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Bitcoin Goes Boom

Will the World's Favorite Cryptocurrency Explode or Implode?

It might not have been word of the year for 2013, but “Bitcoin” figured prominently in the shortlists. Known formerly only to true geeks, the mysterious cryptocurrency was in the news almost every day. Many of the stories were tales of riches gained and lost: a Norwegian student who discovered that the 5,600 bitcoins he purchased for $24 in 2009 were now worth $700,000; a British man who accidentally threw away a hard drive containing digital keys to bitcoins worth over $6 million. Others were tales of crime: websites where anonymous buyers could use bitcoins to buy drugs or even pool money for potential assassinations of public figures. And still others focused on attempts at regulating Bitcoin, which ranged from declaring it altogether illegal (Thailand) to embracing it wholeheartedly (Switzerland). 

Why all the fuss? Much of it has to do with Bitcoin’s pure novelty and its wild price fluctuations (from under $20 per bitcoin at the start of 2013 to a high of $1,203 in December to around $925 now). But above all, it is because Bitcoin is an extraordinary idea -- one whose ramifications no one can fully foresee. Its foundational premise is that monetary systems do not need a central government. Instead, Bitcoin relies on clever mathematics to ensure that everyone plays by the rules. In theory, at least, no one can control Bitcoin. And this means, of course, that nobody can tell Bitcoin users what they should and shouldn’t be spending their money on -- for good or for ill. That presents regulating agencies with difficult questions: Should they try to control Bitcoin? Can they control it? 

If all this sounds familiar, it should. The world faced these same questions in the early days of the Internet. Whether Bitcoin is more like AOL or Google, of course, is yet to be seen. Still, how governments choose to respond to it could change global finance for good.

Click here for the full infographic.

HOW IT WORKS

Bitcoins are sometimes called virtual cash. But a better analogy is to Rai stones, a currency historically used in Yap, an island in Micronesia. Yapese used large stone disks, up to 12 feet in diameter, to pay for big transactions. Difficult to move, however, Rai stones were often just left in their place. A person using his stone to pay someone else would publicly announce the transfer of the stone’s ownership. According to one anthropologist, a large stone once fell into ocean en route to the island. Rather than mourn the loss, the islanders continued to accept the stone as a valid form of payment, even though no one ever saw it again.

Bitcoin works like Rai stones hidden in the sea. The system allocates units of value, called bitcoins. Like a stone under the ocean, a bitcoin has no use other than as a form of payment. You can’t touch or see it. But it has value because people agree that it does and because its numbers are limited. Around 12 million bitcoins are currently in circulation. That number can grow only by around 25,000 bitcoins per week. Such guaranteed rarity, users expect, will ensure that bitcoins retain their worth.

All forms of money require the currency to be in limited supply. Sometimes the supply is limited by nature -- there is only so much gold in the world. Other times, we trust some authority to ensure it. The world relies on Washington, for example, to issue a limited supply of U.S. dollars and to punish anyone who puts out counterfeit ones. In Bitcoin's case, no centralized institutional backer is needed. It is neither a company nor an association. No one party is keeping track of account balances -- the participants do it collectively, aided by clever mathematics. The scheme is based on a paper published in 2008 under the pseudonym Satoshi Nakamoto, and a piece of software released by Nakamoto in 2009. (The software is open source -- anyone can inspect or modify it.) Nobody knows for sure who Nakamoto is, or even how many Nakamotos are out there. And nobody, not even Nakamoto, is fully in control. The system just proceeds by the rules defined in his paper, with rare modifications adopted by a consensus of users. The lack of centralized control makes regulating Bitcoin difficult -- and intentionally so.

The 12 million bitcoins now in existence are distributed among individual accounts. Much like the Yapese and their Rai, account holders do not physically hold any bitcoins. Rather, everyone knows how many coins belong to each account, based on the public history of transfers. To transfer bitcoins, one simply announces the transfer, naming the new account. Once the announcement is confirmed, the bitcoins are understood to belong to the new account. Although all Bitcoin transactions are public, the identity of account holders is not. All anyone knows are the account numbers involved in each transaction. This creates two challenges.

The first challenge is easy to understand: How does one know that an announcement was made by the true account holder without knowing who that owner is? Bitcoin solves this first problem with so-called digital signatures, a well-worn cryptographic technique that dates to the 1970s. Each public account number comes with a secret matching key -- essentially a long number that can be plugged into a mathematical formula to generate a confirmation code. The math behind this scheme allows others to verify the confirmation code without knowing the secret key. (However, if the owner of the account ever loses the secret key, as happened to the unlucky British man, then he or she can no longer transfer his or her bitcoins. In other words, the account holder still technically has the coins, but can never spend them.)

The second challenge is subtler: How do we prevent someone from gaming the system by falsifying the time stamps on his or her transfer announcements? One user could first announce a transfer of five bitcoins to a second user’s account in exchange for $5,000 in cash and then announce that he or she had transferred all of his or her bitcoins to a third account the day before. The second user would be tricked into paying for bitcoins from a now empty account. The problem of verifying the true time of an announcement without the aid of a trusted overseer has stumped computer scientists for years. If some computers record that they saw an announcement yesterday and others do not, which should one trust? Nakamoto’s paper finally solved the riddle with a clever combination of engineering and economics.

Bitcoin transaction announcements are recorded in so-called blocks, each block containing a record of transactions that happened in a span of roughly ten minutes. Every block ends with a mathematical puzzle. The next block must start with a solution to that puzzle to be considered valid. The resulting chain of puzzles forms an official history of all transactions.

Anyone can try to solve a puzzle. They are designed so that a computer using a simple program can figure out the answer, but only with a lot of trial and error. The difficulty of the puzzles is automatically adjusted so that, no matter how many computers are playing the game, someone hits the jackpot -- successfully “mining” a block -- roughly once every ten minutes. People who allow their computers to participate in this game are called miners. The lucky miner who is the first to solve the last block’s problem gets a prize, currently 25 bitcoins, worth a bit over $20,000. Those 25 bitcoins are generated out of thin air, so that the total number of bitcoins grows by 25 every 10 minutes.

Whoever generates the solution is also in charge of creating the next block, which includes a record of any transfers that were announced while miners’ computers were working on the last puzzle. Some of these transfer announcements will come with a small optional transaction fee -- a tip from the transferor to the miner who will record the transaction. (Miners can skip transactions. The tip helps ensure diligence.) The new block defines a new puzzle to be solved by the next block. And the cycle begins again.

This scheme makes it extremely difficult to forge the history of transactions: to do so, the fraudster would need to create an alternative history of puzzle-solution pairs, one for every ten-minute period. That would require staggering computing power. Not even Google’s data centers would be of much help in this task. 

Click here for the full infographic.

WHAT IS IT FOR?

There are many legitimate uses for Bitcoin. It offers a simple and secure payment method: the payer is fully in control of how much money is transferred and when, so there is no reason to worry about unauthorized charges or identity theft. In the last year, many companies -- including Overstock.com, Newegg, and, most recently, TigerDirect -- announced that they would start accepting bitcoins as payment. Wider adoption of Bitcoin could help put a dent in a fraud problem that costs merchants billions of dollars every year.

Bitcoin’s transparent and decentralized design also helps new players to enter the highly centralized and byzantine world of electronic payments and allows them to do things that would have been difficult otherwise. For example, a number of firms are starting to use Bitcoin for remittance payments, bypassing traditional gatekeepers and offering their services at a fraction of the rates charged by companies such as Western Union. (The global remittances to developing countries add up to hundreds of billions of dollars.) 

Yet not all of Bitcoin’s implications are positive. Its promise of anonymity also makes the currency very attractive for illegal transactions.

One famous example of this is Silk Road, an online marketplace for illegal drugs and stolen credit cards that has been in operation since 2011. Briefly shut down by U.S. law enforcement in 2013 (only to be relaunched a month later), Silk Road attracted media attention for openly flouting the law. Processing a little over a million dollars’ worth of illegal transactions every month, however, Silk Road represents a relatively meager sort of criminality. Bitcoin might also become a tool for large-scale money laundering. In other words, it could be used for transactions that are not illegal per se but that help disguise the origins of funds obtained through illegal activities. If Bitcoin can, in fact, deliver what it promises, international efforts to stamp out large-scale crime and corruption might take a serious hit.

Consider a typical large corruption scheme: A company wants to bribe an elected official with $10 million, in order to “win” a contract worth 50 times as much. Both parties want to make the deal, but how would they actually make the payment? It is hard to physically transfer $10 million in cash inconspicuously (over 200 pounds of paper in hundred-dollar bills). Wiring that much money is also risky. In recent years, many jurisdictions have started to require financial institutions to monitor their clients’ activities and alert authorities about anything considered suspicious. Such regulation often requires especially close monitoring of high-risk individuals such as current and former elected officials. People who engage in money laundering usually know that all of their transactions may be closely watched.

The most practical solution today involves sending the money through corporate vehicles, trusts, or nonprofit entities. The company offering the bribe sets up an offshore shell company, which then makes a wire transfer to a trust fund that names a person connected to the official (a family member or a friend) as a beneficiary. Such schemes can, indeed, tie up investigators but even they have become increasingly risky with the expansion of international anti-money-laundering and anticorruption regulation. 

Bitcoin promises a seemingly unbeatable solution: if the corrupt company can obtain $10 million worth of bitcoins, it can transfer those from their own anonymous account to one controlled by the corrupt official. Nobody would know where the money went. Not even the company that paid the bribe would be able to prove that the account into which it transfered bitcoins belongs to the official. And as long as the official was careful, the bribe could never be seized by the government or stolen.

In practice, of course, using bitcoins for such large bribes is not easy. One problem is the relatively small volume of dollar-to-bitcoin trade, which means that anyone attempting to make a large payment may have trouble doing so without adversely affecting the exchange rate. The fact that Bitcoin transactions are public also means that sophisticated analysis can undermine anonymity of users who do not take careful steps to cover their tracks. Nor can Bitcoin protect users from many traditional police tools, such as informants or sting operations. Finally, the volatility of the dollar-to-bitcoin exchange rate remains a major problem: within the last three months, the value of one bitcoin has oscillated between $200 and $1,200. (Those fluctuations, of course, also make it harder to use Bitcoin for many legitimate activities.) Such problems, however, may turn out to be much simpler than those presented by alternative money-laundering methods. And they could further dissipate with growing use of Bitcoin. As more people use the currency, the price will likely be more stable and exchanging large amounts would present less of a challenge.

IS IT GOOD?

With all Bitcoin’s potential for good and ill, it might well make sense to try to regulate it. But would that be possible? Bitcoin’s decentralized structure makes oversight difficult. The government cannot order Bitcoin to flag suspicious transactions, since it is not a legal entity but a network of participants, many of whom are anonymous. Of course, the same used to be said of the Internet, yet today, almost every country on the planet enforces rules for online conduct. And although people can sometimes get away with breaking the law online, the get caught quite often. Similarly, there are several ways for governments to cope with Bitcoin. These steps will not prevent every instance of wrongdoing, but they will make each more challenging.

The crudest approach would be to simply prohibit the use of Bitcoin and similar systems. (For example, the central banks of Iceland and Thailand have declared the use of Bitcoin software to be illegal in those countries, although neither country appears to be set on enforcing the ban.) Treating Bitcoin software as a criminal tool and punishing people for using or having it would deter many users. Sure, you might never get caught, but most people wouldn’t want the risk. The downside, of course, is that this would also eliminate any potential benefits of the legal uses of Bitcoin as well, such as security and low fees. After all, paper money is also a key tool of money laundering, yet governments do not ban it, recognizing the many conveniences that it offers.

A milder version of such prohibition would be to allow personal use but ban financial institutions from engaging in Bitcoin transactions, as China did in December 2013. This would not affect the use of Bitcoin for smaller crime but would put a dent in large-scale schemes. Again, however, it would also eliminate many of the currency's benefits. It is also worth remembering that no regulator can fully control today’s global finance sector. If the United States bans American banks from trading bitcoins, Swiss banks would be happy to take the extra customers. And if the United States manages to strong-arm Switzerland into the same regulatory regime, other countries will be standing in line.

Another solution would be to closely monitor Bitcoin transactions. Financial institutions could be asked to record all transactions involving Bitcoin and to report anything suspicious. Since the chain of Bitcoin transfers within the network is public, policing the endpoints of the system (where bitcoins are converted into traditional money, goods, or services) might make it possible to link any official offering a bribe to the one receiving it. For instance, the U.S. government announced in March 2013 that any financial institution issuing or exchanging virtual currencies would be subject to the same monitoring and reporting rules as regular financial institutions. And it has recently showed that it is serious about enforcing compliance. Such regulations may be quite effective in discouraging money laundering. Unfortunately, they may also endanger some legitimate uses: smaller companies might lack resources to implement the mandated tracking, leaving the market to the larger institutions that are less interested in pursuing innovative solutions based on Bitcoin. 

A subtler approach would be for the government to work with large Bitcoin players. Although Bitcoin was meant to be fully decentralized, in practice, most transactions today pass through a handful of accounts. Shutting them down might be ineffective, since new ones would take their place. Working with them, however, could be productive. Eager to maintain their current position, the large players may agree to self-regulate rather than decide to take a stand and risk a more heavy-handed response from the authorities. Such self-regulation could involve modifying the Bitcoin protocol to reduce anonymity. 

WHAT IT MEANS

Whatever the fate of Bitcoin, it is worth remembering that it is only the first (and the most well-known) of several distributed cryptocurrencies in existence today. Such alternatives range from the likes of Dogecoin, a cryptocurrency whose most notable difference from Bitcoin is the use of a whimsical dog logo, to Zerocoin, which promises a substantially higher degree of anonymity. Without a doubt, there will be many more in the coming months and years.

Different cryptocurrencies will likely find different uses. Those that allow for a large degree of oversight (perhaps through some form of self-regulation) might enter the mainstream. Others that make oversight exceptionally hard might be ideal for truly illegal activities but find themselves shut out of the mainstream as a result. And a range of cryptocurrencies operating between these extremes could come on the market.

Today, no one knows what Bitcoin and other cryptocurrencies will bring. The situation harks back to the early days of the Internet, when expectations for the new technology ranged from utter skepticism to wild pipe dreams. Cryptocurrencies are likely here to stay, although they might look very different two decades from now. Bitcoin could turn out to be the cryptocurrency equivalent of CompuServe or AOL -- revolutionary for its time, only to be forgotten later when a better technology emerged. Or it could turn out to be like Amazon.com, making the best of its first-mover’s advantage and dominating the industry for years. Cryptocurrencies will probably not bring about the libertarian rapture promised by some proponents -- but ignore them at your own peril.

Click here for the full infographic.

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