Good Thinking

The rise of Bitcoin: Bonanza or bust?

The rise of Bitcoin: Bonanza o...
The Bitcoin - global anarchist financial revolution, giant scam, great investment or some combination of all three? Either way, it's a remarkable story.
The Bitcoin - global anarchist financial revolution, giant scam, great investment or some combination of all three? Either way, it's a remarkable story.
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The Bitcoin - global anarchist financial revolution, giant scam, great investment or some combination of all three? Either way, it's a remarkable story.
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The Bitcoin - global anarchist financial revolution, giant scam, great investment or some combination of all three? Either way, it's a remarkable story.
Graph showing the value of 1 Bitcoin from 2009-2013. Created at bitcoincharts.com.
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Graph showing the value of 1 Bitcoin from 2009-2013. Created at bitcoincharts.com.

Money is a delusion – but a delusion that works as long as it's shared. The value of a US dollar was once tied to a government guarantee that you could, at any time, exchange it for a quantity of precious metal – but since America officially abandoned the gold standard in 1971, its value is now more or less rooted in its ubiquity. If large swathes of people decided they would no longer accept it, it would suddenly be worth a lot less.

Government currencies like the American dollar are also a bit odd, in that a government can decide to print more money at any time to serve its own purposes. This is very handy for the government, but through inflation it causes each individual dollar to be worth a bit less each time.

It's a problem that will persist with pretty much any currency that's managed by one central organization. And distrust of these organizations is one of the strongest driving forces behind alternative currencies like Bitcoin. The idea is to create an entirely new currency that's widely accepted, fairly stable, and more or less inflation-proof because the money supply can't be increased at the whim of some central figure.

So how do you create a new currency?

The answer, more or less, seems to be that you simply build it, convince people it's worth something, and give them an incentive to get on board.

Bitcoin was first proposed in 2008 – a fortunate time, since faith in the global banking hegemony and government control of money was crashing as the global financial crisis kicked in.

It was designed by "Satoshi Nakamoto" – a pseudonym, possibly for a group of anonymous designers who have never revealed themselves. Bitcoin's key selling points from day one were solid, trustworthy and transparent technology, a controlled money supply and a built-in early adopter bonus that made them very cheap to produce while the currency got off the ground.

The third point is probably the most important; Bitcoins are produced by getting a computer to crunch complex algorithms. Once a certain amount of work is done, you create a brand new bitcoin. That amount of work was very quick and easy early in the piece, so early adopters were able to churn out large numbers of coins. But the algorithms are designed to become progressively more difficult over time, until a point some time around 2040 when the supply will be capped forever at around 21 million bitcoins.

Effectively, if you got in early, you could use your personal computer to churn out thousands of bitcoins – giving early adopters a heavy incentive to find things to do with them. But now, the Bitcoin mining process is already so difficult that you need a specialized rig bristling with dozens of graphics cards to make any decent progress.

This gradual restriction of supply is what Bitcoin advocates maintain makes the currency inflation-proof. There's no such thing as "quantitative easing" in the Bitcoin world. In fact, as the money supply crawls to a stop, the currency should deflate over time, making each bitcoin increase in value.

Of course, it also makes the Bitcoin system look a lot like a pump and dump scam as well – early adopters mined huge amounts of bitcoins early on for very little effort, and stood to gain huge amounts of cold, hard, non-virtual cash if they could convince other people the bitcoin was worth something. But let's backtrack a little before we explore that.

How bitcoins work

The most important feature of a digital unit of currency is that ownership can be authenticated, and the money can't be spent twice. You can ensure this by keeping a central ledger somewhere of who owns exactly which bitcoins – but the genius of the Bitcoin system is that this ledger is completely decentralized and run as a peer-to-peer system like the BitTorrent network.

When you make a transaction, the Bitcoin network sends out a notice and a confirmation process takes place. In this confirmation process, the transaction history of the particular bitcoin being moved is checked against the records of a number of different nodes in the system. Only when several nodes "agree" that the bitcoin is authentic does the actual transfer occur.

A bitcoin itself is just a string of letters and numbers – the system would be vulnerable to all sorts of hacks if it wasn't for this peer-to-peer tracking system. And although the bitcoin's entire transaction history is sent around the network for checking, it's only a series of bitcoin wallet addresses that are used, rather than account names – making it virtually impossible to work out exactly who owned the coin in the real world.

This also makes it virtually impossible to prove you owned a bitcoin if you misplace its alphanumeric code. If you delete your wallet file or forget your passwords, your money is gone forever.

Getting money in and out of the Bitcoin system

First off, you need a wallet. You can either download the original Bitcoin client and run it on your own computer, or you can trust a third party online service like MyWallet to take care of it for you. From there, there's a number of ways to buy bitcoins with regular cash. You can strike a deal directly with another bitcoin owner over at Bitcoin OTC, use a big-time currency exchange like Mt.Gox or any number of others.

If you want to keep your identity as far away from the transaction as possible, you can use a cash deposit service like bitinstant – you notify the service that you want to buy X dollars worth of bitcoins, they give you some deposit details, and you simply walk into a bank (or another deposit location like a 7-11 or Walmart store) and drop off the cash with a given account and reference number. Once the transaction is verified, the bitcoins are transferred to your ownership. The process takes less than an hour and costs you a four percent fee.

To get money out of the system, you've got to effectively sell your bitcoins. The easiest method is probably to register with a big exchange, sell your coins and have them transfer the money to your local bank account.

There's other services that will pay you back through Paypal, vouchers and all sorts of other options – and if you want to keep things totally anonymous, you can always strike a deal directly with somebody who wants to buy the bitcoins, and dodge the transaction fee in the process.

What's a bitcoin worth?

Graph showing the value of 1 Bitcoin from 2009-2013. Created at bitcoincharts.com.
Graph showing the value of 1 Bitcoin from 2009-2013. Created at bitcoincharts.com.

As I write this, close to US$30. Here's a live update. The currency is still pretty volatile, its value changes constantly. If you'd bought yourself a bitcoin in December last year, you'd have doubled your money in the last 50 days.

That's nothing compared to the gains the early adopters have made, though – bitcoins were worth literally nothing back when the system went online in January 2009. They were trading for less than US$0.10 back in September 2010, and only broke the US$1 mark in February 2011. They spiked up to US$27 in May 2011, then crashed down to US$3.50 within a couple of months when Mt.Gox and MyBitcoin were hacked, resulting in a leaking of user information and some straight-up bitcoin theft.

Right now, it's riding higher than it ever has and spiking upwards like crazy, and there's every chance you can still make money as a speculator – as well as every chance that it'll crash again before 2014.

What can you buy with bitcoins?

Lots of things. Bitmit is like a sort of Bitcoin eBay, although its most popular items are cash buybacks, electronics components, video games and the odd porn site membership.

There's a heap of traders that accept Bitcoin payment listed on the Bitcoin wiki, selling everything from photographic services, to pizzas, to coffee beans and hotel stays.

Of course, most people don't get into anonymous crypto-currencies to buy coffee beans. The anonymous nature of the service also opens the door to the online black market, and this is where Bitcoin seems to have made its biggest mark.

Through deep-net, highly encrypted and anonymous sites like Silk Road, you can have an astonishing array of illegal drugs sent straight to your doorstep through the post in virtually undetectable fashion. Silk Road deserves its own article – it's fascinating.

Through other sites, you can order pretty much anything from weapons to the services of a hitman. It's all anonymous, so trust is paramount and there's a lot of scammers out there trying to take you for a ride, as well as plenty of ways to expose yourself to the risk of being caught.

And of course, you can use bitcoins to send money to organizations like Wikileaks or The Pirate Bay, even if payments are blocked by organizations like PayPal or Visa.

Pros and cons of bitcoins

Pros:

  • They're more or less anonymous if you take the right precautions, meaning your transactions can't be tracked or taxed
  • They will never devalue due to inflation - in fact, a slow process of deflation is built into the algorithm
  • There is often no transaction fee when moving bitcoins
  • You can buy things with them
  • You can trust the authenticity of your bitcoins, and prove your ownership of them
  • You can speculate on bitcoin values by buying and selling them as the market fluctuates

Cons:

  • Like U.S. dollars, they have no inherent value. If other people don't want them, they're worthless
  • Bitcoins will never be any good for over-the-counter or face to face payments, because every time you make a transaction, there's a roughly 10 minute wait as the network validates the bitcoins' ownership. This wait will get longer in the future, too.
  • Like cash, if you lose your Bitcoin wallet, you lose your money
  • Currently, the most popular uses for bitcoins seem to be speculation, scams, money laundering and black market contraband sales. This is not escaping the attention of the authorities. However, it remains to be seen if they can actually do anything to stop it
  • They can be stolen

A couple of final thoughts about Bitcoin

There is definitely money to be made in this system for smart operators. Of all the attempts at creating an anonymous digital currency, Bitcoin is far and away the most successful to date.

But there's still a few reasons, beyond just the bitcoin's volatile value, to pause before you jump in with a substantial amount of your own money.

Firstly, while there are more than 1.8 million registered Bitcoin users, a large amount of the money seems to be concentrated to a few users. We know this, because while it's totally anonymous, you can get a hold of the entire transaction history for the network. In October 2012, this report was released showing that the vast majority of Bitcoin accounts hold very small amounts of money, more than 75 percent of all bitcoins are being hoarded instead of being spent, one anonymous figure holds around 25 percent of all the bitcoins in circulation, 90 percent of Bitcoin traffic seems to be speculative trading and not goods and services purchases, and it seems as if other large holders are trying to shift their bitcoins around a lot to conceal exactly how much they own.

So while Bitcoin advocates point to the fact that the currency is definitely being used for goods and services to prove that it's not some sort of giant Ponzi scheme, it's also irrefutably true that the vast majority of existing bitcoins aren't being used at all. And while the idea of the whole system is to create a currency that's not at the mercy of some central administration, you could easily argue that a few key figures hold a huge amount of power over the bitcoin's value.

Secondly, if one person or group were to control enough "nodes" of the Bitcoin checking system, it's theoretically possible for that group to change the rules and start fraudulently awarding itself money. You'd need to control a lot of the network to make it happen ... But then, according to some sources Deepbit's mining collective already clears more than a third of all Bitcoin transactions.

And thirdly, there is an awful lot of genuinely dodgy stuff going on in this system. From hacking and theft, through scams and money laundering, to illegal contraband sales, there's a reasonable chance that any bitcoin you buy is directly or indirectly helping bad guys do business. But then, it's up to you whether that's better or worse than giving your cash to a national government, isn't it?

25 comments
Grammar Nahtzi
Deepbit is less than 10% of the network.
James Mead
Bitcoin is A number 1 - OK!
Steven Dakh
Hey man! Awesome article! This is one of the best Bitcoin articles I've read. Just wanted to point out one thing. For over the counter transactions, it wouldn't really be a problem because to do a double-spend attack, you would have to be the first node that the stores computer connected to. This could easily be mitigated. The transaction would be weeded out by all the other nodes it hits before it gets to the store. Any major attack would be rare and OTC transactions would be relatively small so it's well worth the risk especially if you know within 10 minutes if you were scammed. Maybe we all have to build a secure buyer/seller trust system to protect each other and build ratings. Thanks!
Zafolo
Overall a good article, it got only a few minor points wrong. This is no shame as Bitcoin is a complex topic. First, the article says "Bitcoins will never be any good for over-the-counter or face to face payments, because every time you make a transaction, there's a roughly 10 minute wait as the network validates the bitcoins' ownership. This wait will get longer in the future, too." It is correct that a normal payment requires a number of confirmations which are issued in average every ten minutes. The frequency of confirmations will not decrease. However, if you use sites like MtGox and send bitcoins from trusted addresses, the receiver could trust that address and accept the payment instantly. Look up the topic of "Green Addresses" in the bitcointalk.org forum. Maybe this is once useful to buy coffee or some magazine in Gare du Nord. A second thing is that the mining pools do not allow a 50 % attack by their structure and the incentives Bitcoin gives. The miners own bitcoins and have invested a lot of time, money and hardware to profit from it. They do not have incentive to corrupt the block chain. It is also not easy to generate corrupt transactions, as all old transactions are confirmed constantly by the system, adding new layers of cryptographic security. Think of a bunch of notaries signing over and over a common ledger with the signatures of their fellows. This is what the bitcoin network does. To break the ledger, you would need to fake _all_ the signatures. The third thing is the perceived power of the unknown holders of the large part of existing bitcoins. You can argue that the disparate distribution of wealth is unjust, and I would agree. But Bitcoin effectively dissociates wealth from power. The only power these people have is to sell their bitcoins. It is not the same thing to be a John D. Rockefeller, and to just own the amount of money as he. The fourth point is the use of Bitcoin in the net. With sites like WordPress.com, Reddit, Mega, or companies like Memory Dealers, there are already many millions of users which can send bitcoins to pay their services. Also, it is possible to buy things like Amazon gift cards which are a kind if intermediate currency. The fifth point is the thing with the Bitcoin shadow economy. While such things as Silk Road certainly to exist, they are greatly exaggerated and I feel the author couldn't resist the urge to add a fascinating dark note to the article. In the medium term, Bitcoin will be much more effective for migrant workers living abroad sending support to their family. An especially low point is mentioning of hit men which are supposed to work for bitcoins. These offers are certainly either scams or set up by the FBI. If you ever want to kill somebody, you need at least to be a bit more intelligent (but I guess your wish would be probably part of that latter problem, too).
Daishi
I'm not familiar with Bitcoin but my first observation is that if Bitcoins were worth $3 a year ago and $30 now it seems to fluctuate by quite a lot (more than standard currencies and even significantly more than the stock market) Doesn't this huge amount of fluctuation sort run counter to the principals that would typically be desired in a currency? Sure normal currencies have inflation but bitcoin doesn't eliminate that fluctuation, it just reverses it and at least right now at an alarmingly more rapid pace. It was already almost $30 once around June 2011 before it dropped to around $3 in December of 2011 so it's certainly not immune to a rapid decline in value that surpasses inflation.
Henry Brade
The article is relatively neutral, but there is a high number of fallacies. I will try to correct some of them. "But the algorithms are designed to become progressively more difficult over time, until a point some time around 2040 when the supply will be capped forever at around 21 million bitcoins." The algorithms in Bitcoin are not designed to become more difficult over time. The difficulty of Bitcoin "mining" is entirely dynamic, and it's based on how much computing power the network has at any given time. Mining has become more difficult over time due to increased competition. It is true that the amount of new bitcoins awarded for participating in Bitcoin mining will halve every 4 years, which is almost the same as an increasing difficulty. It's not the same, however. The article also misses on the fact that the main purpose of Bitcoin mining is to confirm Bitcoin transactions and to make it possible for a decentralized ledger to work at all. Creating new bitcoins is a secondary function which acts more as an incentive for people to help maintain the network. Anyway, the overall difficulty of Bitcoin mining and the increased difficulty of earning coins that way has more to do with increased competition than it has with any inherent algorithmic rule. "Of course, it also makes the Bitcoin system look a lot like a pump and dump scam as well – early adopters mined huge amounts of bitcoins early on for very little effort, and stood to gain huge amounts of cold, hard, non-virtual cash if they could convince other people the bitcoin was worth something." It's quite important to note that every new technology has early adopters, it applies to any technology startup for example. There are also risks involved, most new technologies and companies fail. Bitcoin hasn't failed, and this has obviously been good for the early adopters. They were the people who made it happen, so they deserve it. When do you see Google founders blamed for orchestrating a pump & dump scheme? There is absolutely no difference between Google and Bitcoin. Early Google investors are now quite rich because they were early adopters. Bitcoin is a highly useful monetary technology, it can only be misunderstood as a pump & dump if one does not understand its usefulness. That is not the fault of Bitcoin, it's the fault of the person who hasn't researched it enough. "What can you buy with bitcoins?" This whole section seems a bit 2011. That's when Silk Road was the centerpoint of Bitcoin. These days Bitcoin is used increasingly for international money transfers, as an alternative to sensoring payment services such as PayPal. It's exploding in online gambling. Porn sites are starting to accept it. Major online services such as WordPress, 4chan, Reddit, Mega are accepting it. Bitcoin Store was opened, which competes with Amazon. It sells over 500,000 products, often cheaper than Amazon. And only for bitcoins. Payment processor BitPay alone has 2,700 merchants these days, etc. And as far as I know, you actually can't buy guns or hitman services from Silk Road and similar sites. Most or all of that are scams. Guns were sold at one point in a site called Armory but they closed it. Silk Road is mostly used for drugs and prescription medicine. "Pros and cons of bitcoins" (this section had a high amount of fallacies) "They will never devalue due to inflation - in fact, a slow process of deflation is built into the algorithm" There is no deflation built into the algorithm. Deflation of the monetary base would mean a reduction in the amount of bitcoins. Bitcoins are inflating at a slowing rate until there is a fixed amount of them. The only deflation that will happen is due to lost coins, which is negligible. If we're talking about price level deflation, that has nothing to do with the algorithm either. Bitcoin will experience deflation if there is growth because of the fixed amount of money, but only if there is growth. Deflation doesn't happen by itself, nor has the algorithm anything to do with that. "Like U.S. dollars, they have no inherent value. If other people don't want them, they're worthless" Bitcoins have no inherent value, true, but it's a common mistake to believe that any currency has any significant value besides the faith people base in it. Even gold has only very limited inherent value, it's shiny and used in jewelry, it has properties that are useful in electronics. How much of gold's current value is based on that? 10% at most. Everything else is based on gold's monetary properties, which are excellent. Fact is, Bitcoin has those same properties, and other properties that far exceed gold's capabilities. "Bitcoins will never be any good for over-the-counter or face to face payments, because every time you make a transaction, there's a roughly 10 minute wait as the network validates the bitcoins' ownership. This wait will get longer in the future, too." This is false. First of all, the wait to validate Bitcoin transactions is never getting longer. It's fixed at 10 minutes per confirmation. The system automatically adjusts it to 10 minutes every 2 weeks. To be absolutely sure a transaction can't be counterfeited, one needs to wait at least 3 confirmations, or 30 minutes on average. However, double spending a transaction in the stage before confirmation is in itself fairly difficult. If the merchant has taken some precautions, only the first 10 seconds is a real problem. Thus, at least with small amounts, Bitcoin is reliable enough for OTC as well. It's much more likely that merchants suffer from credit card fraud. On top of this, Bitcoin can be supplemented with escrow. There is a system called "green addresses" which means that a trusted site handles the payment through a green address, which the merchant trusts 100%. Then the merchant can accept instant transactions. "Like cash, if you lose your Bitcoin wallet, you lose your money" Unlike cash, you can backup your bitcoins, and keep your Bitcoin wallet encrypted with a password at all times. This means that a smart Bitcoin user can recover from both a computer malfunction and a theft. Bitcoin wallets can even be set up with 2 factor authentication, meaning that a code needs to be entered from a second device such as a smart phone. Then even key loggers are useless for stealing bitcoins. "They can be stolen" Indeed, but so can anything else.
Alastair Carnegie
Thanks Bitcoin Criminals, you are providing us with invaluable information. Especially as the myth that factoring large dual-prime composite numbers is allegedly 'asymetrically complex'. When in reality a very elementary algebraic method exists within ultra polynomial time constraints. Here is a hint,:- "You don't need a 'Sieve of Eratosthenes' to factor 10057, because 101 x 101 = 10201, subtract the dual prime composite, and the remainder is 12 x 12, and 101 + 12 = 113, and 101 minus 12 is 89. ...113 x 89 = 10057." The polunomial time method is only slightly more complicated, and can factor any large dual prime or multi prime composite in milliseconds, with arbitrary precision calculator software. The Royal Military Police Surveillance Division are very grateful to Bitcoin for the valuable intelligence. Thanks!
Gavin Andresen
RE: large dual-prime composite numbers: Bitcoin doesn't use RSA public keys, so I suppose we're safe from the Royal Military Police Surveillance Division for now (phew!). If you want to worry about police surveillance, I would be more worried about that little tracking device that we all carry around with us known as our "mobile phone."
EUbrainwashing
This is the clearest article I have read yet explaining the nature of Bitcoin. The fact is that I am still muddled by it - sure I would have a dabble but how can I consistently price my products if the value of the Bitcoin is up and down? I would have to offer a price in an established national currency and accept Bitcoins at a quoted rate. That makes Bitcoin a payment method and not a currency. I am reasonably computer literate having owned a PC computer since 1986. I am in business and I deal all over the world with reasonably big chunks on money. Frankly: if I don't 'get it' who will? If I cannot see how I can use Bitcoin to conduct my regular UKP 100,000+ export transactions I suspect not enough other people will either for Bitcoin to reach a meaningful critical mass. One of the BIG problems with the existing money system is people don't understand it either; they don't know where money comes from, how it works, who produces it. But it is backed with the power of the nation state (whatever the hell that means but it is more than enough for most folk to buy into). If Bitcon was produced, underwritten and guaranteed by eBay/PayPal or MercedesBenz or Sony or Tesco or some such other ghastly corporate enterprises with strong trusted brand profiles the public may just base their decision on blind faith in band confidence. With Bitcoin being a difficult to understand protocol and of unknown robustness it is not going to change the world (in my humble esteem).
Jim Pelkey
What if they changed their name to the Federal Reserve Bank; would that make it any safer and believable?