Understanding bitcoin
You might still confuse virtual currency (which can also be referred to as virtual money, Internet currency, Internet money, digital currency, and digital money) with mobile money. This realization, coupled with the publicity the currency has enjoyed in the last two weeks, has prompted me, in today’s article, to try and explain precisely what virtual […]
You might still confuse virtual currency (which can also be referred to as virtual money, Internet currency, Internet money, digital currency, and digital money) with mobile money. This realization, coupled with the publicity the currency has enjoyed in the last two weeks, has prompted me, in today’s article, to try and explain precisely what virtual currency is, and to tell you how it works. The virtual currency with by far the most activity is Bitcoin, and is also the main focus of today’s article. I will also write about the recent actions of the United States (U.S.) Congress to regulate Bitcoin. This event, which might have at first scared the heck out of Bitcoin dealers, actually turned out to be a blessing in disguise. That is, the event signifies that the U.S. government has given a tacit approval to deal in Bitcoin, as long as a few (reasonable) regulations are followed.
What is virtual money?
Virtual money is an Internet-based currency, which can be used to pay for your purchases on the Internet. It does not draw from the dollars, Euro, Naira, or the Pounds Sterling that you have in a bank somewhere.
Spending Bitcoins
Let’s say Aisha wants to use Bitcoins (not dollar, Naira, or Pound Sterling) to buy a book from Ahmed’s bookstore. Both Aisha and Ahmed will need to install a Bitcoin wallet on their respective computers or smartphones. (A wallet is basically a file on Aisha’s computer hard drive that allows her to access multiple Bitcoin addresses.) The first address is automatically generated for Aisha once she installs the wallet; she will have to generate subsequent addresses on her own. Each of the addresses will contain a certain balance of Bitcoins, and it is into one of such addresses created and owned by Ahmed that Aisha pays, from the money (Bitcoins) in one of her own addresses. To make a payment, Aisha tells her Bitcoin client (local computer network) the number (fraction) of Bitcoins to pay into a specified address in Ahmed’s wallet. Note that when Aisha generates an address or one is automatically generated for her, a private key, which is only known to Aisha, as a well as public key, which is known to the public, are generated for the address. Anyone on the Bitcoin network can use the public key to verify that the transaction request that Aisha made is in fact coming from the legitimate account owner (Aisha).
Aisha’s transaction is then verified and confirmed via some rather complicated mathematical/computational procedure called mining, about which neither Aisha nor Ahmed need to concern themselves. Upon confirmation of Aisha’s transaction, which takes approximately 10 minutes, Ahmed’s money in the address that Aisha paid into can now be used by Ahmed to make purchases of his own. All confirmed transactions are included in the “block chain,” which is a public ledger on which the entire Bitcoin network relies. This enables Aisha’s wallet to calculate the spendable Bitcoin balance that Aisha has left at any point in time.
You can consult Bitcoin wiki for more detailed information, including exchanging Bitcoins for regular, physical currencies such as the dollar. The value of Bitcoin fluctuates violently. At the time of U.S. regulation of Bitcoin two weeks ago, one Bitcoin was worth one thousand U.S. dollars.
The regulations
Like other digital currencies before Bitcoin, the U.S. government did not seem to accept Bitcoin with open arms since its inception in 2009. The dealings in Bitcoin were unregulated and the currency was quite convenient for paying for illicit drug trafficking and for money laundering. Because of the small volume of activity, the U.S. government seemed to have been on a “watchful waiting” mode before March of this year. However, with blossoming Bitcoin activities (which the title of my article in this column on 13 May 2013, “Digital Money Won’t Go Away,” suggests), the U.S. government began warning Bitcoin businesses in March of this year to comply with some laws. Then in November this year, the U.S. Congress developed the “Know Your Customer” (KYC) laws. The KYC laws require: a) stringent checking of the identities of the people dealing in Bitcoin, b) close monitoring of accounts, c) reporting of suspicious activities, d) mandatory registration as money transmitters (such as Western Union or MoneyGram), and e) registering with the U.S. Treasury Department’s Financial Crimes Enforcement Network, or FinCen.
Bitcoin exchanges and brokers in the U.S. that are unable to meet the new regulations are folding up their businesses. Also, the KYC rules have made banks and other companies wary about dealing with Bitcoin companies. In all, I think the recognition of Bitcoin by the U.S. Treasury is a blessing in disguise, as serious and capable Bitcoin companies will be working hard to comply with the KYC laws.
Government regulations are one thing – they cover money laundering and drug trafficking, but consumer protection against volatility or currency failure is certainly a completely different story. The lessons of e-gold might be useful here. The e-gold currency was founded in 1999 by Douglas Jackson, who had hoped his currency would rival or even replace “flat currencies’ like the dollar or Euro. Jackson, a sole operator of the e-gold currency, liquidated the vaults of gold that backed e-gold when e-gold operations were shut down by the U.S. government for operating an unlicensed money transmitter business and aiding money laundering. According to some, the best lesson from e-gold is that currencies, like Bitcoin, should be backed by verifiable assets that can be liquidated to pay users should something go wrong.