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I recently completed a six part series examining alternative payment systems and comparing them to the PayPal X Platform. As I wrapped that up, I asked readers to weigh-in on which topic they’d like to read about next. I received votes for several topics on the list including a request for coverage of the eBay APIs (watch for more from me on that coming soon). But the one request that caught me off guard was for an article on Bitcoin.

Bitcoin is a relatively new digital currency. But there’s much more to it when you dig a bit under the covers. Shall we?

What is Bitcoin?

Here’s the high level description of what Bitcoin is and provides from its Wikipedia page:

Bitcoin is a digital currency created in 2009, based mainly on a self-published paper by Satoshi Nakamoto. (It) enables rapid payments (and micropayments) at very low cost, and avoids the need for central authorities and issuers. Digitally signed transactions, with one node signing over some amount of the currency to another node, are broadcast to all nodes in a peer-to-peer network. A proof-of-work system is used as measurement against double-spending and initial currency distribution mechanism.

The Bitcoin site WeUseCoins.com provides a high level video overview of what Bitcoin is, how the coins are created, and what you can buy with them (click here if the YouTube video fails to load below).

For more detail, you can also watch a short Ignite presentation from the current Principal of the Bitcoin project, Gavin Andresen (@gavinandresen). Click here to watch Gavin’s presentation on YouTube if the embed below isn’t working for you.

You can get a feel for the frequency of Bitcoin transactions by watching them occur via the Bitcoin Monitor site.

Interested in the nitty gritty of how the system works? You can dig deeper by reading Nakamoto’s original “Bitcoin: A Peer-to-Peer Electronic Cash System” paper (click here for PDF). There is also a Bitcoin wiki with links to much more information, a FAQ, discussion forums, and developer information; click here to jump to the wiki. You can also link to more information on the Bitcoin project and community via Bitcoin.org.

One very important thing to note:

The Bitcoin system is based upon public-key cryptography. Without the crypto, you’d have no Bitcoin. Bitcoin being crypto-currency leads to some interesting properties, not the least of which is that it cannot be inflated by a central bank or governmental authority. This means that Bitcoins have commodity-like properties similar to gold and other precious metals.

Bitcoin’s being based upon public key cryptography also means that there are concerns about it being used for nefarious purposes. Governments and organizations interested in cryptography, money laundering, and cyber attacks are taking close looks at Bitcoin. We’ll discuss these issues more later.

Acquiring and storing Bitcoins

In order to use Bitcoins, you must first have a Bitcoin wallet.

You can either download a piece of wallet software to install on your computer (click here for links to download the official Windows, Mac, or Linux client or here to grab the source from GitHub) or use an online wallet. There are options for the latter listed on the “Getting Started with Bitcoin” page from WeUseCoins.

The official Windows wallet starts up like this (note that the provided Bitcoin Address has been removed from this screenshot):

Here’s an example online wallet, Instawallet, which creates a new wallet for you by default when you visit their homepage:

To continue using the same Instawallet in the future, you would need to bookmark the unique wallet URL assigned to you. The Instawallet site notes that you should only view this option as a “spare change” wallet, rather than store a large amount of Bitcoinage here.

Whether you choose to use a downloaded wallet or an online one, there are some potential gotchas to consider. If you lose your downloaded wallet, say through a system crash or theft, you also lose any coins stored in it. Likewise if you use an online wallet such as Instawallet and lose the URL or authentication information for that wallet, or the service provider disappears, or anything else keeps you from reaching your online wallet, you may also loose coins. So be sure you have a backup and security strategy in place to avoid any problems later.

Whichever approach you choose, once your wallet is ready you will have a new Bitcoin Address. You use this address to send and receive coins.

So how can you get some Bitcoins to try the system out? There are several options listed on the aforementioned “Getting Started with Bitcoin” page. But perhaps the easiest option is to use a free service from Gavin Andresen, Free Bitcoins. Gavin’s service will transfer a small amount of coinage (0.001 Bitcoin, or BTC, as I write this) for free to whatever receiving Bitcoin Address you specify. The only catch is that you do need a Google account (free to acquire if you don’t already have one).

For example, I entered my Google account information and Bitcoin Address for Instawallet into the Free Bitcoins “faucet” and it sent 0.001BTC my way.

After a little bit of time for the network communication and computations to happen in the background, the Bitcoinage appeared in my Instawallet.

There are a number of other ways you can add coins to your wallet. You can earn them, purchase them in a market (check out Bitcoin Charts for a view into the various markets and currency-to-Bitcoin purchases), and even buy them over the counter (OTC). Bitcoins can also be created via a process known as “mining“, but for most consumers and merchants interested in Bitcoins for commerce but not in becoming a mining business, the amount of computational horsepower required may be prohibitive (see this ZDNet article for more on mining).

Using and accepting Bitcoins

However you acquired your Bitcoins, once you have some you will probably want to start using them. There are a wide and growing variety of legitimate services and merchandise being sold today for Bitcoins. Visit the “Trade” page on the Bitcoin wiki to see a list of many of the available items.

What if you want to accept Bitcoins as a method of payment? The same wiki contains a Merchant Howto to help you get started. It provides information on both manually accepting Bitcoin and automating Bitcoin based purchases. And you can automate purchases via existing shopping cart solutions (for example a Magento Payment Gateway Plugin) or programmatically yourself using a JSON-RPC interface.

For more information on the Bitcoin ecosystem, I would recommend reading through the linked resources on Dave Mackey’s “A Bitcoin Primer“.

Threats and opportunities

As Bitcoin has gained somewhat wider acceptance and much wider visibility, criticism has been heaped upon it. There have been exchange data issues, threats against the system because of its use in black market purchases for illegal items such as drugs, and claimed heists of large sums of Bitcoinage. There has also been some incredible speculation which saw the value of 1 BTC, as expressed in US dollars, climb nearly 1000% in a single month earlier this year!

Things have gotten so heated in this space that even the CIA is studying up on Bitcoin. So what are the significant threats and opportunities for Bitcoin?

One major threat to Bitcoin’s longterm success is ease of use. Needing to have a working knowledge of “crypto-currency” and “peer-to-peer” may not turn off techies, but it certainly confuses a lot of other people. If people can’t understand Bitcoin, they won’t use it. If not many people use Bitcoin, it will continue to see non-sticky value jumps versus other currencies. And large swings in value lead to a further lack of confidence in any currency or commodity.

The opportunity inherent in this problem lies in making the Bitcoin system very easy to use. Implementers need to concentrate on bulletproof clients and merchant software if they hope to maximize Bitcoin uptake. And for goodness sake, hide the cryptography details and never use the acronym “p2p” in getting started guides and consumer-oriented documentation!

Another threat to Bitcoin’s viability is that it has in fact been used in certain high profile illicit markets. The opportunity here is for legitimate Bitcoin users and supporters to educate their governmental representatives on the many legitimate uses of Bitcoin. Just as with dollars or any other currency or commodity, Bitcoin is inherently neither good nor evil. But unlike the other more established value stores and means of commerce, Bitcoin is terribly new, and therefore poorly understood, which in some cases leads to fear. Education is the only way out of that.

Click here to read the complete article on the PayPal X Developer Network including discussion of the biggest potential impediment to Bitcoin’s long-term viability.