What's Bitcoin and why does it have so many imitators?
Conventional payment systems like PayPal and Visa are centralized. A for-profit company operates the network and ensures that it is secure and reliable. But Bitcoin operates on a different model. Instead of being run by a for-profit company, Bitcoin operates as a peer-to-peer network. Its security is guaranteed by cryptographic algorithms instead of government or corporate managers.
One consequence of this design: the Bitcoin network has its own currency. The PayPal corporation guarantees that if you deposit one dollar into a PayPal account, you'll be able to get a dollar back later. But no one owns the Bitcoin network, so there's no one to guarantee that one unit of Bitcoin currency will have a stable value against conventional currencies. Instead, Bitcoin's unit of value, also called the Bitcoin, floats against conventional currencies. One bitcoin is currently worth about $800, up from less than a dollar at the start of 2011.
Bitcoin's success has attracted a legion of imitators, called "altcoins." One list shows 63 different altcoins in existence.
I read that one of these alternatives is called the "Dogecoin," named after a dumb Internet meme. This is all a big joke, right?
Yes, Dogecoin is a joke. Though weirdly it's a joke that, at least on paper, is worth millions of dollars.
Because Bitcoin is an open-source project, anyone can take the source code, modify it, and then use the modified software to create their own Bitcoin-like network. The founders of Dogecoin took the source code of another Bitcoin variant called Litecoin, made some further tweaks, and rebranded it as "Dogecoin." That's a reference to the canine variant of lolcats, an Internet meme where a grammatically challenged dog makes excited statements.
Dogecoin has been around for less than a month. In that time, the value of all dogecoins in existence has skyrockted from zero to more than $8 million.
How can an imaginary currency based on an annoying Internet meme be worth millions of dollars? I must be missing something.
People waste money on stupid stuff all the time. Look at the Beanie Babies craze, for example. You only have to find a few thousand suckers before a previously worthless asset becomes worth millions of dollars.
And there really are a lot of people willing to pay cash (or at least Bitcoins, which are easily converted into cash) for dogecoins. The order book of the virtual currency exchange Cryptsy shows there are buyers willing to spend hundreds of Bitcoins, worth hundreds of thousands of dollars, for Dogecoins.
Presumably some of these buyers are people who are willing to drop a few dozen dollars to participate in a fun Internet joke. And others may be speculators hoping that they'll be able to unload their Dogecoins at a profit before the market collapses.
What about the other virtual currencies? They're all jokes too, right?
Maybe not. While the value of Dogecoins has been rising quickly, the currency still isn't among the top 10 alternatives to Bitcoin. Unlike Dogecoins, the leading Bitcoin alternatives were designed to be serious alternatives to Bitcoin.
Bitcoin's pseudonymous creator, Satoshi Nakamoto, did an amazing job of building a payment network that is secure, scalable and useful. But he wasn't perfect; he made some design decisions that might not look so great in retrospect.
The problem is that thanks to Bitcoin's decentralized design, it's not easy to change the core Bitcoin protocol. Hence, if you have an idea for an improved version of Bitcoin, it's easier to start your own virtual currency than to try to convince the Bitcoin community to change how Bitcoin works. So over the past three years, a number of people have introduced Bitcoin alternatives that borrow some ideas from Bitcoins but also fix perceived flaws.
What kind of flaws does Bitcoin have?
Most of the altcoins have focused on improving mining, the process the Bitcoin network uses to process transactions. In the Bitcoin mining process, hundreds of computers race to solve a repetitive math problem. The winner of the race gets to add a "block" to the Bitcoin network's global transaction register, and to award itself 25 bitcoins (roughly $20,000) for its trouble.
Critics see two big problems with this system. One problem is that the mathematical formula at the core of the Bitcoin mining process, called a hash function, can be performed much more efficiently by expensive, custom-designed computers than with an ordinary PC. As a result, mining has become an increasingly specialized activity, with people spending thousands of dollars on chips whose only function is to mine Bitcoins. This hardware is so much more efficient than ordinary PCs that it's no longer cost-efficient to mine Bitcoins with an ordinary PC — the electricity consumed is worth more than the bitcoins produced.
That, critics warn, risks undermining one of Bitcoin's core virtues: its decentralization. The security of Bitcoin's transaction-clearing process requires that no one control more than 50 percent of the network's computing power. Bitcoin's designer envisioned thousands of ordinary users running Bitcoin software on their PCs, ensuring that no one could gain a large market share.
But thanks to the rise of dedicated hardware, Bitcoin mining has become increasingly professionalized. Miners have organized themselves into "pools," and a handful of pools control the overwhelming majority of the network's computing power. Critics worry that these pools could eventually gain de facto control over the network, undermining one of the network's key selling points.
A Bitcoin alternative called Litecoin replaces Bitcoin's hash-based mining process with an alternative that's harder to accelerate with dedicated hardware. Litecoin's developers hope that this will make Litecoin mining a more democratic activity, with anyone being able to cost-effectively mine Litecoins on their PCs.
Litecoin was one of the first Bitcoin alternatives to be introduced, and it is the most popular decentralized payment network after Bitcoin. As this is being written, the value of all Litecoins is more than $500 million.
Man, that was complicated. Can we take a music break?
Sure, here are the Baha Men singing their classic song "Who Let the Dogs Out":
And here is 2012 presidential candidate Mitt Romney demonstrating his rapport with voters by quoting the song's lyrics:
Okay, you said Bitcoin mining has two big flaws. What's the second one?
The second Bitcoin flaw is the one Paul Krugman alluded to in a recent column: The mining process is a computational arms race. The more computing power you have, the greater your influence over the Bitcoin network and the more Bitcoins you can earn. And as miners throw more and more hardware at the problem, they consume more and more electricity.
The Bitcoin principle that miners with more computing power earn more Bitcoins is known as "proof of work." Several Bitcoin alternatives use an alternative principle called "proof of stake," where miners with the most virtual cash earn the most. That approach eliminates the incentive to spend ever-larger sums of money on mining hardware, which is good for the environment.
Several virtual currencies use variations of the proof of stake principle. Nextcoin, which is now one of the five most popular virtual currencies, uses it. Another popular currency, Peercoin, uses a hybrid model — you need both computing power and peercoins to mine more peercoins efficiently.
In addition to the energy savings, advocates of proof-of-stake currencies like Nextcoin and Peercoin argue that it makes the network more secure against takeover attempts. Recall that you could take control of the Bitcoin network if you obtained a majority of the network's computing power. With a proof-of-stake currency, on the other hand, taking control requires gaining a large share of the outstanding coins. For a successful virtual currency like Bitcoin, that could cost billions of dollars. And a successful takeover would destroy confidence in the currency, devaluing those same shares. This, advocates argue, provides stronger security than Bitcoin's proof-of-work scheme.
Altcoins bring other improvements, too. For example, the Bitcoin network takes 10 minutes, on average, to "confirm" a transaction. Some alternative currencies are designed to process transactions more quickly.
Okay, so Bitcoin isn't the most cutting-edge virtual currency around. Does that mean it's doomed?
So far, Bitcoin partisans haven't had any reason to worry. All bitcoins in circulation are worth around $10 billion. Its nearest rival, Litecoin, has a total market value of around $500 million. The other virtual currencies are worth much less.
That's probably because currencies exhibit what economists call "network effects": The more people use them, the more valuable they are. The fact that Bitcoin was the first currency to market gives it a huge advantage. It gets the most publicity, has the most startups supporting it, has the most merchants accepting it, and has the most users invested in it, literally and figuratively. As long as Bitcoin continues serving users' needs adequately, it has a good shot at remaining king of the hill indefinitely. And while most of the proposed improvements to Bitcoin are theoretically interesting, none seem to be compelling enough to induce users to switch in large numbers.
Then why are people willing to spend millions of dollars on Litecoin, Peercoin, Nextcoin and the rest?
It's possible multiple virtual currencies could co-exist side-by-side indefinitely. People sometimes describe Litecoin as silver to Bitcoin's gold.
But holding altcoins can also be seen as a bet on Bitcoin's eventual failure. So far, Bitcoin has weathered all the storms it has sailed into, including a major bug in the core Bitcoin software that caused a glitch back in March. But it's still possible that future developments will reveal fundamental flaws in the Bitcoin protocol. For example, the increasing centralization of Bitcoin mining could lead to a costly fight over control of the currency, or make it vulnerable to greater government regulation.
If Bitcoin stumbles, others stand ready to take its place as the leading decentralized payment network. If that happened, the value of other virtual currencies could soar as users fled Bitcoin in favor of less-known alternatives. Buying altcoins now is a way of covering your bases in case the market eventually switches to an alternative currency.
So should I buy some dogecoins or not?
If you want to blow $100 on a dumb Internet meme, be my guest. But don't expect to make a profit.