Bitcoin bet

It is dismissed by critics, disliked by many banks and a mystery to most people. So why do some argue bitcoin is about to remake international finance?

Bitcoin | Illustration: Shutterstock

By Danny Bradbury
November 28, 2013

By Christmas, you’ll be able to walk into at least five locations across Canada, feed your Canadian dollars into a machine, wait 10 minutes, and retrieve a slip of paper with a long string of numbers on it. Most people won’t know what to do with it, but those in the know are clamouring for the privilege. Welcome to the mysterious world of bitcoin.

The bitcoin ATMs, made by Las Vegas-based Robocoin, have been purchased for $18,500 each by Bitcoiniacs, a bitcoin exchange based in Vancouver near Granville Island. Bitcoiniacs founder Mitchell Demeter believes that by putting the machines in Vancouver, Calgary, Ottawa, Montreal and Toronto, he’s at the forefront of a revolution in digital cash.

“Bitcoin is to finance what the Internet was to communication,” Demeter said. “It changes everything. It allows you to send money instantly around the world...with no middleman. That changes the financial landscape.”

He isn’t the only one excited about bitcoin, which is a form of digital payment like no other. It’s a currency in its own right, but it has no central bank, and no one to manage it. It isn’t printed or minted like regular cash, and you can’t hold it. Instead, it is created by computers, from pure mathematics. Try to spend it, and most merchants will look at you as though you’re mad. But at $1.2 billion, its market capitalization is already worth more than the individual GDPs of 21 countries. The founder is currently worth around $100 million in bitcoins—and no one, not even the people currently in charge of it, know who he is.

The mysterious Nakamoto

They know him only by his nickname, Satoshi Nakamoto. He first appeared in 2008, publishing an academic paper on an obscure cryptographic forum. The paper described a unique system that would be used to create and spend money in a completely decentralized way (see sidebar on how bitcoin works).

Nakamoto turned on the first computer in the bitcoin network—his own—in early 2009. He gathered a team of online disciples who worked with him to refine and improve the code behind the bitcoin network. Then, around the end of 2010, he posted a final message on the board, saying that he’d be less involved. Then he vanished, leaving the disciples—now the team of core developers—to carry on. None of them had ever actually met him.

Yet today, bitcoin is big business. The currency is valued against other fiat currencies like the U.S. dollar, and the price is still volatile enough that people can make their fortunes buying and selling it. When people first started trading bitcoins, the value was less than five cents to the U.S. dollar. In March this year, it spiked to $266, and then crashed.

At time of writing, it was bouncing between $120 and $140.

This volatility and high value has led tens of thousands of people to join the bitcoin network, hoping to make money via trading the coins, or creating them. Many use their computers to “mine” for new coins (see sidebar), which has made mining itself a big business. In fact, a whole industry has sprung up around it.

Manic miners

“Mining is a gold rush and a technical arms race all in one, and anyone across the globe can take part,” said Sam Cole, co-founder of KnC Miner. “Not even the technology behind algorithmic trading used by the largest banks in the world has progressed this fast.”

Cole’s is one of several companies producing computers dedicated to mining bitcoins. When Satoshi Nakamoto switched on the first bitcoin mining computer in January 2009, he was able to mine bitcoins with relative ease. In fact, he mined thousands of them in short order. But as more people caught wind of the opportunity to mine their own digital currency, competition increased, and it became harder to create them.

Where once you could compete with a laptop, the process later got so complex that you needed a desktop computer loaded with graphics cards. The special graphical processing units (GPU) that these cards use to generate complex graphics for computer games are also well suited to bitcoin mining. GPUs dominated this space until other more specialized technology superseded them. The latest are application-specific integrated circuits (ASICs), which are computer chips specifically fabricated to solve these problems.

Companies promised ASIC-based miners for months, but few delivered. Those that did would often keep large banks of them for themselves, running them in data centres and mining bitcoins as quickly as possible.

In the fourth quarter of 2013, several ASIC vendors are planning to ship more miners, including KnC Miner, which spent more than $3.5 million designing and engineering its own chip before it even reached a fabrication plant.

Others, such as CoinTerra, are not far behind. They are selling these boxes for thousands of dollars to customers desperate to get their hands on them so they can mine their own bitcoins before the competition really kicks in.

Show me the money

The $64,000 (500 bitcoin) question you’re probably asking right now is “why?” Bitcoin, after all, has no intrinsic value. It isn’t linked to any real-world asset. It is entirely arbitrary. It has value only because the people producing it say it does.

“Much more than a currency or a payment network, bitcoin is programmable money that brings the promise of finance automation and innovation,” said Andreas Antonopoulos, author of a forthcoming O’Reilly book on bitcoin, and host of the biweekly Internet-based bitcoin radio show Let’s Talk Bitcoin. “Bitcoin promises an instantaneous, frictionless interconnected global economy that is as rich in innovation as the Internet and that can empower billions of people through financial access.”

Bitcoin tinkers with the very concept of money, hoping to find a better way to structure finance, and avoid repeating miseries such as the boom/bust cycle and future economic meltdowns. As a decentralized currency with no great and mysterious Oz pulling levers behind the curtain, it is designed to be guided by the crowd.

Bitcoin’s challenges

The idealism is charming, but can it survive, and if so, can it make money? Getting merchants to accept bitcoin is one step along the road to mainstream adoption. Getting ATMs in front of consumers is another. But simply getting people to understand it will be difficult enough.

“The technology is ready for primetime, the user experience and user knowledge is not,” said Charles Hoskinson, head of the Bitcoin Education Project, an online service to help educate people about bitcoin. “Bitcoin needs its AOL moment,” he said, pointing out that AOL helped make the mass market aware of the Internet and what it could offer. Venture capitalists must help fund companies that will build services atop the basic protocol, making it easier to use.

This lack of usability is one of the reasons getting merchants to accept bitcoin is an uphill struggle. When physical establishments such as bars and restaurants elect to take payments in bitcoin, it makes the news, placing it firmly in the “gold for nerds” category. It’s a Catch-22 situation for bitcoin advocates: merchants won’t accept it until people use it. People won’t use it until merchants accept it. And most of them still don’t understand it anyway.

However, it is happening, slowly. “On a local scale here in Vancouver, there have been more and more merchants accepting bitcoin,” said Piotr Piasecki, a bitcoin enthusiast who wrote his thesis on the subject, and who is working with the U.S.-based Bitcoin Foundation industry group to explore a Canadian chapter. A branch of the Waves coffee shop in downtown Vancouver began accepting bitcoin, he explains (this is the same branch that will host Canada’s first bitcoin ATM). “Those businesses benefit from the extra customers brought in by the Vancouver Bitcoin Meetup group,” he said.

In the meantime, BitPay, which provides a way to process bitcoin payments easily on its Web sites, has now signed 10,000 merchants, showing that the currency is steadily moving toward mainstream adoption.

Perhaps the biggest opportunities thus far, however, are financial. “I’m seeing some good financial innovation, in terms of the way that bitcoins can be invested, and that is really intriguing,” said Stuart Hoegner, a gaming attorney who is general counsel for the Bitcoin Alliance of Canada.

For many people, the real value in bitcoin lies in taking long positions in what is still a volatile market, buying bitcoin and selling it for a profit later. Calgary-based Virtex is one of several exchanges around the world offering such services, but most of them have had their problems.

In the U.S., regulators closed down an account owned by Mt Gox, the incumbent bitcoin exchange, which had failed to get a money services business licence. Exchanges elsewhere have had to close because banks refused to do business with them, worried they would not meet regulatory requirements. Virtex, too, had its account closed by RBC in the spring, and was forced to limp along on other bank accounts. It managed to get its money services business licence by signing a third-party partnership with an existing licence holder.

So there are many challenges—banks are ambivalent, or even hostile, about dealing in it; the CRA’s rules around taxing it are far from clear; and FINTRAC, the financial regulator, said money services business licences aren’t required. But Hoegner said this is likely to change in the future. Amid this uncertainty are opportunities for businesses here in Canada and further afield. “They have a new payment channel that does not have chargebacks or credit card fees, that gives them access to a global consumer base, that doesn’t require access to banks, and that needs to collect less data about customers to do business,” Hoskinson said.

In a world where it still costs upwards of $15 to make a basic international bank transfer, that has to be of interest.

How Bitcoin works

Bitcoin is a software protocol for exchanging and managing digital currency on an entirely decentralized basis. There are other digital payment systems, such as PayPal, but whereas PayPal can shut down your account and freeze your assets whenever it deems this necessary, no one controls your bitcoin address. When you spend bitcoins, there is no single authority to stop you, or to charge you fees.

Anyone can be a bitcoin user. Setting up an address is simple; a software-based wallet produces them randomly at the click of a button, and many people have multiple addresses. Sending someone bitcoins simply involves entering his or her address into your wallet. In many cases, these addresses are encoded as QR codes, making them easy to scan with a smartphone camera.

The software that manages a bitcoin address also connects to the rest of the bitcoin network. All of the autonomous computers in the network also maintain a constantly updated copy of a general ledger. This ledger, called the blockchain, records which addresses exchanged bitcoins, and how much was transferred.

Whenever anyone spends any bitcoins, information about the transaction is broadcast to the rest of the network, which then has to write it in the blockchain for it to be confirmed.

A list of recent transactions to be confirmed is gathered into a collection of transactions known as a block. This block is added to the end of the blockchain, updating the general ledger. But before this can happen, it must be digitally signed to mark it as complete. To digitally sign the block, a computer must use the data making up the transactions to solve a mathematical problem.

Computers on the bitcoin network compete to do this using additional software in a process called “mining.” The reason they compete is that the first computer to solve the problem and sign a block gets a reward of 25 bitcoins. This reward is automatically acknowledged by the rest of the network, and written into the blockchain. It’s not insubstantial; each bitcoin is currently worth around $120 to $140, and with a new block mined every 10 minutes on the bitcoin network, that adds up quickly.

Bitcoin terms

Bitcoin Client - software that sends and receives Bitcoins.

Bitcoin Network - network of computers where transactions are broadcasted. Also maintains the blockchain.

Wallet - a file that stores Bitcoin addresses and the private keys needed to use them.

Blockchain - like a ledger, it records which addresses Bitcoins exchanged and how much was transferred.

Bitcoin Address- encoded as QR codes, this is the payment destination, which is required to send someone Bitcoins.

Miner - someone who helps create blocks for the blockchain. A miner receives 25 new Bitcoins for every block created.

Private Key - hidden secret number related to an address which permits access to send Bitcoins. If the key is lost, the currency in the wallet is gone forever.

Bitcoin Protocol - every node in the network is required to download a copy of every Bitcoin transaction.

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