Bitcoin has had a volatile journey since it was launched in 2009, attracting attention among conventional investors as well as the black market. Regulators and policy makers are also following Bitcoin, raising the occasional eyebrow as they evaluate Bitcoin’s risks and benefits and how to regulate this little understood virtual currency. Some media reports have confused Bitcoin with more popular electronic money (e-money) schemes used in many low-income countries to reach the unbanked. But the two are markedly different and should not be conflated. This Brief provides information about Bitcoin and contrasts Bitcoin with e-money to avoid alarm about the former to the detriment of the latter.
One way to comprehend virtual currency is to first understand fiat currency. Fiat currency is any legal tender designated and issued by a central authority that people are willing to accept in exchange for goods and services because it is backed by regulation and because they trust this central authority. Fiat money is similar to commodity-backed money in appearance and usage, but differs in that it cannot be redeemed for a commodity, such as gold (European Central Bank 2012).
By contrast, virtual currency is “a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community.” Although there are different types of virtual currencies (European Central Bank 2012), this Brief will focus on virtual currencies with “bidirectional flow” since these currencies intersect most directly with the real economy. Virtual currencies with bidirectional flow may be bought and sold according to prevailing exchange rates and may be used to purchase both real and virtual goods and services.
Bitcoin was launched in 2009 as an alternative to fiat currencies by an unknown computer scientist using the pseudonym Satoshi Nakamoto (n.d.). Bitcoins are not printed like fiat money, but instead are “mined” using computing power in a distributed global network of volunteer software developers. At its core, Bitcoin is nothing more than a digital file that lists every transaction that has ever happened in the network in its version of a general ledger called the “block chain.” Bitcoin is the first example of a growing category of money known as cryptocurrency in which open-source software solves complex mathematical calculations to mine more Bitcoins (Coin Desk 2013a). These “miners” make the Bitcoin network function by validating transactions and thereby creating new Bitcoins. This occurs when the Bitcoin network collects all the transactions made during a set period of time (usually every 10 minutes) into a list called a “block.” Miners confirm these blocks of transactions and write them into the block chain by competing against each other to solve mathematical calculations. Every time a miner’s system finds a solution that validates a block of transactions, that miner is awarded 25 Bitcoins (Coin Desk 2013b). Every four years, this reward is halved so that the total number of Bitcoins will never exceed 21 million.
For a new user not interested in the mining process, the most popular way to obtain Bitcoins is through a traditional exchange where fiat currency is converted into Bitcoins and then stored in a Bitcoin wallet. Wallets come in many forms, including desktop access, mobile access, and online web-based access. Each has its own risks as both desktop and mobile access are susceptible to hackers, a hard drive crash, or a lost mobile device. Online access uses third parties that may also be hacked, cheat its users, or go bankrupt (Lee 2013).