Bitcoin. Source: http://www.bitcoin.org/Ever since the dawn of the Internet and of the information age, writers and visionaries have visualized the disruptive changes that such technologies would eventually have on our lives; they have imagined futures where we spend more of our lives online than offline, and where ubiquitous access to technology and connectivity would be a strong decentralizing force, placing power in the hands of the people.

One of the cornerstones of this vision is the need for a decentralized, distributed, and pseudonymous currency in order to digitally transmit value from person to person. You cannot truly transfer power into the hands of the people without giving them economic sovereignty, and they cannot have economic sovereignty so long as money and currency are tied to the real world and controlled by monopolistic central banks and governments.

Many various ideas have been tried over the years, such as RipplePay, eCache, and ecash. For various reasons, none of these systems have taken off. Why did they fail? Some of them were flawed because they relied on a centralized model, and others were flawed because they only work if humans are completely trustworthy, something that cannot always be relied upon. However, there is a new distributed currency which has been rapidly gaining in popularity, and it has the potential to succeed where others have failed. This new system is called Bitcoin.

What is Bitcoin?

 
Bitcoin. Source: http://www.bitcoin.org/smf/index.php?topic=687.0Bitcoin is a pseudonymous, decentralized electronic currency, and it has been designed in such a way that it functions similarly to physical commodity money, such as gold. This implementation solves both the problem of centralization as well as the issue of trust. To see how, first we need to look at the properties of money, and why physical commodity currencies such as gold were chosen spontaneously as money by the people, and why they have held their value for so long.

What are some of the properties of good money?

Divisibility

Money should be easily divisible into arbitrary units of value in order to handle all sizes of transactions, from the small to the very large.

Durability

In order to be a reliable store of value, money must stand the test of time. Anything which decays or rots would not be a good choice.

Fungibility

A good money is fungible; that means that each unit is identical to every other unit. One dollar is equivalent to another dollar, and one kilo of gold is identical to another kilo of gold. Money can then act as a numeraire or measure of value, just like a meter is a measure of distance.

Scarcity

The ideal money is one which holds its value and does not steal value through arbitrary inflation and deflation. When it comes to fiat currencies, central banks are supposed to fulfill this role, and when it comes to physical commodities such as gold, this standard is enforced by the laws of the universe. It is physically impossible for someone to conjure up a cubic meter of gold out of thin air, which is why it can preserve its value so well.

Adds value

For something to begin life as money, it should add value in order to seed its own growth. Gold added value through its beauty and artistic uses, and Bitcoin has the potential to add value through the properties of decentralization, openness, and pseudonymity. I mention openness as the project itself is open source, and the code, protocol, and implementation are all open to scrutiny and analysis.

I consider these to be among the most important properties that something needs in order to be accepted as money. It is ideal if the properties of money are inherent in the medium itself, such as with gold. Gold has all of these properties and more, and this is why it was not only chosen spontaneously by the people across different continents and cultures, but it is also why it has held its value for thousands of years. Fiat currencies have value through legal force and convention; gold has value due to the physical properties of the universe. Legal force waxes and wanes, and conventions can change, but the laws of the universe stay constant.

So, how does it work?

So far, I’ve explained what money is but I haven’t yet said how this applies to Bitcoin. How can a digital currency possibly be scarce? After all, digital storage and processing power are extremely cheap and getting cheaper by the day. What’s to stop someone from doing a simple copy & paste and inflating the currency to nothingness?

Bitcoin has employed a novel solution which uses encryption and brute-force power in order to preserve the scarcity of the currency. To start off the network, Bitcoin uses a concept known as “mining” — people devote their resources to solving a very difficult cryptographic math problem, and those who succeed generate some bitcoins. The difficulty of this problem is adjusted by the total production of bitcoins, so that the network as a whole produces a relatively constant rate of coins. The problem of cheating is essentially solved because a cheater cannot possibly hope to amass the amount of computational power needed to overpower the rest of the network. We trust online shopping and we trust encryption because we know that cryptographic keys are very difficult to break; so it is the same with Bitcoin.

Total bitcoins over time. Source: http://upload.wikimedia.org/wikipedia/en/5/54/Total_bitcoins_over_time.pngThe graph on the left is a chart of the overall Bitcoin supply over time. As you can see, the Bitcoin supply is currently in a period of inflation. This inflation acts as an incentive for people to participate in the network and “mine” bitcoins, and it is distributed in accordance with the expenditure of resources. This inflation will taper down over time and the currency will eventually reach a point of equilibrium where there is neither inflation nor deflation. The supply of bitcoins will never be inflated past 21,000,000 BTC, so mining will get progressively more difficult. At this point, the network will transition over to transaction fees. Since anyone can run a Bitcoin node, these fees should tend toward the marginal cost of running a node, and therefore should be quite low.

What can Bitcoin do?

Bitcoin has the potential to revolutionize the online payment industry, but furthermore, it could even place economic power back in the hands of the people. Hefty transaction fees currently discourage micropayments, but Bitcoin could completely change that, opening up a whole new micropayment industry in blogging, online gaming, and many other areas. Bitcoin is also open, peer-reviewed and decentralized, which means that its fortunes don’t change on the whim of a single dictator in charge, or even a single monopoly power. In fact, I fully expect there to be competing digital currencies in the future as Bitcoin continues to grow, and this competition will help ensure that quality of the money remains first and foremost.

Where to get it

Bitcoin can be downloaded from Bitcoin.org. There are currently clients available for Windows, Mac OS X, and Linux.

FAQ

If I install this, will this eat up my CPU and share my files?

Bitcoin is not filesharing software, so it does not share your files. It only uses your CPU if you want to try to “mine” bitcoins, otherwise it uses practically no CPU at all.

Can I take my bitcoins to the local bank and get some cash in exchange?

I think it’s a little early for that. What you can do though is participate in one of the many exchanges and trade bitcoins for USD, EUR, or other various options.

So, I don’t get it — is the value of a bitcoin determined by the resources expended to produce a bitcoin?

Like anything else, the value of a bitcoin is determined solely by supply and demand. If the market value of a bitcoin is higher than the production cost, then it will be worthwhile to devote resources to mining more bitcoins. In this sense, the cost of mining will tend to approximate the value, but it does not drive the value. It is the combination of supply and demand that drives the value. It is entirely conceivable that at some point, the cost of mining a bitcoin will be astronomical, nearing infinity, yet the supply will be stable and the value of a bitcoin will be determined by demand. At this point, transaction fees will support the network and the value of a bitcoin should rise and fall in conjunction with its underlying economy.

If the value of Bitcoins rise, then isn’t this deflation?

I define inflation and deflation as changes in the monetary supply, and it is when we define them in this way that we can see the damage that they cause. If someone could just conjure up a billion dollars out of thin air and spend it at today’s prices, then they have effectively stolen value from everyone else. Likewise, the deflation that follows an unsustainable credit boom and the ensuing bubble burst can be painful. However, neither of these events are possible with Bitcoin because they are not under the control of a monopoly issuer and cannot be inflated the way that fiat currencies can. Instead, their value will be determined primarily by voluntary trade, which means by how much others value them.

Ok, so, what can I do with these Bitcoins?

The market for Bitcoins is still small, but it is growing every day. Popular services include VPN servers, VOIP, and web hosting, and many tangible goods are also available, such as books and T-shirts. You can check out many different services available at the Bitcoin trade page, and you can visit the Bitcoin faucet to get some free coins to get you started.

Bitcoin trends
Bitcoin technical chart. Source: http://bitcoincharts.com/charts/mtgoxUSD#vzlztgSzm1g10zm2g25zi1gMACD

Bitcoin technical chart. Source: http://bitcoincharts.com/charts/mtgoxUSD#vzlztgSzm1g10zm2g25zi1gMACD

Bitcoin really took off last year; it rose from a market value of about $0.005 per BTC (bitcoin) to nearly $1 per BTC; this is an increase of value of over 200x! With over 5 million coins in circulation, Bitcoin is currently in a nascent point of growth, and the sky is the limit.

My Bitcoin account

Donate BTC. Source: http://www.bitcoin.org/smf/index.php?topic=687.0If you liked this article and want to send some Bitcoins over, my address is: 17gqLL6RHpkHgSDG6RxA6QtRvwtcxasZDo. Any donations will be graciously accepted. :)

Further Reading

So, reader, what do you think about emerging digital currencies and Internet technology in general? I believe that nascent technologies such as Bitcoin and its future derivatives have the real potential to drive change and innovation in our world. When the news around the world is bleak and people are pessimistic about the economy and the world in general, I just look at the trends in technology and in our amazing progress forward, and I become an optimist again.

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About

Kevin has left the office, and he is currently fighting the rat race by working on his own business. He enjoys exploring unvisited places around the world and gaining new experiences. He believes that by properly managing our energy and time, we can learn to invest our lives wisely.

76 Comments Kevin on Feb 28th 2011

76 Responses to “Bitcoin: The Digital Currency of the Future”

  1. Gee, I thought the currency of the past and the future was gold and silver. The concept of digital money has been tried before with limited degrees of success. How is this different that would make it succeed.

    You know, most modern currencies have been semi-digitized already by banks, governments and credit card companies.

    • Kevin says:

      Yep, but digitizing an already-existing currency isn’t the same as creating a new one. Bitcoin is different; if it will still be around in 5 years I don’t know, but I think they have already had significant success compared to predecessors. Even if they don’t survive in their current form I believe they do represent a big step forward.

      I don’t think gold & silver are going anywhere, either… in fact, the more competition we have between currencies, the better. That’s why I’m for letting people transact in whichever currency they wish and against any laws that restrict this freedom.

      • Flooz.com couldn’t succeed even with Whoopie Goldberg advertising for it. What do these guys have at BitCoin that would make me want to convert some of my dollars into their currency?

        • Kevin says:

          Well, they don’t have Whoopie Goldberg… ;)

          Right now, what “they” have is everything available on the trade page. Going forwards, I personally think that microtransactions and private transactions are a big win though, as well as the fact that this platform is open, free, and you could build an infrastructure around it. The technology is at a very young phase right now, but it shows a lot of promise. It’s also much more transparent than a couple of guys hanging out in a dark alley on a Tor network somewhere.

    • Bob says:

      In the past, digital currencies that end up being successful enough to be useful have also proven to be a target for regulatory bodies that are ostensibly worried about activities like money laundering.

      Previous attempts at digital currencies were rather easy to shut down. A government merely had to walk to a company’s headquarters, seize their equipment, and walk away.

      Bitcoin doesn’t have a headquarter. If tomorrow you and me are the last bitcoin users on earth, we’ll still be able to do business with bitcoins just fine.

      So that’s part of what’s different and interesting about this.

  2. And it will all be accomplished via our phones. Guess I better learn to text …

    • Kevin says:

      That’s another cool trend as well. It’s already begun, but more and more computers are going to become like appliances, computing is going to be more and more distributed across various devices and the lines between desktop, mobile, console, will blur. Our kids are going to make us seem like old fogies!

  3. DoNotWait says:

    Interesting one Kevin! I learned something new today! Not sure if I’m convinced that it will work out, but it will be interesting to follow the growth in the next months/years.

    • Kevin says:

      There are already thousands of dollars being traded in BTC every day, so while in the overall scheme of things it is still tiny, it definitely has a presence and is growing rapidly. An ecosystem is slowly building up around the currency.

  4. How much will they charge for sending and receiving money? That’s my question, I hope it’s less than 3% :)

    • Bob says:

      There’s no “they”. That’s a big part of the appeal.

      Other attempts at creating a workable currency out of thin air had centralized components that were responsible for ensuring smooth transactions (and charging fees in the process.) Unfortunately, that central component was also an obvious target for anybody interested in seeing the currency go away.

      By eliminating central authorities, Bitcoin has no such weakness, and as such it should prove more resilient to attempts to shut it down.

      More directly to the point of your question, currently the vast majority of money transfers are done without any fees taken. In the future, some bitcoin nodes that dedicate computational power to mining and to effectively notarizing transactions might start requiring fees to process transactions. As that happen, you’ll have a choice to still put no fee and wait until a bitcoin node accepts it, or attach a fee to it and have it processed faster.

      • nas says:

        To further clarify, the fees will be set by a completely free market system. Anyone can become a payment processor and charge whatever fees they deem appropriate. Supply and demand will determine the market price. Again, there is not central authority. It really is a unique system, unlike any previous digital currency.

  5. Sounds kind of nutty to a dinosaur like me, but who knows what will happen in 5 years.

    • Kevin says:

      Indeed. Well, TV and telephone were “nutty” to people a century ago, too. ;) The idea of digital currency itself is one whose time is going to come sooner or later, and right now Bitcoin looks like the best iteration of the idea. It will be interesting to see how things continue to move forward.

  6. Wow, trying to understand and create currency is way out of my league. I’m impressed people are trying to make a go at it.

    I personally think there will always be a need for a tangible trade-able currency that is not in digital form. There are still a lot of people in developing countries that don’t have access to computers and digital media…probably the bulk of the population out there.

    I think as a percentage of the world economy, if it happens, it’ll just be a drop in the bucket.

    • Kevin says:

      Actually, access to mobile technology is significantly more widespread than computers; I believe more than a billion phones ship per year now? Many companies are trying to move payment technologies onto the mobile market, and this technology is a good fit because corruption is often rampant in these areas, but corruption is more difficult without a centralized scheme to tap into and control. I think in 5 years from now as costs keep falling we’re going to see ubiquity of the smartphone… it will be quite interesting.

  7. To me, I can’t see it really taking off. However, I have been wrong about other things in the past, which means it will be a huge hit!

    • Kevin says:

      In one sense, it’s already taken off; thousands of dollars are traded every day and some people have substantial balances ranging in the tens and hundreds of thousands of dollars. This value isn’t coming from anything other than people’s desire to use this currency.

      I don’t claim that this technology is perfect, but as an evolutionary work it is a big step forward. It’s also open source which means that hundreds and thousands of eyes have pored over it, looking for exploits and flaws. I believe that a guy out there even co-opted all of his companies machines to try and take over the network…

  8. It all just sounds so crazy that I can’t wrap my mind around it! Is online banking not enough? I just don’t forsee this becoming anything but hype.

    • Kevin says:

      It’s really two different markets; this would be more of a competitive threat to PayPal and not your online banking, and PayPal has disgusting fees. ;) This technology has already moved beyond the hype phase, but in the global scheme of things it’s still quite tiny. It’s growing quite rapidly, though.

  9. grondilu says:

    Hi,

    if you have some bitcoins and want to buy gold with it, here is an auction for a swiss gold coin.

    http://www.biddingpond.com/item.php?id=312

    Check out the market place forum and the #bitcoin-otc channel on freenode to see my selling history.

  10. Most interesting; I had researched a barter system a while back. Are you concerned about it being a scheme, regulation, tax issues, etc?

    • Kevin says:

      Everything is open and the code can be scrutinized so I don’t think it’s a scheme, but whenever money is involved scammers are always attracted like flies. Regulation & tax issues are definitely going to be big concerns for this system and all others like it, as I can imagine all sorts of ways that a system like this can step on the state’s toes, and it’s not going to be too happy about it.

  11. Aloysa says:

    It sounded really crazy to me and I had to re-read a few sentences to see if I can even understand this Bitcoin English. :-) Anything digital just scares me because it seems so much easier to steal. Especially digital money. Maybe I am just paranoid.

    • Kevin says:

      I’m concerned about anti-theft too. If all one has to do is install a keylogger or trojan to rip you off then we have some work to do on the security end of things. I can also see websites springing up to act as “digital vaults”, but there’s certainly an element of risk there that you don’t have when you use CCs, for example. At the same time there are many advantages, too, so it becomes a tradeoff.

    • Aloysa, you’re not being paranoid– you’re 100% right to be worried. Bitcoin is young and has a ways to go before it is both really easy to use and really safe for people who aren’t computer experts.

      Kind of like cars when they were first invented– you used to have to be able to repair your own car if you wanted to drive!

  12. Jeff says:

    Kevin,
    Do you really think Biticon has a chance of staying around for more than a couple of years? It seems that it may just be a “fad.” Realistically, I don’t see how this internet currency could stay around/survive.

    • Kevin says:

      I honestly can’t say for Bitcoin as the specific software, but I think the idea itself is definitely not a fad. Bitcoin has shown that it can work, and now it’s only a matter of building an ecosystem around this. It’s also entirely possible that it runs afoul of some regulation and it becomes illegal to use such software, but that’s another issue entirely.

  13. Dr Dean says:

    I am curious how the one world order conspiracy theorists see this.

    Will it be a threat or a boon if that is your mindset??

    Just curious. Will be worth watching, thanks for giving us all something to think about!

  14. Evan says:

    I don’t get it I hope I am missing something.

    One of the qualities has to be that other people accept it! If I can’t pay for my pizza in BitCoin…or I can’t pay for my car, cable, internet, coffee, etc. then the currency is worthless. At best it is a computer game where I can win points.

    • Kevin says:

      No you’re not missing anything. That’s the key ingredient needed in order for this to grow! It is already accepted by some places but not a great deal of places, but this has improved a lot since 6 months ago and it’s continuing to improve.

      P.S. The currency is not worthless ATM because you can trade it for non-digital currency. Now if it is in a bubble or not is open to debate.

  15. […] lastly WTF is a BitCoin? Well read The Digital Currency of the Future and find out! I don’t think I’m downloading any software that shares files over the web and […]

  16. I thought I am going to read about farmcash :P

    The whole digital currency is fascinating to me. I can’t wrap my head around a completely new currency system (other than paper, metals and barter). But I guess that is what people would have felt when they moved from pure bartering to a metal/paper currency. At this point I can’t speculate whether it will make my life easier or more difficult with fraud…

    • Kevin says:

      That’s a good point, Suba. It’s a new paradigm that is in its infancy, and things are probably going to change and evolve a lot before everyone is using this. That’s the beauty of open source, decentralization, and free competition without arbitrary red-tape holding you down — things can evolve fast, and it is the user/customer that benefits.

  17. […] InvesItWisely talks about Bitcoin: The Digital Currency of the Future […]

  18. Mike says:

    In my opinion we will see gold and or a basket of commodities officially enter back into the system. This seems “different” yet, I believe we are still a few years off.

    In government and Central Banks things are usually done when they are a last resort…eg crisis management. The coming changes in the monetary system will take many by surprise yet, the writing is on the wall IMO.

    Nice post – informative and thought provoking.

    Have a good weekend. Mike

    • Kevin says:

      Funny thing is that it wasn’t so different only a few decades ago. What i’m curious is if this change will come about via allowing competing currencies within national borders or whether it will come about as a result of a peg. Can a peg ever be successful? I don’t know. It seems that holding anything to an artificial value is always bound to introduce distortions into the system, though hard to argue with the idea that the current system is any less distortionary.

  19. DIY Investor says:

    Interesting. A couple of points. If its biggest attraction is that it isn’t controlled by a monopoly issuer then it will have a difficult time being accepted because most people (huge understatement) are clueless in understanding the subtle tax that central banks impose on people with their monopoly powers. I for one am interested in anything that could get us past the fiat monopoly controlled system now in effect.
    A second point is that I wonder about the supply and demand aspect and how volatile the currency will be. We see supply and demand daily in the stock market wild swings as valuations are all over the place.
    Third point: monetary systems are really nothing more than keeping score of who owns what. It is done digitally today with score being kept by (in the U.S.) the Federal Reserve. For another system (the Yap Islanders) readers might want to check out

    http://economistsview.typepad.com/economistsview/2005/09/yapping_about_m.html

    • Kevin says:

      If the scorekeeper plays banker, then it’s quite easy for them to cheat and take out a couple $500s when nobody is looking…

      I think you’re right about the idea but with any technology it’s the early adopters and the evangelists that really drive the innovation and push it out in a form where it will be accepted by the masses. Bitcoin is not there yet, but could it conceivably become so? As more of the economy moves online, I don’t see why it, or technologies like it, can’t continue to play an increasing role. It’s another way for us to keep score, except nobody gets to play banker so it’s a little harder to cheat.

      It might seem unstable when you compare it to USD-denominated prices since like gold, it should be a gradually appreciating form of currency which stands in stark contrast to all central-bank issued currencies which gradually depreciate in value. However, the difference is that supply & demand would reflect actual market fundamentals since there isn’t anyone standing by ready to drop additional coins from a helicopter. In fact it’s quite something that the value has risen so much in spite of the very large initial inflation of the money supply that has occurred until now as a result of its birth.

    • Kevin says:

      The Yap Islanders system was pretty interesting. Basically the stones serve as records so that everyone knows who did what, and it’s very easy to keep score. Also, since the stones are unique and bulky the value can’t be easily replicated or stolen…

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  21. I guessed times are changing and for each era, a new form of payment has evolved. Gold and silver were popular form of payment. There is the monetary currency with the US dollar being the most popular the past few decades (although other currencies are catching up as well). Back in the days, I’ve read about eGold as a form of electronic payment but I’m not sure how it works. I’m guessing that there are some similarities between the two.

    • Kevin says:

      The most fundamental aspect of Bitcoin is that it is not a derivative of any other currency; e-gold is a derivative of gold, but Bitcoin simply is, just like the element gold is. It has certain properties which lend usefulness to its use as money, and it has some attractive qualities such as no/low transaction fees, pseudonymity, and non-repudiation which you won’t really find in anything else. This is why I say this is really the birth of something new, something that has only been discussed in theory until now but that we are now seeing being born.

      Maybe this won’t be the first widely successful attempt, but it is the first to achieve some degree of success and set the step for the next to follow. In the end civilization is the result of the sum of all that our ancestors have done before us. We stand on the shoulders of giants, and this is just the next step.

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  24. 101 Centavos says:

    I hope something comes out of this, as competing currencies breaks the monopoly of the central banks. As long as Bitcoin can maintain scarcity through its encryption requirements, and evade the grasp of the money center elite through decentralization, then it has a decent chance.

    • Kevin says:

      I think so, too. There are some significant challenges that lie up ahead (how to protect against keyloggers/trojans? How robust is the encryption against exponentially increasing computing power?) but the nature of the development model means that people can try out competing solutions, and those solutions which work better will be the ones that succeed. Bitcoin can create a new space in which rapid experimentation and development can proceed.

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  27. Forest says:

    Really interesting stuff Kevin. I don’t quite see how it could break free from real money at this stage because obviously I guess they earn real coin off your mining efforts and use that to run their company…. Not sure how they would ever get off that but in many ways I hope they do…. May have to give it a try myself.

    • It is just like earning money in any foreign currency: if you can, you want as many as expenses as possible paid in that currency (so you don’t have to pay exchange fees), but eventually you do take profits and exchange them so you can pay your mortgage or pay the corner grocery store.

      The list of expenses you can pay with bitcoins is growing every day– it it not TOO far-fetched to imagine that eventually banks and corner grocery stores might accept bitcoin as another payment method.

    • Kevin says:

      Check out the forums and the site, Forest! You might just find it interesting.

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  29. Len Penzo says:

    Very interesting article, Kevin! The key to any currency is undisputed widespread acceptance by the people who use it. Until and unless that occurs, I can’t see this idea ever gaining real traction. Personally, I think this idea will eventually fizzle out. Then again, I though Google stock was overpriced shortly after it’s IPO too. ;-)

    All the best,

    Len
    Len Penzo dot Com

    • Kevin says:

      And the iPhone might have been a bit of a hard sell before 2007, too. ;) Skepticism is healthy and to be encouraged; many ideas eventually fail, but remember that this idea isn’t asking people to fork over some money in return for ordering groceries online, or something like that. It’s more of a concept. The idea of distributed currency is a concept that has already been proven, but it’s just a little harder to say who’s going to execute the idea well and when the time is right. Plus, it doesn’t need widespread acceptance by a large segment of the population. Even 1%, even 0.01% would be huge.

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  36. Did you try mining for bitcoin?
    I tried for a days and my computer generated so much heat, it was making me hot. It sounds like you need to set up the GPU to do the heavy lifting.

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