Bitcoin: A global experiment in free money

Bitcoin is a global online currency, free from the interference of regulators and nation states. But is it a revolution or a scam? Simon Wilson investigates.

What is a Bitcoin?

It's a decentralised' digital currency that is arguably more a wildly speculative investment punt than a genuinely useful online currency. Bitcoin is based on an open-source but highly complex peer-to-peer internet protocol.

It is "decentralised" in the sense that, unlike a fiat' currency backed by a state or other authority, Bitcoin has no central bank or institutional control. It is policed only by its community of users and governed by the cryptographic keys and safeguards built into its source code by the (anonymous) creators.

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Bitcoin's aims are modest yet almost frighteningly ambitious: its website Bitcoin.org presents the project as a libertarian monetary experiment and freely acknowledges that it might not work. But, equally, its aim is for Bitcoins to become a ubiquitous global online currency that bypasses banks and brooks no interference from regulators or nation states.

How does it work?

Instead of a central bank, new Bitcoins can be issued or mined' by anyone with a computer powerful enough to solve complex mathematical problems problems that automatically become harder to ensure that supply slows over time.

Currently, there are about 11 million Bitcoins, and the total that can be created, under the program governing the system, is 21 million, a theoretical limit not due to be reached until 2140. Coins can be used to buy goods from anyone who accepts them, and they can also be traded, with transactions cryptographically authenticated and viewable by users in a log called the blockchain'.

Is it secure?

Up to a point. Bitcoin's creators admit to one major security scare in August 2010 when a "major vulnerability" in the Bitcoin protocol was discovered and exploited: a mischievous user created billions of coins before the transaction was noted and erased from the log.

Otherwise, the system has functioned continuously, though there have been hiccups along the way, including security breaches, Bitcoin exchanges springing up and disappearing and several thefts.

The latest stumble occurred this month, when a 'fork' developed in the log due to a technical blip caused by some users, but not all, switching to a new version of the protocol. No immediate consensus emerged within the user community as to which blockchain was the legitimate one, and the value of a coin slumped 23% before matters were resolved a few hours later.

How much is a Bitcoin worth?

The value of a Bitcoin has fluctuated wildly since its launch, but overall the story is of an astronomical growth rate that has led many to regard the project as either a classic tulip-style mania or a Ponzi-style scam.

In dollar terms, one Bitcoin rose from being worth a few cents in 2010 to a bubble-style peak of $30 in June 2011. It then plunged to a couple of dollars again, held steady between $5 and $10 for most of 2012, before surging to all-time highs in March 2013 of in excess of $80.

The latest surge takes the currency's monetary base to around $1bn, and led to widespread predictions (for example from The Economist) that the next crash is due any day now.

Is a crash imminent?

Buying Bitcoins is the most speculative of punts: it's no coincidence that its biggest fans are internet libertarians and forex professionals having a bit of fun. Nor is it reassuring that a quick glance at Blockchain.info, the public log of all transactions, reveals that the majority are made at the site of SatoshiDICE, a betting game based on the value of Bitcoins.

On a practical level, one of the purposes of Bitcoins to facilitate cheap, anonymous transactions without interference from state authorities is attractive to money-launderers and criminals. Bitcoin is the currency of choice on Silk Road, an online clearing house for illegal drugs hidden in a hard-to-access part of the internet.

So it's just a dodgy scam?

Not necessarily. At the heart of Bitcoin is an apparent contradiction that may not be resolvable; namely, that rational actors cannot be expected to spend money if they expect it to increase in value, and that for a currency to survive, it needs users, not just speculators.

Nevertheless, the extraordinary surge in exchange value of Bitcoins particularly in recent weeks, apparently in response to the Cyprus chapter of the eurozone crisis suggests that some rational actors are not just buying in the hope of making a quick buck by selling on to a greater fool, but in the expectation that Bitcoins will prove a durable, secure alternative currency.

If Bitcoin is a scam, it is a highly unusual one in that its creators make no claim that its purchasers will make a profit, and acknowledge that the experiment could fail.

Who got the ball rolling?

The great mystery of Bitcoin is the identity of Satoshi Nakamoto' the pseudonym for the person or group who designed the original protocol in 2008 and launched the network in 2009. All the programmers named as possible candidates (for example, by the Fast Company and New Yorker magazines) have denied responsibility, and it is possible not even the current group of developers leading the project are aware of Satoshi's real identity.

What is known is that Bitcoin grew out of a concept called crypto-currency, which was first described in 1998 by Wei Dai on the cypherpunks mailing list. As for Satoshi, he says he "moved on" to new projects in 2010.