|A Bitcoin ATM|
Unlike the American dollar or British pound – which are guaranteed by central banks that set interest rates and print currency, stabilizing their value – bitcoin is decentralized. No one controls it. In part for that reason, its value has yo-yoed wildly. After more than quadrupling against the dollar between January and August 2017, bitcoin fell by a third in the first two weeks of September. Some blamed...
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...a crackdown on digital currencies in China and the “fraud” comments from J.P. Morgan Chase CEO Jamie Dimon, who compared bitcoin to the Dutch tulip bubble of the 17th century. Yet as Fortune magazine noted, bitcoin meltdowns have been a regular feature of its brief lifetime.
This volatility makes it unlikely bitcoin (or another cryptocurrency, such as ethereum) will become an effective store of value (like gold) or a unit of account (like the dollar) anytime soon. You wouldn’t want to be paid in bitcoin, since your real (i.e., dollar-denominated) salary would fluctuate all over the place. And you wouldn’t want to spend bitcoin today if you think it’d be worth a lot more tomorrow.
In this explainer, we discuss what makes bitcoin different from the old-fashioned greenback and why some governments are trying to ban it. We describe how the blockchain technology behind the system could revolutionize many other industries. And we look at how a bitcoin outgrowth known as initial coin offerings (ICOs) is testing regulators.
How bitcoin works
Any bitcoin transaction – let’s say between a buyer (me) and a seller (the London Sushi Workshop) – creates a unique digital code that is stored in an online, open ledger known as a blockchain. Everyone has access to the blockchain, but no one can see who those buyers and sellers are unless they wish to be identified. Each has a unique, pseudonymous address for the transaction.
The London Sushi Workshop’s balance, which has grown because I paid my tuition, is a series of codes, also known as personal keys. The sushi school can keep them in “cold storage” – offline on something like a USB stick – or print them out. Or the school can keep them in something called a “wallet,” which is run by an online third party and, just like your physical wallet, can be stolen (or in this case hacked). When the London Sushi Workshop wants to convert bitcoins to dollars or pounds, it can make the transaction through an online exchange (also third parties, which have likewise been hacked, resulting in losses for individuals) and transfer the cash to a bank account.
This decentralization puts bitcoin beyond the reach of regulators, but also creates risks. Third parties in the “wallet” or “exchange” businesses do not offer the kind of insurance you get at a bank. And, like with cash, if you print your bitcoin codes and stash them under your bed, you run the risk of losing all in a fire or robbery.
Blockchain and mining
An anonymous programmer calling himself Satoshi Nakamoto introduced bitcoin in a 2008 paper. The widely cited paper may be best remembered for something else, though: Nakamoto also introduced the first working blockchain, the technology underpinning bitcoin.
Blockchain is an online ledger of all transactions that’s available for anyone to view and copy, but that no one individual controls. Instead, it lives on many computers, where it is constantly updating itself. This decentralization and openness ensure a transaction can’t be faked – because that transaction wouldn’t appear on all the other copies of the ledger. If one copy of the ledger does not match the rest, that copy will stand out. Thus blockchain is sometimes called a “distributed ledger” or “distributed ledger technology” (including by J.P. Morgan Chase, which is researching how to use it).
For the bitcoin blockchain, powerful computer networks called “miners” validate the most recent transfers, ensuring someone doesn’t send money they don’t have. These miners’ computers compete with one another to verify and then lock the transfers onto the ledger, where they never can be changed, adding a new block of confirmed transactions about every 10 minutes.
As an incentive for constantly checking and verifying bitcoin transactions, the miner that succeeds in creating a new block is rewarded in new bitcoins that he has created. These days, the reward is 12.5 bitcoins and there are about 16.5 million bitcoins in circulation (worth, as of this writing, about $65 billion in U.S. dollars). By design, the reward drops by half about every four years until, sometime a few decades from now, the miners have created 21 million bitcoins. The creator artificially capped bitcoin at that number, ensuring the currency cannot be debased by oversupply; the coins can, of course, be divided into smaller and smaller units.
Because the database is distributed across such a broad network, hacking it would require enormous computing power. Any would-be fraudsters with that much computing muscle would find it more profitable to mine the blockchain and create new bitcoins.
The blockchain solves the “double-spending problem” that plagued earlier cryptocurrencies, whereby someone could spend the same money in two places (or counterfeit it). Today, sending the same bitcoins to two different sellers would create a “fork” in the blockchain, immediately rendering one of the transactions invalid.
Likewise, it’s not possible to alter a transaction record. To go back and change a link in the chain, you’d have to change all the links that follow. That would require more computer power than all the computers that are managing the blockchain put together. The altered chain wouldn’t match; it would be a clear counterfeit.
These days, miners often work with specialized computer farms that use loads of electricity; sometimes they share resources to form “mining pools.” You could run a mining application in the background of your work computer, but it likely wouldn’t net you anything besides a slower computer. (Check out this Quartz feature on a farm using subsidized, coal-powered electricity in China, which is home to 58 percent of the world’s major mining pools, according to a University of Cambridge study; the U.S., the second-largest host, has 16 percent.)
The promise of blockchain
Some researchers see blockchain as having revolutionary applications beyond bitcoin, such as trading stocks, safely storing data and managing supply chains, all without a middleman. It is a “foundational” technology, argues a 2017 paper by two Harvard Business School professors, with the potential – perhaps in decades – to render accountants, traders and even contract lawyers superfluous. Blockchain “has the potential to become the system of record for all transactions. If that happens, the economy will once again undergo a radical shift, as new, blockchain-based sources of influence and control emerge.”
Initial coin offerings
A new trend in cryptocurrencies is the “initial coin offering,” or ICO. ICOs raised $2.2 billion in the first nine months of 2017, according to one industry estimate. These are not bitcoins, but essentially a new digital currency used to fund a specific product.
ICOs work like this: A company raises capital by selling virtual coins or tokens. Perhaps these coins could be used later to participate in the project, or they offer some other future reward. But they do not offer the same rights demanded by a venture capitalist or shareholder. Indeed, though they sound suspiciously similar, an ICO is not an IPO – initial public offering (which is when a company begins selling shares to the public and becomes listed somewhere like the New York Stock Exchange). Rather, ICOs happen well outside the regulated banking industry and governments fear they encourage risky speculation.
The Securities and Exchange Commission (SEC) – the regulator of U.S. financial assets – has warned investors that some ICOs may constitute fraud, and that some coins may in fact function like securities and need to be regulated as such. Canada’s securities regulator has issued a similar statement.
Governments don’t like bitcoin much. Its anonymity allows users to operate in the shadows, sell narcotics, capitalize on ransomware (software that hijacks a computer until the owner pays a ransom in a cryptocurrency) and maybe, some fear, finance terrorists.
Plus, there are tax implications. In most countries, citizens are required to pay taxes on earnings. But the taxman can’t peer into your bitcoin holdings the way he can look at your Bank of America statement (though, by law, Americans are required to pay taxes on bitcoin profits).
And finally, cryptocurrencies undermine government authority. North Korea may be using bitcoin to evade sanctions.
In September 2017, China took steps to ban cryptocurrency transactions shortly after banning new ICOs. After both announcements, bitcoin’s value tumbled.
Bitcoin believers argue that the community can regulate itself. But Tim Swanson, a scholar of cryptocurrencies at the Singapore University of Social Sciences, wrote on his blog in September 2017 that the idea the cryptocurrency community can police itself ignores its users’ self-interested motivations. Some users, trying to drum up demand, discount the threat posed by hackers (who exploit weaknesses in third-party systems used to store bitcoin). Others lobby against regulations because “much of the original bitcoin infrastructure was set up and co-opted by bitcoiners themselves, some of whom were bad actors from day one.”
A cat-and-mouse game between regulators and bitcoiners seems likely to occupy both communities, as well as scholars and governments, for the foreseeable future. Proposals for an outright ban are unlikely to end the conversation, since, to work, any ban would require harsh punishments, says a 2017 paper in the Journal of Economic Behavior and Organization.
One potential solution is for governments to issue their own cryptocurrencies. A September 2017 report from the Bank for International Settlements – the Basel-based arbiter for central banks – describes some projects in the works. Sweden, for example, is thinking about using blockchain technology in some of its central bank’s currency-trading infrastructure. In America, some have proposed “Fedcoin” as a government-backed crypto-dollar. Though Fedcoin may attract users, it is unlikely, suggests one American central banker, to satisfy diehard bitcoiners.
Because there is no official organization or bank behind bitcoin, this explainer referenced a number of community forums for data, such as bitcoin.org and the Bitcoin Foundation, which the Washington Post once described as the “closest thing the anarchic bitcoin community has to an official public face.”
The Initiative for Cryptocurrencies and Contracts at Cornell University publishes some of the most cutting-edge research.
This blogpost by freeCodeCamp is a fun and easy-to-follow bitcoin explanation.
Oh and, by the way, the bitcoin blockchain occasionally splits. Fortune explains. Fortune’s blockchain reporter, Jeff John Roberts, also has an intriguing look at what happens to your bitcoins when you die.
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A good overview of bitcoin, who uses it, who mines it and where, is this 2017 paper from the University of Cambridge Center for Alternative Finance.
- On bitcoin volatility:
- On security: