Alex Constantinou
During 2007 – 2009, an individual/group with the pseudonym Satoshi Nakamoto created Bitcoin and released the blueprint for the open-source digital currency onto the internet. Being open-source means that the technical code, upon which Bitcoin is built, is completely laid bare for anyone around the world to review at any time. What this translates into, is highly rigorous testing of the code by any coder, developer, or even hacker. The cryptography which encrypts/authenticates the transactions is said to be highly secure.
So what exactly is Bitcoin? Where do they come from? How does it work? What makes it valuable to society? What is it backed by? What are the implications for fiat currencies such as the Rand, Pound, US Dollar, Euro, Yen and the like?
A Bitcoin is the unit of currency by which transactions can be made. They are denoted as ‘BTC’, and 1 BTC is divisible into eight decimal places such 10.38747774 BTC. The smallest unit of 0.00000001 BTC is better known as one ‘Satoshi’ and may be more practical for day-to-day use (e.g. 10 Satoshi could purchase a loaf of bread depending on the future value of the BTC). One BTC is currently worth roughly $120.
Bitcoins are the world’s first decentralised digital currency. They are peer-to-peer and non-political; meaning there is no central authority and they are not affiliated with any government. The rules specified in the mutually agreed upon code are that a maximum of 21 million Bitcoins can be ‘mined’. So, just like a real-world commodity such as gold, there is an absolute limit on the global supply of Bitcoins, and their current value depends on the amount that has been mined to date and the demand for both existing and expected production.
The way in which Bitcoins are created is through the use of computational power employed to solve an increasingly complex mathematical problem designed to produce a steadily diminishing supply of Bitcoins. Any computer can be used to ‘mine’ Bitcoins using its processing power. Higher processing power relative to other miners results in relatively faster mining. This gives rise to vigorous competition between miners from around the globe. As world mining power increases, it becomes increasingly difficult to maintain a steady supply. The solving of these problems unlocks what is known as a ‘block’ roughly every 10 minutes. Each solved block contains a reward of a certain number of Bitcoins which halves roughly every 4 years. It is currently 25 BTC per block. This system produces the following predictable and certain supply curve. Most of the coins will be mined by 2033, the remainder by 2140.
The role of miners is two-fold. On the one hand they mint new BTC, and on the other hand they compete to confirm transactions, attracting a small fee as a reward. One of the most revolutionary aspects of BTC is the transaction ledger which is not stored on any centralised location, but rather is vastly replicated and updated by a swarm of mutually distrustful participants competing in a peer-to-peer network. The transaction ledger is one giant record of all transactions that have ever occurred. The peer-to-peer network constantly confirms and agrees on the public record. Transactions need to be confirmed multiple times (by random miners in a proof-of-work process) before they form part of the transaction ledger. This means that creating counterfeit coins and injecting them into the public ledger is next to impossible, since the network would not confirm but rather reject rogue coins. The proof-of-work process also prevents double-spending because each transaction is instantly broadcast to the network for confirmation.
So, now that we know what Bitcoins are and how they are created, why would a conventional society want or use them? In general, Bitcoins are attractive and useful because they incur minimal transaction fees, allow for very quick payments, have no geographical restrictions, are irreversible, highly secure and cannot be manipulated by any one government, central authority or individual. To turn this question around, in a world currently characterised by massive financial instability, why wouldn’t one choose to invest and transact in Bitcoins relative to some paper currency backed by a highly indebted foreign country?
As a result, the Bitcoin economy is fast growing, with new vendors around the world accepting Bitcoins as a form of payment alongside their local currencies. In some cases, only Bitcoins are accepted. There are currently 1000s of vendors now accepting Bitcoins, ranging from web hosting and music, to physical products such as toys and home appliances, to conventional services offered by dentists and hotels. A Finnish software firm has offered to pay part of staff’s salaries in Bitcoin. The latest major vendor to accept Bitcoins is Foodler (announced 17 April 2013); which is an online food ordering service covering 48 U.S states servicing more than 11 million people. They have already begun receiving food orders with Bitcoins.
The implications of a successful decentralised virtual currency are vast. This depends on how widespread their acceptance and use become. It is entirely possible that Bitcoins are somehow discredited and the market collapses entirely. On the other end of the spectrum, it is also possible that their adoption continues to grow exponentially and that they become the global currency of choice. The implications of the entire world using a single decentralised currency are staggering and this requires extensive research in its own right. Currently, the Bitcoin experiment falls somewhere between these two extremes, and it looks more like a commodity than a currency. It has seen tremendous growth and been through two major ‘flash’ crashes, when confidence in the whole idea suddenly dips or speculative greed turns into fear, inducing panic selling. Despite this, the project seems increasingly resilient, with strong vested interests to see it succeed.
Bitcoin is merely the first of its kind, with other competing alternative virtual currencies (with their own features and supply limits) already emerging. Bitcoin’s market cap is currently over $1 billion. Even if Bitcoin itself should fail, it seems that a Pandora’s Box has been opened; and fiat currency is facing its first significant challenge since its roots in the 11th century. Recent crises, such as the one occurring in Cyprus, are only likely to drive more people towards a decentralised currency in which the holder has autonomous control. Might the growing influence of an unknown collective of internet geeks provide a necessary yet virtual constraint on the ability of governments and their central banks to mismanage their real economies?