In February 2013, version 0.8.0 of Bitcoin was released. This virtual payments system is the financial equivalent of Latin, the language with no native speakers. In the case of Bitcoin, though, what you are dealing with is a financial structure with no central bank, no one regulatory body as such, and no physical form.

That may sound odd – so let’s look in more detail at Bitcoin, how it works, and what its future might be.

What is Bitcoin?

The brief description of Bitcoin given above is overly simplistic, and as you might expect, there’s plenty of thought behind this means of paying for goods and services – it is, by no means, an unregulated system.

In principle though, its features are as follows:

  • Bitcoins can be transferred across the network via peer-to-peer (i.e. like a BitTorrent);
  • Transactions cannot be reversed;
  • A block chain prevents double spending (the Bitcoin equivalent of counterfeiting);
  • Transactions are verified in 10-60 minutes;
  • Transactions can be made even when the individual’s computer is not switched on.

Bitcoins

Some of that might still not make much sense, so let’s ask a more pertinent question:

Where is Bitcoin?

Bitcoin has no physical form and no central ‘bank’ or regulator as such – so where is it?

The answer is that Bitcoin, as a currency, exists in a P2P network that is regulated and verified by its users. Each time a transaction is made, it must be verified before the recipient’s funds are cleared. It is the block chain verification system that underpins the whole Bitcoin system.

In order to verify a block of transactions, an active computer somewhere on the network is assigned the brute force task of repeatedly generating a hash key for the block – a randomly generated value that describes the entire block – until one is obtained that would be very unlikely to occur for any other set of transactions.

You don’t really need to understand this process – all that matters is that this key, once generated, can be transmitted to the rest of the network and used to confirm that the transactions in the given block were legitimate and the funds can be cleared.

This process is the reason behind the 10-60 minute delay before funds clear, but it also means there is no need for a central payments processing system – verification and clearing of funds happens ‘in the cloud’.

Bitcoin Inflation

A further key principle of Bitcoin is the increase in the number of units of currency circulating in the system.

Important aspects of this are:

  • No more than 21 million Bitcoins can ever exist;
  • Transactions are very cheap, or totally free;
  • A ‘reward’ is paid for processing a block of transactions;
  • Bitcoins can be divided into eight decimal places.

The impact of these aspects is that, while Bitcoin’s exchange rate with real-world currencies can change, the system itself will grow to a maximum size of around 21 million Bitcoins, and stay at that level.

Bitcoin Inflation

In this way, the expansion of the currency is fixed (and dictated by the number of ‘rewards’ paid out for block verification) and should plateau by around 2030. In Bitcoin, there is no such thing as quantitative easing.

As the 21 million Bitcoin limit is approached, the rewards for verifying a block are due to drop by half – from 50 coins per block to 25 in 2013, 12.5 in 2017, and so on at intervals of about four years.

There is also a provision to adjust the difficulty of verifying a block in response to the total computing power of the network, keeping the generation of new Bitcoins (and the verification rate of transactions) fairly consistent overall.

If 21 million coins doesn’t sound like a lot for an entire currency, then consider how a single Bitcoin may be divided.

Most currencies have two decimal places – £1.00 is 100p, while dollars and euros divide into cents, and so on. Bitcoin is different – it has eight decimal places, so a single Bitcoin can pay for transactions with 100,000,000 different values.

With 21 million Bitcoins in circulation, that’s a total of 2,100,000,000,000,000 smallest ‘units’ of currency when the network is operating at full capacity.

volume-of-bitcoin-trading_chart

Bitcoin Bugs

A system that is policed by its users is clearly going to raise security concerns for some people – and what’s worse, Bitcoin is an open-source project, meaning any vulnerabilities in its code are available for those with the right technical expertise to see.

There are already several known and corrected flaws listed on the Bitcoin Incidents wiki page, but Bitcoin claim the only major incident occurred – and was fixed – in August 2010.

The Output Overflow Bug

The August 2010 issue was caused by a vulnerability in Bitcoin’s verification process, which did not account for transactions so large that they overflowed the permitted size.

On August 15th 2010, over 184 billion Bitcoins were generated in a transaction, and sent to two addresses on the network.

The usual checks for this failed because of the sheer size of the transaction, and because of a further vulnerability of the system that allows the input and output of a transaction to differ, in case a processing fee has been deducted.

Users spotted the unusual transaction within 1.5 hours, a patch was available within about four hours, and the ‘correct’ version of the network was making its way from peer to peer about five hours after the malicious transaction was first recorded.

‘I Just Got Hacked’

In June 2011, a Bitcoin Forum user with the handle ‘allinvain’ reported an apparent hack of his Bitcoin e-wallet, which was hosted on his own computer at home.

Bitcoin users are responsible for their own security – including protecting their wallets and, if they wish, encrypting the contents to prevent hacker attacks.

Allinvain claims that he noticed some unauthorised access to his Bitcoin slush pool, changed his password and went to bed, leaving a virus scan running overnight.

He awoke to find 25,000 Bitcoins had been taken from his account and transferred to a user identifiable only as a 34-character random account name.

(A Bitcoin slush pool is a means by which multiple users can pool their computing resources, allowing them to verify blocks faster and share the reward payout.)

Across a 32-page discussion on the Bitcoin Forum, the situation remained unresolved, until allinvain ended the discussion on August 9th 2011.

The latter stages of the debate had seen him accused of manufacturing the apparent theft himself, in order to persuade other users to make sympathetic donations to his account – something allinvain denied.

Bitcoin in the Real World

Bitcoins are not considered to be a ‘currency’ in the eyes of the law – at least, not under US law. Instead, they are treated as commodities, and spending them is defined as bartering.

For the purpose of most transactions, Bitcoins are traded by members of the public through private, unregulated transactions – and that makes the system appealing to many people for many different reasons.

value-of-one-bitcoin-in-us-dollars_chart

Among these are the relative degree of anonymity and even secrecy afforded to Bitcoin users (the currency has been compared to cash, rather than card-based or conventional electronic transfers, in terms of its traceability), giving them a sense of privacy over how many Bitcoins they own and what they spend them on.

More recently, however, some Bitcoin exchange operators – notably the French firm Bitcoin-Central – have sought to regulate the system, or at least their part of the network, in order to gain bank status and therefore qualify for national-level government protection.

Understandably, this has left long-term supporters of Bitcoin as an unregulated currency unimpressed, and risks degrading the founding principles of the network.

It is unclear what the long-term impact of such moves might be in the future, or whether Bitcoin will survive to see the minting of its 21 millionth unit of currency.

While the Economist link given above estimates that this will happen in 2030, the process could actually take much longer.

Bitcoin’s own prediction is that block #6,929,999, which will take the total number of coins in circulation to its maximum level of 20,999,999.9769, will not be generated until 2140.

The Internet itself has only existed for about 30 years – which begs the question of whether Bitcoin, which launched just four years ago, can survive for another 120-130 years.

bitcoins-the-taxless-currency_50290bac2c2be

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ABOUT THE AUTHOR:

Matt Sawyer is the editor of Monetarism.co.uk. When I'm not blogging I work in digital marketing. I'm not selling financial products or luring you into pyramid schemes. I simply enjoy writing about money and investment, and I hope others enjoy reading.

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4 Comments on this article. Feel free to join this conversation.

  1. Ahmed April 9, 2013 at 12:15 pm - Reply

    Good article to understand Bitcoins mechanisim.

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