Bitcoin Basics

By November 4, 2015Bitcoin Business
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A bitcoin ATM machine at a restaurant in San Diego. Credit Mike Blake/Reuters

Bitcoin is both a virtual currency and an online payment system — one that some people believe will transform the global financial system. But the details of this new technology have remained a mystery to most.

Bitcoin is both a type of digital token, or virtual currency, and the network on which those tokens can be stored and moved around.

Each unit of the virtual currency is nothing more than an entry on a digital ledger, just as most dollars and cents exist only as entries on a bank’s digital ledger. The price of a Bitcoin is set on the open market, generally on exchanges where people offer to buy and sell Bitcoin, similar to the way that a stock’s price is set.

Normal currencies are, of course, tracked by banks — and their employees and computer systems. Bitcoins, in contrast, are kept on a ledger that is maintained and updated by any user of Bitcoin who wants to help. The constantly updated ledger is kept on the computers of all the users — just as Wikipedia entries are written and kept current by the encyclopedia’s users rather than by any central authority. The work maintaining Bitcoin’s ledger is done according to rules that are established by the Bitcoin software.

It is the communally maintained ledger on which all Bitcoin accounts and transactions are recorded — known as the blockchain — that makes the currency so different from existing ones.

Because there is no central authority in Bitcoin — just the network of users keeping the records — there is no one to shut down accounts or demand personal information from Bitcoin users. Anyone can open an account and spend whatever Bitcoins they have as long as they have the password — or secret key — for their account.

Where do Bitcoins come from?

From the moment the Bitcoin network started operating in 2009, a new bundle of Bitcoins — initially 50 — was released every 10 minutes or so, essentially for free, to one of the computers helping to update and maintain the blockchain ledger.

Computers on the network take part in a sort of computational race to win these new coins, a process that came to be called Bitcoin mining. This giveaway provided an incentive for people to join and support the network with their computers. New coins will be released in this way until there are 21 million in the world (currently scheduled to happen sometime in 2140).

Once a user wins a new bundle of Bitcoins he or she can divide them up in any way — up to eight decimal points — and distribute them to anyone else with a Bitcoin address. Initially, people sent their Bitcoins to friends for free. Now, there are exchanges on which people offer to buy and sell Bitcoins and the price has swung wildly, reaching a high above $1,200 in intraday trading in late 2013.

How do you spend a Bitcoin?

Anyone with a Bitcoin address, which is similar to an email address, can send and receive Bitcoins from anyone else with a Bitcoin address. Creating a Bitcoin address is free. Each address comes with a private key, a sophisticated password, that provides access to the coins in the address.

There are thousands of merchants that now accept Bitcoin payments online. These companies will generally provide a Bitcoin address where money can be sent in order to complete a transaction. For the merchants, Bitcoin is preferable to credit-card payments because the merchant doesn’t have to pay a fee to a credit-card company. For consumers with credit cards, there is less of a clear advantage to using Bitcoin.

Why was Bitcoin so attractive to drug dealers?

The online drug bazaar known as the Silk Road offered a place for vendors to sell illegal goods, like heroin and cocaine, for Bitcoin.

Because Bitcoin can be sent anywhere in the world almost instantly, essentially for free, and because the payments can be sent without either side knowing the identity of the other, the system is an obvious choice for criminal activity.

Law enforcement officials have had some luck in tracking down Bitcoin users by looking at the I.P. address associated with a particular Bitcoin address, or by tracking down users on the blockchain ledger of all Bitcoin transactions. But this has proved to be a slow and relatively unsuccessful investigative method.

The operator of the Silk Road was eventually apprehended, not because his Bitcoin transactions were traced, but because he accidentally left his personal email address on a public website. The Silk Road was quickly replaced by imitators that are still flourishing today, offering drugs for Bitcoins.

Is Bitcoin useful for things besides buying drugs?

The Silk Road helped demonstrate that Bitcoin could be used to send money quickly and cheaply around the world, without requiring a bank account.

Slowly, there is increasing interest in using the Bitcoin network as a payment system for legitimate purposes. One often-discussed use is as way for immigrants to send remittances more cheaply to family members overseas who don’t have bank accounts or government identity cards. This has begun to catch on in places like Argentina, Indonesia and Africa.

Other developers have looked to use Bitcoin for very small online payments, of a few cents, which are generally not possible in the existing financial system because of the minimum payments required for credit-card transactions.

More recently, financial institutions have grown interested in the idea that the Bitcoin network — and its ledger, the blockchain — allows for direct online transactions of all sorts, even those that don’t involve Bitcoins. Banks and financial firms are now looking at using the blockchain to allow for cheaper, faster stock and bond trades.

Bitcoin is both a type of digital token, or virtual currency, and the network on which those tokens can be stored and moved around.

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