[Note: This is the second in a three part series. You can read the introductory post here and part three here.]

How Bitcoin Works (The Simplified Version)

In order to use the Bitcoin system, a user installs a “wallet” on their computer or mobile phone. Once installed the wallet generates a Bitcoin address (similar to an email address) that allows the user to send and receive payments. Bitcoins are divisible to 8 decimal places yielding a total of approx. 21×1014 currency units. This allows a person to spend a fraction of a Bitcoin (the current exchange rate as of April 15, 2012 is 1 Bitcoin = $95.36000). Unlike standard e-commerce and money transfer system, Bitcoin transactions are irreversible.

How Bitcoin Works (The More Complicated Version)

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A Bitcoin is merely a chain of digital signatures attached to a transaction log. In the very first transaction of the system, Nakamoto’s computer program (which is open source and distributed across a peer-to-peer network) created 50 Bitcoins. When Nakamoto spent some of the coins, it created a new transaction that subtracted the amount from his account and credited it to the recipient’s. All such transfers entail the owner digitally signing a hash (a numerical value created by an algorithm) of the previous transaction and providing the public key for the encryption to the next owner. Both items are then added to the coin’s transaction log. A payee can verify the signatures to verify the chain of ownership, which prevents double spending of the same coins.

This transaction—and all subsequent exchanges—is distributed to the entire network for verification. Collections of transactions, known as “blocks,” are deemed valid when another computer on the network creates a transaction log for it that matches the previous blocks. To prevent the falsified logs from being accepted, the system must provide a means of verification that is prohibitively costly to any individual user, but relatively cheap for the network as a whole. As explained in The Economist:

This is done by making it into a forced-work task, which involves using the valid blocks and the new transactions to generate a digest consisting of 256 bits (i.e., any number between 0 and 2256). The task is complete when the system’s algorithm spits out a hash value below a preset target (like 11 in the example above). The target is set so that the puzzle is solved by someone on the network, and a new block approved, every 10 minutes. To keep this rate constant as the network’s ranks swell and its combined computing power grows, the target is lowered in order to make generating a value below it harder. (Conversely, if the network were to shrink, it would get easier again.)

As a reward for providing the computing power necessary to validate the logs, the first user whose computer finishes the RPOW task is rewarded with a set number of new coins. This is how new Bitcoins are added to the money supply. Because blocks are created at a steady average rate (about every ten minutes), 300 new coins were added to the system every hour for the first four years (210,000 blocks). The system is designed so that the minting rate will decrease by half every four years.  In 2012 the number of new coins issued per block dropped to 25 coins. In 2017, the rate will be 12.5, and so on, until the total supply plateaus at 21 million coins around the year 2030.

The following shows how the total Bitcoins will be added to the system over the next twenty years.

bitcoinrate

 

Why are Bitcoins Valuable? 

Most global currencies are fiat money—money that has value only because of government regulation or law. Fiat money is not convertible by law into anything other than itself, such as gold or silver, and has no fixed value in terms of an objective standard—it’s value can fluctuate based on numerous economic factors. In contrast, commodity money is a medium of exchange that may be transformed into a commodity, useful in production or consumption. Commodity money can be based on minerals (e.g., gold or silver), found objects (e.g., shells or stones), or consumer good (e.g., cigarettes in prison or POW camps). Although it was the dominant medium for exchange for over two thousands years, commodity money has fallen out of favor because of it limits the scope for monetary policy and other actions that alter the value of money.

Bitcoins are a form of commodity money. Technically, Bitcoins have no intrinsic value since they are nothing more than bits created by a laborious process on a decentralized network of computers. But because the supply is limited (they are rare commodity not easily produced) and their use is recognized as a medium of exchange, they are assigned a value by their users. Their worth, like the stones of Yap, is solely determined by what people believe they are worth.

So why would anyone assign value and use Bitcoins as a medium of exchange? The answer lies in the way they can be used and the types of people who would be attracted to the advantages of using Bitcoins.

Who Actually Uses Bitcoin?

            There are three main groups of people who are attracted to the Bitcoin system:

1. People who are obsessed with privacy.

2. People who despise the government and/or the Federal Reserve System.

3. People interested in online experiments and/or peer-based innovations.

privacyOf course such a list isn’t exhaustive, and there is much overlap between the groups. But the nature of the system makes it appealing to such groups precisely because this was the intent of its founder.

Almost nothing is known about Satoshi Nakamoto, the man (or woman) who devised both the concept and the original Bitcoin program. The name is Japanese but there is no Japanese version of the Bitcoin program. Nakamoto has also not written a single line of Japanese either in his code or in his sparse online writings. After starting the Bitcoin project in 2007, his involvement tapered of in late 2010. He has not been heard from since.

As to his political motivations, the only clue is a message he left on a cryptography mailing list. In response to a claim that the Bitcoin system would be “socially useful and valuable” Nakamoto wrote: “It’s very attractive to the libertarian viewpoint if we can explain it properly. I’m better with code than with words though.”

The intent and motivations of the founder are usually of no concern when evaluating new technologies. However, the case of peer-based systems such a Bitcoin, they can be a useful starting point for understanding how the project will evolve and its likelihood of success. Crowd-sourced technology projects are often driven as much by political and social concerns as they are with economics. Bitcoin is a prime example. The system is cumbersome, limited in use, and has many economic disadvantages (which we’ll discuss in the next section) that far outweigh—at least for the common user—any advantages. The primary motivation for advancing the system is to advance concerns common to cyberlibertarians: online privacy and a disdain for fiat money.

silkrateThe concerns of some privacy enthusiasts, however, have less to do with political abstractions of liberty than with a desire to have their financial transactions hidden from the view of law enforcement. For example, the website Silk Road made headlines a couple of years ago for becoming the first online marketplace for illicit drugs to accept the digital currency. In an exclusive interview with Gawker.com, a customer of Silk Road shared his online buying experience:

About three weeks ago, the U.S. Postal Service delivered an ordinary envelope to Mark’s door. Inside was a tiny plastic bag containing 10 tabs of LSD. “If you had opened it, unless you were looking for it, you wouldn’t have even noticed,” Mark told us in a phone interview.

Mark, a software developer, had ordered the 100 micrograms of acid through a listing on the online marketplace Silk Road. He found a seller with lots of good feedback who seemed to know what they were talking about, added the acid to his digital shopping cart and hit “check out.” He entered his address and paid the seller 50 Bitcoins—untraceable digital currency—worth around $150. Four days later the drugs, sent from Canada, arrived at his house.

“It kind of felt like I was in the future,” Mark said.

Not everyone, though, is enthusiastic about narcotics being bought with cryptocurrency. When Senators Chuck Shumer of New York and Joe Manchin of West Virginia heard about the article, they demanded federal authorities investigate and shut down Silk Road. “It’s an online form of money laundering used to disguise the source of money, and to disguise who’s both selling and buying the drug,” said Schumer.

Despite the Senator’s legitimate concerns about online narcotics trafficking, he shouldn’t be as concerned about the use Bitcoin for money laundering. Although users of Bitcoins can remain anonymous, they aren’t untraceable. As Jeff Garzik, a member of the Bitcoin core development team, told Gawker.com, “Attempting major illicit transactions with Bitcoin, given existing statistical analysis techniques deployed in the field by law enforcement, is pretty damned dumb.” Ironically, drug users who thought they were using Bitcoin to conceal their transactions are likely making it easier for the DEA to collect a database of their purchases. 

And lest you think I’m exagerating the appeal of Bitcoin for illicit transactions, here is a chart from May-June 2011 that showed the rise in demand for Bitcoins after Gawker made the public aware that they could be used to buy drugs.

bitcoindrug

However, buying drugs is not the only government-avoiding activity that Bitcoins help facilitate. They can also allow American citizens to gamble online using foreign gambling sites and bypass a U.S. Government ban on online gambling or the transfer of funds to offshore gambling sites. The currency also allows people to avoid taxes and can facilitate donations to groups that are targeted by federal agents. Bitcoin users, for instance, can provide money to groups like WikiLeaks without worrying about the U.S. Government shutting down their PayPal accounts.

Most people who exchange Bitcoins, though, are (presumably) not using their money to buy psychedelic mushrooms from Canada or play online blackjack in Antigua. Many are simply enthusiastic and supportive of a system that allows them to put their monetary theories into practice. Whether these economic practices are sound, though, is a question that we will examine next post.

[In part 1 of this series we looked at how humans determine what is considered money and how Bitcoin came into existence. In part 3 we’ll consider the disadvantages of Bitcoin, it’s future, and why it should matter (to everyone, but specifically to Christians).]