Understanding Bitcoin and cryptocurrencies

Note: Our guide to understanding Bitcoin has been fully updated. This feature was first published in April 2014.

While once a curiosity of the internet, Bitcoin and other cryptocurrencies are considered by some to be the money of the future. However, over the last several years, Bitcoin has certainly had its ups and downs – literally.

Cryptocurrency is an attempt to replace money transactions with a digital medium of exchange using peer-to-peer networking. The first decentralized cryptocurrency, and still the most successful, was Bitcoin, which was created in 2009 by the mysterious developer Satoshi Nakamoto, who subsequently left the project in late 2010.

Virtual money, real impact

The idea is that you use cryptography to control the creation and transfer of money, rather than relying on central authorities.

Since the success of Bitcoin, there have been over 3,000 other virtual currencies introduced with varying degrees of success and popularity such as Ethereum, Litecoin, Monero and Dash. There have even been crowdfunded cryptocurrencies such as Lisk.

Many other cryptocurrencies have just died because of lack of interest, and the simple fact that no one used them. Non-Bitcoin cryptocurrencies are collectively known as altcoins and they are more or less based on the same idea of a decentralized digital medium for exchange.

Their success depends on how much ‘cash’ (the total value of transactions) they have sloshing about the peer-to-peer network (i.e. the virtual economy). Since Bitcoin is open source, anyone can develop their own cryptocurrency using the same technology.

A short lesson in scarcity

Bitcoins derive their value partly through their scarcity, which is defined by a cryptographic lottery. You can buy Bitcoins on online cryptocurrency exchanges or you can earn them through a process known as ‘mining’.

Bitcoin mining programs compute an encryption function called a hash on a set of random numbers. Coins are awarded to whichever miner happens to compute a number below a certain threshold.

Originally, Bitcoin mining was handled by standard PCs with powerful graphics cards, but as the hash difficulty has increased, the preferred method to mine Bitcoins is to employ a Bitcoin ASIC, a chip that has been designed specifically for this task. However, with the higher value of cryptocurrency – in particular Ethereum – and recent advances in GPU processing power, miners have once again been turning to graphics cards for mining.

This lottery favors those with the biggest and fastest machines, and currently there are about 17 million Bitcoins in circulation. Note that the total number of Bitcoins in (virtual) circulation will never exceed 21 million because of the way the system was designed.

As the Bitcoin network gets bigger, the hash gets more complex, and miners get fewer Bitcoins for their trouble, hence they always need better hardware and higher Bitcoin prices to make it worthwhile.

As a currency, Bitcoin is still a niche market. However, multiple established retailers accept it as payment including Overstock, Expedia, Newegg and the Dish Network.

Since Bitcoins can be spent on the internet without the use of a bank account, they offer a convenient system for anonymous purchases, which also makes it possible to launder money and buy illegal products. Since there is no money stored anywhere, accounts can't be frozen by police or PayPal administrators.