What is Bitcoin?
When people say “Bitcoin” they are referring to one of two things.
1. A digital currency.
2. A payment system used for sending and receiving money online.
Typically the term is used to apply to the currency itself, but the payment system is every bit as important as the currency. Let me explain both.
Bitcoin as a Currency
Bitcoin is a digital, decentralized, peer to peer, pseudonymous currency based on cryptography. If that sentence made no sense to you, don’t worry – I’ll break it down for you.
Digital – Bitcoins exist only as code, they do not exist as anything physical. People can (and have) made physical representations of Bitcoin, but ultimately they are based in the digital world.
Decentralized – There is no central bank or institution that issues or controls Bitcoin. It is a group of individuals all over the world who run the program that keeps the monetary system running.
Peer to Peer – You control your own Bitcoin, and when you send Bitcoin to someone else, it goes directly to them. There are no banks or middlemen.
Pseudonymous – While all Bitcoin transactions are publically viewable in an open ledger called the Blockchain (we’ll get to that later), the sender and receiver are only known as a string of numbers and letters. If you’re careful about your identity, using Bitcoins can be done anonymously.
Based on Cryptography – The strength of Bitcoin as a digital currency lies in the code, which uses strong cryptography to ensure that the coins cannot be accessed without proper permission.
Bitcoin is the first digital currency that has these characteristics, and as a result it is the first digital currency to become widely adopted on the internet. As of June 2013, it is handling nearly 60,000 transactions each day, and this number is accelerating quickly.
Bitcoin as a Payment System: Solving the Double Spend Problem
As a new digital currency, Bitcoin is impressive, but the truly revolutionary aspect of Bitcoin is in a new payment system. Before I explain this system, let me briefly describe one of the primary reasons why digital currencies have always failed in the past.
In the physical world, money can’t be in two places at once: once you spend it, it is inside store A’s cash register and it can’t be in store B’s cash register. With digital currency, this isn’t necessarily true. Since digital currency is computer code, the same money could actually reside in multiple places. This is obviously a huge problem, and would lead to rampant fraud.
However, we do transact huge amounts of money digitally today, so how come we don’t see more double spending? Well, we have services that take care of the problem, such as PayPal. They review all the transactions to ensure that the same money isn’t spent twice.
But there are substantial problems with using a centralized service to deal with the double spend problem. First, they are a single point of failure. This means that if PayPal were to have technical problems – or perhaps if they don’t like what you are trying to purchase – then you can’t move your money at all. Also, you have to pay them for their service, typically with fees that are 2% or even
Bitcoin’s payment system solves the double spend problem, does it without relying on a single point of failure, and requires substantially smaller fees. It does this by using a public ledger called the lockchain, which I’ll discuss in more detail later in the book.
History of Bitcoin
Where did Bitcoin come from? Even though it is only five years old it already has a unique story.
The idea for Bitcoin came from a developer named Satoshi Nakamoto. That was the name on the original paper that laid out the technical aspects of the new project – but it was a pseudonym. The real identity of Satoshi Nakamoto is still unknown.
The original paper was written in October 2008. The nine-page paper briefly touches on each of the major aspects of the system that Satoshi envisioned, as well as naming this new “Peer-to-Peer Electronic Cash System” with the moniker that it uses today: Bitcoin.
After the paper was published, Satoshi created the first software program to begin mining (the process of creating Bitcoin). In January 2009, Satoshi mined the first set of Bitcoin, named the Genesis block. Shortly after, he announced the project to a group of cryptography experts, many of whom were a part of the “cypherpunk” movement. Satoshi developed many of the ideas of Bitcoin from previous cypherpunk works. Initially, this group of computer experts approached Bitcoin as an interesting hobby, discussing how the system may or may not work, and how governments may react to it.
It wasn’t until the beginning of 2010 that Bitcoin was used for real-world transactions. By this time, a larger community of developers had reviewed the code – along with Satoshi – and released version 0.2, improving the client. The first Bitcoin transaction for a physical good occurred on May 21, 2010, when a Bitcoin user named Laszlo purchased a pizza worth $25 – for 10,000 Bitcoins!
This transaction spawned the famous “Bitcoin Pizza Index,” which continually updates the price of that first pizza (as of the writing of this book, worth over $1.2 million).
The Bitcoin community slowly grew over 2010. Mt. Gox, the largest Bitcoin exchange, was founded, and made it easier to buy and sell Bitcoin. The price eventually reached parity with the US Dollar in February 2011, and soon after began rising rapidly.
This rapid rise was primarily a result of increased media attention. Several new sites began covering Bitcoin, and average internet users began buying them. Also, news of “The Silk Road” began to emerge. This hidden website allowed users to buy and sell illegal merchandise – mostly drugs – using Bitcoin for security and anonymity.
This newfound attention, and scrutiny, drove the price higher still, reaching a high point of $31 in June 2011. But this rapid price increase would soon deflate. The largest exchange, Mt. Gox, had their database compromised by hackers. This led to some large-scale thefts of Bitcoin totaling in the hundreds of thousands of dollars, which shook confidence in the new currency. The price dropped dramatically, and many wrote off Bitcoin as a failure.
But Bitcoin wasn’t finished, and it slowly began to build more users and followers over the next year. By the end of 2012, there were more users than ever before, and more businesses began accepting Bitcoin as payment for goods and services.
2013 was truly the breakthrough year for Bitcoin. Starting the year around $13, the price began rapidly increasing as Bitcoin received more news coverage than ever before. Well-known internet brands began accepting Bitcoin, such as Wordpress and Reddit. New users came into the market quickly, and because it isn’t easy to obtain new Bitcoins, the demand outstripped supply and prices rose
further. By April 10th, the price was a staggering $266 per Bitcoin.
That price soon collapsed when Mt. Gox again had technical problems, this time due to a long lag time for placing orders. New buyers panicked when the price began dropping, and the flood of sell orders dropped the price down to $55 in a few days.
After this last bubble, the price has slowly increased and remained much more stable. This is likely due to the increased acceptance of Bitcoin from merchants, and the new services that continue to pop up to make obtaining and trading Bitcoin easier.
As of the writing of this book (June 2013), the total number of Bitcoin transactions has nearly reached eighteen million, and the market cap (number of Bitcoins times price) is over $1 billion. It isn’t known exactly how many people use Bitcoin, but estimates are typically between 100k and 200k, and growing rapidly.
In absolute numbers, the United States has the most Bitcoin users, but per capita, Scandinavian countries have the most users. The most rapidly growing adopters of Bitcoin are now – at least temporarily – the Chinese, after several reports on Bitcoin hit their mainstream media. Because of the necessity for having a computer and internet infrastructure, we have yet to see developing countries use Bitcoin frequently.
The Future of Bitcoin
Where is Bitcoin headed? No one knows for sure, but a popular refrain is heard in the Bitcoin community: In ten years, either Bitcoin will be worth nothing, or significantly more than today. I believe this is true.
The idea of digital money that you manage yourself is a powerful one, and in the first four years of this monetary experiment we’ve seen explosive growth. It’s easy to see continued growth in both individual users and businesses that accept coins. If it continues at its current pace, the value of 1.0 BTC will continue to rise compared to other currencies. Eventually, goods and services might be
priced in Bitcoin itself, instead of relying on other currencies to judge value. Online shopping might not require entering your credit card information, or signing up for a PayPal account. Your identity wouldn’t need to be revealed when purchasing goods, unless you made that choice.
Another aspect of Bitcoin that I haven’t discussed is the potential for smart contracts, which use the cryptography inherent in Bitcoin to facilitate more complex transactions, such as escrow services, arbitration, or even estate management. If Bitcoin becomes more popular, these services will likely be
implemented in the code (as Satoshi originally intended).
But the future is far from certain. There are three primary threats to Bitcoin that I see on the horizon, that could substantially restrain—or even destroy—this new monetary system.
1. Technical. Right now the Bitcoin economy runs fairly smoothly, handling tens of thousands of transactions daily. But what will happen if that hits millions of transactions daily? Can Bitcoin handle the same amount of volume that a major credit card does? There is speculation on both sides of the issue, but no one really knows. If the system isn’t able to handle a large amount of transactions, its value is obviously limited.
2. Governmental. Because Bitcoin can be used for illegal activities (so can cash), and because the Bitcoin system is inherently difficult to regulate, governments across the world might decide to limit their citizens’ ability to use Bitcoin. If this happens, it will obviously inhibit the Bitcoin economy significantly.
3. Competition. Right now, Bitcoin is the clear leader among digital currencies, but it isn’t the only one. Several alternative cryptocurrencies have taken the Bitcoin code, altered it, and launched their own currency. Some of the most popular ones include Litecoin, PPCoin, and Ripple. These aren’t nearly as valuable as Bitcoin, but it is possible that one day another digital currency could replace Bitcoin if it were significantly better.
If Bitcoin can handle large transactions, avoid government restrictions, and beat the competition, I believe it will become the standard currency of the internet. This monetary experiment has evolved from a nine-page paper written in Fall 2008 to a billion dollar marketplace today, with millions of dollars of investment capital flowing into new start-ups, and new services launched each week.
Only time will tell if Bitcoin will be as revolutionary to our current monetary system as email was to the old system of communications. It’s certainly off to a great start, and I hope this guide has helped you to join this grand monetary experiment.