What are bitcoins?

Bitcoin is a digital payment system or currency that was developed in 2009 by an anonymous software developer who goes by the name Satoshi Nakamoto. Bitcoin refers to the system of electronic payments, while individual bitcoins refer to the unit of currency itself. Bitcoin is type of cryptocurrency because it uses electronic encryption to control the creation and transfer of money or bitcoins.

Users wanting to send or receive bitcoins need to use software on their PC, smart phone or other device that is referred to as a digital wallet. The wallet program generates and stores codes referred to as keys and communicates with other parts of the Bitcoin network. Bitcoin uses a form of security known as public-key cryptography, in which pairs of cryptographic keys or codes, one public and one private, are generated. A Bitcoin transaction then uses these two codes to transfer bitcoin ownership between wallet addresses. Because anyone with a private key can spend all of the bitcoins in the wallet, the essence of Bitcoin security is ensuring that private keys are kept secure and not lost or stolen.

Bitcoin uses a public database which records all bitcoin transactions and is known as the block chain. The block chain records current bitcoin ownership as well as all prior bitcoin ownership. By keeping a record of all transactions, the block chain prevents any double-spending of bitcoins. New bitcoins are created by a process called bitcoin mining where participants in the Bitcoin system make their computers available for verifying and recording bitcoin payments, which involves maintaining and updating the block chain database, in exchange for transaction fees and newly-created or mined bitcoins. Currently, bitcoin mining pays 12.5 bitcoins (about A$283,000 at current prices) for each new block of transactions their computers unlock and process and this amount will be halved approximately every four years so that by the year 2140, there will be approximately 21 million bitcoins in existence compared to around 16.7 million currently. Bitcoin miners also receive transaction fees (currently about US$6-20 per transaction) to process individual bitcoin transactions.

Bitcoins can be bought and sold for many different currencies from individuals and from companies, such as online bitcoin exchanges which offer bitcoin buy and sell bids at market prices. The market price for bitcoins has been very volatile with prices currently about US$16,700 per bitcoin having risen from US$970 at the start of this year although prices fell 30% in the second week of September after China banned bitcoin exchanges. Although bitcoin ownership is not anonymous, and the block chain contains ownership records, bitcoins have been used for illicit purposes such as to buy drugs, guns and for online gambling. As a result, many countries have subjected bitcoin exchanges to the same form of anti-money laundering laws that apply to traditional financial services.

Bitcoin’s popularity and skyrocketing price has polarised people with many suggesting it is in an unsustainable price bubble that will likely burst. They suggest that the current high level of price volatility, use in illicit activities, lack of security due with regular loss and theft and the large number of competing cyrptocurrencies (over 1,300 and growing) means that bitcoins have limited appeal as a longer term investment, a store of value or use as a means of payment. Attempts to value bitcoin, based on its potential role as a means of payment or a substitute for precious metal investments suggest that they it is significantly overvalued at current prices.

However, other bitcoin believers, many of who were the early adopters based on the belief that US Dollars, Yen and Euros would be debased by central bank money printing, still believe that bitcoins will gain greater acceptance with consumers, companies and regulators over time. There is some evidence that this is starting to happen with the Chicago Board Options Exchange launching trading in bitcoin futures earlier this week, which allows investors to purchase exposure to bitcoin prices on a regulated exchange without the need to purchase actual bitcoins through a bitcoin exchange.