Bitcoins have been causing quite a stir and amassing much interest recently. Part of this is thanks to the price skyrocketing in recent weeks. This digital currency of choice for hacktivists, described as “gold for computer nerds” is a peer-to-peer decentralised currency, meaning it isn’t controlled by any bank or government.
Bitcoin value in USD (08/04/2013)
In the past, things worked differently. First there was commodity money, which was money that derived its value from the commodity from which is was made of, like gold, silver or seashell.
Then representative money was introduced. This money represented a value in gold. Banks stored gold and could only issue currency if they had the equivalent in gold in the bank vault.
The modern system of money, in which a national bank does not have to provide the equivalent in gold, means that the state can print an arbitrary amount of money. This fluidness was what enabled monetary policy, which is the idea that you can control a country’s economy, including unemployment and inflation, by changing the amount of money going into it.
An Okpoho manilla served as the traditional form of commodity money in West Africa until the 1940s
So how are Bitcoins different? Bitcoins do not rely on a central issuer like a bank or government. The way the Bitcoin protocol works is that everyone can see that a transaction has taken place on the public log, but only the two parties that took part in the transaction know where the money came from and went. To verify transactions, a complex algorithm has to be solved (very inefficiently) with a brute force method. This requires large numerical power, supplied by ‘miners’ who use their computer’s resources to help with the transaction of Bitcoins. Once one of these miners have completed enough of these puzzles they are rewarded with Bitcoins. The ease with which these Bitcoins are mined becomes exponentially harder until a finite amount (฿21 million) has been reached. The system itself is encrypted to prevent anyone from meddling and the code is self-sustaining to prevent inflation (no quantitative easing here, sorry Mr. Osborne). This fixed amount differentiates it from Dollars, Sterling, or Warcraft Gold and makes it comparable to other traditional commodities such as gold and therefore subject to speculation.
When first introduced they were very cheap, ($1 could get you ฿1300, which means that if you had invested $1000 in Bitcoins at the time, you would now have 182 MILLION DOLLARS!), the price then rose steadily until the first bubble back in 2011, largely due to media coverage, where it peaked at $33 but returned to normal (roughly $2) few months later. The recent surge in value, over 300% in a month, coincides with the financial crisis in Cyprus and no doubt the lure of a deregulated alternative investment channel – a safe haven from the prying hands of the European Central Bank, a role which Bitcoin fulfills. The current value of the Bitcoin economy stand at over $1Billion, the rise in value generates more interest (creating a positive feedback loop) and perhaps another bubble. So, as it stands, are your Bitcoins any safer than a Cypriot bank account?
All transactions occur over a p2p (peer-to-peer) network, making them all public. You are only identified by your Bitcoin wallet address, a random string, beyond that there are no identifying characteristics. Buying and trading Bitcoins utilises public key cryptography, to encrypt the transactions. You can see these transactions occurring at blockchain.info. The anonymity of using Bitcoins is helpful to people who are not able to use normal payment services as they live in a country which block them, people who live in oppressive regimes etc. It also facilitates the exchange of illegal goods and gambling. Famously, the darknet website called the Silk Road, where drugs (among many other things) are sold, only accepts Bitcoins. There are also many legal ways to spend your Bitcoins, you can buy coffee, pizza, even a house directly without exchanging them for Dollars, Sterling etc… WordPress now accept them as a form of payment too. A full list of legal online and material services and products can be found here. With such a volatile currency, you must be thinking how is it possible to conduct business in a currency that fluctuates in such a short time. The reality is that the cost of products and services being sold for Bitcoins are expressed in dollars and converted at the market rate for Bitcoin at the time of transaction.
The future of Bitcoin relies on people’s confidence and their willingness to use them. This relies on a trust the it can hold its value. Unlike normal currencies it doesn’t have governments or central banks backing them. Its current volatility arises from a relatively low amount being in circulation. The main trading exchange MT.Gox has already come under attack from hackers hoping to cash in and one wonders how long it will be until the rush to be first out of the market leads to the next crash. In the long term, the currency has already gained large acceptance and usage around the interwebs to secure its future. Hopefully by then it will settle to a more stable amount and be a more viable alternative form of payment, making transferring money as easy as sending an email.
-Salman
Feature image by Isokivi