Sunday, June 19, 2011

Bitcoin, a Peer to Peer Virtual Currency

Bitcoin is a peer-to-peer virtual currency that seems to pop up in the conversation everywhere I look. A virtual currency is is a currency that is created on computers and traded on the internet. A couple of examples of virtual currencies are Linden Dollars in the online world Second Life and Gold in the massive multiplayer online game World of Warcraft (WOW). People in third world countries play WOW to collect WOW Gold and sell it for real money to players in the first world so that they can buy more powerful armor, weapons and spells to use in the game. Bitcoin is different in that its purpose is to be a currency like dollars, euros or pounds, whereas Linden Dollars and WOW Gold are an element of their games and have no real purpose or value outside of the game.

The other aspect of Bitcoin is that it is a peer-to-peer currency. Bitcoin is created by mining for it against a cryptographic algorithm. Once Bitcoins are created they are traded on a peer-to-peer network. When a transaction has taken place, it is broadcast to the peers on the network, they confirm that the transaction is valid and has taken place. The peer computers add the transaction to the history so that the transaction becomes permanent. There is no central authority that creates or manages Bitcoin, it manages itself through its network of peer computers all running the same software.

One feature of Bitcoin that has excited interest is that it promises secure anonymous transactions, like cash, but over the internet. While this may seem like a good thing, it is also a problem as it means that Bitcoin is an extremely useful currency for people who want to get around the law. Bitcoin has the problem that it needs to establish itself as useful currency with a legitimate reason to be. If the major use of Bitcoin turns out to be to abet criminal activity it may find itself under attack from governments that want to suppress it.

I am going to do a couple of posts on Bitcoin, one examining the economic aspects, and the other looking the technical and security aspects. In the mean time here are a number of links on related issues. My interest in a virtual currency comes from several direction. In the past I have written in this blog about both Virtual Goods and Virtual Economies.

A big question at the moment is the whole issue of what is Money. Some politicians, concerned about monetary policy have called for a return to the Gold standard, which has resulted in others asking this question. This American Life did a Podcast on that subject and came to the conclusion that Money is much more ephemeral than we may think. Planet Money did a related story where they looked at the small Pacific island of Yap where they used giant round stones as money. When a stone changes hand because of a payment, as the stone is large and heavy, the stone remains where it is and everyone on the island just knows it belongs to someone different. If you think that is strange, it is not that different from the way we manage gold. The gold bars sit in a bank vault and their ownership is digital bits recorded on a disk that is revolving at 7200 RPM. When the gold changes hands, a new record of ownership is written to the disk, however the gold remains exactly where it is. I will have to write more about virtual goods in real economies another time.

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