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Have you ever wondered how digital money works? Any ordinary digital file such as an MP3, AVI or PDF can be copied an infinite number of times, and sent to an infinite number of people. This simple fact is the basis for the file-sharing and torrent movement. So why can’t you do the same thing with electronic money? What is to stop you from spending the same $100 at 20 different stores? This is informally referred to by computer scientists as the “problem of double-spending [8].” Up until now, it has been solved with a system of trusted third parties called clearing houses. In our current financial system, in order to send money to another party, you have to go through a clearing house, which guarantees that the amount you send matches the amount by which your account is debited. It is the integrity of the clearing house which prevents double spending in our system today.

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Though you may not have been aware of it, you have been sending and receiving money through clearing houses your entire life. Any time your employer makes a direct deposit into your bank account in the United States, that money has gone through the Automated Clearing House, a network operated in partnership between the Federal Reserve and the Clearing House Payments Company [3]. Additionally, any time you use a credit or debit card, your digital money is sent through Visa, Mastercard, American Express, or another private clearing house. With 90% of our money supply now in digital form, almost the entire economy is built upon this network of just a few central clearing houses [2]. But what if that were to change…

Blockchain.info_

In November 2008, a mysterious party operating under the alias, Satoshi Nakamoto submitted this letter to the Cryptography and Cryptography Policy Mailing List. The letter links to a paper written by Nakamoto in which he presents a revolutionary new solution to the problem of double-spending, which he calls Bitcoin. In the Bitcoin network, rather than sending payments through a central clearing house, all transactions are broadcast across the internet to be picked up by every “miner” in the network. The miners then add the transaction to a public ledger of all transactions ever carried out on the Bitcoin network, called the block chain. The payer would then be unable to spend those coins again, because the ledger would indicate that they had become the property of the payee [1]. Evidently the idea caught on. Bitcoins have been entering circulation as payment to the miners at a controlled rate ever since. Once the supply reaches 21 million BTC, new coins will cease to be created, and miners will be paid solely by transaction fees instead.

In the Bitcoin network, identities are represented by randomly generated sequences of numbers and letters called “public keys,” which enable participants to remain completely anonymous if they so desire [9]. In contrast, however, the block chain keeps a record, which traces the history of every coin in the network, making Bitcoin the most transparent financial system ever. This combination of privacy for the individual and transparency for the system is absolutely unprecedented. It is also unbelievably efficient.

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On the day of writing (December 14th, 2013), the largest transaction on the Bitcoin network was for 69,500 BTC, then valued at $59.5 million [4].

If this transfer were to have been made via PayPal, depending on the country of destination, it would have carried a transaction fee of between .5 and 2% or between $297 thousand and $1.19 million [5], making it completely impractical.

As a more likely option, if you were to wire money directly from your bank to the bank of the recipient, this transfer would cost a flat rate of about $45 [6].

Finally, if you were to make an expidited wire transfer through a company like Western Union, which specializes in international money transfers, the fee would be about $22, and would take 1-2 business days [7].

As of December 2013, however, the transaction fee necessary to ensure immediate inclusion in the block chain is $.09, and takes only 1 hour. The fees and processing times for bitcoin transactions are the same no matter the time of day nor the country of destination.

In summary, cryptocurrencies like bitcoin are not merely an ideological alternative to our current monetary system, they are a technological revolution in a very meaningful sense. They enable greater personal privacy, as well as unprecedented transparency for the system. Transfers on the network are faster than an expedited wire, exponentially cheaper, and solve the problem of double-spending without relying on the integrity of any central clearing house. Indeed it is hard to overstate just how revolutionary this technology is.

And it’s timing could seemingly not be more opportune. In the not-so-distant wake of the 2008 mortgage crisis, there seems to be more skepticism toward government monetary systems than ever. The fact that the monetary base is created on loan, its inflationary expansion and the general lack of transparency of “high finance,” have received widespread and scathing criticism in recent years. These are three enormous problems which bitcoin has seemingly solved with the a few simple keystrokes. Are cryptocurrencies the answer we’ve been waiting for? While it’s hard to answer with certainty, I would absolutely not rule it out.

Sources

[1] Nakamoto, Satoshi. “Bitcoin: A Peer-to-Peer Electronic Cash System.” Bitcoin. Bitcoin Project, n.d. Web. 14 Dec. 2008.
[2] “Money Stock Measures – H.6.” Board of Governors of the Federal Reserve System. N.p., 19 Dec. 2013. Web. 20 Dec. 2013.
[3] “Intro to the ACH Network.” NACHA. 2013 NACHA – The Electronic Payments Association, n.d. Web. 20 Dec. 2013.
[4] “Largest Recent Transactions.” Largest Bitcoin Transactions. Block Chain, n.d. Web. 20 Dec. 2013. <https://blockchain.info/largest-recent-transactions>.
[5] p”Fees.” PayPal Fees – For Purchases, Getting Paid and Personal Transfers – PayPal. Paypal, n.d. Web. 19 Dec. 2013. <https://www.paypal.com/us/webapps/mpp/paypal-fees>.
[6] Fowler, Janet. “8 Low-Cost Ways To Transfer Money.” Investopedia. Investopedia, 21 Apr. 2011. Web. 14 Dec. 2013. <http://www.investopedia.com/financial-edge/0411/7-low-cost-ways-to-transfer-money.aspx>
[7] “Fees & Delivery Methods.” Money Transfer Methods and Fee’s. Western Union, n.d. Web. 20 Dec. 2013. <http://onlinefx.westernunion.com/fees/>.
[8] Ryan, Mark D. “Digital Cash.” Digital Cash. University of Birmingham, 31 Jan. 2007. Web. 14 Dec. 2013.
[9] “Anonymity.” Bitcoin Wiki. N.p., 30 May 2013. Web. 14 Dec. 2013.

Further Reading

Bitcoin White Paper

Khan Academy Bitcoin Series

Bitcoin Wiki


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