Factbox - What is Bitcoin - currency or con?

LONDON Mon Apr 2, 2012 12:16am BST

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LONDON (Reuters) - Bitcoin is a mathematical money system driven by code. It allows users to send money directly from their computer to another on the other side of the world.

Units can be sold on online marketplaces in exchange for dollars, euro, sterling, Polish zloty, Australian dollars, renmimbi, yen and others.

The free-floating exchange rate is volatile. At the peak of a speculative bubble in June last year, one Bitcoin was worth almost $30. It has been trading between $4 and $5 for the past month.

Other online units of exchange like gold-backed electronic money, Facebook credits, or the Linden dollars of the virtual world Second Life rely on the authority that creates them to function. The same could be said of everyday government-issued money.

Bitcoin is different because it works without a central authority. It is a shared peer-to-peer system relying on the network of people using it to work.

HOW DOES IT WORK?

A problem facing creators of non-physical currencies is how to ensure users do not spend their money twice.

Before Bitcoin was invented, the standard way of resolving this was for all transactions to be checked by a central authority.

Bitcoin solved this problem in a new way by publishing all transactions on a commonly accessible history. It could read: "Ben gave five Bitcoins to Joe. Joe gave two Bitcoins to Anna and three Bitcoins to Jane."

Instead of a central authority recording and verifying payments, any Bitcoin user can do this, and there is an incentive to do so.

Anyone who sets their computer to do the energy and time-consuming work of verifying payments is automatically rewarded 50 Bitcoins every time they add a ‘block' of transactions into the history. This activity is known as ‘mining'.

A maximum of 21 million Bitcoins will be released to miners at a gradual rate that halves every four years. 8.5 million are currently in circulation.

If more people start mining, the programme automatically makes it harder to create history blocks, regulating the supply of money.

In this way, the designer of Bitcoin managed to combine independence from a central authority with an impartial way of distributing the currency.

If a programmer tried to alter the Bitcoin code - for example to try to increase the number of Bitcoins in circulation - this rule would algorithmically disagree with all the other computers on the network.

He would be able to branch out into a new currency that worked according to his new rules, and would be free to encourage people to join his new system, but he couldn't impose his changes on the original Bitcoin.

Once all the Bitcoins are in circulation - most will be issued within a decade - users will have to attach a fee to their transactions, to give an incentive to the miners who verify the transactions and keep building the history.

WHY IS BITCOIN LIKENED TO CASH?

Actual Bitcoins do not independently exist. The number of Bitcoins each user is entitled to spend is written in the history of payments.

When people talk of ‘storing' Bitcoins, they are really talking about storing their private key. This key is needed to instruct the system to unlock and transfer their wealth to another user: "Sophie gave ten Bitcoins to Felix."

The private key must be kept on a computer or a USB stick, protected against theft. Like cash kept under the bed, anyone who accessed it could use it to transfer Bitcoin to themselves.

Although all transactions are openly visible, payments are between abstract endpoints. Without finding a way to link these endpoints to users, as with cash, payments cannot be traced back to a person.

And like cash, transactions are difficult to reverse. Once a payment is written into the history, it is very difficult to undo, and becomes almost impossible once more and more transactions are written on top of it.

(Reporting By Naomi O'Leary; Editing by Will Waterman)

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