"zcopley" via flickr
If Bitcoins were in the physical world, they might look like this. However, Bitcoins are purely digital in the virtual world.
Paper money can be counterfeited. PayPal could be breached. ... But with Bitcoins it is cryptographic in nature and to break into it you would have to break the code and it is not clear that that is possible with today's technology. —Jerry Brito, senior research fellow at the Mercatus Center

When 14-year-old Manix Wolan decided to invest in bitcoins, he thought it was a pretty good idea. "Bitcoins had gone from $5 to $120 in one year," he says, "That would obviously catch the eye of anyone who wanted to make money."

His father, Alan Wolan, the author of "Moneyology: A Kid's Guide to Money," also thought bitcoins were a good investment. He had been teaching his son about stocks and investing. He also was a big fan of putting money into gold and silver and found a lot of appeal in the characteristics of this new virtual money.

"When I learned about bitcoins I thought it was like electronic gold," he says.

Unlike dollars, which are backed by the U.S. government, or euros, which are backed by the European Union, bitcoins are a monetary system outside the control of any one nation. They are entirely digital. You can't hold them like a coin. They are based on complex mathematical algorithms and cryptography and various protocols that make them practically anonymous. But they can be used like money — usually in online transactions.

After bitcoins were invented in January 2009, the number of transactions per day hovered around 500 for two years. Now there are around 50,000 transactions a day for things ranging from buying a cup of coffee to hiring a lawyer. They also have a darker side.

Dirty money

As bitcoins have become more prominent, they have attracted the attention of regulators who are worried about the currency being used for illicit transactions. Earlier this month, the FBI arrested Ross William Ulbricht, the formerly anonymous purveyor of the online illegal drug website, Silk Road. The website used bitcoins to hide the identity of buyers and sellers. The FBI electronically seized 26,000 bitcoins, according to the Guardian, and is trying to access 600,000 bitcoins Ulbricht is thought to own, worth about $80 million. Arrests continue to be made around the world as that bitcoin-based black market collapses.

In March, the U.S. Treasury Department notified various companies trading in bitcoins that they need to protect against money laundering. But unlike other monetary systems and payment systems, there is no central authority to regulate.

Virtual money

In some ways bitcoins are like using PayPal to buy something on the Internet. In other ways they are like airline frequent flier miles. They are like bags of virtual cash. They are like using a credit card. The analogies fly when experts try to explain what bitcoins are.

Kevin McIntyre, an economics professor at McDaniel College in Westminster, Md., compares bitcoins to the private money that was used in the 1700s and 1800s before the federal government started issuing money. Banks used to issue their own paper money, backed up by valuable metal such as gold or coins. Such money was vulnerable to collapse if more paper was issued than was available in their reserves.

Bitcoin is like that, except it is a pure "fiat" money — its value comes entirely from what its users think it is worth.

Using bitcoins

McIntyre says there are several ways people are using bitcoins.

First, he says, people are using them as a speculative financial instrument — like investing in British pounds or the euro. People buy them, hoping the value will go up.

He says another use is popular with the "tinfoil-hat-wearing, Ayn Rand, Libertarian, anarchist crowd" who are concerned about institutions like central banks and their control over money supply. Bitcoins are outside the control of such institutions.

Because bitcoins do not identify their users, they are practically anonymous. A record of the transaction is kept, but who is paying that amount to whom is hidden by the coins' encryption. This means, McIntyre says, bitcoins are great for people who have privacy concerns.

This is the area that has governments concerned, since bitcoins could be sent by terrorists or drug dealers. Forbes recently used bitcoins to successfully purchase drugs online from the now defunct Silk Road — although the transaction was not quite as untraceable as some bitcoin users may think.

McIntyre, however, sees the positive uses of a private currency. He says people in oppressive countries could use it to transfer money or hide it from the government.

Jerry Brito, a senior research fellow at the Mercatus Center, a free-market leaning think tank at George Mason University in Arlington, Va., calls bitcoins a "censorship-resistant currency." A blogger in Iran can pay for their Wordpress.com account in bitcoins without the government being able to track them. A charity operating in Russia can use bitcoins to transfer money into the country easier.

But, in normal life, bitcoins are not yet convenient to use, McIntyre says. Transferring bitcoins can take about a day.

No central authority

The biggest problem bitcoin backers had to solve was an issue that had long made virtual money virtually worthless: Virtual money is just too easy to copy, says Brito.

He says the difference between cash and virtual money is similar to the difference between a book and a Microsoft Word document. The book can only be given to one person. A Word document can be copied and sent to multiple people.

In the same way, a person could take a virtual amount of money and send it to multiple people.

Normally this sort of problem is solved by a third party. The third party — such as PayPal, Visa, MasterCard, etc. — keeps track of who pays what to whom. This central authority keeps everyone honest.

But central authorities are easy to influence, pressure and regulate by governments. For example, the controversial Wikileaks had its funds frozen by PayPal — stopping donations.

Bitcoins' creator, the mysterious "Satoshi Nakamoto," came up with a way to solve the problem of double spending without creating a central authority. Nakamoto (an online pseudonym) created an electronic record or ledger that would keep track of every transaction ever done with bitcoins. Everybody who used bitcoins would have access to the record.

Instead of a central authority creating and maintaining a ledger, bitcoins' ledger, called a "block chain," could be maintained by anyone. To stop hackers, the records of transactions could only be added to the ledger after complex mathematical puzzles were solved by multiple users. The method makes it impossible for even a group of hackers to mess with the records.

As an incentive to get people to work on the ledger block chain, people can be rewarded with bitcoins.

So multiple levels of encryption and mathematical puzzles and incentives and dividing responsibility take the place of a central authority and make bitcoins secure.

"Paper money can be counterfeited," Brito says. "PayPal could be breached. ... But with bitcoins it is cryptographic in nature and to break into it you would have to break the code and it is not clear that that is possible with today's technology."

This isn't to say that individual bitcoins couldn't be stolen. The money is kept in virtual wallets on computers, and if somebody hacks into it, they may be able to steal the key numbers that identify the money. And then, if it is taken, it is gone.

Brito contrasts this with payment systems with central authorities like credit cards or PayPal. "Basically, they offer consumers insurance," he says. "With a credit card, you can have your transaction reversed. There is fraud protection. With bitcoin, it is final like cash."

Bitcoin paying

Many people are buying up bitcoins in hopes that its value climbs relative to the dollar. The more bitcoins are used, the more legitimate they become, the more they could be worth. Right now, however, general use of the money is in the future — but here and there businesses are beginning to accept bitcoins as payment.

Ryan Hurley, an attorney with Rose Law Group in Scottsdale, Ariz., recently persuaded the firm to accept payments in bitcoins. This policy attracted one client so far who is interested in developing a bitcoins business.

Hurley says he recently was explaining bitcoins to a friend.

"Are you crazy?" the friend told him. "Who will trust it? Who is Bitcoin? Who am I trusting?"

Hurley says that is like asking "Who is email?"

Hurley has invested about $500 into bitcoins, about 4.8 bitcoins.

McIntyre at McDaniel College is in for about $20 or a fifth of a bitcoin.

Brito at Mercatus Center owns 3 bitcoins.

Alan Wolan says he invested about $50,000. His son also invested an undisclosed amount.

"I think that it was good that right after we bought it that it went down," he says. "That is a good lesson for a kid. Not everything goes up. It is impossible to predict the direction of everything."

Wolan says he is not worried about the price right now because he is in for the long haul.

"My bet on Bitcoin is basically a bet on the idea," Wolan says. "I still believe in the idea. Now whether it will work is an empirical question I can't answer."

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