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7 things you need to know about Bitcoin
7 things you need to know about Bitcoin
Bitcoins are all the buzz. The virtual currency is riding a rollercoaster of speculation, rising exponentially in value and reaching a high of $260 this Wednesday before plummeting to $130. What’s more, the largest Bitcoin exchange in the world just survived a coordinated hack attack, and bitcoin-generating malware is spreading across Europe like wildfire via Skype.
Yet despite all the sound and fury surrounding this made-up money, most
people have a hard time understanding exactly what Bitcoins are—and how
they work. This is troubling, especially if you’re thinking of investing
your own time and money in the Bitcoin phenomenon.
Starting your own bitcoin wallet
isn’t necessarily a bad idea. Bitcoins aren’t tied to the fortunes of
any single nation’s economy. They’re easy to exchange, and they aren’t
subject to transaction fees. But you need to know a few important things
before throwing your money into the volatile Bitcoin market. You need
to understand how the Bitcoin system works, where it succeeds, and where
it’s weak.
Bitcoins are created, traded, and controlled by the people
Simply put, a bitcoin is
an algorithm-based mathematical construct—a unit of measurement
invented to quantify value. It’s sort of like the dollar in that way—but
unlike the dollar (or any other form of fiat money,
really), Bitcoins are decentralized. The original Bitcoin algorithm was
created by a developer with the pseudonym Satoshi Nakamoto, but the
currency itself is created, traded, and controlled by Bitcoin users,
rather than by a central authority like a bank or a government. Bitcoins
are completely digital, too: You’ll never lay hands on a physical
Bitcoin unless you purchase a physical facsimile like this.
Each
of these physical Bitcoins has a private key embedded beneath the
hologram that links to a Bitcoin address worth the amount shown on the
face of the coin.
The currency also has a finite supply that’s limited by design. The
algorithm that fuels the Bitcoin network is designed to generate 21
million Bitcoins, and the system automatically regulates itself to
ensure that the supply of Bitcoins grows at a smooth, steady pace. At
the current rate, all 21 million Bitcoins should be generated by 2140.
And because the Bitcoin network tracks and records every Bitcoin
transaction, you can actually see exactly how many Bitcoins have been
created at any given moment at Blockchain.info,
a website that monitors the Bitcoin network and hosts Bitcoin wallets,
the containers owners use to store their digital riches.
We’re definitely in a Bitcoin bubble
Bitcoin is big right now, probably too big for its own good. Since a
Bitcoin has no value beyond what someone is willing to pay for it, the
price of Bitcoins tends to change quickly. Indeed, in mid-January a
single Bitcoin was valued at $15, which makes people who bought Bitcoins
back then and sold them at $260 apiece yesterday very successful
investors.
The currency’s popularity (and therefore price) increases in international markets that have become unstable—say, when a government threatens its citizens with capital controls and currency restrictions, as Cyprus did last week.
“Bitcoin is a very volatile asset, and the recent developments in the
price of Bitcoins do have some of the characteristics of an economic
bubble,” says Professor Magnus Thor Torfason, Assistant Professor of
Business Administration at Harvard Business School.
The value of bitcoins can only keep going up, right? Right?!
Torfason is currently working on publishing a paper that focuses on the
value of Bitcoin. Though he’s cautiously optimistic about the future of
Bitcoin, he says that it’s hard to recommend the currency to the average
PC user. “Even if we assume that
Bitcoins will eventually be worth ten times their current value, they
may drop to a tenth of their value between now and then,” says Torfason.
“We don’t really have good methods for assigning value to a currency
like this, so you should treat any investment into Bitcoins as an
extremely high-risk investment.”
You can mine Bitcoins, but the gold rush is over
You don’t have to put your own money on the line if you want to jump
into the Bitcoin market. Instead, you can “mine” Bitcoins by putting
your PC to work crunching code on the Bitcoin network. If you’re lucky,
you could earn a whopping bounty of 25 Bitcoins.
Here’s how it works: Batches of Bitcoins are awarded to Bitcoin
miners—people who volunteer to install and run a Bitcoin client on their
PCs. The client uses CPU and GPU processing power to solve very complex
math problems, and then shares those solutions with the entire network.
The problems are extremely difficult to solve, but easy to verify as
correct, and they incorporate logs of transactions on the Bitcoin
network. As a result, miners track and verify Bitcoin payments as they
work.
The first client to solve a given block of transactions is awarded a set
number of Bitcoins—25 as of publication, down from 50 when Bitcoin
began—once the work is verified by other clients on the network. That
fixed number is halved every four years, until at some point no more new
Bitcoins will be created.
This
fantastic infographic from Bitdata illustrates how Bitcoin mining is a
crucial part of how the Bitcoin network operates. (Click to enlarge.)
The algorithms involved in Bitcoin production are far too complex for
most non-crypto-nerds to grasp, which is why most people use the term Bitcoin mining. It’s analogous to toiling in tough conditions in search of gold. And as with gold, only a limited supply of Bitcoins exists.
But unlike gold, Bitcoins enter the world at a rate that shows very
little variation. The Bitcoin algorithms dynamically change in
difficulty based on how often Bitcoins are being awarded; and this
ensures a smooth, steady drip of virtual currency into the network. If
mining drops off, Bitcoins will become easier to mine. If mining becomes
exceedingly competitive—as it is now, with Bitcoin miners investing in
high-end PCs and server farms as part of a processing-power arms
race—Bitcoin mining becomes more difficult.
“At this point, mining for Bitcoins is a very bad idea,” says Vitalik Buterin, head writer at Bitcoin Magazine. “You’ll basically get nothing. The best way to get Bitcoins is to buy them on an exchange.”
My research suggests that Buterin is right: These days, you probably
won’t earn many Bitcoins through mining unless you’re part of a mining
pool—a group of users who combine their processor resources
cooperatively to chew through solutions faster, and thus increase their
rate of earning Bitcoins. Plenty of mining pools exist, each with its
own rules and methods of distributing Bitcoin rewards. If you’re
interested in getting into mining, pick a promising group from this
short list of big Bitcoin mining pools and contact the pool operator.
Most major retailers don’t accept Bitcoins (yet)
If you do decide to take the plunge and buy some Bitcoins on an exchange like Mt. Gox,
you’ll need a place to spend them. Bitcoin is still young, but the list
of merchants that accept Bitcoins is growing rapidly as the currency
gains traction through media exposure. The lion’s share of Bitcoin
business still happens online, as befits a virtual currency—you can
spend Bitcoins at Reddit, WordPress, Mega, and WikiLeaks, for example. But brick-and-mortar businesses—mostly bars and corner stores with connections to Bitcoin advocates—are gradually adopting the currency as well.
Adam CroweA Reddit user claims to have found this plaque in a corner food market in British Columbia.
You’ll find a much, much bigger list of websites where you can spend your hard-earned Bitcoins on the Bitcoin wiki, and a growing list of businesses that accept Bitcoins in the real world.
Bitcoins aren’t protected or insured by anyone
Bitcoin transactions are irreversible. Once a Bitcoin transaction is
broadcast to the network it can’t be revoked. So a hacker who accesses
the PC that stores your Bitcoin wallet can send your entire Bitcoin
fortune to another wallet—and there’s nothing you can do about it.
Caveat emptor.
Of course, if the PC that stores your Bitcoin wallet is owned by a third
party that insures it against theft—say, a respectable Bitcoin wallet
hosting service—you might be able to recover the value of some or all of
your stolen currency. For example, the recently hacked Bitcoin wallet hosting service Instawallet shut itself down in the wake of a devastating hack attack and provided refunds to users who had lost 50 BTC or less.
Nobody knows who really created Bitcoin
Bitcoin’s creator was a coder and cryptography enthusiast who communicated on the cryptography mailing list under the name Satoshi Nakamoto. Nakamoto designed the network and launched Bitcoin in June of 2009, mining the first 50 Bitcoins to form what became known as the genesis block.
Nakamoto disappeared shortly thereafter. Many reporters have tried—and failed—to
unearth Nakamoto’s true identity, but so far the progenitor of the most
successful virtual currency ever made remains a mystery.
Bitcoins aren’t the first virtual currency, and they won’t be the last
Bitcoin would appear to be the most successful virtual currency we’ve
ever seen, but it’s not the first. From e-gold to Beenz to Facebook
Credits, people have been trying—unsuccessfully—to build viable virtual
currencies for more than a decade.
These has-been virtual currencies
failed for different reasons. Some were shut down by the government
authorities on charges of money laundering. Some were shut down by their
owners at the culmination of elaborate scams. And some petered out when
people stopped buying them. Because Bitcoin is decentralized, it can’t
be shut down by anyone. Yes, individual Bitcoin exchanges can be
targeted by financial regulators—but since nobody runs Bitcoin, it can
only peter out from lack of interest.
Remember e-gold? Me neither.
A hacker could theoretically destroy the Bitcoin network by tampering
with the code in an exploit to end all exploits. However, in the four
years since its inception, the Bitcoin code remains uncompromised.
Individual users and exchanges may be hacked, but the Bitcoins
themselves have so far proved unassailable.
That’s probably why a number of Bitcoin clones are poised to enter the
market. From TerraCoin to Ripple to PPCoin, plenty of virtual currencies
based on the open-source Bitcoin code are eager to compete for your
real-world money. For now, it’s probably a good idea for most consumers
to keep a safe distance from virtual currency: The wild fluctuations in
value that make Bitcoins so interesting to study could make you a
millionaire one day, and a pauper the next.
Adam Crowe