A good friend of mine and I were talking the other day and he asked me if I had ever heard of Bitcoins.  Never having read or seen anything about this type of currency before, I was amazed to hear that this was a potential online currency system and it was gaining serious traction.  Once our conversation ended, I took to the net and ready up as much as I could about Bitcoin.org, its algorithm and how it functions.  According to my analysis, Bitcoins are NOT a scam.

What are Bitcoins?

Bitcoins are a form of online currency created in 2009 by Satoshi Nakamoto. It is also the name of the open source software designed in order to use this currency.  If you want to pay for something online and the receiver accepts Bitcoins, you can transfer them from your account and close the transaction.  Anyone can create an account at www.Bitcoin.org and begin accepting Bitcoins.  The other option of course is to mine Bitcoins, an extremely complicated task for anyone not mathematically and program savvy.

I wish I could sit down and explain to you step by step on how to mine Bitcoins, but thats simply not going to happen.  Instead, allow me to provide a brief synopsis on how Bitcoins are mined straight from Bitcoin.

New coins are generated by a network node each time it finds the solution to a certain mathematical problem (i.e. creates a new block), which is difficult to perform and can demonstrate a proof of work.  A proof of work is a piece of data which was difficult (costly, time-consuming) to produce so as to satisfy certain requirements. It must be trivial to check whether data satisfies said requirements. Producing a proof of work can be a random process with low probability, so that a lot of trial and error is required on average before a valid proof of work is generated.

How many Bitcoins are there?

If you look at the market today, more than 6 million Bitcoins are currently in existence.  According to a specific timetable in which 10,500,000 Bitcoins will exist after four years, and every subsequent four years, the amount of new Bitcoins is halved.  So, for example, in years 5-8, 5,250,000 Bitcoins will be mined, years 9-12, 2,626,000 Bitcoins will be mined and so on, until 21,000,000 total Bitcoins are in existence.  It is at amount, that the creation of Bitcoins will cease to exist and the world will be left with 21,000,000 Bitcoins.

The reason this is done is similar to why the Federal Reserve doesnt print an unlimited amount of currency .  Should the demand continue to grow for Bitcoins, the cost of acquiring them will increase over time, like a good stock or commodity (silver or gold anyone?).  This method ensures that a proper amount of Bitcoins are released each and every year, and that the market for Bitcoins does not become saturated.

Why are Bitcoins valuable?

Bitcoins hold value for the same reason that Apple stock or a $20 bill hold value.  Its because merchants and individuals are willing to accept them as a form of payment, albeit electronic.  If tomorrow, the world decided that Gold was useless and it could not be used to create anything of value, the price would plummet.  Gold would serve no purpose in our economy and therefore be of no value.  Similarly, Bitcoins are only valuable when others want them, and right now, the demand is high.

So high in fact, that the value of one Bitcoin is currently worth around $18.  That number is up tens of thousands of a percent from where it was just a year ago, however if you compare that value to what a Bitcoin was worth 1 week ago, its down around 40% (high was $30 just seven days ago).  The virtual crash of the Bitcoin is the first in its history, and most likely not the last.

You can see from the graph above that the value of a Bitcoin is now actually worth $17, dropped $1 just in the last hour (and was as low as $13 earlier today).  The volatility of this market is just crazy right now with all of the publicity and problems Bitcoins have had in the last week.  The dollar amount a Bitcoin is worth is determined by an active online trading platform, which is open 24/7/365.   To find out what the current dollar value of a Bitcoin is, visit this graph.

How do you cash in Bitcoins?

The biggest problem facing the Bitcoins empire is the difficulty in exchanging your Bitcoins for paper currency.  Previously, everyones favorite online payment method, Paypal would gladly process Bitcoin transactions, however that has stopped, as all new transactions are blocked.

Currently the most well published ways to convert Bitcoins to USD or vice versa is to use Dwolla or Liberty Reserve.  These methods can be just as simple as using Paypal, however few consumers know of them and transactions can take a long time.  Add to the fact that Bitcoin was having trouble with Dwolla recently, and you have a good reason as to why the market crashed like it did.  Consumer panic about whether or not these Bitcoins will hold their value over time.

The Bitcoin conclusion

If its difficult to grasp the idea behind Bitcoins, just consider them an online stock.  The value of a Bitcoin can go up or down at any time, depending on who is buying and selling them and at what price.  While the actual metrics are more complicated than stocks, the value of a Bitcoin is only what someone else is willing to pay.  Considering their recent struggles with conversion, now may not be the best time to get aboard the Bitcoin train.

But that doesnt make this idea a scam.  Sure, there is potential to lose money in the Bitcoin market and if you think you can mine Bitcoins, you could spend thousands of hours earning very little, however the risks are clear.  Invest wisely!