Bitcoin’s rally is accelerating as the U.S. Department of Justice’s description of the digital currency as a “legal means of exchange” bolsters the prospect of wider acceptance as an alternative payment system.

Bitcoins, which exist as software and aren’t regulated by any country or banking authority, surged to a record $744 on Bitstamp, an active Web-based exchange where they trade for dollars, euros and other currencies, after the remarks at a hearing by the U.S. Senate’s Homeland Security and Governmental Affairs Committee. The gains extended an advance that has seen the price of Bitcoins quadruple in the past two months and climb 45-fold so far this year.

Growing interest from investors in China and a limited supply of Bitcoins have also been fueling the increase in price, while last month’s closing of the Silk Road Hidden Website — where people could obtain drugs, guns and other illicit goods using Bitcoins — was already spurring speculators to bet Bitcoins would gain more mainstream acceptance. Now, government agencies from the U.S. Secret Service to the Financial Crimes Enforcement Network have weighed in to say that the virtual currency that’s designed to be difficult to trace has potential benefits, as well as risks.

“These hearings mean Bitcoin is finally coming into its own; it’s a real thing and it’s not going anywhere and these hearings highlight that,” said Jerry Brito, senior research fellow at the Mercatus Center at George Mason University.

Legal Use

Introduced in 2008 by a programmer or group of programmers going under the name of Satoshi Nakamoto, Bitcoin is being used to pay for everything from Gummi bears to smartphones on the Internet. There are 12 million Bitcoins in circulation, according to Bitcoincharts, a website that tracks activity across various exchanges. Bitcoins can potentially reduce banking-transaction fees, making it an attractive tender for those seeking to trade via the Web or in stores.

Tom Carper, a Democrat from Delaware who is chairman of the Senate committee, said today that while “knowledge and expectation gaps are wide,” the government should establish rules to ensure legitimate use.

“We all recognize that virtual currencies, in and of themselves, are not illegal,” Mythili Raman, acting assistant attorney general at the Justice Department’s criminal division, said at the hearing. “We are nimble enough and aggressive enough to be able to combat the threat. We are up to the challenge.”

Market Action

Speculative trades exceeded transactions for goods and services by 20 to 25 times in the latest quarter, said Vladimir Maslyakov, co-founder of brokerage Exante Ltd., which has set up a Bitcoin investment fund.

“The real economy is not growing as fast as the price,” said Maslyakov, who said his firm now holds about 60,000 Bitcoins and is seeking approval to solicit funds from U.S. investors. “Speculators are usually much faster.”

Justin Hanneman, who does technology support for a Web-hosting company in Austin, Texas, said he has invested more than $9,000 in Bitcoins since April.

“I cling to them for dear life,” said the 23-year-old, who plans to hold onto almost all of his 50-plus Bitcoins — now worth about $30,000 — for at least a year.

The demand for Bitcoins, governed by rules embedded in the software of the virtual currency, is outstripping supply, fueling the price surge. That also makes it difficult for people to use the digital money to buy goods and services, since the value of items priced in Bitcoins is difficult to pin down.

Supply, Demand

Patrick Murck, general counsel for Bitcoin Foundation, said that there remain “consumer-protection issues” around the use of Bitcoins.

“It’s very much an experimental currency, and should be considered a high-risk environment,” Murck said. “It’s not quite ready for mass consumer adoption today.”

There are about 30 transactions per minute, at an average amount of 16 Bitcoins, Francois Velde, a senior economist at the Federal Reserve Bank of Chicago, estimated in a report published earlier this month.

“Bitcoin seems to be primarily a speculative investment for now,” Velde said in an interview.

While demand continues to climb, with trading volumes up more than 400-fold in the past 12 months, supply is increasing at a predictable rate, thanks to the way the virtual money is designed. Those seeking to create new Bitcoins must use powerful computers to solve complex software problems embedded in the currency, which exists as software.

Silk Road

“Supply is limited and doesn’t grow extensively, and there’s more demand as there’s more public awareness,” said Axel Merk, president of investment-adviser Merk Investments LLC in Palo Alto, California.

Bitcoin’s rally reversed course in early October, when U.S. prosecutors said Ross William Ulbricht, known on Silk Road as “Dread Pirate Roberts,” ran “the most sophisticated and extensive criminal marketplace on the Internet” and shut down the website. Ulbricht denies the charges and will seek bail at a hearing set for Nov. 21, his lawyer, Joshua Dratel, said last week.

When Silk Road was shut down, the virtual currency lost a third of its value within days as holders sold, predicting a crackdown. Instead, the willingness of authorities to stamp out illegitimate use has come to be seen as an endorsement for Bitcoins, making users and investors more comfortable taking risks with digital money.

China Joins

“The Silk Road closure, and the fact they survived that, it means that Bitcoin is maturing,” Merk said. “The rogue players are being eliminated, and the players that are able to fit into the regulated world are surviving.”

Jeremy Allaire, the co-founder and former chief executive officer of Brightcove Inc. (BCOV), is seeking to become one of those players. He’s now CEO of Circle Internet Financial Ltd., a startup that’s creating tools and services for individuals and businesses to use Bitcoins.

“Silk Road was perceived as a very significant milestone,” said Allaire. “We all know there’s been dramatic growth in the amount of Chinese consumer interest.”

Bitcoin also gained further legitimacy and attention when a subsidiary of Baidu Inc. (BIDU), China’s top search engine, started accepting Bitcoins on Oct. 15. Chinese Bitcoin activity has exploded, with the number of yuan-based trades jumping 30-fold in the past two months and making BTC China the top online-exchange by volume.

Bitcoin Funds

After Baidu’s decision and a documentary on Chinese television on Bitcoins earlier this year, interest in the virtual currency in China took off. BTC China surpassed Mt.Gox and Bitstamp earlier this month as the top market for exchanging Bitcoins with other currencies.

While BTC China’s average daily trading volume was about 1,100 Bitcoins during the month of January, transactions have been at about 90,000 per day so far in November, according to Bitcoincharts.

“I am very, very bullish on the price of Bitcoin,” Bobby Lee, BTC China’s chief executive officer, said in an interview. “We’ve become the world’s largest Bitcoin exchange. We have the most liquidity. We’ll bring stability to the market in terms of price eventually. Until then, there’s going to be frenzied buying.”

Bitcoin Portfolios

U.S investors, including wealthy families, are allocating more of their investments into Bitcoins in order to diversify portfolios, according to Barry Silbert, CEO of SecondMarket Inc., which connects investors with private company shares.

“We are now seeing the principals of Wall Street firms and funds investing their own funds into Bitcoin,” said Silbert, who said he’s working with Pensco Trust Co., Entrust Group Inc. and Equity Trust Co. to offer investors the ability to buy Bitcoins for individual retirement accounts. SecondMarket’s Bitcoin Investment Trust has already attracted $15 million, more than the $10 million he projected for 2013, Silbert said.

Underscoring how speculative Bitcoin trading is dominating the market for the virtual currency, online-retailer BitcoinShop.US said it’s experiencing declining orders. Since products on the Web store are priced in Bitcoins, shoppers are hesitant to shop for jewelry, computers and other goods on the website. The number of orders plummeted 20 percent last week, according to Michal Handerhan, co-founder of BitcoinShop.

Insane Volatility

“For the last five days, it’s been really slow, and it’s because the rate’s gone up so fast, people are holding the Bitcoins back,” Handerhan said in an interview. “When the rate goes up really rapidly, it’s against us.”

In order for Bitcoins to retain their value while gaining broader acceptance and use, the virtual currency has to become stable, fluctuating no more than 25 percent a year, said Nicholas Colas, chief market strategist at ConvergEx Group in New York. That may not happen for at least another year, he said.

“People say it’s good volatility, but it impedes the growth in the Bitcoin ecosystem,” Colas said in an interview. “Bitcoin volatility right now is insane.”

(Source: Bloomberg)