Say you bought a milkshake from Cookout. You give cash for the value of the milkshake. There is a physical entity that went from your hand into the sales person at the window.
When you make an online payment for the headphones you bought on Amazon via your credit card, or pay an artist whose graphic design you bought via PayPal, the proof of the fact that you paid and the opposite party received is kept by third party agencies like your credit card company or PayPal. This proof is a called a ledger.
Electronic currencies are electronic documents, just like Microsoft Word documents. These can be duplicated and copied without effort. You can then give one copy of the same money to pay for the headphones and another to buy the graphic design poster. This problem is called double-spending.
The ledger is the sole proof of the online transactions that you have make. The credit card companies and PayPal are central entities that take the responsibility of keeping a history of online transactions and the funds associated with those transactions.
Bitcoin is the first concept of electronic money that attempts to solve this problem in a distributed manner as opposed to a centralized manner adopted by the credit card companies or PayPal.
Bitcoin was first invented in 2008 by a programmer who goes by the pseudonym Satoshi Nakamoto. The encrypted ledger exists; not in the hands of a centralized agency, but in the hands of the users themselves.
Try to imagine this ledger as a chain of blocks. Each block represents one transaction involving Bitcoins. This universally unique copy of the ledger is updated for every transaction that is made.
Physical currency is generated and commissioned by reserve banks. So who generates these Bitcoins? Bitcoins are generated by an algorithm. If you are willing to donate your CPU power to run parts of this algorithm, the parts running on your CPU might just generate a Bitcoin and voila, you are the proud owner of a Bitcoin!
In addition to making your own Bitcoins, donating CPU power will also enable you to charge transaction fees for the transactions that use your Bitcoin. Even though this mechanism seems dubious, it is cryptographically limiting. The total number of Bitcoins in the whole universe is limited to 21 million.
As of this writing, the Akamai protected Mt.Gox exchange quotes the value of one Bitcoin to be $309. It was $125 at the start of October. This means that if you own a Bitcoin, either by generating one or buying one, you can sell it for an equivalent amount of $309.
The problem with virtual currencies is that it is not under the control of a single entity and hence not under the control of the government. Online trade stations and vendors have started offering an option to pay via Bitcoins in addition to credit cards and PayPal. Most notable include Reddit, WordPress, Baidu etc. The downsides includes no surveillance of transaction histories and hence purchases of illegal objects like drugs, ammunition and black trade is attracted towards Bitcoins.
The Silk Road was an online trading service that provided anonymity to its users by using the Tor cryptographic technique of anonymous communication. One could view and trade anonymously, and most of these trades were illegal. The FBI raided the Silk Road quarters and confiscated 1.2% of the total Bitcoins that can ever come in existence.
There is a lot of debate and ambiguity over concepts of virtual currency. For example, one issue is whether Bitcoin even comes under the jurisdiction of trade commissions. How does even one confiscate Bitcoins ? These are questions that are being debated as you read this.
The invention of Bitcoin has certainly opened unexplored avenues. But are they legitimate or is it all just a big bubble that will one day burst and cause massive financial and economic imbalance in the world as we know today?
