Once upon a time, currency value was tied directly to the value of gold. But today, most currencies have a floating value, which is managed by central banks who, like the bitcoin open sourcers, carefully manage the money supply to fight inflation in times of economic growth and to push growth in times of economic stagnation.
How do bitcoins become money?
For the most part, they are exchanged for dollars or other currencies at exchanges like Mt. Gox in Japan. PrivCo estimates that 80 percent of bitcoins are turned into U.S. dollars. And 20 percent are held in inventory by processors and recirculated as bitcoins. The processors charge a fee like brokers to buy and sell bitcoins on the speculative marketplace, which fluctuates wildly at times.
[Read: Should You Invest in Bitcoin?]
Although the general trend in bitcoin's value has been higher, economists see it as a potential bubble that would pop if the speculators lost interest in trading and making money on their virtual currency. Some Web-based businesses are starting to accept bitcoins as payment, but this is a gamble since they must eventually go to the speculative marketplace to convert the virtual money to dollars. There is no guarantee of what amount they will recover.
Aren't more places accepting bitcoins?
Digital currencies are nothing new, but their use traditionally has been limited. Some online games or virtual-reality sites like Second Life mint virtual currencies as a reward for users on the site. The Linden dollars of Second Life managed to create a market as enthusiasts paid real money for them. But in essence, these currencies are not much more than the extra ball a pinball player gets for high scores, although they can be transferred to other players for money.
Bitcoin's backers have a more ambitious goal in mind. Their crypto-currency is meant to be a global currency operated without government fiat or oversight. As such, bitcoin's early buyers tended to be people with a passionate interest in secrecy. While they may have been well-intentioned skeptics of government control, their coins gained a following from people engaged in illegal activities.
Some of the most active users of bitcoins are those who use the secret network for buying drugs and other illegal items on Silk Road, an illicit marketplace that accepts them as currency, accounting for about 1.3 million bitcoins a month or 4.5 percent of all coins traded, according to a study last year by Nicolas Christin, associate director of Carnegie Mellon University's Information Networking Institute. The bitcoins used by Silk Road traders are eventually exchanged for dollars, making the drug seller one of the key users in the digital currency's development.
Drug dealers were willing to take a gamble on the nascent currency because the upside of their transactions was so great that they could risk losing money if a deal failed to produce what the bitcoin buyers really wanted: dollars. International economic sanctions against Iran also created demand for bitcoins. The influx of narco-dollars and laundered money helped fuel bitcoin's rise by adding cash to the speculative marketplace. International monetary crises like the Cyprus freeze on its own currency also spurred demand for the relative safety of bitcoins.
Why doesn't the government try to stop the illicit trading?
It has. The growth of bitcoins led to action. As of March, the U.S. Department of Treasury's Financial Crimes Enforcement Network has ruled that bitcoins will be regulated as a real currency. This will allow users who adhere to monetary regulations to keep trading and using bitcoins, but will subject the currency to existing rules on money laundering and bank-reporting requirements, meaning more transparency. Many legitimate backers of bitcoins applauded this as a big step forward. Secrecy advocates have vowed to keep doing business as usual and scoffed at the notion it can be regulated.