You know all about the dollar. You’ve probably seen a peso. You’ve heard of the Euro. These are some of the most famous currencies in the world, and just about everyone has heard of them or used them at some point in their lives. But have you heard of Bitcoins?
If you spend much time reading news articles online, the name probably sounds familiar. To put it simply, Bitcoins are a fairly new form of currency that are generating quite a lot of buzz in financial, political, and technological circles. After several clients asked me about this new phenomenon, I thought it was high-time for a letter on the subject … a subject that could have major implications for the future of commerce as we know it.
What are Bitcoins, exactly?
Bitcoins are actually a kind of “digital currency” in that, for the most part, they only exist electronically. An easy way to think of them is to imagine an online game where you can pay for items, tools, and other things using the “money” found within the game. Digital currency is similar to that, except you can actually use it to purchase goods and services in real life.
Bitcoins are one example of digital currency. More specifically, Bitcoins are a kind of “cryptocurrency,” which relies on cryptography (the art of writing in code) and peer-to-peer networks (which share files and information across multiple computers without the need for a central server) to work.
Complex? You bet. The future? Very possibly.
To put it simply, a Bitcoin is a piece of electronic money, completely separate and independent from any national currency, which you can use to purchase goods and services from vendors who accept it. They are not issued by any country, are not controlled or regulated by any bank, and have nothing to do with Visa® or MasterCard®. Bitcoins are completely decentralized, and are maintained by some of the very people who use them. They have value because the people who use them see them as valuable … not because any authority proclaims it.
Why are Bitcoins important, and why are they getting so much press?
The very fact that Bitcoins are not issued, controlled, or regulated by any bank or country is what makes them so intriguing to many people. Fans of Bitcoins see the following advantages over more traditional currency:
Bitcoins have lower transaction costs, which is valuable for sellers, especially small-businesses. Usually, when you buy something with a credit card, the merchant/vendor who accepts your card has to pay a fee to the credit card company. This can become extremely expensive over time. But transaction fees for Bitcoins are either extremely small or nonexistent. Additionally, Bitcoin users can transfer money to each other without fees, too. That’s not the case for more traditional forms of transactions, like banks, wiring services, or even PayPal®.
Some people value the neutrality of Bitcoins. Unlike traditional currencies, Bitcoins cannot be controlled or manipulated by any central source, like a government or bank.
Because Bitcoins are both decentralized and finite (the supply of Bitcoins will eventually be capped at 21 million)1, they are far less vulnerable to countries with weak economies or poor monetary management, reducing the risk of inflation or collapse.
These and other advantages are making Bitcoins increasingly popular. Some people even think that Bitcoins may replace national currencies one day as the world standard.2 While that day is probably extremely far off (if it ever even happens), the prospect of it, and the nature of Bitcoins in general, has led to a surge in publicity over the past few years.
Where do Bitcoins come from and how do they work?
The origin of Bitcoins is complex and a little bit mysterious. Bitcoins first came to light in a paper published in 2008 under the name “Satoshi Nakamoto.” The paper discussed how a peer-to-peer network could generate “a system for electronic transactions without relying on trust,” or in other words, without relying on a central authority to guarantee the currency’s value. The name Satoshi Nakamoto is a pseudonym, and no one knows who the creator of Bitcoins really is.1
Because the Bitcoin system is run over a peer-to-peer system, and because the code that runs the system is open source (meaning it’s freely available to the general public), the creator’s identity doesn’t really matter. In fact, the enigmatic Nakamoto has faded from public view, and his or her pseudonym hasn’t been seen online in quite some time. The protocol that keeps the Bitcoin system going is in place, and like the currency itself, needs no oversight from a central authority.
Here’s a very simplistic look at how Bitcoins work. Volunteers all around the world devote their computers to running special software to maintain a kind of public “ledger” of every Bitcoin transaction. These volunteers are known as “miners,” and it’s their activities—“mining”—that actually create new Bitcoins for circulation. Mining involves each computer attempting to solve “irreversible cryptographic puzzles,” sort of like math problems on steroids. When each problem is solved, a set number of Bitcoins are awarded to the miner. The miner can keep, spend, or transfer these Bitcoins as he or she chooses.
How do people like you and me get Bitcoins? Assuming you don’t want to become a miner, there are several ways. One way is to find Bitcoin “lotteries.” These are websites that give Bitcoins away in a lottery-type system. The more common way is to buy Bitcoins with cash. As of January 23rd, 2014, a single Bitcoin was worth over $800.3 You can expect the number to be different by the time you read this, as the value of Bitcoins can fluctuate dramatically (Early last year, one Bitcoin was worth about $13).3 Finally, you can also get Bitcoins by selling something and accepting Bitcoins as payment.
What’s preventing Bitcoins from replacing regular currency?
Lots of things. While an increasing number of merchants are accepting Bitcoins, they are still far from the mainstream. This is partly because they are relatively new, and partly because they can be difficult for the average person to understand. A third reason is that Bitcoins have become, whether fairly or unfairly, associated with the black market (The same could be said of regular cash, however). But the biggest reason is because the legal implications of Bitcoins are still unclear. National governments and international banks have a vested interest in maintaining the status quo, and the implications of how Bitcoins will affect the status quo are still being worked out.
Are Bitcoins a suitable investment?
Currently, investing in Bitcoins is primarily the province of speculators who hope the value of Bitcoins will continue to skyrocket.4 There are just too many questions still to be answered before Bitcoins can really become a suitable investment for most people. Will various governments try to regulate Bitcoins, and if so, what will those regulations be? Will the value of Bitcoins ever stabilize, or will it continue to swing wildly? Will Bitcoins become more mainstream, or remain mostly in the hands of enthusiasts?
The biggest question is whether Bitcoins are truly here to stay or whether they’re just a passing fad. After all, it’s certainly possible for the Bitcoin system to collapse entirely. Some experts see Bitcoins as having no intrinsic value—they’re only worth something as long as people consider them worth something. Of course, that’s also true of gold or the dollar. Gold is only valuable as long as people think of it as valuable. The dollar is only valuable as long as we trust the government backing its value. But gold and the dollar have the advantage of tradition and history—two of the sturdiest crutches of all. Bitcoins have no such prop.
So for now, Bitcoins should probably be seen as exactly what they are: an alternative form of currency. You can use them, and be one of the growing number of people who do. Or you can elect not to use them, and no one will bat an eye. But whether Bitcoins are truly the future is a question only the future itself can answer.