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What is Bitcoin? The future digital currency explained

The history of Bitcoin, how it works, what happens next

Bitcoin

We explain Bitcoin, the virtual digital currency. Read on for the history Bitcoin, how it works, and what happens next. See also: Bitcoin: Seven reasons to be wary.

While many of the world's currencies are struggling to emerge from the devastating economic crash of recent years there is one that continues to rise and increase in value.

The strange thing is that it isn't issued by any bank, controlled by any government, or even freely available in physical form. Yet in February 2013 the total worth of the fledgling global currency was valued at over £180 million, and it just keeps growing.

Bitcoin is an online, decentralised, crypto-currency, that is monitored and administered by the massive peer-to-peer network that uses it. The currency has online exchanges that trade in the commodity, one of which - Bitcoin Central - recently partnered with a French bank to become a registered Payment Services Provider (PSP) under EU law, meaning it can now offer debit cards, account insurance, and many other normal banking facilities to Bitcoin customers.

The currency has also seen mainstream adoption through companies such as Wordpress and Reddit who accept  payment in Bitcoins for their various memberships and services.

'The one thing that proponents of this idea are really pushing,' explains Jan Piotrowski from the Economist magazine, 'is that Bitcoins are a wonderful way to transfer money across borders at very, very little cost. Normally when you transfer money between banks, the banks charge through the roof.

Now with exchanges such as this one [Bitcoin Central], where the accounts will be guaranteed by the French equivalent of America's Federal Deposit Insurance Corporation - so guaranteed by the state - you can convert your Euros to Bitcoins at a very cheap rate. You can then transfer your Bitcoins, or pay for a service in Bitcoins, in any country you wish because the system is globally distributed and there are no borders within the virtual peer-to-peer network that governs it.'

Bitcoin: the history

The currency is the technically brilliant brainchild of a shadowy figure who goes by the pseudonym of Satoshi Nakamoto. No one knows Satoshi's true identity but this is of less importance than you might think as Bitcoin is essentially a mathematical protocol and set of principles that Nakamoto released in open source form back in 2009. Bitcoins (BTC) are created by a process called mining, which involves computers solving incredibly complex mathematical problems.

These processes require intense amounts of computational power, not to mention the accompanying electricity bills, which deliberately restricts the rate at which Bitcoins can be created. This ensures  scarcity, which in turn controls inflation and helps protect the value of the currency. In many ways it mimics the old nature of Gold as a currency, where it would be found reasonably easily at first, then become increasingly difficult as sources depleted, requiring more advanced machinery to excavate the deeper lying supplies.

'What Bitcoin can do in theory,' argues Katherine Mangu Ward, editor of Reason magazine, 'is protect people from their own governments. Right now the Federal Reserve can make money less valuable - the money you have, that you've earned - just by devaluing the currency. In theory what Bitcoin does is take that power away from the Government and gives it to individuals'.

Bitcoins are a limited commodity that has no central government or bank to issue new units - they can only be created by the completion of tasks - and if companies build supercomputers to mine more efficiently, then the algorithm notices this and adjusts the difficulty accordingly to protect the currency and maintain a steady rate of creation. It's an incredibly complicated, admittedly confusing, system, but it needs to be if the currency is to remain stable and secure in the long run.

In fact there is an actual total limit to the amount of BTC that will ever exist - 21 million - but this is not due to be reached until 2140.

This isn't the first time that something like this has been attempted. The now ubiquitous Paypal actually set out initially with the vision to be a stateless currency.

'This was the dream of Paypal,' Katherine Mangu Ward confirms, 'to be a currency outside of governments. The weak-point of Paypal was that there was a central place that could be shut down. You could go to the Paypal servers and say 'we're gonna clamp down on this'. Bitcoin is different. It's stored on lots of different computers, it's a diffuse peer-to-peer technology, so there's no one place you can go'.

The anonymous, unregulated nature of Bitcoin has brought its fair share of controversy, with the most famous involving an Australian website that traded contraband solely through the online currency. The Silk Road was thought to be earning over £1 million per month from the sale of goods including cocaine, cannabis, heroin, and for a time even guns. This led US Senator Chuck Schumer to declare the currency an 'online form of money laundering used to disguise the course of money, and to disguise who's both selling and buying the drug'.  

Online gambling sites have also appeared, with Bitcoins as their payment of choice.  One of the biggest, Ireland based SatoshiDice, recently even reported profits of nearly £400,000 in the just the first six months of trading.

One major concern for potential investors is the actual online nature of the currency itself. In the short space of time that Bitcoin has been around there have been significant hacking attacks. Mt. Gox - the world's largest Bitcoin Exchange - had around 500,000 coins valuing $8.75 million stolen in 2009, causing a devaluation of the currency which dropped from 17.50USD per BTC to 0.01 in the space of a day.

Then a year later another Exchange - Bitfloor - was also attacked, resulting in currency worth $250,000 being stolen. Skeptics have also voiced concerns of potential vulnerabilities that will appear as new, more casual, users start to enter the Bitcoin arena, with malware already known to be circulating online.

Despite these major setbacks the trading continues on Bitcoins and as of February 2013 the currency has recovered and actually increased in value to around $30 per BTC. The financial sectors are also taking note as venture capitalists begin to invest in Bitcoin related businesses, with electronic processing service Bitpay receiving over $500,000 at the start of the year.

It's still very early days for the currency, and there will undoubtedly be a few problems to overcome in the crucial next few years, but with goods and services increasingly moving online, and confidence in the banking sector seriously eroded, maybe Bitcoin has emerged at just the right time?

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