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Bitcoin: Cryptography and the Crowd

Direct democracy from a geek’s perspective. Image: TraderTim/flickr

Bitcoin is the world’s first decentralized, digital currency. Its extraordinary performance over the last half year has caused quite some stir, not only among ‘cyber geeks’. Users and supporters see Bitcoin as a technological breakthrough and expect its spending possibilities to increase as exponentially as its price. Meanwhile, critics point to many of these same characteristics as flaws. They are waiting for the bubble to burst, calling it a structurally flawed experiment.

How it works: This video – made possible with donations from the Bitcoin community– explains the basic idea behind the new currency:

To acquire Bitcoins, users can buy them on a trading platform or become ‘miners.’ The latter requires hardware and electricity – both usually purchased with conventional money.

What sets Bitcoin apart from other currencies is the way it is administrated: Bitcoin isn’t backed by any government or other legal entity, nor does it have a central clearing house that sets the rules and checks transactions. The entire system is underwritten by a peer-to-peer network and relies on self-policing by its members. While such control-mechanisms have proven successful in the past, most people still prefer to devolve this sort of responsibility to the authorities – be it due to a lack of trust or for ideological considerations.

Bitcoin users remain partially anonymous and their accounts cannot be frozen, hence many fear that the system provides a gateway to illegal activities. While most will agree that facilitating money laundering or drug businesses shouldn’t have a place in any monetary system, opinions regarding the financing of organizations such as Wikileaks are deeply divided*.

Bitcoin’s predictable and decreasing rate of creation is another point of contention. This is supposed to keep a lid on inflation and goes down particularly well with those opposing interventionist monetary policy: no authority can play with the value of the currency by manipulating its supply. Critics, on the other hand, say that the decreasing rate of money creation over time automatically entails growth-inhibiting deflation and is designed to reward early adaptors. (Ironically, this argument is based on the assumption that Bitcoin is successful.)

As with any other currency, Bitcoin’s future value and persistence depend on institutional arrangements and on the level of trust people put in those arrangements. The system is technically sophisticated and — because of its open-source character — may even be safer from cybercrime than traditional financial institutions. But this doesn’t change the fact that ordinary users have trouble trusting an unprecedented system that they cannot personally assess. At the end of the day, many feel uncomfortable putting their hard-earned savings into a system that relies on cryptography and the crowd. Regardless of how the story continues, Bitcoin has sparked a renewed debate about what makes a good monetary system in a globalized world. One could only wish that some of the more established practices within the current financial system would undergo similar scrutiny.

* See Grinberg, Reuben for a preliminary discussion of legal issues surrounding Bitcoin.

5 Responses to “Bitcoin: Cryptography and the Crowd”

  1. Although the thinking behind the bitcoin currency is valid, it does suffer a weakness in the storage.

    This becomes apparent in the first robbery involving bitcoins, as reported by PC World:

    The weak point here is the security of the user’s computer which would in most cases be less secure than a bank’s IT.

    Up to date, no solution for this is in sight.

  2. @Marcus – actually there is a very good solution. There are online wallet services, where users can keep their bitcoins stored safetly with various providers, just as you do now with a bank. If you’re worried about your own PC’s security, then it’s a great option. Certainly some of these online wallet services will be attacked as well, but they will strengthen and evolve over time as the market demands security.

  3. @Marcus, @Erik: Although the option is not built into the standard client, using a live CD system which records nothing on disk, you can create a bitcoin address and print the details required to spend the money on paper and turn the computer off. Then you can receive bitcoins by publishing the address, while to spend them, you would have to type the data in from the paper. Lock the paper up in a safe deposit box, and your bitcoins are secure. Adjust the procedure to fit your requirements.

  4. Dude left 500k in his WALLET unencrypted and on an insecure machine…like in the “real” world, there are pickpockets.

    The “heist” only proves the value of bitcoin

  5. New research suggest that bitcoins are not completely anonymous: