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Bitcoin: Everyone’s Talking About It, But Nobody Seems To Know Much About It
If ever there were a topic in dire need of the Digital Media Mom treatment, Bitcoin is it. I’ve found that a complete, detailed explanation of Bitcoin can be incredibly lengthy and technical so I’m going to try a different tack. My emphasis in this article is on making Bitcoin easy for consumers to understand. It won’t cover ALL the details, but by the end of this article you should have a pretty firm grasp on what Bitcoin is, how it came about, and how the Bitcoin system works in general terms. Those who want to dig deeper can always Google to their hearts’ content to find all those other, more detailed and technical articles.
This article was weeks in the researching and writing, so if you find it at all helpful or informative, please share it with your social networks.
The Environment That Laid Out The Welcome Mat For Bitcoin
In the early 2000′s, economic and political events caused many people in the U.S., Asia-Pacific region and Europe to lose faith in their respective national economies, and by extension, their government-backed currencies (e.g., U.S. dollars, British pounds, etc.). They began to resent the governmental administrative overhead that devalues money before it’s even been minted (e.g., the Treasury department, the Fed), and the fees for conversion to different forms (e.g., cashier’s check vs. personal check vs. cash, all of that vs. foreign currency exchange).
Some started to resent paying taxes on their money to support all the governmental systems they felt were failing them following economic crashes, Wall Street scandals and government bailouts. Some also resented having virtually every cent they spent monitored, tracked and regulated by those same governmental systems.
Many strongly wished to return to a cash economy to do away with these currency-related ills and issues, but in our modern, plugged-in world, a cash economy would be impractical.
The Birth of Bitcoin
In 2008 a man named Satoshi Nakamoto devised a plan for a new type of currency that would eliminate all the perceived problems of existing currencies, and cut all the world’s governments out of the equation to boot. He just needed a large, receptive community of tech-aware people to adopt the new currency and start using it in place of existing types of money. Nakamoto was already hooked into the global, online community of programmers, web developers and tech pundits, which is almost like a virtual nation with no borders and no government, and a very large number of its members are fed up with existing economic problems. Perfect! That community quickly got on board with Nakamoto’s concept, and the new currency was christened “Bitcoin”.
It would be a global currency. No single government would have jurisdiction to regulate or monitor it. Anyone in any part of the world could exchange this currency for goods and services with anyone in any other part of the world, all with no need for exchanging currencies (or paying exchange fees). A downturn in any national economy would have little to no effect on this new currency, because it wouldn’t be tied to any single nation or government. Its value would not be dictated or even affected by any government entity or agency. Owning Bitcoin would be like having cash in an offshore account: your goverment wouldn’t know about its existence, its value, or what you’re doing with it.
It would be a digital currency. This new type of money would work like “credits” do in Star Trek: there would be no paper bills/notes or metal coins to be stolen or counterfeited. There would be no need for banks to store or manage this new “money”, consumers and businesses could freely exchange it amongst themselves from personal accounts they maintain themselves (sort of like PayPal). No more bank account maintenance fees, no more fears of failing banks.
It would have an “open book” ledger. This means that every person who ever buys, sells, or exchanges Bitcoin would have access to view the Bitcoin transaction ledger and even maintain a local copy of it. Transparency to this degree would accomplish two things. First, it would be much easier to build consumer trust in Bitcoin when every single person using it can look at the Bitcoin transaction ledger anytime they want, and even keep a local copy. Second, this open ledger system eliminates the possibility of any one person or group trying to “cook the books” or enter false transactions, as we all know banks and investment firms have famously done, repeatedly, with existing currencies. Essentially, every Bitcoin user would be helping to keep every other Bitcoin user honest.
It would enable truly anonymous online transactions. With everyone so concerned about NSA spying, it’s not surprising that people are less and less trusting of the government when it comes to their personal information and details of their finances. Any worries about being “outed” by a given company or individual employee of the company after purchasing anything that could cause public embarrassment would be a thing of the past.
Similarly, Bitcoin would facilitate transactions across state and national borders in situations where a given product or service is legal in the one location, but not in the other. Today, such transactions are largely kept to a minimum by laws that limit trade across state and national lines, and the evidence in such cases often boils down to a paper trail of financial transactions. With Bitcoin, not only would there be no paper trail, there would be no personally-identifying information recorded as part of the transaction. There would also be no sales or use tax, either in the location the order came from, nor in the location it’s shipped to.
It would allow consumers to bypass certain regulatory and tax fees they currently pay on existing currencies. Again, if no government agency is involved, there’s no government agency to impose a sales tax on Bitcoin transactions. There’s no government agency to impose customs fees in importation or transfer of Bitcoin. Employers who pay employees in Bitcoin wouldn’t be subjected to the same employment taxes and regulatory fees as those who use existing currencies, and employees wouldn’t have to pay income tax on Bitcoin.*
*Note that while at this point in the article I’m talking about the projected advantages of Bitcoin from back in the days when it first came into being, this one has been borne out. The IRS has recently classified Bitcoin as a form of property, not currency and not income, so while it may be taxable to the same extent as any other type of property with monetary value it cannot be treated the same as money or income by the IRS. As of this writing, U.S. state-level taxing authorities have yet to weigh in on Bitcoin.
It would enable truly anonymous online transactions. The flip side of this “GOOD” is that a virtual currency like Bitcoin would be ideal for conducting seriously criminal transactions. In fact it turns out that there are numerous online marketplaces for virtually ANY illegal product or service you can imagine where virtual currency is the only currency in use—specifically to keep names and indentifying details out of the transactions, and to eliminate any possibility of a paper trail. Seriously, anything from military-grade weapons to murder for hire can be had on these sites.
It would allow consumers to bypass certain regulatory and tax fees they currently pay on existing currencies. The downside of this one is that if the tax rolls are seriously depleted, there’s a lack of funds for everything those taxes are intended to support: police, firefighters, street and freeway maintenance, public schools, public safety agencies like the EPA and CDC…you get the idea.
It could result in the collapse of the existing financial services sector. Before you start burning Wall Street day traders in effigy and thinking, “Good riddance to those crooks!”, bear in mind the larger implications. The financial services sector employs millions of rank-and-file employees, and manages billions in retirement funds and investment funds. Bitcoin may never reach a level of use that could justify investment bankers being willing to use it as the foundation for 401k and IRA accounts.
Recall that offshore account example. It’s bad enough that billions of dollars have already been eliminated from the U.S. economy by the 1% stashing it away in offshore accounts that are untraceable, untaxable, and contributing nothing to the U.S. economy. Now imagine what would happen if everyone could squirrel their money away in a similar fashion.
No Banks = No Guarantees. There is no FDIC or other banking, finance or government entity standing behind Bitcoin to ensure it retains its value or that individual consumers aren’t robbed of their Bitcoin. This is the flipside of having an entirely consumer-controlled currency.
How can a made-up currency have value?
Basically, the same way ANY currency has value: consumers only have to BELIEVE it has value to INSTILL value in ANY currency.
You’ve probably thought all along that a U.S. Dollar is backed by some tiny bit of actual gold or silver in Fort Knox, and that if push came to shove, it would be possible to exchange your U.S. Dollars for equivalent-value bits of those precious metals. In the modern world, this is no longer the case. It may surprise many to learn that the venerable U.S. Dollar hasn’t been tied to the gold standard since the 1970′s, and isn’t backed by ANY precious metal or other commodity.
The only reason U.S. Dollars have value is because collectively, people BELIEVE they do, and have, in a sense, agreed to ACT as if they do. This is why the value of various world currencies fluctuates every single day, and why economists are always talking about “consumer confidence”. The less confidence consumers have in a given economy, the less that economy’s currency is worth.
Introducing a new currency is just a matter of getting a large enough population of people around the world to believe in its value and act as if it has value, just the same as any existing currency. The same thing happens anytime a new nation emerges somewhere in the world.
Given that it’s not tied to any existing currency or precious metals, how is the value of Bitcoin determined?
The value of Bitcoin fluctuates just the same as any other currency. The more demand there is for it, the more each Bitcoin is worth. The less demand, the less value. Bitcoin value fluctuations are being tracked by various exchanges around the world, just the same as any other currency, so it’s easy to check the Bitcoin “exchange rate” for other world currencies at any given time by checking sites like Bitcoin Wisdom.
Also, when Nakamoto came up with the idea for Bitcoin, he knew that the only way for it to hold any value would be to ensure a limited supply. After all, anything that’s readily available in limitless supply doesn’t tend to be very valuable. So he set an upper limit of 21 million on the global supply of Bitcoin: once 21 million in Bitcoin is out there in the world, no more will ever be “minted”.
Where does Bitcoin come from, how is it “minted”?
This is perhaps the most difficult aspect of Bitcoin to understand. I think I’ve got a way to explain it that’s pretty simple, but some background is needed first.
You probably already know what encryption is, and how it keeps computer transactions secure: the sending computer scrambles the data it wants to send so the data can’t be read by any other people or computers en route to its final destination, and the destination computer has a sort of “key” it can use to unscramble the data after it arrives. This is commonly referred to as a security “handshake” between the sending and recipient computers.
To ensure the utmost in security for Bitcoin, Nakamoto devised a system of incredibly complex equations for scrambling Bitcoin transaction data at the sender’s end, and equally complex equations for unscrambling Bitcoin transaction data at the recipient’s end. He also set up those calculations such that with each transaction, the complexity of the equations would increase slightly; this would prevent anyone from re-using the calculations from prior transactions to steal Bitcoin (sort of like how a kid might try to steal the answer key to an upcoming test).
Only the most powerful computers can handle the millions of calculations involved in solving Nakamoto’s scramble/unscramble equations, which also prevents hackers from stealing Bitcoin en route from buyers to sellers and vice-versa. Essentially, the hacker would have to invest so much money in computers to do the unscrambling that he’d be losing money on the deal, it wouldn’t be worth the effort to steal Bitcoin at all.
GIVEN THAT, HERE’S HOW BITCOIN IS “MINTED”. OR “MINED”: Nakamoto simply offers Bitcoin as a payment to anyone who’s willing to own and operate the computers needed to scramble and unscramble Bitcoin transaction data. Every time a Bitcoin transaction takes place, one of these “Bitcoin Miners” is using his or her computer to handle the transaction. Every so many transactions, the Miner is rewarded with Bitcoin in a transaction that’s added to the open ledger.
That’s how Bitcoin enters the marketplace, and anyone who’s willing to invest in the computing power can become a Bitcoin miner at any time, up until the limit of 21 million Bitcoin in circulation is reached. Because all of this mining is governed by pre-programmed equations the rate at which each new Bitcoin will be released is already known, and it’s already known that the 21 million Bitcoin ceiling won’t be reached for over 100 years.
The Miner who’s received a Bitcoin then goes on to either use the Bitcoin as currency to buy things, or takes it to a Bitcoin exchange to trade it in for a different, “regular” type of currency. The exchange process works the same as any international currency exchange, but instead of exchanging U.S. Dollars for Euro, for example, the Miners are exchanging Bitcoin for U.S. Dollars, or Euro, or any other pre-existing currency. The Exchange can then turn around and sell the Bitcoin to other exchange customers who wish to exchange their U.S. Dollars, or Euro, or other existing currency into Bitcoin.
Who’s in charge of managing Bitcoin?
There’s no central governing or regulatory body to oversee Bitcoin, and even Nakamoto doesn’t actively take part in its creation or exchange anymore. The Bitcoin “mining” operation is all automated, existing equations govern the dispersal of new Bitcoin, and thousands of computers spread across the globe are involved in mining Bitcoin, updating the open ledger, and processing Bitcoin transactions. Again, this is why no single government could ever control or regulate Bitcoin, and why it’s said that each Bitcoin user is managing his or her own Bitcoin (as opposed to using banks and finance companies as intermediaries).
Now you’ve got the basics on Bitcoin: what it is, where it came from, and how it works as a form of currency. In Part 2, I’ll get into the specifics of how people who aren’t Bitcoin miners can get Bitcoin, what can be done with it, the recent FBI seizure and re-sale of Bitcoin from online marketplace Silk Road, and my own personal experience with buying Bitcoin.
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