Understanding how the Bitcoin works;
Bitcoin is a peer-to-peer payment network based on an open source protocol[disputed – discuss] and a digital currency used in the network. Introduced in 2009 by pseudonymous developer Satoshi Nakamoto, Bitcoin is one of several so-called cryptocurrencies as it uses public-key cryptography. When paying with Bitcoin, no exchange of digital notes or tokens takes place between buyer and seller. Instead, the buyer requests an update to a public transaction log, the blockchain. This master list of all transactions shows who owns what bitcoins currently and in the past and is maintained by a decentralized network that verifies and timestamps payments. The operators of this network, known as "miners", are rewarded with transaction fees and newly minted bitcoins.
Bitcoin has been a subject of scrutiny due to ties with illicit activity. In 2013 the FBI shut down the Silk Road online black market and seized US$28.5 million worth of bitcoin. However, the United States is currently considered to be Bitcoin friendly compared to other governments. In China, new rules mean bitcoins cannot be exchanged for local currency, and the European Banking Authority has warned that Bitcoin lacks consumer protections. Theft of bitcoins can and does occur. Generating and storing keys offline mitigates such risks, however.
Commercial use of Bitcoin, illicit or otherwise, is currently small compared to its use by speculators, which has fueled price volatility. Bitcoin as a form of payment for products and services has seen growth, however, and merchants have an incentive to accept the currency because transaction fees are lower than the 2-3% typically imposed by credit card processors. Notable vendors accepting bitcoin include OkCupid, Reddit, and Virgin Galactic.
"Bitcoin", capitalized, refers to the protocol and transaction network but "bitcoins", lowercase, refers to the currency itself.
Integral to Bitcoin is a public transaction log, the blockchain, that records bitcoin ownership currently as well as in the past. By keeping a record of all transactions, the blockchain prevents double-spending. Cryptography is used to protect the integrity of the blockchain.
This master list of all transactions is maintained by a distributed network of computers that does the payment processing work of Bitcoin. Users who devote computing power to maintaining the blockchain in this way are called "miners" and are rewarded with newly created bitcoins as well as fees. Payment processing work done by miners verifies each transaction as valid and adds it to the blockchain. As more bitcoins come into circulation the reward for doing payment processing decreases and will stop altogether when the Bitcoin upper limit of 21 million bitcoins has been reached. As Bitcoin achieves wider recognition and more people compete to mine the coins, competition for the limited number of bitcoins awarded for payment processing work becomes steeper and more powerful computers are needed in order to compete—a fact which has spawned a technology boom in sales of Bitcoin mining technology. In addition, Bitcoin is designed to increase the difficulty of payment processing as more miners connect to the network.
Payment processingThrough various exchanges, bitcoins are bought and sold at a variable price against the value of other currencies. While there may be a seemingly large number, exchanges regularly fail, taking client bitcoins with them. A published research study showed that of 40 Bitcoin exchange markets studied, 18 ended up closing over a period of 3 years. Bitcoin prices are fragmented and vary widely across exchanges.
In order to make a payment, a user requests an update to the master transaction list, the blockchain, and the transaction is validated by the network. Although transactions can be validated instantly, it takes bitcoin miners approximately 10 minutes to record the payment within the blockchain and confirm it was not spent twice. In addition, transactions that pay a fee may be processed more quickly.
Bitcoin payment processing fees are optional and generally substantially lower than those of credit cards or money transfers. Currently, doing the work of payment processing is rewarded with newly created bitcoins. But this reward is halved every few years, eventually phasing out all together when the total number of bitcoins have been released. Once the Bitcoin ceiling of 21 million units is reached, payment processing will only be incentivized with transaction fees.
Wallets allow a user to make and accept payments using Bitcoin. At the most basic, a wallet stores a public key, which some refer to as a Bitcoin address, and its associated private key. They come in a variety of forms: apps for mobile devices and computers, hardware devices, and paper tokens. When making a purchase with a mobile device, the use of QR codes to simplify transactions is ubiquitous.
Bitcoin functions using public-key cryptography, in which a pair of cryptographic keys, one public and one private, are generated. In the case of Bitcoin, the public key functions as an address to which payments can be sent, and the private key acts as a safeguard; it must be presented when making a payment from an address. Because anyone with a private key can spend all of the bitcoins associated with its corresponding public key, securing and protecting is important to prevent theft, which has occurred on numerous occasions. The practical day-to-day security of Bitcoin wallets remains an on-going concern.
The main ways to acquire bitcoins are: exchanges (where bitcoins can be bought and sold for cash), mining, and selling items for bitcoins.
First mentioned in a 2008 paper published under the pseudonym "Satoshi Nakamoto" (a Japanese name that roughly translates as "Thinking clearly inside the foundation"), Bitcoin became operational in early 2009, with the release of the firstopen source Bitcoin client and the issuance of the first bitcoins. The currency had early technical problems such as a 2009 exploit that allowed the creation of unlimited bitcoins.
On average, bitcoins have appreciated rapidly in relation to other currencies including the US dollar, euro, and British pound. In 2011 the value of one bitcoin rapidly rose from about $0.30 to $32, before falling back down to $2. Bitcoin began attracting media attention in late 2012, and numerous news articles have been written about it. In 2013, some mainstream services such as OkCupid, Baidu, Reddit, Humble Bundle and Foodler began accepting it. That year also saw the first interventions by law enforcement. Assets belonging to the Mt.Gox exchange were seized, and the Silk Road drugs market was shut down.
During November 2013, the China-based Bitcoin exchange BTC China overtook Japan-based Mt.Gox and Europe-based Bitstamp to become the largest Bitcoin trading exchange by trade volume. On 19 November 2013, the value a bitcoin on the Mt.Gox exchange soared to a peak of US$900 following a United States Senate committee hearing, at which the committee was informed that virtual currencies were a legitimate financial service. On the same day, one bitcoin traded for over RMB¥6780 (US$1100) in China. With roughly 12 million bitcoins in existence as of November 2013, the new price increased the market cap for Bitcoin to at least US$7.2 billion.
On 5 December 2013, the People's Bank of China announced it was prohibiting Chinese financial institutions from using bitcoins. Following the introduction of these new rules, the value of bitcoin dropped and Chinese internet giant Baidu reversed its policy of accepting bitcoins for certain services. Starting in October 2013, Baidu had been allowing clients of website security services to pay with bitcoins. Buying real-world goods with any virtual currency has been illegal in China since at least 2009.
Certain non-profit or advocacy groups accept bitcoins including WordPress, Tor Project, and the Electronic Frontier Foundation.
The highly volatile value of Bitcoin has led to some questions about its ability to function as a currency. Few are willing to use a currency with a highly variable value. Its deflationary bias, which incentivizes hoarding and removes money from circulation, is also cited as a stumbling block to Bitcoin becoming a functional currency.
Even if Bitcoin fails to make it as a currency, it may continue to prove useful as a payment processing system. Volatility has little effect on its utility in this regard since money would need to be converted to bitcoins only for the short time it takes to make a payment or transfer. Processing fees are substantially lower than those of credit cards or money transfers. Some feel that Bitcoin may be especially well suited to facilitating cheap cross-border money transfers.
Currently Bitcoin does see limited use as a currency. By November 2013 there were about 1,000 brick and mortar businesses willing to accept payment in bitcoins, and more than twenty thousand merchants online.
Some have suggested that Bitcoin is gaining popularity in countries with problem-plagued national currencies, as it can be used to circumvent inflation, capital controls, and international sanctions. Bitcoins are used by some Argentinians as an alternative to the official currency, which is stymied by inflation and strict capital controls. In addition, some Iranians use bitcoins to evade currency sanctions.
Financial journalists and analysts have suggested that there was a link between higher Bitcoin usage in Spain and the 2012-2013 Cypriot financial crisis.
Many have mentioned speculative bubbles in connection with Bitcoin, and Reuters journalist Felix Salmon correctly predicted the bursting of one such Bitcoin bubble in April 2013.
Noted individuals who have named Bitcoin a bubble include Former Federal Reserve Chairman Alan Greenspan; a core developer of the Bitcoin protocol, Mike Hearn; and Economist John Quiggin.
Nick Colas, a market strategist for ConvergEx Group, is among those who see Bitcoin's quick rise in price as nothing more than normal economic forces at work.
Bitcoins are often traded as an investment by speculators who expect the currency to increase in value as its popularity widens. The European Banking Authority has warned that the risks of engaging in such speculation go beyond the possibility that the value of Bitcoin drops.
Bitcoins have been described as lacking intrinsic value because their value depends only on the willingness of users to accept them. Their vulnerability to hacking and theft also makes their use as an investment more questionable.
Derivatives of bitcoins are thinly available. One organization offers futures contracts against multiple currencies.
Bitcoins have attracted the attention of some Wall Street types with Peter Thiel's Founders Fund investing US$3 million and the Winklevoss twins making a US$1.5 million personal investment as well as making an attempt to launch a Bitcoin ETF.
Economists have had a mixed reaction to Bitcoin. Some have responded positively to Bitcoin, including François R. Velde, senior economist of the Federal Reserve in Chicago who described it as "an elegant solution to the problem of creating a digital currency."
Other economists commenting on Bitcoin have been critical. Nobel laureate Paul Krugman has suggested that the structure of the currency incentivizes hoarding and that its value derives only from the expectation that others will accept it as payment.
Former U.S. Treasury Secretary Larry Summers has expressed a "wait and see" attitude when it comes to Bitcoin.
In November 2013 Richard Branson announced that Virgin Galactic would accept Bitcoin as payment, saying that he had invested in Bitcoin and found it "fascinating how a whole new global currency has been created", encouraging others to also invest in Bitcoin. PayPal President David A. Marcus has said he thinks that Bitcoin is a "great place to put assets" but that it won't be a currency until its price volatility reduces.
The blockchain is a public ledger of every bitcoin transaction. Bitcoin does provide anonymity in that a bitcoin address does not directly identify its owner. However, tracking the flow of bitcoins through the address can give clues as to who the owner is. Bitcoin uses cryptography but does not do so to protect the identities of its users. Bitcoin is anonymous in that it is difficult to associate Bitcoin transactions with real-life identities. In addition, Bitcoin intermediaries such as exchanges are required by law in many jurisdictions to collect personal customer data.[Bitcoin have been criticized by the free software movement activists including Richard Stallman for not being an 'anonymous cryptocurrency' and calls for reformed development. Zerocoin was a proposed add-on to Bitcoin, which employs cryptographic accumulators and digital commitments with zero-knowledge proofs to eliminate trackable linkage in the Bitcoin blockchain, which would make Bitcoin anonymous and untraceable, however it has been suggested by Zerocoin developers that instead of building on top of the Bitcoin protocol, Zerocoin may decide to launch as an alternative cryptocurrency instead.
Bitcoin's association with criminal activities has historically hindered the currency from attaining widespread, mainstream use and has attracted the attention of financial regulators, legislative bodies, and law enforcement. The Washington Post has labeled it "the currency of choice for seedy online activities," and CNN has called Bitcoin a "shady online currency [that is] starting to gain legitimacy in certain parts of the world." Its links to criminal activities have prompted scrutiny from the FBI, US Senate, and the State of New York. The FBI stated in a 2012 report that "bitcoins will likely continue to attract cyber-criminals who view it as a means to move or steal funds".
In March 2013 the US Financial Crimes Enforcement Network (FinCEN) established regulatory guidelines for "decentralized virtual currencies" such as Bitcoin, classifying American "Bitcoin miners" who sell their generated bitcoins as money services businesses (or MSBs), that may be subject to registration and other legal obligations. In August 2013 the German Finance Ministry characterized Bitcoin as a unit of account, usable in multilateral clearing circles and subject to capital gains tax if held less than one year. The New York State Department of Financial Services, citing its authority to regulate money transmissions and its concern with criminal activity (Silk Road in particular), announced an inquiry in late 2013 into possible regulations and guidelines for Bitcoin (a "BitLicense") and the holding of public hearings in New York City.The US Internal Revenue Service has also stated that it is actively working on its own rules for Bitcoin.
At the same time, the European Banking Authority (EBA) gave a nuanced nod of approval to Bitcoin usage. Issuing what was formally a "warning" to consumers its about dangers inasmuch as Bitcoin businesses are not regulated or licensed as banks in EU and EFTA areas, they further admitted that these businesses are not currently required to operate under such regulations, thus acknowledging the status quo.
Some have suggested that due to its close association with illegal purchases, governments could outlaw Bitcoin. This assertion has been made by Steven Strauss, a Harvard public policy professor, and was also mentioned in 2013 SEC filing made by a Bitcoin investment vehicle.Bitcoins are not currently illegal in the US, however. FBI Special Agent Christopher Tarbell has stated that "Bitcoins are not illegal in and of themselves and have known legitimate uses".
Several news outlets assert that the popularity of Bitcoin hinges on the ability to use them to purchase illegal substances. In 2013 The Guardian reported that the currency was primarily used to purchase illegal drugs and for online gambling, and The Huffington Post stated that "online gambling accounts for a huge portion of Bitcoin activity." Legitimate transactions are thought to be far less than the number involved in the purchase of drugs, and roughly one half of all transactions made using Bitcoin are bets placed at a single online gaming website. In 2012, an academic from the Carnegie Mellon CyLab and the Information Networking Institute estimated that 4.5 to 9% of all bitcoins spent were for purchases of drugs at a single online market, Silk Road. As the majority of the Bitcoin transactions were at this time speculative in nature, this academic asserts that drugs constituted a much larger percentage of the products and services bought using the currency, however. The Huffington Post stated in 2013 that online gun dealers use Bitcoin to sell arms without background checks.
Some regulatory and law enforecment authorities, including the European Banking Authority, feel Bitcoin may be used for money laundering. A 2012 report by the FBI acknowledged such fears but stated that there were no known instances of this occurring. Some say one obstacle to bitcoins becoming widely used to launder money is the fact that its transaction history is public. During the US Senate hearing in 2013, Jennifer Shasky Calvery, director of the Treasury Department's Financial Crimes Enforcement Network said that despite the possibility for using Bitcoin that "Cash is probably still the best medium for money laundering."
In June 2011, Symantec warned about the possibility of botnets engaging in covert mining of bitcoins, consuming computing cycles, using extra electricity and increasing computer temperatures. Some malware used the parallel processing capabilities of the GPUs built into many modern video cards. In mid-August 2011, bitcoin miner botnets were detected again, and less than three months later Bitcoin-mining trojans infecting Mac OS X were also discovered. In April 2013 electronic sports organization E-Sports Entertainment were accused of hijacking 14,000 computers to mine bitcoins; the case was settled in November with the organization fined US$1 million if it breaks the law within the following ten years, or $325,000 if it does not.
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