Don't trust anonymous e-currencies like Bitcoin

The Liberty Reserve debacle cast a new light on Bitcoin, but even well-maintained e-currencies aren't worth the risk

The recent bust of Liberty Reserve by the U.S. Department of Justice has many people wondering if Bitcoin, WebMoney, e-Gold, and other online, anonymous e-currencies will be next. Clearly, Liberty Reserve was used mostly for criminal purposes -- the DOJ says "virtually all criminal" -- but there had to be some innocent victims who lost access to their e-currency at least temporarily, if not permanently.

Personally, I'd advise staying away from anonymous e-currencies. But the reason has more to do with security and trust than whether or not a court warrant will render an e-currency immediately worthless.

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Obviously, Bitcoin has the highest profile among these e-currencies. A Pulitzer Prize-winning economist has voiced his opinion on Bitcoin, and the infamous Winklevoss twins have been reported to own 1 percent of all Bitcoins. The e-currency has even been used to buy luxury cars. But if you ask me, these currencies all suffer from the same fundamental flaw.

All money is really about communal trust. Does a group of people agree to use and trust a representative store of value to conduct business? It could be paper currency, a precious commodity (like gold), bank drafts, stock certificates, plastic cards, e-currency, gaming points, or even stones with holes in them. We certainly have more trust in fiat money (that is, money backed by law), but we also trust purveyors of gold, silver, and other precious commodities -- whose prices rush up and down unrelated to their intrinsic value, just like e-currencies. If you want to get philosophical about it, most of your fiat money is represented by bits and bytes, unless you happen to stuff your mattress with cash.

The case against e-curriences

So why don't I trust e-currencies? For the following reasons:

Traditional currencies are backed by nation-states and regulated financial industries, and as much as you might hate or distrust those entities, they have staying power. In my nearly 30 years on the Internet, I've seen e-currencies come and go. When they go, everyone immediately loses everything. Just ask Liberty Reserve's customers.

Nation-states have laws, police, and armies. Those laws make the fiat currency legal. People in those systems accept the their currency. No one in the real world has to accept your e-currency or rock with a hole in it. If someone steals your real currency, the police will at least try and help you get it back. In cases of online theft, you may have a hard time getting a law enforcement authority to determine if a crime has happened. Even then, it's often only because the intangible online value could be immediately traced back to real money. For example, if you tell the police someone stole your gaming points, you'll have a harder time proving a crime occurred if you earned them during the game than if you purchased them with your credit card.

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