Useful Notes: Bitcoin

Imagine a currency that is not under control of a government or centralized financial institution. That is, anyone can mint new money, handle transactions, and remain fairly anonymous to the extent that only a single unique thing, a seemingly random string of numbers and letters, is known about a person. This is the idea of Bitcoins: a cryptocurrency based around cryptographic hashes, using a peer-to-peer network to maintain balances, while shared processing power extends the block chain.note 

Okay, that's a pretty terrible way to describe it.

The way the system works is like so:
  • Transactions are encrypted messages that are broadcast into the Bitcoin network. The network is a peer-to-peer system, similar to Bittorrent. Transactions only specify a Bitcoin address and transfer of ownership of bitcoins is via these addresses.
  • Every ten minutes a bundle of transactions, called a block, is verified through a process called mining.
  • Mining is a process that involves trying to figure out the encryption key used on the transaction via a brute force method. This is compared to the network's target difficulty and if a certain value is reached, the block is considered verified.
  • Once a block is verified, it's grouped into block chains, which are added to a public transaction database.
  • For every block verified, the miner gets 25 bitcoins as a reward. This is also how new coins are added into circulation.

The bitcoin itself is something of a strange entity, since this implies that bitcoins are really records of validated transactions. The symbol for the bitcoin is ฿, which happens to be the same symbol that represents the baht, Thailand's currency, and is partly why Bitcoin is illegal there.

Once block chains are verified, they cannot be changed without redoing the work. And as long as honest nodes who are verifying blocks are outpacing those who are trying to attack the system, then the system remains stable. This led up to something of an arms race, where people would develop customized chips designed to compute the algorithm. Every so often, the target difficulty is adjusted so that verified blocks keep the 10 minute target time.

In any case, Bitcoin is something of a hot topic. Some businesses have accepted it as a valid form of payment. Governments around the world, though, are mixed since it has legitimate and illegitimate uses. Read up on the legal status of Bitcoin as well as Bitcoin's need-to-know FAQ before thinking about getting into the wonders of cryptocurrency.

Just so you don't go out rushing to get mining equipment, note the following:
  • Bitcoins are highly volatile. One minute they may be worth something like ฿1 = $1; the next, ฿1 = $0.01. That is, don't expect this to be another source of stable income.
  • Bitcoins can be lost, often with no way of tracking their existence or proof of ownership, with no recourse such as pressing charges with police or filing a lawsuit. Nor are bitcoin exchanges guaranteed or capable of error correction as, say, banks or stock exchanges are if your monetary loss is the fault of the exchange itself due to hacking or even internal criminal activity. A good example of this is the losses in the Mt. Gox exchange bankruptcy the bitcoins are either in the pockets of hackers or simply wiped out, and anyone who was still using Mt. Gox is most likely SOL.
  • Bitcoins are not legal tender; you can't pay taxes with them directly.
  • Bitcoins, depending on your country's tax laws, are taxable income since they can carry legitimate value (they can be exchanged for goods and services, in the same way regular money can).
  • Bitcoin mining is such a developed hobby that to make a decent amount off mining takes a lot of real-world money. Among other complications, US$500 graphics cards and even costlier ASIC boards will need to mine coins for years before recouping the investment at the current rate of things. Without specialist processors, miners are very likely to pay more in electricity costs than they will gain in bitcoin.
    • The currency itself has a cap of 21 million bitcoins and as of December 2013, 12 million have been mined. Every few years the rate of creation is halved.

Bitcoin has so far led to another cryptocurrency called Litecoin. The key differences are that Litecoin transactions are processed every 2.5 minutes; it uses a proof-of-work algorithm called scrypt, which makes it harder to build ASICs that accelerate the work, and the expected cap is 84 million coins. Litecoin also has a derivative cryptocurrency called Dogecoin. And yes, it's a legitimate cryptocurrency. Bitcoin has also seen its fair share of derivatives, and many other types of cryptocurrencies hoping to be the spiritual successor to bitcoin are also starting to flood the market. Will any of them succeed? It's too soon to tell.