Biting into the Bitcoin

Today, a software programmer sitting in his pad in Bangalore can get video games delivered to his doorstep and not pay for it in rupees. That's because he just paid for it using a type of currency known as bitcoins, which he earned teaching Kannada over Skype to someone in the Americas. Kiran, another computer savvy Mumbai dweller, just sold his car for bitcoins, which he is going to spend at an apartment in Rio De Janeiro.



In the wake of the financial crisis which so severely affects southern Europe, people are increasingly speculating in novel types of currencies in their pursuit of greater financial stability. Millions now use the bitcoins for buying practically anything - ranging from art to home appliances to consumables to entertainment. You can even buy employees at jobs4bitcoins.com!



The bitcoin is stronger than the dollar as of today. It is for real, yet virtual and is the most popular currency of its kind. For people who feel seeing is believing when it comes to money, the Bitcoin even has a physical manifestation that you can use. Virtual currency like Liberty Reserve and e-gold have long co-existed with fiat currency, which is the national currency of the state. But the soaring rise in the usage of the bitcoin has now forced governments to understand and want to identify it.



A virtual currency is an unregulated currency created by developers and used as a medium of exchange for goods and/or services. Bitcoin was put forth by a developer with the pseudonym of Satoshi Nakamoto in 2009. It is based on a concept called crypto-currency. Cryptographic techniques are used to create and control bitcoin transaction. A quick look at the bitcoin site, bitcoin.org, tells you how it works.



You need to install a wallet which will download onto your computer or iPhone. Upon installation, the wallet gives you an address. You let your friend know your address and voila, he can send you some bitcoins. It's as easy as sending an email. A bitcoin can be exchanged for real currency and vice versa at bitcoin exchanges like Mt.Gox.



If you have enough "mining hardware" on your computer, you can become a miner and be compensated for that effort in bitcoins. Mining is a process of spending computational resources to create new bitcoins and to secure bitcoin transactions against reversals. It is easy to think of it as renting out your computer's resources for some bitcoins if you choose to become a "miner".



Getting bitcoins through mining is certainly not quick or easy. But you can make bitcoins for services like filling out surveys, which is easy and now comes paid-for.



A key feature of the bitcoin economy is that it is decentralised. This means that all transactions are between the two parties involved, without a third central authority like a bank. The obvious benefit of this to the user is that there is mostly zero or sometimes a very low transaction fee.



The Bitcoin system's money supply is distributed evenly throughout the network and programmatically created at a rate known to all parties in advance. So the Bitcoin grows at a predetermined fixed rate.



The amount of bitcoins in circulation is predetermined and there will never be more bitcoins than that. On an economic level, this means that the bitcoins cannot be manipulated by governments and political bodies - it cannot be inflated or deflated artificially.



These features of bitcoins are very akin to the features of the now extinct gold standard. Historically, the gold standard was a means of setting exchange rates of different currencies. Under the gold standard, a country freely allowed its currency to be measured by converting it to the price of gold of a fixed amount. This meant that the governments had to back up their supply of currency by gold.



Manipulation of currency by a central authority arbitrarily was not possible in theory. Also the gold standard had other benefits like price stability. However, the gold standard was abandoned by everybody by the year 1971 for a lot of other economic and political reasons.



One obvious defect of the gold standard was the natural unequal distribution of gold on earth. Also, the mining activity was expensive. The Bitcoin takes on many features from the gold standard. Except, in this case, the mining of bitcoins in virtual thereby avoiding many perils of the gold standard.



The Bitcoin is not backed by any commodity nor is it pegged to any currency. It derives its value from demand and supply economics. We can liken this to the value of the "first currency", when human civilisation moved on from barter to IOU/money. People relied on their inherent understanding of the price of goods according to its value. The first bitcoins needed the market makers' intrinsic trade knowledge for price discovery. It is to be noted that while you can make a profit on the float of a bitcoin (buy and sell a bitcoin with respect to a currency) the value of a bitcoin against a dollar fluctuates.



While the Bitcoin is still a popular alternative currency and does not offer all the features of a real world banking system, its future curve seems very promising. Whilst there are theoretical suppositions and speculations in place for whether bitcoins can replace fiat currencies - the future of the world economy and bitcoins is still an open book. With its soaring popularity, especially in times of real-cash illiquidity - we might be on the threshold of a new kind of economics.

