Bitcoin

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Bitcoin is a decentralized digital currency created by developer Satoshi Nakamoto. It does not rely on a central server to process transactions or store funds. There are a maximum of 2,099,999,997,690,000 Bitcoin elements (called satoshis), which are currently most commonly measured in units of 100,000,000 known as BTC. Stated another way, no more than 21 million BTC can ever be created.

As of April 2014, it is the most widely used alternative currency,[1][2] now with the total market cap over 6 billion US dollars[3].

Bitcoin has no central issuer; instead, the peer-to-peer network regulates Bitcoins, transactions and issuance according to consensus in network software. Bitcoins are issued to various nodes that verify transactions through computing power; it is established that there will be a limited and scheduled release of no more than 21 million BTC worth of coins, which will be fully issued by the year 2140.

Internationally, Bitcoins can be exchanged and managed through various websites and software along with physical banknotes and coins.[4][5]

History

Main article: History

A cryptographic system for untraceable payments was first described by David Chaum in 1982.[6] In 1990 Chaum extended this system to create the first cryptographic anonymous electronic cash system.,[7] which became known as ecash. [8] In 1998 Wei Dai published a description of an anonymous, distributed electronic cash system which he called "b-money".[9] Around the same time, Nick Szabo created bit gold.[10][11] Like Bitcoin, Bit gold was a currency system where users would compete to solve a proof of work function, with solutions being cryptographically chained together and published via a distributed property title registry. A variant of Bit gold, called Reusable Proofs of Work, was implemented by Hal Finney.[11]

In 2008, Satoshi Nakamoto published a paper[12][13] on The Cryptography Mailing list at metzdowd.com[14] describing the Bitcoin protocol.

The Bitcoin network came into existence on 3 January 2009 with the release of the first Bitcoin client, wxBitcoin, and the issuance of the first Bitcoins.[15][16][17] A year after, the initial exchange rates for Bitcoin were set by individuals on the bitcointalk forums.[citation needed] The most significant transaction involved a 10,000 BTC pizza.[18] Today, the majority of Bitcoin exchanges occur on the Bitstamp Bitcoin exchange.[19]

In 2011, Wikileaks,[20] Freenet,[21] Singularity Institute,[22] Internet Archive,[23] Free Software Foundation[24] and others, began to accept donations in Bitcoin. The Electronic Frontier Foundation did so for a while but has since stopped, citing concerns about a lack of legal precedent about new currency systems, and because they "generally don't endorse any type of product or service."[25] Some small businesses had started to adopt Bitcoin. LaCie, a public company, accepts Bitcoin for its Wuala service.[26]

In 2012, BitPay reports of having over 1000 merchants accepting Bitcoin under its payment processing service.[27]

Administration

Bitcoin is administered through a decentralized peer-to-peer network.[12] Cryptographic technologies and the peer-to-peer network of computing power enables users to make and verify irreversible, instant online Bitcoin payments, without an obligation to trust and use centralized banking institutions and authorities. Dispute resolution services are not made directly available. Instead it is left to the users to verify and trust the parties they are sending money to through their choice of methods.

Bitcoins are issued according to rules agreed to by the majority of the computing power within the Bitcoin network. The core rules describing the predictable issuance of Bitcoins to its verifying servers, a voluntary and competitive transaction fee system and the hard limit of no more than 21 million BTC issued in total.[12]

Bitcoin does not require a central bank, State,[28] or incorporated backers.

Services

Main article: Wallet

Bitcoins are sent and received through software and websites called wallets. They send and confirm transactions to the network through Bitcoin addresses, the identifiers for users' Bitcoin wallets within the network.[12]

Bitcoin addresses

Main article: Address

Payments are made to Bitcoin "addresses": human-readable strings of numbers and letters around 33 characters in length, always beginning with the digit 1 or 3, as in the example of 31uEbMgunupShBVTewXjtqbBv5MndwfXhb.

Users obtain new Bitcoin addresses from their Bitcoin software. Creating a new address can be a completely offline process and require no communication with the Bitcoin network.

Transaction fees

Main article: Transaction fees

Transaction fees may be included with any transfer of Bitcoins. As of 2012 many transactions are processed in a way which makes no charge for the transaction. For transactions which consume or produce many coins (and therefore have a large data size), a small transaction fee is usually expected.

Confirmations

Main article: Confirmation

The network's software confirms a transaction when it records it in a block. Further blocks of transactions confirm it even further. After six confirmations/blocks, a transaction is confirmed beyond reasonable doubt.

The network must store the whole transaction history inside the blockchain, which grows constantly as new records are added and never removed. Nakamoto conceived that as the database became larger, users would desire applications for Bitcoin that didn't store the entire database on their computer. To enable this, the blockchain uses a merkle tree to organize the transaction records in such a way that client software can locally delete portions of its own database it knows it will never need, such as earlier transaction records of Bitcoins that have changed ownership multiple times.

Economics

Initial distribution

Bitcoin has no centralized issuing authority.[29][30][31] The network is programmed to increase the money supply as a geometric series until the total number of Bitcoins reaches 21 million BTC.[1] As of October 2012 slightly over 10 million of the total 21 million BTC had been created; the current total number created is available online.[32] By 2013 half of the total supply will have been generated, and by 2017, three-quarters will have been generated. To ensure sufficient granularity of the money supply, clients can divide each BTC unit down to eight decimal places (a total of 2.1 × 1015 or 2.1 quadrillion units).[33]

The network as of 2012 required over one million times more work for confirming a block and receiving an award (25 BTC as of February 2012) than when the first blocks were confirmed. The difficulty is automatically adjusted every 2016 blocks based on the time taken to find the previous 2016 blocks such that one block is created roughly every 10 minutes.

Those who chose to put computational and electrical resources toward mining early on had a greater chance at receiving awards for block generations. This served to make available enough processing power to process blocks. Indeed, without miners there are no transactions and the Bitcoin economy comes to a halt.

Exchange rate

Prices fluctuate relative to goods and services more than more widely accepted currencies; the price of a Bitcoin is not static.

In August 2012, 1 BTC traded at around $10.00 USD. Taking into account the total number of Bitcoins mined, the monetary base of the Bitcoin network stands at over 110 million USD.[34]

Security

Main article: Weaknesses

In the history of bitcoin, there have been a few incidents, caused by problematic as well as malicious transactions. In the worst such incident, and the only one of its type, a person was able to pretend that he had a practically infinite supply of bitcoins, for almost 9 hours.

Bitcoin relies, among other things, on public key cryptography and thus may be vulnerable to quantum computing attacks if and when practical quantum computers can be constructed.

If multiple different software packages, whose usage becomes widespread on the Bitcoin network, disagree on the protocol and the rules for transactions, this could potentially cause a fork in the block chain, with each faction of users being able to accept only their own version of the history of transactions. This could influence the price of bitcoins.

A global, organized campaign against the currency or the software could also influence the demand for bitcoins, and thus the exchange price.

Bitcoin mining

Main article: Mining

Bitcoin mining nodes are responsible for managing the Bitcoin network.

Bitcoins are awarded to Bitcoin nodes known as "miners" for the solution to a difficult proof-of-work problem which confirms transactions and prevents double-spending. This incentive, as the Nakamoto white paper describes it, encourages "nodes to support the network, and provides a way to initially distribute coins into circulation, since no central authority issues them."[12]

Nakamoto compared the generation of new coins by expending CPU time and electricity to gold miners expending resources to add gold to circulation.[12]

Node operation

The node software for the Bitcoin network is based on peer-to-peer networking, digital signatures and cryptographic proof to make and verify transactions. Nodes broadcast transactions to the network, which records them in a public record of all transactions, called the blockchain, after validating them with a proof-of-work system.

Satoshi Nakamoto designed the first Bitcoin node and mining software[35] and developed the majority of the first implementation, Bitcoind, from 2007 to mid-2010.[36]

Node implementations include core software such as Bitcoind/Bitcoin-Qt, libbitcoin, cbitcoin[37] and bitcoinj.[38][39]

Every node in the Bitcoin network collects all the unacknowledged transactions it knows of in a file called a block, which also contains a reference to the previous valid block known to that node. It then appends a nonce value to this previous block and computes the SHA-256 cryptographic hash of the block and the appended nonce value. The node repeats this process until it adds a nonce that allows for the generation of a hash with a value lower than a specified target. Because computers cannot practically reverse the hash function, finding such a nonce is hard and requires on average a predictable amount of repetitious trial and error. This is where the proof-of-work concept comes in to play. When a node finds such a solution, it announces it to the rest of the network. Peers receiving the new solved block validate it by computing the hash and checking that it really starts with the given number of zero bits (i.e., that the hash is within the target). Then they accept it and add it to the chain.

Mining rewards

In addition to receiving the pending transactions confirmed in the block, a generating node adds a generate transaction, which awards new Bitcoins to the operator of the node that generated the block. The system sets the payout of this generated transaction according to its defined inflation schedule. The miner that generates a block also receives the fees that users have paid as an incentive to give particular transactions priority for faster confirmation.

The network never creates more than a 50 BTC reward per block and this amount will decrease over time towards zero, such that no more than 21 million BTC will ever exist.[33] As this payout decreases, the incentive for users to run block-generating nodes is intended to change to earning transaction fees.

Mining pools

Main article: Pooled mining

Bitcoin users often pool computational effort to increase the stability of the collected fees and subsidy they receive.[40]

Mining difficulty

Main article: Difficulty

In order to throttle the creation of blocks, the difficulty of generating new blocks is adjusted over time. If mining output increases or decreases, the difficulty increases or decreases accordingly.

The adjustment is done by changing the threshold that a hash is required to be less than. A lower threshold means fewer possible hashes can be accepted, and thus a higher degree of difficulty. The target rate of block generation is one block every 10 minutes, or 2016 blocks every two weeks. Bitcoin changes the difficulty of finding a valid block every 2016 blocks, using the difficulty that would have been most likely to cause the prior 2016 blocks to have taken two weeks to generate, according to the timestamps on the blocks. Technically, this is done by modeling the generation of Bitcoins as Poisson process. All nodes perform and enforce the same difficulty calculation.

Difficulty is intended as an automatic stabilizer allowing mining for Bitcoins to remain profitable in the long run for the most efficient miners, independently of the fluctuations in demand of Bitcoin in relation to other currencies.

Mining hardware

Main article: Mining Hardware Comparison

Bitcoins used to be mined through Intel/AMD CPUs. As of 2012, mining has gradually moved to GPU and FPGA hardware.[41] ASIC-based hardware for Bitcoin mining has been announced by several manufacturers who intend to ship products from late 2012 to early 2013.[41]

Concerns

As an investment

Bitcoin describes itself as an experimental digital currency. Reuben Grinberg has noted that Bitcoin's supporters have argued that Bitcoin is neither a security or an investment because it fails to meet the criteria for either category.[42] Although it is a virtual currency, some people see it as an investment[43] or accuse it of being a form of investment fraud known as a Ponzi scheme.[44][45] A report by the European Central Bank, using the U.S. Securities and Exchange Commission's definition of a Ponzi scheme, found that the use of bitcoins shares some characteristics with Ponzi schemes, but also has characteristics of its own which contradict several common aspects of Ponzi schemes.[46]

Privacy

Because transactions are broadcast to the entire network, they are inherently public. Unlike regular banking,[47] which preserves customer privacy by keeping transaction records private, loose transactional privacy is accomplished in Bitcoin by using many unique addresses for every wallet, while at the same time publishing all transactions. As an example, if Alice sends 123.45 BTC to Bob, the network creates a public record that allows anyone to see that 123.45 has been sent from one address to another. However, unless Alice or Bob make their ownership of these addresses known, it is difficult for anyone else to connect the transaction with them. However, if someone connects an address to a user at any point they could follow back a series of transactions as each participant likely knows who paid them and may disclose that information on request or under duress.

It can be difficult to associate Bitcoin identities with real-life identities.[48] This property makes Bitcoin transactions attractive to sellers of illegal products.[49][50]

Illicit use

Cracking

The cracking organization "LulzSec" accepted donations in Bitcoin, having said that the group "needs Bitcoin donations to continue their hacking efforts".[51][52]

Silk Road

Silk Road is an anonymous black market that uses only the Bitcoin.[53]

In a 2011 letter to Attorney General Eric Holder and the Drug Enforcement Administration, senators Charles Schumer of New York and Joe Manchin of West Virginia called for an investigation into Silk Road and the Bitcoin.[53] Schumer described the use of Bitcoins at Silk Road as a form of money laundering.[29]

Botnet mining

In June 2011, Symantec warned about the possibility of botnets engaging in covert "mining" of Bitcoins,[54][55] consuming computing cycles, using extra electricity and possibly increasing the temperature of the computer. Later that month, the Australian Broadcasting Corporation caught an employee using the company's servers to generate Bitcoins without permission.[56] Some malware also uses the parallel processing capabilities of the GPUs built into many modern-day video cards.[57] In mid August 2011, Bitcoin miner botnets were found;[58] trojans infecting Mac OS X have also been uncovered.[59]

Theft and fraud

On 19 June 2011, a security breach of the Mt.Gox (an acronym for Magic: The Gathering Online Exchange, its original purpose) Bitcoin Exchange caused the price of a Bitcoin to briefly drop to US$0.01 on the Mt.Gox exchange (though it remained unaffected on other exchanges) after a hacker allegedly used credentials from a Mt.Gox auditor's compromised computer to illegally transfer a large number of Bitcoins to him- or herself and sell them all, creating a massive "ask" order at any price. Within minutes the price rebounded to over $15 before Mt.Gox shut down their exchange and canceled all trades that happened during the hacking period.[60][61] The exchange rate of Bitcoins quickly returned to near pre-crash values.[62][63][64][65] Accounts with the equivalent of more than USD 8,750,000 were affected.[62]

In July 2011, The operator of Bitomat, the third largest Bitcoin exchange, announced that he lost access to his wallet.dat file with about 17,000 BitCoins (roughly equivalent to 220,000 USD at that time). He announced that he would sell the service for the missing amount, aiming to use funds from the sale to refund his customers.[66]

In August 2011, MyBitcoin, one of popular Bitcoin transaction processors, declared that it was hacked, which resulted in it being shut down, with paying 49% on customer deposits, leaving more than 78,000 BitCoins (roughly equivalent to 800,000 USD at that time) unaccounted for.[67][68]

In early August 2012, a lawsuit was filed in San Francisco court against Bitcoinica, claiming about 460,000 USD from the company. Bitcoinica was hacked twice in 2012, which led to allegations of neglecting the safety of customers' money and cheating them out of withdrawal requests.[69][70]

In late August 2012, Bitcoin Savings and Trust was shut down by the owner, allegedly leaving around $5.6 million in debts; this led to allegations of the operation being a Ponzi scheme.[71][72][73][74] In September 2012, it was reported that U.S. Securities and Exchange Commission has started an investigation on the case.[75]

In September 2012, Bitfloor Bitcoin exchange also reported being hacked, with 24,000 BitCoins (roughly equivalent to 250,000 USD) stolen. As a result, Bitfloor suspended operations.[76][77] The same month, Bitfloor resumed operations, with its founder saying that he reported the theft to FBI, and that he is planning to repay the victims, though the time frame for such repayment is unclear.[78]

Taxation

In September 2012, the Intra-European Organization of Tax Administrations (IOTA), in Tbilisi, Georgia, held a workshop titled "Auditing Individuals and Legal Entities in the Use of e-Money." The workshop was attended by representatives from 23 countries.[79] Jerry Taylor, IOTA's technical taxation expert, said, "There's an awful lot happening on the Internet environment which is fascinating at the moment and introducing new challenges for auditors when it comes to virtual currency."[79] Bitcoin was mentioned during the workshop.[79]

Matthew Elias, founder of the Cryptocurrency Legal Advocacy Group (CLAG) published "Staying Between the Lines: A Survey of U.S. Income Taxation and its Ramifications on Cryptocurrencies", which discusses "the taxability of cryptocurrencies such as bitcoin."[79] CLAG "stressed the importance for taxpayers to determine on their own whether taxes are due on a bitcoin-related transaction based on whether one has "experienced a realization event."[79] Such examples are "when a taxpayer has provided a service in exchange for bitcoins, a realization event has probably occurred, and any gain or loss would likely be calculated using fair market values for the service provided."[79]

Peter Vessenes, Bitcoin Foundation's executive director, said, since the foundation is trying to pay for everything in bitcoin, including salaries, "How do we W-2 someone for their bitcoins? Do we mark-to-market every time a transfer happens? Payroll companies cringe."[79] The Bitcoin Foundation hopes "to push for solid guidance about its legal and tax treatment." Patrick Murck, legal counsel for the Bitcoin Foundation, said he would like "to help regulators understand the technology better so they can make better decisions."[79] Murck said, "Bitcoin has the potential to become much more than a niche currency, but it needs the guidance and understanding of regulators." and "The full potential of bitcoin could be realized through clearer guidelines and a better understanding by financial and tax regulators." and "Part of making that happen is to talk to regulators, the IRS, and tax professionals and helping them understand that bitcoin is not this nefarious thing, it's just software, it's a community, and there's nothing inherently nefarious about either of those things."[79]

See Also

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