The Future of Virtual Currencies: An Analysis of Bitcoin Part 1 – Introduction

The following few posts will be derived from some research I’ve done into Bitcoin and virtual currencies more generally, covering both technical and economic aspects of the currency.

Almost since the beginning of the Internet, virtual currencies have spontaneously appeared as people search for better ways to transport their digital assets.  Most digital currencies in the past came about from videogame economies where money denominated in real-world currencies (i.e. dollars, euros, pounds) was not appropriate in covering transactions.  As games became more complex, so did their economics, and while the reactions of the companies that run these games varied from trying to ban any interaction between real world transactions and in game money to full-on embracing of the market, the clash between currencies real and digital has been consistently inevitable.

Today, we are witnessing a new era of digital money where virtual goods are no longer simply an extension to real currency into a niche digital market, but are instead becoming a replacement to traditional currencies altogether.  This has been most obvious in the advent of Bitcoin, whose meteoric rise in value in March and April 2013 (and subsequent crash) thrust it into the mainstream.  Bitcoin, and many other digital and “crypto” currencies, rely on a mix of decentralization, in the use of a distributed peer-to-peer system; cryptography, using a public key encryption scheme; and mathematics, as new coins are produced only when computationally complex encryption problems are solved.

Having no backing from any government creates a set of unique circumstances for Bitcoin and other digital currencies. Their demand is based solely on people’s desire to own the currencies and accept them as payment, which can lead to highly volatile movements in value as seen recently with Bitcoin.

bitcoin chart

Chart from bitcoincharts.com

However, it also means that computational algorithms, and not government policy, dictate the currency’s growth, something libertarians and anti-establishment activists see as valuable.

The importance of virtual currencies in today’s ever more digitized world cannot be understated. Looking at the virtual currency market generally and Bitcoin specifically, this series will analyze both how digital currencies function and whether this form of currency is viable on both technological and economic grounds.