The Innovation of Bitcoin: How Does It Really Work?

Exchange of goods and services happens every day around the world. Here are two scenarios in which it may occur.

1. The Middleman

I have an orange, and you want my orange. We agree that you can have my orange if you wash my car. You wash my car, and I give my orange to a stranger along with a dollar bill. That stranger hands the orange to you and keeps the dollar. You have been paid your one orange and the stranger has been paid a dollar for being the middleman in our transaction. This is how most of our monetary transactions currently happen.

2. Peer Exchange

I have an orange, and you want my orange. We agree that you can have my orange if you wash my car. You wash my car, and I give you the orange. No one has witnessed the transaction but the two of us, but we know I had an orange and gave it to you. No third party was involved, and we both got what we wanted: a sweet juicy orange and a clean car.

Crypto-Currency

This is the theory behind Bitcoin and other “crypto-currency,” or electronic money exchange systems. You and I can make exchanges without the need of assistance (and fees) from third parties. The inventor of the Bitcoin system, an unknown person going under the alias of Satoshi Nakamoto, created a peer-to-peer open source software system in 2009 in which regular people could exchange money without the need of a middle man. There are no fees involved—you don’t even need to use your real name.

Digital Fruit

Seems easy enough, right? Before you start crafting fruit baskets, think about what happens once you move beyond fruit. Let’s assume I don’t have a real orange but a digital one. You wash my car, and I give you the digital orange. Since you don’t have the orange in your hand, how do you know it really belongs to you? If there is no third party to validate that I transferred ownership of the orange to you, what would stop someone else from claiming ownership of that fruit?

Keeping Track

Here is part of the beauty of Bitcoin. There is a master ledger that keeps track of each piece of currency exchanged. Rather than being controlled by a single entity, be it a financial institution or some guy in Cleveland, the ledger is maintained by...well, in theory, by everyone. Bitcoins are created as a reward for payment processing work in which users offer their time and resources (computing power) verify and record payments into a public ledger. This process, called bitcoin mining, is the car washing that is performed in exchange for the orange. There is a public record of where bitcoins travel and to whom they belong, so no one can dispute to whom an “orange” belongs.

Bitcoin Exchange

What can you do with these bitcoins? They may be exchanged for other currencies, products, and services. Users can send and receive bitcoins electronically, for no fee or a fee generally less than 2 percent. Bitcoins are kept in an individual’s electronic wallet, usually software on a personal computer or mobile device or through a web application. Think of this as an internal checkbook ledger that keeps track of your crypto-currency.

Critic’s Choice

There are a lot of critics with plenty to say against the Bitcoin system as an unregulated, anonymous exchange of currency. One of the biggest concerns is the ease with which it could be used to finance illegal operations. Unless, however, you have been living under a rock, you know that hard currency has also been used in an anonymous and unregulated manner to fund questionable transactions.

And just like loose coins in your pocket, you can lose (or find) this. Your wallet is secured by a private key, and if you lose this key, or it falls into the wrong hands, your wallet can be emptied. On the other hand, bitcoins can be found, if you happen upon an old wallet. (Rare, but it has happened.) It is suggested that keys be generated offline using a secure computer and saved on external storage (or even on a good old fashioned piece of paper).

Hype or Hyperbole?

Are bitcoins or other crypto-currency here to stay or just the latest digital craze with the life expectancy of MySpace? Commercial use of bitcoins is pretty small throughout the general public but its growth is such that it can no longer be ignored. As of November 2013, there are a reported 12 million bitcoins in existence with a dollar value of approximately $7.2 billion American dollars. That’s a lot of oranges. Also in 2013 the United States Treasury acknowledged the existence of the Bitcoin system and issued rules regarding its use.

Passing fad or potential worldwide currency, bitcoins are an interesting innovation and further proof of how one person’s idea can be developed and strengthened by others. Have you used Bitcoin? What have your experiences been, negative or positive?