Bitcoin is a digital peer-to-peer currency which is run through open source software. It was conceived in 2008 by persons working under the pseudonym Satoshi Nakamoto. The first Bitcoins entered circulation in 2009.
Overview
Bitcoins are part of the first generation of crypto-currencies, which are currencies based on cryptography instead of on a central authority. The cryptography behind a Bitcoin automatically controls its creation and all its transactions.
Each Bitcoin is defined to 8 decimal places. The smallest part of a Bitcoin, which is 1/100,000,000, is called a satoshi.
All Bitcoins are generated through a process known as Bitcoin mining. Every 10 minutes of total Bitcoin mining results in the generation of a number of Bitcoins. This amount is currently 25 and they will be halved every four years. The last fraction of a Bitcoin is scheduled to be produced in 2140 for a maximum of 21 million Bitcoins in circulation. More than half the hard cap on Bitcoins has already been created.
Pros of Bitcoin
All transactions which involve Bitcoins are carried out directly by the network protocol. No central authority is involved. While this may be either a pro or a con, Bitcoin’s developers specifically developed Bitcoin with this in mind. Most Bitcoin supporters identify the lack of a central regulating authority as Bitcoin’s best quality.
The encryption which makes up each Bitcoin makes it the most secure of all current currencies. It is next to impossible to counterfeit a Bitcoin’s data trail. This means that it is cost-prohibitive to attempt to counterfeit Bitcoins, even if Bitcoins were worth 100 times their current exchange value. However, Bitcoin transactions and balances are still vulnerable to theft, because the pseudonym used to process a Bitcoin transaction does not have the same security as the Bitcoin itself.
Bitcoin transactions can be conducted anywhere in the world which has access to the Internet. This gives them a near-instantaneous global reach which leaves wire transfers and even Paypal in the dust. However, the same global reach also makes Bitcoins a useful tool for money laundering.
Governments are not currently equipped to monitor Bitcoin wealth or currency flow on any large scale, which places Bitcoin transactions outside sovereign control and possibly even taxation for the time being. Yet this also places Bitcoins beyond the reach of economic sanctions, which could potentially undermine the effectiveness of economic sanctions completely.
Cons of Bitcoin
The Bitcoin concept is revolutionary. If it or any of its competitors becomes established as a working currency, it will change the way everything that has been taken for granted about money. The effects of these changes on financial markets cannot be predicted. It is possible that they could be severe far beyond the level of the 2007 credit crunch.
Bitcoin is the first major venture of its type, but it is not the only currency of its type. Litecoin is already posing a serious challenge. Other competitors will certainly follow. Even if Bitcoin’s technology were superior, which is not a certainty, there are no guarantees that Bitcoin will not become the Betamax of its generation.
In fact, there are no guarantees of any kind with Bitcoins. You cannot expect their value to remain constant, at least for the short-term future. If your hard drive is corrupted, you cannot exchange the remaining pieces of Bitcoin for the closest equivalent of recoverable data. If someone does develop an easy way to counterfeit them, you have no recourse.
The legality of Bitcoin is not certain. To keep the rate of currency production from escalating into inflation and hyperinflation, most countries restrict the right to create money to the government or to a government-recognized private body. The potential for truly anonymous transactions may also affect Bitcoin’s legality, especially because they are already heavily used by the black market.
Exchange value of Bitcoin
Bitcoin is not backed by a commodity. While it has some similarities with fiat currencies, it has no government behind it to back a fiat value. Instead, the value of a Bitcoin is based entirely on what its peer-to-peer network is willing to pay for it.
At the time of writing, the exchange value of a Bitcoin had reached $266 USD before falling back to under $100 USD. However, this is not precisely an exchange rate, because Bitcoin is not precisely a currency, at least not yet. A currency can be directly exchanged for goods and services and reliably represents their value. Bitcoin’s ability to do that has not yet been tested, and cannot be tested as long as its volatility remains at current levels. While a few businesses, such as WordPress, accept Bitcoins, they calculate the required value in a fiat currency before converting it to Bitcoins at the current market value of a Bitcoin.
Instead, Bitcoin’s value on the open market is closer to that of a new and limited commodity, where no one is sure yet if the commodity will have staying power. The new cryptology application it represents has given it an initial boost, along with the belief in its anonymity. Much of its new value was lost almost as quickly as it was acquired, leading many economists to identify a commodity-style bubble. However, its new value after the bubble burst is still hundreds of times higher than its value when it started four years ago.
Yet in many ways, Bitcoin has not yet been truly tested by the market. All the trading value that Bitcoin has acquired in the past 4 years could evaporate overnight, either through a technology breakthrough or simply through loss of user confidence.
Anonymity of Bitcoin
Bitcoin is commonly believed to be anonymous. As a result, Bitcoin balances, transfers and exchanges are commonly thought to be beyond the ability of government to seize, tax or otherwise interfere with. Neither of these beliefs is true.
Bitcoin transactions are public and have to stay public because they are a part of the encryption process. Even where both parties in a Bitcoin transaction use pseudonyms to protect their identities, their true identities can often be established by cross-referencing known Bitcoin transactions with external information at entry and exit points. Because of this, some conspiracy theorists believe that Bitcoin was deliberately released by the U.S. government to assist in tracking illicit purchases and money laundering.
Additionally, a Bitcoin owner’s privacy is only as secure as the method used to protect his pseudonym. This gives an inherent advantage to Bitcoin users who already have strong privacy protocols such as those via the black market in place. In fact, Bitcoin is the only currency accepted in the Silk Road, an online black market.
Bitcoin exchanges are known parties in large-scale Bitcoin storage and transfers. As a result, Bitcoin exchanges are increasingly common hacking targets. This has already resulted in several large Bitcoin thefts and a few forced closures of Bitcoin exchanges.
Yet there is and will continue to be a high demand for true currency transfer anonymity, usually for the purpose of concealing financial transactions from the government. While the intent behind concealment often flirts with illegality, the fear of a new tax on Cypriot bank accounts has pulled Bitcoin into the international spotlight. Other previous events, such as the freezing of bank accounts during the War on Terror and the outright seizure of bank assets at other times, have made it clear that the Cyprus actions are not unique in history.
One theoretical way in which Bitcoin could meet that demand would be an intermediary transaction which swaps Bitcoins for Zerocoins and vice versa. This creates a break in the chain of transactions that cannot be spanned with current digital technology.
The end of the Bitcoin?
If a filter of this kind succeeds in making the Bitcoin truly anonymous, that will open a new kettle of legal fish. At present, Bitcoin may be tolerated precisely because its transaction record is public, which can provide a useful data trail for government investigators. If that data trail is eliminated, some governments may decide that the usefulness of Bitcoin as a window into underworld operations has ended.
Eliminating Bitcoin could be as simple as choking off its liquidity by hardening government control over entry and exit points. The result would be similar to the economic sanctions placed on Julian Assange and WikiLeaks. If Bitcoin ever lost its ability to be traded for legal goods, services or other currencies, Bitcoin would no longer have a reason to exist.