When the U.S. mortgage market collapsed in 2005, it was sign of more problems to come as many countries in Europe began to suffer from the effects of their governments’ poor money management and over-reliance on debt. Although a financial apocalypse never materialized as some had predicted, one legacy of government debt, inflation and an ongoing recession was a growing mistrust in government-controlled central banks.

Enter Bitcoin, a global electronic currency that was introduced in 2009 and is conspicuously populist; its value is dictated by market forces, freeing it from the control of any central banking authority. But despite its many innovations, this new currency is not without controversy. We’ll take a look at Bitcoin, how it works and why many critics believe it just won’t hold up over the long term.

What is a Bitcoin?

Bitcoin is a decentralized digital currency, or cryptocurrency, made up of a block of encrypted data. This currency exists purely in electronic form, and is therefore exchanged through a secure peer-to-peer file transfer system. Bitcoins are considered to have value because they are accepted as payment by a number of online vendors (you can see which sites currently accept bitcoin here: https://en.bitcoin.it/wiki/Trade). Bitcoin can also be exchanged for gold, so it is often intimately associated with this commodity.

Bitcoin’s value, therefore, is determined by supply and demand in the market, much like gold or any other traded commodity. This has both advantages and disadvantages. The advantage is that it allows this currency to operate without government oversight. The disadvantage is that because of this lack of oversight, Bitcoin is subject to the same volatility you’d see in any traded commodity. If you trade the financial markets, you may already be familiar with the severe dips that can come even on the heels of unsubstantiated bad news. In other words, the market forces that govern Bitcoin’s price are subject to being both highly volatile and sometimes irrational.

How are they created?

New coins are generated, or “mined”, by a network node each time it solves a specific and difficult mathematical problem. In technical terms, mining involves calculating the hash of a block header. This header includes a reference to the previous block, a hash of a set of transactions and a unique 32-bit value called a “nonce”. Bitcoin blocks are generated every 10 minutes, on average, in a process that will continue until 21 million bitcoins are created, which is expected to occur around 2140. At this time, Bitcoins will continue to be traded, but will no longer be mined.

How can I get Bitcoins?

Bitcoins can be attained through a number of avenues. For those who sell goods and services online, the easiest way to attain Bitcoins is to accept them as payment. Bitcoins can also be purchased in exchange for traditional currency through several online exchanges. Bitcoin may also be purchased through PayPal. More technically savvy individuals who have access to a high-end graphics processor may be able to generate their own Bitcoin block, or join a mining pool of computer users to calculate a block and split the proceeds. The generation of a Bitcoin block yields 50 bitcoins.

Is Bitcoin secure?

Bitcoin is referred to as a cryptocurrency because it relies on cryptography for security. Bitcoins are cryptographically signed each time they are exchanged, which requires that each Bitcoin user have both a public and unique private key. These transactions are maintained in a master registry called the blockchain, which is maintained by all of Bitcoin’s users.

Despite these measures, however, Bitcoin is still vulnerable to hacking, largely because Bitcoins are stored on individual users’ PCs. For example, in 2011 a Bitcoin user claimed that he had had $500,000 in Bitcoins swiped from his account. In that same year, a hacker also got into the Mt. Gox Bitcoin Exchange and sold off the currency en masse, causing its value to plummet. Malware has also emerged to launch denial-of-service attacks on competing Bitcoin miners.

Investing in Bitcoin

As mentioned above, Bitcoin can be used as an investment as well as a medium of exchange. In 2010, one lucky Bitcoin investor paid $20,000 for his Bitcoins, then turned around and sold them for $3 million in June 2011. This type of scenario is possible because Bitcoins do not have a set value. So, much like gold, their value is determined by what market participants are willing to pay for them.

Because there is a limited number of Bitcoins being produced, Bitcoin proponents argue that this protects the currency from falling prey to price drops that can occur as a result of oversupply. This type of currency inflation is often what happens with traditional currencies when governments print more money, a scenario Bitcoin was designed to avoid. That said, Bitcoin has been notoriously volatile, so while some investors have made excellent returns, it is certain that many others have and will suffer equally large losses. Also, Bitcoin owners may hoard their currency, which can put the currency under deflationary pressure.

Bitcoin Controversy

While Bitcoin’s supporters claim that it can free people from the “tyranny” of banks, credit card companies and money transfer services, a digital currency presents its own set of problems - ones that Bitcoin, as the first venture into this domain, hasn’t entirely worked out.

Although Bitcoin’s decentralized nature is touted as one of its main benefits, this also means that, unlike traditional financial middlemen, it does not fall under any legal jurisdiction in terms of regulation. As such, Bitcoin has gained notoriety not only for becoming a medium for exchanging goods and services, but also for providing an anonymous, untraceable way to exchange illegal goods, most notably illegal drugs. Plus, with no central bank to back this currency, you can imagine what will happen if it becomes worthless.

Conclusion

Bitcoin presents an interesting foray into a new type of currency – and at an interesting time in history. While it’s hard overlook the appeal of a currency that presents an antidote to many of the problems that are currently plaguing traditional financial systems, Bitcoin also brings its own set of risks and problems. While it seems likely that digital currencies will become a valid medium of exchange in the future, it is less likely that Bitcoin will be the last of such currencies to emerge.