Digital Currency, Beanie Babies, and Crypto-Anarchy: A Beginner's Guide to Bitcoin

Bitcoins. You've heard of them. But do you know what they are? How they are created? What they are used for? If not, don’t despair – despite their growing popularity, many people remain in the dark about this new currency and its profound policy implications.

Supporters of the technology believe bitcoins and other forms of “crypto-currency” have the potential to revolutionize international commerce, saving consumers billions and providing a secure platform for exchange without the hassle of financial institutions or the government in general. Others worry about bitcoins’ uncertainty, its absence of consumer protections and lack of an economic anchor.

In reality, Bitcoin represents all these things and more. It is the Wild West of digital finance, home to pioneers, speculators, hackers and activists, and its emergence is one of the fascinating economic stories of the 21st century.

What the Hell are you talking about?

Bitcoins are a form of digital currency – in essence, a form of electronic cash - that can be used to pay for goods and services, as well as be instantaneously and securely transferred worldwide. “Bitcoin” capitalized refers to the technology, whereas lowercase “bitcoins” refers to the currency itself.

Think of bitcoins like gold or silver. These precious metals are mined by digging holes in the ground or sifting sand in a creek bed. Similarly, bitcoins are “mined” through the use of special software to solve complex math problems. When solved, miners are issued a certain number of bitcoins in exchange. The Bitcoin network automatically makes the problems harder, depending on how quickly they are being solved.

Again like gold or silver, not everyone who wants bitcoins must be a miner. More often, bitcoins are accumulated in trade for goods or services, or purchased on a bitcoin exchange. Presently, one bitcoin is worth hundreds of U.S. dollars, but there is tremendous volatility in the exchange rate.

There is no inherent value in a bitcoin; its value is derived from the willingness of others to accept it as payment. This is dissimilar to the U.S. dollar, for instance, which is by law accepted as a means to settle debts in the U.S. – especially U.S. taxes. If everyone decided to stop accepting bitcoins tomorrow, those remaining would have no value except as collector’s items. Meet the digital Beanie Baby.

Where did all this come from?

The Bitcoin concept has its roots in tech-savvy Libertarianism bordering on anarchy. In the 1990s, due to their mistrust of corporate access to individual buying habits and government control of centralized banking, a small group of self-described “cyberpunks” took it upon themselves to defend economic privacy across the Internet. After a couple of false starts, the Bitcoin protocol was designed and created by Satoshi Nakatomi, and in 2009, he released the Bitcoin software that launched the network and the first units of crypto-currency.

Like in some bad movie, Satoshi Nakamoto does not really exist. The name is a pseudonym. No one knows who he (or she, or they) really is, or if they do know, they aren’t telling. Nakamoto has not been heard from since 2011, and despite a number of investigative efforts that reached a variety of conclusions, his true identity remains a mystery.

Where is all this heading?

Bitcoin shows promise and has certain advantages, but the system is a long way from becoming a viable alternative to dollars, euros, or other, more accepted currency forms.

As a medium of exchange, Bitcoin presents significant policy ramifications, such as uncoupling financial transactions from the icy grip of big corporations and even bigger governments. For instance, users can skip the banks and avoid paying the billions in transactional charges that come with using credit cards, wire transfers and Paypal, and the money is transferred instantaneously instead of hours or days later. In time, streamlining and accelerating monetary transactions could eliminate financial barriers between nations and globalize the world’s economy on a magnitude never before seen.

Additionally, crypto-currency is essentially the same as cash, so credit card fraud and identity theft can be radically reduced. No more sharing your card number, address and security code with online vendors; no more security breaches like the one at Target whereby millions of credit card users had their personal data hacked.

So, Bitcoin is the future of international monetary policy, right?

Slow down, Timmy. Perhaps it is, but many issues remain. For instance, the system was designed to reduce the number of bitcoins mined over time. In fact, the entire universe of bitcoins – approximately 21 million – will be generated around the year 2140. No more will be created, and many will potentially be lost due to consumer negligence and never recovered, reducing the number in circulation and driving up the value of those that remain.

In economic terms, this is referred to as “deflation,” and as the value of a bitcoin increases, its utility diminishes. Look at it this way: if a dollar bought you a car and a penny purchased you a TV, how can you divide the currency small enough to buy lunch?

Moreover, the security of the exchange between buyer and merchant that Bitcoin offers creates its own set of problems. Instead of trusting the merchant with your sensitive data, a consumer instead must trust the seller to make good on the sale with very little recourse. Presently, consumers often rely on the credit card company to intervene in disputes with sellers. Bitcoin exchanges are irreversible, so consumers have no way to get the money back if the item is never sent or arrives damaged.

Governments and regulators are in a quandary about how to respond to Bitcoin, and this uncertainty also has policy implications. In the U.S., reaction has been initially positive. Last year, Obama administration officials who testified at Senate hearings on the future of crypto-currency stressed that Bitcoin has legitimate uses and that no new regulations were needed to police illicit uses of the network. In fact, there has been an emerging consensus that the U.S. government should avoid hampering the growth of the world's first completely decentralized payment network.

However, Bitcoin has not gotten off so easy elsewhere. Russia has taken steps to declare Bitcoin illegal, in large part due to the currency’s easy utilization in the black markets of drug trade, online gambling, child pornography and money laundering. China restricts bitcoins exchanged for local currency, and the European Banking Authority has expressed formal concern over Bitcoin’s lack of consumer protection.

Lastly, it is important to remember that while Bitcoin was thoughtfully conceived and designed it is by no means the penultimate crypto-currency. Bitcoin is at its heart a software program. Because it was released under an open-source license, anyone can use it, and alter it, and create a whole new currency.

And they have. Several other “altcoins” have been created over the years, such as “Litecoin” and “Dogecoin” – even “Coinye West,” named after rapper and blowhard Kanye West. For early adopters of Bitcoin, this raises a concern: Am I investing in the VCR of crypto-currency, or the Betamax? Or, for that matter, the DVD, Blue Ray, or the whatever-comes-next of this technology?

The last word:

Bitcoin may very well represent the future of commerce on Planet Earth, and those who embrace the technology have good reasons to feel optimistic that it does. Its track record of success thus far has been impressive.

That said, consider this: The Sony Walkman offered consumers a new way to listen to music – privately, in transit. Its popularity was huge, but its technological coattails were rather short. Years later, the Apple iPod functioned much in the same way as the Walkman, but its technological advances ultimately helped spawn the digital music explosion; iTunes, Napster, Spotify, Pandora- the list goes on and on. The iPod swamped the Walkman and changed the face of portable music forever.

So, is Bitcoin the iPod or the Walkman? Is it truly revolutionary, or just another good idea? (If you guess wrong, don’t worry – I have a laser-disc player I can let you have for cheap.)

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