What is Bitcoin: FAQs and Facts about the Currency of the Future


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Bitcoin has occupied front pages and preoccupied media for many weeks now and there are mountains of information (or misinformation) about this crypto-currency. Is it for real, or money from nothing? Is it a bubble that’s due to burst? Is it a scam, a ponzi scheme? While complex in itself, the basics ideas of Bitcoin are comprehensible to those willing to invest the time necessary to understand them. And understand we must because regardless of its ultimate failure or success, Bitcoin's very nature challenges the core concepts of the world that we live in today.

What is Bitcoin, really?

http://www.youtube.com/watch?v=Um63OQz3bjo

This explanimation mentions several key characteristics. It’s a decentralized internet currency. There’s no central authority, like central banks or federal reserves, regulating it. “Coins you can send through the internet,” as succinctly stated, with the underlying assumption that the party receiving finds it valuable and its willing to part with goods and services in exchange.

How are Bitcoins made?

They’re generated by cracking complex math problems. Seriously. If you want the nitty-gritty details, here’s a link to the original paper published by one anonymous hacker or group of hackers who went by the alias Satoshi Nakamoto. These seriously heavy number-crunching tasks, in time, will yield a block containing Bitcoins. To join the Bitcoin action, you’ll need to download the Bitcoin software into your machine and put it to the service of the Bitcoin network.

Here’s the thing. The computation that your machine does isn’t just any random task but is actually a validation of the transactions being done across the entire Bitcoin universe. Your participation in the system is rewarded. Here’s why heavy lifting is required.

There’s no central agency monitoring the whole thing, right? It’s a peer-to-peer network much like BitTorrent or Napster. This means all of the nodes are involved in validating the transactions. And as Bitcoins change from one owner to the next, the computation required gets more complex because all the history of all the Bitcoins involved in the transaction goes along with it. This process is called mining. The longer a Bitcoin has been bouncing around the system, the heaver the computation required. In Bitcoin parlance, this shared public transaction log is called a blockchain.

The integrity and the chronological order of the blockchain are enforced with cryptography, thus the label crypto-currency. If someone tries to double-spend a Bitcoin, the whole system will be alerted to this right away and the nodes will reject the younger blockchain with the later timestamp for an identical Bitcoin. The only way to circumvent this is to have greater computing power than all other nodes combined, which is near-impossible.

Bitcoin transactions, like transactions involving ordinary money, are records of the transfer of value. What’s different is that these are records of transfers of value between one public Bitcoin wallet (each with a unique Bitcoin address) to another. The cryptography part is played by a private key known only to the owner of the Bitcoin address. Think of the wallet as your account, and the private key as your PIN, only much longer.

You use private keys to sign transactions, providing a mathematical proof that the transactions originate from you, the owner of the addresses. The signature also prevents the transaction from being altered by anybody once it you’ve issued it. All transactions are broadcast between users and confirmed by the network in the following minutes, through mining as described above.

If you’re still with us up to this point, you’ve probably realized that all this “money out of nothing” argument thrown at Bitcoin is quite false. So you’re not doing the computations yourself. Maybe you’re totally clueless about what kind of computation goes on inside the system’s nodes. Maybe what you really have is lots of spare cash to buy powerful servers to deploy to the Bitcoin network. Still, that’s a very valid investment. Greater network computing power means greater Bitcoin integrity and faster validation of transactions.

There are no available statistics yet on how much it costs to prop up the whole Bitcoin financial system, but look at it this way. On April 12 Washington Post’s Brad Plumer reported that in the last 24 hours computers connected to the Bitcoin network consumed $147,000 worth of electricity to power the number crunching required. Now compare this to the Federal Reserve System that, in 2011, incurred $3.4 billion in net expenses to carry out its responsibilities that includes printing out money and managing its flow.

Is Bitcoin real money?

bitcoin acceptedHere’s the thing about money as we know it today. It has no intrinsic value. Those thick wads of euros and dollars are not, in themselves, worth the value they represent. The value of fiat (or paper) money stems from the general agreement by the majority of its true worth. A dollar can buy a pound of apples or two cans of soda, for example. The value of currency stems from the willingness of merchants to accept them in exchange of goods and services. Dollars, euros, and bitcoins are similar in this regard. So long as merchants accept any of these then they have value and conform to our general idea of what money should be. In this very general sense, anything that serves the purpose is, for all intents and purpose, money. Wampum, giant Yap stone coins, and even Monopoly bills can serve as currency if everyone involved in the system that facilitates transaction have a common understanding of its value.

Money is a medium of exchange to facilitate the transfer of value because our world has become too sophisticated for barter. Other than the obvious difficulty of transporting physical goods, many of us don’t even produce goods that can be traded for other goods. Instead we produce services and create or process knowledge and the value created by these activities are very difficult to break down into sub-units. For the pleasure of watching Beyonce perform live, for example, how many deliveries of pizza will Beyonce take before she’s paid enough to give the delivery boy one ticket to her show? Or how many lectures on quantum physics, if she’s interested in that at all? It’s almost impossible to have a coincidence wants for all potential transactions.

Fiat, or paper, money is the concept of money we’re all familiar with today. It’s a means of payment, and a unit of account. Because it’s standardized into specific values, it can be used to price goods and services, and allows the easy comparison of prices. But “fiat” is a left hook that may catch us in the jaw unawares because we simply do not think about it although we’re always dimly aware of its power. Some argue, and rightly so, that today’s currencies have value because they’re guaranteed by the governments that print them. Enforced, with special emphasis on the second syllable and with this enforcement comes the implied threat of punishment for those who refuse to honor the system within which these currencies are designed to flow smoothly.

One other important dimension of money is its ability to store or keep its value over time, otherwise people will refuse to accept it as payment. This is where the concept of relative scarcity comes in. Money will lose its value if too much of it is printed, but there shouldn’t be too little of it circulating so that growth is stifled. A tight lid on supply should always be maintained. There used to be implicit trust in the collective wisdom of the central authority that opens and closes this lid. The flood of financial scandals and the Great Recession has diluted this confidence to such an extent that the unregulated Bitcoin network is now viewed as a viable alternative to the central authority. But that’s jumping ahead of our story.

So, is Bitcoin real money? For all intents and purposes, it satisfies all three criteria. It is (1) a means of payment, (2) a unit of account, and (3) a store of value.

From Currency to Commodity

Commodities, such as salt, silk and pepper in ancient times and the cash crops (e.g. coffee, cocoa, and sugar) of today may also be effectively used as money if they satisfy all three criteria stated above. Because Bitcoin is heavily traded and hardly used to buy anything, there are arguments maintaining that it has ceased to be viable as a currency.

Here’s one thing that needs to be understood about Bitcoin. Perhaps to ensure that Bitcoins remain scarce, the creators of the system designed it such that there can only be a specific number of Bitcoins that can be possibly generated. There can only ever be 21 million Bitcoins and it’s projected to hit that ceiling in 2040. Right now the number stands at 11 million (head over to Bitcoin Charts if you want an updated count). For now, the number of Bitcoins that can be generated is 300 coins every hour on average. Every four years, though, the rate is set to fall by half. It will drop to 25 coins per block in 2013, to 12.5 coins in 2017, and so on, until the total supply levels off at 21 million.

Think of Bitcoin mining as analogous to real-world mining for gold and other precious minerals. The resources mined are both finite. Unless alchemists finally solve the eternal puzzle, the earth’s supply of gold will stay at current levels. But Bitcoins differ in one fundamental aspect. A lucky gold prospector can strike a rich lode and dramatically change the global supply picture. Bitcoins, on the other hand, are designed to be produced at a steady rate. If someone introduces an exponentially more powerful computer to the network it won’t speed up the creation of coins. However, it will definitely increase by many magnitudes the difficulty for other nodes in the Bitcoin network to crack the computation before it does.

Matthew O’Brien of The Atlantic argues that because of Bitcoin’s fixed ceiling, it has a deflationary bias. As the amount of things Bitcoins can be used to buy increases, the value of each coin also increases. Each coin should be able to buy more goods in the future than it can today, the opposite of how currencies usually work. So why spend it now when you can use it buy much more at a later date? This encourages hoarding. People won’t use Bitcoins to buy anything, further pumping up its scarcity and value. If enough people do this with substantial amounts, Bitcoins will be effectively removed from the economy.

bitcoin valueSomething with this kind of value will open the doors wide for speculators who are willing to take wild risks to win big. The fluctuations in value that result will effectively render Bitcoins useless as a currency. Without the benefit of central authority to regulate Bitcoin values with such creative solutions as quantitative easing, Bitcoin’s finite number designed to promote scarcity and preserve value is a disaster waiting to happen, indeed. That’s unless the network manages to develop a quasi-authority that can police the ranks. Not a farfetched scenario because those who’ve invested heavily will certainly not want to see the investment wasted.

Whether the Bitcoin community is willing to cede territory to regulators and lose some independence and anonymity remains to be seen. Already, there are moves to standardize the technology by globally recognized institutions such as IEEE. Bitcoin startups have registered with FinCen, or the Financial Crimes Enforcement Network Agency, whose mission is to “to safeguard the financial system from illicit use and combat money laundering.”

Meanwhile, it’s being compared to the dotcom bubble of the late 1990s and predictions of a burst and crash abound. On the strength of heavy investment the value of Bitcoins has risen and fluctuated spectacularly in the first quarter of 2013. From being valued at just $20 at the beginning of February, Bitcoin value hit record highs above $250, before falling abruptly to below $150 on April 11th. This pushed Bitcoin talk from the fringes into front pages.

The Shady Flipside of Bitcoin

Prior to this, Bitcoin had been confined to the libertarian circles, outliers wary of government’s power to devalue currency by printing new money and flooding the market with currency. They bristled at the fees required to transact over conventional financial networks, fees that do not add value but increased prices anyway. Most detested was the loss of privacy that accompanied any selling and spending activity. Records were kept for everything bought and sold. Bits of data zipping around the internet could actually tell your whole life story if someone made the effort to put all pieces of the puzzle together.

Bitcoin promised a way around all of this. Unfortunately, these qualities are the very same ones that make Bitcoin the perfect currency for illicit trade. Bitcoin’s validity as a medium of exchange was proven in the worst of places. Because of its anonymity Bitcoin is the preferred currency of Silk Road, the eBay-like online market place for drugs. Porn and weapons, commodities that thrive on anonymity, were also bought and sold with Bitcoin.

That it can be used for illicit trade isn’t an indictment of Bitcoin, however, because this can be done with any other currency or medium of exchange. Whether in dollars, diamonds, or Bitcoins, bad people will always be bad people, and someone somewhere will lose money by means limited only by the imagination of the perpetrator. Bitcoins have been stolen, Bitcoin addresses and wallets have been hacked, and there’s a Hollywood movie every other month about a bank heist. There’s one big difference, though. When someone touches hard cash that doesn’t belong to them, there’s a chance they’ll end up in jail for it. With Bitcoin’s inherent complexity and anonymity, prosecution is next to impossible. And would the Bitcoin community even want government meddling in this decentralized Shangri-La?

Opportunities to take or waste

Level-headed entrepreneurs aren’t daunted by the shady beginnings of Bitcoin. They see online currency as the future and have established startups that enable the Bitcoin economy to interface with mainstream economic activity. BitInstant allows people to convert Bitcoins to dollars and other currencies. From being laughed at when doing the rounds of investors, Mashable reports that transaction volume on Charlie Shrem’s BitInstant has doubled each of the past three months and now totals in the seven figures on a monthly basis. Forbes cites Bitpay, “a company that enables legitimate merchants to accept Bitcoin as a form of payment now serves more than 10,000 merchants and is processing more in transaction volume than the infamous Silk Road marketplace.”

While most of the Bitcoin noise is being generated in developed countries, there are some who foresee Bitcoin’s true impact to be in the 3rd World. While payment systems such as credit cards and PayPal are well established in countries with a developed telecoms infrastructure, it is absent in really poor countries such as Rwanda. What Bitcoin can do in these countries is to enable and empower merchants. The Nyuraka Blog states it elegantly. “Someone in Rwanda that builds a compelling service can instantly start taking payments from the rest of the world, without asking for permission, without filling out any paperwork and with the same fee structure as the biggest retailers.”

The future of online currency

Bitcoin-moneyThere’s one spark of hope that keeps the Bitcoin faithful believing in its future – transaction fees. It is envisioned that participants in the Bitcoin economy will eventually earn more from the fees for verifying transactions than from the actual generation of new coins. Thus, even when no new coins are generated by the system, there is money to be earned. This is also the biggest disincentive for hoarding coins. Fees are voluntary. Participants in a transaction can choose to include them in a transaction and the miner has the option of accepting a transaction for inclusion in a new block being created.

There are technical hurdles facing Bitcoin, but they’re not insurmountable. Bitcoin may grow too fast for its own good. As more users join the system the computational power needed to verify each Bitcoin and transaction will be immense. Upgrades to existing Bitcoin clients can solve this problem.

And then there’s the fear that software propping up Mt. Gox, the main Bitcoin exchange, will break down and take the whole Bitcoin economy crashing down with it. In fact, the wild fluctuation that happened in April 10 was triggered by one such breakdown. The problem was corrected and Bitcoin value stabilized but the incident clearly illustrated the volatile nature of Bitcoin value.

Many are saying that the only thing that can kill Bitcoin is if something better comes along. Bitcoin entrepreneurs such as Roger Ver of MemoryDealers.com, the same angel investor who listened to Charlie Shrem and invested $120,000 in BitInstant, have said as much.

The Economist discusses these alternatives in an excellent article. Litecoin is one such alternative. It’s a clone of Bitcoin and only used by a small community of early adopters. Ripple is one other alternative and it is showing great potential. It promises verification in a few seconds, a huge improvement over the average 10 minutes you’ll need to wait for Bitcoin transaction verification.

The greatest potential of Ripple, however, lies in the potential to function as a central authority for stabilizing value. Although it promises to create only 100 billion Ripple units and no more than that, it will only release 75% to the public. Ripple has not stated this explicitly, but the remaining 25% can be used as a leverage against undesirable movements in the Ripple network much like central banks can mop up excess liquidity in the currency market or perform quantitative easing by infusing the market with new money.

Join the Bitcoin bandwagon?

If we’ve piqued your interest and you’re hungry for more head on over to the Bitcoin FAQ. Or witness the ongoing debate between two Austrians. Peter Surda is an advocate and published a scholarly thesis about Bitcoin. Peter Korda thinks Bitcoin is a bubble just waiting for the right needle to prick it.

Should you join the Gold Rush? Bitcoin is the Wild Wild West of finance at the moment. Unless you have lots of guns or a really big posse you might want sit this one out, wait for the gunfire to die down, and the smoke to clear. On the other hand, you might miss this narrow window of opportunity if you don’t act quickly.

Will you risk hard earned real-world cash
in the virtual Bitcoin economy?

Submitted by Alex Hillsberg

Alex has a keen interest in the stock market, small and medium enterprises and personal finance, pursuing news, stories and issues around these topics for nearly twenty years now. He has written for various financial websites helping average Americans to pursue their financial goals.

Category: Financial News
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4 Comments »

  • Steven says:

    “With Bitcoin’s inherent complexity and anonymity”

    Please keep in mind that Bitcoin is not inherently anonymous.

    Because all transactions are open and public, a bitcoin’s history can be traced back through IP addresses. Of course, an IP address does not directly lead back to a single person – but, and this is just an example, if facebook notices a particular IP address always logs into a particular account, and facebook has reason to believe that the credentials for that account are what they are claimed to be (i.e. a real life person identifiable as such), that anonymity is clearly lost. It’s not simple, or likely, but it’s technically possible.

    Thus there are bitcoin ‘laundering’ services and also alternatives and proposed addons to Bitcoin that would make it truly anonymous.

  • Peter Šurda says:

    Patrik Korda’s argument (or at least a part of it), in that Bitcoin might be in a bubble phase, does not really contradict my argument that Bitcoin is a fundamental innovation and we can expect it or something like it to have far reaching effects. I simply don’t think that a bubble, or in general price volatility, is relevant for anyone else than forex speculators. If you want to use Bitcoin but do not like to be exposed to the price volatility, you can hedge for the price movements. You can either do it directly on the forex markets (which however requires a lot of assets being stuck), using a leveraged derivative service (I haven’t investigated them recently so I don’t know what the current status is), or you use a specialised provider like BitPay, BIPS or Coinbase.

    • Alexis says:

      Peter thanks for clarifying your position. Some questions, though. Did Bitcoin’s “forced” scarcity void its potential as a currency? Will future online currencies need to stay away from this design? Is it possible for governments to start parallel online currencies using roughly the same technology, will their “fiat” online currencies effectively kill ventures like Bitcoin?

      Thanks!

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