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Summary:

Bitcoin is a complex subject, but an important one. Whether it succeeds or fails, it represents a crucial experiment in using technology to turn our financial system upside-down, and it will have important consequences.

Bitcoins

Everybody’s talking about Bitcoin these days, which is quite remarkable given the highly technical nature of the crypto-currency. So why is it such a big deal?

To explain why, I’m going to start with the implications of Bitcoin, then get into the technical nitty-gritty. Why that way round? Because there’s more to Bitcoin than the technical wow-factor, or indeed the crazy speculation that’s going on now. Even if Bitcoin itself fails, it’s a sign of things to come.

All about decentralization

Bitcoin is to state-issued currencies – often referred to as fiat money – as P2P file-sharing is to traditional broadcast media. There is no centralized source for it that can be controlled or moderated or regulated. It is difficult if not impossible to track from the outside. It is more complex to use than its better-known counterpart, but there are at least theoretical advantages to doing so.

network

In the case of file-sharing copyrighted content, the big advantage (apart from not paying for stuff) is the ability to ignore program scheduling or territorially-based release windows. In the case of Bitcoin — which has the added advantage of being lawful — users get to send money anywhere in the world for minimal fees, and to protect that money from the political considerations that influence central banks.

In short, both Bitcoin and file-sharing are peer-to-peer, meaning users get to both cut out the middleman and, on an emotional level, stick it to The Man. That last factor is not trivial: Satoshi Nakamoto (the pseudonym for Bitcoin’s Keyser Söze -like initiator or initiators) seems to have had strong libertarian ideals in mind when he, she or they set the experiment in motion.

Hang on. “Experiment”?

Yup. People may be throwing money into Bitcoin at a scary rate (the total value of all Bitcoins passed the billion-dollar mark at the end of March, and some workers may even be opting to receive part of their salaries in Bitcoin), but it remains experimental. No one’s really sure where it will end up, because no one has really done this distributed, borderless digital currency thing for real before – yes, there are Facebook Credits and Linden dollars, but these are still centralized and controlled as such.

However, now that the train is in motion, in a sense it doesn’t really matter if Bitcoin succeeds or fails. The original Napster failed and guess what? Unlawful file-sharing is still with us, and will remain with us for a long time. On a conceptual level, whatever happens, it’s now very difficult to see a future without Bitcoin or something like it. It may not replace fiat currencies, just as unlawful file-sharing has not killed off lawful distribution, but it may persist as a viable alternative and, by doing so, force change in the way its traditional predecessors function.

Now’s probably a good time to look at the technical side of what we’re talking about.

Crypto-currency

Each Bitcoin user has a digital wallet, which can be stored on a computer or a memory stick, or in a cloud-based service, or technically even on paper. The wallet contains a list of Bitcoin addresses, which in turn contain both public and private cryptographic keys that prove the holder owns their Bitcoins and is allowed to spend them. The addresses are pseudonymous, in that there is no registry of who owns which address, so Bitcoin is great for conducting untraceable transactions.

To receive a payment, the payee gives one of their addresses to the payer. The payer then uses that address to initiate the transaction, signing with their own private key to prove they have the funds, and the transaction then has to be certified by the network (rather than by banks, as happens with regular money).

Mining tar sands

Now this is where the creation of new Bitcoins also comes into play. The network is made up of computers called “miners” that are all competing with each other to solve increasingly complex computational problems. Once a miner beats the others to solving a particular problem, it gets to add the solution as a so-called “proof of work” to a block of transactions, and add that block to the “block-chain” — essentially a record of all Bitcoin transactions that have ever taken place.

As a reward, the miner gets newly-generated Bitcoins, plus the transaction fees they have set. Apart from generating new Bitcoins, this distributed verification system also ensures that people can’t double-spend their Bitcoins.

It is important to understand that, while fiat money is issued and controlled by governments and their laws, Bitcoin is generated and controlled by algorithm. While governments can always print more money according to their needs, there will only ever be just under 21 million Bitcoins (right now there are around 11 million), because that’s how the algorithm works.

Every four years, the number of Bitcoins harvested with each block halves — during the first four years of Bitcoin, each block came with 50 Bitcoins, right now it’s 25, from 2017 it will be 12.5, and so on. But, even after Bitcoins cease to be produced (the current guess is that this will happen around the year 2140), miners will still want to create more blocks because of the associated transaction fees, so the network will still have the incentive to keep the economy going.

The limit on the number of Bitcoins also makes the system inherently deflationary. As the value of Bitcoin cannot be manipulated by a central authority, as long as the Bitcoin economy continues to grow (and as people lose their Bitcoins, removing them from the system) then it follows that transactions will take place in ever-smaller fractions of a Bitcoin. However, this shouldn’t be as much of a problem as it would be with a normal currency, because Bitcoins are infinitely divisible. There is currently a limit of eight decimal places (taking us down from “bitcents” to the “satoshi”), but even smaller fractions could be enabled in the future.

Okay, so who’s using it?

There is some debate around whether Bitcoin is a currency or commodity. The issue there is whether people are converting fiat money into Bitcoin in order to profit off its current meteoric rise in value, or whether they intend to actually spend it.

Golden piggy bank

Bitcoin’s critics frequently point out how its big original user base consisted of people frequenting the Silk Road, the underground online marketplace for drugs and other illegal things. Silk Road only allows trade in Bitcoin, but in the offline world people buy a lot more drugs with dollars and euros, so frankly I fail to see the point there.

It would certainly be a mistake to see Bitcoin’s non-Silk Road usage as widespread, but as people find out about the currency some are certainly starting to use it. You can famously use Bitcoins to buy pizza, but these days it can also be used to pay for VPN and VoIP services, music, cupcakes and, er, Linden dollars. WordPress (see disclosure) takes Bitcoin and Expensify will handle it. “Anarcho-capitalist libertarian” Jeff Berwick also wants to roll out Bitcoin ATMs.

Does Bitcoin have rivals (apart from fiat money)?

Yes, although none as successful. For example, there’s an interesting project called Ripple that is just getting off the ground. There have also been multiple previous attempts at creating non-digital alternative currencies, such as the Liberty Dollar, which earned its creator Bernard von NotHaus a counterfeiting conviction. Bitcoin may share the anti-statist motivation behind that wannabe currency, but it’s hard to see how it could constitute counterfeiting.

Is it smart?

Technically speaking, Bitcoin is very smart indeed, as it’s the first currency that removes the need for a trusted third party – usually a bank – in financial transactions.

Business person with idea lightbulb

That said, however, it’s crazily volatile at the moment. At the start of 2013, one Bitcoin was worth around $13. Things went nuts with the Cyprus crisis in March, and right now the price is bumping up and down around the $137 mark. It certainly looks like a bubble at this point, although the huge amount of interest Bitcoin is getting at the moment could lead to an uptick in use, which would in turn legitimize it as a viable currency. Either way, the current volatility will probably dissuade people from spending their Bitcoins right now, and make life hard for vendors setting prices in Bitcoin.

Then, despite the supposed inviolability of the Bitcoin itself, there are multiple security issues. Before we even consider nefarious activities such as hacking, an interesting wrinkle in the Bitcoin methodology is that, if you lose your Bitcoin wallet, the money is lost forever, to everyone. If you lose your bankcard, it doesn’t wipe out the money in your account, and your bank will issue you a new one. There is no such mechanism in place here; losing Bitcoins is effectively like burning banknotes.

Similarly, if someone steals your Bitcoin wallet by hacking into your computer, there is no heavily-insured bank to absorb the loss. You’re on your own. This happened to a user named “allinvain” back in 2011, costing him 25,000 Bitcoins. You can even get Bitcoin wallets for smartphones these days, but then you’re running a big risk if you lose your phone. As for cloud-based wallets, well, Instawallet has just suspended operations after being hacked.

The best idea is probably to keep your Bitcoins on a device that is securely stored and not permanently connected to the internet.

Should you get Bitcoins? I don’t know – the value against the U.S. dollar could continue to rise, or the bubble could burst. But frankly, I don’t really care. From where I’m sitting, Bitcoin is already proving its worth as a disruptor and as a test-case for how technology could divorce currency from certain external factors. If it fails, it may hurt those who bought into it big-time, but it’s not a large enough ecosystem to have wider repercussions. And if it does fail, it will have successors.

Let’s see what happens next, because the crypto-currency genie is out of its bottle.

Disclosure: Automattic, maker of WordPress.com, is backed by True Ventures, a venture capital firm that is an investor in the parent company of this blog, GigaOm. Om Malik, founder of GigaOm, is also a venture partner at True.

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  1. Reblogged this on SavyTrendy and commented:
    really scary …..

    1. Why scary? What I think is scary is what else is going on in the world these days. Compared to that, Bitcoin very much feels like a safe haven ;-)

  2. We wrote about this recently as well – what if this is not a bubble?

    http://statspotting.com/bitcoins-rise-what-if-it-is-not-a-bubble/

  3. christian perry Thursday, April 4, 2013

    Bitcoins could become a new form of gold, in that governments might buy them as a way to seek strategic holdings outside the realm of fiat currency.

    Great article. I’ve been following bitcoins for years, and while I’m not the owner of any (yet), I’m fascinated by the technocurrency’s evolution. It’s particularly exciting to see the idea go from a passing trend to an increasingly mainstream institution. It won’t be long before jokes are being made about them on late night television.

  4. As a currency, it seems incredibly inconvenient compared to conventional currency. I would speculate the same VPN and pizza vendors you mention might prefer hard currency so they can for their heat and electricity, and I certainly wouldn’t want to limit my dining choices by remuneration method versus degustation.

    As far as a traded commodity, the hockey stick it’s done in the past month, reminds me of the beany baby fad from an earlier decade. Though this is more easily manipulated (witness DDoS attack this week on mtgox exchange).

    I see very few advantages, and a heap of disadvantages.

    1. The hacking issue everyone loves to mention only applies to those who trust others (online wallets/cloud services etc…) with their coins, or leave them in stupid places just like cash. Would you mail your cash to a dude because you saw a poster he put up with his address and a promise to keep your money safe? As for the the Mt GOX issue, it’s equal to someone DDoS attacking the Yahoo Finance page for Coca Cola charts is it not?
      The big advantage that I see which imo trumps any other disadvantage when compared to fiat currency is that they don’t earn private bankers interest while they circulate through our communities or sit in our savings accounts like fiat currency does.
      We’ve creating a system where a few private bankers demand from us compounding interest on almost our entire money supply. When our gov. gave up control of our money supply to private central banks, they took a job we could do ourselves (create the money we need to facilitate our economic exchanges) and they let someone else do it. But instead of just paying someone to do it, they let the banks LOAN us the money AT INTEREST. So how do we pay the interest if we have to borrow the money we need for our economy in the first place at interest? Oh right, with our labour and assets…And no one’s talking about this at all. It’s as if everyone still believes dollars are backed by something tangible and not debt based.
      I guess if everybody tries really really hard to avoid the truth, the current system could proceed until the banks have gathered up everything in the world of any value. Then we won’t need any currencies at all because we’ll just be in debt to the banks. We’ll still owe them all the compounding interest on all the money they created from our signatures and loaned out to us because we were legislatively forced to use it and no other. So at that point, we won’t exactly be holding anything of value to trade with each other anyways. No, they’ll have their debtor prison camps for those of us they can use and for the ones they can’t use…I guess they can always make unpaid debt a capital offense if they don’t want to waste energy keeping us alive.
      Give Bitcoin time. People are waking up.
      (for disclosure I have ~ BTC 50 bought at ~$20 CAD/BTC) I fully intend to use them as a currency and I think as people wake up and smell the freedom it will simply become more profitable for companies to accept them. In a nation where democracy is touted because people can be told what to think and who to vote for, Bitcoin represents a little hope that people actually want a saner world, and that we can have it in spite of the insecure children who currently hold the power. Maybe the world can finally start to grow up. I think we were supposed to learn this shit in kindergarten.

      1. I applaud the occupy Wall street type sentiment, though frankly I seriously doubt any government or private bank really cares about BTC as at best it will look like just another traded currency or commodity which perhaps someday might be on par to Salomon islands shell currency. The rhetoric makes me think of an amoeba’s warpath rebel yell in a great sea of yawning megalodons. I don’t mean any disrespect. My motives are solely cautionary on what I view as an extremely volatile and currently easily manipulated commodity with no intrinsic grounding. Wouldn’t want any well intentioned people to get burned and jaded. I do look forward to BTC 2.0 as an enabling technology for commerce.

  5. ….what about the people that bought say a few thousand of them last year (not me, sadly!) and just kept them – i doubt they really care if its a bubble right now when they’re sitting on couple hundred thousand dollars.

  6. Even if the price crashes, a Bitcoin will remain a Bitcoin with some unique properties. As a minimum, it will continue to show what farce fiat currency has become. For that reason alone (and the inherent consequence of tidying up government finances) Bitcoin could prove to be more essential for retaining our freedom than most people recognise.

    Hard core Americans who know their classics (the founding fathers knew what unsound money would bring) should be able to figure out this immensely important aspect of Bitcoin, if only as a concept.

  7. bitcoin is changing finance the same way the web changed publishing.

  8. Excellent, very well done summary of the state of bitcoin. It is so easy to get swept up in the hysteria on either side of the bitcoin issue and fail to see the big picture – one way or another, a decentralized, stable currency would be an extraordinary thing. I hope we get there soon with bitcoin or otherwise!

  9. It’s a large asset bubble that just underwent the “bull trap” phase; it’s going to collapse very, very soon.
    http://www.ghostagenda.com/2013/04/05/the-bitcoin-bubble-the-rise-and-fall-of-a-virtual-currency/
    Plus, governments tend to look down upon competition in the currency business. It makes them upset for some reason (sarcasm fully intended).

  10. Yes in terms of measure of success, I don’t see bitcoin taking over all world finance. But a role contributing towards keeping the crooks in finance honest would be superb.

    I’m a staunch supporter but I’m very concerned about the future of miners – ever reducing nodes and participants represents a threat as the difficulty exceeds any use for normal computers or their GPUs.

    1. Hugh M Halford-Thompson Tim Friday, April 5, 2013

      But the value of each bitcoin is going up – soon enough to buy more GPUs

      1. That ship has sailed. A year ago, the entire market for high end graphics cards was absorbed by Bitcoin miners. Today, FPGA based rigs are leaving nothing but scraps for GPUs. And ASIC-based rigs are starting to come on the market, which in one fell swoop obsolete the FPGAs.

        Bitcoin mining has long ago become a game of ‘go big or go home’.

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