Have you heard of Bitcoin? If you're a fan of the CBS legal drama The Good Wife, then you may have learned of it for the first time there. But if you're like most, you probably didn't know that Bitcoin existed or even what it is. You know of the dollar, the euro and the peso as ways to buy items and get paid for your service, but these fiat currencies, as they are called, may someday be replaced by a virtual currency that is only in digital form. So, how does it work?

History
The mechanics behind digital currency appear complicated, but the major problem facing it is easy to understand. What would keep you from using it more than once? Assuming your digital currency was placed in your digital wallet, why couldn't you send it out to multiple people at the same time? With traditional currency there is a physical exchange, and unless you have exceptional resources that allow you to counterfeit, you can only use it once until you earn it back.

Because of that, digital currency has to be encrypted; and just like with a credit card, there has to be some kind of clearing facility that keeps track of when a currency is used and who owns it. The early digital currencies were based around this idea, but having one central place seemed like a recipe for corruption to the creators. So they made the clearing house a process that happened on computers all over the world instead of just one place.

They also didn't want the value of the currency to be controlled by a central bank, the way traditional currencies are controlled. The bitcoin system releases a set amount on a certain schedule. Earning bitcoins requires mining them, much like gold but in a digital format. A complicated cryptographic puzzle has to be solved to activate the bitcoin, and the first person to solve it is the successful miner of the bitcoin block, who becomes the owner.

Bitcoins started with the value of pennies in April 2010 but quickly rose thereafter. As the value rose, more bitcoin miners set up powerful systems to unlock the new bitcoin codes. As bitcoins gained popularity in 2013, the price rose significantly, and the exchange rate hit a peak around $230 to purchase one bitcoin. People who had held bitcoins from the beginning were millionaires in less than three years.

The Problems
As bitcoins rose in popularity, problems developed. This was not a mainstream currency with mainstream businesses adopting it. Who would want to accept payment in a currency without a guaranteed value? Next, people without advanced computer skills weren't interested in the hassle of mining or digital wallets, so the system has never reached beyond a relatively small group of technologically savvy people.

Then, a series of online attacks sent the currency plummeting in value. Bitcoins were stolen from exchanges, and in one instance hundreds of thousands of dollars worth of bitcoins were mistakenly deleted. The current value sits at around $90, but with demand faltering and fewer merchants excited about this 21st century currency, some believe that bitcoins may have a shorter life than previously thought.

One of the ideas behind digital currency is to remove the market effects of traditional currency, but quite the opposite happened. As the popularity rose, currency speculators were able to manipulate the price, making this currency even more volatile than commodities like gold and silver, and much more volatile than the dollar.

There's also the problem of trustworthiness. Although traditional or fiat currencies may not be based on an underlying asset like gold, they have an implied value due to their universal adoption. Bitcoins aren't backed by a hard asset or a large government, so there is no guarantee that bitcoins will hold any value in the future.

The Bottom Line
Those who try to develop digital currency face many of the same problems that have plagued paper currencies for generations. Because currency is not only a means to buy and sell but also an investment product, the currency may have to be regulated in some way. Although popular venture capitalist Fred Wilson believes that a digital currency not controlled by governments will make a large scale emergence in his lifetime, he still isn't sure whether that's a good thing.

Related Articles
  1. Forex Fundamentals

    What Causes A Currency Crisis?

    Find out what can cause a currency to collapse, and what central banks can do to help.
  2. Forex Education

    America's Loss Is The Currency Market's Gain

    The Smithsonian Agreement hurt the U.S. in the short-term, but was necessary in furthering real market-driven exchange rates.
  3. Forex Education

    Currency Exchange: Floating Rate Vs. Fixed Rate

    Baffled by exchange rates? Wonder why some currencies fluctuate while others are pegged? This article has the answers.
  4. Mutual Funds & ETFs

    Profit From Forex With Currency ETFs

    There's always a bull market somewhere - and now you can find it with currency ETFs.
  5. Forex Education

    The History Of Money: Currency Wars

    Find out how conflicts have changed the role money plays in our lives.
  6. Forex Education

    The Plaza Accord: The World Intervenes In Currency Markets

    In 1985, the G-5 nations signed an agreement to devalue the United States currency and correct the GDP. To an extent, it worked. But there were casualties.
  7. Forex Strategies

    These Are The Best Hours To Trade the Euro

    Six popular currency pairs and numerous secondary crosses offer euro traders a wide variety of short- and long-term opportunities.
  8. Savings

    Best Places to Exchange Currency in Chicago

    Whether you're leaving the Windy City or arriving with a stack of foreign cash, these are your best bets for currency exchange.
  9. Personal Finance

    Does It Make Sense to Go to College in Europe?

    If you're deciding whether to get a degree abroad, first do your research and talk to alumni who have completed the same program.
  10. Savings

    Traveling Abroad? Get the Best Exchange Rates

    When you exchange currencies, here’s how to make sure you are getting top value on the trade.
RELATED TERMS
  1. XCD (Eastern Caribbean Dollar)

    The currency abbreviation or the currency symbol for the Eastern ...
  2. Transfer Risk

    The risk that a local currency cannot be converted into the currency ...
  3. WM/Reuters Benchmark Rates

    Spot and forward foreign exchange rates that are used as standard ...
  4. Bitcoin Mining

    Bitcoin mining is the process by which transactions are verified ...
  5. Exposure Netting

    A method of hedging currency risk by offsetting exposure in one ...
  6. Covered Interest Arbitrage

    The practice of using favorable interest rate differentials to ...
RELATED FAQS
  1. How is a block chain network useful for trading goods and assets in virtual currencies?

    Perhaps the most famous quote associated with blockchain technology came from an anonymous virtual currency user, who described ... Read Full Answer >>
  2. What types of companies benefit from reporting results utilizing constant currencies ...

    Any company that does a substantial amount of business in foreign countries, and is therefore subject to foreign currency ... Read Full Answer >>
  3. What are key benefits to a country that has engaged in a policy of currency depreciation?

    In the modern world, most currencies represent fiat money not backed by any commodity or precious metal and whose value is ... Read Full Answer >>
  4. How does a block chain prevent double-spending of Bitcoins?

    Double-spending – the incidence of one individual successfully spending a Bitcoin balance more than once – is a major concern ... Read Full Answer >>
  5. What is the difference between barter and currency systems?

    The primary difference between barter and currency systems is that a currency system uses an agreed-upon form of paper or ... Read Full Answer >>
  6. What is a forward contract against an export?

    A forward contract against an export is an agreement between the importer and exporter to exchange a specified amount of ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!