What Is Bitcoin?

The dollar, euro and yen might be the primary language of currency traders today, but online, all the talk is about bitcoins.

The digital currency has been around for nearly two years now, but it burst onto the radar of the mainstream world in June, when Gawker published a story about an underground Website where you could trade the currency for illegal drugs. The chatter surrounding the story eventually faded, but a lot of people were left confused about bitcoins. What are they? How do they operate? And what, aside from illegal narcotics, can they be used for?

What is Bitcoin?

Photo: bitcoin.org

Bitcoin is striving to be a global currency of sorts—one that's not backed by any government or institution. Bitcoins aren't cash, technically. They're an entirely virtual currency. Users exchange online credits for goods and services from select retailers, contractors and online trading houses.

Rather than going through a bank or financial institution, these credits—called tokens by users—are exchanged directly from person to person.

When a transaction occurs, the bitcoin is automatically sent from the buyer to the seller through an encrypted method that's designed to ensure bitcoins can’t be hacked or artificially created.

What’s the point of bitcoins?

Bitcoin's creators like to position the currency as an alternative to the dollar and Euro. They hope to revolutionize the world of finance just as the Web has proven to be a paradigm shift in the publishing world.

That's a lofty (and likely impossible) goal, but it wisely taps into people's frustration and anger with banks following the 2008 financial crisis. By moving the transaction process to a peer-to-peer level, banks are removed from the process, which also lowers fees for both users and businesses.

The process also lets people conduct transactions with virtual (but not complete) anonymity, perhaps the biggest key to its success so far. And as online transactions continue to grow and online data theft becomes a more common occurrence, bitcoin backers see an opening for the system.

How is Bitcoin different from Paypal?

Paypal and other online payment services are reliant on existing financial institutions to work. Your account is generally tied to a credit card or a checking/savings account—meaning that whenever you spend money, you're subject to the same restrictions and limitations you would have for using those. So, let's say you had tied your PayPal account to Visa with a $2,000 credit limit. Before making an online purchase in excess of that amount, you'd have to arrange for a credit extension or make changes to the source PayPal was drawing from. Using bitcoins, users can spend as much as they want—as long as they have a sufficient number of coins to cover the charge.

At the same time, because there's no way for a bitcoin account to be frozen, users can transfer funds wherever they like. For example, last year PayPal (as well as Visa and MasterCard ) blocked users from donating funds to WikiLeaks. Bitcoin donations, however, went through without a hiccup.

Are there other virtual currencies like bitcoins?

Not really. Bitcoin is something of an anomaly. There are some other existing e-currencies, such as Second Life's Linden dollars, but those are generally restricted to the game world. When it comes to real world services, bitcoins are pretty much all that's used today.

There have been other attempts at virtual currency, though. Several years ago, there was a gold-backed digital currency called e-gold that showed some promise, but it was eventually shut down due to rampant money laundering and illegal exchanges.

There are, of course, fears that those same activities will once again become prevalent with bitcoins. But because the currency is exchanged on a peer-to-peer basis, much like BitTorrent files are, it will be harder for a government to it shut down permanently.

How do I get and spend bitcoins?

The first thing you do is set up what's known as a "bitcoin wallet." Here you'll store your coins and keep your dashboard for any transactions. You can either download a program to your PC and install it, or get one online (at sites like Instawallet or MyBitcoin). In either case, it looks a lot like what you see when you log on to your bank account via the web.

From there, you'll need to fill your wallet with bitcoins. If you're the patient type, you can 'mine' them (see below), but most people buy them with real world cash via online currency exchanges, such as Mt. Gox or TradeHill.

Once you've stocked up on bitcoins, you're free to spend them—assuming you can find a vendor that accepts them. If you're looking to hire an individual, such as a graphic artist to work on a project for you, or prefer to shop from very small Etsy-like merchants, it's pretty easy.

Bitcoins are a bit harder to spend in your real world, day-to-day life, but an increasing number of establishments are accepting them. These include New York City's Meze Grill, the Howard Johnson Hotel and Conference Center in Fullerton, Calif., (near Disneyland) and Sugar, an Oklahoma City wedding cake shop. The number of vendors that accept bitcoins is increasing regularly—and includes both online and physical vendors.

(Also, as mentioned above, due to the assumed anonymous nature of transactions, bitcoins are also being used to purchase illegal drugs via well-hidden Web sites.)

When you're ready to make the transaction, whatever kind you choose, you'll open up your bitcoin wallet and digitally transfer the amount to an address the merchant provides. Rather than the typical "john@yahoo.com" addresses you're used to, though, the transfer address will be an illegible string of 30-40 randomly generated numbers and letters—eliminating the need to know who, exactly, you're doing business with.

What are bitcoins worth?

The value of bitcoins in real world dollars fluctuates wildly—often as much as 8 percent per day. As little as two months ago, the exchange rate was $1 USD per bitcoin. That was before the mainstream world learned about them, though—which sent their value through the roof.

Speculators quickly saw potential in this new currency and began buying them through Mt. Gox and other sites. Given the currency's instability, that led to rapid inflation and the currency value peaked at nearly $28 on June 9.

These days, you can expect to pay somewhere between $15 and $20 per bitcoin.

How do bitcoins work?

Because they're virtual, bitcoins aren't backed by any real world commodity, such as gold or a central bank. Instead, they rely on the economic laws of supply and demand, making them something of a roll of the dice for investment-minded speculators—the same people who bet on penny stocks for a big payoff.

Most people who use bitcoins buy them from an exchange or trader. It's the fastest, easiest way to get the currency.

Others, though, dedicate a portion of their computer's power to run a transaction-validating software app, which helps police the system. As a reward, they can earn new bitcoins when they are released.

Doing so is a very complicated and very slow process, though. It's called mining—and the comparison to diamond or mineral miner is apt, since both groups are looking for a material that is not inexhaustible. The bitcoin system is designed so there will never be more than 21 million bitcoins in existence.

Every four years, the number of new coins that will spring into existence—or be mined—will be cut in half, until the supply is exhausted in approximately 2030. After that, the only way to get bitcoins will be via exchanges. (At present, there are about 6.6 million in circulation.)

One other important note: Those previously mentioned complicated transaction addresses (the ones comprised of long strings of numbers) have fooled some people into thinking all bitcoin purchases are completely anonymous. That's not necessarily true.

The system records every transaction, so it can trace the movement of coins and avoid counterfeits. The Bitcoin dev team says law enforcement officials already monitor that log (which is made available to the public), so anyone using the currency to conduct illegal transactions is rolling the dice.

Are bitcoins safe?

Because it's a currency that's based solely in the online world, bitcoins are subject to the same threats as anything else on the Internet, specifically hackers. And that's when the lack of a backing commodity shines through.

On June 19, Mt. Gox, the most popular bitcoin exchange, saw the value of the currency drop from $17 to nearly zero in just a few minutes after hackers gained access to an account with a large number of bitcoins, and sold them all off. The site suspended trading for six days, as it upgraded security and "rolled back" exchange prices to the pre-hack level.

The hack and others like it underscore the problem with the unregulated nature of bitcoins. The unnamed owner of that Mt. Gox account, as well as the owner of another unrelated account who saw 25,000 bitcoins (worth roughly $500,000 at the time) stolen, has little to no chance of recovering his or her investment.

The FDIC doesn't guarantee virtual currencies.