A simple guide to Bitcoin

There remains a lot of confusion about what Bitcoins are, how to use them and whether or not we are in a Bitcoin Bubble. Here's our simple guide to Bitcoin

  • 07 May 2013

Wired.co.uk has been reporting on digital currency Bitcoin for several years, but in the last few months, a single bitcoin's trading value has swung from $30 to $230 and it's been a daily fixture in headlines across the mainstream media. Despite this, there remains a lot of confusion about what bitcoins are, how to use them and whether or not we are in a Bitcoin Bubble. Here's our simple guide to Bitcoin.

What is Bitcoin?

Bitcoin is a peer-to-peer electronic cash system or "cryptocurrency" that doesn't rely on trusting one central monetary authority and allows for anonymous, untrackable and untaxable transactions. The idea was first discussed by members of the cypherpunk mailing list and then a workable system -- which used a distributed database spread across the nodes of a peer-to-peer network (a little like the one that underpins Bittorrent) that could keep track of transactions secured by cryptography -- was outlined by a programmer called Satoshi Nakamoto in a paper in 2008 and built in 2009.

Is it a commodity or a currency?

It seems that Bitcoin is an awkward combination of the two. The commodity value of bitcoins is linked to their currency value, but the more they become like a commodity, the less useful they are a currency.

How do you mine bitcoins?

Anyone can install Bitcoin's mining software, which then uses the computer's processing power (using the CPU or GPU) to carry out intensive calculations -- you can think of it like trying to search for prime numbers. Lots of people might be working on the same unit of work -- a computationally complicated problem. The aim is to find a certain sequence of data, called a "block", that produces a particular pattern when the Bitcoin "hash" algorithm is applied to the data. Whoever's computer manages to do that will win bitcoins.

When it started out, it was relatively easy to mine bitcoins, but as more people are trying to get in on the action, it's become computationally much more challenging -- in the same way that it's easier to find the early prime numbers, but harder now. The network is used to monitor and verify the creation of new bitcoins and all Bitcoin transactions, which are filed in a log. There is a cap on the number or bitcoins that will be produced, which is 21 million, and a pre-defined schedule of how quickly they are released up until 2040. There are currently around 11 million in circulation.

Can I just use my laptop? You can, but you are unlikely to mine any bitcoins.

Because of how hard mining now is, it could take more than three years to generate any coins, running up huge energy and equipment costs. There are plenty of opportunistic IT suppliers keen to sell you expensive equipment dedicated to mining. You are better off joining a mining pool -- a Bitcoin syndicate, if you will -- where you can split any wins between the group based on the amount of work your computer did.

How do I buy bitcoins?

You can exchange regular currencies for bitcoins using an exchange. It's probably best to stick to the biggest -- Mt.Gox -- which handles around 80 percent of Bitcoin trade, as around 45 percent of exchanges fail, taking their users' money with them. Of the 40 exchanges which have worked with Bitcoin, 18 have closed. Of those, five sites were hacked and lost funds, including Bitfloor, which had more than £160,000 stolen and 13 closed without any explanation. Even though Mt.Gox is the biggest, it's not immune to attack, and suffered a number of outages over the last few months following denial of service attacks (hammering the exchange with traffic until it fails).

Why would people attack exchanges?

Mt.Gox believes that opportunists are attacking exchanges to destabilise the market. If bitcoin owners find that they can't access the exchange to convert their money back into currency they might panic and then convert all of their money at the next available opportunity, thus increasing bitcoin supply and reducing the price of bitcoin. This would allow the perpetrator to buy bitcoins at a cheaper price and then wait until the market stabilises again before selling, thus pocketing the difference.

Where can I spend bitcoins?

Bitcoin is very useful if you want to buy drugs and other illegal items without easily being identified. You can spend them on online blackmarkets such as Silk Road. A 2012 study found that around 20 percent of all bitcoins exchanged on Mt.Gox (Bitcoin's largest exchange) each day were spent on Silk Road. However, the site has been under heavy DDoS attack which has led some to report that it is collapsing, while others have said that an individual had been trying to blackmail the organisation.

Beyond Silk Road, you can also spend bitcoins online at Reddit, Wordpress and Mega but so far there aren't so many places in meatspace that accept it yet, with the exception of a few bars with connections to the Bitcoin community. You can see a more comprehensive list of where to spend bitcoins here. Paypal is discussing accepting the currency, which could give it some much-needed legitimacy. The US Treasury is also keen to apply money-laundering rules to Bitcoin and other cryptocurrencies.

Are bitcoins secure? Bitcoin maintains that because all transactions are trackable they are secure, but there have been a few cases where hackers have ransacked electronic wallets used to store secret keys that give you the right to spend your bitcoins, notably when one exchange had 25,000 stolen. Needless to say, there are some extremely smart hackers in Bitcoin. So far, none of the stolen bitcoins have been spent, because those coins can be tracked, but you can still be deprived of your ability to spend them.

Harder mining also means that fewer people will bother dedicating the processing power to mining, which could mean that the overall number of nodes decreases to the point where it could be vulnerable to a 51 percent attack.

What is a 51 percent attack?

Bitcoin records every single transaction on its network in a public record called the blockchain. A new one is generated roughly every ten minutes and shared throughout the network. The determining factor in whether the blockchain is the real one or should be discarded as a fake is whichever is accepted by the most number of mining nodes. If someone is able to take over enough nodes that they could dictate their own, fake, version of the blockchain, they could then counterfeit bitcoins or spend them multiple times. Currently the biggest Bitcoin miner only has 15 percent of the total hashing power, but if this rose to 51 percent it could be disastrous for the cryptocurrency. Those concerned about this risk might want to move to an alternative currency.

Why is Bitcoin so volatile? Bitcoin prices have fluctuated wildly, rising as high as $266 and falling back down to around $76 within a very short space of time before rebounding again. Because of the lack of liquidity in the market and no central authority to influence supply and demand, the currency is vulnerable to speculation and manipulation.

A series of DDoS attacks against Mt.Gox was enough to send the Bitcoin value into freefall.

Should I get into Bitcoin mining now? No. If you didn't get into Bitcoin mining at the beginning, you are unlikely to make any money now -- your energy and infrastructure costs will be too high. You can, however, still invest in Bitcoin as a speculator, with the hope of selling at a higher price. But go into it with open eyes.