Bitcoin

Economystified reader John W. asked me to do a post about Bitcoin.

I've been noticing more and more mentions of Bitcoins in the news lately.  Tons of small retailers and service providers take them, and now some more notable ones, like WordPress, do as well.  So yeah, now's probably a good time for a little primer on the topic.  Thanks, John!

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What are Bitcoins?

Bitcoins are a little bit of a currency, and a little bit of an investment item (like a stock or bond).

Anyone in the world can buy and sell goods (mostly online, though not entirely) using Bitcoins.  Oodles of online vendors accept them, trading Bitcoins for apps, mp3s, ebooks, web services, video games, and so on.  There's few laws, regulations or restrictions regarding their use, so anyone, anywhere can use them.

You buy with Bitcoins the same way you shop online, just like how you've done on Amazon, TicketMaster, whatever, in the past.

You can sell goods and services online for them as well.

Or you can earn them.  EarnFreeBitcoins pays people in Bitcoin to visit certain websites and just browse their online catalogs.  FeedZeBirds will give you small amounts of Bitcoins in exchange for retweeting their customers' tweets.

OR you can get into the fray the old fashioned way - by buying in.  At the time of me writing this, you could buy a Bitcoin for $124 at Mt. Gox, the worlds largest online Bitcoin currency exchange.

Exchanges like Mt. Gox work like any other currency exchange.  Individuals all over the world are offering to buy and sell their Bitcoins for USD, Euros, Pounds, Yen, etc.  When you buy Bitcoins off of Mt. Gox, your buying them from another private individual, just like you.

The price fluctuates a great deal - after all, Mt. Gox is is basically a giant auction house.  Whatever the going price of a Bitcoin is at the moment is the price you would need to pay to get your grubby e-paws on some of that hot virtual currency.

So who's in charge of this scheme?

No one, and everyone.  Bitcoin is an "open-source" currency.  

There is no "Bitcoin Corporation."  Bitcoin just sort of appeared in 2009.  People volunteer to run the project and write code in their spare time, just like with Wikipedia.  Any one with sufficient tech savvy can help out.

There is a Bitcoin Foundation that administers and promotes Bitcoin.  You can join the foundation if you want!  A lifetime membership cost only 1.6 Bitcoins!

Sexy side note - no one knows who actually started the whole thing.  In 2008, a "Satoshi Nakamoto" started posting "virtual currency" manifestos and some of the original code in online forums.  But Toshi has never been identified, and he's never come forward.  Was it a pseudonym?  An anonymous group publishing under one name?  We don't know!  INTRIGUE!!

Where do Bitcoins come from?

Ok, so you can buy a Bitcoin from another individual who's got one.  You can earn some from another individual who's got one.  You can sell a good or service to another individual who's got one.

But where are these Bitcoins coming from in the first place?

Individuals can volunteer their own personal computers and their processors to help administer the Bitcoin system.  These people (who spend their own money on computers and electricity to support the Bitcoin infrastructure) are called "miners."

Every once and a while, a few lucky miners are granted Bitcoins, via a lotto.  About 150 Bitcoins are awarded per hour throughout the world.  The more processing power you're lending to the Bitcoin system, the more likely you are to win.

These miners sell the coins they win into the market, either through an exchange (like Mt. Gox) or by buying stuff online with them.  This puts the coins into circulation.

How many Bitcoins are out there?

Since 2009, 11 million Bitcoins have come into circulation.  The rate new ones are being added is drastically slower, however.  At the rate of 150 coins an hour, only 1.3 million new coins will be added a year.

What's a Bitcoin worth?

Now, because the supply of Bitcoins are limited in the short term, their actual value or worth - i.e., what people are willing to pay for them in traditional currencies, as well as how much stuff people are willing to trade for a Bitcoin - is going to vary with their popularity.  Which is why their value is so volatile.

If Bitcoins get to be super-popular, individuals will be willing to pay more money, or trade more of their stuff, for them.  That'll make the price of one go up.

Conversely, if everyone decides they want to get rid of their Bitcoins, or become desperate to dump them - that is, if Bitcoins become super-UNpopular - their price will fall.

Because the supply of Bitcoins is more or less fixed, and they're so new and the world doesn't know quite what to think of them yet, their value is really volatile.  In its 5 year history, Bitcoins have sold for as little as $0.70, and as much as $266.  The price can fluctuates wildly even within a day.

But here's the fun part: as long as people believe Bitcoins have value, as long as the Bitcoin enthusiasts are willing to accept each others' Bitcoins, then they do have value.  As long as people are willing to accept and trade for Bitcoins, Bitcoins maintain some sort of value.

To hear it in their own words, look at the Bitcoin community's wiki, section: Where does the value of Bitcoin stem from? What backs up Bitcoin?

So what's the appeal?

There's some nice aspects to using Bitcoin as a currency.  

It's not regulated by any govt.  There's no bank or clearing houses involved.  There's no middle man involved in making the payment.

If Joe in Germany wants to buy an ebook from Fred in Bangkok online, Joe needs to get an account with a German bank, give the German bank his Euros, and tell the German bank to go get him some Bahts.  The bank pays some guy to go to a forex market, and buy some Baht and bring them back to the bank.  Then the German bank debit's Joe's account by however much the Bahts cost, contact Fred in Bangkok's bank, transfer the Bahts, credit them to Fred's account.  

And Joe and Fred have to pay for all the middle men along the way, in bank fees and money changers and so on.

Or Joe can just wire Fred some Bitcoin, and Fred can send Joe an ebook.  See the appeal?

Bitcoins also free up the internet to the possibility of some complicated bartering.  

Pretend I'm a web designer who wants a certain ebook.  It I wanted to barter my skills for that book, I would need to find a book vendor, that has the exact book I want, that also happens to need a new webpage.  Not an easy task.

Imagine instead that anyone in the world needs a new webpage, and can pay in Bitcoin.  I can work for whoever in exchange for Bitcoins.  And as long as there exists one book seller out there in the world that both has my book and accepts Bitcoins, I can somehow use my skills as a web designer earn that ebook.  That scenario is way more likely to come up than the pure 1-to-1 barter I described in the previous paragraph.

What's the downside?

The value volatility sucks pretty hard on its own.  If Bitcoins all of a sudden jump in price, it might easily wind up being cheaper for Joe to buy from Fred via the banks, even with all the mess and middle-men.

Bitcoin swears up and down that its program is safe and secure.  That may or may not be entirely true in the long term.  And whereas its very strictly illegal to counterfeit dollars or Euros laws surrounding Bitcoins are really fuzzy right now.

On top of that, how its run and who's in charge of what is not too concrete.  This is essentially a wiki project.  When tough decisions need to be made, who will make them?  And what happens if there's a schism, and people start handling Bitcoins in different ways?

Bitcoins also have come to be associated with a lot of illicit trade.

There's no way to trace who bought any given Bitcoin.  So they offer a high degree of anonymity.  Porn sites accept Bitcoins, as a way of hiding their customers' identities.  So do gambling sites.  And drug traffickers have been reported to deal in Bitcoins.  

Already lawmakers have started looking into legal ways of monitoring Bitcoin transaction, for fear that it might be enabling black market economies.

I guess the major downside today is no one knows much about it, and no one knows what to expect for its future.  How long will it be around for?  What will be its value?  How stable will it be?  Who will accept it?  Who will want it?  That's all up in the air now, which is making people cautious.

Its definitely an interesting experiment.  I'm personally really curious to see how it plays out.  I think its a cool idea.  It may not replace currency as we know it anytime soon, but there's probably a niche out there Bitcoins will fill perfectly.

As an economic experiment, its superbly interesting - but I haven't bought any Bitcoins yet...

Any more questions?

The Bitcoin community runs a pretty detailed wiki.  Check out their FAQs for more and get your info straight from the source.

Also, check out this well-animated, bight-colors video, set-to-hip music, that gives a good concise primer on the whole thing.

Bitcoin Explained from Duncan Elms on Vimeo.