One function of money is as a measure of value. When we use money to measure value, we do not mean that the money exists, rather that the asset, good or service is worth or cost the sum of money. Thus when we say that someone is a millionaire, this means that the sum of all they own minus their debts is more than a million dollars. It does not mean that they have a million dollars in bills stuffed into a mattress.
The men with the green eyeshades often talk about this purpose of money as "unit of account", thinking about it as a measure of value gets to the essence more quickly. So, when I am in a computer store trying to decide whether I should buy the $500 laptop or the $1000 laptop, I use money as a comparative measure of value, by asking whether the $1000 laptop is really worth twice the $500 laptop and an absolute measure of value by asking whether I can afford the $1000 laptop that I really want or whether I should make do with the $500 laptop and save the difference for other needs.
For a measure of value, the best currency is the currency we are familiar with, that we are paid in and that we use every day. Anyone who has been abroad knows the difficulty of commerce with an unfamiliar currency. At first, after every transaction the thought lingers in the back of your mind, did we just get a deal, or were we robbed? However, with repeated use you pick up a new currency. By the end of a vacation you are starting to be able to predict what goods and services will cost in the new currency. When I played World of Warcraft (WOW), I quickly learned the value of WOW Gold through having to work with it all the time.
Bitcoin has another problem as a measure of value, its volatile exchange rate with other currencies. Since its introduction, it has appreciated against all other currencies by about 200,000%. Recently, heavy selling on a Bitcoin exchange caused its value to fluctuate between $0.01 and $17.00 over the period of a day. This volatility makes it difficult to use as a measure of value because its value is uncertain. Most currencies are managed by a central bank and one of the purposes of a central bank is to keep the currency stable with respect to other currencies so that it can be safely used for all the three functions on money. On the other hand, the essence of Bitcoin is that it is completely distributed with no central authority. As it is unmanaged, we can expect its exchange rate to be somewhat more volatile than other currencies.
Another function of money is as a medium of exchange. Before money existed, trading was difficult. If I led a cow to market with the intent on trading it for grain, I might come to an agreement with another farmer that my cow is worth 8 sacks of grain, except that I only want one sack of grain the other farmer only has 5 sacks of grain to trade and he does not want a cow anyway. With money, I can sell the cow for money to someone who wants a cow, buy just as much grain as I need and save any leftover money for other transactions in the future. Money as a medium of exchange greases the wheels of commerce by acting as an intermediary and thus removing barriers to trade.
Bitcoin scores high as a medium of exchange. It can be securely and anonymously traded on the internet for other goods and services. Also it is almost infinitely divisible so it serves for small exchanges. There are two caveats. Firstly a Bitcoin transaction takes about 10 minutes to confirm, so sellers may be unwilling to accept it for immediate transactions where there is no recourse. That is, Bitcoin is good for selling Alpacca socks over the internet, but not for selling hot-dogs at Coney Island. As Bitcoin is an internet currency, this is only of concern to someone who sells virtual goods over the internet without recourse. The Bitcoin FAQ addresses this issue, saying:
Do you have to wait 10 minutes in order to buy or sell things with BitCoin?
No, it's reasonable to sell things without waiting for a confirmation as long as the transaction is not of high value.
When people ask this question they are usually thinking about applications like supermarkets or snack machines, as discussed in this thread from July 2010. Zero confirmation transactions still show up in the GUI, but you cannot spend them. You can however reason about the risk involved in assuming you will be able to spend them in future. In general, selling things that are fairly cheap (like snacks, digital downloads etc) for zero confirmations will not pose a problem if you are running a well connected node."The second caveat is that we typically maintain a reserve of any currency that we regularly use as a float to smooth out transactions. Anyone concerned with the volatility of the value of Bitcoin may be unwilling to maintain a float in Bitcoin and therefore not have a convenient reserve of Bitcoin for doing transactions. If Bitcoin continues to have a volatile exchange rate with other currencies and users do not keep a reserve of Bitcoin for doing transactions, it becomes more cumbersome to use and therefore less useful as a medium of exchange. The end result is that Bitcoin is only used when there is no alternative method of payment. The conclusion is that Bitcoin, or any other currencies usefulness as a medium of exchange does depend on it having a reasonably stable value.
The final function of money is as a commodity like Gold, Oil or Frozen Concentrated Orange Juice (FCOJ). Currencies are commodities that are traded like other commodities for good legitimate reasons. For example, a company that contracts to buy a good that is priced in another currency may want to buy insurance against a change in the exchange rate that would cause the good to become more expensive than when they made the original commitment. Financial companies create and sell instruments that provide this insurance and then trade currencies as commodities to protect their position.
First some words about commodities in general. Owning a commodity does not produce any value. Stocks and bonds may pay a dividend, while a commodity does not, so the only reason for owning a commodity as an investor is the hope that its value will increase so that it can be sold at a profit. In practice owning a commodity is an even worse proposition because money is tied up in owning the commodity that could be otherwise earning interest, so even owning a commodity is a losing proposition unless the commodity increases in value. Then there is a cost for every trade which further saps profits. Thus people who are not Bitcoin speculators will not want to hold more Bitcoin than they need for their day to day needs.
Commodity trading creates a market for the commodity that sets its price. The first test of a commodity is that there is a market where the commodity can be traded efficiently. Bitcoin passes this test as there are several markets for Bitcoin, although a recent attack against the MtGox, the largest Bitcoin exchange may reduce confidence. As an example of the efficiency of trading Bitcoin, MtGox charges a 0.65% charge against every trade.
When evaluating a commodity, we consider how it is used to understand the supply and demand that determines its fundamental price. Bitcoin is a fiat currency which has value because people find it useful as a medium of exchange like the other like other fiat currency: Dollar, Pound, Euro or Yen. The key to understanding the value of Bitcoin like any other currency is money supply, the sum of all the money that people keep in their bank accounts and wallet to smooth out their transactions and grease the wheels of commerce as discussed previously. However there is one difference. With other currencies there is a central bank that manages the money supply to keep the value of the currency stable. With Bitcoin, there is no central bank, rather the amount of Bitcoin is circulation is stable. Thus the base value of Bitcoin depends on demand for its money supply.
The base demand for Bitcoin is to use it as a medium of exchange. If more people regularly do Bitcoin transactions and keep it in their wallet to smooth out their transactions, or they tend to keep more Bitcoin in their wallet because they expect to use it for more transactions, there is more demand for the stable supply of Bitcoin and therefore its price rises. Conversely, if less people keep Bitcoin in their wallet or people keep less money in their wallet the price falls. On top of this base demand, there is demand from speculators who expect the price of Bitcoin to rise and therefore hold it in investment level quantities. The base demand for Bitcoin will tend to keep the price stable, while the speculative demand is likely to make the price more volatile.
Another consideration is whether there are any risks associated with owning the commodity. Bitcoin is a virtual currency and a problem with other virtual currencies has been hyperinflation, caused by someone discovering a software bug that allows them to generate huge amounts of the virtual currency without much effort. This has happened in several Massive Multiplayer Online Games (MMOG), but in each case the game has had a central server that hands out money and a game mechanism that is designed with a specific rate of exchange in mind. Bitcoin is different in that it does not have a central authority and it is traded in a free and open market that sets its value. An attack on Bitcoin could reduce its value, however this could be self defeating as it immediately reduces the value of the attack. I will write a separate post on the security considerations, however it is safe to say that as there is a vibrant market for Bitcoin, it is reasonably safe.
In summary, Bitcoin's purpose is to be used as a medium of exchange for transactions over the internet. Its base value comes from small amounts of it being held in a large number of users wallets because they regularly use it as a medium of exchange. If Bitcoin is heavy used as a medium of exchange, this will tend to stabilize its exchange rate against other currencies and make it more useful as a currency when measured against all the functions of money.