In the last few years, an interesting alternative to paper currency has risen in the form of Bitcoin. I started paying attention to Bitcoin two years ago, and have owned some ever since. I’ve purchased physical and digital goods with it, as well as traded it for cash. It’s particularly intriguing to me because it maintains the core properties of economic models while creating a system of inflation guided by encryption algorithms rather than humans. And it’s grown in huge popularity over that time, with a net worldwide worth of over $750 million USD at the time of this writing.

Many people have asked me about Bitcoin, so here’s a basic introduction to what Bitcoin is and how it works.

Note: I am neither a lawyer nor an accountant. This should not be construed as legal or financial advice. If you use the information in this post, you agree that it is at your own risk.

What is Bitcoin?

A currency can be thought of as a limited supply of something that can be traded. In the case of the US dollar, that something* is paper bills and metal coins, each of which has a value to the total limited supply of all money. The limited nature of a currency is where it gets the value; the idea being that we all collectively trust some entity to manage the supply of the currency. In the case of the US dollar, the Federal Reserve manages the supply against the full faith and credit of the United States.

Bitcoin is a type of currency that is managed not by people, but by cryptography. Transferring currency between people involves computing some work and signing it with a public key. Volunteers verify the transactions using really hard math problems. Every few minutes, a small amount of Bitcoins is given randomly to a miner, slowly and steadily inflating the amount of currency in the system and giving incentive for people to verify the transactions. The history of all transactions are publicly available, but the addresses are basically random data, making transactions hard to identify. The result of this is a system where the supply grows at a well-defined rate that everyone can see. It also means transactions are fairly anonymous, verified by others, and irreversible.

How do you get Bitcoins?

There are two primary ways to get Bitcoins. But before this, you need a program called a Bitcoin wallet, which tracks the Bitcoins you have, and manages your addresses. You can get a Bitcoin wallet for pretty much any desktop OS, for Android, or you can use a hosted site like Mt. Gox or Coinbase (though remember, these sites are hosting your money, so take precautions here). Your wallet manages some extremely sensitive data, and so you should take care to keep it safe and backed up, or you can lose your Bitcoins forever.

The easiest way is the same as with any other currency – by receiving them from someone else. To do this, you create an address with your Bitcoin wallet that you can give to others; for example, my address is 19LayHDujXwVpuLv2cqgFFfBFwmegx3Z8s. You give this address to someone, and they send a certain amount of Bitcoins (or fractions of Bitcoins) to that address. This transaction is submitted into the Internet, where other people verify the transaction to prove that the person actually owns those Bitcoins. Once enough people have verified the transaction, the coins are considered “transferred”, and they’re yours. There are several exchanges to trade Bitcoins with others for other currencies (I use Mt. Gox), though there are often times difficulties in transferring US dollars to one of these (as PayPal and the credit card vendors don’t let you use them for buying Bitcoins). You can also find people who will trade informally in places like #bitcoin-otc on Freenode IRC.

The other way is a process called mining, which involves running a program (a miner) which helps verify transactions on the network. This program verifies other people’s transactions by processing really hard math problems. The result of verifying these transactions, however, is the chance for free money. Every few minutes, a new block of Bitcoins is “found” by a miner, and they get to keep them. Additionally, when other people transfer Bitcoins, they can optionally include a “transaction fee”, which goes to a miner. One problem with this is that finding Bitcoins is difficult to do, because so many other people are trying to do the same. To mitigate this, many people join a mining pool, where any Bitcoins found are distributed among the whole pool. Some people go so far as to build custom computers to do Bitcoin mining at scale, and there are hardware lists that talk about how to get the most bang for your buck.

What do you do with Bitcoins?

You spend them, of course! An incomplete list of vendors to spend Bitcoin at can be found on the Bitcoin wiki. You can buy all kinds of things with Bitcoins, like food, clothes, services, toys, books, and even beer. Many sites will trade by the market value, meaning that they’ll sell something for either $20 via PayPal or $20 at market rate in Bitcoin (so if a Bitcoin cost $1, that would cost 20 BTC).

You can also treat Bitcoins as a commodity and do forex (currency) trading. So if you buy 10 Bitcoin at $1 and sell them at $2, you’ve made a profit of $10. The markets for this tend to fluctuate quite a bit; the month prior to writing this, the value has increased from $30 to peak at $75. But what goes up must come down; in 2011 the USD to BTC exchange rate plummeted from a peak of $33 to $2.51 and took a long time to recover. The volatility means that you could have huge gains, but also catastrophic losses.

Is it safe?

I’ll divide safe into four areas here: value stability, information security, identity, and legality.

You want a currency to be fairly stable in value, meaning that huge swings don’t happen (or at least are rare). Otherwise it’s difficult to put faith in the currency. As of right now, there are still large swings in value that make it difficult to be reliable. It’s certainly more volatile than most paper currencies. So if you’re looking for a safe bet to put your savings into, this isn’t it. The volatility could be desirable if you’re looking for short-term gains, but not for your life savings. Treat it like a gamble.

The Bitcoin protocol has some smartly designed security features. It uses similar encryption to what your computer uses when talking to your bank’s website, and if hackers figure out how to beat that, we’ll all have bigger problems than our Bitcoins being hacked. It relies on a massive network of volunteers verifying transactions and reaching consensus; the only way to work around this is to build a network more powerful than all the world’s supercomputers combined. And it relies on problems that are computationally complex as to require significant time from would-be hackers. The combined result of these layers of security is a system that has only had one major security flaw over two years ago (and hackers have a huge financial incentive to break this system, so you can bet they’re trying). Where hackers have found successes is in attacking online wallet services and exchanges. You should be very careful if you store your Bitcoins in one of these.

Your identity is never attached to a transaction or address. Each transaction, however, is publicly available and has a history. If you share an address and receive Bitcoins from it, and that address is Googleable, your name might be found attached to some Bitcoin. But purely from the network layer, transactions are anonymous. They’re just heavily recorded.

As of this writing, there’s no laws that I know of against owning or trading Bitcoins. There are very few regulations; the only one I know of was actually just implemented today. That also means there’s little safeguards in terms of risk or fraud. Tax implications are also unclear, but you probably should just file it as income. Talk to your accountant and your lawyer, because I am neither.

Should I use it?

Bitcoin is definitely not the easiest thing to use. But there are plenty of things you can buy with it, so it’s a viable currency for many things. And it’s an interesting market for speculation. If you want to buy things online and prefer to avoid PayPal or giving out a credit card, it’s a nice alternative that is basically digital cash.