What are bitcoins?

Bitcoins (BTC) are essentially a form of money, but the difference compared to the notes and bankcoins that you use in daily life, is that bitcoins are purely digital (or virtual).

The money that you use everyday is usually exchanged via banks and financial institutions, as well as psychically handling cash.

Bitcoins, however, are exchanged through what is called a peer-to-peer network of computers. This is similar to any file-sharing system that people use to transfer large files (movies, songs or games) with each other through the internet.

In other words, each computer in the system works as a 'client' for other computers. This means that bitcoins are not controlled by any central authority or government.

Whereas a central government or authority would monitor payments and create the money that circulates in the economy, the bitcoin network itself monitors payments and produces the supply of bitcoins.

How can you use bitcoins?

In order to use bitcoins, you have to download a free software from the internet which is called the 'digital wallet'. You use this wallet like your normal online bank account, except that you make and receive payments which are denominated in bitcoins.

Transactions are carried out directly from user to user – there are no banks or financial institutions in between. This is just like you handing your friend some cash, but it is done electronically instead.

Bitcoins are considered to be anonymous. In fact, those who use them are identified only through series of random numbers and letters which are assigned to their digital wallets.

There is no way to identify who holds a specific wallet. This means that transactions also remain anonymous.

If you want to exchange bitcoins with conventional currencies such as the United States dollar, the British pound or the euro, you can do it by using several dedicated exchanges.

What are the purposes and uses of bitcoins?

Bitcoins can be a way to buy items. In fact, many normal businesses are accepting payments in bitcoins. Some examples include consumer electronics, hotels and travel resorts.

Besides serving practical purposes, traders have recently begun to buy and sell bitcoins to make a profit.

Due to their growing popularity, bitcoins have significantly increased in value and this has led to traders being able to speculate on the future price.

As more and more people are attracted to the market, bitcoins can also be seen as a potential store of value. For instance, after the Cyprus banking crisis occurred in mid-March 2013, investors bought bitcoins in their search for an alternative place where to store their wealth.

How the bitcoin system works

Bitcoins transactions are verified through 'digital signatures'. This means that when you spend bitcoins, you use two keys: one public and one private.

When you send bitcoins to someone, you create a transaction which contains the public key of the new owner and you sign this transaction with your private key.

Through these two steps, the transaction is broadcast anonymously to the entire network of bitcoins users. At this point, everybody knows the new owner of the currency and that the transaction is matched by the holder's private key.

This mechanism provides security against thieving, but it does not prevent a user from spending a bitcoins twice – a problem known as 'double spending'.

In order to solve this issue without resorting to a central authority, the bitcoins network relies on the so-called 'miners'.

Miners process and verify all the network transactions in 10 minutes 'blocks'. These blocks are then added to a public ledger (the 'block chain') which records all successful transactions.

The task of mining is extremely complex. It requires substantial technical knowledge, as well as a lot of computing power and considerable electricity supply.

Besides rewarding the miners for successfully adding a new block to the block chain, this process also represents the way in which bitcoins are created and injected in the system.

In other words, the bitcoins supply is generated and controlled through the very same mining activity.

The growth of bitcoins as an industry

When bitcoins were first launched, $1 could have been enough to buy over 1,000 BTC. In other words, they were not worth much at all. Today, the situation is completely different. In fact, since its inception, the value has increased to a high of over $250.

Bitcoins show clear potentials for growth. This would be encouraged by several factors such as: the greater use of electronic commerce and virtual communities on the internet; the fact that bitcoins provide high level of anonymity, low transaction costs and a quick process of clearing and settlement.

However, obstacles to this growth are: the risks posed to price stability and financial stability; the possibility that regulators would clamp down the bitcoins project due to the risks it presents.

Summary

In this lesson you have learned that...

• ...bitcoins are a digital currency which is created and exchanged through a peer-to-peer computer network. You can use bitcoins quickly, anonymously and with transaction costs close to zero.
• ...you can use bitcoins to buy many items. But, you could also trade the currency to make a profit on its increase or decrease in value.
• ...the idea was created in 2008 and launched in 2009. Technically, the system works through digital signatures and mining.
• ...miners process and verify transactions and are awarded bitcoins for doing so. This is also the way in which bit coins are created.
• ...the use of this currency presents many advantages. These could influence its growth positively.
• ... there are also inherent risks which could push regulators to clamp down on bitcoins. This aspect would hinder their expansion and use.