March 25, 2012
BY: Robert Hallberg, Topics: Bitcoins
What are Bitcoins? It is a decentralized electronic cash system using peer-to-peer networking. It was created by Satoshi Nakamoto as open-source software on January 3, 2009.
In a world with endless money printing by central banks, lack of financial privacy and collapsing banks, bitcoins are certainly an attractive alternative currency. But before we get into that lets take a quick look at how this new virtual currency works.
The idea of creating digital money that is convenient, untraceable, decentralized, and not controlled by a central authority has been on the mind of many libertarian minded people ever since the early days of the internet. But before the arrival of bitcoins, no one had come up with a workable system. Ecash was an anonymous system that got started in the 90s but it failed because it relied on existing infrastructure in the banking system. Other ideas like bit gold and b-money never really got off the ground.
One of the main challenges with a virtual currency has been something called double-spending. The problem is that if a currency is just comprised of data, free from any other physical attributes, then what prevents anyone from just multiplying this data and spending it as many time as they want? Traditionally, this problem has been solved using a central clearinghouse that tracks all transactions; making sure that someone cannot spend the same currency unit twice. However, the approach still requires a central authority to manage the currency and Nakamoto was looking for a more elegant solution that would provide a decentralized currency.
Bitcoins solved this problem with what Nakamoto called the âblock chain.â A block chain can be described as the participantâs willingness to dedicate CPU power to run a piece of software used to mine (create) new currency and form a network to maintain the block chain collectively. In the process they would create new currency units. Each transaction would transmit to the network, and all computers in the network would compete to solve cryptographic algorithms for several transactions.
The difficulty of each problem will increase as the number of miners increase â keeping a lid on the creation to one block every 10 minutes. Furthermore, the size of each block is halved every 210,000 blocks â first from 50 bitcoins, to 25, to 12.5, etc. Around year 2140, the currency will reach its limit of 21 million bitcoins. The chart shows bitcoins in circulations.
The elegant algorithm that makes bitcoins possible also protects it from fraud, and keeps a lid of the money supply preventing runaway inflation. Bitcoins are as anonymous as cash, and the decentralized system prevents anyone to freezing an account by the whim of a central authority.
The currency started off with a value of only a few pennies to a dollar but quickly ran up to $30 per bitcoin at its peak. It is now trading around a $4 to $5 range. The chart shows exchange rate of bitcoins and US dollars.
Is bitcoins the currency of the future?
The purpose of money is to serve as a medium of exchange and a store of value. For something to be âgood moneyâ it needs to have certain characteristics. Aristotle defined the characteristics of good money, 4th century BCE, and they are just as valid today as they were back then. They are:
1 - Durable: A good money is durable and should not fall apart in your pocket. It should be close to unbreakable. This is why we donât use fruit as money.
2 - Divisible: A good money needs to be convertible into smaller and larger pieces without losing its value, so it can fit a transaction of any size. This is why we donât use a porcelain vase as money; once half of it is gone it is pretty much worthless.
3- Consistent: A good money always looks the same, each piece looks the same as the next and it's easy to recognize. This is why we donât use an oil painting as money. Each painting is different even when made by the same artist.
4 - Convenient: A good money contains a high concentration of value into a small package and it is highly portable. This is why water is not used as money, even though it is essential for human life. You would need a truck full of water just to buy groceries, and just imagine how much youâd need to buy a larger item like a house.
5 - Intrinsically valuable: A good money should be something that many people want or can use. This is vital to money functioning as a medium of exchange. Even though, you may not want to carry a gold ring or bracelet, you know that someone somewhere wants it and will take it in exchange for something else of value. This is why we should not use paper for money.
Bitcoins have four out of five of these characteristics. But just like paper money, bitcoins does not have intrinsic value within itself. This virtual currency is a great free market phenomenon and a good medium of exchange but it is not a long-term store of value. Gold and to a lesser extent silver is still the best form of money.
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