Zerocoin reduces proof size by 98%, plans to release as altcoin

A few months ago an extension to Bitcoin called Zerocoin was proposed. 

As you know, Bitcoin is the first digital cash system to see widespread adoption. While it offers the potential for new types of financial interaction, it has significant limitations regarding privacy. Specifically, because the Bitcoin transaction log is completely public, users’ privacy is protected only through the use of pseudonyms.  Zerocoin would change that. 

Yesterday, Matthew Green from Zerocoin project posted this tweet:

Matthew D Green on Twitter

Zerocoin

“We designed a new version of Zerocoin that reduces proof sizes by 98% and allows for direct anonymous payments that hide payment amount.”

“We’re going to release it as an alt-coin. It will take a few months to get it to that point. Bitcoin can do what it wants.”

“We need a few months to clean up the code. We plan to release the client and an alt-chain.”

“Hide payment amount from anyone but the Payer/Payee is the goal. It’s not anyone else’s business.”

In August,  I wrote Cyrpo-Keys are Free Speech and in that article touched on Zerocoin when I wrote:

Bitcoin may seek favor with government regulators and opt for more transparency, but then some other crypto-currency could implement the Zerocoin protocol. We might see LiteCoin or FeatherCoin go full-throttle in the direction of total anonymity, and if that happens the debate (about privacy) will be over. It seems inevitable that at some point one these emerging forks in the Bitcoin road will become an anarchist’s wet dream

For those who are uninitiated, Zerocoin is not intended as a replacement for Bitcoin. It’s actually a separate anonymous currency that’s designed to live side-by-side with Bitcoin on the same block chain. Zerocoins are fully exchangeable on a one-to-one basis with bitcoins, which means you could use them with existing merchants.

Look Out #1, Here Comes ZERO

In the beginning…  the idea was to add the Zerocoin protocol to the blockchain making it possible to redeem Bitcoins anonymously.  Just as paper currency once gained its value from being redeemable for gold, Zerocoins wold gain their value from being redeemable for Bitcoins. It now seems this model may be changing and Zerocoin may soon coin itself.

The problem was that the proofs needed for Zerocoin took a lot of processing power. In addition to the computation cost being high is also seemed Zerocoin required too much storage space to be practical. With the announcement this week that there has been a 98% reduction in proof size, that means Zerocoin is now lightweight enough to be implemented into Bitcoin (or any other cryptocurrency). 

The big news is that Zerocoin is now talking about moving forward as it’s own alt-coin, perhaps as early as a few months from now. This is a radical chagne from the “road ahead” published on the Zerocoin website, it still reads, “Get someone [to] integrate it into bitcoin/litecoin/*coin.”  

Yesterday, Matthew Green said, “Bitcoin can do what it wants.”  

This makes perfect sense because this isn’t a simple change in the Bitcoin protocol. It’s a huge, all-encompassing change, which definitely deserves its own crypto-currency. Having said that, some serous thought need to be given to this new direction. 

The Heat Is On The Street

In the past those individual who were behind eGold and Liberty Reserve were both “done in” by government money laundering laws. In the case of the Liberty Dollar the crime was imitating the USD and in the Post-9/11 World this is also called a form of “domestic terrorism” (whatever that means). The point is Matthew Green needs to lawyer up.

Ross Ulbricht, even if the charges of hiring killers and laundering funds that were held in escrow were dropped, he also allegedly ran a site that facilitated anonymous communication between dealers and users, and he is absolutely in deep water from that, because he knew that that is what was going to happen on the site he created. All he did was create the site, and as a result of everyone using it, he will be charged for helping enable those crimes. The owners of Liberty Reserve were in spain at the time they were arrested too so the US definitely has long arms. Liberty Reserve was also used for many legitimate uses, as what happens with all money, but Zerocoin is very specifically tailored to strip identity from it’s transactions and Bitcoin can and will be able to ensure a high level of privacy, but it doesn’t have the total anonymity that criminals desire, so that means that Zerocoin’s main useful feature is going to be to facilitate illegal activity.

Now Bitcoin also enables crime, but the creator is nowhere to be found, the bell can’t be unrung, the Bitcoin genie is out of the bottle and there’s no-one to blame, and so all that is left is to arrest those that do use it for crime. Satoshi is long gone, unharassable, unarrestable. Matthew Green however, knowing fully well his alt-coin would be used to instigate all manner of illegal activity is actively creating an untracable currency, not a feature of Bitcoin, but his own currency, which means he will be the creator, issuer of coins and the facillitator when this thing goes live.

If this were just math, simply a protocol integrated into Bitcoin (or MegaCoin) then it would be the tens of thousands of miners that would essentially be the issuers, facilitators and creators of this anonymised coin. However, if Zerocoin becomes it own alt-coin then the creator is likely to experience some real serous government heat.

CoinValidation vs Zerocoin

Meanwhile, CoinValidation efforts are gaining steam. Basically, the idea is to build a centralized service that ‘redlists’ (blacklists) every Bitcoin addresses not authorized by this system. In effect, keeping good coins out of the hands of bad people or tagging other coins for having ties to criminals, hackers, and drug dealers. Proponent of such a system will help “keep the bitcoin economy from being a hotbed of crime.”

This CoinValidation and blacklisting taint, are both completely against what Bitcoin was designed to be and the ideals it was founded upon. The more I read about it the worse it sounds. Some have started to call this CoInvalidation based on this Reddit post. This misguided movement to “taint” Bitcoins with even less privacy features isn’t likely to fade away. Some people argue that even the limited anonymity of Bitcoin is too much, calling this its only flaw. The debate is getting quite heated.

How It Works

Here is quote from zerocoin.org

The Bitcoin payment network offers a highly decentralized mechanism for creating and transferring electronic cash around the world. Unfortunately, Bitcoin suffers from a major limitation: since transactions are stored in a public ledger (called the “block chain”) it may be possible to trace the history of any given payment — even years after the fact.

So here is the problem, since the Bitcoin ledger is public, any party can recover this information and data mine to identify users and patterns in the transactions. In other words: Bitcoin transactions are conducted in public. The most common solution to this problem is to use Bitcoin laundries – services that mix together many users’ bitcoins in order to obfuscate the transaction history. Laundries suffer from a number of potential drawbacks, however, as they must be trusted to return coins. Moreover a compromised or malicious laundry offers no anonymity.

Zerocoin achieves this by creating a separate anonymous currency that operates side-by-side with traditional Bitcoin on the block chain. Zerocoins can be thought of literally as coins. They’re issued in a fixed denomination (for example, 1 BTC), and any user can purchase a zerocoin in exchange for the correct quantity of bitcoin. This purchase is done by placing a special new “Zerocoin Mint” transaction into the block chain.

Here is a link to Matthew Green giving a talk about this. As he explains, this system uses standard cryptographic assumptions and does not introduce new trusted parties or otherwise change the security model of Bitcoin. Matthew details Zerocoin’s cryptographic construction, how he envisioned it would be integrated into Bitcoin, and he examines its performance both in terms of computation cost and impact on the Bitcoin protocol.

Dark Wallet

“We believe Bitcoin is fundamentally subversive” said Cody Wilson, “We here to force the conflict.”

In a recent episode of the Keiser Report, Max Keiser interviews Cody Wilson about living in a trifecta of disruptive technologies as a citizen of the future in which bitcoin means a thousand silk roads and fanfare for the common man. If you want to understand the impact the Zerocoin is going to have on the world, watch this interview:

 

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Bitcoin Price Hits $500, a 50x Increase in Just 12 Months

Those bitcoins that made you gasp at $300 just a couple of weeks ago? They were a bargain — the value of 1 BTC has now passed $500.

Prices hit this record and landmark figure at 11.50am GMT on 17 November, and at the time of writing were trading at $503.10 on Mt. Gox.

That means: if you bought a stash of bitcoins at their absolute highest peak price of $266* in April 2013 and then felt nauseous as the price plunged to $65 the same week, you have now almost doubled your investment. Provided you didn’t cut your losses and sell prematurely, that is.

Image

The bitcoin value began rising again almost immediately after that, breaking through the $100 mark again before May and hovering around that region throughout the northern hemisphere summer. It broke through $200 in late October and since then the price charts have been close to vertical, hitting $300 on 6 November and $400 on all exchanges by 15 November.

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There are currently 12,003,175 bitcoins in existence. The total market cap is $5,581,140,286 according to the Bitcoin Price Index, with 1,212,833 bitcoins changing hands in the past 24 hours. An average of 50,535 bitcoins are transacted every hour.

bitcoin price hits $500
The bitcoin price has reached $500 on Mt. Gox. Source: Bitcoincharts

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Why is this happening?

Bitcoin has survived some bumps in that time, most significantly the shutdown of the Silk Road online black marketplace and a number of chilly statements from government representatives. That it has continued to rise despite these setbacks could well be pushing values even higher, as investors sense a more resilient asset than previously thought.

The FBI seized a total of 171,955 BTC from Silk Road in October 2013, an amount so significant there were rumors it could influence bitcoin’s value. It is still unclear what the Bureau intends to do with its haul, if anything.

Nearly every piece of bad news about individual cases heralded more expectations that bitcoin would pay the price.

An asset with more significant value has also meant higher-profile hacks, scams and thefts. Companies like Australia’s Inputs.io found themselves out of their depth as its now considerable deposits came under attack.

What had been worth a few thousand in 2012 was suddenly worth millions, and people with plenty of experience finding naive security holes wanted it.

Rather than face their customers’ wrath, the proprietors of such businesses simply took fright and ran away. As recently as last week, the (supposedly) Hong Kong-based GBL also disappeared, along with its customers’ funds.

Yet the value never fell. Nearly every piece of bad news about individual cases heralded more expectations that bitcoin would pay the price. That it has continued to rise despite these setbacks could well be feeding back and pushing values even higher, as investors sense bitcoin is a more resilient asset than previously thought.

The government has been paying as much attention as the hackers and scammers. The US Senate Committee on Homeland Security and Governmental Affairs (HSGAC) will begin hearings on Monday 18 November with representatives from five wary federal agencies and representatives from the bitcoin advocacy community. Another Senate Committee on Banking, Housing and Urban Affairs will also hold a bitcoin hearing on Tuesday 19 November.

Again, the news of these hearings have had no negative impact on bitcoin’s value.

Silk Road shutdown effect on bitcoin
Silk Road’s shutdown on 2 October 2013 caused only a small dip in the bitcoin price.

Around the globe

BTC China Bitcoin Exchange
ate 2013 also saw an axial shift towards Asia, as BTC China became the highest-volume bitcoin exchange with its own record-setting prices. Reports of media attention and rampant mining activity have made some wonder if China is driving the rise. Even in April, when most gave credit for the bitcoin rise to government bank account confiscations, the factories of Shenzhen were busy cranking out mining hardware and selling it to locals.

The two week shutdown of the US Federal Government in October 2013 over a debt ceiling dispute did little to boost faith in government-backed money, especially the one acting as the world’s reserve currency. Every time the word ‘default’ is even mentioned in this context, no matter what the expected outcome, eyes begin to search for alternative assets.

There have been other alternate theories, including the one that bitcoin value is being driven up by the unfortunate millions desperately acquiring the currency to rid themselves of CryptoLocker malware.

Bubbles

The air in April was thick with the gloating of digital currency cynics and attempts even by technology media to analyze the factors behind bitcoin’s ‘fate’ and look for alternatives. But bitcoin has proved to be more Amazon.com than Pets.com and if it’s a bubble, it is one with a tendency to respawn.

Now, as $1,000 will get you only two bitcoins, the cries of ‘bubble!’ have not gone away.

Garrick Hileman, economics historian at the London School of Economics, said it’s too early to tell whether we’re seeing a bubble in bitcoin. He believes lots of factors are driving the price increase, including pure speculation, increased media coverage and attention from regulators.

“The growing regulatory attention which bitcoin is receiving is likely having a positive effect. This may seem counterintuitive, but to go mainstream, bitcoin needs more regulation, not less.”

Hileman said the US Senate hearings next week will not only bring more publicity to bitcoin, they may also lead to additional regulatory guidance.

“The lack of legal clarity is arguably the single most important issue facing bitcoin right now. For example, banks are scared of bitcoin, and reluctance by banks to work with the growing bitcoin ecosystem is a significant barrier to wider adoption,” he added.

Suggestions of a bubble will probably continue to increase and it’s wise to not get to carried away simply by a rising price. It might be equally prudent to stay ready to pounce on another price drop to $65.

Or we may be laughing at this story a year from now — not because the price has crashed, but because it has soared to even more unimaginable levels. Someone from November 2012 would probably find the idea of $500 quite hilarious too.

* Prices on BTC China were actually over the equivalent of $300 in April 2013, but the exchange trades only in Chinese RMB.

End Of The Silk Road. FBI Nabs the Dread Pirate Roberts

Andy Greenberg, Forbes Staff

After two and a half years running the booming anonymous narcotics bazaar known as the Silk Road, the drug kingpin who called himself the Dread Pirate Roberts has allegedly been unmasked.

On Wednesday, the FBI announced that they arrested 29-year-old Ross William Ulbricht, the Silk Road’s accused administrator, in the Glen Park branch of the San Francisco Public Library at 3:15 Pacific time on Tuesday. Ulbricht has been charged with engaging in a money laundering and narcotics trafficking conspiracy as well as computer hacking. The Department of Justice has seized the Silk Road’s website as well as somewhere between $3.5 to 4 million in bitcoins, the cryptographic currency used to buy drugs on the Silk Road.

Earlier this summer, the Silk Road’s administrator calling himself by the Dread Pirate Roberts pseudonym gave his first extended interview to Forbes over the same Tor anonymity network that has hosted the Silk Road and its users since the site’s creation in early 2011.

Forbes estimated at the time that the Silk Road was earning between $30 and $45 million in annual revenue. In fact, the number may have been far larger: The criminal complaint against Ulbricht states that the Silk Road turned over $1.2 billion in revenue since its creation, and generated $80 million commissions for its operator or operators.

“This is supposed to be some invisible black market bazaar. We made it visible,” says an FBI spokesperson, who asked not to be named. “When you interviewed [Ulbricht], he said he would never be arrested. But no one is beyond the reach of the FBI. We will find you.”

The FBI hasn’t yet revealed how it managed to track down Ulbricht in spite of his seemingly careful use of encryption and anonymity tools to protect his identity and those of his customers and vendors who visited Silk Road as often as 60,000 times per day. The FBI spokesperson declined to offer details about the investigation, but told me that “basically he made a simple mistake and we were able to identify him.”

One clue mentioned in the criminal complaint against Ulbricht was a package seized from the mail by U.S. Customs and Border Patrol as it crossed the Canadian border, containing nine seemingly counterfeit identification documents, each of which used a different name but featured Ulbricht’s photograph. The address on the package was on 15th street in San Francisco, where police found Ulbricht and matched his face to the one on the fake IDs.

The complaint also mentions security mistakes, including an IP address for a VPN server used by Ulbricht listed in the code on the Silk Road, mentions of time in the Dread Pirate Roberts’ posts on the site that identified his time zone, and postings on the Bitcoin Talk forum under the handle “altoid,” which was tied to Ulbricht’s Gmail address.

Read More:

http://www.forbes.com/sites/andygreenberg/2013/10/02/end-of-the-silk-road-fbi-busts-the-webs-biggest-anonymous-drug-black-market/

 

 

 

The follow statement is from the Bitcoin Foundation:

We received several requests to comment on the shutdown of Silk Road. First and foremost, it is important to note that the sanctity of the Bitcoin protocol remains intact and it was not a weakness of the core protocol that led to the apprehension of Mr. Ulbricht. Although Bitcoin is not anonymous by default, Bitcoin addresses were not a factor in solving the case.

“The FBI was able to capture an alleged criminal without any new investigative methodologies being needed and without having to get into changing the nature of the Bitcoin protocol,” Bitcoin Foundation General Counsel Patrick Murck said. “They caught him the same way they would catch somebody using cash.”

This is good for the Bitcoin economy in general and the reputation in specific because it proves that Bitcoins are in and of themselves a neutral store of value or medium of exchange and that privacy does not necessarily have to be compromised for law enforcement purposes.

Bitcoin’s principal attributes of irreversibility and user-defined privacy continue to provide benefits for bitcoin users globally. The Bitcoin Foundation would like to reaffirm that financial privacy sits on a sliding scale expressed differently by different individuals. However, within the Bitcoin transaction network, the specific level of that privacy is determined, managed, and set by the user.

MasterCoin Proposal to Make Bitcoin More Feature Rich

August 1, 2013

MasterCoin protocol Bitcoin

Complete MasterCoin Specification Released

J.R. Willett, aka dacoinminster, is a Seattle-based software engineer and Bitcoin expert. Like many in the Bitcoin community, he sees a future where Bitcoin is adopted by the mainstream for a wide variety of purposes. To achieve that goal, Willett believes that there’s more work to be done around the Bitcoin protocol.

After 2 years of research and discovery, Willett has released a complete specification for building a protocol layer on top of Bitcoin, similar to how HTTP runs on top of TCP/IP. He calls the new protocolMasterCoin.

The coins of the new layer have
•   Additional security features to make your money much harder to steal
•   Built-in support for distributed betting (no need to trust a website to coordinate bets)
•   Capability to hold a stable user-defined value, such as an ounce of gold or U.S. Dollar, with no need to trust a person promising to back up that value

The name of the new protocol layer is “MasterCoin” and it is 100% message-based, meaning that it encodes all its protocol data as hidden messages in the block chain which have special meanings, such as placing a bet, or transferring MasterCoins to another address.

Once you own MasterCoins, you have the building blocks for creating GoldCoin, USDCoin, EuroCoin, and any other real-world asset. These child currencies will then be “meta stable” (holding their values as long as they remain sufficiently backed by MasterCoins held in escrow). Their target values are maintained by protocol actions which control the available supply.

Here is the complete MasterCoin specification.

Willett is inviting early adopters to purchase MasterCoins by sending Bitcoins to the Exodus Address: 1EXoDusjGwvnjZUyKkxZ4UHEf77z6A5S4P. These funds will be used for development of software implementing the MasterCoin protocol.

For more information, read or join the discussion at bitcointalk and Reddit.

Below is a video of J.R. Willett speaking on a Bitcoin expert panel in May 2013.

Willet or Won’t It? (Mastercoin)

Yesterday, JR Willet announced official launch of Mastercoin

which includes an interesting “investment” opportunity. Send coins to the “exodus address” and you will get 100x that amount of master coin. Mastercoins aren’t worth anything now, but neither were bitcoin back in the day, or litecoin when it was launched, or… that’s the general idea.

IIUC, there will only ever be as many MasterCoins as are sent to the exodus address by September 1 2013 (reedit comment from above thread). So if master coin is a success, the initial investors should win big. Well… To be honest, I don’t understand how exactly they win big yet, but I haven’t given up on understanding the whitepaper. Even if the scheme fails, I think the ideas are important, so I am devoting some time to building up real intuition.

TLDR: It sounds like a scam, but I don’t think it is. But that doesn’t mean it will work. But I hope it does! But it has some problems.

The Mastercoin project is in the same spirit as Colored Coins (http://www.bitcoinx.org/) and, less directly, ripple and open transactions. Build services on top of bitcoin where non-crypto assets can also be traded. Open Transactions might fulfill all the requirements without the added complexities of Bitcoin, and without being a burden on its blockchain.

Overall I like the direction Colored Coin is taking better, but the colored coin development effort seems to be stalled in disarray at the moment, perhaps allowing MasterCoin to take center stage.

My concerns with Mastercoin are pretty much summed up by this thread.

http://www.reddit.com/r/Bitcoin/comments/1jftts/official_launch_new_protocol_layer_starting_from/cbeexys

It comes down to… why? Why get behind MasterCoin, and place faith in the centrally managed system and the development effort of Willet, when there is Colored Coin, and Ripple, and… Open Transactions

That being said, while my brain doubts, my heart likes. I like the whitepaper, and I like Willet.

Is It Time to Start Using Bitcoins?

Bitcoin and the Bitcoin Network >>>

Bitcoin and the Bitcoin Network >>>

What is bitcoin?

Just like email was created to send messages from person to person around the world for free, bitcoin was created to send money from person to person around the world for free.

And just like the email system works with email addresses and emails, the bitcoin system works with bitcoin addresses and bitcoins.

While on the email system the format of an address is name@example.com and you have to type this on the “To:” space to be able to send an email, on the bitcoin system the format of an address is a 30 character code like 1JqjAHgjCmNCRUHWKHrtUcvCofhWt9FTSW and you have to copy this on the “To:” space to be able to send a bitcoin.

To start using email you need to go to an email service like Gmail, open an email account, and start sending and receiving emails. On the bitcoin system you need to go to a bitcoin service like Coinbase, open a bitcoin wallet, and start buying, selling, sending, and receiving bitcoins.

Email is something you can create and store in your “Sent emails” box infinitely, and the receiver can also store, copy, and resend endlessly. Bitcoins are something there is a limited amount of and when you send one it goes away from your wallet just like a dollar bill would from your physical wallet. The receiver can store it in his wallet or send it away, but when he does send it away it will be deleted from his computer. Thus, unlike emails, bitcoins are finite and unique. In this way they are more like gold than email; there is a limited amount and they cannot be copied or replicated.

These last two characteristics, finite and unique, are what make bitcoin ideal to be used as a currency. The fact that it is electronic and used only on the internet is what makes it a digital currency.

This is a video that explains bitcoin produced by some of the original bitcoin developers and engineers:

Is it time to start using bitcoins?

As adoption of bitcoin accelerates, its use case and functionality may become more compelling for a growing number of merchants, consumers, traders, and investors. Although it’s not yet suitable for everyone, the following are some features that make bitcoin attractive:

It is a valid currency: While many are still analyzing if bitcoin will be a valid currency or not, I say it is a store of value, an exchange mechanism, and a unit of account, therefore it is already a currency.

A store of value: Although the price of bitcoin has been volatile, since inception it has been gaining value and already has a market capitalization of more than $1 billion. As bitcoin users grow globally its function as a store of value will be reinforced.

A unit of account: Since bitcoins can be used to store value, this value can be compared with the value of any other currency or merchandise. This makes it a valid unit of account to price products and services and to measure cash flows, among other things.

An exchange mechanism: Since it is easy to transfer, bitcoin can be exchanged for products and services or used to payoff debts if the parties agree. Therefore, it can be used as an exchange mechanism.

It is a global network: Just like email, anybody in the world with a computer or a mobile device with internet access can have a bitcoin address. With a bitcoin address and a bitcoin wallet it is possible to send and receive bitcoins to and from anybody and anywhere in the world.

It is decentralized: The bitcoin network is the sum of people transacting in bitcoins with one another directly on the internet. There is no central server or entity, like a government, central bank, corporation, or foundation that controls the network.  Therefore it cannot be manipulated like normal currencies issued by decree and controlled by governments.

It is free: Because it is an open source protocol and it is decentralized its use is free. To store, send, and receive bitcoins has no cost. This must not be confused with the purchase and sale of bitcoins. Bitcoins have value so to buy bitcoins you need to pay for them!

Wallet services: To be able to use bitcoins there are wallet services that are easy to subscribe to and provide the functionality to transact with bitcoins.

Send and receive: The basic functionality of a bitcoin wallet is to manage a bitcoin address so you can send and receive bitcoins. You can see your bitcoin balance and the transaction history so you can track your bitcoin activity.

Buy and sell: Since bitcoins can be stored and transferred they can also be bought and sold. You can do this by transacting with someone directly and then sending or receiving the bitcoins or you can use a bitcoin exchange.

Connected to the dollar system: Some bitcoin wallet services may be linked with your regular dollar based bank account. This makes it easier to convert bitcoins to dollars and vice versa and to move money between your wallet and your account.

Global exchanges: To facilitate the exchange of bitcoins with other currencies there are many global exchanges like Mt. Gox or Bitstamp where bitcoin users can trade them for different currencies like dollars, pounds, yens, or euros.

Sell and get paid: Once you have a bitcoin address it is easy to post it on your website or send by email so other bitcoin users can send you bitcoins in exchange for your products and services. You can also use a bitcoin wallet provider that offers merchant services so you can install a “buy” or “pay” button on your site so you can get paid to your wallet directly.

What are the risks of using bitcoin?

Because it is a new technology in its early stages, bitcoin has certain risks associated with it:

Volatility: Since inception bitcoin prices have been very volatile. Recently the bitcoin price went up from $70 to $260 and then down to $50 again to be traded now at around $100. This happened in a matter of weeks so it is still very volatile to use it as a savings or stable investment mechanism. For now it seems to be suited for very small investments and short term trading. Bitcoin is not suitable for the risk averse because there is a great risk of permanent loss of capital.

Theft: Although the majority of bitcoin services like wallets and exchanges have established bank level security in their systems, some are still not very sophisticated and may be subject to hacker attacks and theft. This is a serious risk in the bitcoin network because once bitcoins are transferred they cannot be recovered.

Trust: Related to the above and because bitcoin has been around for only a few years, all bitcoin services are mainly start-ups or companies with no significant capitalization. This poses an additional institutional risk as the majority of these services wouldn’t be able to respond to customer claims like theft, fraud, or errors.

Accessibility: Many bitcoin exchanges and wallet services have been affected by hackers with denial-of-service attacks (also known as distributed-denial-of-service attacks – DDoS). These are not internal thefts of bitcoins or information, but massive attacks that overload their servers. These attacks make these services unavailable for long periods of time so there can be little or no access to your wallet and thus the ability to withdraw money or transfer bitcoins out of your account.

Conclusion:

Bitcoin is still a new concept, but it’s in the process of being understood and adopted by a growing number of consumers, merchants, and investors around the world. As this process continues the reasons to start using bitcoins are becoming more compelling.

There is also increased investment in the sector and many new finance companies are offering more professional and consumer friendly solutions for everyday use.

Bitcoin is not for everyone at this point because it still poses significant technological and financial risks, namely the permanent loss of capital. However as these risks are mitigated, more consumers, merchants, and sophisticated investors should start learning about and using bitcoin.

How Bitcoin Works

The bitcoin logo

By Investopedia Staff

Bitcoin is a digital currency that exists almost wholly in the virtual realm, unlike physical currencies like dollars and euros. A growing number of proponents support its use as an alternative currency that can pay for goods and services much like conventional currencies. Bitcoin is the first and easily the most popular cryptocurrency, or currency that uses cryptography1 (see “Definitions and Key Concepts” at end of article) to control its creation, administration and security.

Bitcoin was set up in 2009 by a mysterious individual or group with the pseudonym Satoshi Nakamoto, whose true identity is yet to be revealed and who left the project in 2010. It rocketed to prominence in 2013, when the value of a Bitcoin soared more than 10-fold in a two-month period, from $22 in February to a record $266 in April. At its peak, based on more than 10 million bitcoins issued, the cryptocurrency boasted a market value of over $2 billion.

Bitcoin Versus Conventional Currencies

Bitcoin differs from conventional currencies in some very fundamental ways, as noted below (for the sake of simplicity, we use the U.S. dollar as a proxy for conventional currencies).

  • Bitcoin uses P2P technology without a central authority: Bitcoin is a decentralized currency managed by peer-to-peer technology (P2P2), without a central authority. All functions such as Bitcoin issuance, transaction processing and verification are carried out collectively by the network, without a central supervisor or agency to oversee operations. In contrast, a conventional currency is issued by a central bank as part of its mandate to manage national monetary policy. In the U.S., only the Federal Reserve has the power to issue dollars; it is also the central authority that conducts monetary policy, supervises banks, maintains financial system stability, and provides financial services to depository institutions.
  • Bitcoin is primarily digital: Although physical Bitcoins are available from companies such as Casascius and BitBills, Bitcoin has been designed primarily to be a digital currency. Physical Bitcoins are somewhat of a novelty, and the very idea of a tangible form defeats the purpose of a digital currency, according to the most ardent supporters of the concept. Conversely, your dollars exist primarily in physical form; the balances that you hold at your bank and online brokerage can be converted into physical dollars within minutes if you so desire.
  • Bitcoin has a maximum 21 million limit: The total number of Bitcoins that will be issued is capped at 21 million. The Bitcoin “mining”3 process presently creates 25 Bitcoins every 10 minutes (the number created will be halved every four years), so that limit will not be reached until the year 2140. While Bitcoin critics argue that the maximum limit is not large enough, supporters maintain that since each Bitcoin is divisible to eight decimal places, the number of fractional Bitcoins (called “satoshis”) – at 21 x 1014 – will be more than enough for all conceivable applications. Conventional currencies, on the other hand, can be issued without limit.
  • Bitcoin is a complex product: The concepts of cryptocurrencies in general are abstruse and abstract, and understanding how and why Bitcoin works requires a fair degree of technological knowledge.
  • Bitcoin has limited acceptance: It has limited acceptance so far and cannot be used at many brick-and-mortar storefronts, although that may eventually change if it continues to gain traction. The dollar, on the other hand, has near-universal acceptance as the world’s global reserve currency.
  • Bitcoin transactions have limitations: A Bitcoin transaction can take as long as 10 minutes to confirm. Transactions are also irreversible and can only be refunded by the Bitcoin recipient. These limitations do not exist with conventional currencies, where debit and credit transactions are confirmed within seconds; certain transactions can also be reversed for valid reasons by the originator, without having to rely on the recipient’s largesse.
  • Bitcoin balances are not insured: This means that if you lose your Bitcoins for any reason – for example, your hard drive crashes, or a hacker steals the digital wallet in which your Bitcoins are stored, or the Bitcoin exchange where you held a balance went out of business – you have little recourse. Currency balances held at banks, on the other hand, are insured against certain events such as bank failure by agencies like the Federal Deposit Insurance Corporation in the U.S.

How Bitcoin Works

Let’s say you want to test the Bitcoin waters. The first thing you need to do as a new user is install a digital wallet on your computer or mobile device. This wallet is simply a free, open-source software program that will generate your first and subsequent Bitcoin addresses. There are three types of wallets – a software wallet (installed on your computer), a mobile wallet (which resides on your mobile device) or a Web wallet (located on the website of a service provider that hosts bitcoins).

Bitcoin uses public key encryption4 techniques for security. This means that when a new Bitcoin address is created, a cryptographic key pair consisting of a public key and private key – which are essentially unique, long strings of letters and numbers – is generated.

Each address has its own Bitcoins balance, so all you need to do is acquire a number of Bitcoins that will be held at one of the addresses in your wallet. You can acquire Bitcoins through a number of ways – by buying them from a Bitcoin currency exchange such as Mt. Gox or Bitstamp, or through a service like BitInstant that enables fund transfers between Bitcoin exchanges and supports various payment mechanisms.

Note that all Bitcoin transactions are stored publicly and permanently on the Bitcoin network, which means that the balance and transactions of any Bitcoin address are visible to anyone. Experts therefore recommend that Bitcoin owners create a new address for each transaction as a means of ensuring privacy and enhancing security.

Once you have created a Bitcoin address and have acquired Bitcoins, you can use them for an online transaction with a company that accepts Bitcoins as a payment mode. The company will send you the Bitcoin address to which you can send your Bitcoin payment. You direct the payment to that address; while the transaction takes place within seconds, verification can take 10 minutes or longer.

All Bitcoin transactions, without exception, are included in a shared public transaction log known as a “block chain”. This is to confirm that the party spending the Bitcoins really owns them, and also to prevent fraud and double-spending.

Why does transaction verification or confirmation take so long? Because the complex algorithms involved in Bitcoin mining (see description below) take time to solve, even with immense computing power at one’s disposal.

An Example of a Bitcoin Transaction

Let’s assume you want to make an online payment to a company – call it BitChamp – using 5 Bitcoins that you have in an address in your digital wallet. Here are the steps in the transaction:

  1. BitChamp creates a new Bitcoin address and directs you to send your payment to it. This creates a private key (known only to BitChamp) and a public key (available to you and anyone else). Note that just as a seller does not need to know your physical identity if you pay cash, you do not need to disclose your real identity to BitChamp and can remain anonymous.
  2. You instruct your Bitcoin client (the free Bitcoin software you first installed on your computer) to transfer 5 Bitcoins from your wallet to the BitChamp address. This is the transaction message.
  3. Your Bitcoin client will electronically “sign” the transaction request with the private key of the address from where you are transferring the Bitcoins. Recall that your public key is available to anyone for signature verification.
  4. Your transaction is broadcast to the Bitcoin network and will be verified in a few minutes. The 5 Bitcoins have been successfully transferred from your address to the BitChamp address.

Note that only the first two steps involve action by the seller and you respectively. The latter two steps are automatically executed by the Bitcoin client software and Bitcoin network. As well, storing the private key attached to an address safely and securely is of the utmost importance; otherwise, anyone who obtains the private key can control the Bitcoins at that address and use them fraudulently.

Bitcoin Pros and Cons

Bitcoin has a number of advantages:

  • As the first cryptocurrency to capture the public imagination, Bitcoin has “first mover” advantage and a head start over the competition.
  • Total issuance is limited to 21 million, so it is unlikely to be devalued because of the prospect of a massive influx of new bitcoins.
  • As a decentralized currency, Bitcoin is free from government interference and manipulation.
  • Transaction costs are much lower than with conventional currencies.

On the flip side, Bitcoin’s disadvantages include:

  • The price of a Bitcoin has been increasingly volatile, making it difficult to assess its real value and increasing the risk of losses for investors in the cryptocurrency.
  • The relative anonymity of Bitcoin may encourage its use for illegal and illicit activities such as tax evasion, weapons procurement, gambling and circumvention of currency controls.
  • The fact that bitcoins exist primarily in digital form renders them vulnerable to loss.

Conclusion

Bitcoin has made significant progress in its adoption and usage since it was unveiled in 2009. Its evolution over the next few years will determine whether this leading cryptocurrency will become an integral part of the global financial system, or whether it is destined to remain a niche player.

Definitions and Key Concepts

Cryptography refers to the practice and technique of using encryption for secure communication and transmission of data and information.

2 In a P2P network, a group of computers is connected to enable the sharing of resources and information by users, and there is no central location for the network. This is diametrically opposed to a typical client-server network, where the central server controls the level of access by users to shared network resources. Popular applications of the P2P concept are Skype and file-sharing services such as BitTorrent.

Bitcoin mining refers to the computationally-intensive task of generating Bitcoins. While any computer can be put to the task of Bitcoin mining by using a free mining application, in reality a great deal of computing power is required to solve the extremely complex algorithms involved and to share those solutions with the entire Bitcoin network. The mining process is quite complicated and involves advanced concepts such as cryptographic hashes and nonces.

In simple terms, Bitcoin miners use powerful computers to track and compile pending Bitcoin transactions every 10 minutes into a new block. These miners then set to work doing the intensive number-crunching required to verify all the transactions in the block. This is a competitive process, and the first miner to solve the algorithms and verify the transactions transmits the results to the entire Bitcoin network. Upon confirmation by the rest of the network, the block is then added to the block chain. Each block includes a certain number of Bitcoins in a “coinbase” transaction that is paid out to the successful miner. This reward was set at 50 Bitcoins when the system first commenced operations in 2009, but was halved to 25 Bitcoins in November 2012, and will reduce by 50% approximately every four years.

Public key encryption combines a public key and a private key. While the public key is available to anyone, the matching private key is stored securely in the digital wallet and is generally password-protected. Each Bitcoin transaction is signed by the private key of the initiating user, providing mathematical proof that it has indeed originated from the owner of the address, and preventing the transaction from being altered once it has been issued. Since the key pair is mathematically related, any data or information encrypted with a private key may only be decrypted or deciphered with the corresponding public key and vice versa.

Double-spending means spending the same digital currency twice, something that is impossible with physical currencies.

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