Bitcoin is diametrically opposed to all existing electronic currencies, a radically new concept that is quite difficult to explain, to a point that many articles on Bitcoin mistakenly compare it to Beenz, e-gold, Flooz, PayPal, Pecunix, etc, This is always a sign that the authors do not comprehend the main pillar of Bitcoin's design.
Bitcoin is the world's first invention of a decentralized electronic currency, with no central authority or trusted parties whatsoever, as its inventor originally describes. Not even the Bitcoin developers themselves have special control of Bitcoin. Compare this to other e-currencies that are operated by central authorities that are single points of failure: they have a history of regulating transactions (Paypal blocking donations to Wikileak, etc), or simply failing and shutting down (Beenz, etc).
If Bitcoin is confusing to you, that is normal. Bitcoin is best explained by this list of analogies. Read carefully:
- Bitcoin is like digital gold.
- By design, there is a known, immutable, fixed supply of bitcoins, similar to gold being available in limited quantity on Earth. There are 2.1 quadrillion indivisible units of value (0.00000001 bitcoins), and not one more will ever exist.
- Bitcoins are digital, therefore you can instantly transfer them to anybody across the world.
- Bitcoins are stored locally on your electronic device (cellphone, computer), contrary to being stored in an account managed by a financial institution. This is similar to how you can store cash or gold in a physical location of your choice. This means there is no "Bitcoin account" that can be frozen by someone in power (eg. your spouse making malicious claims to seize a bank account during a divorce).
- Bitcoin transactions are technically irreversible. There is no mechanism to revert a transaction, other than convincing the recipient to send the bitcoins back. This solves the fraud problem for merchants, as all the payments they receive are final, whether fraudulent or not. (On the downside, like cash or gold, if bitcoins are stolen from you, the chance of recovering them is generally slim.)
- Payments are sent directly from one party to another without going through a financial institution, similarly to how cash or gold can be handed directly to someone. You do so by sending them from your computer, to the recipient's computer, through the Bitcoin network (which is nothing more than other computers running Bitcoin). Since no one can realistically prevent a computer from getting Internet access one way or another, no one can regulate or block transactions (eg. oppressive governments financially repressing activists.)
- Finally, there is no financial institution, or bank, or company, operating Bitcoin, just like there is no company in charge of "operating gold". There is no Internet server to shut down to terminate Bitcoin. It exists merely as an application running on your computer, which communicates with other Bitcoin users over the Internet. This "mesh" Bitcoin network is called a peer-to-peer network, and this design makes it effectively indestructible, as long as the medium of communication (Internet) exists.
You must be wondering:
- How can Bitcoin offer all the above security guarantees? The entire system is secured by a novel and clever use of cryptographic algorithms. It was so difficult to get right that it had to be designed completely openly. So it was made open source, available for free for anybody to use. Its openness has allowed peer-review of its source code and has attracted a lot of attention from some world-class cryptographers and computer scientists (Jeff Garzik, Dan Kaminsky, Jacob Applebaum, etc). As experts, they are used to find weaknesses in applications, but to their suprise they found Bitcoin well designed, offering the guarantees it claims. If you are enclined to read technical documents, read the Bitcoin design paper, this LWN introductory article, or my first post on Bitcoin.
- How are the coins created? With gold, miners have to perform a lot of work to discover gold deposits in the planet's crust. Bitcoin emulates gold here again: "Bitcoin miners" run specialized software on high-powered computers and solve complex mathematical puzzles. The difficulty of the puzzles ensures that coins are slowly introduced in the system over time, and are randomly distributed to its users. (Depending on your electrical costs, mining may be a profitable activity.) However the vast majority of Bitcoin users acquire them by simply purchasing them from other users or from exchange markets, or by trading goods or services with users owning bitcoins.
- If the coins are stored on my device, what prevents me from making copies, counterfeiting them? The entire network uniquely identifies all coins and tracks all transfers. For example a transfer is recorded like this, coming from opaque addresses, going to other opaque addresses. (Note that this makes Bitcoin not fully anonymous, but at least pseudo anonymous, because it can be hard to figure out who owns which addresses as the Bitcoin software creates new addresses for every transfer and users are encouraged to not re-use them.) If you copy coins and attempt to spend them twice, the network will detect the "double-spend" and reject it.
- Why do Bitcoins have value? What backs Bitcoin? Bitcoin is like gold: nothing backs it. The only reason a currency or commodity has value is because people are willing to trade goods or services for it. Initially, Bitcoin was perceived as having no value. Then early-adopters started to grasp its potential and invested in it. For example, one of the first transactions was two pizzas that famously sold for 10000 Bitcoins. This was a risky trade because Bitcoins were worth virtually nothing at the time. Nonetheless, this trade and subsequent ones helped "bootstrap" the currency, because people knew there would be at least one guy willing to trade pizzas for Bitcoins. Trade and value grew step by step over time. Fast-forward to the present and there is today a thriving community of merchants accepting Bitcoin. This community alone is what gives bitcoins value.
In my view, the unrestricted and decentralized aspect of Bitcoin has the potential to change our society the same way the unrestricted and decentralized flow of information on the World Wide Web changed it.