Unwrapping the riddle of Bitcoin
In a 1939 radio broadcast, then British Prime Minister Winston Churchill described Russia as "a riddle, wrapped in a mystery, inside an enigma."
Were he alive today, Churchill might use the same words to describe Bitcoin — not only for its vaunted user anonymity, but also for the "rabbit out of a hat" way that bitcoins are created, valued, traded and secured.
'Bitcoin for Dummies'
The first thing to know about Bitcoin is that it has no direct correlation to "value for work" — at least, not human work.
Fiat currency arose out of a barter system that said "My beef critter took twice as much work to raise as your pork critter. Hence, I will trade my beef critter for no less than two pork critters."
Because livestock is hard to pocket, we ended up with a representation of its value, i.e., currency.
Bitcoins arose from a computer program that says "His computer can calculate math problems twice as fast as your computer. Hence, he gets 50 bitcoins for his computing power. For yours, you get nothing."
Seriously, that is how it works.
The nuts and bolts
Bitcoin is the brainchild of a Japanese IT whiz who developed the concept as an experiment in virtual currency. Nobody knows for sure who he is and nobody's heard from him for about two-and-a-half years.
Bitcoins are generated (or "mined") by the following process: Cryptographic puzzles are random-generated at a controlled rate by a computer program, then transmitted to a network of volunteer Bitcoin "miners."
Using an open-source software program and powerful computer processors, miners crunch insanely complex calculations to solve the cryptographic puzzles. The first miner to solve the puzzle receives 50 bitcoins.
Naturally, the more processing power a miner has, the faster he can solve the cryptographic puzzles and the more bitcoins he can accumulate. The program will generate puzzles until 2140, when it hits a limit of 21 million bitcoins.
Technically, anyone with a computer and a download of the open-source Bitcoin software can become a miner. However, as more miners enter the system two things happen: 1) problems get harder; and 2) processing power escalates. Resultantly, mining has become the purview of network-operating professionals — don't try it at home.
For what it's worth ...
Bitcoins are sold (anonymously) through online exchanges to (anonymous) buyers who keep their bitcoins in an (anonymous) digital wallet to which only they have the cryptographic key. Lose your key, lose your bitcoins.
The initial bitcoin price was set by miner concensus; the first bitcoin transaction was the purchase of two pizzas for 10,000 bitcoins, which were transferred to a Brit who called a U.S. Papa John's to place the order using his credit card. As of this writing, a bitcoin is worth $87.57 — or $437,850 per pizza.
Today pricing is driven by demand, which comes from several quarters:
- users who are convinced that the world financial system is headed for collapse — during the Cyprus bank panic, bitcoin prices spiked to $266 (then dropped within hours to $160);
- users who want a cloak of anonymity for their illegal trade — in drugs, arms, humans, NSA secrets, etc.;
- users who think virtual currency is a cool concept — Millennials and heavy tech users;
- speculators who think the other groups will keep driving up the cost of a limited commodity.
Transactions are verified by an entire block of network computers to prevent double-spend, and payments are irrevocable.
Bitcoins can be used for legal purchases at about 900 websites and a tiny, but growing, number of brick-and-mortar retailers. In relative terms, though, the numbers are infinitesimal.
An impenetrable paradox?
Bitcoin's intentional lack of transparency is its beauty — and its bête noir.
The U.S. Treasury recently declared that any entity engaged in the exchange of virtual currency for fiat currency must register as a currency exchange and take steps to prevent money laundering.
(Naturally, this makes the launch of the Bitcoin ATM problematic. The machine's developers have solved this dilemma simply by deciding to stay out of deployment and make AML the operator's problem.)
To prove it wasn't joking, the Fed shut down activity on Dwolla, the company that transacts online payments for the world's largest Bitcoin exchange, Tokyo-based Mt. Gox. This persuaded the Japanese giant to rethink its no-registration stance and file an exchange application with the U.S. Treasury.
Also recently, the DEA marked a first, seizing a Bitcoin account belonging to a man arrested for drug dealing on the Silk Road, a black market site on the "deep web," which is accessed with browsers you won't find bundled with Windows 8 or Snow Leopard, and which is notable for the secrecy it affords criminal traders.
No one is certain (or saying) how the Feds cracked the deep web and singled out one suspect's Bitcoin account. What is certain is that they proved anonymity can be breached, which squashes one of Bitcoin's most powerful assets and brings the long-term viability of the currency into question.
Another problem: Bitcoin exchanges can also be hacked. Thieves have already carried out some impressive Bitcoin hacks. Did we mention that Bitcoin is not FDIC insured?