Bitcoins have been appearing a lot in the news lately. As the security of the Euro seems caught in the balance, many people and organizations are starting to look for alternative currencies to save their earnings. For some investors, Bitcoins looks like they just might be that currency. It is independent of any nation or government, meaning that there is much less risk of the currency suddenly becoming worthless.
All this talk about bitcoins has left many people asking an important question, though, “Just what is a bitcoin anyway?”.
The bitcoin is an entirely digital currency. Each user of the currency has what is called a wallet that contains addresses. In each address are a number of bitcoins. Users trade bitcoins by sending these coins from one address to another. The entire process takes place over the internet, and is conducted without the control of a company of government, as the currency is entirely independent.
The idea for digital currency, or as it is technically known, crypto-currency, has been around since 1998 when it was first described by a cryptographer named Wei Dai. Over the years, there have been a number of attempts to make such a currency, but without success.
The problem was how to prevent the users of the currency from cheating by just copying their money over and over again like any other file on a computer. The only viable currencies created required a third-party, whether that be a company, non-profit or a government, to oversee the entire system and make sure that nobody was cheating. That system was risky, though, since if that third party stopped administering the system, the entire currency stopped working.
Then, in 2009, someone operating under the pseudonym Satoshi Nakamota sent out a research paper to a cryptography mailing list in which he described a currency called the bitcoin. His idea was simple: rather than have a third party administer the bitcoin, let the users do it. Everyone that wanted to use bitcoins would have to install a piece of software on their computer. This software would track every exchange that they made and transmit that data to other computers running the same software. Within seconds, a record of that transaction would be saved on thousands of computers around the world preventing users from lying about how many coins they traded or how many coins they had in their wallet.
Nakamota also laid down a system for how new bitcoins could be created. The approach is called mining. Every 10 minutes, any user that wants to mine bitcoins is given a block. Their computer then combines this block with a random number called a nonce. If the right nonce is combined without the block, they would create the correct output and be awarded with a sum of bitcoins. Only the first user to find the correct nonce would get the bitcoins. After 10 minutes, the correct result from the last block would be combined with a new block and the entire process would start again. The award for solving the block started at 50 bitcoins, but every 4 years that amount is halved (it is currently 25) until in 2140 the currency reaches a hard cap of 21 million total bitcoins.
It was brilliant. In that one paper, Nakamota cracked the crypto-currency problem and created a system that would allow the bitcoin to operate without any form of oversight.
Now, several years later, the market for bitcoins has grown dramatically. Many businesses around the world now accept bitcoins in payment, and there are entire black market websites on the internet that deal purely in the currency.
Competition to mine bitcoins is fierce. At the time of writing, the average exchange rate for a bitcoin is about $84, meaning that successfully mining a block is $2016 of profit. Miners fight tooth and nail to be the lucky one to find that block. Specialized bitcoin mining computers costing over $100,000 are common. There are even companies that make computers specialized for mining bitcoins. A few months back, a company called Avalon started an Ebay auction at $500 for nothing more than a place in line to buy one of their latest models when it was released. The auction closed at $20,600.
Even with the obsession centered on mining the coins, though, there are still a lot of people that question their value. They have become especially notorious for huge volatility. In just a week, the value spiked capping out at $266 on April 10th, before crashing down to $105 and then rebounding to $160 within six hours.
Regardless of bitcoins’ future, they have proved a point. Digital currency is possible. It’s a glimpse of what our financial futures may look like.