The buzz surrounding bitcoin can’t be ignored any longer. The digital currency, which came to life in 2009, has experienced wild fluctuations in recent times; in February a single bitcoin traded for $20, today that number stands at $112. Following two huge upward moves in March the currency lost nearly 20% of its value overnight after one of its biggest exchanges fell victim to attack by a group of hackers, triggering a massive sell-off. In the midst of all this drama more than a few people have become bitcoin millionaires by buying up the currency early – but what are these bitcoins really?
Known as a crypto-currency, bitcoin is a type of digital currency that uses cryptographic techniques to ensure security. Furthermore, because bitcoin is not associated with any one country it means that there is no central bank that controls the currency. In fact, credit for creation of bitcoin goes to Satoshi Nakomoto, but no one knows who he is or even whether Satoshi is one person or refers to a group of creators.
All transactions involving the digital currency takes place through p2p (peer-to-peer) networks, a network of individual hosts who agree on how bitcoin is used. Like any other currency bitcoins are traded on exchanges such as Mt. Gox, which hosts up to 80% of all bitcoin trade.
Bitcoin lies somewhere in between being a pure currency or commodity, having characteristics of both. Since bitcoin is free from the influence of any central bank or entity , its value is determined entirely by the laws of supply and demand. It actually behaves more like gold or other precious metals in this regard. Funnily enough, that’s not the only thing bitcoin has in common with precious metals.
The way you get a bitcoin is to mine them, and just like the amount of gold that exists in the world there is a finite number of bitcoins that can be mined. Whereas in a centralized economy the central bank could just print more money and expand the monetary base, there are exactly 21 million bitcoins that will ever exist; currently about 11 million of them have been mined.
Bitcoins are mined from deep mathematical mine-shafts. Using a computer, bitcoins are created every time a miner is able to crack a complex algorithm, leading to the discovery of a new ‘block’ of bitcoins. The difficulty of solving these math problems are always rising, so as to keep the rate of discovery constant. The algorithm actually mimics the rate at which commodities like gold are mined, meaning the last few bitcoins won’t be mined until 2040. At first one could mine using any standard computer but the increasing difficulty of mining bitcoins means that now dedicated mining rigs with incredible processing capabilities are required.
Due to their cryptographic nature, bitcoins are great for conducting anonymous transactions and are used to power the ‘dark web’. For example, using software called Tor, you can hide your identity online and access the digital black market called The Silk Road, the “underground website where you can buy any drug imaginable”.
The influence of the crypto-currency is growing; the financial crisis no doubt had a large part to play in that but bitcoin is also changing the way people think about currencies.MintChip is a new digital currency backed by the government of Canada, which sees the potential for a “huge digital economy that [will] be fueled by smartphones and mobile.” MintChip will be anonymous and allow people to pay each other using smartphones, USB keys, and computers; the traces of the bitcoin philosophy are stamped all over MintChip.
Public sentiment is changing towards digital currencies. Wikileaks and WordPress now accept payments through bitcoin; CNN has even added a bitcoin ticker to its crawler. At first only a few stores would accept bitcoin as payment, one of the first being an online store that sold Alpaca socks; that number is growing, and more stores and even restaurants are starting to accept bitcoin. You can even turn your bitcoins into gift cards from Amazon, Barnes & Noble, iTunes and even national governments are warming up to the idea of using crypto-currencies. Digital currencies, it seems, are here to stay.
Note: Originally posted on the Wall Street Survivor blog on May 16, 2013.