By Jonathan McQuarrie
Lately, Bitcoins have received considerable attention from the media. The recent failure of the Tokyo-based Mt. Gox exchange, where users could exchange their Bitcoins for national currencies, sparked particular concern. The website managed to lose some 850,000 Bitcoins, which at the time were valued at approximately $400 million. For the last month, proponents of Bitcoins, such as Coinbase founder Fred Ehrasam, have been in damage control mode. Despite the recent bad headlines, they argue, the fundamental technological principles behind Bitcoins are sound. They are fond of noting that during the early days of the internet (back in the dimly remembered 1990s), start-ups and failures abounded. They scoff at naysayers like Warren Buffett, arguing that he does not understand the technology behind Bitcoins.
The system behind Bitcoins is indeed complex, but here is my simplified understanding. The origins go back to a 2008 article by ‘Satoshi Nakamoto’ (widely believed to be a pseudonym), where s/he outlined the development of a ‘peer-to-peer electronic cash system.’ The basic goal is to create a system of exchange where two users can spend Bitcoins with values determined and security protected by other users. When two people make an exchange using Bitcoins, their exchange generates a publicly recorded transaction, designed to ensure that a person does not try to spend the same Bitcoin twice. The public transaction has an associated hash (generated by the cryptographic hash function SHA-2), which presents a mathematical challenge. Users called miners verify the transaction by providing a proof for the mathematical challenge. The hash also provides a means for the miner to demonstrate that their computer resources solved the challenge. The miner adds the verified transaction, called a block, to a chain of blocks that extends back to the beginning of Bitcoins, and receives a portion of the fee charged to the people making the transaction in exchange for their work to create blocks. Miners are also able to create new Bitcoins as a reward for their work in extending the transaction block chains—as the chain is extended, more Bitcoins are issued, though the speed at which this occurs decreases as more Bitcoins enter the system. Decreasing speed is designed to ensure that they remain scarce, which is a fundamental element of almost any currency. Calling people who create transaction blocks ‘miners’ emphasizes the scarcity of currency – deliberately evoking connections to gold (that most recognizable of specie) and impressing that in order to get wealth, one must work.
As the ‘mining’ metaphor suggests, historical analogies have been used for explaining Bitcoin’s potentials and shortcomings. Continue reading
