Bitcoin claims that “It is the first decentralized peer-to-peer payment network that is powered by its users with no central authority or middlemen.” That lack of central authority is the primary reason governments are afraid of the cryptocurrency. To understand this fear, it is important to know a little bit about governments and conventional currencies.

In What Do We Trust?

Fiat is a term used to describe the conventional currencies that are issued by governments. Fiat  currencies have value because governments say that they do. To an increasing number of people, that promise means nothing. After all, fiat currencies are not backed by any tangible assets. You can’t return the currency to the government in exchange for a bar of gold or silver, a can of beans, a pack of cigarettes, or any other items that might have value to you. Fiat currencies are backed by the full faith and credit of the government that issued them and nothing more. If you want gold, silver, beans, or smokes you need to exchange your fiat currency with a person or entity that possesses the item that you want.

Why Control Matters

Governments control fiat currencies. They use central banks to issue or destroy money out of thin air, using what is known as monetary policy to exert economic influence. They also dictate how fiat currencies can be transferred, enabling them to track currency movement, dictate who profits from that movement, collect taxes on it, and trace criminal activity. All of this control is lost when non-government bodies create their own currencies.

Control over currency has many downstream impacts, perhaps most notably to a nation’s fiscal policy, business environment, and efforts to control crime. While each of these topics is broad and deep enough to fill volumes, a brief overview is enough to provide insight into the general concept.

Fiscal Policy

While the potential for crime captures the public’s attention, the role currency plays in a nation’s monetary policy has the potential to have a far greater impact. Since governments intentionally increase or restrict the amount of money circulating in an economy in an effort to stimulate investment and spending, generate jobs, or avoid out-of-control inflation and recession, control over currency is an enormous concern. It’s also an extraordinarily complex topic. (For a good primer on monetary policy see How The US Government Formulates Monetary Policy, A Look At Fiscal And Monetary Policy, How do central banks inject money into the economy?, The Federal Reserve: Introduction)

Business

Bitcoin users don’t need the existing banking system. The currency is created in cyberspace, when so called "miners" use the power of their computers to solve complex algorithms that serve as verification for Bitcoin transactions. Their reward is payment with cyber currency, which is  stored digitally and passed between buyers and sellers without the need for an intermediary. On a smaller scale, airlines reward miles function in a similar way, enabling travelers to purchase plane tickets, hotel rooms, and other items using airline miles as virtual currency.

If bitcoin or another cryptocurrency become widely adopted, the entire banking system could become irrelevant. While this may sound like a wonderful concept in light of the recent behavior of the banking industry, there are two sides to every story. Without banks, who will you call when your mortgage payment gets hacked? How will you earn interest on your savings? Who will provide assistance when a transfer of assets fails or a technical glitch occurs? While the financial crisis gave bankers an even worse reputation than they already had, there is something to be said for institutions that oversee timely, effective, and trustworthy asset transfers and their associated recordkeeping. There’s also the issue of the fees banks earn for the services they provide. Those fees generate a lot of revenue and a lot of jobs across the global banking industry. Without banks, those jobs disappear, as does the tax revenue those banks and their employees’ paychecks generate. Money transfer business would also disappear in a virtual world. Nobody needs Western Union or its competitors if everybody is using bitcoin.

Crime

So much has been written about virtual currency and crime, that it is enough to recap the issue by stating that untraceable financial transactions facilitate crime. Drug trafficking, prostitution, terrorism, money laundering, tax evasion and other illegal and subversive activity all benefit from the ability to move money in untraceable ways. The now defunct Silk Road online drug market is a case in point. Its founder credits Bitcoin for its success.

The Other Side of the Bitcoin

Aside from headline-grabbing fact that virtual currencies can and are used to engage in a wide range of illicit activity (it should be noted that cash is used for many of these same transactions), there is a legitimate theoretical argument in favor of their use. It is based on the reality that central bank tinkering with the money supply has induced recessions, exacerbated unemployment, and given rise to a global banking system based on profiteering and corruption. We need look only as far as the mortgage-market shenanigans underpinning the financial crisis of 2009 for insight into why disaffected consumers everywhere would support the efforts of anonymous programmers in subverting a system that has done them no favors. These ideas are not new. The Austrian School, a school of  economic thought founded in 1871, holds among its core tenets the idea that economic manipulation by central banks is not beneficial.

Before You Buy In

Before you convert your national currency to bitcoin, you want to consider a few additional facts. Bitcoin was created by an anonymous computer programmer or programmers (there’s no consensus on this and identities are still unconfirmed). Mt. Gox, the largest exchange service converting dollars to bitcoins, failed in spectacular fashion when hackers allegedly stole bitcoins valued at hundreds of millions of dollars. An earlier alleged hacking netted $8.6 million dollars. Other bitcoin exchanges have also blamed hackers for losses. (Read more Bitcoin Mass Hysteria: The Disaster That Brought Down Mt. Gox)

The currency is digital, so there’s nothing you can touch or hold. Its value fluctuates in a highly volatile manner. It is created by anonymous programmers through a methodology that it too complex for most people to understand much less participate in. (Read more Why is Bitcoin’s Value So Volatile?)

Since bitcoins are stored on users’ computers, “users face the risk of losing their money if they don’t implement adequate antivirus and backup measures” according to Virtual Currency Schemes, a research paper released by the European Central Bank. Hardware failure aside, tossing an old computer in the trash without first removing your bitcoins is also an easy way to lose your digital fortune.

In summary, if you use bitcoin, you are trusting your money to a complex system you don’t understand, people you know nothing about, and an environment where you have no legal recourse. In the traditional world of investing, this would raise enough red flags to make it a bad idea. On the other hand, the European Central Bank reports that Bitcoin is just one of over 500 digital currencies now in circulation around the world. Even it Bitcoin ultimately fails or is relegated a minor role on the world stage, one of its successors could radically alter the way the world thinks of currency.

Bitcoin for Your Thoughts

So what does the future hold for Bitcoin and other virtual currencies? It is safe to say that they are here to stay. You can use virtual currency to make purchases in a wide variety of video games and some retailers like overstock.com and tigerdirect.com. You can also also use bitcoin to safely purchase giftcards for hundreds of business like Home Depot, KMart, and amazon.com. However, the Bitcoin website notes that “Bitcoin is not a fiat currency with legal tender status in any jurisdiction.” And based on the regulatory  and enforcement actions of major governments, including the United States and Russia, that status in unlikely to change anytime soon.

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