Bitcoins: The New Digital Currency

A new form of digital currency has appeared recently. It has been available for about six years but many people have not heard about it or else do not understand it. In the past year or two, publicity has increased, and now tens of thousands of computer users are using this new payment method to purchase everything from coffee and doughnuts to illegal drugs or to pay for charitable donations or for online gambling, an area where the U.S. Government is already trying to control the actions of private citizens.

In many cases this new currency can replace cash, checks, money orders, or credit cards. In other words, it is just like U.S. dollars or Euros or most any other form of currency. It is secure (although with some major caveats to be described later), anonymous, and, so far, is free of government snooping or intervention.

The new currency is called Bitcoin. It is a peer-to-peer currency. Peer-to-peer means that no central authority issues new money or tracks transactions. These tasks are managed collectively by the Bitcoin network. “Collectively” means that no one person or organization is in charge. Instead, all transactions are monitored by everyone’s computer on the network as a safeguard against fraud. In effect, there are thousands of “auditors” monitoring every transaction. If you join the Bitcoin network, you also become an “auditor.” These “auditors” see everything about the transaction except for the names or other identifying information of the individuals involved.

NOTE: Many people claim that Bitcoins and other forms of digital currency are not really currency at all. Indeed, there is some truth to this claim. Depending upon which dictionary you use, Bitcoins and similar cryptocurrencies may or may not meet the definition of currency. Both the U.S. Treasury and the European Central Bank classified Bitcoin as virtual currency to communicate the fact that according to their definition, Bitcoin does not have all attributes of real currency, namely the status as legal tender in any jurisdiction. However, in practical use, Bitcoins and similar cryptocurrencies may be used as currency substitutes in many situations in a similar manner as checks, credit cards, and other forms of “currency substitutes.”

Created in 2008, Bitcoin is a digital currency based on a self-published paper by Satoshi Nakamoto, a rather mysterious person who has never published his address, email address, or any information about his credentials. In fact, nobody is certain if Satoshi Nakamoto is his real name or not. Nobody in Japanese mathematics has ever heard of him before, so the name probably is a pseudonym. He is obviously a mathematician but little else is known about him (or her?). Nakamoto’s “white paper” is available for all to read at http://www.bitcoin.org/bitcoin.pdf.

Bitcoins are not issued by any central bank or any other form of central authority. They are not issued by any government and are not issued by any corporation. Instead, they are bought and sold in the same manner as any other currencies. Bitcoins also can be “mined” by creating them on computers through some complex mathematical formulas. However, the value of mining is limited. The idea of “mining” your own Bitcoins sounds attractive until you realize that you need days and days of computer power to create Bitcoins that are worth a very few pennies. I did some calculations and found that mining Bitcoins on my computer cost more for the electricity to run the computer than the amount of currency that could be mined. A few specially-built computers designed for the purpose of mining Bitcoins can be more efficient. However, these specialized systems are expensive, require a lot of electricity to operate, and still produce very little profit.

How much is a Bitcoin worth? That depends entirely upon what people think each Bitcoin is worth. Bitcoins have no intrinsic value and are not backed up by any other form of currency nor by gold or silver or anything else of value. In other words, Bitcoins are valued in exactly the same manner as U.S. dollars: worthless unless somebody thinks they are worth something. Like U.S. dollars, Bitcoins currently are not backed up by gold or silver or by any other currency. A lot of people apparently believe that Bitcoins are worth something.

As I write these words, one Bitcoin costs about $324 in U.S. funds, but that value tends to fluctuate up or down every day. In the past, Bitcoins have been traded as low as nearly zero and as high as $1,240 at the peak in December 2013 for one Bitcoin. You can speculate in Bitcoins in the same manner as speculating in foreign currencies.

You can buy or sell Bitcoins or use them in commerce down to a tiny fraction of one Bitcoin. For instance, you could purchase something for 0.01090928 BTC (“BTC” is the generally-accepted abbreviation for “Bitcoin.”)

Another difference is that Bitcoins are never printed on paper. You cannot hold them, fold them, or stuff them into your pocket. Nobody has ever seen a Bitcoin, although many people own them. Instead, each Bitcoin exists only as a long series of numbers inside your computer. The numbers are heavily encoded with checksum information and other safeguards. So far, it appears that nobody has ever forged a Bitcoin, unlike U.S. dollars. Any Bitcoins that appear in the network from unaccounted sources will be flagged as an error within seconds, so the likelihood of forgery is low. Existing Bitcoins can be stolen, however, although with significant difficulty.

When Wikipedia says, “A proof-of-work system is used as measurement against double-spending and initial currency distribution mechanism,” that simply means that nobody can spend Bitcoin funds that they don’t own.

The Bitcoin network has been plagued with thefts and with bankruptcy of a couple of Bitcoin clearinghouses (companies that buy and sell Bitcoins). As the technology improves, however, thefts are becoming less of a problem. Bitcoin clearinghouses are still subject to financial problems in the same manner as any stock market clearing house, such as what happened to Lehman Brothers and to other Wall Street firms.

Bitcoins are simultaneously both very open and very secretive. Every single Bitcoin or even a fraction of a Bitcoin that is transacted (changes hands) is visible to everyone else. However, nobody ever sees the name, address, email address, or any other identifying information about the individuals involved in the transaction. The shared information simply says, “Someone identified only by a long series of numbers and letters gave this many Bitcoins to someone else who is also identified only by a long series of numbers and letters.” Everyone can see the transaction. As a result, hundreds of privately-owned computers keep track of every transaction, even though no one can see the names or any other identifying information of the individuals or companies involved in the transaction. Everything is anonymous.

As a result, I can write that “Bitcoins are simultaneously both very open and very secretive.” The financial transactions are very open, but the personal, identifying information of the participants is very secretive.

Bitcoins thrive because of this openness. The software that “mines” Bitcoins is open source and available to anyone who wishes to read the source code. The software that transfers Bitcoins and also monitors and verifies other transactions is also open source; anyone can examine the source code to look for bugs or security problems. Transactions are monitored and verified by thousands of individuals’ personal computers. All this checking greatly reduces the likelihood of fraud. Transactions are open and shared amongst many computers, even though they are always anonymous. With everything open and visible to all, it is probably impossible for anyone to create Bitcoins improperly or to claim to have more Bitcoins than what they actually possess. At least, that has not yet happened in the six years Bitcoins have been in use.

However, it is always possible for someone to hack into an individual’s computer and steal his or her personal Bitcoin account information in the same manner as hacking into someone’s personal checking account and finding the account number and password information there. In other words, if you own Bitcoins, a hacker can claim to be you, and if he has access to your user name, long password, security keys, and other information, that hacker can impersonate you and make transactions in your name. This is exactly the same as someone hacking into a checking account or credit card account that is tracked in U.S. dollars or any other traditional currency. The basic rules of security do not change. The same security is needed for your personal Bitcoin transactions as for your checking account. The primary difference is that the thousands of clearinghouses for Bitcoins do not know your name whereas the banks that handle checking accounts for their customers always know the names involved.

So how do people exchange Bitcoins? If you purchase goods from me, how do you reimburse me? You use the open source Bitcoin software to send money to my Bitcoin address. That address is a long series of numbers. Here is a fictitious example of a Bitcoin address: 1Ftu7kxjVfTw5sQEyHVvXpCmpUhXW7G2aW

NOTE: That is not a real address, so don’t send any funds!

For someone to send funds to that address, they run the Bitcoin software on their own computer and they need an Internet connection. The sender commands the software to send a specific number of Bitcoins to the addressee. In this case, it might be a command “Send 17.386745 Bitcoins to 1Ftu7kxjVfTw5sQEyHVvXpCmpUhXW7G2aW.” Bitcoin client software is available for Windows, Macintosh, Linux, Android, and Apple’s iOS operating system (iPhone, iPad, and iPod Touch).

The software of the sender is identified to the peer-to-peer network by a series of certificates, providing proof that this is the computer that it claims to be. The same is true of the receiving system: it must be the computer it claims to be, as proven by the certificate. Certificates do not care about the owners’ names. Instead, they look only at prior history: “This certificate number has received Bitcoins in the past and currently holds 67.698789870 Bitcoins. Therefore, it is allowed to transfer 23.5780562540 Bitcoins to another certified computer, and the amount of that transaction will be deducted from the amount on hand in the first computer.” Again, all transactions are visible to all computers on the Bitcoin peer-to-peer network, so there are hundreds, perhaps thousands, of “auditors.”

Once the two systems identify each other and agree, they “shake hands” and transfer the funds. They also send copies of the transaction to all the other Bitcoin computers they can find online at the time, which typically is hundreds or thousands of systems in a peer-to-peer network. Each and every one of the other computers will then go through a verification process to make sure the two systems involved in the transaction are legitimate. After all the other computers complete their own verifications, the transaction is “approved” and the funds become available in the receiving system. The entire process requires a few minutes. There is no process of waiting days for a check to clear. The funds are transferred quickly, and the entire transaction is irreversible.

The transfers are totally anonymous. The buyer does not need to reveal his name or location to the seller and vice versa.

Everything revolves around the certificates. In fact, there is no identifying information in a certificate. However, as an example, each computer on the network already knows that certificate number 34DT567SFM12XGY893JKA received 34.95 Bitcoins last week and that the same certificate number today wishes to send 21.35976 Bitcoins to certificate number 34SG69SLG19XGY450JLS, a computer that has been verified on the network before and is trusted.

(Again, those certificate numbers are fictitious and are used here solely as examples. I believe the true certificate numbers are much longer, and all numbers are verified both by checksums and by prior history.)

Of course, there are advantages and disadvantages to this system. In fact, what one person calls an advantage might be called a disadvantage by someone else. For instance, everything is handled without identifying individuals. This is great for privacy advocates but not so great for governments who are accustomed to spying on their citizens’ financial transactions. There is no method for any law enforcement agency, not even the Internal Revenue Service, to track who paid what to whom.

Bitcoin has quickly become a major means of handling money by drug dealers, Mafia, and other criminals, as well as for many law-abiding individuals and corporations who merely wish to keep their financial affairs private from government snooping.

You can find a list of hundreds of (legal) companies that already accept this digital payment method if you look at https://en.bitcoin.it/wiki/Trade#Internet_services and then scroll down… and down and down. It is a long list and that list grows daily. In addition, Bitcoins are now accepted by a few online gambling sites in order to hide those transactions from the U.S. Government. Finally, any two individuals can agree to use Bitcoins for their own private transactions, if they wish. Both individuals need an Internet connection plus the free Bitcoin software.

The use of Bitcoins may or may not violate laws of several countries, depending upon the interpretation of those laws. Most of these laws were written before the invention of digital currency; therefore, the language of the laws often is not clear about purely digital financial transfers.

At this time, it appears to this non-lawyer that there is nothing in U.S. law that prohibits the use of digital currency. However, there may be potential problems with some uses of Bitcoins. For instance, existing U.S. laws already specify that the transfer of amounts over $10,000 must be reported to the Government. How does anyone report such transfers when using Bitcoins where the names of the individuals are not visible, not even to each other? That’s right, the buyer typically does not know the name of the seller and vice versa. What do you report?

Another thing to consider is that Bitcoin transactions are fast and non-reversible. If you send money to someone and they do not deliver the goods, where do you file a complaint? In reality, you don’t. There is no arbitration process. “All sales are final.”

“Escrow services” are popular with Bitcoin transactions where the goods are delivered to a trusted third party who holds them until payment is made and verified. Then the trusted third party releases the goods.

Obtaining your first Bitcoins is a difficult and somewhat circuitous process. The process is described briefly at https://en.bitcoin.it/wiki/FAQ#How_can_I_get_Bitcoins? and then that site gives links to other sites for the details. Be prepared to do a lot of reading if you wish to purchase or redeem Bitcoins!

Once you have some Bitcoins, the process of buying and selling appears to be simple and convenient.

Should you use Bitcoins?

The only advice I can offer is, “It all depends.”

First, do you have any need for Bitcoins? Check the list of companies that accept Bitcoin payments that was mentioned earlier: https://en.bitcoin.it/wiki/Trade#Internet_services.

If nobody offers services you want, and if you cannot find any other use for Bitcoins (such as gambling payments), you don’t need them. However, if you wish to keep your financial transactions private, Bitcoins are for you!

It strikes me that Bitcoins are probably legal today in most countries. They are an excellent method for keeping your private financial affairs just that: private. In some ways, Bitcoins represent the “Wild, Wild West” of the financial world: new, brash, and not well organized. Like the Old West, fortunes will probably be made with the use of Bitcoins. That means that a few fortunes may also be lost. Be aware of the risks before you do anything!

While not controlled or monitored by governments today, I can’t believe that will last very long. Once the politicians and bureaucrats realize that financial transactions are being made outside of governmental control and monitoring, laws probably will be passed to allow governmental agencies to snoop on everything in the same manner as most other existing financial systems already in place. The basic design of the Bitcoin system is to keep everything secret. If Bitcoins cannot be monitored by governments, I bet the Bitcoins will be outlawed by many larger governments. However, the small island nations and other countries that presently specialize in offshore banking will probably welcome Bitcoins.

For more information about Bitcoins, read the following:

http://bitcoin.org/ (You can also download the free Bitcoin software here.)
http://en.wikipedia.org/wiki/Bitcoins
https://en.bitcoin.it/wiki/FAQ
http://www.bitcoinplus.com
https://campbx.com/main.php
http://www.coinbase.com (a service where you can buy and sell Bitcoins)
https://www.dwolla.com/ (an online service that transfers funds from your bank account to a Bitcoin exchange and vice versa. Read the fine print carefully before using!)

MakeUseOf also has a nice explanation of Bitcoins at http://goo.gl/6AVFm.

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