Answers to Bitcoin questions

WASHINGTON — This has been a big week for Bitcoin. On Monday, the Senate Committee on Homeland Security and Governmental Affairs held the first congressional hearing on Bitcoin.

That has left a lot of people scratching their heads. What’s Bitcoin? How do you use it? And why would anyone want to? Read on for answers.

• What’s Bitcoin? Bitcoin is an online financial network that people use to send payments from one person to another. In many ways, Bitcoin is similar to conventional payment networks like Visa credit cards or Paypal. But Bitcoin is different.

First, Bitcoin is decentralized. For-profit companies own the Visa and Paypal networks and manage them for the benefit of their shareholders. No one owns or controls the Bitcoin network. It has a peer-to-peer structure, with hundreds of computers all over the Internet working together to process Bitcoin transactions.

Bitcoin’s decentralized architecture means that it is the world’s first completely open financial network. To create a new financial service in the conventional U.S. banking system, you need to partner with an existing bank and comply with a variety of complex rules. The Bitcoin network has no such restrictions. People don’t need anyone’s permission or assistance to create new Bitcoin-based financial services.

The second thing that makes the Bitcoin unique is that it comes with its own currency. Paypal and Visa conduct transactions in conventional currencies such as the U.S. dollars. The Bitcoin network, however, conducts transactions in a new monetary unit, also called Bitcoin.

• That seems really weird! Why would anyone use a payment network based on an imaginary currency? It is weird. But so far the market has proved the skeptics wrong. There are almost 12 million bitcoins in existence, so the Bitcoin “money supply” is now worth around $7 billion.

Bitcoin has captured the imagination of venture capitalists. A startup called Bitpay, which processes Bitcoin payments on behalf of vendors, raised more than $2 million earlier this year.

Why are people so excited? Bitcoin enthusiasts believe that Bitcoin’s peer-to-peer architecture and low barriers to entry will allow the creation of a new generation of innovative financial services, in much the same way that the Internet’s open architecture led to innovative new online services.

• This just sounds like a bubble. Do people use the currency for anything besides speculation? I just mentioned Bitpay. It provides a good sign of Bitcoin’s growing popularity for “real” transactions. In September 2012, the company announced that it had signed up 1,000 merchants to use its service for accepting Bitcoin payments. Just a year later, the company said, it passed 10,000 merchants.

Bitpay works with a wide variety of merchants. Some sell online services such as Web hosting or virtual private networks. Others sell jewelry and electronics.

And yes, Bitcoin has significant illicit uses. Programs like Satoshi Dice allow people to gamble online. Until recently, a Web site called Silk Road helped dealers sell millions of dollars of illicit drugs.

Another application for bitcoins that is expected to become more important in the future is international payments. Right now, wiring money internationally involves slow, expensive and inconvenient services such as Western Union. Bitcoin is international, and fees can be much lower than conventional wire transfer services. There’s still work to be done to make such a system affordable and user-friendly.

• Who created Bitcoin? No one knows for sure. The currency was created by a person who indentified himself as “Satoshi Nakamoto.” While the name sounds Japanese, Bitcoin’s creator never provided any personal details. He collaborated with other early Bitcoin fans through online forums but never met with other members of the Bitcoin community face to face. Then, starting in 2010 he gradually reduced his involvement in the currency’s development. His last known communication came in 2011.

Before leaving the scene, Nakamoto passed his torch to a mild-mannered developer named Gavin Andressen, who is currently the project’s lead developer. Andressen now works under the auspices of the Bitcoin Foundation, the closest thing the anarchic Bitcoin community has to an official public face.

• Where do bitcoins come from? In a conventional financial system, new money is created by a central bank, such as the Federal Reserve. But the Bitcoin network doesn’t have a central bank. So the system needed an alternative mechanism for introducing currency into circulation.

Bitcoin’s designer solved this problem in a clever way. Hundreds of computers scattered around the Internet work together to process Bitcoin transactions. These computers are called “miners,” and Bitcoin’s transaction-clearing process is called “mining.” It’s called that because every 10 minutes, on average, a Bitcoin miner wins a computational race and gets a prize. Currently, that reward is 25 bitcoins, worth around $12,500. These prizes provide a strong incentive for more people to join in Bitcoin’s transaction-clearing process, helping the currency to remain decentralized.

This reward declines on a fixed schedule: Every four years the reward falls by half. So, from 2009 to 2012, it was 50 BTC, now it’s 25 BTC, and starting in late 2016 it will fall to 12.5 BTC, and so forth. If you do the math, you’ll find that there will never be more than 21 million bitcoins in circulation. Right now, there are almost 12 million bitcoins in circuclation, so the Bitcoin money supply will never be more than twice its current size.

• How do I get bitcoins? One option is to mine them yourself, but that’s not a good choice for beginners. For everyone else, your best bet is to purchase them with a conventional currency. Web sites known as exchanges will let you trade bitcoins for conventional currencies with other users. Even more convenient are companies such as Coinbase, which will withdraw cash from your bank account and convert it to bitcoins. A few Bitcoin ATMs are popping up, which will directly trade paper money for Bitcoins.

• OK. I bought some Bitcoins. Now what? Next you’ll need a place to store them. Bitcoins are stored in “wallets,” which in this case are just files that contain encryption keys, or secret codes that allow you to transfer your bitcoins to other people. There are several options. One is to store them yourself using one of the Bitcoin programs available for Mac, PC and Android.

Another option is to entrust them to a third-party Web site known as a “online wallet.” A third option is what’s known as a “paper wallet,” where you print out your encryption keys and store them in a safe place, such as a safe deposit box. Each has risks.

• I have some bitcoins and found a secure way to keep them. What do I do with them now? There are thousands of Bitcoin merchants online who will sell you everything from jewelry to electronics. You can also spend bitcoins in “real life.” To spend them in person, you need a Bitcoin mobile app. Generally, the store you’re buying from will show you a QR code representing the Bitcoin transaction. You then scan that QR code with your phone, and the mobile app will send the required number of bitcoins to the store. Then you walk out the door with your purchases.

Of course, right now the options for face-to-face Bitcoin transactions are rather limited. Earlier this year, Kashmir Hill of Forbes lived on Bitcoin for a week. Because she lived in tech-savvy San Francisco, she was able to find enough Bitcoin-accepting merchants to get by, but just barely. So Bitcoin is far from being a practical currency for day-to-day use.