12.12.2013

Virtual money: Exchange without value

Anthony Rose looks at the growth of non-governmental virtual money

Bitcoin is an experimental, decentralised, peer-to-peer digital currency that has grown rapidly in visibility over the past few months. Created in 2008 by the pseudonymous individual (or group) known as ‘Satoshi Nakamoto’, it is quickly gaining in both legitimacy and utility.

Bitcoin is built on a system of public-key cryptography, in which a pair of en­cryption keys are generated: one public and one private; bitcoins are stored in an encrypted virtual ‘wallet’. For Alice to send bitcoin (BTC) to Bob all that is required is Alice to cryptographically ‘sign’ the transfer with her private key and then to use one of Bob’s public keys as the address (similar to an account number). Bob is able to use the bitcoin software to create anonymous public keys whenever required, independent of any central financial authority, and convention is to create a new public key for each transaction. The details of every new transaction are appended to the ‘block chain’, which acts as a cryptographically verified public ac­counting ledger for the bitcoin network and is jointly maintained by users. It is possible for anyone on the network to use Alice’s public key to verify that the transfer originated from her. An indi­vidual’s balance simply represents what fraction of the block chain is associated to their private key.

New bitcoins are generated through a process known as ‘mining’. This in­volves nodes on the network crunching numbers in an attempt to solve a math­ematical problem. Each new solution results in the creation of a new block and bitcoins are awarded to those nodes involved in this process. The difficulty of each solution is automatically read­justed by the network, so that approxi­mately every four years the number of bitcoins mined will be halved, and there will eventually be a total of 21 million BTC in the system. A single bit­coin can be divided down to eight deci­mal places, meaning that 0.00000001 BTC is the smallest amount that can be handled in a transaction.

Bitcoin is not simply PayPal with­out fees - many adopters believe that it could become a global alternative for cash. It offers a number of attrac­tive advantages over conventional money: bitcoin allows for instant, pseudo-anonymous payments to any­one, wherever they are in the world. International transaction fees are simply non-existent, as are process­ing fees that are common for debit or credit card transactions. As I am cur­rently based in the US and frequently forced to pay $35 to transfer money to the UK, this is definitely appealing. Bitcoin offers the potential to remove central financial institutions from the flow of money by exploiting the abil­ity to move data online and protect it via strong cryptography. This is why so many of the bitcoin community believe this could be a revolutionary development in finance. Sending mon­ey anywhere in the world becomes as simple as sending an email.

As an example, Wikileaks was able to bypass the financial blockade placed upon it by Bank of America, Visa, MasterCard, PayPal and Western Union by accepting bitcoins, and its donation ‘wallet’ has received just over 3,796 bitcoins as of the time of writing (this information is available via the block chain and public key), and a fur­ther 145 in the fund to defend Edward Snowden. With the price hovering at around $1,000 per BTC, this has clearly been an important source of revenue. A growing number of charities, political parties and online projects are accept­ing bitcoin donations.

The price per bitcoin has grown rapidly over the past year or so, as awareness and adoption has spread. In August 2012 the price was around $10/BTC. Earlier this month bitcoin hit an exchange rate high of over $1,200/BTC, and more businesses are accepting payment in bitcoin every day (both online and offline). This is helped in no small part by the vastly increased awareness of the currency, and deliberate efforts such as ‘Bitcoin Black Friday’, an online parallel to the US consumer bender that takes place after Thanksgiving.

The huge recent increase in price is largely driven by speculation and the volatility of the price reflects this: fluctuations as high as 30% of the val­ue have happened several times this year due to people dumping or buying bitcoins based on the perception of a ‘bubble’ bursting. Another factor in the price rise is the surging market for bitcoins in China, whose government recently stated that bitcoins would be treated as a ‘commodity’ rather than a currency, thus remaining free from banking and currency control regula­tions. A further nod toward legitimacy in China came from the state-owned China Telecom, which recently an­nounced that it would accept bitcoin as a payment for certain smartphone or­ders. Many such small pieces of news can be seen as steps in the ‘right direc­tion’ by bitcoin users and supporters.

There is still a level of inconvenience that acts as a barrier to more widespread bitcoin adoption. Individuals who wish to buy bitcoins currently have to go through one of the online exchanges, which can require a reasonable amount of effort in terms of initially verifying one’s identity and transferring money with which to make a purchase. An alternative is to use a service such as localbitcoins.com and purchase bitcoins from an individual. This system is far from perfect, but with the rise in value and adoption of bitcoins will come inno­vation in terms of improved architecture and online support.

The block chain architecture itself has potential beyond just transferring money. Sensitive, patented or copy­righted material could be ‘hashed’ and the resulting cryptographic string stored in this encrypted public ledger - it would have an indisputable time stamp, proving its existence at a cer­tain time. Many more such applica­tions are likely to be thought of, as the technology matures.

It almost goes without saying that bitcoin, and cryptocurrencies in general, are still very much in their infancy and are essentially their own prototype. What does the future hold? It is, of course, impossible to be pre­cise, other than to say that the fate will be strongly correlated with both the adoption rate and any attempt from governments to regulate against their use. Governments will have a problem taxing something that is very difficult for them to track.

Having said that, there are already London pubs taking payment in bit­coin, and at the other end of the scale Virgin Galactic will also accept bitcoins for a ticket to space (already there has been one taker). Alternative cryptocur­rencies exist and perhaps some other digital currency will appear and replace bitcoin, although with a ‘first-mover advantage’ maybe what we are seeing is the beginning of the future standard for digital currency transactions.

Personally, I believe that anything that allows for us to democratise cur­rency in this way is one that should be taken seriously. The internet has revolutionised a wide range of our day-to-day activities - perhaps most notably in terms of communication. These new digital currencies offer a path to a very different way in which we handle finance.

If you’re interested in reading about the protocol in more detail you can find Satoshi Nakamoto’s original paper at bitcoin.org/bitcoin.pdf.