What's a Bitcoin and why would you want one?

By Woody Leonhard

You might have heard in recent weeks about Bitcoin millionaires — people who raked in vast sums of real money riding this relatively new form of currency.

Bitcoins offer both a fascinating, new approach to money and many potential pitfalls. Here's what you should know about this online phenomenon.

The history of money is fascinating. Ancient humans traded salt for fish, wheat for beer, and camels for wives. Around 9,000 BC, give or take a millennium or three, people started using an intermediary object — something they might not need but could exchange. For example, I'll take one bag of rice for my duck; I'll give you a half-bag of rice for that small clay pot or a whole bag for that big pot.

In Asia, cowry shells (considerably easier to carry than bags of rice, no doubt) were used long ago for bartering. But as trade expanded around the world, more sophisticated forms of "currency" were needed: bronze-cast knives in China, silver bars of set weights in Mesopotamia, gold bars in Egypt.

Around 700 to 500 BC, the first coins appeared — typically, stamped bits of naturally occurring silver/gold metal called electrum. Minted coins followed, their value dictated by the weight and fineness of gold or silver used. Coins from Athens, Persia, and China circulated all over the world.

Around the 11th century, paper money appeared alongside coins in China. In Europe, the first paper money was a sort of IOU used to document loans in gold. The IOUs gradually formalized into official banknotes.

In the 17th century, European governments (and much of the world soon after) moved into the business of issuing paper money, backed by deposits of gold and silver.

Skipping over centuries of hyperinflation, bank runs, and the end of the gold standard, we arrive at the monetary system in use today.

With the exception of cash and trade, every monetary transaction we make today goes through the same basic cycle: you offer to buy something with a credit card or check, a central record-keeping organization verifies whether you have sufficient funds or credit, the purchase is approved, and the transaction is posted to your account.

All forms of electronic money work the same way. You put through a charge using a credit card online, or you receive or send money via PayPal, or you tap your stored-value card or phone to make a payment. As long as you have enough money or credit, you're good. The system works because the currency used remains relatively stable.

Establishing an entirely different kind of money

Bitcoins are currency, but they're unlike anything most of us use today. They're a blend of new technology, old-style bartering, and free-market thinking. Although completely electronic, a Bitcoin's value is set by the open market — not by any government entity.

Like cash, Bitcoin transactions are untraceable. If you want to transfer significant amounts of money through traditional channels, it takes either suitcases of cash or at least one intermediary bank — along with all the required paper trails and fees. Not so with Bitcoins. Using some cryptographic magic and extreme redundancy, the Bitcoin network requires no central bank, no list of Bitcoin holders, nothing that can trace a person to a specific transaction. If that sounds like an ideal setup for money launderers, drug dealers, and/or fugitive prime ministers, you're on the way to understanding the early attraction of Bitcoins.

About four years ago, Bitcoins came to prominence as the preferred currency on the Silk Road website. As reported by the Guardian and other sources, the majority of sales on Silk Road involved drugs. Bitcoins made those transactions untraceable.

Today, Bitcoins are undoubtedly used for less sordid transactions. But their fluctuating value also gives them a commodity- or stock-like aspect. Through 2012, a single Bitcoin's value grew from U.S. $5 to about $13. This year, a Bitcoin cost $266 on April 10 and then fell to $125 the next day, prompting the crash of the largest online Bitcoin exchange, the Japan-based Mt. Gox (site). When the exchange came back online a day later, Bitcoins hit a low of $65. As I write this, a couple of weeks later, the value's almost doubled to $120.

Now that's what I call volatility!

Nobody knows for sure why the Bitcoin market soared, then crashed. One theory places the blame on Cyprus's banking crisis, where thousands of bank accounts received involuntary "haircuts" by a Cypriot government flailing for cash. Panicked depositors ran for alternatives — among them, Bitcoins. Others speculate that organized crime manipulated the market to buy low and sell high. (On April 24, Mt. Gox was also hit by a massive distributed-denial-of-service attack.)

Steve Forbes, no stranger to the subject of money and finance, put it succinctly in his op-ed article, "Bitcoin: Whatever it is, it's not money!" He states that the Bitcoin is too volatile to be "money" in any traditional sense of the term. "It has no fixed value. It trades like a stock or commodity."

To Bitcoin proponents, that's precisely the point. Bitcoins are kind of an anarchist's version of cowry shells — not beholden to any government, bank, political group, or individual trying to corner the market in a specific commodity.

How a distributed-currency system works

As mentioned above, Bitcoins are entirely electronic. At its heart, a Bitcoin is simply a number — like the serial number on a banknote. To use a Bitcoin, you sign in to your Bitcoin wallet, stored either at an online service or in an application on your personal computer or mobile device. The wallet shows your Bitcoin balances; it's also where you get Bitcoin addresses (essentially separate accounts), which you give to other Bitcoin users when transferring the currency. According to the "How does Bitcoin work?" page, the system is somewhat like a distributed email network.

Bitcoins also work somewhat like a typical online bank transfer but with important differences. For instance, there's no bank-like clearinghouse for Bitcoin transactions. Nobody has a list of all account numbers and owners. There is, however, an ongoing list of transfers: which accounts transferred how much to which other accounts. The list is public — it's stored in hundreds of different locations, on hundreds of different computers. (You can see every transaction going by in real time on Clark Moody's site.) Who owns the accounts is, on the other hand, private.

The technical details of Bitcoin transfers — how Bitcoins change ownership and how the system prevents transferring the same Bitcoin twice — involve public-key cryptography and some fancy computing techniques. Unlike a bank, the Bitcoin network doesn't keep track of your Bitcoins — only Bitcoin transactions. Which means you're responsible for protecting your Bitcoin wallet.

When you ask somebody to send money, you have to give them a Bitcoin address — essentially an encrypted public key. The Bitcoin software actually encourages you to generate a new address number for each transaction. If you get money from one person and then send that money to someone else using a different address, it's basically impossible for anyone other than you to know where the money came from or where it went.

There's some time delay on the transactions. Typically, it takes 10 minutes for Bitcoin transfers to take effect. The reasons are complex, but they're associated with preventing double spends — trying to spend the same Bitcoin twice, either intentionally or inadvertently. Since there's no central repository of accounts and balances, the delay is basically the price you pay for having a whole bunch of computers simultaneously verify the transactions.

If you're accustomed to bank wire transfers taking an hour, a day, or even a week to complete, 10 minutes doesn't seem like much of a hardship. And the Bitcoin verification runs 24 hours a day, seven days a week on hundreds of computers, making the system fairly reliable.

Incidentally, the first widely recognized Bitcoin transaction was the purchase of two pizzas. The buyer reportedly paid 10,000 Bitcoins — pricey even at early Bitcoin rates.

Where Bitcoins came from; where they're going

Bitcoins have a fascinating history. The originator of the concept, who went by the handle "Satoshi Nakamoto," has never been identified. I say "went" because Satoshi appeared out of the blue in 2008, published a few papers, never made a public appearance, and stopped answering emails in December 2010. However, the importance of Bitcoins doesn't rest in the person or persons who created it. The creation itself holds the answers to pressing money problems such as making private transactions without resorting to piles of cash.

If you want to keep your Bitcoin transactions private, there are two points of vulnerability to online snoops: when you buy Bitcoins using some other currency, and when you sell your Bitcoins. Once inside the system, you're anonymous. In other words, when you use Bitcoins only to pay for purchases, there's no traceable record. (One person recently sold his house with Bitcoins, another sold a Porsche.)

That obviously presents a problem for law enforcement. Because Bitcoins make investigations more difficult, law-enforcement agencies are leaning hard — sometimes with sanctions, sometimes with legislation — on the Bitcoin clearinghouses to provide information about transactions. Mt. Gox's sign-up page warns that if you try to access your account using the Tor network or public proxy servers (two common means of disguising your location), they might suspend your account and force you to submit anti-money-laundering documents. (A bitcoin.org page, on the other hand, recommends using Tor to hide your PC's IP address.)

Today there are approximately 11 million Bitcoins in circulation. The system is designed to let the number of Bitcoins increase at a very slow rate — by 2140, there should be about 21 million Bitcoins in circulation. If you want to learn more about Bitcoins, take a look at the official Bitcoin FAQ.

Bottom line: If you do become a Bitcoins user, keep in mind that the value of your Bitcoins can change rapidly and unpredictably. Whenever someone asks me whether I'd buy Bitcoins right now, my answer is a resounding "Hell no!" It's an interesting concept — a currency not tied to any country or financial institution — but the recent run-up and decline of Bitcoin pricing give me nosebleeds. Put your savings in Bitcoins, and you might make enough money to retire in the next year. Or you could lose 90 percent of your gamble — er, investment.