Ever since the dawn of civilization, mankind has used currency in exchange for goods and services. Originally, currency was intrinsically valuable because it was made from precious metals. Currently, our currency is made valuable by trust: trust in the government that issued it to honor its value, and trust in the market to accept and use it as a valid form of currency.
Very recently, a group of techies and risk-taking investors have embraced a new form of currency that takes the idea of trust to a whole new level. Bitcoin and other crypto-currencies, named as such because the foundations of their transaction schemes are based in cryptography, are digital currencies whose entire value are based on the digital market's willingness to use them.
Bitcoin originated in early 2009 when a computer scientist, working under the pseudonym Satoshi Nakamoto, released a paper describing the currency in theory and an open-source program to generate and store the currency.
The fundamental theory behind Bitcoin is that the entire transaction history of the currency is stored in a public ledger. As new transactions are added to the ledger, users called miners verify the transactions by running a program that performs complex mathematical calculations using information about the transactions. As a reward for successfully verifying transactions, miners earn newly minted Bitcoins. As more Bitcoins enter the market, the process of verifying transactions, and thereby minting new Bitcoins, becomes increasingly difficult until a cap is reached at 21 million Bitcoins. At this point, no more Bitcoins may be minted.
In practice, using Bitcoins need not be so complicated. In order to own Bitcoins, one does not have to perform calculations or mine transactions. Using one of many online Bitcoin exchanges, anyone can purchase Bitcoins using traditional currency. Bitcoins bought through an exchange or mined are stored in digital wallets. Wallets are essentially an address that is assigned a number of Bitcoins in the public ledger.
To use Bitcoins to make or receive payments, transactions are made. To initiate a transaction, the payer only needs the public address of the payee's wallet. A transaction request is made, and once the transaction is verified by miners, the transaction is completed. In an instant, the transaction amount is removed from the payer's wallet and credited to the payee's. As awareness of Bitcoin increases, a growing number of online retailers has begun accepting payments via Bitcoin transactions.
Personal identities do not need to be associated with Bitcoin wallets. Due to this level of anonymity, Bitcoins have been been linked to illegal activity almost since their creation. It's been estimated that half of all Bitcoin transactions made are online gambling bets. The recently shutdown online drug exchange, the Silk Road, dealt exclusively in Bitcoins.
Proponents of the digital currency are quick to mention the pros of using it: Transactions occur in a matter of minutes rather than the many days traditional bank transfers take; transaction fees are significantly lower than traditional currency transfers, allowing large sums of money to be moved around for very little cost; and ledgers and transactions are distributed and verified by many different individuals to ensure accuracy and fairness.
However, there are downsides to trusting Bitcoin. Since the currency's value is purely speculative, its exchange rate is set by the whims of the Bitcoin market and can fluctuate wildly. At the time this article was written, Bitcoins were trading at $1,186 on MtGox, one of the largest Bitcoin exchanges. One month ago, they were trading at less than $200 on the same exchange. One month from now, they could be trading at $200 once again, or perhaps $2,000.
In addition, the Bitcoin market is still relatively new and lawless. It is not uncommon for Bitcoin exchanges to suddenly disappear, taking all the Bitcoins they are storing on users' behalf along with them. Theft is common because of poorly designed exchange software accidentally giving away users' secret keys. Recently, the underground Bitcoin exchange Sheep Marketplace went dark, taking an estimated $100 million worth of users' Bitcoins with it.
While there are pros and cons to Bitcoins as a currency, it cannot be denied that Bitcoin is an interesting experiment into the nature of money. If digital currency is to be the future of economic systems, Bitcoin may end up being seen as the pioneer that led the way for the digital economic revolution.