By Nicholas Cucci
Network Merchants Inc.
I'm sure many people have not yet heard of bitcoins, but this decentralized, digital currency is taking off. Bitcoins are now the most widely used alternative currency, according to Mt. Gox K.K., a Japanese exchange bank. And bitcoins have strengthened in value against the U.S. dollar over the past year, according to Bloomberg News.
At the end of January 2013, a bitcoin was trading at $20.41 U.S., up 51 percent from the end of December 2012, according to Bitcoinmoney.com.
The European Central Bank has said use of virtual currencies could pose a risk to central banks, Bloomberg reported. Unlike most currencies, bitcoins do not rely on a central bank or government as issuer. Instead, they are maintained on a public transaction ledger across a peer-to-peer network, which verifies them and prevents double spending, according to Wikipedia.org.
Bitcoins may be exchanged between personal computers through wallet text files or from websites that manage them. To users of bitcoins, they have the advantage of not being traceable. Yet, they are considered extremely secure due to their use of cryptography.
Some may wonder what a bitcoin is and why it is relevant to the payments industry. Created by one or more persons under the pseudonym Satoshi Nakamoto, bitcoins will be released at a scheduled rate, reaching an eventual limit of 21 million bitcoins in circulation by 2140, according to Wikipedia.org.
They are released digitally through a process in which "miners" - people or entities willing to commit intensive computing resources - solve cryptographic puzzles that release small allotments of bitcoins to the miners.
Each coin is associated with its current owner's address and public key. Once you're a registered bitcoin user, you may transfer bitcoins by creating a message or transaction - attaching the new owner's public key to a specific amount of coins - and signing it with a private key. Once completed, the transaction record is kept in a block chain, which is the public transaction ledger in the network. All computers in the network maintain copies of the block chain.
Blockchain.info, a bitcoin wallet and "block explorer" with over 30,000 users, described how bitcoins function: "A private key is a secret code, which allows the user to prove his ownership of his bitcoins.
"Every bitcoin address has a matching private key, which is saved in the wallet file of the person who owns the balance. The private key is mathematically related to the bitcoin address, and is designed so that the bitcoin address can be calculated from the private key, but importantly, the same cannot be done in reverse."
The bitcoin mining process requires a function, called a hashcash, a strategy originally devised to fight email spam. In an email, a hashcash is a header stamp that spam filters use to validate legitimate email but which is difficult for a spammer to generate. In the bitcoin system, a bitcoin's hashcash uses symmetric key cryptography, essentially a one-way hashcash function.
A miner searching the network for bitcoins must discover a bitcoin's hashcash by trying random values until stumbling across one, also known in computer-speak as brute force.
This is where the intensive computing resources come in. Solving cryptographic hash puzzles through brute force uncovers bitcoins, verifies transactions and adds them to the network's transaction log. Hashcash functions - in the language of computer networking - are fully distributed and infinitely scalable.
For governments, a major drawback of bitcoins is their ability to be used for money laundering; their use cannot be traced. Users can convert bitcoins to dollars through an exchange like Mt. Gox. Moreover, bitcoin transactions are not subject to chargebacks and refunds, making them attractive to merchants.
This is relevant to the payments industry because of its rapid growth. In January 2013, bitcoins reached a milestone payout of $1 million in a single day. Moreover, Internet gambling sites and organizations such as WordPress.org and Internet Archive are beginning to accept this new payment form.
Following a recent bitcoin news report, National Public Radio's website drew a comment from a representative for Cups and Cakes Bakery of San Francisco, Calif.
The bakery posted a link to a YouTube clip it produced demonstrating the ease with which it accepts in-store bitcoin payments from customers' smart phones. (www.youtube.com/watch?feature=player_embedded&v=UuobtQlE_e0)
The NPR report also noted that online gambling site SatoshiDice recently disclosed profits of about half a million U.S. dollars from its most recent six months of operations.
The bitcoin platform is an interesting development. I'm not sure of its sustainability, but I'd be curious to hear what you think. Send me your questions or comments. How do you think bitcoins will affect the payments industry?
Nicholas Cucci is the Director of Marketing for Network Merchants Inc., a graduate of Benedictine University and a licensed Certified Fraud Examiner. Cucci is also a member of the Advisory Board and Anti-Fraud Technology Committee for the Association of Certified Fraud Examiners, as well as a member of the Electronic Transactions Association's Risk, Fraud and Security Committee. NMI builds e-commerce payment gateways for companies that want to process transactions online in real time anywhere in the world. Contact him at ncucci@nmi.com.
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