by Jack Hough

Friday, June 3, 2011

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Bitcoins are the top-performing money in the world — but what are they?

The best performing currency of the past year isn't Brazil's real, up 15% versus the U.S. dollar, or Australia's dollar, up 27%. It's the Bitcoin. A year ago one was worth half a penny. Thursday morning it hit $10.50. That's a gain of more than 200,000%.

What's a Bitcoin? It's a peer-to-peer system of electronic money that allows payments to be sent directly between two parties without the need for a financial institution. It's related to Bit Torrent, a system for sharing large files like movies, but in this case the "movie" is a file with the currency's entire transaction history. And because users themselves all share that history, "it's more secure than even bank transactions," says Donald Norman, a spokesman for the Bitcoin Consultancy, which is seeking to gain wider acceptance for the currency.

As befitting a virtual currency, no one is quite sure who created the Bitcoin. A white paper and software turned up three years ago listing Satoshi Nakamoto as the author. That's presumed to be a pseudonym. All that's known about Nakamoto, based on his paper and message board comments, is that he's fluent in English and has a deep understanding of Internet security.

Dotcom crash veterans might recall failed currencies like Flooz and Beenz, but those were mere means of online payment. Bitcoin is an entire monetary system. It doesn't require a Treasury Department, because there are no bills or coins to mint. It doesn't need a Federal Reserve to create money. An algorithm does that at a rate that slows by half every four years. There are about six million Bitcoins today. The number will approach 21 million beginning in the 2030s but never exceed it.

The finite supply of Bitcoins might help explain the frantic demand for them. Dollars and euros are created at will by central bankers. Some economists see that as useful for smoothing out wild swings in the economy — making money more plentiful when consumers are hurting and scarcer when they're flush. Skeptics, and there are many, worry that the ability to create money from nothing will be abused by governments that overspend, resulting in gradual debasing of the value of savings. That's why dollar bears cling to gold, and why a few might now be scrambling for Bitcoins.

Users get Bitcoins in one of several ways. "Miners" set their computers to work solving problems in exchange for coins. The more miners there are, the more difficult the problems become, which keeps the rate of supply stable. At recent exchange rates, high-end machines can produce $30 worth of Bitcoins per day, but consume a vast amount of energy in doing so. Some advanced miners have taken to cooling their machines with dry ice to improve their results.

The other ways to get Bitcoins involve trading goods, services or cash. Mt. Gox has emerged as the largest Bitcoin exchange, charging 0.65% per transaction to match up buyers and sellers. More than $500,000 worth of the coins changed hands in a recent 24-hour period. Traders can add funds to their accounts using cash, checks, bank wires or Liberty Reserve, a private online payment service.

Any fiat currency — dollars, euros, Bitcoins — gets its value from trust. Dollars can't be cashed in for anything; rather, we accept them as payment with the belief that others will accept them, too. That's another reason the price of Bitcoins has rocketed over the past year. Two years ago, almost no one accepted them for payment. Over the past year, a handful of early adopters began trading services for them — mostly programmers offering things like website design and hacking consultation. In recent months, a handful of pioneers have begun selling real goods for the start-up money.

Four months ago David Forster, 29, convinced his parents Jim and Nancy, owners of Green Hill Alpacas in Haydenville, Mass., to accept Bitcoins for alpaca socks. Technically, the younger Forster buys the socks for dollars and resells them for Bitcoins. "They said it sounded like a Ponzi scheme but that as long as I wasn't risking their money for Internet coins it was fine," he says.

Sock sales have risen to between 75 and 100 since the experiment began from four dozen during all of last year and orders have come from as far as Finland and Russia. More remarkable is what has happened to pricing. Forster began charging 75 Bitcoins for each pair in February and has since had to lower the price to 5 due to extreme appreciation in the currency's value. "I wish I had kept all of them," says Forster, who traded his Bitcoins on the way up for cash and web services.

More than a dozen sites now sell goods for Bitcoins, including T-shirts, coffee and natural pet food. At least one, The Arms Locker, says it offers firearms. Another, Silk Road, is a forum for people selling recreational drugs. How can that be? Bitcoin transactions leave a record of times and amounts, but not identities, and Silk Road can only be reached through an identity-cloaking computer network called Tor. There's no way to determine the identity of its administrators and since sellers only accept Bitcoins for their wares, they can't be found, either (so long as packages are mailed discretely).

That's one source of discomfort surrounding Bitcoins. Even a libertarian who's comfortable with anonymous gun and drug sales would cringe at the thought that, say, the child pornography trade has a new way to escape detection.

Amir Taaki, a U.K. citizen and project developer for Bitcoin.org, admits that Bitcoins can be used for bad things but says the same is true of cash and that Bitcoins have much potential for good. "Think of all of the people sending money in third-world countries and getting ripped off by outrageous transaction fees," he says. "Bitcoins are here to stay and the world will benefit. The U.S. can ban it but it will still proliferate."

It's not clear what regulators think of Bitcoin. The Constitution gives Congress the sole authority over U.S. money. In March, a North Carolina resident was convicted of minting his own Liberty Dollars to reduce reliance on and compete with the greenback. He faces up to 15 years in prison.

Bitcoins aren't U.S. currency, however, and Norman says the Bitcoin Consultancy doesn't operate in the U.S. And as with file-sharing software, Bitcoin operates as a peer-to-peer network, raising the question of how regulators could stop it if they wanted to. The FBI didn't respond to requests for comment. On a message board, one Bitcoin miner wrote that agents visited his home. They weren't interested in currency, though. Huge electricity usage led them to suspect a marijuana growing operation.