What is Bitcoin?

Update 20 June 2011: Bitcoin suffers its first large crisis, as hackers steal virtual encrypted coin and cause a dramatic plunge in Bitcoin value

What Is Bitcoin?
Bitcoin is a peer-to-peer currency. Peer-to-peer means that no central authority issues new money or tracks transactions. These tasks are managed collectively by the network.

Bitcoin is an encrypted "anonymous" digital currency placed online, beyond the whim and caprice of greedy governments and their corrupt co-conspirators. An anonymous marketplace, where almost anything could be bought or sold, is the dream of free marketeers across time and space. Perhaps Bitcoin will pave the way to this nirvana of free marketdom. More about Bitcoin:

Bitcoin—a pseudonymous cryptographic currency designed by an enigmatic, freedom-loving hacker, and currently used by the geek underground to buy and sell everything from servers to cellphone jammers. No, this isn't a cyberpunk artifact from Snow Crash or Neuromancer; it's a real currency currently valued several times higher than the US dollar, the British pound, and the Euro.

Bitcoin is a virtual currency, designed to allow people to buy and sell without centralized control by banks or governments, and it allows for pseudonymous transactions which aren't tied to a real identity. In keeping with the hacker ethos, Bitcoin has no need to trust any central authority; every aspect of the currency is confirmed and secured through the use of strong cryptography.

Over the last few months, Bitcoin's value has risen by an order of magnitude as the sagas of Wikileaks and Anonymous (among others) have highlighted the limits of a financial system which relies on centralized intermediaries. With a current estimated market capitalization of about $100 million, Bitcoin has recently graduated from a theoretical techno-anarchic project patronized by libertarians and hackers to a full-fledged currency prompting comment from technologists and economists. At the time of this writing, one Bitcoin (BTC) is worth about US$15.

...The Bitcoin solution uses cryptography and an open transaction register. Whenever you spend a Bitcoin, you cryptographically sign a statement saying that you have transferred the coin to a new owner and you identify the new owner by their public crypto key. Whenever they need to spend the coin, the new owner uses his private key to sign it over to some further owner. As soon as a transaction takes place, the recipient (who has a very strong incentive to ensure that you don't spend the coin twice) publishes the transaction to the global Bitcoin network. Now every Bitcoin user has incontrovertible evidence that the coin has been spent, and users won't accept that coin from anyone but the new owner.

...In a process known as mining, individual Bitcoin users attempt to generate new coins by checking the integrity of the transactions list. They confirm the previous transactions and attempt to solve a difficult proof-of-work problem which involves exhaustively trying different solutions. There are a very large number of such potential solutions, so the likelihood of finding the solution depends how many other people are looking for it and how much computing power you devote to the problem. The first client to find the solution announces its good fortune to the whole network and earns a little reward for itself in the form of some shiny new Bitcoins. _ArsTecnica

One new marketplace taking advantage of Bitcoin's anonymity is Silk Road.

Silk Road, a digital black market that sits just below most internet users’ purview, does resemble something from a cyberpunk novel. Through a combination of anonymity technology and a sophisticated user-feedback system, Silk Road makes buying and selling illegal drugs as easy as buying used electronics — and seemingly as safe. It’s Amazon — if Amazon sold mind-altering chemicals.

Here is just a small selection of the 340 items available for purchase on Silk Road by anyone, right now: a gram of Afghani hash; 1/8 ounce of “sour 13″ weed; 14 grams of ecstasy; .1 gram tar heroin. A listing for “Avatar” LSD includes a picture of blotter paper with big blue faces from the James Cameron movie on it.

The sellers are located all over the world, a large portion from the United States and Canada. _Wired

Silk Road accepts Bitcoin as payment, and is accessible only via the Tor network of anonymous proxy servers.

More about Silk Road from Kevin Kelly:

Silk Road is all of four weeks old, so its stealthiness is unproven. In theory it looks viable. But Tor and Bitcoin are open source, so the savvy can see what they are standing upon. But there are inherent challenges with any private currency, and there are inherent challenges with any encryption scheme. At the point where either of these systems touch the legitimate world (and they must to be useful), there is potential for breakdown, scams, break-in, or disruptions.

Bitcoin in particular has serious complexities. It is a private currency, and all private currencies are liable to scams. But an anonymous peer-to-peer one is even more liable, because there is no central enforcement -- by definition. The technicalities of Bitcoin are impressive, complex, and almost beyond the understanding for most lay users. For a sobering critique of Bitcoin, I recommend reading at least one skeptic's take on it before you decide to use it. His argument is that the way Bitcoin is engineered makes it biased towards the earliest users (the value of their "dollars" will increase more than later users) and is therefore a type of pyramid scam. That is a long-term consideration; this deflation probably will not deter a kid who wants to score some speed this week.

And the critique says nothing of the potential weaknesses of Bitcoin's encryption aspect. Usually these cypher schemes are not broken directly, but indirectly via patterns of use. As the cypherpunks say, encryption is economics. Anything can be hacked if you apply enough money. As long as the amount of money in these stealth markets remains modest, they will be secure. But once they rise to some threshold, they will trigger investments into cracking them. Perhaps bit traffic is analyzed network wide, or honey pot sellers rated high by shills set up to pounce on the unsuspecting -- whatever. _KevinKelly

The economic arms war between governments and free marketeers is as old as organised human society. Anonymous online versions of digital currency are likely to take the contest to a new level, as government enforcers devote ever more time and tax resources to stamping out the competition and incorrigible independent minded.

What is Bitcoin?

Previously published at Al Fin, The Next Level