If you were asked what currency experienced the biggest boost to its value over the past year you probably wouldn't say the bitcoin. It is a virtual currency that was created in 2009 and can be traded by registered users online and is kept in a "wallet" on a desktop.
The rise of the bitcoin has been extraordinary. Against the US dollar it has increased from little over $0.5 a year ago to more than $10 today. That makes the 25% appreciation of the Aussie dollar versus the US buck in the last 12 months look fairly paltry.
But if you haven't heard of the bitcoin don't despair. Traders are a fairly exclusive bunch, there are only six million bitcoins worldwide and the algorithm that creates the currency is in a continual process of ramping down production — by 2030 production will cease leaving approximately 21 million of them left in existence.
What is it then?
So how does the bitcoin work and what are the advantages of using it?
In terms of use, you buy your bitcoins from one of a number of exchanges using your local currency — say pounds, dollars or yen.
Your store of bitcoins is kept in a virtual wallet and you can spend them as you would regular money at a growing number of websites.
Alternatively, you can sell them to other users via an exchange called Mt. Gox, which charges a 0.65% transaction fee to match buyers of bitcoins with sellers.
Why would anyone use it?
One of the attractions of the bitcoin is its anonymity. While a transaction in cash involves only the buyer and seller, every time we spend with a credit or debit card a bank knows exactly when we buy, how much we spend and they have constant access to our financial information.
A bitcoin transaction only involves the buyer and the seller and it cuts out the financial institution. In essence it's a bit like an online transaction that mimics cash.
Due to this you are not subject to bank rules, there are no overdraft fees and there are no statements. This might be the currency of the 21st century, but its ethos is much older than that — rather than squirrel money under the bed, you can now do it on a desktop.
Dangers of the new currency
But this anonymity may prove to be the bitcoin's downfall. A group of Senators in the US are asking the US Attorney General to investigate bitcoins after reports they are used in the drug trade.
For anyone who has ever watched US TV shows like 'The Wire' they will know that drug dealers are always trying to break the link between themselves and the cash they receive for drugs.
Destroying the money trail leaves the police with no way of linking them to criminal activity. So the bitcoin is in one sense a drug dealer's version of nirvana.
Reasons for its success
But the rise in the virtual currency's value isn't only down to drug dealers; it is also a reaction to the Federal Reserve and its monetary policy stance.
Quantitative easing — money printing by any other name — combined with more than 2-years of record low interest rates has contributed to the dollar declining more than 15 per cent in the last year alone.
Monetary policy in the UK is leaving the pound looking vulnerable, and the euro might not even exist in the next few years if the sovereign debt crisis continues to rumble on.
Added to this, China doesn't have a free floating currency. Even strong currencies are still affected by central bankers and policy makers — they hike rates and the currency rises, they stop or start to cut rates the currency falls.
All of this leaves foreign exchange markets extremely volatile. Create a currency with no central bank or national identity and you get appreciation like we have seen with the bitcoin.
[Useful: Free guide to trading currency]
Virtually gold
Due to its specific characteristics you can draw a parallel between the bitcoin and a commodity like gold. There is only a certain amount of gold out there and it is not controlled by one central bank.
Since 2009 the price of gold has risen 65%, so it is no wonder that the bitcoin has taken off — it is riding the wave of demand for alternative stores of value different from government-backed currencies.
Is this really the currency of the future?
Well, even though the bitcoin isn't linked to a particular nation it was created by someone. So although it is said there will be no more production post 2030 and only a certain amount of the currency will ever be produced, you can never be sure.
What if a deluge of bitcoins flooded the market causing a sudden devaluation? In contrast, it's fairly certain that no one will be able to "create" more gold of the scale that could influence its price.
There is also reputational and regulatory risk. The fact there is a link between bitcoins and the drug trade may put some people off holding this currency in the first place.
Likewise, the risk of a regulatory crackdown in the US is a known unknown. The consequences could be devastating, especially if the US tries to impose a ban or insists that transactions using the bitcoin become more transparent.
A major risk to its future is that the currency is completely reliant on the web. A cyber-attack or mass internet outages would bring a halt to bitcoin trade. So there are some very serious limitations to this currency.
While the rise of the bitcoin highlights frustration with traditional currencies in the wake of the financial crisis, its extraordinary appreciation may not continue due to the risks highlighted above. For simpler folk a leather wallet full of cash is a safer choice.
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