Earlier this week, a judge in Texas ruled that Bitcoin should be treated as a real currency. Calling yourself ‘Pirateat40’ when launching a venture isn’t a great start when defending yourself from allegations that you’re running a Ponzi scheme. Bad news for the defendant – but what does the decision mean for everyone else?
If you follow tech developments or financial innovation, you’ll be familiar with Bitcoin. But if the phrase ‘crypto-currency’ means less than diddly-squat to you, I thought it might be useful to put up a quick summary since it’s an area that’s going to develop quickly over the next few years.
What is Bitcoin?
There’s a pretty big clue in the word itself. It’s a specific digital currency that isn’t owned or regulated by any bank or institution. Although it’s not been around for long, its ascent has been steep, particularly in 2013. Take a look at this quick video for details:-
What makes it different?
Standard currency (‘fiat money‘) is usually owned and controlled by the central institution(s) in a country. Whilst that brings with it the benefits of stability and reassurance for the masses, it also makes the currency susceptible to outside influence – whether in the form of political interference or plain incompetence. Facing a banking crisis? Your government can simply print more money – thereby diluting the value of everyone’s money within the economy, regardless of where any ‘fault’ for that crisis might lie.
In theory, bitcoins are cushioned from this influence and can be transferred directly from person to person, without territorial restrictions, whilst attracting minimal transaction fees.
The history of Bitcoin
The crypto-currency movement has been around for a number of years. However, the genesis of Bitcoin comes from an algorithm detailed in a paper published by a mysterious individual(s) by the name of Satoshi Nakamoto in 2008. If you track him down, let me know.
The mechanics
Want to create new bitcoins? In theory (ignoring advances in mining technology), anyone can become a bitcoin miner simply by downloading free software. To find the ‘virtual gold’, your computer has to try trillions of digit combinations to finds one that fits a certain pattern. If it does, it submits this combination to a massive peer-to-peer computer network of around 20,000 other ‘nodes’ to be verified, at which stage a fixed number of new bitcoins are created. In reality, however, the mining process has now become so computationally intensive that only those with powerful dedicated processing power can hope to see any real results.
Only one single log of the digital currency is maintained. This records the creation of every bitcoin, in addition to each transaction. By tracking every single bitcoin from the point of creation and checking this record repeatedly, it ensures that there is no way that a bitcoin could somehow be spent twice – or at least, not without pulling the wool over the eyes of the thousands of nodes in the network simultaneously. If your computer helps to verify the creation of new bitcoins or the transfer of existing bitcoins, you receive a small reward, in the form of a transaction fee (a small % of a bitcoin).
The algorithm was designed in such a way that only a set number of bitcoins can ever be created. Predictions are that we’ll hit that limit sometime around 2140. But once we do, remember that unlike gold, each bitcoin is infinitely divisible given its digital properties. The theory is that the currency will be strong enough to withstand the supply of new bitcoins drying up at that stage.
You store your bitcoins in a digital wallet and use them as you see fit with those who are willing to accept them with no external interference.
The bad rep
Perceived to be an entirely anonymous transaction (although in fact it’s not), it’s no surprise that many articles focus on extent to which bitcoins can facilitate black market transactions. For example, you’ll often hear talk of bitcoins being accepted on the Silk Road, an anonymous online marketplace in which drugs and guns are sold freely.
But to me, this sensationalism simply obscures the true story about the extent of the innovation at work here. The opportunity for frictionless payment to change parts of the modern world for the better has significantly wider potential impact – if it gains widespread adoption.
After all, drugs and guns have been around far longer than Bitcoin. Cash payments have always worked just fine before in the black market. In any event, it certainly wouldn’t be the first time that the push toward general adoption of tech innovation has come as a result of the early adoption by certain sub-sections of society.
Stellar growth…and over the cliff
Earlier this year, there was a lot of noise around Bitcoin. In March 2013, with the banks in Cyprus nearing meltdown, the Cypriot government announced that it wanted to confiscate 6.75% of the sum in every bank account in the country. Suddenly, demand soared for bitcoins, an example of people rushing to protect their wealth far away from government interference.
Bitcoin has its own exchange rate which fluctuates against other currencies – violently at times.
Weaknesses
And of course here lies one of Bitcoin’s key perceived weaknesses. Volatility.
Bitcoins have traded from a low of $13 to a high of $266 – within the last twelve months. With no central institution to regulate, audit and control it, and a relatively small number of owners, the roller coaster ride has proved too much for many speculators. But of course, speculation was hardly the reason for its creation.
The other significant risk is security. With the current system, there is always a risk that your wallet could get hacked. With each wallet being the sole record of the bitcoins you actually own, it’s not impossible that you could lose everything. A simple key logging piece of malware could in theory wipe you out. And if it happens, there’s no insurance that you’d expect to cushion your losses in the cases of bank deposit losses. No second chances.
But what’s happening today?
Plenty. Being able to use bitcoins to buy pizzas, donate to Wikileaks, in the WordPress marketplace or to gamble is one thing. But the currency really needs to win the confidence of the public at large if it is ever going to cross that line into mass adoption as a system that will challenge the status quo.
Renowned US investor Fred Wilson has discussed Bitcoin for a number of years on his excellent blog avc.com, and concluded in a post back in 2011 that the currency was at that stage in the ‘trough of disillusionment’ following the ‘peak of inflated expectations’ in terms of Gartner’s “hype cycle”. Subsequently, his VC fund, Union Square Ventures has put real money into a Bitcoin business (Coinbase).
Add to that the fact that the Winklevoss brothers (best known over their claims that Zuckerberg stole the idea for Facebook from them) recently committed to launch an ETF holding their vast bitcoin wealth, together with the recent exit of a bitcoin gambling business for $11.5 million, and the signs are strong that serious attention is starting to circle around the cypto-currency ecosystem.
The future for Bitcoin
I have a really strong feeling about this area. We’re at the start of a significant period of financial innovation and, just like (the original) Napster, I’m convinced the cat’s now out of the bag. Whether Bitcoin itself is ultimately successful, I wouldn’t like to hazard a guess. But I have no doubt that as the bonds between a global society strengthen and faith in institutions to protect individual’s interests continues to weaken particularly in times of trouble, the internet will facilitate the removal of the middleman as it has done in every other industry.
File-sharing didn’t die when Napster finally succumbed to repeated litigation. It lives on today in a variety of improved platforms and it’s inconceivable that the concept itself will now ever disappear.
In exactly the same way, it looks like virtual currency is here to stay. And that in itself raises all sorts of questions about the future of finance, government and business combined. I’d love to know your thoughts – let me know in the comments.
@dugcampbell
PS. By the way, if you’re about Edinburgh on 23rd August, head along to the annual Turing Festival 2013. In addition to some fantastic other speakers, independent Bitcoin developer Mike Hearn will be giving a talk. Grab me and say hi if you’re going.
PPS. For more Bitcoin information, check out this, this, this and this.
Thanks for pulling this together. Like many I’ve been struggling to get my head around the whole thing. Much as I love algorithms I find that this and the mining bit make it all sound so way out.
The idea of a currency outside of the control of institutions though is a concept that is easy to understand. Foreseeing the full potential and imagining the scale of the likely disruption is less easy to picture but certainly both exciting and scary in equal measure.
See you on 23rd
Really glad you found it useful Tim, thanks for the comment.
The whole concept raises fundamental questions that cut across so many established areas of society. The interesting thing is that there’s no guarantee that the ‘answers’ (aka controls) can simply be imposed by those who’ve traditionally been the ones in positions of authority – or that anyone knows where this will actually lead in the end as you say.
In case anyone’s considering mining as an individual though, I suggest you take a look at this chart and think again (http://blockchain.info/charts/miners-operating-profit-margin)!
Look forward to catching up at the Turing Festival Tim
Cogent summary, Dug, good job. Hadn’t heard about silk road. The head of online for Paddy Power in Ireland is a serious forward thinker, I wonder if they’ve a roadmap for accepting bitcoins.
Cheers Sheila. I guess the Silk Road is one of these places that most people *shouldn’t* really know about!
As I’m sure you’ve seen, the environment’s shifting continually, particularly with the New York State Department of Financial Services subpoenaing a raft of high-profile investors and customers this week (http://onforb.es/1eLujiw). I’m sure that uncertainty is scaring away plenty of businesses still.
But it’s a great point re Paddy Power. The impact on a business like that, particularly in light of Satoshi Dice etc, could potentially be huge. They must be thinking about it, surely – both as a risk and an opportunity. Would be fascinating to find out.
Thanks for the comment!
Bitcoin mining is now the reserve of the big boys. My wee ASIC miner is effectively useless now. If anyone is considering mining crypto then Bitcoin should be scrubbed off the list. I turned to mining Litecoin (The silver standard to Bitcoin’s gold) but I suspect it will also succumb to the big boys in due course. Some reckon it is already.
Mining as part of a pool is the most effective way to do it if your interested but be prepared to lay out a good few quid for a couple of decent GPU’s!! It’s not a get rich quick scheme by any means!
Thanks @robertbryce:disqus, it’s a very good point and one that I should have made clear back in August. That ship has long sailed for the hobby solo Bitcoin miner but, for anyone else reading this who maybe isn’t quite as close to the system as Robert you clearly are, that is very much a good thing. It’s an integral part of the system that the computational strain increases over time. I think there’s some fascinating discussions ahead on whether it will actually be Bitcoin that ends up as the ultimate winner when it comes to digital currency, I’d be interested to hear more about your experiences with Litecoin some time.