Bitcoin, the new decentralized digital currency that’s rapidly gaining popularity, was invented in 2008 by a mysterious hacker named Satoshi Nakamoto. He published the original paper describing the protocol, developed the initial implementation, and remained active on the mailing lists until mid-2010, but then vanished. He was presumed to be an individual from Japan, but nobody by that name actually exists, so many now assume Nakamoto is a pseudonym for an individual or group that wished to remain secret. So what did this mysterious person/group/ghost create, and why is it taking the world by storm?
Bitcoin is essentially a new form of money, purely digital and stored on your computer. It can be treated like cash, and payments in any denomination can be made securely and instantly around the world. It is managed and operated by a peer-to-peer network, so no central authorities or banks are involved in these transactions. It is anonymous, so you can buy and sell whatever you want without leaving a trace. This has led to its popularity in underground markets such as Silk Road, where bitcoins are used to buy drugs, weapons, stolen credit cards, assassination contracts, basically whatever you can think of. Because of this anonymity, bitcoin transactions are not generally reported to tax authorities, making them tax-free (at least for now). Transactions are secured by strong public-key cryptography, a very secure mechanism, although it does ultimately depend on the security of your individual computer. If someone hacks your computer, your bitcoins can be stolen, in the same way that someone can steal cash out of a safe if your house is not properly secured.
These are the features of the currency from a user perspective, but what about from a systemic perspective? The primary feature that bitcoin advocates are excited about is the absence of any central authority. There is no central bank managing the currency, as opposed to virtually every government currency, where a national or regional bank, such as the Federal Reserve or European Central Bank, controls the amount of money in circulation. Proponents are excited by this because of perceived mismanagement of U.S. dollars by the Federal Reserve, in conjunction with out-of-control government spending that has led to unprecedented levels of “printing” in recent years. Fears that the government will be unable to control its spending, leading to high rates of inflation, make a deflationary currency scheme like bitcoin seem very attractive.
So how do bitcoins get created? The technical details of the money creation process are a little too arcane to describe quickly or easily, but if you’re technically minded, the protocol is open source and available online. Bitcoins are created in a controlled fashion, at a predictable rate, essentially as a reward for the computational work required to keep the system running. Since this is a peer-to-peer network, it requires a large number of computers running at the same time to keep things running smoothly. This means capital and electricity costs for the participants, so as a reward, new bitcoins are given on a somewhat random basis to those doing the work.
This is what puts bitcoins into the system. This process is called “bitcoin mining,” due to its similarity to gold mining—work is done to produce something of value and put it in circulation.
Bitcoin mining is one of the primary drivers of the hype behind bitcoin. Unsuspecting newcomers are led to believe that all they have to do is run a computer program 24/7, and it will essentially print money. There are numerous sites and blogs describing “mining rigs” — people building out elaborate specialized computers and networks for the purpose of capturing this money as it is created. Now, before you go out and waste your money, I should tell you that the facts do not support the hype. There is so much computational power in the network at this stage that the likelihood of capturing any new coins is very low unless you have an enormous pool of computers at your disposal, and the costs of building and operating such a network will likely outpace your return. If you want to use bitcoin, do it for its utility, not out of hope of getting “free” coins.
The other way to get bitcoins is to trade national currencies for them. There are several online currency exchanges available, such as Mt. Gox, that allow you to trade dollars for bitcoins and vice-versa. This is another driver of the hype behind bitcoin — speculators that are essentially investing in bitcoins, hoping the value will go up, as it has been. The value is extremely volatile, and traders are capitalizing on that, but overall the value has been going up as more people buy into the hype. As of the time of this writing, one bitcoin is worth $22.76.
My analysis of bitcoin has led me to believe that the money creation process is flawed, and the system rewards early adopters to an unfair degree. It has some of the characteristics of a Ponzi scheme as a result. Early adopters have already captured about half of the total number of bitcoins that will ever be generated, and as the rest of us scramble, their value will increase. The deflationary aspect of this virtual currency is also troubling—it doesn’t account for the fact that, as the number of participants increase, the value of the overall economy also increases, but the money supply does not reflect that. Bitcoin is a very interesting experiment, but I believe it is the first of many, with much left to be desired.
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