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financial-world-mining-digital


Mining digital gold
Even if it crashes, Bitcoin may make a dent in the financial world
Apr 13th 2013 | From the print edition




IN 1999 an 18-year-old called Shawn Fanning changed the music industry for ever. He
developed a service, Napster, that allowed individuals to swap music files with one another,
instead of buying pricey compact discs from record labels. Lawsuits followed and in July
2001 Napster was shut down. But the idea lives on, in the form of BitTorrent and other
peer-to-peer filesharers; the Napster brand is still used by a legal music-downloading
service.
The story of Napster helps to explain the excitement about Bitcoin, a digital currency, that is
based on similar technology. In January a unit of Bitcoin cost around $15 (Bitcoins can be
broken down to eight decimal places for small transactions). By the time The
Economist went to press on April 11th, it had settled at $179, taking the value of all
Bitcoins in circulation to $2 billion. Bitcoin has become one of the worlds hottest
investments, a bubble inflated by social media, loose capital in search of the newest new
thing and perhaps even by bank depositors unnerved by recent events in Cyprus.
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In this section
Mining digital gold
Bet lynched
Opening the floodgates
Leaky devils
An overdue move
Rakoffs revenge
A slipping taboo
Weight watchers
The death of inflation
Reprints
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Napster
Internet music
Technology
Internet
Science and technology
Just like Napster, Bitcoin may crash but leave a lasting legacy. Indeed, the currency
experienced a sharp correction on April 10that one point losing close to half of its value
before recovering sharply (see chart). Yet the price is the least interesting thing about
Bitcoin, says Tony Gallippi, founder of BitPay, a firm that processes Bitcoin payments for
merchants. More important is the currencys ability to make e-commerce much easier than
it is today.
Bitcoin is not the only digital currency, nor the only successful one. Gamers on Second Life,
a virtual world, pay with Linden Dollars; customers of Tencent, a Chinese internet giant,
deal in QQ Coins; and Facebook sells Credits. What makes Bitcoin different is that, unlike
other online (and offline) currencies, it is neither created nor administered by a single
authority such as a central bank.

Instead, monetary policy is determined by clever algorithms. New Bitcoins have to be
mined, meaning users can acquire them by having their computers compete to solve
complex mathematical problems (the winners get the virtual cash). The coins themselves
are simply strings of numbers. They are thus a completely decentralised currency: a sort of
digital gold.
Bitcoins inventor, Satoshi Nakamoto, is a mysterious hacker (or a group of hackers) who
created it in 2009 and disappeared from the internet some time in 2010. The currencys
early adopters have tended to be tech-loving libertarians and gold bugs, determined to
break free of government control. The most infamous place where Bitcoin is used is Silk
Road, a marketplace hidden in an anonymised part of the web called Tor. Users order
goodstypically illegal drugsand pay with Bitcoins.
Some legal businesses have started to accept Bitcoins. Among them are Reddit, a social-
media site, and WordPress, which provides web hosting and software for bloggers. The
appeal for merchants is strong. Firms such as BitPay offer spot-price conversion into
dollars. Fees are typically far less than those charged by credit-card companies or banks,
particularly for orders from abroad. And Bitcoin transactions cannot be reversed, so frauds
cannot leave retailers out of pocket.
Yet for Bitcoins to go mainstream much has to happen, says Fred Ehrsam, the co-
developer of Coinbase, a Californian Bitcoin exchange and wallet service, where users
can store their digital fortune. Getting hold of Bitcoins for the first time is difficult. Using
them is fiddly. They can be stolen by hackers or just lost, like dollar bills in a washing
machine. Several Bitcoin exchanges have suffered thefts and crashes over the past two
years.
Ripple effects
As a result, the Bitcoin business has consolidated. The leading exchange is Mt.Gox. Based
in Tokyo and run by two Frenchmen, it processes around 80% of Bitcoin-dollar trades. If
such a business failed, the currency would be cut off at the knees. In fact, the price hiccup
on April 10th was sparked by a software breakdown at Mt.Gox, which panicked many
Bitcoin users. The currencys legal status is unclear, too. On March 18th the Financial
Crimes Enforcement Network, an American government agency, proposed to regulate
Bitcoin exchanges; this suggests that the agency is unlikely to shut them down.
Technical problems will also have to be overcome, says Mike Hearn, a Bitcoin expert. As
more users join the network, the amount of data that has to circulate among them (to verify
ownership of each Bitcoin) gets bigger, which slows the system down. Technical fixes could
help but they are hard to deploy: all users must upgrade their Bitcoin wallet and mining
software. Mr Hearn worries that the currency could grow too fast for its own good.
But the real threat is competition. Bitcoin-boosters like to point out that, unlike fiat money,
new Bitcoins cannot be created at whim. That is true, but a new digital currency can be.
Alternatives are already in development. Litecoin, a Bitcoin clone, is one. So far it is only
used by a tiny hard-core of geeks, but it too has shot up in price of late. Rumour has it that
Litecoin will be tradable on Mt.Gox soon.
A less nerdy alternative is Ripple. It will be much easier to use than Bitcoin, says Chris
Larsen, a serial entrepreneur from Silicon Valley and co-founder of OpenCoin, the start-up
behind Ripple. Transactions are approved (or not) in a few seconds, compared with the ten
minutes a typical Bitcoin trade takes to be confirmed. There is no mystery about the origins
of Ripple nor (yet) any association with criminal or other dubious activities.
OpenCoin is expected to start handing out Ripples to the public in May. It has created 100
billion, a number it promises never to increase. To give the new currency momentum,
OpenCoin plans eventually to give away 75% of the supply. Existing Bitcoin users can
already claim free Ripples and eventually anyone opening an OpenCoin account will also
receive some.
The 25% retained by OpenCoin will give it a huge incentive to make sure that the Ripple is
strong: the higher its value, the bigger the reward for OpenCoins investors when the firm
cashes out. On April 10th several blue-chip venture-capital firms, including the ultra-hip
Andreessen Horowitz, announced that they had invested in OpenCoin.
If Ripple gains traction, even bigger financial players may enter the fray. A firm such as
Visa could create its own cheap instant international-payments system, notes BitPays Mr
Gallippi. And what if a country were to issue algorithmic money?
At that point Bitcoin would probably be bust. But if that happened, its creators would have
achieved something like Mr Fanning. Napster and other file-sharing services have forced
the music industry to embrace online services such as iTunes or Spotify. Bitcoins price
may collapse; its users may suddenly switch to another currency. But the chances are that
some form of digital money will make a lasting impression on the financial landscape.