Monday, 8 April 2013

In case you still don't know what bitcoins are, or else would like to understand them better

Bitcoin is a decentralized, open-source, virtual currency created in 2009 by a man who went by the pseudonym Satoshi Nakamoto.  The true identity of this man remains anonymous to this day - only adding to the mystique of this already mythical currency.

A bitcoin, like a dollar, is a unit of currency, which means it is a medium for storing value and exchanging goods.  Unlike the dollar, however, the value of bitcoin is not backed by a military, nor is it centralized and issued by a central bank, nor can an infinite amount of it be printed.  More unlike the dollar, bitcoin is open-source, which means anyone, anywhere, with little more than a computer and a working knowledge of C++ (programming language) can learn precisely how bitcoin operates, and can participate immediately in the network.  The full code is here  

Essentially, what Satoshi did was to setup a protocol which would allow a network of users to exchange bitcoins with one another, where the transactions themselves are actually verified by each and every user.  That is, as a bitcoin user, you actually participate in ensuring that other people aren't trying to use bitcoins fraudulently.   This has enormous appeal, because it immediately prevents the possibilitiy of someone like a large bank or government from defrauding the entire network, the way they do, on a daily basis, with the Euro and the Dollar (ie. rigged interest rates, market manipulation, etc.). 

Bitcoins are created through a process called 'mining', a term chosen for its analogy to how gold and silver are mined.  Basically, mining requires that a miner devote a large swath of computational resources to solving a difficult math problem.  In return, the miner is awarded bitcoins.  But most importantly, the mathematical problem solved by the miner actually goes towards securing and validating transactions that take place using bitcoin.  How does that work?

Every bitcoin transaction that has ever taken place is stored in something called the block-chain.  The block-chain is made up of smaller units (blocks), each of which has a few hundred transactions.  The entire block-chain is publicly available to anyone who cares to look.  That is, every bitcoin transaction is public (though the IP address and identity of the buyer/seller may be hidden).  Again, major selling point for bitcoin.  You can literally watch transactions as they come through.  As transactions occur, they are added to the most recent block.  The miners attempt to add this block to the block chain by solving a difficult math problem, which involves encrypting the transactions themselves.  By succeeding, the miners are awarded bitcoins (this is built into Satoshi's code), and the transactions in the block they encrypted are added to the block chain, validated, and secured.  The further back something is in the block-chain, the more secure it is.  This is what makes it virtually impossible to defraud the bitcoin network by pretending you have bitcoins when you don't, or by spending the same bitcoin twice (since everyone is verifying ever transaction, they will notice you tried to spend a bitcoin twice, and will only accept one of the transactions in the latest block).

The protocol written by Satoshi mandates that there should only ever be 21 million bitcoins in existence.  Starting from 0, bitcoins have been mined and continue to be mined.  Today there are 11 million bitcoins.  Roughly every ten minutes, another block is encrypted (added to the block chain) and 25 new bitcoins are created and awarded to the miners that succeeded in encrypting it.  That 25 was 50 a few weeks ago, and will be 12.5 in the not too distant future.  From there, it will drop to 0 in the year 2140, at which point all 21 million bitcoins will be in existence and never another.  At that point, miners will not be awarded newly created bitcoins, but probably transactions will take on a 'miners fee' so that miners can continue to be paid for securing the integrity of the network. You too can start mining, but you may need to get yourself some specialized hardware at this point. Satoshi was clever enough to adjust the difficulty of the math problem to math the number of miners in the game - the more miners there are, the harder the encryption becomes (and the safer the transactions become!). It is all set up so that a block gets encrypted roughly every ten minutes

This is the basic essence of bitcoin.  There are many more details, but that is enough to know for now.  Given recent events in Cyprus, the general incompetency of governements, central banks, and fiscal policy, and the ever present desire for humanity to take back control of its resources and interpresonal exchanges from Big Brother, Bitcoin has emerged as a fantastic alternative to the standard nationally issued currencies.  Indeed, as the world economies continue to implode, we can expect to see the price of bitcoin continue to rise - barring of course a great scare or other black swan on the internet scene.

There are by now numerous virtual currencies, many of which have simply ripped the Bitcoin source code and made minor changes (it is, of course, open source).  These are worth pennies right now.  A bitcoin was worth pennies a few years ago.  Last year, a couple dollars.  Last month, a couple dozen dollars.  Right now, $190.  We are literally witnessing financial history.  Whether or not bitcoin will last through the decade is anyones bet, but virtual currencies are here to stay, and bitcoin is making waves.

To get started, you would do yourself a favour by reading extensively on the internet.  Start with the general FAQ

When you're up to it, get yourself a wallet (downloading one is safer than using an internet one, and making yourself an offline paper wallet is by far the safest thing to do.   Note this method does not work for macs, but alternatives exist, like using a virtual machine).  Find someone online that will sell you coins, or better yet someone local you can meet with to execute the trade.  Your bitcoins will then show up in your wallet.  At that point, you can hoard them in hopes of a continual rise in value, or you can spend them at myriad places on the internet, including ebay and reddit.  Of course, at any time, you can sell them to someone for dollars again.  But beware, the Fed is printing trillions of new dollars a year, banks are notoriously fraudulent, and the stock market is in one of its finest bubbles yet.  There will only ever be 21 million bitcoins, there will never be bitcoin fraud (though it is possible for someone to hack into your computer and steal your bitcoins, though this is highly improbable), and no one yet knows if what we're seeing is a bubble, or if this could be a real valuation of the novel financial medium.

As far as I'm concerned, the exploding price of Bitcoin is THE correction we've been waiting for in the markets for years.  Enjoy the ride!