In this two part series, we take a look at technical and legal issues related to virtual currencies, especially Bitcoins. This is the first part on technical aspects of Bitcoins

Before we go into a discussion of Bitcoins, it is important to understand what digital cash is.

What is digital cash?

Digital cash aims to duplicate the functionality of paper cash, by providing it with properties of anonymity and transferability of payment. Digital cash is intended to be implemented data which can be copied, stored, or given as payment (for example, attached to an email message, or via a USB stick, Bluetooth, etc). Just like paper currency and coins, digital cash is intended to represent value because it is backed by a trusted third party (namely, the government and the banking industry). Most money is already paid in electronic form; for example, by credit or debit card, and by direct transfer between accounts, or by on-line services such as PayPal.

Ideal properties of digital cash

Secure: Person ‘A’ should be able to pass digital cash to person ‘B’ without either of them, or others, being able to alter or reproduce the electronic token.

Anonymous: Person ‘A’ should be able to pay Person ‘B’ without both revealing their identities.

Portable: The security and use of the digital cash is not dependent on any physical location. The cash should be able to be stored on disk or USB memory stick, sent by email or SMS. Digital cash should not be restricted to a single, proprietary computer network.

Off-line capable: The protocol between the two exchanging parties is executed off-line, meaning that neither is required to be host-connected in order to proceed. Person ‘A’ can freely pass value to person ‘B’ at any time of day without requiring third-party authentication.

These are the ideal properties, and no known system satisfies them all. It is important to note here that Paypal is not "digital cash", because it doesn't attempt to provide properties similar to cash (anonymity, off-line usage). Instead, it aims to replace credit cards, and is much more secure. In contrast with credit cards, Paypal payees do not have to have merchant status.

What is Bitcoin and how the technology works?

In the language of computer programmers, Bitcoin is a digital currency that is created and exchanged independently of any government or bank. Bitcoin is generated through a computer program and can be converted into cash after being deposited into virtual Bitcoin-wallets, which is created when one downloads a Bitcoin open-source program. When one runs the open source client, it connects to the Internet and links the user to a decentralized peer-to-peer network of all bitcoin users. The user has to create a Bitcoin wallet in order to start doing business with bitcoins, much like an online account or e-cart. The program generates a pair of keys, a public and a private key, which is used while sending and receiving bitcoins over the network. The private key is always hidden. The public key is like an address to identify the key holder. Each Bitcoin address has its own Bitcoin balance. Every time a transaction is made, the public address of each user is made public to the entire network. The process of generating Bitcoins is through a complex algorithm which mines a unique number representing a bitcoin. The algorithm can be assumed to be a worker in a gold mine who is searching for a slab of gold. In this case, the algorithm is searching for an available bitcoin. The upper limit to the number of bitcoins is about 21 million. Bitcoins are used for electronic purchases and transfers. One can use bitcoins to pay other people. Each and every transaction is logged digitally on a transaction log that tracks the time of purchase and who owns how many bitcoins. This ensures that a bitcoin cannot be duplicated. This digital transaction log is called 'block chain'. The block chain records every single transaction and the ownership of every single bitcoin in circulation. Making payments with bitcoins is easier than using credit cards. If one has a wallet, one only has to enter the recipient's address, the amount of bitcoins to be sent, and click OK. The recipient will then simply receive the request for bitcoins in exchange for what he is offering (goods, services, or currency).

How it is different from ordinary e-cash?

Bitcoin has a completely distributed architecture, without any single trusted entity. Bitcoin assumes that the majority of nodes in its network are honest. In contrast, most e-cash schemes require a centralised bank who is trusted for purposes of e-cash issuance, and double-spending detection. This greatly appeals to individuals who wish for a freely-traded currency not in control by any governments, banks, or authorities—from libertarians to drug-dealers and other underground economy proponents (note that apart from the aforementioned illegal usages, there are numerous legitimate uses as well, which will be mentioned later). In a spirit similar to the original motivation for a distributed Internet, such a purely decentralised system guarantees that no single entity, no matter how initially benevolent, can succumb to the temptation or be coerced by a government into subverting it for its own benefit.

How to trade Bitcoins?

Exchanges provide a place for people to trade bitcoins for other types of currency. Payments to a merchant who accepts Bitcoins are made from the bitcoin wallet by entering the recipient's address and the payment amount.

What gives a Bitcoin its value?

This is the most contentious of all questions. In the first year of bitcoin, there were almost no transactions, but people were spending their energy on generating bitcoins. This is possibly because bitcoins have:

1. Value as a collectible, in a similar manner to people collecting rare metals, stones, shells, postal stamps, paintings and baseball cards.

2. Value from betting that other people may find these collectibles valuable and thus would have to buy some of them from earlier collectors, thus making them richer.

Gold is valuable because it’s rare, durable and mobile, and thus can be collected. And once collected, it can only increase in value when more people want it. In case of bitcoins, the value can appreciate or depreciate in the expectation of investors, buyers, sellers and speculators that bitcoins is a “thing of the future”. One must not be under the impression that the peer-to-peer network is responsible for any single price that people put on bitcoin. There’s clearly no rational way to tell how much money bitcoin “should be worth” today or tomorrow. Pure demand and supply for bitcoins is what determines its price. There may be no demand and hence the bitcoin can become junk. Additionally, frequency of transactions is independent from the total value of the supply. The value of a bitcoin is constantly changing, and there is no centralised exchange for it. Thus each time a bitcoin changes ownership, the two parties need to agree on its price. There is no fixed price. Also the difference between bitcoins and other currencies is that there is no centralised bank that prints the currency and sets relative values.

(Shambo Dey, a student of Government Law College, Mumbai, works as a Research Assistant at Vinod Kothari & Company)