Bitcoin Practical User Guide

NEW YORK (MainStreet) — If you think of Bitcoin as a currency, something you merely get from an ATM, you're missing the point. Bitcoin is actually a protocol, an open source cryptographic system that can operate on a peer-to-peer network.

Yes, it can be used to create a commodity people call "virtual money." A single bitcoin is merely a long encryption key whose identity is verified by being added to the ledger of Bitcoin transactions, a process called "mining."

There can be only 21 million individual encryption blocks, according to the protocol. Thus the supply of bitcoins is controlled.

It's this control that makes Bitcoin into what some call a "virtual currency" that can be traded, exchanged for other goods and services and used to create a virtual financial system outside any government regulation. But it is, in fact, a digital commodity.

From a regulatory perspective, the difference is important.

Bitcoin fans like to point to a 2006 interview with Milton Friedman, where he proposed that a computer control the money supply to limit its growth, as their inspiration for a Bitcoin-based currency.

But, as IT consultant Dietrich Schmitz of Herkimer, NY points out, the Bitcoin protocol can do much more.

At the heart of the protocol is the block chain, a database of unique, encrypted identifiers. Right now the technology is being used to identify individual Bitcoins.

But a block chain can be attached to anything, Schmitz says. You can attach a block chain to any copyrighted work, so digital property can be identified when someone pirates it. It can be attached to legal documents, authenticating them even in a digital form.

The block chain is, in short, an identification technology.

Thinking of Bitcoin as "virtual money" is like thinking of a 1979 Apple II as a Visicalc machine, or thinking of a 1985 Macintosh as a desktop publisher. It's confusing an application with the platform it rides on.

In practice, exchanges like Coinbase are simple financial intermediaries.

You use two-factor identification to set up your account. This means you offer your name, a password, but also your mobile phone number. Coinbase then calls that number with another key, which you input back into the system to prove your identity.

Google uses a similar system in verifying its own accounts. Google sends a text message to your phone, you input that number into a Google-connected computer and you can then use your Google account on that computer.

Once you have a Coinbase account, it's up to Coinbase to maintain its security. Coinbase encrypts all wallets and private keys and moves account information, along with private encryption keys, offline so they're inaccessible to hackers, among other security measures.

You move money into Coinbase by connecting it to your bank or credit card account. Coinbase will first perform a "challenge transaction," worth as little as 16 cents, to assure the security of the connection. It's just like connecting your bank and brokerage accounts to one another.

Standardizing strict security measures for Bitcoin processors, and users of the protocol, can prevent bank thefts like the one that allegedly took down Mt. Gox and, more recently, the Flexcoin exchange in Canada, says Schmitz.

Ultimately Schmitz agrees with those who say Bitcoin should be treated as a commodity, not a currency, and offers an example in how he uses it with Overstock.com.

"When you go into the cart and select Bitcoin as your method of payment, Coinbase will push dollars to Overstock instead of Bitcoin," he explains, thus converting Bitcoin in your account to dollars at the going rate. "The broker will behave as though they are any other commodity exchange, following regulations."

Regulations like those for exchanges that trade in corn or gold, and technical requirements like those used for Visa and MasterCard transactions, will in time limit the security risk of using Bitcoin, Schmitz predicts.

But the point is that the Bitcoin protocol doesn't just identify you, your bank, and your virtual currency. It can be used to identify any financial asset, making it secure for the first time.

Just as the Apple II was more than Visicalc, the Bitcoin protocol is more than money.

--Written by Dana Blankenhorn for MainStreet

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