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    Bitcoin: How Does It Work, What's It Do, and Is It a Drug-Fueled Money Laundering Scam Bubble?

    As the world's most popular cryptocurrency continues its meteoric rise, recently reaching a market cap of $1 billion, numerous contrasting storylines have emerged. The typical bitcoin headline might look something like this: Bitcoin is booming. Bitcoin buys you drugs online. Bitcoin is a big "fuck you" to financially inept governments and corrupt banks. Bitcoin is a scam, a ponzi scheme, a bubble. Bitcoin is the future of money. Bitcoin has no future. In light of all the buzz surrounding the first widely used digital currency, it's a good time to talk some bitcoin basics.

    What is bitcoin?

    Bitcoin is the world’s most widely used experimental digital currency. Based on the original paper by Satoshi Nakamoto, the open source, decentralized, peer-to-peer cryptocurrency has been around since 2009. It self-regulates based on a system of computerized mining, public key cryptography, and a decentralized ledger that records all transactions known as the blockchain.

    If the internet revolutionized the phone and communication and 3D printing will revolutionize manufacturing, the concept of bitcoin drags our idea of money into the always-connected future, an internet-of-finance that supports the digital means of transferring value in the age of the network.

    Why bitcoin?

    An early mining rig, via Northwest Pixel

    Bitcoin’s rise to prominence is due to its specific feature set and properties. It’s easily transferrable over the internet; it’s fungible and durable; and the bitcoin network is theoretically secure. This means you can transfer value from one person to the next no matter where they are in the world easily and cheaply over the internet in digital form. And in certain cases, this can be achieved with relative anonymity.

    Given its decentralized model, there’s no need for a central bank. Inflation is predictable and the human element is eliminated. In that regard, it’s the first currency that’s essentially free of government control (although not regulation). New coins are added to the system roughly every ten minutes until the total pool of bitcoins reaches a predetermined limit of 21 million in the year 2140.

    Is bitcoin a scam?

    Stock and interest rising, via The Economist

    Bitcoin has sometimes been called a ponzi scheme since it favors early adopters as the value of bitcoins relative to real world currencies rises over time. In the early days, mining required less investment while producing more bitcoins. People who join the system later on will inevitably have less room to “profit,” if that’s their ultimate goal. Mining also becomes less productive over time as difficulty increases along with adoption.

    The counter to this is the idea of risk and reward. Since the concept of bitcoin and it’s longevity, especially during its nascent stages, has always been inherently uncertain, early adopters are understandably rewarded for taking on more risk and their belief that bitcoin has a future. And how the system works has always been fully transparent. Bitcoin isn’t some blackbox algorithm. If you don’t appreciate the rules, there’s no need to play.

    The astronomical rise in bitcoin’s price naturally breeds fear of a bubble, but that’s an issue that can only be addressed with time. And at this stage, the price incidentally matters very little unless you’re a speculator. Far more important is the continued expansion of the bitcoin ecosystem of services and businesses that support it.

    How do you get bitcoins?

    There’s a myriad of ways to acquire bitcoins and services are continually developed to make this process easier. One of the more straightforward ways is to use a payment processor such as BitInstant or Coinbase, where you can deposit cash and have bitcoins sent directly to your digital wallet for a small fee. One popular wallet service is Blockchain, which you can access via a phone app or through the website. Blockchain allows you to not only store bitcoins but also send and receive them from others.

    Seasoned users may prefer direct access to an exchange. The largest is MtGox, which is based in Tokyo. Exchange access requires more stringent verification, which means producing government identification and proof of address. Verified users can then trade bitcoins in real-time.

    Users can also buy bitcoins from others directly through the internet or locally, via Craigslist or an online marketplace like LocalBitcoins.com. This may be the simplest method although prices are generally not as good compared to the current market value. Various groups, such as the guys behind Bitcoin Machine, are also working on ATM-like dispensaries.

    What can you do with bitcoins?

    The first real-world bitcoin transaction was a Papa John's pizza that cost 10,000 BTC, worth nearly $1 million at today's prices.

    The short answer is not very much, if we’re talking general day-to-day matters. The majority of bitcoin volume as it stands is mostly speculation. A large portion is also devoted to grey market gambling. Satoshi Dice has become incredibly popular and with online poker still awaiting legislation in most states, some have turned to bitcoins for Texas Hold ‘Em. A small portion of overall volume is dedicated toward illegal activities, such as buying drugs on the notorious Silk Road.

    Most businesses don’t accept bitcoins although adoption continues to steadily grow. Wordpress, reddit, and Namecheap now all accept bitcoins. So does Mega. OKCupid recently revealed in an email that the online dating service will start taking the cryptocurrency as payment for its premium members in the coming weeks. There’s also a growing number of bitcoin-specific resellers. And the bitcoin wiki has a map that shows real-world businesses that are already onboard. For now, it’s impossible to predict when adoption might reach a tipping point but the current trend is one of an ever-expanding ecosystem.

    Why does bitcoin matter?

    Instead of looking at bitcoin as a replacement for traditional currencies, it's more practical to view it as a window into possibility of money in the digital age. Just as paper money eventually replaced precious metals and in the last few decades, credit cards replaced cash, bitcoin represents the inevitable evolution of money, or at least one version of what that technological progress might look like. This is the primary reason why bitcoin can still be a success even if it ends up failing.

    Historically, replaced intermediaries of value never become completely obsolete and generally continue to find purpose even with the addition of more advanced options. If bitcoin hypothetically takes over, we’ll still use gold and government backed currency. As Black Swan author Nassim Taleb recently noted in a reddit AMA, "bitcoin is the beginning of something great: a currency without a government, something necessary and imperative." The events in Cyprus and across Europe along with the general state of the world economy have helped push these concerns to the forefront. But at the very least, bitcoin helps to legitimize the concept of a virtual currency.

    Is bitcoin legal?

    As an unprecedented, disruptive technology, the proliferation of bitcoins has long fallen in a nebulous grey area as it fell outside of the regulatory framework. It's illegal to produce your own currency in the U.S. (and in most countries for that matter), but bitcoin isn't technically a currency. This legal uncertainty has complicated mainstream adoption as bitcoin is often associated with criminal activities in the press. But focusing on criminals is not only unfair, it distracts from bitcoin's primary purpose.

    It's natural that lawbreakers are first movers when it comes to technologies that have yet to be properly addressed by the various enforcement institutions. If technological progression makes your life easier, it invariably makes the lives of criminals easier as well. That's more of a human issue than a bitcoin problem. There will always be kiddie porn on the 'net just as a certain portion of U.S. dollars in circulation will always be devoted to criminal enterprises.

    The recent guidance from the anti-money laundering arm of the U.S. Treasury, FinCEN, brought further clarity to the situation by addressing decentralized virtual currencies for the first time, tacitly giving bitcoin the legal stamp of approval, while also paving the way for further regulations. But the big takeaway is that using bitcoins to purchase goods and services is legally okay. Likewise, those who operate bitcoin businesses, such as exchanges and payment processors, will have to adhere to various regulations. For consumers, this is generally a good thing because these rules protect users and help prevent the dark arts. Bitcoin will inevitably lose some of its cyberpunk mystique, but it's a necessary compromise for increased mainstream adoption. In fact, bitcoin insiders argue that the recent surge in prices is more attributable to the U.S. government's guidance rather than the economic turmoils in Europe.

    @sfnuop

    Top image via Flickr/Paul Nicholson

    More on bitcoin:

    Engineering the Bitcoin Gold Rush: An Interview with Yifu Guo, Creator of the First ASIC-Based Miner

    A Guide to Bitcoin Mining: Why Someone Bought a $1,500 Bitcoin Miner on eBay for $20,600

    Why Bitcoins Are Just Like Gold

    When Governments Take Your Money, Bitcoin Looks Really Good

    Topics: bitcoin, finance, economy, money, currency, crytocurrency, decentralization, open source, peer-to-peer, virtual currency, digital currency

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