Here is what you should know about Bitcoin

What is Bitcoin?
Bitcoin is a digital payment system with no intermediaries or banks; it was invented by a person or group using the alias Satoshi Nakamoto, and released as open-source software in 2009. The U.S. Treasury has categorized it as a decentralized virtual currency though some believe it is best described as a "cryptocurrency." OxfordDictionaries.com helpfully defines cryptocurrency as "a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank."

Bitcoin uses blockchain technology to record its transactions. Essentially, the blockchain is a publicly distributed ledger for certain financial transactions. It is currently mostly used for Bitcoin, but many believe it could be used in a wide variety of financial applications in the future.

As used in Bitcoin, blockchain is a public ledger of all bitcoin transactions that have ever been made. When a transaction is completed, it is recorded on a new "block." When the block is full of such transactions, it is added to the end of the "chain" in sequential order, and a new block is created. Full blocks are a part of the blockchain's permanent database. Each node -- a computer connected to the bitcoin network for the purpose of verifying transactions -- automatically gets a downloaded copy of the blockchain upon joining the network. The blockchain records information like the time and amount of each transaction, but it does not store any personal information on the parties involved.

Even industry experts who believe that bitcoin is not a sustainable monetary unit think blockchain technology could radically change the way financial transactions are facilitated in the future. The benefits of this system are that it is transparent, secure, and streamlined so that there are fewer parties involved in facilitating each and every transaction.

Even as the existing payments system in developed countries becomes ever more convenient and secure, space is still littered with middle parties taking a small amount from each transaction. These players include payment processors, payment networks, issuing banks, and acquiring banks. The dream of Bitcoin and other monetary systems based on blockchain technology is for players to be free of these inherent costs of exchanging currency for goods.

For a much more detailed explanation of what bitcoin is, where bitcoins come from, and how they work, please check out fellow Fool Matthew Frankel's article on this subject from earlier this year, "What Is Bitcoin?"

The potential problems with investing in Bitcoin
A circuit board with the Bitcoin symbol on top

There are a few primary concerns surrounding Bitcoin that potential investors should be aware of. First, it is not backed or regulated by the good faith of a government or other entity. This stands in stark contrast to the dollar, yuan, pound, and other forms of currency used around the globe. So, many people view Bitcoin as something akin to Monopoly money, because it is neither a fiat currency nor is it based on something of tangible value like gold. In other words, a bitcoin is worth exactly what people perceive its worth to be. While, in a sense, this is true of any currency, the value of a bitcoin is much more fickle than other forms of currency because of its unregulated nature.

Second, bitcoins are not traded on Wall Street. They cannot be bought or sold through a brokerage. Instead, one must set up a Bitcoin "wallet," which can probably best be thought of as a bank account exclusively for bitcoins. Once this account is set up, its holder can link to a traditional banking account and use those funds in local currency to buy and sell bitcoins.

If this process sounds a bit cumbersome, it is. This means Bitcoin is much less liquid than traditional equities, creating more volatility and wild swings. For instance, in the past week alone, the value of one Bitcoin went as high as $1,263.41 but, at this writing, stands at only $969. That's almost a 25% swing within a week -- something virtually unheard of with any other type of currency.

Finally, the unique way of buying and selling bitcoins not only contributes to its illiquid nature but has also contributed to higher rates of fraud and theft through uninsured Bitcoin exchanges. While these problems were far more prevalent in years past, it should still be mentioned that none of the Bitcoin exchanges have yet established a long business track record.

This brings us back to the SEC's rejection of the Winklevoss twins' proposal to launch a bitcoin-based ETF. Such an ETF would have solved at least some of these problems. It would have made trading bitcoin much more liquid, and assuaged many investors' fears of potential theft. Viewed in this light, bitcoin's massive sell-off on the news makes a lot of sense.

The Foolish conclusion
Digital image of a Bitcoin superimposed on binary computer code

Where do the price and value of bitcoin go from here? Unfortunately, my crystal ball is broken. I personally believe that within a few years, Bitcoin could fall anywhere -- from being known as a worthless experiment, to being the greatest disruptive force the financial industry has ever seen.

If I knew investors who wanted to purchase a small, speculative position in bitcoin, I wouldn't try to talk them out of it. However -- and I cannot stress this enough -- nothing should be invested in Bitcoin currency that an investor isn't comfortable losing.

Investors intrigued by the concepts of Bitcoin and blockchain technology, but unwilling to take the plunge on such a speculative investment, may want to consider investing in one of the many financial and technology companies actively working to find other applications for blockchain.