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Bitcoins: Digital cash with transactions processed by volunteers

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Terry Woods
Bridging the gap, in a way you can understand, between what you want and tech that can achieve it. Websites, web based software, email...
I wrote this article because there are many articles out there that don't seem to understand the essence of what bitcoins really are.

Bitcoins are worth a look because they have the potential to save us from tithing our money to credit card companies when we spend it.

Bitcoins are a digital currency that can be spent online in a similar way to real cash. Transactions are processed and validated through a peer-to-peer network running the open source Bitcoin software, avoiding the need to rely on a single party (such as a credit card company) for the processing and verification behind the scenes. This can eliminate most of the transaction and exchange fees involved in particular with online spending and international money transfers.

The somewhat official website for bitcoins is http://www.bitcoin.org/ and Wikipedia has more detail too. I say somewhat official because nobody owns the concept of bitcoins – it is run by volunteers through open source software. The software and algorithms behind it were released by an apparently fictional character “Satoshi Nakamoto”, and the peer-to-peer network keeps it running.

The volunteers doing the transaction processing also are (temporarily) eligible for random payouts of new bitcoins. This appears to have been a very clever method of releasing the initial bitcoins out into the community and it is helping the currency reach a tipping point for acceptance. (See "Mining" below). These payouts will be replaced by transaction fees in the long run, as the total number of bitcoins will never exceed 21 million (but it's ok - they can be split up).


Benefits of using bitcoins


Make online payments easily and with very low transaction fees. Credit card companies have a stranglehold on the online transaction market and this is a chance to replace them with something more efficient. Payments are as easy as copying and pasting an account number into your bitcoin client application and choosing how many bitcoins to send. Retailers accepting credit cards get charged 2% or (much!) more of every transaction made and the consumer wears the cost in the end. If the payment is to a foreign currency, you'll probably lose another 4 to 10% in exchange losses and fees. International money transfers charge even more, with something like a $25 fee being the norm even for small amounts.
To receive payments, simply generate and share an account number for the payment to be deposited against. With bitcoins, smaller payments such as a 25 cent donation become feasible, which is great news for providers of free software (or music, or other electronic media) who are keen to accept a donation. You can generate as many account numbers as you like for tracking your receipts. With this feature, you can of course easily make payments to friends whenever you like. In bitcoin forums, it's become the norm to include a signature on posts with a receiving account number such as "Donate to 16ABa3SREb3YxkdYpVdkMkMech6oFQVf5C if my comments were helpful" because it's so easy to do.


Limitations


Transactions need to be verified through the bitcoin network before they can be considered complete – this prevents for example double spending of bitcoins by spending the same coins twice in different locations at the same time. The verification process can take an hour or two before it can be considered foolproof, so someone receiving a large payment needs to wait a while for the transaction confirmations to be received.
A user’s bitcoins are stored in an electronic wallet, similar to a wallet for real cash, which exists as a file on your computer. The wallet file can be stolen (i.e., copied), in which cases you will probably never get your bitcoins back, or it can be lost (if you don't have a backup, or can't recover your wallet data, you can't get your bitcoins back). Software for managing bitcoins needs to mature before the average user can reliably prevent their bitcoin wallet being stolen by hacking.
Bitcoins are in a phase of growth as a currency, and only a very limited number of retailers accept payment in bitcoins. Many of the current retailers sell electronic media or services which has a minimal cost to the retailer for each sale. In the meantime, it could still prove very useful for international money transfers, but there is quite a range of physical goods to be bought too.
Currency exchange rates for bitcoins are still fluctuating fairly heavily, so while you are holding bitcoins there is a risk of the value dropping, but you might also make a gain. Various exchanges are listed here. The future viability of bitcoins relies on the technology continuing to work as intended, and there being a demand for them. The demand is likely to improve, but the technology needs to remain robust as the scale increases.
Not quite anonymous, yet. Some sources have been claiming that bitcoin transactions are anonymous, however the default functionality does NOT provide that protection. Wikileaks found out the hard way that banks, credit cards and PayPal are affected by politics when their donations were blocked and accounts suspended - no matter your opinion on the ethics of Wikileaks, this type of behaviour is dangerous to the concept of freedom of speech. In the future, software might be available to provide for easy anonymous transactions, but it's not there yet.
Downloading the block chain. When you first install the bitcoin client application, it needs to download the chain of historic transaction blocks before it can list your transactions, calculate your balance, and send payments, which I understand is approx 500MB at the time of writing (July 5th 2011). The bitcoin client app will need to be modified to address this, but a team of enthusiastic developers are maintaining it.


Mining bitcoins


As an incentive to provide the back end transaction processing for bitcoins, participants have a chance to earn 50 bitcoins (currently worth around $700) for their efforts. This is referred to as "mining" because it's reminiscent of mining for gold nuggets. The payouts are earned somewhat like a lottery, with the bitcoin software automatically adjusting the chances of winning (the "difficulty") based on the processing power of the network. This mechanism also provides a neat way for distributing the (approx) 21 million bitcoins amongst a large number of people to help with acceptance of the currency.

It turns out that ATI graphics cards are by far the best hardware to perform bitcoin mining. The automatic adjustments in difficulty to date mean that mining bitcoins with a CPU is unlikely to even cover the cost of the power to run it. The difficulty rating is sufficiently high that even users with powerful ATI graphics cards tend to join forces into "pools" of miners and work together, splitting the rewards. The "bonus" rewards for mining will eventually decrease over time to nothing, and the end result will be that small transaction fees will need to be paid by bitcoin users as a reward for the miners, but these should be much less than what we're paying to credit card companies.

Mining really deserves its own article, but the Bitcoin Forum Mining section has all of the info necessary to get started for moderately technically competent users.
 
Disclaimer: I am a hobbyist bitcoin miner, participating in pooled mining with a single ATI 5770 graphics card which covers the cost of my power. My motivation for learning and sharing knowledge on bitcoins is mainly a technical interest, plus a desire to see humanity paying lower transaction fees for financial transactions.
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Author:Terry Woods
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by:Justin Owens
Well written article.  Thank you for the time and energy you put into its creation!

DrUltima
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by:Terry Woods
I have since written a 2nd article on Bitcoins, going into more detail of some of the risks involved:
http://www.experts-exchange.com/Software/Internet_Email/A_7149-Risks-of-Bitcoins-Don't-Get-Virtually-Mugged.html
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by:Gary
Great article - better than most stuff you find online.
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