Bitcoin, Explained

Everything you need to know about the new electronic currency.

| Wed Apr. 10, 2013 3:00 AM PDT

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What is a Bitcoin? How did you pay for your coffee this morning, by cash? By credit card? If a growing number of bank-fearing techies have their way, you'll soon be able to pay for that mocha latte through an untraceable virtual currency called Bitcoin. As of this month, Bitcoins are worth over a billion dollars, and interest in the currency is skyrocketing. Here's everything you need to know about a currency that sounds like it belongs in a fantastical realm: You can't touch it, it's prized in the underworld, its creator disappeared in a cloud of mystery, and if you want to keep it safe, you should keep it hidden in a bunch of different places.

No, but really. What is it? A Bitcoin is a unit of currency, launched in 2009, that only exists online and isn't controlled by any kind of central authority, like the US Federal Reserve. You can send Bitcoins to anyone who has a web connection (or hand someone your hard drive containing the currency.) You hold on to Bitcoins by setting up a virtual wallet, either through a third-party website, or by storing it on software run on your computer—although storing your Bitcoin wallet only on your computer is about as secure as stuffing hundred-dollar bills under your mattress. As soon as you have your wallet, you're part of the big Bitcoin network. If you want to buy something from your neighbor, you simply need to obtain their anonymous identification number and send them some Bitcoins, which takes between 15 minutes and an hour to process. If you are confused, here is an awesome one-minute video from PandoDaily.

What is a Bitcoin wallet? A Bitcoin wallet is a service that holds your Bitcoins for you. Unlike banks, Bitcoin wallet firms don't generally invest the money you deposit with them. But there's a catch—Bitcoin wallets don't have the Federal Deposit Insurance Corporation backing that insures Americans' bank deposits up to $100,000. "There's no such thing as FDIC insurance when it comes to Bitcoin," says Reuben Grinberg, an attorney at Davis Polk & Wardwell who specializes in financial matters and wrote an early legal analysis of Bitcoin. If your Bitcoin wallet gets robbed or collapses, you're out of luck. Here's what a Bitcoin phone wallet looks like:

Why do people use Bitcoin?

Bitcoin appeals to people who are suspicious of financial institutions and central banks like the US Federal Reserve. "There are types like me, libertarian gold-buggish folks," for whom "inflation is a constant worry" and who "see the cryptography in Bitcoin as insulation against inflation,"  explains Jim Harper, the director of information policy studies at the Cato Institute. People seeking privacy in their financial transactions—for legitimate or illegitimate reasons—might also use Bitcoin because it's more anonymous than financial transactions using credit or debit cards. "A lot of these people who have a deep distrust of government are really interested in anonymity and autonomy. They want to keep the government out of their business," Grinberg says. "In a lot of these people's minds, governments will come and go, financial instruments will disappear, you could have have anarchy, but Bitcoin will be here to stay." As with gold, the idea is that the value of Bitcoin could survive some sort of cataclysm. The value of Bitcoin isn't actually very stable however, so that may not be a good bet.

Where do Bitcoins come from? New Bitcoins are created in a process called "mining," which involves Bitcoin users attempting to figure out a complex mathematical solution related to the current number of Bitcoins. Grinberg compares it to finding the missing piece of a puzzle. Whomever finds the puzzle piece wins a certain number of Bitcoins, and the process starts all over again. Finding the Bitcoin solution involves an incredible amount of processing power, and so users often band together in "pools" in order to find the solution and to earn Bitcoins more regularly. However, there have been incidents where Bitcoin users have illicitly attempted to use other people's computers to mine Bitcoins. You can do this by hacking people's computers and telling them to mine Bitcoins. In one incident referenced by the FBI, a system administrator at a university in New York set its computers to mine Bitcoins for him.

Is Bitcoin legal? In the United States, the answer is probably yes, but it could depend on what state you're in. Doing something illegal with Bitcoins—like bribing someone or buying drugs—is still illegal.

How much is a Bitcoin worth?

In August 2012, the exchange rate for 1 Bitcoin was about $10. When Kevin Roose of New York magazine wrote about buying a Bitcoin on April 4, the price was at $140. And as of Tuesday night, April 10, it's up to $234. It's not clear why, but Harper says the rapid price rise could be attributed to anything from increased media attention to concern surrounding the financial crisis in Cyprus, where bank accounts were going to be taxed to finance a bailout of the island nation's financial sector.

How many Bitcoins are there? The Bitcoin foundation states that there will never be more than 21 million Bitcoins at a time. That could create a problem for the currency, however, because people might sit on their Bitcoins rather than buy things with them, hoping that they appreciate in value.

What can you buy with them?

You can buy anything from any company that accepts Bitcoins as currency. There aren't that many of them. However, privacy activists have lauded the ability of Bitcoins to preserve the anonymity of political dissidents to publish online in countries where Internet access is restricted. The Freedom of the Press Foundation says that Bitcoin "offers the potential for a censorship-resistant currency." One of the more popular uses for Bitcoin, however, seems to be the purchase of illegal drugs, because like cash the transactions are harder to trace, but unlike cash, they can take place over long distances. "When you're talking about normal American consumers, is there anything legal they can get with Bitcoins that they can't get with dollars or with their credit card?" Grinberg says. "I think the answer is no."

Why do people say Bitcoins are easier for criminals to use?

Bitcoins provide a certain amount of anonymity for users, because the accounts are just numbers and not necessarily linked to an individual identity. You can also create a new wallet for each new Bitcoin transaction, further hiding your identity. But it's not completely anonymous, says Grinberg. Bitcoin users who reveal information to third parties, either a Bitcoin wallet provider or even through joining pools to mine Bitcoins, are making it more likely their identities could be discovered. But because all Bitcoin transactions are public, it's theoretically possible that you could use the account numbers to discover someone's identity. "It’s possible that using statistical techniques and information that's publicly available you could find out a great deal about Bitcoin users," Grinberg says. Also if you're using a third-party Bitcoin wallet, the feds have a number of ways to compel corporations to reveal user information when it comes to matters of national security.

Can you use Bitcoin to avoid taxes? Yes, in the same way you could use cash to avoid taxes. The more that people use Bitcoin this way, however, the more likely that governments will get get better at finding people who do so. "Just like people who accept cash, it's generally easier to evade taxes," says Grinberg, "but as a large-scale tool to evade taxes," he's "not sure" it would work. If you earn income with your Bitcoins, you technically still have to pay taxes on them.

Can they be hacked?

Bitcoin wallets and exchanges can be hacked. "There's plenty of stories where Bitcoin exchanges have been hacked," says Cato's Harper. "One of the weaknesses of Bitcoin by far is that people don't know very well how to secure their Bitcoin." Of course, identities can be stolen and regular bank accounts hacked too.

Which famous people use Bitcoins?

Wikimedia Commons

Ashton Kutcher's venture capital firm, A-Grade Investments, invested in a Bitcoin pay network, according to Beta Beat. And BuzzFeed speculates that there has to be at least a few Bitcoin millionaires, although they only managed to track down a Reddit user claiming to be one. So if celebrities are using Bitcoins, they're not bragging about it. Who should be the next Bitcoin celebrity spokesperson? Users in this Bitcoin forum note that Sean Penn, Charlie Sheen, President Obama, and the woman who "works for Fox Sports and also plays the character 'Chelsea' on TNA Wrestling on Spike TV" would all make good candidates.

What does Obama say? The Treasury Department released a statement in March saying that certain entities—but not the average Bitcoin user—may have to register with FinCEN, the wing of the Treasury Department that deals with financial crimes and money laundering. "Someone who mines some Bitcoins and then uses them to buy goods or services, and not as part of business—would likely not have to register," Grinberg says. "However, once you move beyond that minimal level of involvement in the Bitcoin world," like setting up a Bitcoin exchange, you might have to register. Grinberg says it's still not entirely clear what the rules are yet.

Will Bitcoins ever replace national currencies? That seems like a long shot right now. "There's enough to be cautious about with Bitcoin that I don't see whole countries abandoning their currency and using Bitcoin," Harper says, although he argues that Bitcoin could be useful to people in countries without a stable currency. "It doesn't bring us to libertarian Shangri-La or anarcho-capitalism or anything like that."

Is Bitcoin going to bring down the world financial system? Probably not. "It's still a drop in the bucket in terms of the world economy," Grinberg says. "It's not crazy to think it might go much higher and that its market cap might become so large to exert some influence on, if not the world economy, the local economies where it starts getting used more

Who invented Bitcoin? Bitcoin's founder is Satoshi Nakamoto, which is a pseudonym. Nakamoto "released Bitcoin to the world at the beginning of 2009, but said he had been working on it since 2007," explains Gavin Andresen, whom Nakamoto made coadministrator of the software when he left the project. The idea was mentioned before that, but Jon Holmquist, head of marketing at BitcoinStore.com, says Nakamoto was responsible for combining and solidifying the ideas into a practical paper. Both Andresen and his colleague say they have "no idea" of the founder's real identity. Nakamoto's alleged profile on P2P Foundation claims that he is a 38-year-old male living in Japan, although that has been met with skepticism, given his strong command of American English.

How do I convert dollars to Bitcoins?

There are a number of ways to convert dollars to Bitcoins, but as Grinberg notes, "it's not straightforward" for the average person, and "even the 'easy' version is hard." Also, if you live in a rural area, or have qualms about handing over all of your bank information to an anonymous internet stranger, then you might want to just give up now. The major Bitcoin exchanges don't accept credit cards—because of that whole anonymity problem–so instead, you're encouraged to purchase Bitcoins by adding your bank account information to a site like Coinbase, and transferring money that way. You can also get Bitcoins by using your phone, the virtual program Second Life, wire transfer, or at a cash deposit location like CVS. Bitcoin users caution against PayPal—because it might freeze your account—and say that "buying Bitcoins in person can be fun and safe!" If you want to meet a stranger in 7-11 and give them cash for Bitcoins, here is a website to find a trusted serial killer distributor.

In which other countries can you buy Bitcoins? Canada, Mexico, Argentina, Brazil, parts of the European Union, the United Kingdom, Russia and Malaysia, to start. Mother Jones asked Andresen whether you could buy Bitcoins with, say, the Indonesian rupiah, and he said that "I don't know if there is an exchange from Indonesian currency to Bitcoins yet."

Will Bitcoins ever be used by banks? Many users like Bitcoin precisely because they see it as an alternative to putting their money in banks. But it's possible that more traditional banking institutions using Bitcoin could pop up at some point.

This piece has been edited to clarify that how federal regulations apply to Bitcoin entities remains hazy.

UPDATE 1, 7:10 a.m. PST, Friday, April 12: Winklevoss Twins Revealed to Have Millions of Dollars in Bitcoins

The New York Times reported Thursday that Cameron and Tyler Winklevoss, the Olympic rowers turned Internet entrepreneurs who sued Mark Zuckerberg for allegedly stealing the idea for Facebook, own almost $11 million in Bitcoins. They also appear entirely unfazed about the violent drop in the value of a Bitcoin over the last couple days (as of Friday morning, it had plummeted to $77 from the $234 it was valued when this article was published on April 10).

“People say it’s a Ponzi scheme, it’s a bubble,” Cameron Winklevoss told the paper. “People really don’t want to take it seriously. At some point that narrative will shift to ‘virtual currencies are here to stay.’ We’re in the early days.”

 

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