A Bit About Bitcoins

If you’ve been following the news recently, you’ve probably seen at least a mention of bitcoin.  The latest was negative press about hackers compromising a major Bitcoin trading web site and plunging the value of the virtual coinage from around $17.50 per coin to around one cent.  But what’s the fascination with bitcoin and is it worth using?

In a nutshell, bitcoin is an attempt to create a new form of currency, accepted throughout the world, that uses peer-to-peer computer technology to facilitate all of the transactions.  Unlike other forms of currency, bitcoin has no “middle man”.  There is no need for a bank or central payment processor.  Payments go directly from sender to receiver. Perhaps the most interesting part of the system is the fact that bitcoin currency isn’t backed by anything tangible such as gold or silver.  The virtual coins are slowly created out of thin air by “mining” software that users can install on their computer(s), in exchange for performing the computations required to process bitcoin transactions.

As one might imagine, one of the biggest challenges of introducing a new form of currency is finding merchants willing to accept it as a form of payment.  As it stands today, that’s a big hurdle for bitcoin to overcome. There are a number of places you can spend these virtual tokens, such as online backup company GBVault or the currency converter  BitEgg, which allows you to purchase NewEgg gift cards in exchange for bitcoins.  The anonymous nature of the currency also attracts those who wish to conduct illegal transactions.  An “anonymous marketplace” called Silk Road is already known as a major clearinghouse for illicit drugs, where bitcoin is the standard form of payment.  (Silk Road, in keeping with their promise of anonymity, isn’t even accessible via a standard web URL.  Users must install and configure the TOR software on their computer before it can even be visited.)  Even Silk Road has limits on its offerings, however.  Any good or service with a primary purpose of defrauding or causing harm to others is banned, so no stolen credit cards or weapons of mass destruction are allowed.  Bitcoin core development team member Jeff Garzik points out that the transactions aren’t truly anonymous, because all transactions get recorded in a public log.  Despite the identities of the parties being anonymous, law enforcement could use sophisticated network analysis techniques to parse through the flow of data and eventually pinpoint a user conducting large numbers of transactions.

Bitcoin’s developers have implemented a strategy that they believe best serves to ensure the currency remains stable in the long-haul.  For example, they’ve designed the system so no more than 21 million bitcoins will ever exist (a limit they predict will be reached some time around the year 2040).  As users running the mining software create new batches of virtual coins, they get distributed back to the users in a probabilistic manner to those with the highest amount of computing power.  As time goes on, it requires more and more computation to produce additional bitcoins.  This ensures the currency is created in a slow, controlled manner, but it also means early adopters stand to benefit more than users who get on-board later.  Bitcoin’s founders say they believe this is only fair, since the early adopters take a larger risk and deserve more potential reward for doing so.  Detractors claim this amounts to a classic pyramid scheme.

Regardless of the long-term success as an alternate form of payment for goods or services, the other aspect to bitcoin is the ability to convert it to and from U.S. dollars or several other “real world” currencies.  This sets it up as a potential investment medium, in and of itself.  If you believe the popularity of bitcoins will increase in coming weeks or months, you can convert some “real world” money into it, using one of the available exchange services, such as TradeHill or ExchangeBitcoins. Then, just like with a stock, wait for an opportunity to sell again when the value goes up.

From what I’ve seen so far, it looks like this is just the first generation of virtual currencies that has achieved enough mass acceptance to really become viable.  It has some things going for it, such as the lack of any transaction fees and the lack of any governmental body placing controls on it that satisfy their own interests at the expense of other users of the currency.  On the downside?  It’s complicated to use.  The encrypted, decentralized nature of bitcoin means it could literally take days for someone to get money converted from the U.S. dollar to bitcoins and subsequently to complete a purchase with them.  Additionally, all aspects of security are left up to the individual user.  The software creates a wallet.dat file on the computer that the user then has to encrypt and properly secure.  Symantec Corporation reports that a trojan-horse virus has already been developed that attempts to steal the contents of this file from infected machines.  There is also the potential issue of hackers trying to create large bot nets of infected computers that they can hijack for use as mining systems to generate more bitcoins for themselves.  I think the concept has great potential, but I’m not so confident the current implementation will be the one that finds lasting success.  It’s certainly a good financial experiment though, and I can see it sticking around until a superior replacement comes along to supersede it.