How-to Understand Bitcoins, a Bitcoin Primer

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Bitcoins are a hot topic right now, and while there is a detailed Wikipedia entry, a FAQ at bitcoin.org, and all manner of articles looking at recent volatility, we thought a comprehensive primer would come in handy.

What Is Bitcoin?

Bitcoin is first and foremost a virtual currency. It is also a decentralized currency, meaning that there is no one person or party in charge of it. It's not backed by a government or any form of hard asset, which means that its value is protected only by the integrity of a distributed network of accountability and the willingness of people to accept them for goods or services.

Another way to think of that is to take yourself back to 1994, when a question that many people asked was, "Well, who owns the World Wide Web?" Today, almost everyone understands that the Web is nothing more than a bunch of servers communicating with client computers (we, the surfer) using a series of mutually agreed upon protocols (starting with HTTP).

No one owns the Web, and no one party controls it, but many, many parties contribute to the overall integrity of this worldwide network we call the Web.

Bitcoin is similar. Just as Tim Berners-Lee devised and proposed the HTTP protocol, Bitcoin was initially proposed by an anonymous programmer or group or programmers going by the pseudonym "Satoshi Nakamoto." Today, that protocol is tended to by Bitcoin.org, and many parties contribute to the overall integrity of the currency.

You can read up on the early history of what Mr./Ms./Mrs./Messrs. Nakamoto started at Wikipedia, but the short version is that he/she/they proposed the open source concept of Bitcoin in 2008 and the first Bitcoin client was launched in 2009. Since then it has grown to be a pretty big deal, with the value all outstanding Bitcoins topping $1.2 billion.

Anonymous

Bitcoin is also as close to anonymous as one can get, though Bitcoin officially claims transactions are not anonymous. Each Bitcoin is attached to an address, and they are sent and received by digital wallets that are also attached to an address. That means names aren't associated with the transactions, but at the same time, every transaction is publicly logged and available to view by anyone and everyone.

This combines to make for functional anonymity (that will increasingly make governments tense), while leaving the system as a whole transparent and constantly auditable. In fact, that's what Bitcoin miners (more on miners in the section about where Bitcoins come from) are doing, constantly tracking and auditing transactions.

Getting Bitcoins

There are a host of exchanges where you can buy Bitcoins. We haven't tested any of them and can't vouch for one. Do your research on the exchange of your choice before spending your real money for virtual money.

That said, MtGox is considered the most widely used exchange. In fact, it is so widely used, problems with MtGox's ability to handle a huge increase in transactions led to a spectacular collapse in price of Bitcoins in the last few days, from US$266 per Bitcoin to as low as $105. As of this writing, it was trading at $114.

Bitcoins

To start, you'll need to download a Bitcoin wallet. Bitcoin-QT is the original wallet that forms "the backbone of the Bitcoin network," as Bitcoin.org puts it. It's available for Mac, Windows, and Linux.

There are also Bitcoin wallets for Android (untested by us) that will generate a QR code you can use to pay for things at brick and mortar retail stores that accept Bitcoin.

As of this writing, there do not seem to be any functioning Bitcoin wallets for iPhone or iPad, though there any number of Bitcoin current quote apps. We recommend reading user reviews before downloading.

There are also "Web wallets" that allow you to access your wallet through a browser. These wallets store your Bitcoins on remote servers, however, meaning that should anything happen on their end, your Bitcoins are kaput.

What Can I Do With a Bitcoin?

Spend them, of course. It's a currency, after all. Ah, but what you really wanted to know is where you can spend them. The bad news is that you can't yet spend them on Apple's iTunes, and you can't spend them at Amazon. The good news is that there is an ever-growing number of places where you can spend them.

SpendBitcoins.com maintains a directory of businesses that accept them. That directory isn't currently organized in a useful way, but there is a description with each of the hundreds of businesses listed.

In October of 2012, GreyCoder put together a list of places taking Bitcoins. It's much less comprehensive, and some of them are no longer functioning, but the list is organized into categories that are more useful.

The Bitcoin Wiki also maintains a list of exchanges and businesses that accept Bitcoins.

Of course, many people that own Bitcoins are simply investing/speculating in them. The Winklevoss Twins reportedly own a $11 million cache of Bitcoins, for instance. The two bought some 108,000 BTC, a stake that is currently worth more like $12.3 million.

Being such a new currency—and one with a relatively small number of units in the market—speculator and investors alike can send Bitcoins on massive swings. Bitcoin.org said that as more and more vendors begin accepting the currency, the price should stabilize. Time will tell if that's the case.

Adam Curry recently tweeted a link to a handy chart looking at the super bubble that formed in recent days.

You Are Here

Note the ever-rising mean line.

Where Do Bitcoins Come From?

Another concept to wrestle with is where Bitcoins come from. They're not minted or printed, but rather generated digitally. Mind you, there are some physical Bitcoins out there, but those physical representations are tied to a Bitcoin that was created digitally.

Unlike every national currency in existence, Bitcoins are not created willy nilly, or even on demand or by the order of any party. Instead, they are produced on a schedule, 25 new Bitcoins roughly every ten minutes. Those Bitcoins are distributed to Bitcoin "miners," server owners who are part of the network that maintains the logs that track Bitcoin transactions.

These servers are key to the existence and integrity of Bitcoin, which is why they are rewarded with the new coins.

But wait, there's more to this: in 2017, the number of new Bitcoins created will be halved to roughly 12.5 every ten minutes. Four years after that, it will be halved again, and then every four years after that.

In 2140—that's 127 years from now—the final Bitcoin will be minted, and it will be a fractional Bitcoin denomination (more on denominations below). That's a long-range plan, eh?

What's extra interesting (to us) is that when all is said and done, there will be precisely 21 million Bitcoins that were created. OK, that's not precise. It will really be 20,999,999.9769 BTC. In comparison, there are many trillions of U.S. dollars in circulation.

As of this writing, there are precisely 11,026,550 BTC in circulation, more than half of the eventual total. In fact, the first 50 percent of the total planned were created in just 4 years. Thanks to the law of halvesies (there's probably a real name for what they're doing), it will take another 127 years to make the other half.

Here's a chart demonstrating the distribution curve over time. Note that this chart approaches the 21 million mark at the top, but it only extends to the year 2033, 107 years before the last coin is issued.

Bitcoin Creation Chart

Source: Bitcoin Wiki

This makes Bitcoin deflationary by design. Assuming that people remain willing to trade them, Bitcoins will rise in value relative to other currencies as more people use them. Add to that the reality that many Bitcoins will be permanently and forever lost when people lose their Bitcoin digital wallets, and that relative value should escalate in perpetuity, especially once our grandchildren's grandchildren see the last Bitcoin created.

Please let us emphasize this point. Unlike a bank, Bitcoin doesn't give you any mechanism for recovering a lost security key. If you lose your wallet, your Bitcoins are just gone. Some of the web-based wallets do offer password recovery, but they also have the risk of exposure on their end.

If a wallet is lost, those Bitcoins are lost not only to the user, but to the Bitcoin economy. They are not replaced or given to anyone else, they're just gone, all value associated with them wiped out. All things being equal, that value will eventually be be reflected in the overall price of Bitcoins, as dictated by the law of supply and demand.

Bitcoin recommends that you back up your wallet to a thumb drive or write your key down on a piece of paper that you store somewhere very safe.

Spare Some Change?

At $114 per bitcoin, you may be asking how change works. As noted above, Bitcoins are deflationary, meaning that all things being equal, their value will rise relative to other currency assuming greater interest and use.

The Bitcoin protocol allows for up to eight decimal places of division. The smallest denomination is therefore 0.00000001 BTC. That unit is called a "satoshi," named for the pseudonymous creator of the currency.

In comparison, a U.S. dollar allows for two decimal places of division.

At today's price of $114, a satoshi would be worth $0.00000114, slightly more than a thousandth of a cent. That's a meaningless number for transactional purposes, of course, but the higher the value Bitcoins rise, the more useful those smaller decimals become.

Other denominations include (directly from Bitcoin.org):

1 BTC = 1 bitcoin
0.01 BTC = 1 cBTC = 1 centibitcoin (also referred to as bitcent)
0.001 BTC = 1 mBTC = 1 millibitcoin (also referred to as mbit (pronounced em-bit) or millibit or even bitmill)
0.000 001 BTC = 1 μBTC = 1 microbitcoin (also referred to as ubit (pronounced yu-bit) or microbit)

If Bitcoins were to rise to $1,000 per BTC, an mbit would be worth $1, a very useful denomination. At $100,000 per BTC, even a microbit is worth $US0.1 (a dime), a denomination that is traded millions of time per day in the U.S. alone.

In other words, as the value scales up, a Bitcoin will remain a Bitcoin, but it will be traded in ever-smaller denominations as needed. There are another eight decimal places provided for in the protocol, too. They aren't used right now, but could be activated when needed.

Security

The secret sauce for Bitcoins is how to spend them and how to track those transactions. If they are not tracked properly, fraud, both intentional and accidental, will ensue. That's where those Bitcoin miners come from.

Each Bitcoin has a "block chain" associated with it that is effectively a record of transactions associated with that Bitcoin. Bitcoin miners are busily running a series of complex algorithms that test the authenticity of these block chains.

Because this task is distributed to an increasingly vast network of miner operators, there are processes included in the Bitcoin protocol that are intended to keep any given Bitcoin from being spent more than once (a "double spend" in Bitcoin parlance). From the Bitcoin FAQ:

That the block chain cannot be easily forked represents one of the central security mechanisms of Bitcoin. Given the choice between two block chains, a Bitcoin miner always chooses the longer one - that is to say, the one with the more complex hash. Thusly, it ensures that each user can only spend their bitcoins once, and that no user gets ripped off.

On the other hand, this means that users have to wait many minutes—approximately 10 minutes on average—to be able to spend Bitcoins they have received. This is because the transactions are being verified and added to the block chains.

There is much more on the security front at the Bitcoin site.

The Man

Bitcoin is fascinating, and there is a lot of attention being paid to it by a lot of folks. That includes governments, which are not at all pleased about folks being able to trade money outside of their scrutiny and control, the very thing that makes Bitcoin so desirable in the first place.

Criminals could use it to launder money, and terrorists could use it to transfer funds around the globe without all those pesky forms. The rich can also use Bitcoins to get money off an on-shore with paying some of those pesky taxes.

There are many legitimate use for Bitcoin, of course, but it will be interesting to see if (and really, that's probably "when") governments are able to effectively collar the currency.

Most recently, the Financial Crimes Enforcement Network (or FinCEN), a bureau of the United States Department of the Treasury, claimed jurisdiction over virtual currencies such as Bitcoin. In a report issued on March 18th, FinCEN said that Americans can use Bitcoins, but that entities based in the U.S. that generate virtual currency units (i.e. mine Bitcoins) are "money service businesses" that are subject to regulation.

That hasn't been tested, and it's anyone's guess what will come of it. The Bitcoin markets don't seem to be all that concerned about it, either, so maybe there's little to it.

Conclusion

We aren't here to offer you financial advice, and as of this writing, we have no position in Bitcoins. Do your research, and if you get involved with the Bitcoin economy, pay attention to who you're doing business with and where you put your money.

Bitcoins have been around for 4 years now, a long time for an online business, but not all that much time for something like a "new currency." The market is wildly volatile, too, as witnessed by the recent bubble/collapse. There are a lot of articles about what happened, just as there have been each time it has happened during the last four years.

Stacks of Bitcoins courtesy of Shutterstock.

Comments

Mark TT

I wanted to buy some Bitcoins, but here in UK, we need middlemen with huge fees, and a transfer SEPA to an euro account or an international wire is very expensive. Fortunately I found in some forums this helping guide:

howtogetbitcoinsuk.blogspot.co.uk

Lee Dronick

I am a bit leery of Bitcoin, I will probably sit this one out.

Lancashire-Witch

Me too Lee.  If it’s on the Net it can be hacked or stolen.

iJack

Read it. Still don’t get it. What’s wrong with regular money? Or PayPal?

smichea

I think one important thing to tell to readers that might consider buying bitcoins is that a large amount of bitcoins where created at the very beginning, by Satochi and friends.
So keep that in mind : you will just give a large part of your money to him (them smile )

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