Over the last few days it is possible I have become fixated on Bitcoin, a cryptographically controlled virtual currency that presently exchanges at around $800 per. By “presently” I mean this morning. If you are reading this in 2014, odds are the value of Bitcoin has done something surprising, as the chart above suggests it might. Bitcoin has been extremely susceptible to market fluctuations since its creation in 2009. Part of that volatility owes to Bitcoin’s gradual acceptance as currency; until 2011, Bitcoins traded for exactly zero dollars, because you couldn’t use them to buy anything. Now, though, several legitimate retailers accept Bitcoin, and so do a lot of illegal ones.
All of that is interesting, and I invite you to read the last link above and become obsessed with Bitcoin, as I have. I do not encourage you to purchase a Bitcoin miner and start producing your own Bitcoins, because they are currently exchanging at 400% of their all-time high value, which was achieved one month ago. Maybe Bitcoins are going to keep going up and up. Or maybe they’ve gotten a lot of news coverage recently, and their 4800% annual appreciation rate is the result of speculators.
Also, Bitcoins are very difficult to mine. Transactions made with Bitcoin are not centrally administered or tracked. Instead, all transactions are recorded in “blocks” in a massive file called the block chain, which is disseminated to all users of the Bitcoin client. Each block in the chain is a chunk of cryptographic data that satisfies certain requirements—one of them being to record recent Bitcoin transactions. Creating a new block takes a lot of work.
Some of the difficulty of that work comes from encoding all previous blocks in the chain in the new block, plus the recent transactions, plus a new transaction that gives a decimally-small amount of Bitcoin to the block creator. This is why the practice of creating new blocks for the chain is called “mining”: you get some Bitcoin to discover a block that makes the ongoing system of Bitcoin exchange work. When that happens, more Bitcoin enters circulation, in the same way that digging gold out of the ground adds to the amount of precious metal that can be made into currency.
Here’s the kicker: it is relatively easy to encode a bunch of transactions into a new block, so the system introduces arbitrary constraints that make it much harder. For example, your block has to start with three zeros. This constraint dramatically increases the amount of computing power necessary to identify a suitable new cryptograph, a phenomenon called proof of work. Bitcoin is designed so that, as more blocks are discovered and more Bitcoins enter circulation, each proof of work becomes more difficult. Difficulty is progressively adjusted so that a new block is recorded about once every ten minutes.
This aspect of Bitcoin is not logistically necessary. If the sole purpose of each block in the chain were to record transactions, blocks could be created with much less computing power, electricity, and effort. The proof of work serves two vital functions in the larger Bitcoin economy, however.
One, it makes transactions difficult to falsify. Since each block contains the whole block chain that came before it, altering a transaction means altering multiple blocks retroactively, which demands a prohibitive amount of computing power. This system for preventing hacking, fraud and double-spending of Bitcoins is a form of logistical security, as if we prevented theft of the Hope Diamond by making it a load-bearing architectural feature of the Smithsonian. It is clever, but it is not the only reason behind proof of work.
The other advantage of proof of work is that it maintains the connection between Bitcoin and real-world resources. You know why you shouldn’t buy a bunch of GUI Bitcoin miners and quit your job? Because the amount of Bitcoin you get for discovering new blocks won’t cover the electricity you burned to calculate them. The total number of Bitcoins that can enter circulation is capped at 21 million. Until then, mining is limited by the cost of electricity, the sophistication and availability of hardware, and the arbitrarily increasing difficulty function.
The beauty of this system is that people only have incentive to create as many Bitcoins as the Bitcoin economy demands. As more transactions occur—particularly when those transactions can buy real and valuable things—the value of Bitcoins increases, and so miners have more incentive to write new blocks. Lest the production of Bitcoins exceed the public’s desire to use them as currency, the difficulty function and makes the proof of work less worth it to perform.
It’s a fascinating experiment in currency management and, best of all, it’s decentralized. Bitcoin operates on a peer-to-peer network, so no one is in charge. Or its creator is manipulating it in some way that we don’t understand, and it’s a pyramid scheme. Either way, I think it is very interesting. Don’t send me Bitcoin for Christmas, though. The crash is coming.