‘Change’ in Your Wallet? Bitcoins and the Future of Money

 

When credit cards first arrived, there were legions of skeptics who were not impressed. Today, cash comprises less than 7% of the money supply in the US. Most of us carry multiple credit cards and a world without them is almost unthinkable.

 

More recently, online bill payment has suffered from the same malady. The fact that banks routinely provide this service for free, and sending a check in the mail actually costs you money in stamps, envelopes, checks etc. is not enough. The cynics are adamant, and there are plenty of them around.

 

Get ready. Another change is in the offing.

 

It is still early days, but a revolution is in the making. Names like Bitcoin, Litecoin, Ripple, Namecoin, PPCoin, Terracoin, DigitalCoin etc. are entering our consciousness and the media is beginning to follow with interest.

 

You know it is getting serious when Congress and the Feds take note. Last week, on August 13, 2013 the Senate Committee on Homeland Security announced plans to probe Bitcoin, the digital currency, and the regulatory regime (or lack thereof) that governs it. 

 

For the moment, let’s answer some basic questions on Digital Currency and how it works.

What is digital (and crypto) currency?

Digital currency is electronic money that acts as alternative currency. This currency is not produced by any government-endorsed central banks. But it is real money and can be used to buy goods and services.

Cryptocurrency is a type of digital currency and Bitcoin, is an example of a digital cryptocurrency.

More about Bitcoins.

Bitcoin is the most famous of the cryptocurriencies. It first made an appearance in 2009 and was created by Satoshi Nakamoto, a pseudonym for a person or group, whose identity still remains unknown.

Once acquired, Bitcoin resides in digital wallets and is paid from there. You don’t need a computer for that.

 

Bitcoin has no regulator and only exists in a peer-to-peer network that is verified by its users.  (More on that below). Bitcoin lets you send money to anyone online, anywhere in the world, and for less than one cent per transaction. So, it has very low overhead and virtually no extra charges.

 

Bitcoin has speculative value (like other regular currencies) and can also be changed into other major currencies. The price of a Bitcoin spiked to an all-time high of $266 on April 10, 2013. It currently hovers at $ 114.

 

How do you get Bitcoins?

There are two ways to get Bitcoins. You can create them, or buy them in the open market.  Most of us reading this will buy them with our “normal” money. 

 

But Bitcoins are first created by a process called mining.

 

 

What is mining? Think of this as the ledger the old guy atop the pulpit in Mary Poppins has at the bank.  All transactions with Bitcoins must be captured in this one big electronic “book”.  Each new transaction is crossed-checked in the “book” to verify that Jack indeed has the 200 Bitcoins he says he has and that he is now giving them to Corporation Z (in return for some service or goods).  Once the transaction is verified, it gets added in the “book”.  And the process continues.

 

For the technically inclined, a little more detail in the blue font below:

 

·         Mining is a process which collects Bitcoin transactions from the internet (e.g. John pays Susan 5 Bitcoins etc.) and bundles them into blocks.  Since there is no central authority, the transactions have to be verified in a peer-to-peer network of computers.

·         These blocks strung together, create one authoritative block chain which does not allow any duplicate blocks, and is a list of all transactions approved to date.

·         The way Bitcoin makes sure there is only one block chain is by making blocks really hard to produce. So instead of just being able to make blocks at will, miners have to compute a special cryptographic hash of the block that meets specific criteria.

·         Mining for Bitcoins involves an enormous amount of computer power. (Recently the Australian Broadcasting Corporation caught an employee using the company's servers to generate Bitcoins without permission). Bitcoin has reached a stage where miners are using special machines that are useless for anything else.

 

 

·         The difficulty of the criteria for the hash is continually adjusted based on how frequently blocks are being found. So, it doesn’t get easier. This also allows Bitcoins to be produced in a predictable and limited rate.

·         When you do hit the lottery and find a hash “good enough to count”, you get rewarded with Bitcoins.

·         Bitcoin circulation will not exceed 21 million and a little over 11 million have already been mined. The prediction is that block #6,929,999, which will take the total number of coins in circulation to its maximum level of 20,999,999.9769, will not be generated until 2140.

·         If 21 million coins doesn’t sound like a lot for an entire currency, then consider how a single Bitcoin can be divided. Most currencies have two decimal places e.g. $1.00 is 100 cents. Bitcoin is different – it has eight decimal places. With 21 million Bitcoins in circulation, that’s a total of 2,100,000,000,000,000 smallest ‘units’ of currency when the network is operating at full capacity. 

All of this sounds like a lot of geeky work, and frankly, it is.

What if you just wanted to go out and ‘buy’ some Bitcoins? Well, there are several currency exchanges which allow you to buy Bitcoins.

These include Mt. Gox, Bitstamp, CampBX, Intersango, Virtex  etc. 

 

What can I actually buy with Bitcoins?

Merchants around the world accept these currencies. From bakeries in San Francisco, a sock manufacturer in Massachusetts, online casinos to even a dentist in Finland. They all accept Bitcoins.

·         An increasing number of physical stores, restaurants and other venues accept Bitcoins as well.  You can find lots of Bitcoin-related services on the Bitcoin Wiki.

·         You can check out Bitcoin's largest online auction house at http://www.bitmit.net

·         Turn your Bitcoins into gift cards from Amazon, Barnes & Noble, iTunes and many more at SpendBitcoins.com.

·         Or buy music, ebooks and other downloadable content at CoinDL.com

 

Is all this safe?

The source code for Bitcoin is free and is public, which means that just about every hacker in the world has had a crack at it. And thus far, they’ve all come to the same conclusion: surprisingly, it really works.

But this does not mean there have not been Bitcoin thefts.

·         On 19 June 2011, a security breach of the Mt.Gox Bitcoin exchange caused the nominal price of a Bitcoin to fraudulently drop to one cent on the Mt.Gox exchange, after a hacker allegedly used credentials from an Mt.Gox auditor's compromised computer illegally to transfer a large number of Bitcoins to himself.

·         In September 2012, Bitfloor, a Bitcoin exchange, also reported being hacked, with 24,000 Bitcoins being stolen.

·         On 3 April 2013, Instawallet, a web-based wallet provider, was hacked resulting in the theft of over 35,000Bitcoins worth $4.6 million

·         Just this past week, Google has confirmed the existence of a critical Android flaw that put Bitcoin wallets created on Android devices at risk of theft. 

·         Now Systech, a high profile digital forensics company is offering a Bitcoin tracing service.

 

 

Here is where this gets more interesting (and why they are becoming so popular…)

In July 2013, Cameron and Tyler Winklevoss, the twins best known for their part in the creation of Facebook, filed a proposal with securities regulators that would allow any investor to trade Bitcoins, just as if they were stocks. The twins also own 1% of all Bitcoins that have been mined to date. They are betting on Bitcoins. 

 

 

When Cyprus (and then Spain) went through financial doldrums earlier in the year and the government was threatening to take over the bank accounts of ordinary citizens, Bitcoin use spiked.

Even with trade sanctions, there is one currency in Iran that has kept its value and can be used to buy goods from abroad: Bitcoins.

Bitcoins are also the currency of choice for a number of illegal activities. This is in fact the reason for Congress’s interest in Bitcoins.

The Silk Road, is a marketplace hidden in an anonymized part of the web called Tor. On June 1, 2011, Adrian Chen published an article headlined “The Underground Website Where You Can Buy Any Drug Imaginable”. Carnegie Mellon Professor Nicholas Christin studied the Silk Road and concluded that law enforcement authorities could stop it by disrupting its use of Bitcoin. All of this caused an uproar and Senators Joe Manchin and Chuck Schumer wrote to the Attorney General and demanded that the Silk Road be taken down (a futile request in this world of globalized networks).

Bitcoins still are the only currency accepted on the Silk Road and with online arms merchant Executive Outcomes too.

And finally, Bitcoins are anonymous, so no TAXES. Think about that….the Cayman’s and their safe-haven cousins are all paying very close attention.

What about other variations of digital currencies:

There are several other variations of Bitcoin, each experimenting with some of the shortfalls of Bitcoin.

Litecoin is less dependent on the activity of a small number of dedicated miners with expensive equipment, and allows a larger pool of miners to compete. It is also able to validate transactions in a few minutes, much faster than Bitcoin (which can take 10-60 minutes).

 

 

PPCoin’s design is intended to gradually phase out conventional mining altogether. Instead these are awarded in a kind of lottery.

 

 

You discount digital currency at your own risk. Admittedly this is still an experiment. But, a lot of good ideas start as a techie experiment. The internet itself, was one such experiment. Digital currencies are not going away. They are changing and adapting to the customer and even to the regulators. There is a desire to play in the mainstream of payment options. Traditional financial product companies are looking on with great interest and even perhaps even a little angst.

Could Digital Currency put the makers of leather wallets out of business? Time will tell.