Bitcoin explained: what is Bitcoin?

15th Apr 2013 | 09:14

Bitcoin explained: what is Bitcoin?

Is it time to cash in on the Bitcoin trend?

You've probably heard a lot about Bitcoin over the past few weeks, but we'll forgive you if the details are still a little hazy.

So allow us to help...

What is Bitcoin?

Bitcoin is essentially a digital currency - a form of money stored in an owner's online "virtual wallet", free from the control of governments or central banks.

Bitcoin was released in 2009 by someone going by the pseudonym of Satoshi Nakamoto who wanted a virtual currency that was unrestrained by regulation.

Why is Bitcoin in the news?

Five years later and Bitcoin has hit headlines for rocketing in value past US$1 billion (£656 million, AUS$959 million) - US$147 (£96/AUS$141) per coin - which is impressive for an invisible currency with no inherent value, and with only 11 million of its virtual "coins" in circulation.

But this isn't some sort of magic bean commerce like Facebook Credits. The tech heads love the geeky details, but this is the first virtual currency that has the potential to turn the world economy on its head. That is, if a certain few things play out.

What caused the Bitcoin boom?

While Bitcoin has existed for some time, the recent spike has been largely attributed to the economic crisis in Cyprus. Crypto-currency suddenly offered a more appealing way of housing money with promise of constant access.

But while the extent of that relationship is debated, it was just the spark that lit the fuse. Dr Vili Lehdonvirta, economic sociologist and researcher of virtual economies at the London School of Economics, reminds us that the real culprit is the media for propelling the attention.

The irony doesn't escape us here, but it's still an important point to make.The limited number of Bitcoins means that inflation just doesn't happen. So intrigue leads to demand, and the only way is up.

Bitcoin

"The question now," says Lehdonvirta, "is how many people buying Bitcoin are buying it to start using it as a means of payment, and how many are buying it because they are hoping that the price will continue to go up in value?"

Will the Bitcoin bubble burst?

But with too many people looking to make a quick buck, a bubble burst has seemed imminent. More and more people want a slice of the Bitcoin pie, despite the fact that the currency is only accepted by a small number of outlets.

"What Bitcoin needs to achieve is wider acceptance as a means of payment as an exchange mechanism," says Legdonvirta. "Until it does that, this kind of value driven up by people hoping to stash their money in a safe place from the tax man is not sustainable."

And he's right. As of April 15 the value of Bitcoin has now plummeted to around $100 (£65/AUS$95) per coin.

Is Bitcoin safe?

The cryptographic technique that Bitcoin is based on is the same type used by commercial banks to secure their transactions.

"The thing with Bitcoin is that it's purposefully designed to be non-manageable," Lehdonvirta adds. "There's an inbuilt algorithm which determines the number of Bitcoins in circulation at any given point in time."

So technologically speaking, it should be pretty robust. But there are always risks, and if loopholes were to be exposed, it could have dire consequences.

And it's because of these risks that Bitcoin recently hit the headlines for less positive reasons, when the virtual exchange Mt.Gox was hit with a DDoS attack by a group of hackers - and Bitcoin's value took a dip.

Meanwhile Instawallet, a Bitcoin storage site, was taken offline permanently, after its database was hacked into.

Electric feel

But as Lehdonvirta quickly reminds us, it's not just these sorts of attacks that are a problem - we need an eye on the future at all times.

"There is of course this possibility that future computers such as quantum computers are able to crack these kind of cryptographic hashes. That would obviously completely compromise Bitcoin."

Though the strength of the algorithm makes this unlikely, that doesn't make it impossible. "If it does occur it would have catastrophic effects," he warns us.

And while governments guarantee bank accounts against fraud and theft, Bitcoin doesn't enjoy the same safety measures. If it's gone, it's gone - with also almost zero chance of being able to reclaim the money if you do find yourself "virtually pickpocketed".

Just ask the victim of the first large-scale Bitcoin theft, who had half a million US dollars worth of Bitcoins stolen in 2011. The heist took place overnight, with him waking to an empty virtual wallet in the morning. It was, essentially, a bedroom bank raid.

But if someone wanted to cause more widespread damage, they would probably have to take control of 51 per cent of the global Bitcoin network of this virtual economy.

So while transactions themselves might be safe for now, Bitcoin users will need a more secure piggy bank if virtual currency can be truly practical and secure.

What's the future for Bitcoin?

So how far can Bitcoin actually go as a viable alternative to normal currency? "The number of Bitcoins is limited," says Lehdonvirta. "And the huge deflation that creates simply makes it unfeasible for Bitcoin to be adopted on a massive scale."

But, as he then reminds us, this might be missing the point. Bitcoin is not the only crypto-currency that exists right now, and it won't be the last.

"Now that this kind of ingenious design based on distributed cryptographic currency has been demonstrated as a working principle, people are confident to create others that address some of the shortcomings of Bitcoin," he says.

"I wouldn't be surprised in the future if we saw other crypto-currencies that will become even bigger than Bitcoin."

Really, the future of virtual currency hangs in the balance of the world economy. "Politicians need to quickly restore confidence in the Euro," says Lehdonvira. "Otherwise you'll quickly find yourself in a situation where people are moving more and more of their money into places where others can't get hold of it".

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