Bitcoin - a Layman's Guide

A physical bitcoin.

A recent computer virus infection at the Swansea, Massachusetts, police department brought the topic of bitcoin to local attention. This nasty virus encrypted several computer files, effectively holding them for ransom. If the cops wanted their files back, the perps demanded to be paid in bitcoin. Luckily, all ended well with no damage, injury, or loss of confidential data. But it did require the very real expenditure of $750 to buy two bitcoins.

What the heck is a bitcoin?

One thing is certain – bitcoin is extremely popular on the web. As of this writing, Google reports nearly 35 million hits on the term. Most of the descriptions are highly technical and loaded with computer jargon. Let’s try to demystify it.

Bitcoin is a virtual currency. This means that no physical bills or coins are required to represent value – bitcoins live in computers. While this may seem odd, consider that our own dollar has very nearly become a virtual currency. For many folks, it is common to have their wages (or government pension) automatically deposited into their bank account. Bills can then be paid using the bank’s online bill paying system. Groceries, restaurant meals, gasoline, and untold other goods may be purchased using a credit card. Nary a dollar bill is seen.

Another characteristic of bitcoin is that it can facilitate anonymous transactions. (That’s why the perps required the Swansea police to pay in bitcoins). But this is not an unfamiliar characteristic of our dollar. While credit card and banking transactions are easily tracked, a suitcase full of cash is fairly anonymous (unless the bills are marked).

Bitcoin differs from the dollar in one significant way: it is not a fiat currency. Fiat currencies are issued and backed by central authorities such as the Federal Reserve Bank (dollar), European Central Bank (euro), or Bank of England (pound). For citizens living in these stable countries, a fiat currency is a good thing. But not so for those living in economic paradises such as Venezuela and Argentina, where bitcoin is gaining popularity as an alternative to the uncertainties of high inflation rates, devaluation, and the risk of expropriation. Further to their credit, bitcoins cannot be counterfeited.

Where did bitcoin come from? The idea was first presented in a 2008 paper written by "Satoshi Nakamoto" (which may be a pseudonym for an individual or group). The currency is only possible because of developments in powerful yet affordable computers, high speed networks, and distributed processing. It is very much a child of the Internet Age. Bitcoins are “mined” by enthusiasts with powerful computers searching for the solution to a very difficult cryptographic problem. When a new bitcoin is discovered, its existence is added to a distributed, public ledger.

Each bitcoin is unique and the total number of bitcoins is limited (mathematically) to some 21 million. All of the easy bitcoins have been discovered and it is becoming progressively more difficult to find (solve) each new one. This insures that bitcoins will never be devalued by “printing money”, which governments are wont to do.

Bitcoins are stored in (and spent from) electronic wallets. Your wallet might be an iPhone app or a discrete (miniature computer) device. You can buy bitcoins from a broker and store them in your "wallet". From there, they can be spent to buy goods and services in much the same way as a debit card. Physical bitcoins are available from vendors such as Casascius. These physical coins each contain the unique identifiers of the virtual bitcoins they represent.

How is all this working out in practice? Pretty darned well. On October 30, Time Magazine reported that “Bitcoins took yet another step toward mainstream use on Tuesday, as the world’s first ATM converting the virtual currency to conventional cash, and vice versa, was introduced at a coffee shop in Vancouver, Canada.” In a recent Wall Street Journal article (11/14/13), the story of the Craigs was chronicled. Austin and Beccy, an adventurous couple, successfully paid all of their expenses using bitcoins during a 100 day, three continent odyssey (albeit with some difficulty at times).

Are bitcoins here to stay? The signs are good. At a Senate committee hearing on Monday 11/18/13, US authorities termed bitcoin a “legitimate financial service.” The concern of illicit activity was felt to be manageable under existing banking and currency laws. Federal Reserve Bank Chairman Ben Bernanke, in a letter to the committee, wrote that virtual currencies “may hold long-term promise, particularly if the innovations promote a faster, more secure, and more efficient payment system”. Bitcoin prices surged on the Tokyo Mt. Gox exchange in response.

At one time, ATMs were new and strange to many of us. But given time, this brave new world of virtual currency will become equally ordinary. This is how science fiction comes true – one iPhone app at a time.

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Update 11/21/13 - "Bitcoin now accepted as tuition payment at Cyprus university."