Bitcoin is one of the most fascinating and least understood phenomena of our times. It is either the future of money and commerce, a doomed experiment by libertarian idealists, or the subversive and dangerous tool of hackers and digital pirates – depending on who you ask.
In this article I’d like to look past the hype and get to the truth of what bitcoin is, and what it isn’t. I’ll explain the theory and the history of bitcoin, it’s implications and potential for the future, in everyday language that you don’t have to be a mathematician or a programmer to understand.
Let’s start by taking a look at the origins of Bitcoin, and how the whole thing got started.
The Rise of Bitcoin
In November of 2008 a paper was posted online entitled Bitcoin: A Peer-to-Peer Electronic Cash System. It described in detail how to create and operate a digital currency using a decentralized, peer-to-peer network, similar to file sharing systems like Napster. The paper was released under the pseudonym “Satoshi Nakamoto.” The true identity of the author remains a mystery, and the subject of much speculation.
It didn’t take long for the theory to become a reality. Bitcoin version 0.1 came out in January of 2009, and the first bitcoins were “mined” by the mysterious Nakamoto. Early adopters were mostly cryptographers and anarcho-activists, who embraced Bitcoin because they believed in the principle behind it: the idea of a decentralized, open source economy. For them, Bitcoin represented anonymity and freedom – freedom from government regulation and costly bank fees.
In those days, the currency had little “real world” value. The first time bitcoins were used to actually purchase something was in 2010, when Laszlo Hanyecz, a programmer from Jacksonville FL, paid a fellow bitcoin enthusiast 10,000 btc (valued at about $25) for a couple of pizzas from Papa John’s.
2011 saw the launch of the Silk Road, the online drug marketplace which used Bitcoin to enable users to send and receive payments anonymously – something never before possible. While many Bitcoin enthusiasts do not support or condone the Silk Road, there is no denying that it was a driving force behind the rise of the new currency. The so-called “eBay for drugs” provided an infrastructure and an incentive that didn’t exist before, opening up a vast new market for bitcoin spending, and introducing a whole new audience to the potential of digital currency.
On February 9th, 2011 the value of a bitcoin reached $1 for the first time, sparking a wave of media attention. But even though the mainstream was beginning to catch on, the price stayed relatively flat for the next two years.
2013 was the year of the “Bitcoin boom.” The price climbed up above $200 in the spring, before a hacking incident at Bitcoin Central destroyed confidence and the price crashed. Then in November, despite the recent closing of the Silk Road, the price skyrocketed to an all-time high of $1242. Remember the guy who paid 10,000 BTC for two pizzas back 2010? Those coins would have been worth more than $12 million. Hope they were tasty, Laszlo…
But What Exactly Is A Bitcoin, Anyways?
Bitcoin is a digital cryptocurrency, which means that 1) there no physical bills or coins, they exist only in digital form, and 2) that they are secured by encryption. It’s also a network of users working together to process and verify transactions. Without the network, the currency doesn’t exist.
But don’t think that because bitcoins only exist in the digital world, that they aren’t real. Bitcoins are every bit as real as your Facebook page, or the website you are visiting right now. Bitcoins are no more imaginary than any other currency.
Think about it: when you swipe your card to pay for lunch, no actual money changes hands. When an automatic payment goes through, when your paycheck is deposited, or when a loan goes through, it’s all digital. A bank teller just changes the balance in the computer system, and voila. Those digital dollars only have value because we all, as a society, agree that they do. Even paper money would be worthless if we if that collective agreement crumbled.
Same with bitcoins. Their value comes from supply and demand, a fair amount of speculation, but above all the consensus of the bitcoin community.
How Does It Work?
You have money in your bank account, right? And whenever you move or spend that money, the bank records it in their ledger. All deposits and withdrawals are recorded, keeping track of how much money you have at any given time. This is the bank’s essential function: record keeping.
Bitcoin works in much the same way, with one key difference: instead of a bank keeping track of transactions and maintaining the ledger, the entire network shares that responsibility. There is no overseer, no central authority. Instead, there is a public, open source file called “the block chain.” Instead of an account number, you have an encrypted address. The bitcoins you buy are allocated to your address and saved in the block chain.
When you want to spend your hard earned bitcoins, you send out an electronic message (verified by your password or private key) instructing the network to transfer X amount of bitcoins from one address to another. Because both addresses are encrypted, the network must then decipher the encryption in order to process the transaction. There are many such transactions happening every second, so they are grouped together in bundles called “blocks.” When a block has been “solved” and all transactions verified, it is recorded in the public ledger – which is why it’s called the block chain.
The average block contains several hundred transactions, and it takes about 10 minutes – and a great deal of computing power – to solve each one. Computers around the world are racing to be the first one to solve the block, because it rewards them with bitcoins. This is how new bitcoins are generated, and the process is called “mining.” The people who run these computers are called miners, and you can think of them as bank clerks, processing transactions and keeping the network up and running – and being rewarded for their efforts.
Why Does It Matter?
As mentioned above, Bitcoin makes possible many things that weren’t possible before: anonymous payments, instant payments, cheap and easy transfers across international borders, etc. All these things are significant breakthroughs that make Bitcoin a force to be reckoned with.
But the genius of the Bitcoin network lies in it’s decentralized, open source nature. It is a system of currency and exchange that functions without oversight or regulation. Instead of trusting in some central bank (and the greedy, overly-ambitious people that run it), the network of users put their trust in the block chain, in the algorithm that runs it. No one controls Bitcoin: it is run by the pure and incorruptible principles of science and mathematics.
This is especially important given the history of banks and financial institutions, and their tendency to try and maximize profits with toxic loans and derivative speculation. Not only have these giants frequently driven themselves to bankruptcy, depending on taxpayer bailouts to keep them afloat, but they have thrown the world economy into turmoil, affecting the livelihoods of people everywhere.
Bitcoin enables people to take control of their own finances. Anyone with internet access can buy and sell bitcoins, no credit check or permission slip required. That doesn’t seem like a big deal if you live in the U.S. or Europe, where there is a bank on every corner. But billions of people in the developing world have no access to banks, no checking accounts or credit cards, and no way to send or receive payments – and Bitcoin just might be their ticket to the opportunities and conveniences of the modern financial system that we take for granted.
Bitcoin Today (and Tomorrow)
The market couldn’t sustain the stellar $1000+ price range for long. By 2014, the price had fallen below $900. In February the largest bitcoin exchange in the world, Mt. Gox, closed it’s doors and declared bankruptcy, after it discovered that it’s system had been hacked. 750,000 of it’s customers’ coins had gone missing, and another 100,000 of it’s own, in total more than $500 million dollars worth. This revelation dealt a blow that the Bitcoin economy is still recovering from. The price fell to less than $300 by 2015, making BTC the worst performing currency in the world last year.
The IRS also passed a ruling in March of 2014 that Bitcoin would not be recognized as a currency, but as a form of digital property – and taxed accordingly. Governments around the world, including Russia and China, are nervous about Bitcoin, because it is decentralized and beyond their control. Law enforcement agencies fear that Bitoin will be used launder money, or spent on the black market a la Silk Road. Legislators are still struggling to understand the currency and it’s implications, in order to figure out how best to regulate it.
But the news isn’t all bad. The number of bitcoin wallets – and thus, presumably, bitcoin users – continues to rise, despite the market’s ups and downs, and is expected to exceed 12 million by the end of the year. 2014 also saw a tremendous outpouring of venture capital investments in Bitcoin businesses and start ups, to the tune of $335 million. To put that in perspective, it’s more than the first round of investment in dot-com start ups in 1995.
In January of this year it was announced that San Francisco based Coinbase had raised $75 million in investment capital. Coinbase aims to make bitcoin more accessible to the masses with it’s user-friendly online wallet and exchange. It also partners with over 100,000 merchants and retailers – including Microsoft, Expedia and Dish Network – to process bitcoin payments, making it easier than ever for bitcoin users to buy real world goods and services.
Coinbase is criticized by bitcoin “purists” for accepting government oversight and regulations, and holding onto their users coins and private keys. They claim that it betrays the founding principles and ideals of the bitcoin network – and they’re right. But the fact remains that Coinbase is one of the most popular and fastest growing bitcoin services, and has done more than anyone to bring bitcoin into the mainstream, and get big businesses onboard.
It is still early in the “Bitcoin revolution,” and the future is of course uncertain. Time will tell whether Bitcoin is embraced as a free and open currency, or if it will degenerate into another kind of speculative investment like stocks and bonds, or if it is in fact just an imperfect prototype of new and better technologies to come.
As a model, it has many applications as yet undreamed of. In the years to come, we will no doubt see a new wave of open source, peer-to-peer networks that bring innovative solutions to many of the problems inherent in centralized bureaucracies, and put the power back into the hands of the people.
But with investments pouring in, more and more users every day, and more and more merchants accepting bitcoin payments (even if it is through a third party like Coinbase), the stage is set for Bitcoin to continue to grow, and play a major role in the world economy.