Unlike other currencies, Bitcoin is underwritten not by a government, but by a clever cryptographic scheme.

For now, little can be bought with bitcoins, and the new currency is still a long way from competing with the dollar. But this explainer lays out what Bitcoin is, why it matters, and what needs to happen for it to succeed.

Where does Bitcoin come from?

In 2008, a programmer known as Satoshi Nakamoto—a name believed to be an alias—posted a paper outlining Bitcoin’s design to a cryptography e-mail list. Then, in early 2009, he, she, or they released software that can be used to exchange bitcoins using the scheme. That software is now maintained by a volunteer open-source community coordinated by four core developers.

“Satoshi’s a bit of a mysterious figure,” says Jeff Garzik, a member of that core team and founder of Bitcoin Watch, which tracks the Bitcoin economy. “I and the other core developers have occasionally corresponded with him by e-mail, but it’s always a crapshoot as to whether he responds,” says Garzik. “That and the forum are the entirety of anyone’s experience with him.”

How does Bitcoin work?

Nakamoto wanted people to be able to exchange money electronically securely without the need for a third party, such as a bank or a company like PayPal. He based Bitcoin on cryptographic techniques that allow you to be sure the money you receive is genuine, even if you don’t trust the sender.

The basics

Once you download and run the Bitcoin client software, it connects over the Internet to the decentralized network of all Bitcoin users and also generates a pair of unique, mathematically linked keys, which you’ll need to exchange bitcoins with any other client. One key is private and kept hidden on your computer. The other is public, and a version of it dubbed a Bitcoin address is given to other people so they can send you bitcoins. Crucially, it is practically impossible—even with the most powerful supercomputer—to work out a private key from someone’s public key. This prevents anyone from impersonating you. Your public and private keys are stored in a file that can be transferred to another computer—for example, if you upgrade.

A Bitcoin address looks something like this: 15VjRaDX9zpbA8LVnbrCAFzrVzN7ixHNsC. Stores that accept bitcoins—for example, this one, selling alpaca socks—provide you with their address so you can pay for goods.

Transferring bitcoins

When you perform a transaction, your Bitcoin software performs a mathematical operation to combine the other party’s public key and your own private key with the amount of bitcoins that you want to transfer. The result of that operation is then sent out across the distributed Bitcoin network so the transaction can be verified by Bitcoin software clients not involved in the transfer.

Those clients make two checks on a transaction. One uses the public key to confirm that the true owner of the pair sent the money, by exploiting the mathematical relationship between a person’s public and private keys; the second refers to a public transaction log stored on the computer of every Bitcoin user to confirm that the person has the bitcoins to spend.

When a client verifies a transaction, it forwards the details to others in the network to check for themselves. In this way a transaction quickly reaches and is verified by every Bitcoin client that is online. Some of those clients—“miners”—also try to add the new transfer to the public transaction log, by racing to solve a cryptographic puzzle. Once one of them wins, the updated log is passed throughout the Bitcoin network. When your software receives the updated log, it knows your payment was successful.

Security

The nature of the mathematics ensures that it is computationally easy to verify a transaction but practically impossible to generate fake transactions and spend bitcoins you don’t own. The existence of a public log of all transactions also provides a deterrent to money laundering, says Garzik. “You’re looking at a global public transaction register,” he says. “You can trace the history of every single Bitcoin through that log, from its creation through every transaction.”

How can you obtain bitcoins?

Exchanges like Mt. Gox provide a place for people to trade bitcoins for other types of currency. Some enthusiasts have also started doing work, such as designing websites, in exchange for bitcoins. This jobs board advertises contract work paying in bitcoins.

But bitcoins also need to be generated in the first place. Bitcoins are “mined” when you set your Bitcoin client to a mode that has it compete to update the public log of transactions. All the clients set to this mode race to solve a cryptographic puzzle by completing the next “block” of the shared transaction log. Winning the race to complete the next block wins you a 50-bitcoin prize. This feature exists as a way to distribute bitcoins in the currency’s early years. Eventually, new coins will not be issued this way; instead, mining will be rewarded with a small fee taken from some of the value of a verified transaction.

Mining is very computationally intensive, to the point that any computer without a powerful graphics card is unlikely to mine any bitcoins in less than a few years.

Where to spend your bitcoins

There aren’t a lot of places right now. Some Bitcoin enthusiasts with their own businesses have made it possible to swap bitcoins for tea, books, or Web design (see a comprehensive list here). But no major retailers accept the new currency yet.

If the Federal Reserve controls the dollar, who controls the Bitcoin economy?

No one. The economics of the currency are fixed into the underlying protocol developed by Nakamoto.

Nakamoto’s rules specify that the number of bitcoins in circulation will grow at an ever-decreasing rate toward a maximum of 21 million. Currently there are just over six million; in 2030, there will be over 20 million bitcoins.

Nakamoto’s scheme includes one loophole, however: if more than half of the Bitcoin network’s computing power comes under the control of one entity, then the rules can change. This would prevent, for example, a criminal cartel from faking a transaction log in its own favor to dupe the rest of the community.

It is unlikely that anyone will ever obtain this kind of control. “The combined power of the network is currently equal to one of the most powerful supercomputers in the world,” says Garzik. “Satoshi’s rules are probably set in stone.”

Isn’t a fixed supply of money dangerous?

It’s certainly different. “Elaborate controls to make sure that currency is not produced in greater numbers is not something any other currency, like the dollar or the euro, has,” says Russ Roberts, professor of economics at George Mason University. The consequence will likely be slow and steady deflation, as the growth in circulating bitcoins declines and their value rises.

“That is considered very destructive in today’s economies, mostly because when it occurs, it is unexpected,” says Roberts. But he thinks that won’t apply in an economy where deflation is expected. “In a Bitcoin world, everyone would anticipate that, and they know what they got paid would buy more then than it would now.”

Does Bitcoin threaten the dollar or other currencies?

That’s unlikely. “It might have a niche as a way to pay for certain technical services,” says Roberts, adding that even limited success could allow Bitcoin to change the fate of more established currencies. “Competition is good, even between currencies—perhaps the example of Bitcoin could influence the behavior of the Federal Reserve.”

Central banks the world over have freely increased the money supply of their currencies in response to the global downturn. Roberts suggests that Bitcoin could set a successful, if smaller-scale, example of how economies that forbid such intervention can also succeed.