



Cracking the cryptic world of bitcoin and virtual currencies


Bitcoin and its many online imitators have the power to revolutionise global currency, yet relatively few of us know what it is or how it works.

Whoever or whatever he is, Satoshi Nakamoto's legacy has flourished.

Whoever or whatever he is, Satoshi Nakamoto's legacy has flourished. Photo: Reuters

The story of cryptocurrencies and why they have suddenly bobbed to the surface from the deep, dark reaches of online activity starts with the name Satoshi Nakamoto.

In 2008, Nakamoto - who purported to be a 37-year-old male living in Japan disillusioned with the global banking system - popped up as the author of an online manifesto on a peer-to-peer electronic cash system. A year later, Bitcoin was born when "Nakamoto" turned his theory into the uncrackable code that underpinned a new virtual currency.

For a time, he actively engaged with the Bitcoin community. But in April 2011, his posts and emails suddenly ceased with a see-you-later message.

Bitcoin slugs sitting in a box ready to be minted.

Bitcoin slugs sitting in a box ready to be minted. Photo: AFP

Conspiracy theories emerged, including that the Nakamoto manifesto was the work of a reclusive mathematics genius called Shinichi Mochizuki, a group of economists attempting a large-scale social experiment or a government agency.

Whatever the truth, his legacy has flourished. The value of the bitcoin market today tops $US10 billion ($11.1 billion).

Last month, The New York Times published a 3000-word homage to Bitcoin, written by Marc Andreessen, one of Silicon Valley's most respected venture capitalists.

Andreessen, whose firm has already invested $US50 million in bitcoin-related ventures, sees the cryptocurrency as a way to disrupt the cosy, high-cost, high-fee world of banking and usher in new ways to pay for goods and services.

"Bitcoin, as a global payment system anyone can use from anywhere at any time, can be a powerful catalyst to extend the benefits of the modern economic system to virtually everyone on the planet," he writes.

The cryptocurrency movement is likened to Napster, the peer-to-peer music pirating network which briefly flourished in the late '90s and early part of this century before it was shut down by legal authorities at the behest of the music industry. While Napster perished, its DNA lived on in legitimate online services such as iTunes and today's many music streaming services such as Pandora, Spotify and Rdio.

There's institutional indifference - despite links to drug and arms dealers, terrorists and money launderers - but the smart money is betting that cryptocurrencies will live on too.

Here's how these virtual currencies work:

What is a cryptocurrency?

A cryptocurrency is a digital or virtual medium of exchange that uses encrypted software to maintain a secure and transparent network for transactions controlled collectively by those using the network.

It's a peer-to-peer operation, not unlike the file-sharing protocol BitTorrent which is most closely associated with the illegal sharing of movies, TV shows and music.

How many cryptocurrencies are there?

The market for such payment instruments is dominated by bitcoin, but there are other currencies including litecoin and, more recently, dogecoin (pronounced dohj coin), both of which are based on Nakamoto's code.

Others have exotic names such as ripples, megacoin, kittehcoin, lottocoin, doubloons, hobonickels, nanotoken and philosopher stones. There is a "sexcoin" which claims to specialise in servicing adult content consumers, performers and producers.

There are about 80 listed on one of the leading cryptocurrency tracking websites, but many of them have tiny market capitalisations and turnovers.

What are they worth?

At the time of writing, one bitcoin is worth $US825. At the lower end of the scale, one dogecoin is equal to $US 0.0016 - in other words, one US dollar is worth 625 dogecoins.

Values fluctuate based on supply and demand (and market sentiment). The bitcoin to US dollar exchange rate recently dropped after the founder of a leading bitcoin exchange was arrested over his links with the Silk Road online drug bazaar. But over the past year, bitcoin has jumped by over 5000 per cent.

Overall, bitcoin's market capitalisation is north of $US10 billion, litecoin's is $US500 million plus, dogecoin is hovering around $US60 million. Languishing near the bottom of the league at $US80,000 is craftcoin, a specialist cryptocurrency designed for use inside the Minecraft virtual world.

How are cryptocurrencies established?

The key feature of the Bitcoin protocol and its spin-offs is that everything is governed by algorithms, including the rate at which the currency is created (or mined) - the equivalent of printed or coined in the physical world.

The algorithms determine the release of coins at a decreasing rate over time until there is a final pre-determined worldwide supply (only 21 million in the case of bitcoin). This mimics the extraction of a finite resource - such as oil - in the real world.

What is "mining"?

Mining is the the process whereby computers are challenged to solve complex mathematical problems (algorithms) so their owners can obtain the virtual coinage as reward. As the supply shrinks, the mathematical equations become progressively more difficult to solve.

Theoretically it is possible to start mining using your home PC but as the challenge becomes harder, more computational grunt is required to crack the codes. For this reason individuals often join pools to get access to supercomputers or huge server farms (networked arrays of smaller computers).

In this case, the proceeds of mining are split. Serious miners would also consider buying (or renting) purpose built mining hardware to do the job. You have to download the software and set up a virtual wallet to receive the mined coin.

How do you buy and sell it?

It's a bit like a direct transfer between accounts with verification determined by the algorithm, which ensures that the same unit of currency can't be owned by more than one person.

In most cryptocurrencies, accounts known as wallets are stored either locally on hard drives or remotely in the cloud.

While individuals and entities can (and do) adopt pseudonyms to go about their business, every transaction they make is recorded in a ledger called the blockchain, held by every currency owner, and each time a transaction is made, the ledger is updated. That's why in the case of bitcoin, it takes about ten minutes to ratify a transaction. In the case of dogecoin, it takes a minute. This process of checking the ledger ensures that the coinage is not double-spent.

Because of its widespread adoption, bitcoin is the most liquid of the alternative currencies. Companies, individuals in person, bitcoin exchanges and even bitcoin ATMs will cash them into US dollars and other currencies. Other cryptocurrencies, such as dogecoin, generally have to be swapped first into bitcoin.

What can you buy with it?

While the bartering of goods and services in return for bitcoin on a person-to-person level over the internet has become standard, in recent months larger enterprises have begun accepting bitcoin in lieu of conventional cash or credit. In the US, discount internet retailer, electronics online retailer TigerDirect and two Nevada casinos have recently announced they would accept bitcoin as payment. In Australia, acceptance is largely limited to small businesses and sole traders. There have been examples of people selling real estate and cars in exchange for virtual cash.

Is it safe?

Not for the uninitiated. It's still the Wild West. Despite the built-in safety checks, the infrastructure around cryptocurrency markets is vulnerable and the bigger ones have proven a magnet for thieves, hackers and fraudsters. But the same could be said of the sharemarket.

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