What are Bitcoins?
Bitcoins have been a very hot topic in the news recently, reaching an all-time high value after a largely positive hearing in the US Senate and increasing Chinese interest. We thought we’d try to shed some light on this cutting-edge currency with the lovely What Weekly readers.
In simple terms Bitcoin is to paper money what email is to paper mail; basically Bitcoin is cash for the internet.
More specifically, Bitcoin is a crypto-currency. This means that it’s a form of currency that exists only in digital form and the underlying software is drawn from the world of cryptography and IT security. Each individual Bitcoin is represented by a complex string of numbers and letters that is stored in a digital “wallet.” Every Bitcoin wallet is a part of the Blockchain, the network that keeps track of where all the Bitcoin are and insures that Bitcoin can’t be counterfeited. Because the Blockchain is simply made up of all the individual user’s wallet’s stored on their computers it is completely decentralized and insures that no one organization or individual can take over or manipulate the Bitcoin system.
Bitcoin is a fully functioning currency. Each individual Bitcoin is represented by a complex string of letters and numbers that are stored in the owners digital “wallet.” Everyone who has a wallet becomes a member of the “Blockchain” which is the software that verifies Bitcoin’s authenticity. Because the Blockchain is entirely made up of user’s computers it is 100%decentralized and believed virtually impossible to hack. There are currently around 4 million Bitcoin in the world – only a total of 11 million can ever be mined based on the underlying software – this means Bitcoin is inherently deflationary as there is no central bank that can print more of them. Bitcoin is represented on currency exchanges as the symbol “BTC” or the currency code: “B⃦”
How are Bitcoins made?
Bitcoins are created by setting a computer to solve complex math problems. This is referred to as “mining.” Every time a problem is solved a Bitcoin is released and it’s release is recorded to the Blockchain network. As more Bitcoin are created the problems automatically become more difficult to solve. An average household computer would take so much time to solve these problems that the electricity costs would not be worth it. Because of the current difficulty, Bitcoin are mined by specially-made computers just for this purpose – once they are mined, many miners then sell a portion of the coins on Bitcoin currency exchanges, so the average person can trade his or her native currency for Bitcoin.
An individual could invest in Bitcoin mining equipment but the entry cost probably starts in the $3-4000 range. Some entrepreneurial individuals have pooled together investors to buy a share of mining equipment and then these investors would get a percentage of all the Bitcoin mined by the equipment they helped fund.
Because of the underlying algorithms, there can only ever be 21 million Bitcoins mined. For many people this is very appealing because it means no central bank could just decide to print more Bitcoin, which would cause inflation, or any of the currency manipulation that is seen in current government-backed currencies.
Who Created Bitcoin?
No one knows for sure, or at least no one is telling the public about it. There is a person who went by the pseudonym “Satoshi” who first introduced Bitcoin online, who seems to be the creator or at least the chief developer of the project but this person’s identity has never been exposed; in fact some digital data seems to suggest that “Satoshi” was multiple individuals. Some people believe it was a university or government behind it but there is no public knowledge to verify this.
Despite this lack of knowledge about the creator – the Bitcoin software is open-source and many experts have pored over the code to ensure that there are no backdoors that would allow a government or organization to spy on or manipulate the Bitcoin network. Bitcoin is founded on trust in the algorithms and software code rather then any individuals or organization.
Why are Bitcoin valuable?
In general currency has value because of scarcity and utility. The US dollar has utility because it is accepted for goods and services all over the world and it has scarcity because only the US Government can produce more of it. Bitcoin has utility because certain communities, including technology and libertarian circles have adopted it as general currency. While it has limited utility compared to the US dollar – most items you would find on Amazon can be bought with Bitcoin through intermediaries or through stores that directly accept Bitcoin. Because of it’s anonymity Bitcoin has also been popular in transactions that happen on grey or black markets. Bitcoin has scarcity because of the previously described mining process. The value of Bitcoin, just like other established currencies, is decided by the consensus people who use them.
This chart displays the current value of Bitcoin on the Mt.Gox exchange in US Dollars:
Where do I get Bitcoin?
Unless you have access to supercomputers to mine Bitcoins efficiently you would need to purchase them from people who already have Bitcoin. Generally the easiest way to do this is to use a currency exchange like the Japanese site Mt.Gox for a small percentage-based fee. You send money from your bank account to the exchange’s bank account and they will sell you bitcoin at the current market price.
If you decide you want to sell your bitcoin, you can also do the process in reverse. If many people decide to sell all at once the value will go down and if many people decide to buy the value will go up. This is a microcosm of how large, established currencies function even the US Dollar or Chinese Yuan.
Is Bitcoin Legal?
Yes. There is no law, US or international that can be interpreted to criminalize bitcoin. Certain banks and financial institutions would be barred from using them but this will not affect the vast majority of individuals and businesses. Theoretically one would have to pay capital gains taxes on any increased value in one’s Bitcoin if he or she were to convert back to US dollars, but would remain untaxed if kept in Bitcoin. People have been concerned that Bitcoin will be targeted by the US Government because of its use in black and grey market transactions as well as its potential threat to large US banks and financial institutions.
Other efforts to digitize and anonymize online transactions have been shut down by governments – but all of these systems were token-based, so they simply exchanged digital units for US dollars rather then functioning as self-sustaining currencies. Also, the lack of central authority would make this enormously difficult – the bitcoin network is solely made up of the people who have Bitcoin wallets.
What are the Advantages of Bitcoin?
There are several exciting advantages that were impossible before the advent of this technology. Bitcoin is enormously safe if used properly, far safer then keeping your money in a bank, which have seen many security flaws. Because the underlying software uses cryptological and IT security principles it is much more resistant to hacking and manipulation then even the largest financial institutions.
Many of the things that people find appealing about gold are also true of Bitcoin – just like no more gold can be created, once all 21 million Bitcoin have been mined, no more bitcoin can be created. This make it an inherently deflationary store of value – meaning that no one can create more of it and cause it’s perceived value to decrease because of a sudden lack of scarcity. Unlike gold and other precious commodities, Bitcoin is easy to store securely, requiring only some computer security knowledge and a computer that only needs very little processing power.
Bitcoin is very easy to move around – instant and free transfers are built in to the software. Bitcoin also represents an investment opportunity – because this is a brand new currency many believe that the value will rise enormously for some time. We have already seen Bitcoin grow from a value of around $3 a coin to its current highs.
What are the Disadvantages?
Bitcoin is very young. While many believe that the resiliency for the 4 years or so it has existed is proof that it will flourish, it is possible that the value could crash. The perceived value of the US dollar is backed up by the full force of the US military and tax base while the perceived value of Bitcoin is backed up by algorithms (some proponents argue this is in bitcoin’s favor – algorithms can not abuse and manipulate currency or print more as they see fit.)
Some still believe that powerful banks will view it as a competitor and have it targeted by governments – again this would be very difficult as Bitcoin is entirely decentralized.
The biggest current disadvantage is likely the volatility – large swings in the value can make it difficult to use Bitcoin for everyday spending. This is especially true for businesses to spend bitcoin as they may have trouble predicting the cost of future capital outlays.
Bitcoin is a very exciting concept. Many people are losing faith in the large financial institutions and governments that have such a profound influence on traditional finance and investing. It may not be Bitcoin specifically, but with the technology currently available as well as the demand for more secure, fairer financial dealings it is hard to imagine that something revolutionary won’t happen in this space.
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(Full Disclosure: The Author has a long position in Bitcoin and offers Bitcoin related business services through What Works Studio)