at the start of 2013 was around $10 per Bitcoin, but it rose to as high as $260 earlier this month before plunging back down to $68. That´s still an increase of 680 percent so far this year.

“Much of that can be attributed to the Mt. Gox exchange temporarily shutting down because of heavy trading that overwhelmed the exchange,” Moore said. “Studying why these exchanges fail helps us better understand the risks of Bitcoin.”