What Are Bitcoins?

ImageBitcoins have been in the news quite a bit lately, and I suspect we are going to hear a lot more as more merchants begin accepting them.  Bitcoins are digital currency. If you think of a $100.00 bill as being a compact disc of recorded music, a Bitcoin is like an MP3 file.  Bitcoins are gaining popularity throughout the world because they can be exchanged peer-to-peer, transactions in Bitcoins are anonymous, and the transaction fees involved are extremely low compared to credit card and currency exchange fees.

There are currently 21 million Bitcoins, but only 11 million are currently in circulation.  New Bitcoins are created through “mining,” a complex series of mathematical computations, the idea being that introducing new Bitcoins will be as difficult as “mining” for more gold. Like gold, Bitcoins can’t just be created out of thin air in the same way government fiat money can just be printed (e.g., the U.S. dollar). In theory, mining will prevent the risk of Bitcoin inflation like we have seen with other government currencies.

Like any currency, Bitcoins only hold as much value as consensus allows.  As of this writing, 1 Bitcoin (BTC) = $674.8, but its value is extremely volatile, oftentimes swinging 20-30%.  Like currency trading in Japanese yen or the Iraqi dinar, there is money to be made (and lost) in Bitcoin speculation.

Nobody owns or centrally controls the Bitcoin network.  While developers are constantly making changes to the software, they can’t force a change in the Bitcoin protocol because users are free to choose whatever software or version they use.  Because the whole system falls apart if software and procedures aren’t compatible, there are huge incentives for users and developers to ensure ongoing consensus.

The number of businesses and individuals using Bitcoins is currently small but growing rapidly. While most Bitcoin users are web-based companies, brick and mortar businesses are starting to use them as well. Payments in Bitcoins are easier to transact than with a debit or credit card, and they can be received without a merchant account.  Both parties in the transaction have what are known as “wallets” where Bitcoins are electronically stored.  When a transaction takes place, the buyer transfers Bitcoins from his wallet to the seller’s wallet by typing in the seller’s wallet’s address, or by scanning a QR code.

Bitcoins work a lot like cash in that they are difficult (though not impossible) to trace. That is one reason drug dealers and other criminals are learning to conduct business in Bitcoins.  No personal information is tied to a Bitcoin transaction.  In countries without political freedoms, Bitcoins are becoming a way for oppressed citizens to fund political candidates and/or movements without being identified.

There are some concerns about Bitcoins.  Currently, they are not readily accepted.  It will be some time before their use is widespread enough to exploit the network effect.  Secondly, their value remains volatile.  Bitcoins sitting in your electronic wallet might be making or losing you money, much like owning the Mexican Peso did during the 1990’s.  Finally, as Bitcoins become more popular, we can expect governments to step in to regulate and tax them.

The internet has brought the whole world closer together, and Bitcoins are one way for citizens of the world to send and receive payments electronically across jurisdictions conveniently, securely and anonymously.  It remains to be seen whether Bitcoins will live up to their hype; however, like any new technology, I suspect this is going to be exciting.

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