Should We Be Worried About Bitcoin?

04/24/2013 05:19 EDT | Updated 06/24/2013 05:12 EDT
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A computer screen displays the Bitcoin logo on an internet website in London, U.K., on Wednesday, April 10, 2013. Bitcoin, developed in 2009 by a mysterious programmer known as Satoshi Nakamoto, is a form of virtual cash that's made secure by complex computations and isn't backed by any government. Photographer: Chris Ratcliffe/Bloomberg via Getty Images

Is there an anonymous, free, and untrackable virtual currency currently making its sweep across the World Wide Web? It is not quite that simple, but Bitcoin is poised to become the next big thing in computing and finance.

How do Bitcoins come into existence? According to The Economist:

Unlike other online currencies -- such as the new Amazon Coins -- the supply of Bitcoin is not determined by any central issuing authority. Instead, new coins are generated according to a predetermined formula by thousands of computers solving complex mathematical problems. As more coins are generated, these problems get ever more complex, increasing the cost of computing power necessary to generate them, and so setting a floor underneath the price. Mimicking gold, the currency is designed to be deflationary.

The money is generated through Bitcoin "mining," which is:

The process of making computer hardware do mathematical calculations for the Bitcoin network to confirm transactions and increase security. As a reward for their services, Bitcoin miners can collect transaction fees for the transactions they confirm along with newly created bitcoins.

The term "mining" is a misnomer: while Bitcoin mining does seemingly extract a finite resource, what miners truly do is protect the integrity of the Bitcoin. Each transaction is "confirmed" in order to verify that a malicious spender has not "double-spent" his Bitcoins. Double-spending occurs when a seller spends the same Bitcoin more than once.

This may confuse consumers, as this problem cannot occur with a physical currency. For example, if Johnny has a single loonie and goes to two stores, he can spend his single loonie only once. With Bitcoin, malicious buyers can send the same amount to multiple sources at once.

To protect against double-spending, Bitcoin has a publicly accessible database of all transactions called a block chain. It creates a temporal ordering of transactions, so that if there is an issue with double-spending, the transaction that came first will be the successful one. Bitcoin "blocks" are the records of each transaction that need to be "confirmed," and the confirmations are done through mining. When the blocks are confirmed by the miners, they are appended to the block chain. And, in return for their work, the miners receive payment.

Bitcoins have been programmed to become more complex to mine over time. Every 2016 blocks, it takes more time and more computing power to process the next block. Approximately every 10 minutes a block is mined and yields about 25 Bitcoins; this yield will be halved every four years while the difficulty continues to increase: in 2017, each block will only yield 12.5 Bitcoins, and so on quadrenially. In total, a maximum of 21-million Bitcoins will be generated, expected to be reached in the year 2140.

In the past, mining was only done on regular computers, at first on the processor, and later on graphics cards. But of course, as with any niche market, specialized mining computers have been developed that are capable of nothing else but mining, known as an Application Specific Integrated Circuits (ASIC). These ASICs are so much more energy efficient and powerful than regular graphics card-based mining that it is highly unlikely that today's successful miners are using non-specialized machines. These are fairly pricey machines. They can range anywhere from $150 for the very basic entry model to $30,000 for the most advanced model. Tools exist to calculate profitability for miners based on energy prices, the cost of the hardware, and the processing power of the hardware.

While Bitcoin has been heralded as the future of anonymity, two researchers at the University College Dublin claim that it is not truly anonymous and that very often users and their transactions can be identified. Relying on a case where an individual claimed 25,000 Bitcoins were stolen from him, the researchers were able to track the flow of the cash and generated a visual image of the interactions between the victim (the green dot below) and the thief (the red dot).

Thief Network

Dan Kaminsky from Business Insider notes that:

When $50,000 of BitCoins is stolen today, and is $500,000 of BitCoin five years from now, every last cent of that filthy lucre can be monitored with acute cryptographic precision until the end of time.

The official page of the currency notes that Bitcoin is not anonymous, and that "anyone can see the balance and transactions of any Bitcoin address." The site recommends that users use multiple addresses and even create a new one each time money is received.

While this currency certainly has potential and will likely take off, it will never be able to offer the same security as online banks or Paypal can: once a Bitcoin transaction occurs, it can never be reversed. The sender must rely upon the goodwill of the recipient to refund the money in the case of a dispute; there is no central arbitrator to resolve disputes as with Paypal. And, if money ever gets stolen and re-routed using Bitcoin, there is no way to freeze the perpetrator's account or to reverse the transaction.

It will be curious to see how governments respond to this currency. The United States Financial Crimes Enforcement Unit has released a guidance suggesting that Bitcoin exchangers and miners must be required to register as Money Service Businesses under the Bank Secrecy Act. Timothy Lee of Forbes says that these guidelines are actually positive for Bitcoin, as it signals that American regulators are not going to try to force Bitcoin to change or shut down. However, as with all decentralized peer-to-peer protocols, it will be virtually impossible to regulate the end user of the product.

While miners are wealth-producers, attempts to regulate them will likely fail because of the decentralization inherent in mining: there are numerous mining apps available and a large number of pools that users can join. With all these numerous avenues it will become unfathomably resource-intensive to monitor them all. When someone joins a pool, they are lending their resources to the pool and receive a pay-off when a block is mined based on the amount of processing power they contributed. Many of the mining pools are hosted in countries outside of the United States and there is a significant portion of blocks that have been mined by unknown sources; these factors combined would make regulation near impossible.

The Bitcoin is, without a doubt, fascinating.

Originally published in The Prince Arthur Herald.

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