Bitcoins: What are they, and how do they work?

Bitcoin is one of the first attempts to create a real-world currency with no governments, no central banks, and no rules

It started, and ended, with a click. With one touch of a mouse, a hacker managed to transfer 25,000 credits of online currency – then worth almost $500,000 dollars – to his own account. The transfer is visible on a public register; the original owner has publicised his plight online, but to no avail – the money is gone.

This hack, which happened in June 2011, was the first major online heist for Bitcoins, one of the world’s newest currencies, and the subsequent panic left many casual users reeling.

Days later, it was dwarfed by hack number two: an attack on the currency’s biggest online exchange, involving more than 400,000 Bitcoins – worth almost $9m (£5.5m). The attempt to sell off the coins was a sale so huge it plunged the value of each coin from more than $17 to $0.01.

The exchange, MtGox, was promptly taken offline, and is planning to reverse the transactions. No-one knows what the currency will be worth – if anything – when it reopens.

Such is the strange world of the online frontier. Bitcoin isn’t the currency of an online game or Facebook fad – it’s one of the first attempts to create a real-world currency with no governments, no central banks, and no rules. More than 6,500,000 Bitcoins are in circulation, in an online economy, which was worth over $180m shortly before June’s hack.

No bank or government issues new Bitcoins. Instead, they are “mined” in batches of 50 as a result of intensive calculations carried out on PCs across the world. Anyone wanting to mine the coins installs mining software, which carries out intensive calculations on a certain unit of “work”.

Whichever computer around the world solves the problem receives 50 Bitcoins. Six months ago, this reward was worth less than $1. At the start of June 2011, it was worth $1,000. The work generally needs powerful computers to pay off: some developers involved with the project estimate a typical laptop could work for two years without ever generating any coins.

Given the rocketing value of the coins – and the increasing difficulty of mining them – it’s no surprise people have started going to extraordinary lengths to generate them.

Users on mining forums discuss cooling their computers in dry ice to allow the processors to run faster, customising specialist chips, or borrowing networked computing power to generate more coins. One even reported the upturn in his electricity use was so significant his house was raided by police, who were concerned that he might be farming cannabis.

Members of the hacking collectives LulzSec and Anonymous, behind many of the high-profile hacks of recent weeks, may have found a more innovative solution: using other people’s computers.

The groups’ famed distributed denial-of-service attacks rely on botnets – networks of computers to which hackers have gained access, usually without the owners’ knowledge – to provide the weight of numbers to take down high profile targets.

Several purported members of Anonymous, plus intermediaries linked to Anon and to Lulzsec, have confirmed some individuals connected to the organisations have used their botnets to “mine” Bitcoins.

Credible reports suggest some individuals connected to Anonymous have botnets with more than 100,000 active computers. A network of this size, even mining Bitcoins inefficiently, has the potential to generate 400 to 500 coins a day – worth in excess of $7,500 before the crash.

Coders in the Bitcoins community are divided by the involvement of the hacking collectives in their community. While some deny any botnet mining occurs, others concede it’s a factor, and admit a slump in processing power data in April signified a botnet being turned off. One, who preferred not to be named, acknowledged it was “neat that those guys decided they could get a better return from participating in Bitcoins than by attacking it”.

The attractions of Bitcoins to such communities are manifold. It’s an online-only experiment with no government or corporate involvement. It’s accepted as currency on hundreds of sites worldwide, including one claiming to sell illegal drugs and several selling pornography.

It is also, despite having a public register of all transactions, capable of being totally anonymous. Users taking other precautions will find the only occasion at which they might link their Bitcoins wallet to their real identity is when transferring their coins into real cash at privately owned exchanges.

Given these can base themselves anywhere in the world, and often reject regulation, law enforcement agencies have a problem – if the Bitcoins experiment survives, criminals and money-launderers may soon have a near-untraceable channel through which to funnel their proceeds.

Perhaps as troubling to some agencies is WikiLeaks’ recent decision to embrace the new currency, giving its donors the prospect of anonymity as secure as the site claims its whistleblowers enjoy.

Such prospects trouble those driving the development of the currency far less; instead, the majority see the benefits of an unfettered currency as outweighing the costs.

“The freedom to easily, instantly, and at very low cost pay anybody in the world is the fundamental idea,” says Gavin Andresen, described as Bitcoin technical lead. “The internet gives us the ability to communicate with anybody in the world easily, instantly, and at very low cost; I think it should be as easy to pay somebody across the world as it is to send them an email.”

Another, Nils Schneider, puts it more succinctly: “Bitcoin is an experiment to make a ‘raw’ digital currency. Such a currency does not need supervision.”

Schneider also lacked sympathy for the victim of the 25,000 Bitcoin theft which first brought security jitters to the fledgling community. Bitcoin wallets at present are stored with no encryption whatsoever by default, and transfers of stolen material are irreversible unless half of all Bitcoin users agree to it.

Asked – before the MtGox hack – about the situation, Schneider said: “We’re working on adding encryption to the wallet so it can’t be stolen that easily again. But other than that, Bitcoin is like cash. You have to secure it yourself and shouldn’t keep too many Bitcoins on an easily hackable computer.”

He added that should the currency take off, he hoped banks would emerge to aid people in securing their wallets.

Perhaps the simplest explanation for what brought thousands of users – many non-technical – to an unprotected currency is the sheer increase in value it attained in recent months. On 1 January 2011, Bitcoins were worth 30 cents each. By 9 June 2011, they were worth $29.55.

The total volume of US dollar to Bitcoins traded on MtGox was $146,000 in January. In the first two weeks of June alone, this was 143 times bigger, at $21m worth of trades.

Bitcoins have been generating value from nothing, and breaking the economic rules of virtually every currency. By design, Bitcoins at present have an inflation rate estimated by one developer at 7,200% (this will automatically drop to 0% over the next 30 years).

Such hyperinflation usually causes the exchange rate of a currency to plummet – as happened to Germany in the early 1930s, or Zimbabwe over the past decade. Bitcoins’ value instead increased almost a hundredfold in six months.

Even those most centrally involved in Bitcoins agree that prior to the MtGox hack Bitcoin was in a bubble – and that a loss of trust could be fatal: “The growth rate is certainly not sustainable. I don’t know if the current value with respect to established currencies is sustainable or not; certainly if people lost trust in the Bitcoin system its value would crash,” says Andresen.

“Bitcoin is an experiment that has never been tried before. People should think of it as an internet startup – it might be wildly successful, or it might fail. In any case, I do not expect that the road ahead will be smooth: even if Bitcoin is ultimately successful, I expect more price bubbles, scams, software bugs, failures of Bitcoin-related businesses and other problems that I can’t even imagine right now.”

Given Bitcoin’s travails, the more idealistic developers are keen to point out the wider benefits an open currency could have, if it became established. Controversially – within the community at least – some also acknowledge legal oversight may be necessary for these to be realised.

“People in the third world are at the mercy of corrupt governments and banks,” says Amir Taaki, co-founder of Bitcoin Consultancy. “Bitcoin can drastically reduce overheads and fight corruption. At present, it’s possible to pay up to 23% commission on an international funds transfer. That’s not capitalism, that’s a corruption of capitalism.”

Just days after the massive hack of MtGox brought the fledgling currency to its knees, its idealists awaited its reopening to see if a currency without rules, government, or corporate control could withstand its first crash to survive long enough to deliver any of its potential benefits.

The wealthiest Bitcoin users have more pressing concerns. It’s only when the exchange reopens that they’ll learn if their electronic wallets are worth millions of dollars, or less than the $10 USB stick on which they’re stored. It’s a tense wait.

One comment on “Bitcoins: What are they, and how do they work?

  1. Superb post but I was wondering if you could write a litte more
    on this subject? I’d be very thankful if you could elaborate a little bit further. Appreciate it!

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s