Created in 2009, Bitcoin is a digital form of currency that has escalated in value over the past several years. Although the number of merchants using Bitcoins is still small, the concept is growing as service providers like Dish Network and others let buyers pay with Bitcoins. With more businesses accepting the currency, understanding how it works can open up more payment options for you.
How Bitcoin Works
Bitcoin is a digital currency with a value that, just like the U.S. dollar, fluctuates. So, if you are purchasing an item that sells for $50 USD, you need to know how many bitcoins are required to make that purchase. Several online tools exist to show you the current exchange rate including CoinDesk and bitcoinexchangerate.com.
In essence, bitcoins are digital cash. When you purchase an item with paper and coin currency, for example, at the local fast food restaurant, the seller does not need to know who you are. You pay cash and move on. Bitcoins are the same concept. The buyer and seller do not need to validate each other for a transaction. Since a bitcoin transaction is similar in concept to cash, no middle man exists.
Removing the middle man, like banks, from the currency is part of the appeal of bitcoin. Some of the currency's strengths are:
- Faster transfer of funds: With a bitcoin transaction, because there is no middle man, it can take less than an hour for money to exchange hands, compared to two to three days for other types of electronic transactions.
- Anonymous transactions: Persons wanting to safeguard their online identity are attracted to the fact that Bitcoin rivals in-person cash transactions for anonymity. Users are identified only by number.
- Lower fees: Since businesses are charged transaction fees from credit cards, banks and even PayPal, one of bitcoin's strongest appeals of for companies is the low or non-existent transaction fees. Reducing or eliminating these costs can be passed on as savings to the consumer.
- Inability to freeze accounts: Due to the redundancies built into the bitcoin system, no one, including a government, can take control of someone's wealth.
- Harder to steal: Unless someone has access to a bitcoin owner's computer and the required passwords, the coins cannot be stolen.
- Transparency: When the currency was created, the creator used open source coding which lets developers access the program to continually improve the product. The coding also creates a public log of every bitcoin transaction, which further adds to the transparency of the currency.
Since the middle man is removed and transactions are secured using military grade encryption, it would seem the currency is a no-brainer for online transactions. However, a few downsides exist.
- Volatility: The value of a bitcoin has ranged from a penny to hundreds of dollars. Investment sites like Motley Fool point out that most national currencies experience rising and falling values. However, no established national currency has experienced as much volatility as Bitcoin - which is up to five times higher than other currencies, according to Motley Fool.
- Abandoned coins: One inherent problem with the system is lost coins. If a user, for instance, tosses away a significant number of coins when trashing a hard drive, these coins are forever 'lost' inside the system. The system is aware they exist, but no one can access them.
- Stolen wallets: Although, in theory, the coins cannot be stolen, theft has occurred as hackers have found their way into bitcoin wallets. These wallets are used in a manner similar to real-world wallets - as a way to keep a small amount of cash on hand. Wallets without secure back-up systems can be hacked.
- Untraceable payments: What is considered one of the system's greatest strengths is also one of its weaknesses since this feature has led to criminal use of the currency. For example, the ease of anonymously making illegal purchases of drugs or firearms with the currency reveals its downside.
How to Get Started
Three common ways to enter the Bitcoin world are:
- Accepting them in a purchase
- Purchasing them
- Mining for them
For businesses, the simplest way to get into the market is to accept bitcoins for purchases. As an individual, the easiest way is to buy bitcoins through an exchange. Mining for them, is similar to mining for gold. It's harder, requires specialized equipment and can be time consuming.
Mining for Bitcoins
When the currency was created, a finite number of Bitcoins was programmed into the system - 21 million coins. Also designed into the system was a mechanism to make it harder to mine a coin as fewer coins were available to be mined. With more than 12 million coins in circulation, the payout for mining has decreased 50 percent (currently 25 coins) while the time it takes to mine has increased.
What this means to the layperson is quite simple. You need a computer system that is fast and designed for one task - mining. These machines cost around $12,000, according to CNBC.
In the report, CNBC explains the mining process. Mining is verifying bitcoin transactions to prove they are legitimate. Using a few pieces of free software, miners tackle a blockchain of transactions and find the key that opens the virtual padlock on the collection of transactions. As of November 2014, it takes 35,985,640,265.08 attempts to crack open the lock, according to BlockChain.
Future of Bitcoin
Whereas there is a lot of doubt regarding the viability of the currency, it has a strong following among users and speculators. The speculators are betting that the currency will become globally accepted while the users simply prefer the currency as a method of payment.
In a publication from the Chicago Federal Reserve, the agency states, that Bitcoins "represents a remarkable conceptual and technical achievement, which may well be used by existing financial institutions," suggesting the currency is expected to survive.