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Bitcoin Electronic Currency: The Future of Money
What is Bitcoin?
The first completely decentralized, anonymous, electronic currency has been created, and its name is Bitcoin. Its creator is Satoshi Nakamoto, a cryptography expert. Bitcoins are digital tokens that can be exchanged anonymously between users across the internet or stored on disk. Bitcoin serves the purpose of not just a currency, but also of an online virtual banking system.
Although Bitcoin is not a “hard” currency in the sense that it is not directly backed by a commodity, it differs greatly from traditional government issued fiat currency and regulated banking in several important aspects:
• Bitcoins have no central issuer whereas fiat currency is issued at will by a central bank. Currently, Bitcoins are slowly being issued in a decentralized manner, but new issuance will forever halt at exactly 21 million coins.
• Bitcoin transactions are anonymous whereas a wire transaction in a government run banking system requires a federally licensed financial institution to act as a middleman. This third party must report on transactions to the regulators, and so in effect all financial transactions are monitored by the government. With Bitcoin, no third party can spy on, prevent, control, or tax transactions.
• Bitcoin ownership is private and not subject to outside inspection and therefore asset monitoring or confiscation for any reason is nearly impossible.
It is also worth pointing out that gold-backed digital currency – such as what GoldMoney offers – also differs from Bitcoin in important ways. Gold has the obvious advantage of thousands of years of historical precedent as money, as well as having a physical form that can be used in trade. However, the major disadvantage of a gold-backed currency is that it requires a central repository, which implies (1) storage fees (2) vulnerability to raids and inspections and ultimately (3) complete monitoring and control by regulators. The unfortunate fate of both E-Gold and the Liberty Dollar is tantamount to the fact that any centralization of a currency system is vulnerable to outside monitoring, tampering or outright confiscation. Bitcoin does not have any of these risks.
How do I use Bitcoin?
My own experience using Bitcoin has been a blast, especially when compared to the slow and cumbersome nature of traditional financial institutions. To use Bitcoin, the place to start is bitcoin.org. There’s no registration or payment required to start – just download the software. After installation, you’re ready to exchange Bitcoins with your friends across the world. If you want a few coins to start with, go to freebitcoins.appspot.com for some initial bit-capital.
The quantity of services that use Bitcoin is small but steadily growing. Notable websites thus far are bitcoinmarket.com and mtgox.com, which allow exchange between various fiat currencies and Bitcoins, and biddingpond.com, which is an implementation of e-bay with Bitcoins. You can visit bitcoin.org/trade to see a list of services that accept Bitcoin.
How does Bitcoin work?
Everyone that uses Bitcoin has a balance stored in their account. This balance can be changed by sending and receiving money in transactions. A transaction is money changing ownership from one account to another: it specifies the giver account, the amount, and the receiver account. When you want to make a transaction, you announce the details of it publicly to everyone.
Each user has the ability to perform a digital signature with their account, which operates just like a normal hand-written signature. Before announcing a transaction, the giver signs the transaction first. In this way, everyone can take a look at any publicly announced transaction and know that the giver account owner truly agreed to that transaction.
When a transaction is announced, everyone audits the transaction to ensure that it is valid. This is possible because everyone knows the balance of each account. (Despite this, nearly complete privacy is achieved because account ownership is not known, and each user can own an unlimited number of accounts – ideally, you should create a new account to receive the balance of each new transaction.)
Dealing with Dishonesty
Not everyone is allowed to publicly confirm the validity of new transactions – if this were true, the system would be too easy to fool if a large number of users were dishonest. Instead, after successfully auditing the transaction, users must place the new transaction on top of a virtual stack of the previous transactions. To seal the transaction on the top of the stack, they must perform very difficult computational work – this is akin to the physical work required to cement blocks on top of one another. As a reward, those who complete this work first get a small transaction fee, and then they share the new stack with other honest users who audit and verify that it is correct. Honest users accept the tallest stack as the correct and most up-to-date consensus.
Dishonest users cannot possibly build a stack of false transactions continuously faster and taller than honest users, because it is likely that the combined computational resources of honest users will be greater than that of any single cooperating group of dishonest users. Even if a group of dishonest users managed to get more resources than honest users, they would have to decide between using it to earn legitimate transaction fees, or to destroy trust in the currency and thus the legitimacy of their own wealth.
Finally, it’s worth noting that many details were left out of the above description for simplicity. You may want to visit bitcoin.org and read the FAQ or technical paper for more information.
Despite the fact that Bitcoins do not exist in the physical sense, a cursory glance shows that they do serve the primary functions that make money useful. Bitcoins provide medium of exchange (anonymous and across great distance), unit of account (private), divisibility (up to eight decimal places), scarcity (21 million limit), portability (transferred electronically), and store of value (current exchange rates – as of August 2010 – put 1 Bitcoin, or BTC, equal to 0.065 USD).
I believe that Bitcoin has enormous potential, but it will have to stand the test of time and the marketplace. Even if Bitcoins do not catch on in the mainstream, it still provides a glimpse into a decentralized monetary future. As distrust in central banks continues to increase as the financial crisis drags on, my expectation is that private currencies will continue to grow in popularity. Finally, for those who claim that Bitcoin is too virtual: what about the US dollar?
Satoshi Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System”, www.bitcoin.org