Updated 9/30/2013 -- © Christian Wagner
1) Should I buy Bitcoins?
2) But I keep seeing all this stuff in the news about them and how
No. Tech journalism is uniformly terrible, always remember this.
3) How does this shit work? It doesn't make any sense!
No, it really doesn't. It's impossible to accurately explain Bitcoin in anything less than mind-numbingly boring technical terms so you should probably just not worry about it. Go do something useful instead.
1) I really want to understand how Bitcoin works. Please.
Okay, you asked for it. With some severe simplifications and a painfully neutral pov:
Bitcoin is a decentralized "cryptocurrency". It is a network of software that shares a common protocol designed to allow secure transfer of Bitcoins between users. It uses distributed cryptography to verify transfers and balances.
Bitcoin is also the subculture that has sprung up around this software, which includes additional software that is not part of the core design. The most high-profile of these are trading services that allow users to buy and sell Bitcoins using US dollars and other real-world currencies.
Bitcoins users have files called "wallets". This is sort of a misnomer, because these wallets do not actually contain anything except a cryptographic private key. One's Bitcoin balance is actually recorded inside the distributed network, which is why you cannot edit your wallet file to give yourself more Bitcoins. Bitcoins can be added to a particular balance using a public Bitcoin address, which acts as a cryptographic public key. The private key is contained in the wallet, and Bitcoins cannot be transferred out of a balance without that private key.
(If you don't understand public-key cryptography, do some reading because you can't really understand Bitcoin without it. If you can't understand public-key crypto then you should probably just stop reading right now and not feel too bad about it, because crypto is weird complicated shit.)
Transfers between wallets are recorded in "blocks", which are verified by the distributed cryptography system. The act of verifying transactions and then adding those transactions to the historical "blockchain" is called "mining". Transactions are stored in the blockchain using cryptographic hashing methods (as described in the previous link under "Digital Signatures") which allow the entire blockchain to be independently verified for consistency and integrity. In order to make blockchain verification an attractive prospect, the design of Bitcoin gives "Bitcoin miners" two reasons to tie up their computing hardware to maintain the network, both based around competition.
The first reason is that Bitcoin transfers can contain optional transaction fees which are paid to the miner that verifies the transaction. Paying a transaction fee makes it more likely that your transaction will be processed in a timely manner, because those transactions are more attractive to the miners.
The second reason is that mining gives the miner a chance of receiving a batch of newly created Bitcoins. The more cryptographic power one brings to bear, the more likely it is that the next batch of new Bitcoins will be yours. There are a fixed number of Bitcoins which can ever be mined, and the difficulty of the cryptography will continue to increase over time.
An important aspect of mining is that the network is designed to handle one complete block (containing a specific number of transactions) every ten minutes. If more computing power is added to the distributed network, making the blocks take less time to process, the difficulty of the cryptography increases. The inverse is also true. This scaling difficulty is meant to help prevent a single user or group of users from gaining complete control over the network by using more computational power.
The distributed verification process determines the "truth" of a transaction block by whether or not the majority of the network (as measured by contributed cryptographic work) considers it valid. The original designer thought it unlikely that any one user or organization could acquire a majority of the network's cryptographic power and therefore "cheat" the system in some way.
Bitcoin verification power is typically measured in the speed at which a system can perform cryptographic hashes, which are required to verify the blockchain and to add transactions to it. The current difficulty of the mining process is determined by the amount of "hashing" required to add a new block to the chain.
These are the core aspects of the original Bitcoin design. In short, Bitcoins are assigned to "wallet" addresses, with balances stored in a distributed "blockchain". The accuracy of the blockchain is verified by "miners", who have a vested interest in doing so through a reward system. Attacks (such as double-spending) are prevented by the distributed nature of the network, where any invalid transactions will be caught by other mining systems.
2) That was painful to read.
It was painful to write.
3) So what have people done with Bitcoin?
Bitcoin was originally a proof-of-concept project by an anonymous crypto specialist who used the pseudonym "Satoshi Nakamoto". It is unlikely that he was actually Japanese, but his identity still remains a mystery. Bitcoin was meant to be a testing ground for theories about how cryptocurrencies might work. At first, Bitcoin was a curiosity and there was little participation in the network, as Bitcoins had no real-world worth.
This all changed as Bitcoin was discovered by three types of people. First, there were the internet libertarian types who liked the idea of a currency that was not controlled by a government. For them, Bitcoin represented an ideology. Second, there were people who wanted to use Bitcoin as a semi-anonymous international currency for illegal transactions, such as drugs, weapons, or illicit pornography, as well as a possible method for laundering money. For them, Bitcoin represented safety from the law. Third, there were people who viewed Bitcoin as a method to get rich by getting in on the ground floor of a new kind of money. These people saw Bitcoin as an investment.
The history of Bitcoin is too complicated to go into detail here, but these three groups shaped the Bitcoin network and community into what it is today, which is a gigantic goddamn mess of idiocy, greed, and bad decisions.
4) What happened to the neutral pov?
5) Well, then where is Bitcoin right now?
Right now, the Bitcoin community has been overwhelmed by the use of Bitcoin as, essentially, a commodity to be bought and sold. Individual Bitcoiners may talk about the future of Bitcoin as a currency, but the vast majority of Bitcoin transactions today are the buying and selling of Bitcoins themselves using real-world money, and not the buying of goods or services using Bitcoins. There is an extremely limited number of things you can spend Bitcoins on without first converting them to real-world money, and many of those are done through third-party Bitcoin-to-dollars systems where the merchant never sees any Bitcoins.
Bitcoins are purchased and sold much like other commodities such as gold, petroleum, and the like. Exchange services are set up, where people who wish to buy the commodity put forth "buy orders", where they offer to buy a certain amount of the commodity at a given price, and these buy orders are matched with "sell orders" put in by people who wish to sell that commodity.
There are several Bitcoin exchanges that let one buy and sell Bitcoins using dollars and other currencies, but the most important one is "Mtgox". Amusingly, Mtgox started life as "Magic: The Gathering Online eXchange", an exchange service for virtual Magic: The Gathering cards.
When someone says "Bitcoin is at $150" or something similar, usually they mean that the most recent buy order on mtgox was for $150 a Bitcoin.
The market prices for Bitcoin have historically tended to rapidly inflate and then crash spectacularly. Bitcoin's market value has dropped by 50% in less than a day on multiple occasions.
Recently (mid-2013) most of the major Bitcoin exchanges have run into problems with government currency regulations, which has made it very difficult for people to convert Bitcoins back into real currency. Mtgox, for example, currently has a waiting period of about two years before you can withdraw any of your money. Bitcoin supporters often recommend performing Bitcoin-to-dollars transactions in person, which not only sort of defeats the idea of it being an anonymous digital currency, but also feels uncomfortably like arranging a drug deal.
6) What if I want to "mine" Bitcoins instead of buying them?
There is currently absolutely no reason to do this, because the combination of a scaling difficulty level and a competitive reward system has led to a Bitcoin mining arms race where everybody is a loser.
The original design of Bitcoin did not account for the possibility of specialized, expensive hardware which could make mining without that hardware almost useless. Certain kinds of ATI Radeon video cards proved so effective at performing Bitcoin hashing that mining solely on a general-purpose PC gives negligible results, due to the vastly increased hashing difficulty. Miners purchased huge amounts of these video cards to create custom (and often hilarous) "mining rigs" which do nothing but convert electricity into waste heat and Bitcoins.
The stakes have been raised again with the advent of specialized Bitcoin-only ASIC hardware which is even more effective than the video cards were. With huge amounts of specialized Bitcoin computing hardware being added to the network every week, the difficulty has been rising extremely quickly; currently, the majority of ASIC equipment cannot mine Bitcoins fast enough to pay for its own electricity requirements, much less its original purchase price. The more hashing power is connected to the Bitcoin network, the less profitable mining becomes for everybody.
The future of Bitcoin mining appears to be in the hands of a small minority of users who can afford ASIC equipment, making the "distributed" nature of Bitcoin something of a joke. In addition, the Bitcoin network now must use vast amounts of power just to maintain itself, power typically generated by fossil fuel plants and in amounts far out of proportion to its actual usefulness. It is a tremendous waste of actual real-world resources that could be better used on something important (like, for example, watching cat videos).
The real winners in this arms race are the manufacturers of Bitcoin ASIC equipment, which is usually sold for real-world currency and not Bitcoins. This is strongly analogous to the people who made the most money during the California gold rushes in the 1800's, who were the ones selling equipment and services to the miners, not the miners themselves.
If you really want to own Bitcoins (maybe because you want to buy drugs), buy them with real money. It's stupid, but it's less stupid than mining.
7) Is Bitcoin actually anonymous?
In one sense, yes. A Bitcoin address is not necessarily tied to any single person.
In most other senses, no. By design, Bitcoin relies on distributed verification of transactions and balances. This means that every single transaction performed by a Bitcoin address is always going to be visible to the entire rest of the network. There is literally no privacy when it comes to Bitcoin addresses, and once someone can associate your identity with a public address, it is relatively simple for them to track literally all of your activity using that address. This includes, for example, transferring your balance to a different Bitcoin address in an attempt to re-anonymize yourself.
8) So could Bitcoin ever be a real currency?
No, for one simple reason. Bitcoin does not scale. The network is very specifically designed to process a very limited number of transactions in each block, and each block by definition takes about ten minutes to process, regardless of how powerful the Bitcoin verification network is. The more popular that Bitcoin becomes, the slower it will be for every single transaction to get processed. The claim that Bitcoin is "instant" is demonstrably false.
(It is also not "free", because while adding a transaction fee to your Bitcoin transaction is technically optional, without a fee it is unlikely that your transaction will be verified any time soon. Fees are a de facto requirement to get your transactions processed.)
More importantly, the blockchain size is increasing rapidly. The blockchain file is currently many gigabytes in size, and the entire chain must be downloaded in order to mine or verify your own transactions. (Or to track somebody else's transactions: see the part about anonymity above.) You can use a third-party service to store and transfer your Bitcoins, but these services have historically tended to get hacked or just suddenly vanish, taking all your internet funny-money with it.
If Bitcoin actually became popular as a currency and not just as a speculative commodity, the blockchain would swell to an absurd and unmanageable size. Visa (for example) maintains multi-terabyte (at least) databases of financial transactions; now imagine if everybody who wanted to safely use a Visa card had to have a copy of all that data (including lists of everybody else's transactions).
9) Wait, does that mean that every advantage that people claim Bitcoin has is not actually true?
Yes. It's not anonymous, it's not free, it's not instant, and it's not convenient. It's extremely difficult to make money on it, mining is useless, and it's literally impossible that it will ever go into widespread use. Unless you have an ideological stake in the concept of Bitcoin (or want to buy drugs and/or child porn), there is literally no reason to get involved in it.
There's actually one thing that Bitcoin supporters claim about Bitcoin which is true: it has no chargebacks. Bitcoin transactions are irreversible. Whether this is actually an advantage or not probably depends on whether you've ever been ripped off before. If you haven't, then getting involved in Bitcoin is probably a good way to fix that.
10) Can I use this FAQ elsewhere?
Sure, go ahead. Attribution-NonCommercial-ShareAlike 3.0 Unported Creative Commons license, please.
You can find the markdown version of this document here.