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Bitcoin and the Digital-Currency Revolution

About a half-billion dollars worth of it vanished from an online exchange in Tokyo. A prosecutor in Manhattan arrested the 24-year-old vice chairman of its most prominent trading body on drug-related charges of money laundering. Its founder’s identity remains a mystery, and last year, it shed two-thirds of its value, losing an additional 44% in just the first two weeks of January. In his year-end letter to investors, Warren Buffett’s advice about it was emphatic: “Stay away.”

The digital currency known as bitcoin is only six years old, and many of its critics are already declaring it dead. But such dire predictions miss a far more important point: Whether bitcoin survives or not, the technology underlying it is here to stay. In fact, that technology will become ever more influential as developers create newer, better versions and clones.

No digital currency will soon dislodge the dollar, but bitcoin is much more than a currency. It is a radically new, decentralized system for managing the way societies exchange value. It is, quite simply, one of the most powerful innovations in finance in 500 years.

If applied widely to the inner workings of our global economy, this model could slash trillions in financial fees; computerize much of the work done by payment processors, government property-title offices, lawyers and accountants; and create opportunities for billions of people who don’t currently have bank accounts. Great value will be created, but many jobs also will be rendered obsolete.

Bitcoin has some indisputable flaws, at least in its current iteration. Its price fluctuates too wildly. (Who wants the cost of their groceries to vary by 10% from week to week?) Its anonymity has made it a haven for drug dealers. “Wallets” (as the individual software applications that manage bitcoin holdings are known) have proven vulnerable to cyberattack and pillaging, including the wallets of big exchanges such as Tokyo’s Mt. Gox and Slovenia’s Bitstamp.

Even though the core program that runs bitcoin has resisted six years of hacking attempts, the successful attacks on associated businesses have created the impression that bitcoin isn’t a safe way to store money. Until these perceptions are overcome or bitcoin is replaced by a superior digital currency, the public will remain suspicious of the concept, and regulators will be tempted to quash it.

Like any young technology, bitcoin is a work in progress, but its groundbreaking core software program is constantly being improved. It is open-source and copyright-free, and thus accessible to anyone who wants to peer inside it, copy it, suggest improvements or create applications for it.

Inspired by this potential, “probably 10,000 of the best developers in the world are working on bitcoin,” estimates Chris Dixon, a partner at the venture-capital firm Andreessen Horowitz. This volunteer army has developed military-grade encryption to make bitcoin wallets more secure and insurable and also new trading tools to help stabilize the price. The faults of digital currency are being resolved.

The workings of bitcoin and other digital currencies can be confusing. When we think of a currency in the abstract, we tend to think of a physical currency in the offline world—a dollar bill or a gold coin—so we imagine bitcoin as some sort of digitally rendered equivalent, much as a Word document is a digital stand-in for a physical page of text.

But there is no such thing as the digital equivalent of a dollar bill. Bitcoins exist purely as entries in an accounting system—a transparent public ledger known as the “blockchain” that records balances and transfers among special bitcoin “addresses.” Owning bitcoin doesn’t mean having a digital banknote in a digital pocket; it means having a claim to a bitcoin address, with a secret password, and the right to transfer its balances to someone else.

This ledger is what gives bitcoin its potential to disrupt global finance. In the current dollar-based monetary system, we entrust banks and other fee-charging intermediaries to act as gatekeepers to nearly every transaction. Those centralized institutions maintain closely guarded in-house ledgers and, with that information, determine whether their customers have enough credit to write checks, buy goods with credit cards or wire money.

With bitcoin, the balances held by every user of the monetary system are instead recorded on a widely distributed, publicly displayed ledger that is kept up-to-date by thousands of independently owned, competing computers known as “miners.”

To understand how it works and why it is more efficient and less expensive than the existing system, let’s take a single example: buying a cup of coffee at your local coffee shop. If you pay with a credit card, the transaction seems simple enough: You swipe your card, you grab your cup, you leave.

In fact, the financial system is just getting started with you and the coffee shop. Before the store actually gets paid and your bank balance falls, more than a half-dozen institutions—such as a billing processor, the card association ( Visa, MasterCard, etc.), your bank, the coffee shop’s bank, a payment processor, the clearinghouse network managed by the regional Federal Reserve Banks—will have shared part of your account information or otherwise intervened in the flow of money.

If all goes well, your bank will confirm your identity and good credit and send payment to the coffee shop’s bank two or three days later. For this privilege, the coffee shop pays a fee of between 2% and 3%.

Now let’s pay in bitcoin, assuming that your favorite coffee shop accepts it (more than 82,000 merchants world-wide already do). If you don’t already have bitcoins, you will need to buy some from one of a host of online exchanges and brokerages, using a simple transfer from your regular bank account. You will then assign the bitcoins to a wallet, which functions like an online account.

Once inside the coffee shop, you will open your wallet’s smartphone app and hold its QR code reader up to the coffee shop’s device. This allows your embedded secret password to unlock a bitcoin address and publicly informs the bitcoin computer network that you are transferring $1.75 worth of bitcoin (currently about 0.0076 bitcoin) to the coffee shop’s address. This takes just seconds, and then you walk off with your coffee.

What happens next is crucial. In contrast to the existing system, your transaction is immediately broadcast to the world (in alphanumeric data that can’t be traced to you personally). Your information is then gathered up by bitcoin “miners,” the computers that maintain the system and are compensated, roughly every 10 minutes, for their work confirming transactions.

The computer that competes successfully to package the data from your coffee purchase adds that information to the blockchain ledger, which prompts all the other miners to investigate the underlying transaction. Once your bona fides are verified, the updated blockchain is considered legitimate, and the miners update their records accordingly.

It takes from 10 minutes to an hour for this software-driven network of computers to formally confirm a transfer from your blockchain address to that of the coffee shop—compared with a two- to three-day wait for the settlement of a credit-card transaction. Some new digital currencies are able to finalize transactions within seconds.

There are almost zero fees, and the personal information of users isn’t divulged. This bitcoin feature especially appeals to privacy advocates: Nobody learns where you buy coffee, the name of your doctor or—if you’re into that sort of thing—where you buy your illegal drugs.

Because the fees in the current credit-card system are paid by merchants and because banks indemnify cardholders against theft of their personal data, such savings and privacy benefits often don’t impress American consumers. But even if we don’t bear those costs directly, we pay them through hidden fees and pricier cups of coffee.

The advantages of digital currency are far more visible in emerging markets. It allows migrant workers, for example, to bypass fees that often run to 10% or more for the international payment services that they use to send money home to their families.

Bitcoin’s unidentified creator—a person or persons operating under the pseudonym of Satoshi Nakamoto—has provided a novel solution to a problem that has dogged societies for centuries: the distrust among strangers in commercial transactions with one another. In any exchange, how could someone feel secure unless there is a face-to-face handover of physical currency or some other valuable good?

When banks were invented in Florence in the late 1400s, a centralized solution emerged: People didn’t have to worry about trusting strangers anymore; they could just trust their banks to absorb the credit risk. Using internal ledgers to keep track of everyone’s balances, banks became the middlemen through which exchanges could now occur.

Banking unleashed the Renaissance, the Industrial Revolution and the modern age. But a new problem arose: As the world’s monetary intermediaries, banks became powerful—perhaps overly powerful—repositories of information and influence. The financial system was and remains vulnerable to bank failures, as we were painfully reminded during the financial crisis of September 2008.

One month after that meltdown, Satoshi Nakamoto released the initial document describing bitcoin. For the first time, people had a decentralized solution to the financial-trust problem. Here was a new form of currency that could be transferred online without involving fee-imposing, third-party institutions.

But many still ask: How can a bitcoin have value if it isn’t “backed” by gold or a government? If you can’t hold a currency in your hands, if it doesn’t bear some central authority’s insignia, how can it be worth anything?

Here we have to remind ourselves of some economic fundamentals: Money’s essence doesn’t reside in tangible currencies, which have no intrinsic value—beyond, say, a dollar bill’s modest usefulness as a bookmark. Much the same can be said of bitcoins, which are made up of bits and bytes.

In the broadest sense, money is, instead, an all-encompassing, society-wide system for keeping up with who owns or owes what. Physical currencies are simply symbols or tokens in that system, representing a shared standard of value for tracking wealth holdings. What Nakamoto’s blockchain invention offers is an online, decentralized and fully public mechanism for recording those shifting balances. It deals directly with the essence of money.

As promising as that idea may seem, there hasn’t been much public buy-in, largely because of the concerns about volatility, insecurity and criminality that have continued to dog bitcoin. Although many companies now accept bitcoin (the latest and biggest being Microsoft Corp. ), global usage of the digital currency averaged just $50 million a day in 2014. Over that same period, Visa and MasterCard processed some $32 billion a day.

Still, a “Who’s Who” of Internet pioneers is betting on a bright future for bitcoin. Ignoring its careening exchange rate, such investors as Netscape founder Marc Andreessen and LinkedIn founder Reid Hoffman put $315 million into bitcoin-related projects last year—triple the venture-capital investment of 2013, according to the digital-currency news site Coindesk. And 2015 has kicked off with an announcement by the digital wallet provider Coinbase of a $75 million injection of new funds by investors including the New York Stock Exchange and the venture arm of the Spanish banking giant Banco Bilbao Vizcaya Argentaria SA.

What most excites these investors is bitcoin’s promise as a platform whose future applications are almost unimaginably broad. They see a precedent in the core Internet protocols adopted in the 1980s, when no one foresaw such things as Facebook, Twitter or Netflix. Already, hundreds of specialized apps are being built on top of the digital-currency blockchain software, which is seen in this context as a kind of base operating system.

Some developers are building digital-currency tools for the world’s 2.5 billion “unbanked” people, in a bid to bring them into the global financial system. Others are packing additional information into the core programs to create applications well beyond currency transfers: software-managed “smart contracts” that need no lawyers, automated databases of digital assets and copyright claims, peer-to-peer property transfers and electronic voting systems that can’t be rigged.

A key idea here is that data in a blockchain ledger is made irrefutable by the computing consensus that goes into it. A blockchain is distributed across many independent computers rather than residing on a central server. So, unlike bank- or merchant-based data, such information is, in theory, invulnerable to attack or corruption. It is considered impossible for an outsider to hack thousands of computers simultaneously and there are no insiders to manipulate the central server’s software. This, in theory, makes blockchain data reliable and incontrovertible.

As innovation in digital currency accelerates, it will matter less whether Mom and Pop own bitcoin or even know what it is. Big multinationals and financial institutions could incorporate its decentralized technology into their payment and database systems while we obliviously keep using our dollars or euros.

If bitcoin thus becomes an ubiquitous if largely invisible part of the world economy, many believe that its price will rise. A small but growing number of hedge funds and family investment offices are betting on just that, taking stakes in bitcoin-investment vehicles.

But the growth of digital-currency technology has even more profound implications. It could reduce financial costs overall and leave more money in people’s pockets. At the same time, it could spell job losses—potentially rendering obsolete millions of positions in traditional intermediary services.

These aren’t idle concerns. Wall Street bankers and Federal Reserve staffers are discussing ways that this technology could make the financial system more efficient. Regulators in New York’s Department of Financial Services and elsewhere are designing rules to reduce the risks from digital currencies even as they encourage innovation. The governments of the U.K. and Mexico are exploring the use of blockchain technology to enhance financial networks and strengthen economic governance.

Despite the scandals and price swings in bitcoin’s brief history, the financial establishment is taking notice. One key reason, as former U.S. Treasury Secretary Lawrence Summers told us, is that the “substantial inefficiencies” of an outdated financial system make it “ripe for disruption.” That alone means it would be “a serious mistake to write off [digital currencies] as either ill-conceived or illegitimate,” Dr. Summers said.

In the end, the rise of digital currency may be a matter of evolutionary destiny. The Internet has disrupted and decentralized much of the world economy, but the centralized world of finance remains stuck in the 15th century. Digital currency can help it adapt and survive.

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