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Thursday, 6 February 2014

In Cryptography We Trust : A Short Guide to Bitcoin

Editor’s note: This is a guest post by Michael Chishala, a Zambian writer and regular contributor to the discussions on the ZE Facebook page. Follow him on Facebook.
What is Bitcoin?

Bitcoin is a form of decentralized currency system similar to Dollars or Pounds, except that it is completely digital (based on computer hardware and software). These "digital coins" can be used like traditional money for transactions between two parties. They are "mined" (like gold or silver) from a special "peer-to-peer" computer program that sits on a distributed worldwide network of computers. The mining process involves using computers to solve complex mathematical problems and getting rewarded with the bitcoins which the "miners" can then trade for other things just like silver can be exchanged for Dollars or used to pay people's wages. Bitcoins can be traded on an exchange just like Gold can be traded on the London Metal Exchange. The Bitcoin system makes extensive use of encryption technology (hence sometimes called a "crypto-currency") and because it is a peer-to-peer network, there are millions of copies of the records of how many bitcoins there are and all the transactions between different parties using Bitcoin.

This makes it virtually impossible to counterfeit a bitcoin or spend the same bitcoin twice because it is extremely unlikely that any person or organization can take control of sufficient copies of the "Bitcoin Ledger" (called the "Blockchain") on the computers in the world and alter the records to their advantage. Once a false transaction is picked up by the system, it is automatically blocked from all the copies of the public Bitcoin ledger (transactions are validated by between six and eight trusted computers on the network). However, it is possible to steal or lose bitcoins if there is poor security. For example, you can lose your bitcoins if a Bitcoin Exchange is hacked into. You can also lose the digital "wallet" that you keep Bitcoins in (it is a file on your computer which can be lost if the computer is hacked into or crashes and you did not back up the wallet).

Who created it?

We don't know. It was anonymously released to the public in 2009 as a downloadable software platform by a person (or persons) going under the name "Satoshi Nakamoto". Nakamoto's identity has never been discovered, despite many gallant attempts.

Why is Bitcoin necessary?

Short answer: Inflation and government meddling.

Long answer: All the major currencies in the world today are no longer backed by a commodity such as gold or silver, they way it was about a hundred years ago when there was a "Gold Standard" and a "Silver Standard". Back then, currencies were essentially paper certificates that proved that you had deposited gold, silver or any other acceptable commodity in the bank (a little similar to title deeds). In America in the 19th century, you could deposit tobacco in a warehouse and get certificates that could be used for payments. A single certificate saying you had a hundred ounces of gold could be divided into many smaller certificates (denominations) and could then be exchanged freely between people or even deposited directly into a bank account. They were the forerunner of today's banknotes. They could be taken to any bank anywhere and exchanged for the actual gold, silver or tobacco. This is why originally on every banknote it was written, "I promise to pay the bearer on demand". The bank or merchant promises to pay you the equivalent amount in gold, silver or copper that is written on the banknote.

In the olden days, a bank could only print banknotes according to how much gold or silver it held in its vaults. This also applied to Central banks. However, after the Gold Standard was progressively abandoned, partially during the Bretton Woods Agreement of 1944, central banks began printing money not connected to physical commodities like gold or silver. This is called "Fiat Money". In collusion with governments, central banks began to create much more money than the productivity of economies. Over time, this began to create inflation and since all the major currencies of the world are doing the same, many people began to yearn for another medium of exchange that was free from inflation and government manipulation the way the US Dollar or Pound is. This is what set the stage for the birth of Bitcoin and other digital currencies. The worldwide global financial crisis of 2007-2008, partly blamed on the US government's creation of money out of thin air (so-called "Quantitative Easing") was perhaps the straw that broke the camel's back.

In 2010, Wikileaks released a lot of damaging information to the US government and many people began donating money to keep it alive after governments tried to have it shut down. VISA, Mastercard and Paypal blocked payments to Wikileaks and its Paypal account was frozen. This incident partially fueled the rise of Bitcoin as the solution to such government meddling. The lack of government control over Bitcoin has made it very attractive to many people.

How is it any different from the money in my bank account? I transfer money electronically anway!

Bitcoin is not managed by any central authority the way Central Banks manage currencies. The US Federal Reserve can control the value of Dollars by producing more or removing some from circulation. This cannot be done with bitcoins.

What are its advantages over traditional paper currencies?

Aside from being "inflation proof", bitcoins do not need a trusted third party when you need to transfer them to someone else. If you want to move money to another geographical location without having to send physical cash, you need a bank or other third party like VISA, Western Union, the Post Office or even a mobile payment vendor. You incur fees for this service. Bitcoin allows you to send money directly to another person without involving any third party. The transaction costs imposed by the system (normally less that one US cent) are very tiny compared to traditional systems and the time to complete the transfer is just minutes. You can give money to someone standing next to you in this way via your mobile phone.

Bitcoins are anonymous (your identity does not exist anywhere in the system, only your Bitcoin “address”). This has made them popular for purchasing illegal goods and services on the Internet such as gambling and drugs. Others use them to circumvent government controls over movement of money. They can even be used to evade taxes. However, it is still possible to trace the owner of bitcoins if they do not cover their tracks properly.

For example, if you order something that gets delivered to your house, it becomes easier to connect your bitcoin wallet expenditure to you. An investigator can study your patterns of expenditure from the public Blockchain and compare them with other information about you. Some software developers have already come up with solutions to obfuscate the transactions from your Bitcoin wallet.

What are Bitcoin's disavantages?

It is not yet in widespread use. It is not yet very user friendly to use. Governments and Banks have not yet adopted it along with all other paper currencies. Governments are suspicious about Bitcoin as it undermines their ability to create money out of thin air and cause inflation. By its nature, it is a "deflationary currency" (its value increases over time). This is because the total number of bitcoins that can be mined is fixed at 21 million and the number that can be mined per year keeps dropping over time until the year 2140 when the last bitcoins will be mined. As demand for Bitcoin as a medium of exchange increases, the value of one unit increases in purchasing power. However, the emergence of competing digital currencies like Litecoin may dampen the deflationary pressures.

There are many currency speculators who are hoarding it. It is currently very volatile due to speculators looking to cash in. It is therefore unsuitable for everyday transactions for the moment. However, the problems around adoption are likely to be solved soon once new advances in technology come online this year, making Bitcoin more accessible. Companies like Google are already working to embed Bitcoin into the Chrome web browser. Bitcoin will soon be integrated into operating systems on cellphones and Tablets and this will significantly accelerate uptake.

Can I use Bitcoin to buy things? What about getting my salary in Bitcoins?

There are many hundreds of organizations across the world accepting bitcoins as payment. Many employers in Europe are already paying salaries in bitcoins. The number is growing but Bitcoin use is still very tiny and less than half is used for traditional payments. However, its use is growing rapidly.

What other potential uses does Bitcoin have? 

It can be used as some form of "anonymous identity" (without names) that can be used to login to websites and other online services. For example, a "members only" website can only admit people that have maintained a certain minimum Bitcoin balance over six months. Since the Bitcoin blockchain is public, this information is available to software programs without requiring express authorization.

People can place bets on horses or political outcomes using Bitcoin such that funds are moved automatically and irreversibly by the system after the result is known. Escrow services are another use whereby payments for goods and services are locked by the system until the buyer confirms receipt. You do not need to hire a bank or other financial institution for this and the costs of the service will be minuscule.

Another interesting idea being developed is crowdsourcing or crowdfunding whereby a person looking for venture capital can pitch their idea to the public and lots of people donate small amounts which then add up to what they need and they only get the money once they hit their target. Websites like kickstarter.com already do this but they charge a 5% commission. Bitcoin removes the middle man as money is automatically moved from Bitcoin wallets only when the total pledges reach the intended target.

What is the future of Bitcoin?

It has the potential to be highly disruptive of the entire financial sector. It can potentially supplant systems like Telegraphic Transfers, Mobile payment solutions, Western Union / Moneygram transfers, VISA / MasterCard and even Paypal. It could even conceivably destroy banking as we know it because it will render a bank account obsolete once employers can pay you directly or you can receive business payments and other money in bitcoins. The role of Banks to keep your money safe from theft will become irrelevant and they will have to transform into lending houses largely.

If widely adopted, there are many potential economic and social side effects. Computing technology has already benefitted with better chips called “ASIC” (Application Specific Integrated Circuit). The unbanked population (60% by some measures) could more easily transact over long distances without need for cash or bank branches. Costs associated with managing physical cash would be reduced over time. Bitcoin funds could be pulled together from many people into Mutual Funds and provide more capital for entrepreneurs.
Bitoin is even safer than banks because in the Bitcoin system, it is impossible to have a "run on the bank". It may affect tax collections as people begin trading services and goods outside the established banking system. 

This may not necessarily be a big problem because all businesses have to be registered and report their income and expenditure. Tax evasion is more likely to occur among individuals and very small businesses that are already evading taxes even under the current system. Better software systems can deal with this in future.
There are many governments that will doubtless attempt to fight Bitcoin with all sorts of legislation. This may affect its uptake speed. However, regardless of what anyone tries to do or how events play out in the end, the cat is now out of the bag. Bitcoin, in whatever form it shall end up, is clearly the future of money and voluntary exchanges. It will also very likely end up being used in ways we cannot yet imagine, as happened to personal computers and the Internet.

Further Reading

1 comment:

  1. This short guide was the one , which I was looking fo. Thanks for the update..

    ReplyDelete

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