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7 things you need to know about Bitcoin

Bitcoin is booming, but don't buy the hype before you read our guide.

Bitcoins are all the buzz. The virtual currency is riding a rollercoaster of speculation, rising exponentially in value and reaching a high of $260 this Wednesday before plummeting to $130. What's more, the largest bitcoin exchange in the world just survived a coordinated hack attack, and bitcoin-generating malware is spreading across Europe like wildfire via Skype. 

Yet despite all the sound and fury surrounding this made-up money, most people have a hard time understanding exactly what bitcoins are--and how they work. This is troubling, especially if you're thinking of investing your own time and money in the Bitcoin phenomenon.

Starting your own bitcoin wallet isn't necessarily bad idea. Bitcoins aren't tied to the fortunes of any single nation's economy. They're easy to exchange, and they aren't subject to transaction fees. But you need to know a few important things before throwing your money into the volatile bitcoin market. You need to understand how the Bitcoin system works, where it succeeds, and where it's weak.

Bitcoins are created, traded, and controlled by the people

Simply put, a bitcoin is an algorithm-based mathematical construct--a unit of measurement invented to quantify value. It's sort of like the dollar in that way--but unlike the dollar (or any other form of fiat money, really), bitcoins are decentralized. The original Bitcoin algorithm was created by a developer with the pseudonym Satoshi Nakamoto, but the currency itself is created, traded, and controlled by bitcoin users, rather than by a central authority like a bank or a government. Bitcoins are completely digital, too: You'll never lay hands on a physical bitcoin unless you purchase a physical facsimile like this.

The currency also has a finite supply that's limited by design. The algorithm that fuels the Bitcoin network is designed to generate 21 million bitcoins, and the system automatically regulates itself to ensure that the supply of bitcoins grows at a smooth, steady pace. At the current rate, all 21 million bitcoins should be generated by 2140. And because the Bitcoin network tracks and records every bitcoin transaction, you can actually see exactly how many bitcoins have been created at any given moment at Blockchain.info, a website that monitors the Bitcoin network and hosts bitcoin wallets, the containers owners use to store their digital riches.

We're definitely in a bitcoin bubble

Bitcoin is big right now, probably too big for its own good. Since a bitcoin has no value beyond what someone is willing to pay for it, the price of bitcoins tends to change quickly. Indeed, in mid-January a single bitcoin was valued at $15, which makes people who bought bitcoins back then and sold them at $260 apiece yesterday very successful investors.

The currency's popularity (and therefore price) increases in international markets that have become unstable--say, when a government threatens its citizens with capital controls and currency restrictions, as Cyprus did last week.

"Bitcoin is a very volatile asset, and the recent developments in the price of bitcoins do have some of the characteristics of an economic bubble," says Professor Magnus Thor Torfason, Assistant Professor of Business Administration at Harvard Business School.

Torfason is currently working on publishing a paper that focuses on the value of Bitcoin. Though he's cautiously optimistic about the future of Bitcoin, he says that it's hard to recommend the currency to the average PC user. "Even if we assume that bitcoins will eventually be worth ten times their current value, they may drop to a tenth of their value between now and then," says Torfason. "We don't really have good methods for assigning value to a currency like this, so you should treat any investment into bitcoins as an extremely high-risk investment."

You can mine bitcoins, but the gold rush is over

You don't have to put your own money on the line if you want to jump into the bitcoin market. Instead, you can "mine" bitcoins by putting your PC to work crunching code on the bitcoin network. If you're lucky, you could earn a whopping bounty of 25 bitcoins.

Here's how it works: Batches of bitcoins are awarded to bitcoin miners--people who volunteer to install and run a bitcoin client on their PCs. The client uses CPU and GPU processing power to solve very complex math problems, and then shares those solutions with the entire network. The problems are extremely difficult to solve, but easy to verify as correct, and they incorporate logs of transactions on the bitcoin network. As a result, miners track and verify bitcoin payments as they work.

The first client to solve a given block of transactions is awarded a set number of bitcoins--25 as of publication, down from 50 when Bitcoin began--once the work is verified by other clients on the network. That fixed number is halved every four years, until at some point no more new bitcoins will be created.

The algorithms involved in bitcoin production are far too complex for most non-crypto-nerds to grasp, which is why most people use the term bitcoin mining. It's analogous to toiling in tough conditions in search of gold. And as with gold, only a limited supply of bitcoins exists.

But unlike gold, bitcoins enter the world at a rate that shows very little variation. The Bitcoin algorithms dynamically change in difficulty based on how often bitcoins are being awarded; and this ensures a smooth, steady drip of virtual currency into the network. If mining drops off, bitcoins will become easier to mine. If mining becomes exceedingly competitive--as it is now, with bitcoin miners investing in high-end PCs and server farms as part of a processing-power arms race--bitcoin mining becomes more difficult.

"At this point, mining for bitcoins is a very bad idea," says Vitalik Buterin, head writer at Bitcoin Magazine. "You'll basically get nothing. The best way to get bitcoins is to buy them on an exchange."

My research suggests that Buterin is right: These days, you probably won't earn many bitcoins through mining unless you're part of a mining pool--a group of users who combine their processor resources cooperatively to chew through solutions faster, and thus increase their rate of earning bitcoins. Plenty of mining pools exist, each with its own rules and methods of distributing bitcoin rewards. If you're interested in getting into mining, pick a promising group from this short list of big bitcoin mining pools and contact the pool operator.

Most major retailers don't accept bitcoins (yet)

If you do decide to take the plunge and buy some bitcoins on an exchange like Mt. Gox, you'll need a place to spend them. Bitcoin is still young, but the list of merchants that accept bitcoins is growing rapidly as the currency gains traction through media exposure. The lion's share of bitcoin business still happens online, as befits a virtual currency--you can spend bitcoins at Reddit, WordPress, Mega, and Wikileaks, for example. But brick-and-mortar businesses--mostly bars and corner stores with connections to Bitcoin advocates--are gradually adopting the currency as well.

You'll find a much, much bigger list of websites where you can spend your hard-earned bitcoins on the Bitcoin wiki, and a growing list  of businesses that accept bitcoins in the real world.

Bitcoins aren't protected or insured by anyone

Bitcoin transactions are irreversible. Once a bitcoin transaction is broadcast to the network it can't be revoked. So a hacker who accesses the PC that stores your bitcoin wallet can send your entire bitcoin fortune to another wallet--and there's nothing you can do about it. Caveat emptor.

Of course, if the PC that stores your bitcoin wallet is owned by a third party that insures it against theft--say, a respectable bitcoin wallet hosting service--you might be able to recover the value of some or all of your stolen currency. For example, the recently hacked bitcoin wallet hosting service Instawallet shut itself down in the wake of a devastating hack attack and provided refunds to users who had lost 50 BTC or less.

Nobody knows who really created Bitcoin

Bitcoin's creator was a coder and cryptography enthusiast who communicated on the cryptography mailing list under the name Satoshi Nakamoto. Nakamoto designed the network and launched Bitcoin in June of 2009, mining the first 50 bitcoins to form what became known as the genesis block.

Nakamoto disappeared shortly thereafter. Many reporters have tried--and failed--to unearth Nakamoto's true identity, but so far the progenitor of the most successful virtual currency ever made remains a mystery.

Bitcoins aren't the first virtual currency, and they won't be the last

Bitcoin would appear to be the most successful virtual currency we've ever seen, but it's not the first. From e-gold to Beenz to Facebook Credits, people have been trying--unsuccessfully--to build viable virtual currencies for more than a decade.

These has-been virtual currencies failed for different reasons. Some were shut down by the government authorities on charges of money laundering. Some were shut down by their owners at the culmination of elaborate scams. And some petered out when people stopped buying them. Because Bitcoin is decentralized, it can't be shut down by anyone. Yes, individual Bitcoin exchanges can be targeted by financial regulators--but since nobody runs Bitcoin, it can only peter out from lack of interest.

A hacker could theoretically destroy the Bitcoin network by tampering with the code in an exploit to end all exploits. However, in the four years since its inception, the Bitcoin code remains uncompromised. Individual users and exchanges may be hacked, but the bitcoins themselves have so far proved unassailable.

That's probably why a number of Bitcoin clones are poised to enter the market. From TerraCoin to Ripple to PPCoin, plenty of virtual currencies based on the open-source Bitcoin code are eager to compete for your real-world money. For now, it's probably a good idea for most consumers to keep a safe distance from virtual currency: The wild fluctuations in value that make bitcoins so interesting to study could make you a millionaire one day, and a pauper the next.


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