A survey of the origins, history so far, characteristics, and legal status of the digital currency bitcoin.
Still somewhat obscure, and perhaps dubious, to mainstream consumers, bitcoin has risen from relative obscurity in early 2013 to become one of the most talked-about financial instruments in the new economy. But what exactly is bitcoin and what are some of the legal and economic issues associated with this potentially revolutionary alternative to state-authorized fiat currency?
The answers to these questions are the subject of this article, A Bitcoin Primer (this article is intended as an informational reference only and not intended to constitute advice regarding legal or investment matters).
Bitcoin is the first broadly traded currency of its kind, a peer-to-peer medium of digital exchange known as a cryptocurrency. Secured through digital encryption, it is subject to no authorizing government authority – unlike the US dollar, the British pound, the euro, etc. Instead, it rests upon the decentralized principle of use by the mutual agreement of an online community of willing buyers and sellers.
When bitcoin transactions occur, the buyer reveals only a digital bitcoin address to the seller, but maintains the secrecy of his or her private encryption key. If this key is ever lost, the bitcoins in the owner’s digital wallet will be forever lost as well.
The Origins of Bitcoin
The designer of bitcoin was a person – or a group of people – known by the pseudonym Satoshi Nakamoto. After describing the basic principles of bitcoin in a 2008 paper, Nakamoto revealed the bitcoin software and released the first bitcoins in 2009. By 2010, after an initial flurry of activity, Nakamoto gradually disappeared from view, leaving the currency to be arbitrated and defined on its official website, bitcoin.org. In the meantime, though many have speculated, the true identity of Nakamoto remains unknown.
A virtual currency designed to emulate the scarcity of real-world precious metals such as gold and silver, bitcoins are created through a process called mining. This activity involves the use of computer processors to solve so-called high hash rate, or highly complex, mathematical equations. "Hash rate" is simply a unit of measure that refers to the immense computer processing power needed to perform rigorous mathematical operations.
Once a bitcoin miner manages to solve enough of these particular problems, he or she opens a block. This block is added to the block chain, a public database that keeps a record of all bitcoin ownership and transactions. The miner is also rewarded with an agreed upon number of bitcoins – 25 at the time of writing.
When the bitcoin was first released in 2009 the complexity of the mathematical problems required to open a block was relatively low – solutions could be achieved using only the computing power of an ordinary consumer laptop. Over time, these problems were designed to radically increase in difficulty. Jump several years later and their solution requires the greater power and speed of customized and application-specific computer processors. This is supposed to ensure the continued scarcity of bitcoin, as well as its ultimately limited maximum of some 21 million coins, all of which are predicted to be mined by the year 2040.
Despite its somewhat nefarious-sounding status as a cryptocurrency and the shadowy nature of it creator, bitcoin (at the time of this writing) is thought to be an entirely legal, open-source experiment in alternative currency. However, its seemingly anonymous and untraceable nature – though the developers of bitcoin, by definition, systematically and sequentially record every bitcoin transaction – has led bitcoin to be viewed by some as a conduit for money laundering and other illegal activity.
The most telling example of this so far has been the popular associated of bitcoin with Silk Road, an online black market known for its sale of illicit drugs. Silk Road was, at least temporarily, shut down by the FBI in October of 2013. During this time, FBI agents seized some 144,366 bitcoins from its proprietor’s confiscated computer, and solidified one popular perception of the digital currency as a plaything for criminals and thieves. (Reuters, “New Silk Road Drug Bazaar Opens a Month After FBI Bust.”)
But, associations between bitcoin and money laundering, black markets, unauthorized mining, and other illegal activities in the aftermath of the Silk Road seizure, though valid on the surface, belie a more fundamental truth: bitcoin, like the US dollar, is a form of monetary exchange and thus will inevitably be used for illicit ends alongside its legal and legitimate functions. Because, or perhaps in spite, of this future legislation of bitcoin in the US and elsewhere appears to be likely.
Because bitcoin it still in its relative infancy as a currency, economists have pointed to one very real drawback: its volatility. When measured against conventional currencies, bitcoin values have fluctuated extraordinarily. After years of being valued at the smallest fractions of a US dollar, the digital currency exploded in 2013, briefly reaching a high of $1,240 before plunging below the thousand dollar mark. Commentators have noted that the volatility of bitcoin looks to be a long-term problem, with cycles of boom and bust appearing to be inevitable at this stage in its development. (BloomsbergBusinessweek, “Bitcoin's Volatility Problem: Why Today's Selloff Won't Be the Last.”)
Thus, for the time being at least, reasoned economists urge consumers that bitcoins are still very much a high-risk investment with a long-term potential that remains to be seen.
Whatever its current limitations, bitcoin and its open-source derivatives offer one of the most innovative and exciting developments in currency and finance of the early twenty-first century. Readers can be assured that the bitcoin will continue to appear in financial and legal news for the foreseeable future. We’ll be keeping an eye on it as well.