To borrow a phrase from "Seinfeld," it's a currency about nothing.
Bitcoins have no intrinsic value. But since they were introduced to the world in 2009 by inventor Satoshi Nakamoto (a pseudonym), they have turned into a billion-dollar market and have been designated a currency by the U.S. government. Since the days when stones and shells were recognized as a means of payment, currency has taken many forms. What makes bitcoin a currency is what it does, not what it is. "To the extent it looks, walks and acts like a duck, this 'duck' is a currency," says Sam Hamadeh, chief executive officer of private-company research firm PrivCo.
Here are some questions and answers explaining how bitcoin became a currency. The answers were supplied by Bitcoin.org, the Bitcoin Foundation, Hamadeh and the website of Mt. Gox, the largest marketplace for trading bitcoins.
What are bitcoins?
Nothing but a randomly assigned set of unique numbers, not encrypted or particularly complicated. They are linked to individual signatures to prove ownership. That ownership can be transferred between parties.
How are they allotted?
They can be bought second-hand on exchanges or "mined" as new bitcoins. Bitcoin prospectors who want new coins must solve math problems of varying complexity that are posed by members of the Bitcoin open-source consortium. Solving the problem gets you assigned to a pool that will be granted a number of the coins. Cracking the math problem, which requires a large amount of computing power and can take weeks, does not assure you will get any bitcoins, but puts you into a lottery that gives you a chance at winning one.
Why does it sound like a game?
There are overlaps in the gaming and bitcoin community. Super-fast gaming chips have been used by many bitcoin miners, and online game players have long competed for rewards like virtual money. But this time, it's serious.
What does it mean that bitcoins are "open source"?
In theory, the thousands of volunteers who review and approve bitcoin allotments provide a check on the system to make sure the supply is closely monitored and verified against a master list. While the algorithms, or computer codes, users must solve are secretive, the master list, known as the "block chain," is publicly viewable, just as the code for open-source browser Firefox is open. The theory is that the more eyes there are on a transaction, the more secure it is.
Other open-source groups have managed success using a similar open process. Linux, the widely used open-source computer operating system, was developed by thousands of users who contributed code and maintain the integrity of the software. Wikipedia, the online encyclopedia, works on the same concept. The ethos is as old as the Internet itself, which is carried by millions of computers in a peer-to-peer, decentralized network based on a set of common rules.
How many bitcoins are there?
Bitcoin's rules are based on a mathematical formula that will grow until the number of units hits 21 million, at which point it will shut down. In theory, the bitcoins may be broken into many smaller parts so the money supply can be expanded to meet growing demand.
How do bitcoins gain value?
Value is subjective. The bitcoin numbers themselves are worth nothing – just as gold is just a piece of metal until someone pays for it.
Initially, they were worth pennies. But speculators have bid up the value of a single bitcoin to as high as about $290. The overall value of all bitcoins in circulation is now calculated to be $1 billion, a sizeable figure but a tiny fraction of all global currencies. Vastly more currency is denominated in bank credits and accounts held by governments and individuals and estimated by the International Monetary Fund to be worth about $150 trillion.
How does "real" money gain value?
The piece of paper the dollar is printed on is worth nothing on its own. But banks allot credit to individual banking accounts regulated by government central banks. Their value comes from a government's backing, know as a "fiat," Latin for "let it be done." Every government has a fiat currency, even if it decides to peg its currency to U.S. dollars, as some Latin American, Gulf region and Asian countries do, and because the gold, oil and other global commodities are priced in them.
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.
So how will that regulation work?
Buyers whose bitcoins that are ultimately converted to spendable dollars risk prosecution if they fail to report transactions of $10,000 or more. FinCEN works with foreign governments as well as domestic law enforcement. Its increasing use of advanced technology can detect unusual money flows in and out of the banking system. It will be a huge deterrent to hidden transactions and a setback for the $10 trillion global black market in which the virtual currency was becoming the coin of the realm.
Could such scrutiny spell the end for bitcoins?
It's a turning point. Bitcoin is more likely to follow the path of Linux, which began as free software and is now widely used by thousands of companies for some or all of their software needs. Once mainstream companies like IBM began to use it in custom applications, it became ubiquitous and legitimate. And although the software was technically free, companies charged for maintaining and installing it. Bitcoin could evolve the same way, playing a role in making e-commerce payments cheaper and more efficient. And legal.