The Bitcoin market is booming.
The internet's favorite virtual currency is up over 230 percent since the beginning of the year and up 40 percent from Monday to Wednesday alone.
The latest leg up may be because it looks like the market may finally be going mainstream – now, U.S. banks are getting involved.
Nick Colas, Chief Market Strategist at ConvergEx Group, wrote in a recent note to clients that "there is much to learn from this first online success story in the world of stateless currencies," and there's a lesson to be had in global economics from the Bitcoin market.
Of course, as is the case with most good economics lessons, it's all about supply and demand.
The first thing to understand is how the total amount of Bitcoins in circulation (the money supply, if you will) expands.
Transactions aren't cleared through a central server. Instead, the exchange platform is distributed across thousands of computers, peer-to-peer style (like many popular filesharing networks).
In order to expand the total supply of Bitcoins, users also run complex algorithms on this peer-to-peer network to solve cryptographic puzzles. Each time a puzzle is solved, additional Bitcoins get credited to the accounts of those who solved the puzzle.
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So, that is how the "money supply," as it were, expands in the Bitcoin market.
However, each new puzzle gets incrementally harder to crack. The system was designed this way in order to limit the growth of the supply of Bitcoins.
"The overall supply of Bitcoin in the system therefore grows at a slow and pre-ordained rate," writes Colas. "There are currently 10.8 million bitcoins in the system, and this will cap out at 21 million coins in just over 125 years (2140, to be precise)."
Now, as the virtual currency continues to take incremental steps toward mainstream adoption, there is a big demand driver to boost prices.
Here, then, is the lesson, as Colas writes in his note (emphasis added):
When incremental adoption meets relatively fixed supply, it should be no surprise that prices go up. And that’s exactly what is happening to BTC prices. What’s interesting to note is why BTC prices plummet, which they did in the back half of 2011. The cause was a very short-lived hack attack on one Bitcoin “Wallet” company out of Japan, which caused the price to drop from $27 down to $2 in a few months. Confidence in money as a store of value is the ultimate driver of its value, both in the cyber and real worlds.
I have no idea which way Bitcoins will trade in the next 2 days or 2 years, but the whole process of starting a new Internet currency is a great case study in how real people use real currency. Limiting supply has clearly been a huge plus for the BTC. Becoming known as a currency for illegal drugs and gambling is more problematic, of course. But let’s not forget that the U.S. Treasury printed 3 billion $100 bills in the 2012 Fiscal Year. Most of those (the Federal Reserve estimates 80%) go overseas and many of them simply facilitate the global drug and arms trade, not to mention tax evasion and human trafficking. So the BTC’s growing role in the same types of business might qualify it for “Reserve currency” status sooner than anyone thinks.
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