Bitcoin is an online payment system invented by Satoshi Nakamoto, who published the invention in 2008 and released it as an open-source software in 2009. Bitcoin allows users to send payments within a decentralized, peer-to-peer network and is unique in that it does not require a central clearing house or financial institution to clear transactions. Users must have an Internet connection and Bitcoin software to make payments to another public account/address.
In a Bitcoin transaction, there is no third-party intermediary. The buyer and seller interact directly (peer to peer), but their identities are encrypted, and no personal information is transferred from one to the other. However, unlike a fully anonymous transaction, there is a transaction record. A full transaction record of every bitcoin and every Bitcoin user's encrypted identity is maintained on the public ledger. For this reason, Bitcoin transactions are thought to be pseudonymous, not anonymous. Although the scale of Bitcoin use has increased substantially, it still remains small in comparison with traditional electronic payment systems, such as credit cards, and the use of dollars as a circulating currency.
Satoshi is the smallest unit of Bitcoin; 1 bitcoin contains 100 million satoshi. By design, the supply of bitcoins cannot exceed 21 million (2,100 trillion satoshi). The total amount of bitcoins in circulation will increase predictably, based on Bitcoin's underlying code, until it reaches the cap in 2140. The current supply is 12 million bitcoins, or 57 percent of the eventual total.
Bitcoin offers users the advantages of lower transaction costs, increased privacy, and long-term protection of loss of purchasing power from inflation. However, it also has a number of disadvantages that could hinder wider use. These include the sizable volatility of the price of bitcoins, the uncertain security from theft and fraud, and a long-term deflationary bias that encourages the hoarding of bitcoins.
Bitcoin is a protocol for exchanging value over the Internet without an intermediary. It is based on a public ledger system, known as the block chain, that uses cryptography to validate transactions. Bitcoin users gain access to their balance through a password known as a private key. Transactions are validated by a network of users called miners, who donate their computer power in exchange for the chance to gain additional bitcoins. There is a fixed supply of 21 million bitcoins that will be gradually released over time at a publicly known rate. There is no monetary authority that creates bitcoins. The capped supply of 21 million is known to all, and the rate of supply diminishes over time in a predictable way. As a store of value, this means that bitcoins are inherently deflationary. It also means that there is no government or central entity to make discretionary decisions about how much currency to create or to attempt to defend it through monetary policy.
To process a bitcoin-denominated transaction, Bitcoin verifies two facts addressed by current payment systems like PayPal or Visa. The first is that when User A transfers a bitcoin to User B, User A has a bitcoin to spend (i.e., prevention of counterfeiting). The second is that when User A transfers a bitcoin to User B, User A is not trying to transfer the same bitcoin to another user, User C, simultaneously (i.e., prevention of double spending).
As Bitcoin matures, an ecosystem of companies is emerging to support consumers and retailers in storing, exchanging, and accepting bitcoins for goods and services:
Banks and wallets store bitcoins for users either online or on storage devices not connected to the Internet, known as “cold storage.”
Exchanges provide access to the Bitcoin protocol by exchanging traditional currencies for bitcoins, and vice versa.
Payment processers support merchants in accepting bitcoins for goods and services.
Financial service providers support Bitcoin through insurance or Bitcoin-inspired financial instruments.
Bitcoin has three qualities that differentiate it from other currencies and payment systems. First, it is peer to peer, transferring value directly over the Internet through a decentralized network and without an intermediary. Current payment systems, like credit cards and PayPal, require an intermediary to validate transactions; Bitcoin does not. As a result, Bitcoin has been referred to as “Internet cash,” as it can be exchanged from person to person much like paper currency today.
Second, although Bitcoin is open, it is securely authenticated. Traditional payment systems rely on the privacy of transaction information to maintain security. For example, the compromise of a credit card transaction can result in the release of valuable information that can be used to conduct future transactions. In comparison, Bitcoin relies on cryptography. As every transaction is validated with cryptography by the network of miners, Bitcoin functions because of its openness, not despite it.
Third, Bitcoin is self-propelling. Bitcoin uses its own product, bitcoins, to reward or “pay” miners who are providing the computing power that serves as the engine of the transaction verification system. As a result, the system does not require the same type of overhead that traditional payment systems might require.
These three aspects are part of what drives Bitcoin's success, enabling a nearly frictionless global payment system.
The future of Bitcoin, or of similar crypto-currencies, is quite uncertain at best. It depends on the ability of the unit to replicate the functions of a currency. While Bitcoin may meet one characteristic of a currency, it does not meet most of the requirements needed for an account or a physical asset to become a stable currency.
See also Mobile Money; Money Laundering
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