Some have called it the solution for a global currency; others have derided it as a cover for illegal activity. What is it? Bitcoin: an electronic currency which is completely decentralized, owned by no one government or entity. Bitcoin is traded between users who semi-anonymously identify themselves using any number of alphanumeric codes, allowing them to exchange currency anywhere in the world without any third parties.
Bitcoin operates on the economic principle of scarcity. There are a limited number of Bitcoins in circulation. New Bitcoins are created by users running programs called “miners”, which participate in solving arbitrarily generated mathematical problems. The user whose program solves the problem first is awarded a new Bitcoin. The Bitcoin protocol is designed to make mining Bitcoin take longer and longer, until the maximum number of 21 million Bitcoins has been created. This has been predicted to occur around 2050. To compensate for the limited number of Bitcoins and their increasing value relative to traditional currencies, Bitcoins can be exchanged in fractional amounts.
One might ask: if there is no central entity governing the fairness and accuracy of Bitcoin transactions, how is a transaction’s authenticity guaranteed? Bitcoin’s security system works on a peer-to-peer network similar to Napster or BitTorrent. Each transaction is broadcasted to as many users as possible and becomes part of the transaction history that every Bitcoin user holds on their computer. New transactions are verified based on this globally distributed transaction history.
Since the Bitcoin system was created in 2009 by a mysterious developer who goes by the pseudonym Satoshi Nakamoto, the value of a single Bitcoin has risen from virtually nothing to about $800 as of January 2014. This has financially rewarded many early adopters of Bitcoin, though some analysts insist that Bitcoin represents an economic bubble. Bitcoin has also enabled online drug trafficking exchanges to thrive with little interference from authorities; one such website, the Silk Road, continues to function despite a prolonged FBI sting operation that captured its former leader.
However, Bitcoin is being used in legitimate ways as well. Many online companies are starting to accept Bitcoin as payment, including major retail website Overstock.com, blog hosting platform Wordpress.com, and domain name registrars Namecheap.com. Bitcoin has several advantages for online merchants: it carries no transaction fees, has a low risk of inflation and is transferred directly from customer to business. However, it is liable to theft by hackers and loss if it is not backed up. Bitcoin has historically gone through periods of dramatic value change – these have been overwhelmingly positive, but the volatility of the currency is still a headache for online merchants. Also, Bitcoin income should be reported as capital gains, so taxes still apply. Bitcoin may not be ready for the average online retailer, but it is an interesting technology that is worth paying attention to in the years to come.
Published on January 30, 2014