Category Archives: Bitcoin

My Awesome Announcement

I hate tooting my own horn but this is one of the proudest moments in my still short social media law career.  Please forgive the somewhat staged presentation but those who know me know that if I’m going to tell a story I need to make it interesting.

I was at the University of Texas Co-op’s law school location last week browsing the Nutshell books.  (Go with me, people.)  For those of you not in the legal profession, congrats on that by the way, know that the Nutshell series is put out by West Academic (one of the biggest names, if not the biggest name, in the legal publishing world) and is a fantastic resource for an overview of legal issues in a particular topic.  They aren’t casebooks–larger books with often edited cases to look at judicial rulings on certain areas.  Nutshells get right to the point and provide essential information on the overall legal topic.  I used more than one when I was in law school and as a practicing attorney.

But I noticed something was missing from the Nutshell section.  Can you spot it?

Can you spot what's missing?

Can you spot what’s missing?

That’s right, there’s no Social Media Law in a Nutshell.

Let’s fix that, shall we?

I’m proud to announce that I will be writing Social Media Law in a Nutshell for West Academic.  My co-author, Thaddeus Hoffmeister, is a professor of law at the University of Dayton School of Law and has previously published a book on social media in the courtroom.  His knowledge of social media litigation, evidence uses, and applicability in criminal cases will combine with my information on the marketing, content, employment and other social media uses to make this a comprehensive review of social media across all legal channels.

Doing this as a Nutshell book feels perfect right now.  There isn’t a wealth of case law on social media issues, but there are certainly cases out there.  In some areas the most fascinating legal issues are taking place outside of a courtroom so a Nutshell allows us to cover those topics in ways a casebook couldn’t.  Plus, when the movie rights get picked up we all agree that Hugh Jackman can play me.  He’s just a more talented and better looking version of me who can also sing and dance and has a better accent.  The resemblance is uncanny.

I’m not sure when the book will be released but it certainly won’t be until 2015 at the earliest.  Rest assured I’ll let you all know as the process unfolds.

Yesterday I published the 100th blog post here on SoMeLaw Thoughts.  When I look back at how much has changed in social media since I started writing about it, not just my own professional involvement, it’s staggering.  I feel incredibly lucky to take this journey and contribute to the field as well as participate in a line of books that I personally value.  To join the ranks of the Nutshell books blows my mind.

Thanks to all of my readers and friends on social media who have pushed/pulled/heckled me along the way.  An even bigger thanks to my family for putting up with my little side projects.

Now, if you’ll excuse me, I’ve got some writing to do.



Filed under Affiliates, Amazon, Apple, Authentication, Bitcoin, Celebrities, Charity, Commercial Activity, Consumer Protection, CopyFUD, Copyright, Criminal Justice, Crowdfunding, Cyberbullying, Ebooks, Email, Employment, Facebook, Fair Use, First Amendment, FTC Endorsement Guidelines, Google, Identity, Informal Tone, Instagram, Kids, Laws, Net Neutrality, Pinterest, Privacy, Social Content, Social Gaming, Social Investment, Social Marketing, Social Measurement, Social Media and the Law, Social Media Law in a Nutshell, Social Media Lawyers, Social Media Policies, Social Media Risks, Social Platforms, Social Tracking, Technology, Terms and Conditions, Trademark, Twitter

Everything You Wanted To Know About Bitcoin But Were Too Afraid To Ask, Part 3: Bitcoin Risks, Chuck Norris, and Pork Loin

Now that we’ve learned the basics of money in part 1 of this primer and how bitcoins and Bitcoin work in part 2 it’s finally time to talk about the problems and legal risks facing bitcoin adoption.

Which are significantly more serious than issues surrounding Cabbage Patch Kids adoption.

The Downside Of Bitcoin As Currency

There are plenty of potential downsides to using bitcoins as a virtual currency and these could be insurmountable obstacles in terms of its future.  Here are some of the big ones.

Fluctuating Value

While speculators may love the idea of buying bitcoins today and reaping a huge profit tomorrow, that isn’t the kind of thing you look for in currency.  For example, this primer took a while to write (longer than it’s taken you to read this far and man, hasn’t that felt like forever?).  When I wrote the section about bitcoins being worth around $515 that was true when I was writing it (March 28, 2014).  Today, as I write this section (March 31) the value is around $460.  That kind of huge fluctuation isn’t what people look for in terms of a currency–they may look for huge swings for other types of investments but that won’t make bitcoins succeed as a currency.  You don’t want both sides of a transaction trying to figure out how much the money will be worth by the time the transaction is done–then it turns into a complicated bartering system.

To some extent, this is a hurdle that any new currency will face.  As long as the currency doesn’t have widespread adoption then it will be valued mostly by its conversion to other forms of currency.  But without some kind of longer-term stability, it will be difficult for a true bitcoin economy to emerge as the amounts charged for goods and services will fluctuate too wildly.

The 51% Attack

One of the greatest strengths of the Bitcoin network is also its greatest weakness.  Bitcoin was created to replace those trusted, proprietary third parties that verify transactions.  To do so, the Bitcoin network was created with a complicated transaction ledger (the Block Chain we discussed in part 2) and mining system.  For those transactions to be verified, the majority of Bitcoin miners have to agree that the latest batch of verified transactions are correct–this process not only verifies the Block Chain but also sets to reward the miner that first solved the mathematical problem.

Verifying the solution requires agreement by at least 51% of Bitcoin miners.  That distribution built into the Bitcoin network is designed to make it so that no single party is taking over verification and leading to them increasing transaction costs (leading them to increase transaction costs closer to the 2.9% being charged by most third parties today).  But that distribution comes with a significant disadvantage: at any time someone can come up with enough hardware to make themselves 51% of the Bitcoin mining network and suddenly they can rewrite all the rules.  They could move bitcoins to their own accounts or issue all remaining bitcoins to themselves.  It’s possible that these changes could be undone, but that could be difficult.

It’s also an attack unique to Bitcoin–51% of the world’s nations could decide the US dollar is worthless and that wouldn’t impact our ability to use the dollar here in the US.  The 51% attack on Bitcoin could completely destroy the system.

Like this almost killed Superman.

While the deeds that could be accomplished by someone in the 51% position are hypothetical, the actual ability is not.  In January of 2014, one network of Bitcoin miners accounted for more than 42% of the network.  A deliberate push by that network could have easily tipped it over the 51% number–fear of that takeover made many miners leave the network but it does reveal an actual, serious threat.

Current Third Party Protections

We discussed earlier how US retailers could save $11.7 billion a year if they moved to bitcoins given the reduced transaction fees.  But one thing that should be considered is how credit card companies and others provide valuable services in exchange for those higher transaction costs.  In addition to your losses being capped for fraudulent charges with credit cards, most third parties will also have reward programs and dispute resolution processes that could make the extra transaction fees worthwhile.

Forget all the bonus miles and extra hotel nights for now–those dispute resolution processes are very important.  If you have a fraudulent charge on your credit card today you can contact the credit card and dispute it.  They will have their own process for deciding the issue but you have a good chance of getting the issue correctly resolved.  (I’ve had to do this maybe a dozen times over the past decade, every one resolved in my favor.  That’s not to brag but to highlight an actual need.)

Bitcoin has no dispute resolution process.  A completed bitcoin transaction, once verified into the Block Chain, cannot be undone.  A reverse transaction could be completed if both parties agree to transfer the money back, but that is a new transaction and not removing an earlier one and is completely subject to the whims of the new bitcoin owner.

Private Keys Lost

Earlier we learned that having money in the Bitcoin network really means you have two things: the public address of that money (which anyone could have) and the private key that allows you to control where that money can be moved.  If you lose that private key then you have lost the money.

This is true for currency as well.  If you stand at the top of a mountain and wave a $20 bill around and the wind rips the bill out of your hand, you don’t have that $20.  If someone walks up to you with a gun and demands the $20, same thing.

Unless you’re Chuck Norris. Chuck Norris makes money when he gets mugged.

The concern here is that private keys are not designed to be remembered by human brains.  So you need some kind of storage method to intervene.  Wallet programs or websites are the easiest place to store them, both for their ability to remember long strings of numbers and because they can be utilized to complete bitcoin transactions in the future.  But programs and websites can be hacked.  Or a virus on your hard drive can detect wallet programs, deduce that you have bitcoins, encrypt all of your files, and demand a bitcoin ransom or it will delete the key and you lose everything.  That’s not a hypothetical risk, that’s a real virus.

As an additional method of security, some people place private keys in what is called cold storage. This means the files are removed from an Internet-connected device. They may be printed to paper and deleted from online records or they are placed on a USB drive that is placed in a secure location like a bank safety deposit box. This certainly makes the keys less susceptible to an online attack but they are still subject to the same limitations as physical currency (loss, theft, damage). If you wanted to have a physical stockpile of currency, there are easier ways. But security around private keys is vitally important since if you lose the keys you lose your money.

The problems with losing a private key, losing your money, are not unique to the bitcoin economy. The same thing could happen to your bank accounts if they were hacked.  But there are a lot more safeguards in place and laws to help you in that event.  The bitcoin economy has not matured enough to address these risks, giving you virtually no recourse if you lose your keys.

Other Technical Issues

The 51% attack is the easiest technical issue to understand but there are several other that can impact bitcoin transactions.  One which has gained some attention is called transaction malleability (very technical article on how it works can be found here).  Understanding this attack is a bit difficult–just know that an attacker can modify transactions before they are entered into the Block Chain.  The modified transaction is seemingly innocent–it doesn’t change where the bitcoins were transferred.  But it does modify the final verification hash and since there is no standard way for wallet programs to operate, some wallet programs would see the modified hash as proof that the first transaction failed and the wallet needed to send bitcoins again.  The result is that a nefarious seller could trick a wallet into spending twice as many bitcoins as it should–and like we discussed before, there’s no recourse.

When one of the larger bitcoin exchanges, Mt Gox, announced it had lost several hundred thousand bitcoins it claimed this was due to transaction malleability.  While that cause has been questioned, it is also true that in the days following Mt Gox’ announcement this attack was found to be responsible for double charging over 300,000 BTC’s worth of transactions.

Plus we were really, really sure we knew the Ace was in the middle.

There are several other potential weaknesses and attacks with the Bitcoin network and to some extent that should be expected with a new technology.  It’s also true that our current third party verification systems have also been subject to attacks and data breaches.  We just have a lot more experience dealing with the technology that has been around for decades.

Bitcoin Legal Issues

Beyond facing technical issues and obstacles to having bitcoins adopted as officially recognize currency, the Bitcoin network and bitcoin transactions also face significant legal challenges in the near future.  Here are some of the most important.

Currency Or Commodity?

The IRS recently issued guidance that bitcoins will be treated as commodities rather than currency under US law.  Brazil has just done the same and other countries will determine their own treatment.  This triggers certain legal treatments that differ from currency–if someone pays you in bitcoins then it is like you were paid with gold bars rather than Euros.  This not only requires you to figure the amount you were paid in terms of how much those bitcoins were worth when you received them, but if the value of those bitcoins change by the time you use them then you also need to record that amount.  And if the new amount is higher than you can be taxed under capital gains.

Tax treatment depends on your overall income situation and I’m not a tax expert, so take this all with a grain of salt.  But short-term capital gains (for commodities or investments held for under a year) you will be taxed 35% of the gain.  If you held that commodity for over a year then that falls to 15%.  Let’s see that in action.

Say I agree to pay you $25 in bitcoins (BTC, if you recall) if you hold my place in line at Franklin BBQ on one dreary day in January.  Leave aside the ethics and propriety of such a transaction.  In June, Franklin BBQ adds pork loin to the menu.  You are eager to try the latest BBQ awesomeness, especially because Franklin is now taking BTC as payment.  Pork loin is being sold for $12.50 a pound, quite a deal, and you decide to order 4 pounds.

This shall now be called your bitcoin pork loin.

Lucky for you, BTCs have doubled in their US dollar conversion since January so you are able to use the exact amount of bitcoins I paid you to purchase your $50 of sweet, smoky BBQ.  Because you received $25 in a commodity (BTC) and were able to turn it in for $50 in goods you have now realized a gain of $25.  Since this was based on something you held for under a year you now owe 35% of the gain, or $8.75.  If you had been able to hold on until January, and assuming BTCs are still worth double compared to when you received them, then you would only pay 15% of the gain, or $3.75.  But, really, who can wait that long?

The good news is that technically you still made out pretty well–you were able to get $50 in goods for the equivalent of $33.75.  But the bad news is that you have to keep track of all your transactions, when you got BTC, how much they were worth, how much you got for them when you exchanged them for something else, or else the IRS may take issue with your filings.  And that’s never a good thing.

It’s also bad news when you compare to a standard currency exchange.  People make investments in foreign currency just like they can buy stocks and bonds or gold or collectible Elvis plates.

Fact: the Fat Elvis plate can hold six full-size pork loins.

When you make money off a currency investment you are typically taxed 23% of the gain (they use a 60/40 rule to determine the amount, 60% taxed at long term 15% rate, 40% taxed as short term at the 35% rate).  Just the fact that the IRS is treating BTC like stocks or other commodities puts it into a category different from, and less advantageous than, other forms of foreign currency.

Legally Used?

Although the US has determined that BTC can be used for transactions and just has a specific way of dealing with the tax implications, other countries have declared bitcoin transactions to be illegal or placed restrictions on their use.  Bitcoins cannot be used in Iceland and their use has also been restricted in Taiwan, India, Japan, and China, among others.  This is still an emerging technology so it would be in your best interest to look into bitcoins’ legal standing in a country before you embark on transactions with them.

Anonymity And Money Laundering

Anonymity and Bitcoin is a fascinating issue.  On the one hand you have people claiming that bitcoin transactions are completely anonymous and this makes it attractive to criminal elements.  On the other hand you have people claiming that bitcoin transactions are publicly trackable and that you can follow every bitcoin from person to person which is something you can’t do with cash currency today, making it even more secure than cash.

Who’s right?  They both are.

Although every bitcoin transaction is public knowledge, what is known is the amount that was transferred and the address to which the amount was transferred.  If you can determine who owns or controls that bitcoin address then you know how much they received.  But there is nothing that compels bitcoin addresses to be identified, unlike many countries which have laws that require bank accounts to be registered in people’s/companies’ names.

If a bitcoin is ever stolen (through a technical attack or someone stealing the password) then you can absolutely know where the bitcoins were transferred–but that may not help you.  Especially if the destination was some large bitcoin transaction site that you then lose in the shuffle.  Perhaps the thief takes 5,000 BTC from your account and then start sending out batches of 100 BTC now and then.  It would be impossible to say that those were your BTC and not someone else’s.

The identification of bitcoin transactions doesn’t necessarily make it more secure, but it also could make it easier to follow.  Like a double-edged sword, it cuts both ways.

Double edged swords: as awesome to look at as they are to use in analogies.

Another way bitcoin transactions are like a double-edged sword is that the person handling it may face the most risk.  We’ve already seen one example of an entrepreneur arrested on money laundering charges for providing a service to convert bitcoins to cash faster than the Bitcoin network allows and we could see more actions like this in the future.  Even though bitcoins are treated as commodities, money has its own set of regulations and new companies rising to meet the gaps in the Bitcoin economy could run up against this highly regulated space.

The Future Of Bitcoin(s)

Where does this leave bitcoins and Bitcoin moving forward?  While there are significant challenges to bitcoins being adopted as an actual currency there is a degree of interest in the technology that could keep it alive long enough to be accepted.  This could change in an instant if the Bitcoin network is compromised or a few large countries declare it completely illegal, but for now it has a chance to be adopted if it can deliver on the promise of reduced transaction fees.

Of far more interest, I think, is the Bitcoin network itself and the idea that you can securely transfer unique codes from person to person.  If the Bitcoin network becomes more refined and then modified to use more than bitcoins, it’s entirely possible that other, actual forms of currency could be exchanged on the network.  That could be an interesting application of the technology and its promise of cheap, efficient transfers without the downside of a new, unregulated (by a traditional authority) currency.

Whatever happens with bitcoins and Bitcoin, hopefully by reading this primer you’ll understand what’s at issue.  But if you do have suggestions for refining the primer, please contact me and let me know.


Filed under Bitcoin

Everything You Wanted To Know About Bitcoin But Were Too Afraid To Ask, Part 2: bitcoins, Bitcoin, and Ishtar

In part 1 of this primer on bitcoins we first took a step back and took a look at money.

Okay, I see it.  Now I want it.

Okay, I see it. Now I want it.

Now we’re going to dive into the world of bitcoins so we can understand what they are and how they work before we return with part 3 of the primer on some of the downsides and legal risks of bitcoins.  If you are interested in reading more about bitcoins there are plenty of resources available online but I highly recommend this 25-page research paper by Goldman Sachs that approaches bitcoins from a variety of angles and where I obtained many of the data points for this section of the primer.

The Two Bitcoins

Before we delve into the fun world of bitcoins we need to clear something up.  Bitcoin can actually refer to two different things.  One uses the capital B and is called Bitcoin.  The other one has a lower case b and is called a bitcoin.  This gets super confusing when the word starts a sentence so the capital letter doesn’t tell you anything.  But they are two very different things.

bitcoins, the lower case version, are a form of virtual currency in that they were created to be used as online money.  How they are treated legally is a very different matter that we’ll discuss later, but for the most part when you read about people buying a villa in Bali with bitcoins, or an ATM for bitcoins here in Austin, or how a site was hacked so members lost all their bitcoins you are reading about the lower case bitcoin.

The capital letter Bitcoin is the technology that makes bitcoins a potential currency.  And it’s actually the more important of the two.  But we’ll talk about that later.  For now, let’s discuss how bitcoins could be used as virtual currency.

Bitcoins as Currency

First, let’s clear up one thing about bitcoins as a potential currency: they were not created to buy illegal things.  This is a common misconception about bitcoins–that the mob or criminals are using bitcoins to buy drugs, weapons, and DVDs of Ishtar.

Technically still legal. For now.

So Why Make Bitcoins?

Bitcoins were created like so many other internet services: to make things cheaper.  The paper that launched it all starts innocently enough:

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.

When you buy something on the Internet you almost always use a credit card.  Sometimes you might use a direct bank transfers, other times you could use another trusted third party like Paypal.  But all of those transactions involve a third party not directly involved in the transaction.  Those third parties get paid for ensuring the transaction goes smoothly.  On average, those third parties will take just under 3% of the total transaction (they take around 2.5% for physical retail transactions due to the increased risk of fraud in the e-commerce market).  In 2013 an estimated $609 billion in goods and services was purchased online.  Meaning $17.8 billion was given to banks and credit card companies and Paypal and others.

The hope is that using bitcoins could reduce those transaction costs to only 1%.  That would be $6.1 billion in total fees and would save the industry $11.7 billion.  Of course, whether the saved money would result in lower prices to consumers or just higher profits to the companies would remain to be seen, but the hope is that the money eventually flows to the consumer.

But how do you create a brand new form of currency without having the same kind of third party involvement?  The purpose of using bitcoins to buy things was to be cheaper, after all–it wasn’t just to create a new form of currency with the same transaction costs (although some people really liked that idea too).  So the system of bitcoins and Bitcoin was created to try and create a new form of currency: the bitcoin.

Okay, I’m ready.  What’s a bitcoin?

Glad you asked and that you’ve stuck around this long.  The short answer is that a bitcoin is like any other digital file, a series of 1s and 0s that can be used by certain programs.  In this case, those programs are wallets that both hold your bitcoins and allow you to transfer them to other wallets so you can pay for things.  In this way, bitcoins acts like currency.

Anyone who has worked with computers knows about two essential digital functions: copy and paste.  So if the bitcoin is just a digital file, what’s to stop people from hitting a few buttons and becoming virtual billionaires or turning the bitcoin economy into hyperinflation 1946 Hungary like we discussed in part 1?  And how do you ensure the reliable transfer of these bitcoins without using a trusted third party that will want it’s 2.9%?

“I want my 2.9%!”

The answer to those questions is what makes bitcoins look and act like a virtual currency (also called cryptocurrency) in meeting those five essential elements we discussed in part 1.  How these bitcoins can be used also forms the basis of Bitcoin, the network.

1. Bitcoins have fixed units of measurement

The standard unit for a bitcoin is the BTC just like the standard unit in the United States is the dollar.  However, unlike the dollar which can be divided into 100 cents, a bitcoin can be divided into 1 million pieces.  The smallest trackable unit of a bitcoin is currently 0.00000001 BTC.  What that is worth, in terms of buying power, will be discussed later.  But just like fixed money had an advantage over a barter system because everyone agreed on how much of the currency was being traded, bitcoins have a common and precise measurement.

2. Bitcoins don’t disappear

By virtue of being digital and on a shared network, bitcoins don’t disappear.  They may, however be stolen just like gold jewelry.  Or you may forget your password to the wallet that holds your bitcoins, just like you could bury a jar of gold coins and forget where they are.  But the bitcoins themselves don’t disappear.

3. Bitcoins are controlled and scarce

Rather than having a government or central bank issue new bitcoins, the Bitcoin system is responsible for creating new bitcoins.  We’ll discuss how that happens later when we talk about Bitcoin mining, but know that there is an algorithm for adding new bitcoins to the BTC economy.  And there is a fixed number of bitcoins in the BTC economy.  If you want to see the current amount you can check this graph and see how there are a bit over 12.1 million BTC as of March 24.  The rate at which BTC are added is based on the number of BTC transactions rather than a fixed time.  That’s why the line on the BTC supply isn’t straight–it fluctuates based on activity.

Adding currency is done by issuing authorities all the time, lest you think BTCs are going the way of the pengo.  The US mint produces new money every day–about 95% is used to replace older, damaged notes while the rest can be held in reserve or issued as new currency.  One potential concern that comes up with bitcoins is that the current method for creating and verifying bitcoins has a cap of 21 million BTC (this will be reached by around 2140).  However, bear in mind that there is currently only $1.2 trillion dollars in the world economy (this is the M0 money supply, or actual money in the forms of notes and coins) and there is a grand total of around $10.5 trillion dollars in total when you count other money supplies (this fact and a nice breakdown of the difference between money supplies can be found over at HowStuffWorks).

$10.5 trillion dollars counted down to the last cent looks like this: $10,500,000,000,000.00  (16 digits)

21 million BTC counted down to the last decimal place looks like this: 21,000,000.00000000 (16 digits)

Meaning that even with a finite supply of BTC, it seems like there would be enough for a BTC economy to function.

4. Bitcoins are transferable

Bitcoins can be transferred between indviduals using their wallet programs and the Bitcoin network.  Several online vendors have also started taking BTC directly, such as Overstock and WordPress.  And those are just the directly transferable BTC transactions–there are bitcoin ATMs that are starting to pop up and there are multiple BTC exchanges that let you convert BTC into other forms of currency for indirect BTC transactions.  Directly or indirectly, BTCs are transferable.

5. Bitcoins have value

Now this is where things start to get tricky.  First, there is no denying that bitcoins have value.  While I write this the price for 1 BTC is somewhere between $515 and $520.  People using BTC agree that there is value to them, but the value fluctuates wildly.  Bitcoins could be purchased back in April, 2013 for around $100.  At the end of November, 2013, bitcoins were being sold for $1,000 or $1,100.  There have been huge spikes up and down throughout the year.

Compare that to how many Euros could be bought for one dollar over the last year (if you follow the link you’ll need to click the 1Y button to show the year).  At the lowest point of the year it cost $1.27 to purchase 1 Euro.  At the highest point it cost $1.39.  That is what happens with generally stable currencies.

The unstable value of bitcoins is also a large criticism for its use as a currency.  If a currency can’t be relied upon for its value then people will stop using it.  Hungary had to give up the pengo and replace it with something completely new.  The majority of BTC value spikes are due to speculators trying to make money–they aren’t using BTC to buy things but rather hoping the value will go up so they can make money off it.  Whether they do or not, there is no denying the volatility they’ve created.  And that can be a bad thing for bitcoins.

Consider this: in 2010, a programmer convinced someone to buy him two pizzas in exchange for 10,000 BTC.  At the time, bitcoins had no value since very few people had them or used them.  Those same bitcoins would be worth millions.  There is no way that programmer could have known this, but everyone today who participates in the BTC economy knows the value fluctuates wildly.  This makes both sides less likely to use them for transactions.

The Big B Bitcoin

But now we have to talk about Bitcoin, the network that made a new virtual currency possible.  Remember that in order for bitcoins to be a viable currency not only did they need to meet the five essential elements (which they more or less do, with some warnings) but they also needed to have a method of transferring those bitcoins without involving a third party taking it’s 2.5%.

The solution to the problem of avoiding the dreaded 2.5% transaction fee while still being a trusted method of transfer is the capital B Bitcoin system.  Here’s how it works.


To understand Bitcoin, we start with wallets.  In order to conduct business transactions involving bitcoins you need to have a wallet.

That velcro ripping sound every time you open it? Money. So money.

In this case, a wallet is a collection of two essential things paired with optional items:

Essential thing #1: A public address

Think of this like the address that people send money to, much like your physical address is where the Amazon drone can drop off your copy of Ishtar.  For bitcoin transactions, an address is typically a random string of 34 characters such as


Essential thing #2: A private key

This is like your mailbox key that keeps other people from getting their slimy hands on your copy of Ishtar.  You go to your mailbox and unlock the door to pull out the sweet, sweet desert comedy stylings of Beatty and Hoffman.  (I know, it doesn’t exactly work with the drone–let’s just imagine that the drone can wirelessly open the door to toss in the DVD, mmkay?)

For bitcoin transactions, a private key is a 256 bit number that can be reduced down to a 51 key string such as


So unless you’re really good at memorizing pairs of 34 and 51 character strings you will probably use wallet software to store your public address and private key for you.

Optional thing #3: Money

Just like with a regular wallet, it’s nice but not necessary to put money in it.  But if you want to send money, you need to have money.

Now, here’s where the wallet starts to get a bit tricky because unlike physical currency this is all virtual.  So instead of having money you have an address that Bitcoin, the network, agrees has a positive balance of bitcoins.  Think of that address as a pocket within your wallet.  And each of those pockets has the two essential elements–the public key and private key.  If the Bitcoin network says that pocket has bitcoins in it, then you have money to spend.

The Bitcoin Block Chain

When it’s time for you to conduct a bitcoin transaction, your wallet and the wallet of the other side in the transaction uses the Bitcoin network to add the transaction to the Block Chain.  This is a giant database that is a complete ledger of every transaction involving a bitcoin.

Say you are buying my copy of Ishtar because I have grown weary of all that sand.  We have agreed to complete the sale using bitcoins.   I have my wallet create a new address for you to send me money.  (This isn’t required but highly encouraged to keep all transactions secure.)  I send you the public key for this new address and await payment.

You instruct your wallet to deposit the agreed upon amount of bitcoins into my new address.  The instruction you give your wallet will include the address where the money is going as well as where the money is coming from (because your wallet probably has multiple addresses/pockets of money from different transactions).

The instruction sent from your wallet will be signed using your private key.  Your wallet then transmits this instruction to the Bitcoin network where miners race to verify the transaction.  Mining can technically be done by anyone with a computer and special software but doing so quickly requires specialized hardware and software.  Speed matters because transactions are lumped together in batches (typically the last ten minutes’ worth) and the first miner to verify the batch is rewarded with 25 bitcoins.

The reward for being the second miner to verify a transaction block? Nothing. Because bitcoins are for winners.

Verifying the transaction is a very technical mathematical operation that looks at the old bitcoin address (where the money came from), the new bitcoin address (where it’s going), and the signed transaction (which factors in your private key but doesn’t disclose it to anyone).  The process allows all the pieces of information to be checked without also revealing your private key.  It also ensures that the same bitcoins aren’t used in multiple transactions–the double spending problem associated with digital cash.  Regular currency avoids double spending because you hand over a physical item like a ten dollar bill–you don’t have that same bill to be used again.  Electronic transactions utilize a third party to ensure that the purchasing party doesn’t spend the same money twice (typically by establishing limits and then ensuring the purchasing party pays their bills).  For bitcoin transactions each transfer is based on the old address and the new address–the same money cannot be used twice.

Once the transaction is verified it is added to the Block Chain, the giant ledger of every bitcoin transaction ever made.  It is possible to follow a bitcoin transaction backwards from address to address all the way back to when the bitcoin was first created (as a reward for mining).  If you’re into that kind of thing.

Mining and Transaction Costs

Mining is the replacement for the current system which uses a trusted third party as the go-between with today’s transactions.  Today, if you wanted to buy my copy of Ishtar I would wait for a message from a trusted third party (American Express, Paypal, etc.) before handing it over.  With a bitcoin transaction I am waiting for confirmation from the Bitcoin miners before I hand over the DVD.  The good news (for me) is that it’s far less expensive to complete our bitcoin transaction since I am not paying the 2.5% of the total to the third party verifier.  The bad news (for you) is that the verification doesn’t come instantly.  And if you were ever using your credit card at a store and had to wait 10-15 minutes for verification of the payment you’d be pretty frustrated.  As it is, those extra 15 minutes of waiting for Ishtar could seem like forever.

Of course, the real forever is when you watch the movie. Because this is the most exciting thing in the film. Oh, sorry, spoiler alert.

For most online transactions this 10-15 minute delay doesn’t matter much–whether the Ishtar DVD is put into an envelope and sent immediately or 15 minutes later shouldn’t matter much.  But this does prevent a limitation for bitcoin transactions in the real world where speed matters.  There are already some bitcoin payment providers that are attempting to bridge this timing gap by providing instantly accessible transactions, but those come with a higher transaction cost and might not be as desirable.

Speaking of transaction costs, we discussed earlier how bitcoin transactions were aiming for 1% transaction fees instead of today’s trusted third parties taking 2.5%.  But we also just learned that miners are being paid with newly minted bitcoins–money not attributed to either the buyer or the seller.  So where is the 1% coming from?  Mostly from the wallet providers as a cost for converting bitcoins into currency.  In the future, however, all the bitcoins will be issued so miners can’t be paid with new money–instead the Bitcoin network allows for transaction fees to be built into the transactions.  Miners then will function similar to third parties today, taking a portion of the transaction to ensure the transaction is completed and the hope is that they take 1% or less.  Because otherwise that would be a lot of work for nothing.

Now I’m Going To Blow Your Mind A Little Bit

Because you’ve come a long way in understanding this new form of virtual currency and the system that makes it work, here’s a fun little bit of information to blow your mind.  Feel free to just skip this section if it confuses you too much but otherwise it’s a fun thing to think about at this point.

There’s no such thing as a bitcoin.

We’ve been talking about virtual currency this whole time trying to make the equivalent connections between these small b bitcoins and actual money because that’s how our minds work.  We’re used to money and we’re accustomed to electronic transactions with money because we’ve used credit cards and those are backed by real money.  But there aren’t any bitcoins.

There is no this.

All there is in this bitcoin economy is Bitcoin–the network that verifies the Block Chain.  A positive number, divisible into a million pieces, is created and passed from address to address.  But that’s all it is–an address of a number where we first imagined something of value existed and then we moved it to the next place.  Nothing was ever there in the first place.

In this case, bitcoins are really like fiat money.  It only has value so long as everyone agrees it has value.  And that is the start of some of the risks facing Bitcoin.  Risks that we will cover in part 3 of our primer next week.

Ready to read part 3?  Then here you go.


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Everything You Wanted To Know About Bitcoin But Were Too Afraid To Ask, Part 1: Chickens, Yams, and Small Italian Cars

This is part 1 of the primer.  Part 2 can be found here where I describe bitcoins and the Bitcoin network.  And here’s part 3 where I discuss the risks and legal issues surrounding bitcoins.

I’m here to help.  I know the pain that you’ve experienced when you were at your last dinner party or work lunch and all your colleagues started talking about bitcoins and block chains and cryptocurrencies and malleability attacks.  You wanted to participate.  Maybe you even tried to toss in a random statement like “Gotta be careful of those dime teeth because you don’t want to be bitbyacoin.  Heh heh” and then everyone at the table stared at you for a bit.  Maybe they patted your head and took away your fork and knife too.

Like I said, I’m here to help.

Bitcoin and virtual currencies are hot topics these days.  But they’re not as simple as they seem.  They appear to be easily understandable (It’s money, right?) but then a story comes up about a website being hacked and all the bitcoins are gone and suddenly you don’t think you get it anymore.  Or they start throwing around how it’s actually different from current money.  Or they start calling money fiat money and then you’re totally lost.  That’s where these posts come in.

I started putting this primer together because I find some of the legal issues around bitcoins to be fascinating.  But in order to discuss those legal challenges you have to understand how bitcoins work and what’s new about them.  And to understand that you also have to step back and think about the role of money.  So that takes a while.

Rather than post this all as one giant article, I’m breaking it up a bit (because Lionel told me to) to make it easier to digest.  For the first part of the primer, we aren’t even going to talk about bitcoins but rather the basics of money.  If you’re a money theory expert then you can just come back tomorrow for part 2 where we start talking about bitcoins.  But if you’re a money theory expert, you probably don’t need this primer.  Everyone else, let’s get started.

The Basics: What is currency?

To understand bitcoins and the related world of virtual currencies we first have to take a step back and think about the concept of money.  It’s a strange exercise for those of us who don’t engage in this kind of thinking, we’ve just grown up using money to buy things.  But embedded within our daily usage of money are several important concepts that are worth noting.

(Please note that currency is a very complicated topic and I’m not covering all aspects, just some highlights.  If you want to read more about it–well, you are connected to the Internet.  Use that.)

1. Money has fixed units of measurement

If you have a ten dollar bill that is worth ten dollars.  What that buys you depends on how much someone wants to charge for a good or service, but both sides in a transaction agree that the ten dollar bill is worth ten dollars.  This gives money an edge over barter systems where two sides in a transaction agree to swap goods or services.  Say in a barter system there is a man who will sell you a goat for the low, low price of three chickens.  But you walk in with three sickly chickens and he refuses to make the sale based on you not having enough chicken as payment.  Or you come in with two extremely healthy, robust chickens and insist they are worth the same as three ordinary chickens.  Barter systems have the potential to make each transaction a negotiation and that can be inefficient.  Money has an advantage by removing the argument about how much the proposed payment is worth.

Another advantage of using money or some substitute item of value, like gold or other precious metals, is that you have fixed units that can be divided.  Most modern forms of currency have smaller units in the form of coins and larger units in the form of paper.  With precious metals you can measure the weight and divide the metal into pieces with less weight.  You can’t divide a chicken.  Well, you can, but only once and then you can’t use it again a week later.

Keep the change.

Keep the change.

2. Money doesn’t disappear

Did you ever wonder why gold is sometimes referred to as a substitute for money?  (Or why government money used to be a voucher for that value in gold?)  There are a few reasons–it isn’t readily available but also not completely rare, it is very dense so you can store a lot of its value (weight) in a small space, and you can find gold all around the world so that makes it a good exchange internationally.  But another really good reason for using gold or other precious metals like silver is that gold doesn’t dissolve upon contact with air.  Or water.  Or coffee.  Or any other substance that you might accidentally spill on it during the day.

The Trobriand Islands famously use yams and scored banana leaves as currency among the native population.  This is a tradition and annual practice for them, but I think we can all agree that it’s really difficult to save up for a big purchase over the years when your money might start to rot and smell and grow mold.

“I just finished saving up for that new house. My giant stack of yams is just around back. Wait…what?….NOOOOOO!!!!”

Generally speaking, we like having money that you can keep and use whenever you need to without worrying if your money has been made useless through contact with air, water, coffee, or evil, evil squirrels.

3. Money is controlled and scarce

For modern currency, money is typically issued by a government or central bank.  This not only regulates the amount of money in circulation but also lets each form of currency come up with ways of ensuring the integrity of money by making sure the amount of money in circulation is authentic and scarce.  Scarce being a relative term–there could be billions or trillions of it floating around, but the scarcity is because it is limited.  If you have an economy based on unlimited currency you can run into situations where the issuing government just starts making more and more money, decreasing the value of the money already in circulation and causing people to increase prices.  This is called hyperinflation and one of the many concerns that governments attempt to address when issuing currency.

That’s not to say governments don’t screw this up.  The worst case of hyperinflation ever recorded was the Hungarian pengo in 1946.  In 1944, the largest paper note in the country was 1,000 pengo.  By the middle of 1946 there was a paper note worth 100,000,000,000,000,000,000 pengo.  That’s One Hundred Quintillion pengo.  At the worst time of this hyperinflation, prices were doubling every 15 hours.

“That’ll be 500 pengo. No, wait, 520 pengo. Too late, now it’s 550 pengo. Screw it, just give me three yams.”

Keeping money scarce, both through controlling how much is issued and ensuring there are no counterfeit supplies, is an important aspect to modern currency.

4. Money is transferable

Money is designed to be exchanged.  That’s its sole purpose.  I’m not saying you are obligated to exchange it once you get it–savings are good, people–but money that can’t be given to others as payment is useless.  At its simplest, currency in the form of coins and paper notes can be physically given to someone else.  You give someone a ten dollar bill in exchange for something worth ten dollars.  At the slightly more complicated level both sides of a transaction can trust a third party to transfer the money for them.  You give your credit card number to a vendor when buying your ten dollar item–the vendor trusts the credit card company to send them ten dollars and the credit card company trusts you to pay the ten dollars.  And by trust I mean you both signed contracts with the credit card company that allows this transaction to take place.

It’s a giant stack of trust.

5. Money has value

This last element is not just the byproduct of the first four but they certainly feed into it.  Ultimately, though, money must have actual value to be used to purchase things.  That value can come from three different origins.

First, the value can be inherent to the item.  This is what happens in the barter system. A chicken is, by itself, valuable.  How much value can be debated, and will be negotiated when exchanging for something else, but if you have a chicken you have some value.  Tasty, tasty value.

Second, the value can come when the currency is a voucher for something valuable.  Historians believe the earliest form of currency were paper vouchers that could be redeemed for grain stored in Sumer’s temple granaries.  The island of Yap used large stone wheels as currency called Rai stones.  Moving these wheels around wasn’t practical so instead the currency became the oral tradition of remembering who owned which stone.  Currency in this case becomes an easier substitute then hauling around the actual item of value you are exchanging.  It’s more efficient than the first type of value.

On the plus side, you almost never lost your wallet.

Third, the value can be conjured out of thin air.  No joke.  This is called fiat money.  It comes from the Latin “Fiat” meaning “small Italian car.”  Or, if you prefer the more often used definition,

a command or act of will that creates something without or as if without further effort. – Merriam-Webster Dictionary

Governments do this a lot, create something out of nothing.  Like the legal limits to vote or the requirement to pay taxes.  Or money.  While currencies used to be attached to gold reserves (you may have heard of the Gold standard), that isn’t true anymore–all modern currencies are simply created by their issuing authority.  Their value derives from people accepting those values.  The various issuing authorities work very hard to keep that value consistent, but different countries and regions will change their opinion of the currency’s value from time to time.  This is why you have fluctuating exchange rates and people who make a living buying and selling currency from different origins.

These five elements together combine to form the essential characteristics of modern currency: fixed units, doesn’t disappear, scarce, transferable, and valuable.  In part 2 of the primer we’ll learn what is a bitcoin and how it potentially has these five characteristics and could be considered a modern currency.

Continue this primer with part 2 (how bitcoins and the Bitcoin network work).  Or skip ahead to part 3 of the primer (legal issues and risks surrounding bitcoins).


Filed under Bitcoin