Bitcoin – The First Generation of Virtual Currency

The assessments of the new virtual currency have expressed fascination to its novelty, and, on the other hand, doubts about the feasibility of the whole endeavour. At the same time the use of bitcoins in online shopping seems to be on the rise.

In recent weeks, the Bitcoin saga has included a rapid rise in the value of the currency, followed by an abrupt crash, and then levelling of value. Future will tell what comes next. What is interesting is that Bitcoin’s fate has not been covered only by tech-savvy geek websites, but also by eminent powerhouses of Western journalism, such as The Economist, The Washington Post and The New York Times.

In terms of the world economy the Bitcoin Bubble was, of course, completely insignificant event with next to nothing consequences. Yet what makes Bitcoin interesting is the way the virtual currency challenges traditional ways of thinking and creates something completely new with ultra-modern technological tools.

In a world struggling to find a way out of the economic downturn, there seems to be a clear interest for new ways of thinking about money.

Bitcoin is the world’s first widely-used decentralized virtual currency. The project was initiated in 2009 by a mysterious person or a group going by the pseudonym Satoshi Nakamoto. Unlike traditional currencies, Bitcoin is not managed by a centralized financial institution. Instead, the foundation for the currency comes from a peer-to-peer network, in the same way as, for example file-sharing service BitTorrent.

Bitcoin is based on advanced mathematical algorithms, which are solved by the Bitcoin software running on one’s computer and communicating with peer-to-peer network. Computing, or “mining”, the algorithms results in new money – bitcoins – for the user. The system is constructed so that the mining becomes gradually more difficult, and the number of bitcoins in circulation can never grow larger than about 21 million.

Bitcoin is completely decentralized. It does not have a central bank that could decrease the value of the currency by printing more money. Hence, Bitcoin could be perceived as a kind of digital gold. Since the start of the project, people have built powerful computers for mining bitcoins – and some ordinary people have even had their computers hijacked for the purpose of mining virtual money for malicious attackers.

The creation and transferring of bitcoins is confirmed by the peer-to-peer network. All transactions between users and new created bitcoins are tracked into a collective log.  Bitcoins can be changed for traditional currencies with different exchange rates, and they can also be transmitted directly from one user to another in the network.

Bitcoin’s biggest advantage over traditional currencies is that it is truly universal currency. Global transactions can be made easily without any exchange costs and bank charges. For this reason Bitcoin appeals both to ordinary consumers interested in online shopping and globally operating criminal networks.

Few deny that the Bitcoin offers a convenient payment method for online shopping. The virtual currency is universal and completely independent of any third-parties. Payment with bitcoins is free and easy. Ecommerce merchants do not need to pay transaction fees to e-payment providers or credit card companies, or wait for the payments to show up on their account.

In the future, most of the online stores will probably support Bitcoin or some other new digital payment method, which helps the merchant to save a few per cent in costs by eliminating transaction fees. Merchants are also drawn to the fact that it is impossible to cancel a Bitcoin payment after it is confirmed.

Bitcoin can already be used to pay for web hosting or online gaming. The number of web stores accepting bitcoins is steadily increasing. Currently you can use bitcoins to purchase, for instance, consumer electronics, shoes, games, health products, musical instruments – and pizza. For many online stores accepting bitcoins seems to be a way to signal that to store is dedicated to following technology trends.

The number of physical stores accepting bitcoins is still extremely marginal. In Finland, the vegetarian fast-food restaurant Vegemesta is reportedly the only non-ecommerce business currently doing this.

Bitcoin remains a bit problematic payment method for businesses. If you accept bitcoins today, you can never be sure what they’re worth tomorrow. After the last week’s news, how many people would like receive their wage in bitcoins? There is also a darker side to the currency. Bitcoins are particularly popular currency in the illegal drug trade conducted in anonymous networks.

Bitcoin divides opinions. In one corner we have zealous Bitcoin defenders, and on the other, skeptics who see the new currency as nothing more than a ludicrous techie project.

Bitcoin proponents emphasize the currency’s independence of external authorities. Bitcoins cannot be printed by the decision of any central authority. Consequently, the currency cannot also be destroyed by attacking central leadership.

As a fully digital currency, bitcoins are easy to transfer, and their authenticity can be reliably verified. Surely, the proponents readily admit, there are risks connected with the whole endeavour. In the last couple of years the Bitcoin community has witnessed several Bitcoin thefts and crashes of exchange services.

On closer analysis, the ideas of Bitcoin’s supporters seem to stem from lack of confidence in governments and their monetary policy. Bitcoin takes a grassroots, market-based approach to currency without the involvement of governments, central banks or enterprises.

Bitcoin software is open source and the creation of money is open for anyone to see. The project is, indeed, influenced by the values of the open source movement, such as openness, collaboration, lack of centralized control, and the use of new technology for the advancement of society.

Even the more critical commentators tend to recognize Bitcoin’s theoretical elegance and innovative mathematical foundations. Critics, however, accuse Bitcoin’s proponents of misunderstanding the nature of money and monetary policy.

Surely Bitcoin’s peer-to-peer approach to money goes against the de facto model of monetary control, which places a central bank in control of the availability of money. In this model, the value of money is not tied to any material, such as gold, but instead it is based on the decisions of a group of economists. Their job is, very roughly put, to regulate the currency so that its value does not fluctuate according to the whims of the crowd. The arrangement is designed to enable social stability and make long-term financial planning possible.

The award-winning economist and opinion leader Paul Krugman has accused Bitcoin enthusiasts for wanting to create a pristine currency based on mathematical absoluteness, a currency that would above human frailty and the political process. Bitcoin proponents have not, Krugman says, understood that money is always a social contract and only meaningful within the sphere of human activity.

In the spirit of chartalism, Krugman points out, that the legitimacy of traditional paper money is based on the backing of the state. The state accepts the particular currency as a legitimate method of payment and a way to pay taxes. In Krugman’s view, Bitcoin’s value is, however, based on nothing else but a self-fulfilling prophecy that people want to use them for payments in the future. Krugman’s writings have prompted several online replies from Bitcoin’s supporters.

Some estimates suggest that Bitcoin is only the first generation of digital currencies, soon to be replaced by more advanced and easier to use competitors. Some of these are already available, such as Litecoin and Ripple. Whatever its name will be, we will most likely see some kind of decentralized virtual currency becoming popular payment method in the future – at least for ecommerce.