Bitcoin: The World's New Currency? [Updated]

Imagine if the Internet had its own money. Not some kind of a rip-off money-like scam in the vein of the Microsoft points or the discontinued Facebook credits, but rather a fully fledged Internet currency allowing you to buy anything from an anchovy pizza to concert tickets to a personal jet. A currency that would be independent from any governmental control whatsoever, that would hardly be prone to financial crises, that would not be issued in whooping numbers to fill in virtual any hole in a nation's economy. And what if I told you that there is such a currency? It's been around for more than four years by now and is called 'Bitcoin'. It's totally free from any government control, it's completely community-driven, and it allows you to make money... by solving math equations.

A Little Bit of History

The bitcoin project (or should I say 'bitcoin experiment'?) started in 2008 with a whitepaper by a certain Satoshi Nakamoto, a mysterious and now semi-legendary figure. In his text, Satoshi first outlined the technical ways to launch an e-currency-based transaction system he called Bitcoin. Almost five years later it has grown to be the most popular alternative currency with the money supply amounting for over US$360 million. The Bitcoin enthusiasts have come as far as to hope for it to replace the world's other dinero in the distant future.

Of course it is hardly imaginable that the Bitcoin fans will ever see their final goal see the light of day, but the new currency's profile keeps getting higher and higher. Currently, its exchange rate with the US dollar is at the historical maximum of $35 per bitcoin. That's quite a rise compared to the $5 rate last summer. The number of businesses accepting payments in Bitcoin has been on the rise for the last four years as well: among the largest ones are Reddit and WordPress.com. So, the virtual currency has started attracting even serious economic players.

Multibit: An Obvious Choice for a Bitcoin Beginner

What's the secret?

What makes Bitcoin so different from the dollar, yen, or euro? First of all, it is electronic. Of course, it is not something completely unprecedented, just look at the wide use of credit cards, electronic transactions and super-computers operating on the global stock markets. What is completely new is that the electronic media, and more specifically the wallet.dat file, stored on your device, is the only value carrier of Bitcoin. There is no physical backup of it: no banknotes, no metal coins, nothing. To start using the new-fangled electronic currency, you need to download and install one of the Bitcoin wallet apps and exchange your old-fashioned hardware money for several e-currency units. The most popular wallet apps include bitcoin-qt (the original client), Armory, Multibit, and Electrum. The first two are advisable only for the advanced users who are sure they know Bitcoin inside out, whereas Multibit and Electrum are the obvious choice for beginners wishing to try out the new currency.

Bitcoin: The Original Bitcoin Wallet App

It may give you a false impression that conterfeiting Bitcoin is easy. In fact, it would be a highly unfeasible task. Bitcoins can only be used if you install any of Bitcoin wallet apps on your computer, thus becoming a part of a vast Bitcoin user network. The said network has a very strict pre-defined way of bringing new money into circulation. Without delving too deeply into the technical details (if you feel brave you can look them up here), I can briefly state that it can only be issued by a whole specialized PtP network solving extremely complex math tasks through bruteforce. Each computer successfully solving one task receives a reward of 25 bitcoins. The complexity of the equations is constantly adapted to the total computing power of the solving network, so that new solutions can be issues according to a sophisticated algorithm, scheduled until 2140. By that time around 20 million Bitcoins are planned to have been generated. It is technically impossible to generate them in any other way or change the size of the planned final money stock. If someone wants to change any detail of this procedure, they will have to gain endorsement of the community's majority, otheriwse their versions of the wallet apps will be plain and simple illegit and their versions of Bitcoin will have no purchasing power.

Decentralized money?

This peculiarity of Bitcoin brings us to its another important feature of the new currency: it is not issued by any state or centralized authority. The only source of its value is an agreement of its users. In effect, should Bitcoin become the only currency used, the government will have no power to affect its value, say, by carrying out currency interventions. In fact, the state will be completely deprived of any means to pursue a monetary policy.

The rise of Bitcoin can also be the banks' Doomsday. So, here's how the banking system is supposedly working now:

It is obvious that if Bitcoin with its fixed amount of cash (well, of cash 2.0) prevails, the perpetual growth of the banking system can be ended. Even though it will still be possible to create money through loan giving, the overall amount of the circulating cash will stay constant, so money creation processes will be at the very least impeded.

A Fly in the Ointment

Of course, this all is not that easy as it seems to be at the first glance. Many of the economy experts are warning the Bitcoin trade is showing all characteristics of a market bubble like the Dot Com bubble back in 2000, which nearly ruined the IT industry back then.

Another concern of the experts is the electronic nature of Bitcoin. All transactions in the new currency are based on an RSA-like two-key mechanism (more about the RSA here). It means that as soon as malicious attackers crack your personal key, they get access to all of your money. Besides, all transaction details are fastidiously recorded in the Bitcoin network, so you can always track down the purchaser provided you have enough time and resources. On the one hand, it can be used against illegal drug and weapon trade, as well as money laundering, but on the other hand, it can mean the complete monitorability of all transactions within an economy. In other words, if some law enforcement organization rolls out a transaction surveillance system powerful enough, it can accumulate more power than Orwell's Miniluv could ever think of.

So, Bitcoin has its pros and cons. Undoubtedly, this is largely an ideologically colored project that can be risky if you are not completely sure you know what you're doing. Using Bitcoin also requires some technological expertise as you start using wallet apps, but the benefits it can bring to you can be enormous. The snag is, the losses can be enormous, too.

Update: Looks like the Bitcoin mining system is not that perfect as the community claims. This alarm message was posted on the official Bitcoin forum last night. The technical gobbledygook about what happened to the Bitcoin system basically boils down to the conflict between two versions of the client programs. Version 0.7 could not digest an unusually long transaction block, produced by the more robust version 0.8 and it led to splitting between the 'older' and 'newer' Bitcoin networks. If the Bitcoin community had not taken urgent (very urgent) measures, the split could have become irrevesible. Givs food for thought, doesn't it?