Thursday, December 19, 2013

A virtual currency that's made real millionaires

Bitcoin? That’s like Monopoly money for geeks, isn’t it?
PayPal for drug dealers?
Linden Dollars?
Go on, then tell us.
It’s an open source peer-to-peer electronic money system. Or crypto-currency, if you prefer. It was introduced in 2009 by the mysterious ‘Satoshi Nakamoto’.
I don’t prefer. Crypto-currency?
It uses cryptography to make sure transactions are secure and to keep a record of the number of Bitcoins in circulation.
Go on then, explain how it works.
I was hoping you wouldn’t ask.
Whenever a Bitcoin transaction occurs, a digitally signed payment message is broadcast to a decentralised network of computers. These computers then solve ‘cryptographic puzzles’ to verify the trans-
action and update the record of Bitcoins in circulation, known as the blockchain. This is called ‘mining’ because the owners of the computers, miners, are rewarded with Bitcoins for using computational power.
Business Insider described it like this: ‘Miners assemble “blocks” consisting of Bitcoin transactions, a hash record of the prior transaction block in the blockchain and an extra randomly assigned number. The miner then repeatedly hashes the block, making a small change to the extra number [each time], until the hash number satisfies a rare criterion.’

It’s thanks to the blockchain that once a Bitcoin is ‘spent’ its owner no longer controls it. You can’t spend the same one twice.

That makes sense. But to have value as a currency, there must also be a limit on the number of Bitcoins in circulation.

There is. As the number grows, the cryptographic puzzles required to mine them become more difficult, and thus require more computational power. Rewards for solving them are halved at regular intervals. And the whole system is designed to create a maximum of 21 million Bitcoins, at which point production will stop.
A virtual currency that's made real millionaires

So the recent growth in popularity must have made mining more difficult?

Yep. According to Business Insider, the number of hashes being processed, measured in gigahashes per second, has grown exponentially since the summer of 2013. It grew 275-fold between January and the start of December, and tenfold between September and December alone. So more and more computing power is needed to mine Bitcoins, for less and less reward.

The guys who started mining in 2009 must be pleased with themselves.

Yes, perhaps with the exception of James Howells, who mistakenly threw out the hard drive that stored his Bitcoin wallet and didn’t realise his mistake for several months. There are £4m worth of Bitcoins in a landfill in Newport, Wales - at least, according to Howells’ account.

Ouch. Isn’tthere a better way to store Bitcoins than on your Mac’s hard disk?

There are other ways, but whether they’re better is moot. Apps for mobile devices can act as wallets, and you could argue that you’re less likely to throw out your smartphone than a hard drive from a deceased laptop. But phones get stolen, of course. There are also paper wallets, which have QR codes printed on them. When you want to enter a transaction, you scan the QR code with a mobile device and the wallet is updated.

Paper money, huh? Revolutionary.

It sounds like a minefield.
It is, and governments and economists are still trying to figure out how to deal with it. On the one hand, transaction fees are a fraction of those charged by traditional payment processors, and there are no big banks involved. On the other, Bitcoin has become notorious because it’s used on what the newspapers love to call the Dark Net. Most infamously, the FBI seized 26,000 Bitcoins when it shut down the drugs marketplace Silk Road.

In December, This Is Money reported: ‘There are concerns that the anonymity of Bitcoin will attract international money launderers, drug barons and other criminal users.’

Not so different from big banks, then. Except that it’s anonymous?

Not quite. It’s hard to associate transactions with real-life identities, but not impossible. The Washington Post reported that ‘sophisticated analysis of past Bitcoin transactions could reveal patterns that unmask users.’ It’s also likely that Bitcoin intermediaries will eventually have to comply with banking regulations in their territory, and so will have to collect customers’ personal data.
Any other pitfalls?

There’s no central bank, so no lender of last resort. Bitcoin isn’t legal tender, so transactions are informal agreements between parties, and only a few retailers accept it. The rapid growth in value -now north of $1,000 per Bitcoin - has led many to believe it’s a bubble. Botnets have hijacked users’ PCs for illicit mining. And at the start of December, China banned its banks from handling Bitcoin, causing a dip in the currency’s value.

Economists are split on Bitcoin’s merit. One, Paul Krugman, wrote in the New York Times that a successful monetary system incentivises transactions, but with Bitcoin ‘there has been an incentive to hoard rather than spend’.

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