Take the basic unit of information, bit, and add to the basic unit of currency, coin, and what do you get? Bitcoin, a new digital currency that "uses peer-to-peer technology to operate with no central authority," to issue bitcoins, a "completely digital and decentralized currency," according to the company's website.
The Philosophy of Currency
If you're not an economist, chances are you don't have existential conversations about currency that go something like this: Q: Why does a dollar equal a dollar? A: Because we all agree it does. When, in reality, a dollar is a prettily printed piece of paper and nothing more, in the economy it represents values because we all agree that piece of paper is equivalent to the worth of whatever we exchange it for–a car, a pack of gum. In many small rooms in many corners of the world there are conversations going on about how a dollar stacks up against a pound or a peso, but at the core resides this philosophical question about value.
A bitcoin has the same starting place. To some extent, it means something because its users agree it does. But there's nothing physical backing it up. (And really there isn't much backing up the Federal Reserve either outside of the government's promise to repay its debt, but that's neither here nor there.) A bitcoin is just an abstraction floating in cyberspace.
Just as there's a finite amount of gold, there's a finite number of bitcoins to be had–21 million to be exact. And, as there's a limited number of bitcoins in circulation, the value of these digital nuggets increases over time. In fact, according to Bitcoin Watch, a bitcoin as trading at 1 BTC to $120 USD.
How on Earth Does That Work? An extremely simplified overview...
Bitcoin uses the same methods to create bitcoins as the National Security Agency (NSA) uses to encrypt files–cryptography. Every bitcoin is a very unique and extremely large number in hexadecimal format generated by a secure hash algorithm (SHA), which has been used by the NSA to turn text files (for example) into a single fixed value "hash." Due to the number's length and the complexity of the algorithm used to generate it, the resulting hash is near impossible to duplicate. This makes for good security for the NSA and difficult counterfeiting for Bitcoin.
This unique cryptographic key assigned to every bitcoin means that its verified by the network each time its transferred within the system, which makes the history of each individual bitcoin traceable.
If you're thinking that all that fancy algorithm talk doesn't convince you that bitcoins are worth anything outside of the cyber-universe, you're not alone. That's because bitcoin, and all crypotcurrenices like it, are meant to be subversive. As Techopedia explains:
Cryptocurrency is considered a counter-culture movement related to cypherpunks, who advocate the use of cryptography as a route to social and political change. Cryptocurrency presents a form of this movement in that it is essentially a fiat currency, which means it only has value if people agree to such and use it as a medium of exchange.
Bitcoin's technical lead, Gavin Andersen, told Forbes that cryptocurrency has the power to be the decentralized "currency of the people," a currency that is not subject to the inflationary movements of the centralized bank.
As the currency is tied to no particular country, its value is unaffected by a central bank, which means a bitcoin's value is completely tied to supply and demand–much like gold.
Mining for Bitcoin Gold
According to Matt deCourcelle, a cryptocurrency analyst at Bitcoin, once you sign up for a Bitcoin Wallet, you're assigned a hash (again, a very large algorithmically-generated number) and your computer becomes a player in a lottery, attempting to arrive at 64-byte number before any other computer on the Bitcoin network does.
In the Bitcoin community, this practice is known as "mining," and it takes place every time a transaction is made, as the large network of computers search for a new hash to assign to the transaction. Once the hash is found, it's assigned to the transaction. This verifies the transaction, and the successful assigning of a hash to the transaction is broadcast throughout the network.
As a reward, a new bitcoin is created and distributed to the computer that found the hash assigned to the transaction. What happens after all 21 million bitcoins are created? Even Bitcoin admits that the lack of a bitcoin reward to the successful computer will create "less of a guarantee that the amount of mining being performed will be sufficient to maintain the network's security," making the short answer: No one knows.
For the time being, however, the faster your computer can mine, the better. Bitcoin miners spend a lot of money on new hardware and powerful machines, attempting to make their systems faster and more competitive in the bitcoin mining game. Some miners even hijack other computers to employ them in the mining process.
After you mine your heart out, or simply want to cash in your chips, you have to find a buyer for your stash. And, yes, that buyer has to agree that your bitcoins are worth something. Perhaps surprisingly, there are several Bitcoin exchanges, providing the market to cash the digital currency in.
Like many, you might wondering why people would spend so much time and money mining Bitcoins. "Because it's like gold, or more accurately, the gold of the Internet," says deCourcelle. "As long as people trust that this currency has value, people will continue to invest in Bitcoin."
The Currency of the Future?
There has been speculation that digital currency could replace good, old-fashioned coinage, but Todd Hirsch of The Globe and Mail isn't impressed.
"The fact that Bitcoin is made up of binary code and has no physical presence isn't what makes it unique," says Hirsch. Not only are there other digital currencies out there, but electronic purchases are made daily with debit cards that essentially do the same thing–trade code.
What makes Bitcoin unique, says Hirsch, is that bitcoins "can be transferred without a financial institution acting as intermediary." Now, because some online vendors are accepting bitcoins, the digital currency is beginning to look a lot more like traditional money.
Currently, there are 766 vendors that accept bitcoins, according to the company's website. Some specialize in the bitcoin market, like Bitcoin Shirt Shop, while others are more general, like Nouveau Technologies, who sell Silly Putty and PEZ worldwide.
Though these retailers may accept bitcoin as payment, imagine an employer offering to pay you in bitcoins. For most of us, it's not a currency we're willing to trust. After all, if it's not accepted at the gas station or the grocery store, how much value does it have outside the limited Bitcoin universe?
Lack of confidence will also plague bitcoins as it attempts to play other roles of common currency–borrowing and lending is one. Though there are bitcoin lenders out there, what legal recourse is there if a borrower skips town? And without the ability to enforce contracts, it's unlikely that bitcoins will really gain much traction as a viable, global currency.
"But much of Bitcoin's appeal is that it exists outside the view, or reach, of any government's legal system," says Hirsch, who doubts that Bitcoin will take steps toward addressing contractual law enforcement issues between lenders and borrowers of bitcoins. If it did explore legal enforcement, it would lose its subversive appeal.
And More Issues...
As The Economist explains: "The entire network is used to monitor and verify both the creation of new Bitcoins through mining, and the transfer of Bitcoins between users. A log is collectively maintained of all transactions, with every new transaction broadcast across the Bitcoin network." This, of course, raises privacy concerns.
Christian Dumontet, a founder of Foodler (an online restaurant ordering service), began using Bitcoin earlier this year. He told Wired that "It's very easy for merchants to inadvertently expose the details of their supply chain, their finances, and their spending habits."
Though it is possible to exchange money anonymously, the problem comes with bundling. Most transactions can be assigned an individual address–one sale, one transaction, one address. But when a vendor decides they would like to bundle deposits together, in order to convert bitcoins to dollars or pay suppliers, the transaction is recorded on Bitcoin's public ledger. This makes it possible for competitors to track how money is distributed throughout Bitcoin's network, opening an avenue of insight into how someone conducts their business.
Privacy and identity verification go hand and hand. You want to be sure that the address you send your bitcoins to is the correct one, but Jon Matonis of Forbes says, "If bitcoin exchange regulation becomes so effective that exchange operators are required to link specific bitcoin addresses to individual customers, then users may have few remaining choices should they want to maintain transactional privacy."
The complexity of the system lends itself to another user entirely, the nefarious money launderer or terrorist funder. This will, of course, eventually attract the attention of U.S. and foreign governments.
In fact, according to Robert Wenzel of Economic Policy Journal, the U.S. Government has already seized assets of two Bitcoin exchanges and, in cooperation with Costa Rican authorities, arrested Bitcoin's president, Arthur Budovsky, in Costa Rica, in May.
"Liberty Reserve [a bitcoin exchange] has emerged as one of the principal means by which cyber-criminals around the world distribute, store and launder the proceeds of their illegal activity," according to the indictment filed in the U.S. District Court for the Southern District of New York.
Despite these setbacks deCourelle is optimistic. "I'm having a hard time wrapping my head around what the world may be like 5-10 years from now, if cryptocurrencies really do take off," he says, "but I'm excited for the possibilities."
deCourcelle, M. (2013). "Bitcoin for Dummies: What is Bitcoin?" Trading Vega, April 15, 2013.
Economist, The. (2013). "How does Bitcoin work?" The Economist, April 11, 2013.
Hirsch, T. (2013). "Why Bitcoin doesn't have what it takes." The Globe and Mail, June 5, 2013.
Matonis, J. (2013). "The Politics of Bitcoin Mixing Services," Forbes, June 5, 2013.
McMillan, R. (2013). "How Bitcoin Lets You Spy on Careless Companies," Wired, June 5, 2013.
Technopedia. (n.d.). "What is Cryptocurrency?"
Wenzel, R. (2013). "US Government Seizes Assets of Another Bitcoin Exchange; Firm President Arrested," Economic Policy Journal, May 28, 2013.