Bitcoin is a “digital currency” that’s received quite a bit of attention recently. Over the past month or so, I’ve spent some time trying to understand what it’s all about. For those of you who, like me, have found it frustrating trying to piece together a basic understanding of Bitcoin, I’ve written what I hope will be a useful introduction and overview.

A brief history of money

Before getting into Bitcoin, it’s useful to first appreciate why we’d even be interested in something like a digital currency. Although the following is simplified, it’s helpful in understanding the promise of Bitcoin.

Long ago, gold was used as money—i.e. people exchanged gold for goods and services. Addressing the need for convenience, businesses sprung up offering to store one’s physical gold in warehouses, in exchange for paper receipts. So for example, with 10 receipts for an ounce of gold each, you could return to the warehouse, and receive your 10 ounces back (minus a small storage fee).

It turned out that those paper receipts were so convenient that people began exchanging those, instead of gold, in the marketplace for goods and services, making those receipts the first paper currency.

Of course, those receipts had no physical value in and of themselves. Their value was derived from the reputability of the warehouses and the common acceptance of the receipts in the marketplace. No government was required to declare those receipts to be currency; the only requirement was the common acceptance in the marketplace.

Over time, societies began to believe that government, rather than private businesses, would be the preferred entity to issue and control paper receipts, and that’s how currencies like the US Dollar came into existence.

At first, each US Dollar was backed by physical gold, but under President Nixon in 1971 the United States broke the relationship between the US Dollar and its underlying gold. (Other countries have similar currency histories.)

So today, our US Dollars, just like those gold receipts, have no inherent value in themselves. Rather, they derive their value from social consensus.

Drawbacks to government-controlled money

Many economists believe that a key advantage of government-controlled currency is that the government can add to or take away from the overall money supply at its discretion. When the economy grows—in terms of overall goods and services—the government can create new money in order to keep general prices stable and to help ensure full employment. This is called “inflating the money supply”, or more simply, “inflation”.

This feature of government-controlled currency is also one of its critical disadvantages, because governments can—and historically always do—inflate the money supply for other reasons.

Say the government owes a trillion dollars. If it doubles the number of dollars in existence by creating new dollars, it can cut the value of its own debt in half. But at the same time, with double the amount of dollars in the monetary system, bidding for the same amount of goods and services in the marketplace, prices will rise. This rise in prices, as a result of an increase in the money supply, are what most people mean when they use the term inflation.

Government-created inflation is a tax on the savings of its society. When the government inflates the money supply, the value of your fixed savings will decrease—just as if the government had physically taken the value away from you in the form of a tax.

Is there an alternative to government-controlled money?

Of course there are alternatives. Just as in the past, currencies don’t exist because governments declare them to exist—rather, they exist when large groups of people exchanging goods and services agree to use them.

The birth of Bitcoin

In 2008, a person known by the online name of Satoshi Nakamoto published a paper proposing the Bitcoin digital currency system.

The paper described a mathematical problem that theoretically has 21 million solutions—and no more. For the sake of simplicity, let’s call any solution to this problem a “Bitcoin”, because that’s more or less what Bitcoins are.

Due to their limited number and mathematical uniqueness, Satoshi realized that a system could be built around Bitcoins, allowing them to be used as a digital currency. And recognizing that for Bitcoin to actually become a currency would require nothing more than broad acceptance, Satoshi then set out on an even bigger contribution—implementing the first version of the Bitcoin software, Bitcoin-Qt.

Bitcoin mining

So where do Bitcoins come from?

The search for solutions to Satoshi’s mathematical problem requires computers, and the process is commonly referred to as “Bitcoin mining”.

An interesting characteristic of the mathematical problem is that as each successive solution (Bitcoin) is found, the next solution becomes increasingly more difficult to find. So while Bitcoins could originally be mined on desktop computers, far more powerful computers are now required.

Today, in mid 2013, only about half of the solutions—i.e. about 11 million Bitcoins—have been discovered.

Individuals and organizations who’ve setup sophisticated Bitcoin-mining computers systems are analogous to those early gold miners, sifting river water in search of those elusive nuggets. And ultimately, it may become simply too difficult to ever find that very last Bitcoin.

Who owns a Bitcoin?

Say you discover a Bitcoin through your own efforts at “mining”. How does the world know that you own it?

Every Bitcoin is associated with an address—i.e. a large and unique number. Here’s the address associated with a few Bitcoins that I’ve bought:

1LTHyTCzX81pyF2TVKK47VxhamXDrnkwiA

This Bitcoin address is actually only one half of a pair of numbers called a cryptographic key-pair and this particular half is called the public key; it’s the half I can show you. The other half—another large number—is called the “private key”. Control of a Bitcoin—i.e. the ability to transfer it to another address—requires access to both keys.

In a way, you can think of the public key as your bank account number; it’s what you reveal to other people when you ask them to transfer money to you. You can think of the private key as your online account password; it’s required to access and to do things with your money.

In practice, a public and private pair of keys is often referred to simply as a Bitcoin “wallet”. When a wallet is created, say by a computer program you use to manage your Bitcoins, it creates both keys—the public key that you can give to people when requesting transfers, and the private key required to further transfer Bitcoins on to someone else.

Although the number of Bitcoins that can exist are limited, there’s no practical limit to the number of Bitcoin wallets—i.e. these cryptographic key-pairs—that can exist. I can choose to keep all my Bitcoins in a single wallet, or I could create hundreds on my computer, and distribute my Bitcoins among them all (if I wanted to). It’s up to me.

Bitcoin transactions

So how does a Bitcoin transaction happen?

At the heart of Satoshi’s implementation is an internet-based accounting ledger. It’s a ledger that’s available to all, and controlled by the whole of the internet-based Bitcoin network. Everybody who participates in the Bitcoin system—from mining computer systems to desktop and mobile Bitcoin wallet applications—participate in the utilization of this distributed ledger.

When a Bitcoin is first discovered through mining, the Bitcoin miner automatically reports this finding to the ledger, as well as the public key associated with the Bitcoin. Whenever that Bitcoin is transferred from one wallet to another, the transaction is also recorded in that universal ledger. In this way, every Bitcoin transaction that has ever occurred, and ever will occur, is visible to all.

How do you physically control Bitcoins?

You can download a Bitcoin “wallet” application for your computer, or you can create an account at an online Bitcoin wallet provider. In the former case, you’re acting as your own Bitcoin “bank”, and in the latter, you’re entrusting your Bitcoins to a third party in the way you’d entrust your US dollars to a bank.

In my own case, I’ve downloaded a Mac application called MultiBit, which controls the private-key associated with that public-key address I posted above. This application, along with the whole internet, knows exactly how many Bitcoins are associated to that wallet (address).

My control over those Bitcoins lies in my control of the associated private-key. If you hacked into my computer, and stole that private-key, then you could control my Bitcoins in that particular wallet in the same way that a bank robber controls the money he steals from a bank. That’s why applications like MultiBit allow you to encrypt your private keys with a passphrase.

What if my private key got destroyed, like in a computer crash? That’s a real risk, and that’s why applications like MultiBit allow you to also backup the encrypted version of your private keys to files that you can store on a USB drive, or in the cloud using something like Dropbox.

As long as I can recover my lost private keys, the universal internet-based ledger can be used to determine how many Bitcoins that private key controls.

How do you send and receive Bitcoins?

So let’s say I want to send you a Bitcoin. Here’s how it works: You would send me the public half of your wallet’s key-pair—i.e. a long number like that I displayed above.

I would then open my Bitcoin wallet application, MultiBit, and click the “Send Money” button. I’d enter your wallet address, and click “Send”.

Within minutes, the transaction would be recorded in the universal internet-based Bitcoin ledger. And just as fast, your Bitcoin wallet application would see the transaction, and know that your wallet address now controls that particular Bitcoin.

Now, say I lived in Berlin or San Francisco, where many physical merchants accept Bitcoin. How would I pay for, say, a haircut with Bitcoin? In this case, the barber would display a QR code at the register corresponding to a Bitcoin wallet address he controls. I’d open my Bitcoin iPhone app, enter the amount of the haircut payment, and then scan the QR code. Upon pressing confirm, some fraction of a Bitcoin would then be transferred from me to the barber. Instantly.

(Bitcoins can be divided to eight decimal places. If a Bitcoin is worth $100, then one of these “milliBitcoins” would be worth about 10 cents.)

Where do you get a Bitcoin in the first place?

You can buy Bitcoins with other currencies (like US dollars or Euros) at Bitcoin exchanges. A popular one in the United States is the Y-Combinator funded startup, Coinbase.

Coinbase allows you to connect your Coinbase account to an American bank, after which you can buy or sell Bitcoins. The funds needed to buy Bitcoins are taken from your bank account (or deposited in your bank account when you sell Bitcoins).

Exchanges like Coinbase create a Bitcoin wallet (address) for you in order to receive the Bitcoins that you buy, and, naturally, their computer systems also attempt to securely control the wallet’s associated private key.

As you can imagine, what many people do having bought and received a Bitcoin at an online exchange like Coinbase is to immediately, and instantly, transfer that Bitcoin to another address/wallet that they control on their computer through a program like MultiBit.

Summarizing where we are

Ok, so far here’s what we’ve learned so far:

Anything can be used as a currency, as long as it’s commonly accepted. A fundamental problem with government-controlled currency is that the government can inflate it, robbing savers of their purchasing power. Bitcoins are unique solutions to a math problem. Their uniqueness and limited supply make them a candidate to be used as a digital currency. Each Bitcoin (or fraction of a Bitcoin) is controlled by cryptographic key-pair, consisting of a public key and a private key. Together, these keys are often referred to as a Bitcoin “wallet”. The public key can be though of as your bank account; it’s a number that you can freely give people when requesting a transfer. The private key can be though of as your account password; it’s required to access your money, and is under your personal control. An internet-based accounting ledger knows the association of every Bitcoin with its controlling public key, as well as its full historical record of transaction. A Bitcoin “wallet” application running on your computer or internet controls your private keys. You can think of it as “holding your Bitcoins”, but in reality it’s just holding your private keys. In combination with the internet-based accounting ledger, the wallet application—as well as everybody on the internet—can know how many Bitcoins are associated with the corresponding public key. You can create as many key pairs (or wallets) as you like. Bitcoin transactions—i.e. transfers from one address to another—are confirmed within minutes and are nearly cost-free 1.

Now that we have an understanding of the basics of Bitcoins, let’s look at some additional issues associated with this developing currency.

Are Bitcoin transactions anonymous?

Given that the universal internet-based Bitcoin accounting ledger tracks every transaction, Bitcoin is in that respect the opposite of anonymous.

On the other hand, the only way a Bitcoin wallet address can be associated to a particular individual or organization, is if that information is made publicly known.

If I publish a Bitcoin address on a “Donation” link on my website, or if my business accepts Bitcoin payment on a particular address, then those addresses are publicly known to belong to me. However, having received payments, if I then transfer my Bitcoins to a new address I’ve created, nobody can know whether I’ve just transferred those Bitcoins to myself, or to somebody else on the internet. The only fact that can be known, is that I’ve transferred my money somewhere.

For some, even that’s not enough anonymity. And for those, businesses have quickly sprung up called “Bitcoin laundry services” (1) (2). For a small fee, they will accept a Bitcoin payment from you, and return the funds to an address that you specify. In between, they mix and distribute Bitcoins from many people across a large number of addresses, so that the payment from your source address to your final destination address can’t be traced.

What’s the state of Bitcoin today?

Although Bitcoin as a currency is still very much in its early stages of infancy, it has certainly gained enough traction to warrant legitimate consideration.

From the beginning, small online services catering to those interested in anonymity—such as web hosting—have accepted Bitcoin. That list has expanded over time to include much larger and visible online services, such as WordPress.com.

And offline, a number of small communities of merchants in cities like Berlin and San Francisco have begun accepting Bitcoin as payment for physical goods and services.

In total, its estimated that the Bitcoin currency sustains a global economy of roughly $650 million.

As with most promising early-stage technologies, Bitcoin is receiving growing attention among investors and venture capitalists.

As mentioned previously, Paul Graham’s Y-Combinator funded the Coinbase exchange startup.

Ashton Kutcher and Chris Dixon both mentioned at TechCrunch Disrupt that they are investing in Bitcoin start-ups.

Former Facebook-executive Chamath Palihapitiya discussed his strongly optimistic Bitcoin views in this very interesting video from the same event (be sure to watch that one; the Bitcoin discussion happens at the end).

Finally, there’s the Winklevoss twins. They have purchased something like $10 million worth of Bitcoins, and have filed with the SEC to form a “Bitcoin ETF”, traded on the stock exchange.

Bitcoin risks and concerns

What stands between Bitcoin today and its broader acceptance as a currency? Risks; lots of them—conceptual, technological, social, political and economic risks.

Defects in the underlying mathematical model could be discovered that invalidate the concept of Bitcoin as a feasible currency system.

If hackers could, through a distributed “botnet” attack control more than 50% of the global Bitcoin networking processing power, they could seize control of the network itself 2 .

. The growing interest in Bitcoin among people could simply stagnate, and the essential “common acceptance” required of any successful currency could never become established on a broad enough scale.

Governments, facing the consequences of loss of currency control, could attempt to regulate Bitcoin or even make it illegal. There’s already a clear indication that the US government is looking into the regulation of virtual currencies.

But of the concerns I’ve read, one of the most intriguing in my mind is whether a deflationary economy would be sustainable.

If the world’s economy were based on Bitcoin, then as the amount of goods and services expanded with the growth of economies, prices would generally drop because there’s a only a fixed number of Bitcoins available to bid for those goods and services. This is what’s considered a “deflationary economy”.

Many economists believe that in a deflationary economy, people will defer spending and hoard their money, expecting it to be worth more in the future. Economic theory also says that a healthy economy requires that people are spending.

For those wishing to read a more in-depth discussion of Bitcoin risks, there’s an entire risk section of the Winklevoss SEC filing.

Bitcoin usability

As someone involved in product design, I couldn’t end this article without commenting on the state of Bitcoin usability today. In short, it’s got a long way to go.

The most important product component in the Bitcoin ecosystem is the Bitcoin wallet application—i.e. the application you use to manage your Bitcoin addresses, your private keys, and to make Bitcoin transactions.

The first wallet I downloaded for the Mac was the free, open-source Bitcoin-Qt. With an interest in broad compatibility, Bitcoin-Qt uses cross-platform technology instead of the Mac’s native programming technologies—and so it suffers from the fact that it doesn’t feel like a Mac application.

But a much bigger problem is that the application has to be fully synchronized with the global accounting ledger before it can be used. On its first launch, I had to wait for it to download 6GB (gigabytes!) of data—which took a few days! Subsequently, each time you open the application you’ll have to wait again while it catches up with the network—with the amount of time depending on how long it’s been since the last time you opened the app.

Fortunately, another app exists called MultiBit, but which somehow doesn’t need to maintain a full, local copy of the global Bitcoin ledger. Obviously, that’s a much more sustainable model in the long-term, if we presume (hope) the number of Bitcoin transactions, and hence the size of the ledger, grows a lot.

But, alas, MultiBit is also based on cross-platform development technologies, and feels alien running on a Mac.

There’s definitely a need and opportunity for major progress in the usability of Bitcoin wallet applications. And if we think in terms of the role of the wallet application in the larger Bitcoin ecosystem, there are even bigger opportunities. I plan to follow up this article with another, outlining some of those ideas.

So should you buy some Bitcoins today?

Unless you’re interested in buying goods and services that currently are exchanged in Bitcoins—e.g. if you happen to live in Berlin or San Francisco, or purchase online services accepting Bitcoin—then pretty much the main reason you’d want to buy Bitcoins today would be as a speculative and risky investment.

The exchange rate of Bitcoin is extremely volatile. Initially, Bitcoins traded in the cents. Today, a Bitcoin trades at roughly $85, having peaked recently at $200. As you can imagine, some of the people (mostly geeks) who got into Bitcoin very early, have become multi-millionaires. And according to some calculations, if just 1% of the world’s currency transactions happened in Bitcoin, a single Bitcoin could become worth $100,000.

Conclusion

For myself, I find the concept of Bitcoin to be seductively intriguing from technical, social and political standpoints.

It’s fascinating to consider that math and cryptography could be the basis of a monetary system. It’s fascinating to consider a global, distributed accounting ledger able to track every transaction and track which address controls every Bitcoin fraction in existence. It’s fascinating to consider the ability to transport millions of dollars on a pen drive and transfer them instantly via the internet to anywhere in the world, nearly cost-free.

Socially and politically, it’s fascinating to consider a world in which every person or business can be their own bank, exchanging money between each other freely, securely, instantly and for the most part, privately. And it’s fascinating to consider a world in which governments are unable to control the money supply.

Of course, that social and political world-view, if it happens, is likely a good ways into the future. But I have the same intuitive feel that it will eventually happen as I had back in 1996 that the internet would change the world. Bitcoin may not ultimately be the technology to realize that vision (though it may be!), but Bitcoin is the seed and prototype that gives us confidence that it could happen.

In the meantime, I’m going to continue following the story.