Bitcoin: How the Internet Created Its Own Currency
Bitcoin is a peer-to-peer decentralized digital currency. It differs from traditional, government-backed currencies in that there is no central issuer, and there are no middlemen involved for various transactions.
Back in 1998, the concept of crypto-currency was described by Wei Dai on a cypherpunks mailing list. Crypto-currency is an electronic currency that relies on cryptography to regulate functions such as value and counterfeit protection. Bitcoin is the first implementation of that idea. Its protocol was published in a white paper by Satoshi Nakamoto in 2008. In 2009, Nakamoto released the first Bitcoin client and issued the first Bitcoins.
The supply of Bitcoin is regulated not by a central bank, but by software. The original rationale behind Bitcoin was to create a type of electronic currency that was anonymous, secure and independent from governments or other central authorities.
While still a nascent currency, various organizations such as WikiLeaks, the Internet Archive and the Free Software Foundation accept donations in Bitcoin. Moreover, thousands of smaller merchants accept payment using Bitcoin.
Bitcoin Mining: How Bitcoins Are Created
With a traditional fiat currency (think the U.S. dollar or the Euro), a central bank (like the Federal Reserve) issues currency. That’s not the case with Bitcoin.
Instead, coins are generated using a process called mining. Think of mining as a lottery. Computers connected to the network (known as miners) aim to find the solution to a certain mathematical problem. If they successfully solve the problem, a new block is created. Until December 2012, the value of each block is 50 BTC (Bitcoins). Every four years, the value of solving a block is halved.
Mining was designed to be a resource-intensive process. In the early days of Bitcoin, users used traditional computers to mine for different blocks. Today, miners often use high-powered graphics cards and machines designed specifically for optimal Bitcoin mining. Moreover, there are networks of computers that work together in various pools to find blocks.
The more powerful your system, the greater the chance that mining will produce a new block. As a result, there are individuals and groups that invest in computer equipment designed to mine more efficiently. They are betting that the cost of the equipment (as well as the resulting electricity) will be offset by the value of the Bitcoins themselves.
The Bitcoin system is designed so that the difficulty of uncovering a block can be increased or decreased. This keep the output of the currency more consistent.
Bitcoin Exchanges: Buying and Selling Bitcoins
One of the basic tenets of Bitcoin — and all crypto-currency — is the absence of a central banking authority. That doesn’t mean, however, that there aren’t entities that exist in the same way.
In the Bitcoin world, these are known as exchanges. These exchanges allow people to buy and sell Bitcoins with one another. The major Bitcoin exchanges include(the largest Bitcoin exchange), CryptoXchange and Intersango.
The most popular exchanges allow users to buy and sell Bitcoins using local currencies. For some, this can be a profitable source of arbitrage and big trades can impact the overall value of the larger Bitcoin economy.
Many of these exchanges also act as eWallet’s for users to store their Bitcoins. This is convenient because it offers an easy way to buy and sell from an exchange account, however, it can be risky because if the exchange is hacked, the eWallets can be stolen.
This has happened to a number of large Bitcoin exchanges in the past — with hackers absconding with thousands of Bitcoins. You can read more about eWallets and what to watch out for before using one in this Bitcoin.it Wiki article.
Users can also store their own wallets on a local computer, USB drive or even print out a wallet address for offline safe-keeping.
A small number of real-world and online establishments accept Bitcoin as a form of payment. It’s important to understand that like any other currency, the value of Bitcoin fluctuates all the time. At the time of this writing, Mt. Gox values a BTC at ~$10.75 USD — however that could fluctuate up or down, depending on the Bitcoin market as a whole.
Some shops that accept Bitcoin may accept less than market rate (depending on current exchange values) in order to obtain more Bitcoins. Others can adjust their pricing depending on overall values.
Many in the Bitcoin community use the currency to trade or barter with one another. At forums such as BitcoinTalk.org, users post messages of what they are willing to buy or sell with Bitcoin.
Because Bitcoin is like cash, the onus is often on the buyer to trust that the seller won’t run off with Bitcoins without providing a product or service. It’s similar to the early days of eBay, where community reputation can act as a voucher for who to trust and who to ignore.
The anonymous nature of Bitcoin means that the currency can also be used for seedier business transactions. The online marketplace Silk Road has been described as “the Amazon.co of illegal drugs.” Silk Road sellers sell illegal drugs such as LSD, heroin and marijuana.
Buyers conduct all transactions using Bitcoin. The hidden nature of the marketplace (it uses the Tor network to hide traffic) coupled with the technology around Bitcoin makes it ideal for drug transactions.
Is This the Future?
Some see Bitcoin as a future type of currency. While it’s a stretch to see a decentralized currency gaining mass adoption, many of the ideas involved with Bitcoin, especially when it comes to online transactions and distributed computing for security could be used with existing fiat currencies.
The Royal Canadian Mint’scarries on many of the same ideas as Bitcoin, but in a way that is backed by the mint itself. The MintChip project is still in its infancy but if it works, it could shape the future of Canadian currency.
Have you ever used Bitcoin? What do you think of the alternative currency? Let us know in the comments.