If
you want to buy drugs or guns anonymously online, virtual currency
Bitcoin is better than hard cash. Canny speculators have been hoarding
it like digital gold. Now the world's leading bankers are even talking
about as a rival for real money. How does it work, where can you get it
and is it the future?
A sign above a bar in Germany. Photograph: Alamy
The past weeks have seen a surprising meeting of minds between
chairman of the US Federal Reserve Ben Bernanke, the Bank of England,
the Olympic-rowing and Zuckerberg-bothering Winklevoss twins, and the US Department of Homeland Security. The connection? All have decided it's time to take Bitcoin seriously.
Until
now, what pundits called in a rolling-eye fashion "the new peer-to-peer
cryptocurrency" had been seen just as a digital form of gold, with all
the associated speculation, stake-claiming and even "mining"; perfect
for the digital wild west of the internet, but no use for real transactions.
Bitcoins
are mined by computers solving fiendishly hard mathematical problems.
The "coin" doesn't exist physically: it is a virtual currency that
exists only as a computer file. No one computer controls the currency. A
network keeps track of all transactions made using Bitcoins but it
doesn't know what they were used for – just the ID of the computer
"wallet" they move from and to.
Right now the currency is tricky
to use, both in terms of the technological nous required to actually
acquire Bitcoins, and finding somewhere to spend them. To get them, you
have to first set up a wallet, probably online at a site such as
Blockchain.info, and then pay someone hard currency to get them to
transfer the coins into that wallet.
A Bitcoin payment address is a
short string of random characters, and if used carefully, it's possible
to make transactions anonymously. That's what made it the currency of
choice for sites such as the Silk Road
and Black Market Reloaded, which let users buy drugs anonymously over
the internet. It also makes it very hard to tax transactions, despite
the best efforts of countries such as Germany, which in August declared
that Bitcoin was "private money" in which transactions should be taxed
as normal.
It doesn't have all the advantages of cash, though the
fact you can't forge it is a definite plus: Bitcoin is "peer-to-peer"
and every coin "spent" is authenticated with the network. Thus you can't
spend the same coin in two different places. (But nor can you spend it
without an internet connection.) You don't have to spend whole Bitcoins:
each one can be split into 100m pieces (each known as a satoshi), and
spent separately.
Although most people have now vaguely heard of
Bitcoin, you're unlikely to find someone outside the tech community who
really understands it in detail, let alone accepts it as payment. Nobody
knows who invented it; its pseudonymous creator, Satoshi Nakamoto,
hasn't come forward. He or she may not even be Japanese but certainly
knows a lot about cryptography, economics and computing.
It was first presented in November 2008 in an academic paper shared with a cryptography mailing list.
It caught the attention of that community but took years to take off as
a niche transaction tool. The first Bitcoin boom and bust came in 2011,
and signalled that it had caught the attention of enough people for
real money to get involved – but also posed the question of whether it
could ever be more than a novelty.
The algorithm for mining
Bitcoins means the number in circulation will never exceed 21m and this
limit will be reached in around 2140. Already 57% of all Bitcoins have
been created; by 2017, 75% will have been. If you tried to create a
Bitcoin in 2141, every other computer on the network would reject it as
fake because it would not have been made according to the rules of
currency.
The number of companies taking Bitcoin payments is
increasing from a small base, and a few payment processors such as
Atlanta-based Bitpay are making real money from the currency. But it's
difficult to get accurate numbers on conventional transactions, and it
still seems that the most popular uses of Bitcoins are buying drugs in
the shadier parts of the internet, as people did on the Silk Road
website, and buying the currency in the hope that in a few weeks' time
you will be able to sell it at a profit.
This is remarkable
because there's no fundamental reason why Bitcoin should have any value
at all. The only reason people are willing to pay money for the currency
is because other people are willing to as well. (Try not to think about
it too hard.) Now, though, sensible economists are saying that Bitcoin
might become part of our future economy. That's quite a shift from
October last year, when the European Central Bank said that Bitcoin was
"characteristic of a Ponzi [pyramid] scheme". This month, the Chicago
Federal Reserve commented that the currency was "a remarkable conceptual and technical achievement,
which may well be used by existing financial institutions (which could
issue their own bitcoins) or even by governments themselves".
The First Bitcoin ATM, in Canada. Photograph: REUTERS
It might not sound thrilling. But for a central banker, that's like
yelling "BITCOIIINNNN!" from the rooftops. And Bernanke, in a carefully
dull letter to the US Senate committee on Homeland Security, said that
when it came to virtual currencies
(read: Bitcoin), the US Federal Reserve had "ongoing initiatives" to
"identify additional areas of … concern that require heightened
attention by the banking organisations we supervise".
In other words, Bernanke is ready to make Bitcoin part of US currency regulation – the key step towards legitimacy.
Most
reporting about Bitcoin until now has been of its extraordinary price
ramp – from a low of $1 in 2011 to more than $900 earlier this month.
That massive increase has sparked a classic speculative rush, with more
and more people hoping to get a piece of the pie by buying and then
selling Bitcoins. Others are investing thousands of pounds in custom
"mining rigs", computers specially built to solve the mathematical
problems necessary to confirm a Bitcoin transaction.
But bubbles can burst:
in 2011 it went from $33 to $1. The day after hitting that $900 high, Bitcoin's value halved on MtGox, the biggest exchange. Then it rose again.
Speculative
bubbles happen everywhere, though, from stock markets to Beanie
Babies. All that's needed is enough people who think that they are the
smart money, and that everyone else is sufficiently stupid to buy from
them. But the Bitcoin bubbles tell us as much about the usefulness of
the currency itself as the tulip mania of 17th century Holland did about
flower-arranging.
History does provide some lessons. While the
Dutch were selling single tulip bulbs for 10 times a craftsman's annual
income, the British were panicking about their own economic crisis. The
silver coinage that had been the basis of the national economy for
centuries was rapidly becoming unfit for purpose: it was constrained in
supply and too easy to forge. The economy was taking on the features of a
modern capitalist state, and the currency simply couldn't catch up.
Describing
the problem Britain faced then, David Birch, a consultant specialising
in electronic transactions, says: "We had a problem in matching the
nature of the economy to the nature of the money we used." Birch has
been talking about electronic money for over two decades and is
convinced that we find ourselves on the edge of the same shift that
occurred 400 years ago.
A Bitcoin wallet on a smartphone. Photograph: Bloomberg via Getty Images
The cause of that shift is the internet, because even though you
might want to, you can't use cash – untraceable, no-fee-charged cash –
online. Existing payment systems such as PayPal and credit cards demand a
cut. So for individuals looking for a digital equivalent of cash – no
middleman, quick, easy – Bitcoin looks pretty good.
In 1613, as
people looked for a replacement for silver, Birch says, "we might have
been saying 'the idea of tulip bulbs as an asset class looks pretty
good, but this central bank nonsense will never catch on.' We knew we
needed a change, but we couldn't tell which made sense." Back then, the
currency crisis was solved with the introduction first of Isaac Newton's
Royal Mint ("official" silver and gold) and later with the creation of
the Bank of England ("official" paper money that could in theory be
swapped for official silver or gold).
And now? Bitcoin offers
unprecedented flexibility compared with what has gone before. "Some
people in the mid-90s asked: 'Why do we need the web when we have AOL
and CompuServe?'" says Mike Hearn, who works on the programs that
underpin Bitcoin. "And so now people ask the same of Bitcoin.
The web
came to dominate because it was flexible and open, so anyone could take
part, innovate and build interesting applications like YouTube, Facebook
or Wikipedia, none of which would have ever happened on the AOL
platform. I think the same will be true of Bitcoin."
For a small
(but vocal) group in the US, Bitcoin represents the next best
alternative to the gold standard, the 19th-century conception that money
ought to be backed by precious metals rather than government printing
presses and promises. This love of "hard money" is baked into Bitcoin
itself, and is the reason why the owners who set computers to do the
maths required to make the currency work are known as "miners", and is
why the total supply of Bitcoin is capped.
And for Tyler and
Cameron Winklevoss, the twins who sued Mark Zuckerberg (claiming he
stole their idea for Facebook; the case was settled out of court), it's a
handy vehicle for speculation. The two of them are setting up the
"Winklevoss Bitcoin Trust", letting conventional investors gamble on the
price of the currency.
Some of the hurdles left between Bitcoin
and widespread adoption can be fixed. But until and unless Bitcoin
develops a fully fledged banking system, some things that we take for
granted with conventional money won't work.
Others are intrinsic
to the currency. At some point in the early 22nd century, the last
Bitcoin will be generated. Long before that, the creation of new coins
will have dropped to near-zero. And through the next 100 or so years, it
will follow an economic path laid out by "Nakomoto" in 2009 – a path
that rejects the consensus view of modern economics that management by a
central bank is beneficial.
For some, that means Bitcoin can never
achieve ubiquity. "Economies perform better when they have managed
monetary policies," the Bank of England's chief cashier, Chris Salmon,
said at an event to discuss Bitcoin last week. "As a result, it will
never be more than an alternative [to state-backed money]." To
macroeconomists, Bitcoin isn't scary because it enables crime, or eases
tax dodging. It's scary because a world where it's used for all
transactions is one where the ability of a central bank to guide the
economy is destroyed, by design.
For Bitcoin developer Hearn,
that's not a concern. "Bitcoin's monetary policy would only be relevant
if it were to be adopted by an entire economy, which isn't going to
happen any time soon."
Already, alternatives based on Bitcoin
have sprung up: for instance, Litecoin speeds up transaction processing
and Freicoin introduces measures to stop people hoarding their money,
but both are essentially the same technology, "forked" from the
original. There's even nothing to stop a nation state declaring its own
version of Bitcoin as legal tender.
So even if the currency of
the future looks like Bitcoin, it might end up being a distant successor
of the pioneer. "Is the technology of Bitcoin a window into the
future?" asks Birch. "Yes. Is Bitcoin itself? No."
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