WTF is Bitcoin?

A short FAQ on Bitcoin.

What is Bitcoin?

Bitcoin is a cryptocurrency. It consists of data (information; a string of 1s and 0s), rather than anything physical. It uses mathematical algorithms, or cryptographic algorithms, to determine who owns what money, and prevent people from cheating by stealing money or spending the same money twice.

Why is this suddenly interesting?

Previous cryptocurrencies needed to be centrally managed. Bitcoin makes the entire process distributed which cuts out a single point of failure, and makes it hard for any government to control and shut down.

Won't this piss off a lot of people?

Probably. Banks just lost a lot of business. However they will still be able to continue to offer other financial services. Governments don't like it because they no longer have a privileged position, and can't manipulate it.

What's the harm?

Bitcoin facilitates transactions, and that includes money laundering, buying illegal things and other illegal activity. It's impossible to freeze criminal assets, and criminals can operate internationally in hostile jurisdictions.

Investors could end up losing a lot of money if they treat Bitcoin as an investment.

Is Bitcoin anonymous?

Not really. Bitcoin keeps a public ledger, which means that it's fully traceable. You can nab individuals whenever they attempt to spend Bitcoin at a later date, or do anything in the real world involving their Bitcoin. Computer addresses can be traced. It's less anonymous than cash. 

Won't it just be banned?

It's quite likely that Bitcoin will be banned in some countries. This could mean that exchanging Bitcoin for other currency would be illegal, it could mean it's illegal to run a Bitcoin server, perform bitcoin transactions at all, or it could mean that network traffic is blocked or deliberately disrupted.

Bitcoin is however becoming part of our Zeitgeist - its widespread use may eventually become accepted and therefore hard to ban.

Bitcoin, or Bitcoins?

I say "Bitcoin", since you usually trade in fractional quantities, rather than round numbers.

How do you "own" Bitcoin?

Someone "signs" Bitcoin to say that you are the new owner. You keep this information in your "wallet", which is a digital store of all your Bitcoin. You can then sign away the Bitcoin to someone else at a later date.

What is a digital signature?

Like all things digital, a signature is just a long number (in 1s and 0s). The existence of a signature "proves" that a certain thing happened, because such a number could (almost) impossibly occur by chance.

Each user has a randomly generated key that is split into two parts: a public part and a secret, private part. A user can create a signature by combining a statement (being signed) with their private key. The clever part is that anyone who has the public key can validate that the signature is real, even though they don't know the private key. This clever mathematical trick underpins much of cryptography today.

You effectively create a  statement like "Fred now owns Bitcoin number 123 - Bob," that is guaranteed by mathematics to be authentic.

What prevents you giving the same Bitcoin to different recipients?

This is the so-called double-spend problem, and has been the traditional bane of cryptocurrencies. Bitcoin solves this by broadcasting every transaction to other computers in the Bitcoin network.  Each computer then sets to work creating a block chain - performing a computation and distributing it further across the network. It is a network of trust. It would be very difficult to coordinate enough computers in the network to subvert this process.

Bitcoin is interesting because it's the first system that performs this in a decentralised way that appears, for now, to be genuinely difficult to cheat.

What is mining?

Bitcoin mining is the way in which Bitcoins are created. Bitcoins are deliberately difficult to compute, so there is in theory a steady supply of new Bitcoins. But there's a catch - the number of Bitcoins is still finite.

Isn't this an awful waste of energy?

Hmm. Yes, in a way. The whole system relies on difficult computations which by their very nature consume a lot of electricity.

Isn't "real" money just data as well?

Yes, yes it is. Real money also exists primarily in computer databases, and can be conjured up at will by governments. 

How can data be valuable?

Information has traditionally always been valuable - this isn't weird at all. Information confers a right, or a power.

How is Bitcoin different to fiat currencies?

Governments guarantee fiat currencies, but there's nobody guaranteeing or protecting Bitcoin. Part of the beauty and horror of Bitcoin is that it's guaranteed by cold dead mathematics, not politics. If a system's impossible to cheat, you don't need lawyers either.

How is Bitcoin different to gold?

Many people make a comparison to gold. Gold has been around a lot longer, so there's an established consensus that gold is valuable and an approximate idea of its value. Gold is also finite, just like Bitcoin.

If gold was discovered tomorrow, it would probably also go through a period of extreme volatility, and there would be no guarantee that society would agree that gold was valuable. In fact, the Inca gave all their gold away to the Spanish because they did not see it as a valuable metal!

What is the true value of Bitcoin?

The glib answer is that the market is always right, and is whatever people are willing to pay. The value of Bitcoin comes from two parts. First, it's utility in facilitating transactions, and secondly its value as an asset. Neither of these is particularly well defined.

Isn't is all just a big Ponzi scheme?

Hmm. Ponzi schemes are guaranteed to fail because exponential growth required for a Ponzi scheme is guaranteed to end eventually. There is no such inherent limitation with Bitcoin. Of course the currency is likely to see large gains and losses, but that is not the same as a permanent catastrophic collapse.

What about Tulip Mania?

Some have argued that the current bubble is similar to "Tulip Mania" that swept the Netherlands in 1637. Tulips were seen as a form of investment, creating a bubble that eventually and spectacularly burst. Tulips were fashionable, and of course fashions change, but there are still many differences. For a start, Tulips aren't durable, and are easy to produce. This gives then a low intrinsic value, whereas the intrinsic value of Bitcoin is unknown and they are expensive to produce. Others have argued that Tulip mania was due to the rules of the Dutch futures market at the time, rather than a sudden passion for flowers.

Since Bitcoin are inherently useless, Bitcoin only has worth if people believe in it. Certainly people could wake up tomorrow and collectively decide that Bitcoin is junk. The longer Bitcoin hangs around, the less likely that is to happen.

What is a Bitcoin wallet?

A wallet is where you store your private key(s), and a record of all the Bitcoin you own.

What happens if I lose my wallet?

If you fail to back up your wallet, and your hard disk gets corrupted, you just lost all your Bitcoin. For this reason, people need to be really careful about backing it up. You can also store your wallet in the cloud, using a number of providers who charge a fee but are perhaps more secure. You could also get hacked, or get a virus, and someone could read the contents of your wallet, and steal all your money.

Bitcoin that is lost is permanently out of circulation.

What are the investment risks?

Lots. The main problem is volatility. Nobody knows what a Bitcoin is actually worth, and the whole thing could come crashing down at any moment. Governments may take action against Bitcoin, making it harder to spend or liquidate. Your Bitcoin wallet could get hacked, maybe you get a virus, or you lose your private keys. If you trust a third party, they may get hacked or just steal your money. You don't have legal protections. The entire network could get shut down. There could be some mathematical weakness in the whole system that breaks it completely, or a flaw in the software that steals or compromises the whole system.

Ultimately though, the world seems to be conjuring up more and more money, and the problem is simply where to invest it.

Should I invest in Bitcoin?

Bitcoin has characteristics of gold and junk stocks. You have to be really careful, however could make sense if you like insane risks or as part of a balanced portfolio. You have been warned! Bitcoin will continue to do extremely well until it doesn't.

Bitcoin is not necessarily any more risky than individual stocks and shares, so risk is not per se a deal breaker for investment, but it's hard to gauge whether this asset is over or underpriced. People are just extrapolating past trends which is never a good idea.

What happens when the servers start going out?

Bitcoin relies on a network of trust. No network means no value. Software is relatively ephemeral, and the biggest problem would happen if people stopped bothering to run the servers. It seems pretty shaky as a long term investment. Yet there is enough money in Bitcoin to keep the servers running a LONG time.

Should I invest in other cryptocurrencies?

Anyone can invent a cryptocurrency these days. In fact, the Bitcoin software allows you to set up a new cryptocurrency. It's extremely unlikely that any of these will gain the same traction as the original Bitcoin, unless something special happens or they are backed by a government.

Could I ever get paid in Bitcoin?

Not in the foreseeable future. Bitcoin needs to be legally recognised by governments, which is unlikely to happen for reasons mentioned above.

Are cryptocurrencies the future?

There is a lot of active research in this area - the company that develops the next cryptocurrency will become very rich. Governments will want to play a more central role in any future cryptocurrency - the inability to create new currency seems to be a deal breaker.

Is Bitcoin the future of currency?

Bitcoin will remain a thorn in the government's side for a long time. Like all new technology, we don't necessarily understand its implications or know what to do with it yet. There are also structural problems with Bitcoin - it uses lots of electricity, and is deflationary in nature. These do not mean that Bitcoin will die, but hopefully that something better can come along. I don't see Bitcoin as ready for the prime time yet, and it remains a risky investment. Nevertheless, with great risk comes great opportunity.

The more intriguing question is whether we can do away with traditional banking structures. I guess the answer is: not for now.