Bitcoins are often underrepresented as being just currency, but they're much more. They're the internet's first, what economists would call, bearer instruments that encourage trade and discourage mistrust.
In a previous post, I'd laid out the technical details of what goes into mining and transacting with bitcoins (BTC). My original idea was to talk about why they are an important invention, but also felt that the technology mattered enough to merit a post of its own.
BTCs are not a fiat currency. That means they're a kind of money that has not acquired its value from a government, a government-backed organization or a law. Instead, BTCs acquire their value by assuring security, anonymity and translatability, and are most suited for performing transactions that could do without incompetent interference from banks and public bodies. In short, BTCs are not government-backed.
They’re ‘produced’ by users who have a piece of open source code using which they perform multiple encryptions to ‘mine’ a coin. The rest of the network then checks the validity of the coin using similar encryptions. There’s a mediating regulatory system that’s purely algorithmic, and it automatically and continuously adjusts the difficulty of mining a coin until all 21 million have been mined.
The technical intricacies behind the currency have built up to provide the virtual currency with some critical features that have, in the recent months, made BTCs both a currency and a commodity.
Bitcoins are different because they're made differently
The commodity value rests in its currency value (and some speculative value), which isn't just a number but a number and some implications. The number, of course, is somewhere around $124 for 1 BTC today (June 2, 2013). The implications are that you don't have to reveal your identity if you're an owner of BTCs. This is partly because the currency has no central issuing authority that's regulating its flow, therefore no body that wants to know how the coins are being used and by whom.
Think World of Warcraft and in-game money: You play the game, you make some, you hoard and safeguard it. Now, imagine if you could use this money in the real world. That's what BTCs are.
As a collateral, you also get to transfer coins anonymously. You do this between what are called wallets, each of which contains 'addresses' to locations on the web; each address contains some bitcoins.
The technical architecture is such that once coins are sent, they stay sent; there's no way to reverse the transaction other than by initiating a new one. There are also far fewer security concerns than those tagging along with offline currencies, such as forgery and material damage. BTCs simply exist as a string of numbers and characters on the internet. Their veracity is established by the mining network.
They are also invisible to banks and taxmen. Why are they invisible to banks? Because the implied authority of BTCs arises from its ‘democratically’ secured birth and distribution, and doesn't need an institution like the bank to verify its validity, nor, as a result, will it be subject to a processing fee (the 'democracy' is ironic because there's no one to take the blame when something about the coins goes wrong). Why are they invisible to taxmen? Because they are not issued by a government.
Thus, on the upside, there is no authority that can debase the currency, mishandle it out of greed or just plain incompetence, nor lend it out in waves with no thought spared for the reserves. As Warren Buffet wrote in 2012: "Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control."
The threat of deflation
On the downside, because of the anonymity and irreversibility of transactions, and if your system is left vulnerable to a hack while you take a nap, your BTCs can be stolen from your wallet forever, with no way to find out who took them. However, this is only a minor glitch in the bitcoins system; an even larger one is the threat of deflation.
At the moment, there are some 11 million BTCs already mined, with the remaining 10 million to be mined by 2025. Even by about 2020-2022, the supply of BTCs as regulated by the network will become so low as to be, for all practical purposes, considered constant. By then, price discovery would've matured, and speculations diminished, so that each coin will then have an almost fixed, instead of constantly increasing, price-tag. This process will also be aided by scale.
Unfortunately, if, by then, millions use BTCs, the absence of anyone to issue new units would lead to spiking demand and, thus, value, resulting in an enormous deflation of commodities. And in a deflationary environment, economies don't grow; this is where a primitive crypto-currency differs from government-issued notations of currency (this is also what happened in 1636). So, a widespread adoption of BTCs is not a good thing, but it's a good place to start thinking what about currencies needs to be fixed.
An ideal currency, for example, might be able to transcend borders and appeal to things other than nationality to be held valuable, like BTCs can be converted into a host of other currencies, and even be used to denote value in different countries simultaneously.
For instance, a service titled Mt. Gox operates out of the US that lets you convert dollars into BTCs. However, ever since the FBI decided to crack down on the system because it was a violation of federal law for individuals to create private currency systems, Mt. Gox has necessitated photographic identities of its users since May 30, which defeats the central purpose. Of course, Gox's faulty policies that made it harder to obtain coins were also to blame. The moral's that they’re attracting the wrong kind of attention and that makes them even less attractive an asset.
Lighting the way ahead
At the end of the day, BTCs offer a lot of promise about refining future payments. Extensions to it like Zerocoin assist in the preservation of anonymity even if it has been violated by government interference. In the future, BTCs might even tear down paywalls and boost trade. Even fight spam (by making you pay a thousandth of a BTC to a receiver every time you sent out a mail. If you sent out a billion, you'd have paid up - all without the hassle of using a credit card)!
At the moment, though, bitcoins are assailed by important flaws as well as heady speculation that's driving their mining, but they're showing the way ahead well enough.