Introduction to How Bitcoin Works
They're a bit like money ... and they're a bit like a financial bubble. They're bitcoins, and they are suddenly ubiquitous, showing us a little glimpse of what the future of money might be like.
Bitcoins are generally defined as a type of virtual currency, brought to life by the Internet, very powerful computers and the willingness of lot of people looking to embrace new forms of monetary exchange.
Bitcoins share many similarities with other currencies, but the most important one is that more and more merchants, retailers and individuals, both online and offline, accept bitcoins as payment. You can buy pizza with bitcoins, subscribe to an online dating service, or even shop at your favorite superstore.
Yet bitcoins are also very different from traditional currencies. Unlike dollars or pounds, bitcoins aren't backed by any government. They're a completely decentralized form of money. Bitcoins aren't linked to any sort of central banking system or issuing authority, and that's a big part of their appeal -- instead of being swallowed into system that's often sullied by human greed and manipulation, this currency exists in an online world driven by mathematics and clever encryption protocols.
You can use bitcoins for all sorts of real transactions. To do so, you first buy bitcoins however you like, either through your credit card, a bank account or even anonymously with cash. Then your bitcoins are transferred directly into your Bitcoin account, and you can send and receive payments directly to a buyer or seller without the need for a typical go-between, such as a bank or credit card company.
By skipping the middle man in the transaction, you pay far less in associated fees. Each party in the deal can also maintain a much higher level of anonymity, which has both pros and cons for everyone involved. Think of bitcoins as a digital equivalent of a cash transaction. If you're so inclined, it's a nearly untraceable way to do business.
Spending or receiving bitcoins is as easy as sending an e-mail, and you can use your computer or your smartphone. That simplicity belies the fact that there's a whole lot of complicated math protecting all of these transactions to maintain their legitimacy and security.
Keep reading to see more about the mysterious rise of bitcoins, as well as the inner workings of the network that keeps this so-called "crypto-currency" alive and kicking.
Bitcoin's Backstory
The genesis of Bitcoin is the stuff of Internet legend. In 2008, a person (or persons) working under the pseudonym Satoshi Nakamoto published a document outlining the feasibility of the Bitcoin concept. Nakamoto mentioned the 2008 financial crisis -- as well as the failures of government-backed currencies and corruption of existing banking systems -- as a motivating factor for inventing a new currency.
Bitcoin could be, perhaps, a purer form of money, working for regular citizens of the world instead of being leveraged against them by the powers that be.
In 2009, Nakamoto released the first Bitcoin application, and also "mined" the first bitcoins for circulation. Then it was just a matter of spreading the word about this new currency.
To use bitcoins, you need wallet software, which encrypts and maintains your bitcoin balance on your personal computer. To get started, you must first download and install the wallet software to your computer or smartphone. Then you can fill your wallet with bitcoins by using your bank account, credit card or other form of payment.
Then it's just a matter of finding a vendor that will accept bitcoins as payment. Although pickings were slim when bitcoins first launched, these days there are many merchants that accept these newfangled coins. That includes restaurants, clothing stores, dentists and many others. Some people even use bitcoins for property rental and vehicle purchases. And if you use a related service such as Bitspend or Bitpay, you can use bitcoins for purchases from any retailer you can imagine, from big box stores to the smallest businesses.
If you follow financial news at all, you already know that bitcoins aren't just used for goods and services. A lot of the hype around bitcoins has centered on speculating in the currency itself, via currency exchanges such as Mt. Gox, which currently handles the bulk of bitcoin transactions. That is, people invest their real-world cash in bitcoins, hoping that the latter will appreciate in value. Already, fortunes have been made (and surrendered) as the value of bitcoins has careened all over the charts.
But how does this invisible, virtual currency wield so much financial power? How can a brand-new type of money be a workable concept? Well, it's complicated. Keep reading and you'll see how bitcoins come to life.
One Complicated Coin
Bitcoins aren't like gold. No one can dig them out of the ground. They're not like paper money, either. No central authority prints hard-to-counterfeit, tangible paper bills for circulation. Instead, bitcoins depend entirely on a decentralized computer network and some amazing feats of cryptography.
For starters, understand that the entire Bitcoin system runs on P2P (peer-to-peer) network. This P2P architecture is similar to file-sharing networks like the ones that allow people to freely distribute data of all kinds, including copyrighted music, movies and more. It's a resilient system.
In other words, there isn't a central computer hub running all of the bitcoin-related processes. Instead, each Bitcoin user's computer is part of the network, collectively sharing the computing burden of generating bitcoins and logging their transactions. It's this decentralized nature that makes Bitcoin impervious (so far) to government meddling, free of regulation and monitoring.
Before anyone can even use a Bitcoin, those coins must be mined, by a so-called bitcoin mining process. Any computer can begin mining for bitcoins by using a free mining application. Mining requires the entire network of Bitcoin-participant computers to do a set amount of work before being rewarded with a bitcoin. Basically, that work means a whole lot of number crunching -- and the spoils go to the owner of the computer that completes the set of number crunching at hand. Some people invest many thousands of dollars in very powerful computers just to mine bitcoins, and in essence mining has become a computing arms race, and only those at the leading edge stand to gain anything in the way of profit.
The exact amount of work required is variable. The network adjusts that workload so that the number of bitcoins rises at a steady, predetermined rate. It will continue to do so until the number of bitcoins in circulation reaches its ultimate number, which is 21 million. Currently, the mining process creates 25 bitcoins every 10 minutes. Every four years, the number of coins that can be mined will be halved, until the capped limit of coins is reached in the year 2140. After that point, the number of bitcoins in circulation will be static.
As you already know, you hoard your own bitcoins in a digital wallet. When you send or receive coins, they are verified by a digital signature, called a public-encryption key, which prevents counterfeiting and makes coins recognizable to the network. In a sense, the network shares an open ledger (called the blockchain) of all bitcoins, which provides a trustworthy and redundant way of maintaining the number of bitcoins in circulation.
All of this works thanks to Bitcoin's ingenious open-source (that is, viewable to everyone) code. Open-source software is commonly used by programmers who are opposed to corporate profiteering and control. Any skilled programmer can see how Bitcoin's programming works, and that's OK -- it's not the code that protects transactions. Instead, it's the shared network that verifies the legitimacy of each transfer.
A Question of Money
When you have a store of bitcoins in your wallet, you can leave them there and hope that they appreciate it value. Or you can cash them out into local currency. If you store them on your computer, it's imperative to remember that there's no central company with a backup of your wallet.
That means you have to create a backup record of your balance. It's best to store that record on a device such as a flash memory drive that can you keep in a safe location. Otherwise, if your hard drive dies and takes your wallet down with it, you'd lose your bitcoin savings.
Bitcoin transactions are irreversible and generally very fast. However, because the bitcoin verification process must share data regarding the transaction with the entire network, sometimes you'll wait minutes before a payment is completed.
Because there are no national regulations for bitcoins, you can transfer them into or out of any country and dodge the steep fees that other such services charge. And because the system has no governing authority, your account has no limits and can never be frozen.
It's at this point that many people wonder about the legitimacy of bitcoins. How can a currency just appear overnight on the Internet and have actual value? Economists might offer a long, philosophical explanation about the history of money, but the short answer is this: All currencies have value only because people believe that they have value.
Bitcoin is no different in that regard. It's been embraced by libertarian-minded activists, financial speculators and people who simply no longer trust government-backed banking systems. These people trust the mathematics and encryption of the Bitcoin system, and their trust has been contagious, lending even more legitimacy to this virtual currency.
More than a Bit Scary
Bitcoin is slowly gaining more legitimacy. But, there's the matter of people really trusting a currency. And that's where this new currency gets scary. Rampant speculation has turned the valuation of bitcoins into a neck-snapping roller coaster ride. In 2010, a unit of 1 bitcoin was worth just a few cents, but it rose steadily to around $30 in the middle of 2011. Near the end of that year, though, it zoomed violently down to only around $2.
But then bitcoin value made a remarkable recovery, rising to a sky-high $260 in early 2013. Then, once again, it crashed, dropping to just below $100. Those who bought low and sold high made a lot of dough; others lost mighty sums.
To many observers, this crash brought to mind the dot-com and housing bubbles. Some economists warn that the bitcoin system is a bubble just waiting to burst, perhaps again and again. They think it's a currency built only for suckers and speculators.
There's also the fact that online currency exchanges continue to be a hub for most Bitcoin transfers. The exchanges are necessary, of course, because they help you convert bitcoins to and from local currency. However, in a system that's supposed to be decentralized, these exchanges offer up a tasty target for government regulators and malicious computer hackers.
Hackers, for example, may not yet be able to exploit Bitcoin's elegant system in order to create fake coins or fraudulent transactions. But they can definitely attack the exchanges, which are as vulnerable as any other kind of Web site. In one widely publicized incident, hackers launched a DDoS (distributed denial-of-service) attack on the popular exchange Mt. Gox, rendering the site unreachable to just about everyone. Chaos ensued and bitcoin value plummeted.
The exchanges themselves are risky in another way, too. Many people store their bitcoins in their exchange accounts under the assumption that these sites are the safest storage method. But nearly half of bitcoin exchanges have folded, often taking every user's savings down in flames, too [source: ScienceDaily]. So if you do buy bitcoins, don't think of your exchange account as a good place to store your hoard.
Bitcoins are definitely a high-risk asset. And as you're about to see, there are other potential downsides to the Bitcoin system.
Extralegal Activities
If bitcoins seem a bit anarchist, well, that's because they are. They dodge the traditional paradigm in which government regulators control and manipulate the money supply.
With bitcoins, people all over the world can engage in online gambling, which the U.S. federal government seriously disapproves of. Bitcoins are also infamously and irrevocably linked to Silk Road, a black market Web site where people can anonymously purchase about anything, including illegal drugs. On a related site, called The Armory, you can ring up a few weapons with little hassle.
Or you can visit a site called Black Market Reloaded and buy just about any product or service you can imagine. Need a kidnapper or hired gun? With enough bitcoins and some investigative work, you could potentially find the right person for any job [source: Buterin]. If you're into sabotage, you could buy classified information from anonymous informants. Or less nefariously, you could snag some tasty (but banned in the U.S.) Cuban cigars [source: Brito].
On Silk Road, bitcoins are the only accepted currency. After perusing illicit goods and seller ratings, a buyer transfers bitcoins into escrow. Once the buyer confirms that he or she has received the items, those bitcoins are released to the seller and the deal is complete. Millions of dollars in goods and bitcoins change hands through Silk Road's site each year [Source: Economist].
The relative anonymity of Bitcoin could eventually enable tax evasion, too. Traditionally, hiding your assets in some offshore account takes some real legwork. With Bitcoin, though, you can potentially stash millions of dollars in your digital wallet, safely out of view of all tax collectors, and you could complete this process in just an afternoon.
Governments and concerned citizens obviously take issue with this sort of backroom Internet wheeling and dealing. Governments don't want citizens skimping on taxes, and their drug and arms enforcement agencies understandably aren't happy about people finding high-tech ways to skirt their laws.
In spite of these sort of legal or ethical concerns, and even though their value is crazily unpredictable, Bitcoin has endured. That leaves a lot of economists and consumers wondering just what's in store for the future of currency.
Bitcoin is Just the Beginning
The sharp peaks and valleys in bitcoin value are clear warning signs that this new crypto-currency is anything but stable. Until more people actually use these coins to buy things, as opposed to speculating in the currency itself, it's difficult to say whether bitcoins are here to stay.
At the moment, bitcoins fluctuate so much in value that the coins themselves are the primary draw. Stock gamblers and speculators play games to push bitcoin value to stratospheric heights so that they can sell and make profit.
Entrepreneurial nerds assemble staggeringly powerful stacks of computers dedicated solely to mining bitcoins, competing against other like-minded miners. In the process, they burn so much cash on PC components and electricity that they don't make as much as they'd like in actual coinage. And as a side note, their energy consumption draws the ire of some environmentalists, who say that miners suck enough electricity to power 31,000 U.S. homes per day [source: Brown].
There are also plenty of unanswered questions about the nature of virtual currency itself. Is the world truly ready to switch from centuries-old paper and metal, government-backed money to a purely online version? Only time will tell.
If people really are ready for digital-only currency, is Bitcoin the answer? There are plenty of competitors to Bitcoin prepared to swoop in and cash in on the digital money market share. They include PPcoin, Litecoin, Ripple, Freicoin and Namecoin, among others. Each of these systems claims to have strengths that other currencies can't match.
Whether it's bitcoins, dollars or francs, our global economy requires all of us to trust a system of currency that makes sense. Perhaps in the coming years, a digital currency will garner enough trust that it begins to overtake more traditional currencies. Until then, however, the bitcoin phenomenon may fade, bit by bit, into the Internet ether.