In short, Bitcoins are a form of virtual currency and exchange system based on a distributed (P2P) network of computers running a small piece of open-source software. The key point is that there is no central authority and transactions are validated by peers in the network. Bitcoins are generated with a method called mining, which basically consists in consuming computing power to “discover” new blocks of the cryptography chain that keeps the network secure (this is vastly oversimplified). When you discover a new block, you are awarded an amount of Bitcoins, plus all transactions that are later processed using that block grant you a processing fee (very much like credit cards). The entire system ensures by design that there cannot be more than roughly 21 millions Bitcoins (to avoid inflation and favor deflation). Currently, about 6.5 millions have been mined. You can also purchase Bitcoins for real money (USD, EUR, etc.) via brokers/traders/exchanges. Bitcoins are “stored” in digital wallets. At the current state of a system, such wallet is nothing more than a file on your hard disk. The system’s cryptography and hashing algorithms ensure (theoretically) that it’s not possible to forge money because no other peers in the network know about its existence and thus cannot approve any transaction regarding it.
As Joannes already pointed out in his post, Bitcoins have raised a variety of reactions but they seem to somewhat gain momentum. My initial reaction has been something like “Wow, cool, how does this work?”. Then reality kicked in and I’ve spent some time learning the details of this new new thing.
Why I’m Putting All My Savings Into Bitcoin by Rick Falkvinge describes how the virtual currency value has improved 100,000% in 14 months. The guy allegedly invested all his savings into Bitcoin currency in the hope to cash it out later and make profit (in real dollars). Funnily enough, this has nothing to do with Bitcoins being a currency used to trade goods and services, but rather working just as financial speculation means. Nothing new here.
Why Bitcoin Will Fail As A Currency by a guy known as Tav, whose real name is too long and complex to write (his own words). Pretty superficial analysis that gets to the point: the system itself is created to favor deflation, meaning that at a certain point, 0.01 Bitcoins will be worth thousands of Euros, which makes the currency impractical to use (very much like banknotes with 1,000,000,000 printed on them in some African Countries subject to hyperinflation). Before switching to EUR, in Italy we had notes valued at £500,000 (worth €258.23). That was really funny.
Links.org by Ben Laurie reports a number of potential flaws and inefficiencies in the cryptography system used by the network. Mostly technical, but the key aspect in my opinion is that to mine all the 21 millions Bitcoins, we’re using computing power, that is energy, that is mostly non-renewable resources like oil and coal. The funny thing is that as more Bitcoins are mined, the network will make it harder to mine for more, actually requiring more computing power. This makes the system resilient to people or organizations that want to get all the money, but it becomes actually a giant waste of precious resources. I couldn’t agree more, as after all we’re just moving bits around for no good reason (well, if you don’t consider financial speculation).
An anonymous individual (did I mention I don’t like nicknames?) keeps a blog and posts arguments in favor of Bitcoins. Some of them go beyond my comprehension but are interesting to read as counter-arguments presented in other places.
Last but not least, Why bitcoin will fail by Avery Pennarun is a very funny but practical analysis of why, allegedly, Bitcoin will fail as a currency. Trust me, it’s very funny and worth reading. Key take-away point: Governments will squash it.
It turns out there is a large number of websites and real online businesses accepting Bitcoins for payments. I’m impressed (for real).
I don’t have the knowledge nor expertise to judge the system economically and financially, but I’m tending to believe that this thing cannot work in the long run.
Leaving out all my thoughts about actual usability, security and perceived trust in the system by actual users, there is one main show-stopper in my opinion, already pointed out by Avery Pennarun: Governments will outlaw it. The very nature of the P2P distributed infrastructure makes it impossible to know what’s happening inside it. It’s impossible to track transactions back to individuals or businesses, as each of them simply has one ore more alphanumeric identifiers. As an example, in Italy it’s already forbidden to pay something cash over a certain amount (€5,000 IIRC) for the very purpose of tracking money, know who should pay taxes and find suspect and illegal activities. That limit is going to be lowered further over time. Freelancers, in certain business areas, cannot accept cash payments over €250. Everything must be traceable. This an actual law, already existing and enforced in a EU Country. I’m not sure, but I guess similar regulations are present in most EU Countries and probably USA and Canada. For what I understand, and to avoid problems, I wouldn’t even think about accepting Bitcoins payments, either as an individual or for my company. It’s just too problematic, and frankly (so far) EUR has proven to be pretty strong a currency…
One major strength in the distributed nature of the currency is that Governments cannot physically shut it down, meaning that, whatever means Governments will find to block the protocol in a certain geographical area, the global network will still be working happily. This very fact is likely to get attention itself and cause trouble. Governments are scared of social networks and a distributed, non-traceable network for exchanging money will drive them nuts. The fact that you can still use Bitcoins even if your Country outlawed them makes you nothing more than a criminal in the authorities’ eyes. Will it be worth the risk?
That said, it’s so crazy it might even work.