The term Bitcoin has become such a big phenomenon by now, even small shops in my town (Delft) are accepting it as a payment method. Café de Waag will accept bitcoins for food and drinks. While No13 has fashion clothes to offer for bitcoins.
So what is Bitcoin?
You might already have guessed it’s a type of monetary system. It’s in fact the first decentralized digital currency. Decentralized means that there’s no bank, country, company or person that controls or owns the money. This works because the Bitcoin network uses peer-to-peer technology —like torrents— to operate, validate and secure the network. Now being decentralized also means there is no such thing as "interest", there’s no "loans" and the value of bitcoin doesn’t depend on a country’s welfare.
Fiat money is money that has no entity backing it other than the issuer, usually a government. When the United States dollar finally disconnected from the gold standard in 1971 it became a fiat currency. Basically the USA declared, “The dollar has value because we are ‘Murica” and the world said, “OK”. In actuality, the US dollar has no intrinsic value other than the fact it is issued by the United States. Most modern currencies are fiat money.
Bitcoin follows the same principle, in that its value is determined by perception. Instead of the trust of some government entity being evaluated to determine the value of Bitcoin, other factors (the technology, widespread acceptance, understanding of e-money, etc.) are taken into consideration. When magazines and online entities write intriguing articles about Bitcoin, people take interest in it, the demand goes up and so does its value v. government-back currencies. Likewise when Mt. Gox is DDoSed, a Bitcoin service shutters, or $250,000 worth of bitcoins is stolen, people get nervous, demand drops, and so does Bitcoin value.
The Bitcoin network is a peer-to-peer payment network that operates on a cryptographic protocol. Users send bitcoins, the unit of currency, by broadcasting digitally signed messages to the network using Bitcoin wallet software. Transactions are recorded into a distributed public database known as the block chain, with consensus achieved by a proof-of-work system called mining. The block chain is distributed internationally using peer-to-peer file sharing technology similar to Bit Torrent. The protocol was designed in 2008 and released in 2009 as open source software by “Satoshi Nakamoto”, the pseudonym of the original developer or group of developers.
Why should you use Bitcoin?
There’s a lot of benefits to using bitcoin over existing currency. For starters, saving your money is safer since your bitcoins are saved on a medium of your own choice. And because the money is digital, it can be saved in a tiny container. A USB flash drive is a great solution, and if you encrypt your wallet you can even keep your money on Dropbox or a similar service for a backup.
However, your bitcoins digital wallet can be lost. Just like with real wallets, if you lose your digital wallet, you lose your money.
Sending and receiving money is also considered safer because transactions are semi-anonymous. All Bitcoin transactions are public information. Anyone can know the amount, the time, and the wallet numbers of the two participants. They may not necessarily know who the human owners of the digital wallets are. So you may send and receive money without ever adding your name, address or account details. That being said, it’s still a risk to send bitcoins since transactions are not reversible. Bitcoin transactions cannot be undone, except by a second voluntary transaction of the same amount in the opposite direction. (This is unlike credit cards, where the merchant can lose the received money to a “chargeback” even after they have shipped the product.)
As a buyer using Bitcoin, keep in mind that there is likely nobody to petition for help should a seller not ship you a product (as governments and their courts will likely be quite unfriendly to Bitcoin, see below). For this reason, buyers would be wise to deal only with reputable sellers, or use escrow services.
Bitcoin transactions happen virtually instantaneously, and the transaction is then verified by the peer-to-peer network of Bitcoin users. The more positive confirmations you receive from the network, the more likely the transaction is valid and final. This can take a few minutes.
For big spenders there’s a benefit of really small transaction fees and no taxes. Transaction fees are actually still non-obligatory, but to ensure fast verification of transactions, small fees help mining pools to accept your transaction faster and verify it within minutes.
The benefit of almost no fees and instantaneous transaction makes the system very viable for larger global transactions since sending money through banks to the other side of the world may be a real hassle and includes lots of fees and taxes. Even PayPal has fees of 2.9% + $0.30 per sale and usually takes a few days to process the transaction.
How does Bitcoin have value?
Bitcoins have value because they are useful as a form of money. Bitcoin has the characteristics of money (durability, portability, fungibility, scarcity, divisibility, and recognizability) based on the properties of mathematics rather than relying on physical properties (like gold and silver) or trust in central authorities (like fiat currencies). In short, Bitcoin is backed by mathematics. With these attributes, all that is required for a form of money to hold value is trust and adoption. In the case of Bitcoin, this can be measured by its growing base of users, merchants, and startups. As with all currency, bitcoin’s value comes only and directly from people willing to accept them as payment.
The price of a bitcoin is determined by supply and demand. When demand for bitcoins increases, the price increases, and when demand falls, the price falls. There is only a limited number of bitcoins in circulation and new bitcoins are created at a predictable and decreasing rate, which means that demand must follow this level of inflation to keep the price stable. Because Bitcoin is still a relatively small market compared to what it could be, it doesn’t take significant amounts of money to move the market price up or down, and thus the price of a bitcoin is still very volatile.
To be continued…
As I delve into the world of Bitcoin, I’ll update my blog with new findings and experiences. So far I’ve invested €50,- in Bitcoin just as an experiment. I received 0.10421875 BTC for that amount of euros.
If you’ve got any bitcoins to spare and would like to donate me a cup of coffee, I’d very much appreciate it! My donation address is: 1BCC7Wu95u9AYo45dV33iHPyNFtDuqj5gj