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This chapter is from the book

Then Came Bitcoin

Bitcoin has been around for only about a half-dozen years. It has been a short but eventful life, with the Bitcoin economy rising from nothing to close to $6 billion today.

Pre-2008: Crypto-Anarchy

Throughout the 1990s and 2000s, there arose considerable interest, in some circles, in cryptology and crypto-anarchy. If you’ve never heard of crypto-anarchy, know that it involves the employment of cryptographic tools to avoid detection (and often prosecution) when sending and receiving information over the Internet and other computer networks. Crypto-anarchists tend to be motivated by one (or more) of three main issues. First, defending against the unwanted surveillance of Internet-based communications. Second, defending against Internet censorship. And third, participating in what they call “counter economics,” in essence conducting economic transactions outside of traditional financial systems and across national boundaries, often for illicit reasons.

It’s this last motive that inspired some of the leading crypto-anarchists to turn their attention toward cryptocurrency. This led to the development of several pre-Bitcoin virtual currency concepts, including Wei Dai’s b-money, Nick Szabo’s bit gold, and Hal Finney’s RPOW. None of these ideas made it much past the conceptual stages, however—although all were obvious influences on what came next.

2008: Gestation

The world (or some part of it) first heard about this thing called Bitcoin in August of 2008. Two things happened then. First, on August 15, Charles Bry, Neal King, and Vladimir Oksman—three scientists/academics working in the field of encryption—filed a patent application for an invention for updating and distributing encryption keys. Second, on August 18, the domain name bitcoin.org was registered. Something was definitely in the works.

The big bombshell dropped on October 31, 2008, when a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” was posted to the Internet. This paper detailed the methods of using peer-to-peer (P2P) networking to facilitate electronic transactions—essentially spelling out all the ideas behind the concept of Bitcoin. (You can read the paper yourself online at bitcoin.org/bitcoin.pdf. It’s only 8 pages long and easy enough to digest.)

The author of that paper, and the de facto founder of Bitcoin, went by the name of Satoshi Nakamoto—in retrospect, a fictitious name for a secretive character. But back then Nakamoto was onto something important, and on November 9 he registered the Bitcoin project at SourceForge.net, the home of much open-source software development. There was more to come.

2009: Birth

The development of Bitcoin continued apace, and on January 3, 2009, Nakamoto mined the very first Bitcoins, the so-called “genesis block.” On January 9, he released the first open-source Bitcoin client (v0.1). Three days later, on January 12, the first Bitcoin transaction was recorded, from Nakamoto to Hal Finney—a name you’ve heard before.

Finney was (and is) a developer at PGP Corporation, a company at the forefront of public-key cryptography—the technology behind Bitcoin’s encryption capabilities. He is also a noted activist in the field of cryptography, responsible for running several anonymous remailer servers and staging a contest to break Netscape’s export-grade encryption. In 2004, Finney created the first reusable proof-of-work protocol, dubbed RPOW, which was a system that required some work from the service requester before a credit of some sort would be applied; a version of this protocol was incorporated into the Bitcoin mining process. It goes without saying, then, that Finney was integral to the creation of Bitcoin (which is why some claim that Finney himself is actually Satoshi Nakamoto—which Finney, of course, denies).

Back to our story, and to that first Bitcoin transaction. This first transaction created what is known as the genesis block, the initial block in the ever-growing Bitcoin block chain. Nakamoto’s genesis block was composed of 50 Bitcoins—50 BTC, in Bitcoin parlance. The value of those first Bitcoin transactions was negotiated by individuals on the bitcointalk forums, which is where all interested parties hung out online. (You can access the bitcointalk forums today at https://bitcointalk.org.)

Throughout the balance of 2009, Nakamoto and others continued to work on the Bitcoin technology and the associated trading process. During these early days there were no formal Bitcoin exchanges; all the trading took place between individuals on the bitcointalk forums. For example, in October of 2009, forum member NewLibertyStandard set the exchange rate of 1 dollar equaling 1,309.03 BTC, or $0.0007/BTC. (Bitcoins weren’t worth a whole lot back then.)

2010: Getting Real

It wasn’t long before the first “official” (or as official as anything can be in the decentralized world of virtual currency) Bitcoin exchange was established. Trading at Bitcoin Market, owned and operated by bitcointalk member dwdollar, began on February 6, 2010. As of May 2010, the exchange rate on Bitcoin Market was $0.004/BTC.

Of course, the exchange rate fluctuated based on supply and demand, and there was little of either. For example, bitcointalk member laslo established the exchange rate of $0.0025/BTC by paying jercos, another user, 10,000 BTC for two pizzas worth approximately $25.

July of 2010 saw the establishment of another Bitcoin exchange named Mt. Gox. (Remember that name; it becomes very important later on.) Mt. Gox actually got its start in 2007 as an online exchange for Magic: The Gathering Online trading cards; the name comes from Magic The Gathering Online eXchange. The site went through several different permutations before settling in as a Bitcoin exchange.

Before Mt. Gox opened, the Bitcoin exchange rate was $0.008/BTC. Five days later the value had increased tenfold, to $0.08/BTC. (This increase in value was also due in part to an influx of new Bitcoin users, as v0.03 of the Bitcoin software was released that month.)

In August of 2010, a major vulnerability in the Bitcoin protocol arose, which enabled users to bypass Bitcoin’s built-in restrictions and create an indefinite number of Bitcoins. This was not a good thing, as more than 184 billion BTCs were generated in a single transaction on August 15, effectively making worthless the entire currency. Fortunately, the fraudulent transaction was quickly spotted and reversed, and the bug was fixed—not yet to be repeated.

That little setback out of the way, the Bitcoin exchange rate continued to climb throughout the rest of the year, reaching $0.50/BTC. By November, the total value of the Bitcoin economy surpassed $1 million.

2011: Ups and Downs

By January of 2011, 5.25 million Bitcoins had been generated. On February 9, 2011, Bitcoin reached parity with the U.S. dollar, with Mt. Gox reporting an even exchange rate of $1.00/BTC.

This increase in the exchange rate resulted in an even larger influx of users. The exchange rate subsequently declined, however, dropping to $0.70/BTC by the middle of March.

In April of 2011, TIME magazine provided even more exposure by publishing one of the articles about Bitcoin in the mainstream press. Not coincidentally, the value of the Bitcoin economy passed $10 million by the end of that month.

Mt. Gox had quickly become the largest Bitcoin exchange, but several others were launched throughout 2011. These included exchanges for British pound sterling (Britcoin), Brazilian real (Bitcoin Brazil), and Polish zloty (BitMarket.eu).

After the TIME story, the Bitcoin exchange rate saw a rapid rise. The rate hit $10.00/BTC in June and peaked at $31.91/BTC on June 8. This gave the Bitcoin economy a $206 million market capitalization. However, that peak was followed by a precipitous drop just four days later, when the exchange rate went back down to $10.00/BTC again. This was a good demonstration of the volatility of the Bitcoin market.

Then the unthinkable happened. On June 15, 2011, the Mt. Gox database was hacked and fake sell orders were placed for more than 25,000 BTC from 478 user accounts. This drove the price of Bitcoins (at Mt. Gox, anyway) down to $0.01/BTC. This would have wiped out hundreds of investors, except that Mt. Gox was able to reverse all the phony trades.

That wasn’t the only low point for Bitcoin in 2011. In July, the operator of Bitomat, the third-largest Bitcoin exchange, announced that he had lost access to the wallet.dat file that held approximately 17,000 BTC, worth about $220,000 at the time. The operator announced that he would sell the service for the missing amount, intending to use funds from the sale to refund his customers.

In August another Bitcoin exchange, MyBitcoin, was hacked. This caused the exchange to shut down, refunding just 49% of customer deposits, for a loss of nearly $800,000.

Despite those obvious lows, there were plenty of high points in the world of Bitcoin in 2011. For example, in July of 2011, Intervex Digital released BitCoins Mobile, the first Bitcoin app for iOS devices. In August, the first Bitcoin Conference and World Expo was held in New York City. And in November, the first European Bitcoin Conference was held in Prague.

2012: Rocky Times

Let’s face it, 2012 wasn’t the best of years for those trading in Bitcoins. Not only did the price of Bitcoins not increase much, ending the year at just $13/BTC, but it also was a time of much internal turmoil and criminal activity.

For example, in March close to 50,000 BTC was stolen from the Linode exchange. And in September the Bitfloor exchange was hacked, with more than 24,000 BTC stolen.

In August, a lawsuit was filed against the Bitcoinica exchange, as a result of close to a half-million dollars in lost savings. The exchange was hacked twice in 2012, which led to allegations that Bitcoinica neglected the safety of its customers’ investments.

August also saw the closing of the Bitcoin Savings and Trust, which left around $5.6 million in Bitcoin-based debts. This led to an investigation by the SEC of the exchange as being kind of a Ponzi scheme.

The news in 2012 wasn’t all bad, however. In December Bitcoin-Central (now called Paymium) became the first Bitcoin exchange licensed as a bank in Europe, which put a veneer of respectability on the whole endeavor.

2013: Looking Up (Sort Of...)

After the dismal year prior, 2013 looked to be a bit of an improvement for the world of Bitcoin. It started with a very healthy increase in the currency’s value, with the exchange rate breaking the 2011 peak of $31.91/BTC on February 28, 2013. The price continued to rise over the next few months, breaking $100/BTC by the first of April. At that point the Bitcoin market cap passed $1 billion.

Later in April, Bitcoin exchanges Mt. Gox and BitInstant had problems due to insufficient capacity, which resulted in delays in processing trades. This caused the exchange rate, which had risen to $266/BTC, to quickly drop to $55/BTC. (The rate stabilized near $160/BTC within a few hours of the issue, however.)

Mt. Gox saw more problems in May, when the U.S. Department of Homeland Security seized more than $5 million from its U.S. accounts. The reason was that Mt. Gox had not registered as a Money Service Business (MSB) with the government’s Financial Crimes Enforcement Network (FinCEN). FinCEN had earlier established new regulatory guidelines for what it called “decentralized virtual currencies” that classified Bitcoin miners and exchanges as MSBs—and, as such, subject to registration and other legal requirements. (For example, FinCEN’s guidelines require Bitcoin exchanges to disclose large transactions and suspicious activity, comply with money-laundering regulations, and collect information about their customers.) Because Mt. Gox hadn’t yet registered, the government took action.

The exchange got a reprieve in June, when it finally received its MSB license from FinCEN. Mt. Gox’s problems didn’t end there, however. The exchange suspended withdrawals in U.S. dollars on June 20, after which the Tokyo branch of the Mizuho Bank (which handled all of Mt. Gox’s transactions) pressured the exchange to close its account. Mt. Gox announced that it fully resumed withdrawals on July 4, although users reported that few withdrawals in U.S. dollars had been successfully completed. By November, it was reported that Mt. Gox users around the globe were experiencing delays of weeks or even months in withdrawing funds. Obviously, the exchange’s problems with the U.S. government were continuing to create problems between Mt. Gox and the banking system.

Mt. Gox aside, there were several instances of major Bitcoin theft throughout the year. In April, Instawallet, a provider of web-based Bitcoin wallets, was hacked, resulting in the theft of more than 35,000 BTC, valued at more than $4.6 million. In October, Australian Bitcoin wallet provider Inputs.io was hacked for a loss of 4,100 BTC, worth more than $1 million. Also in October, a Bitcoin trading platform owned by Global Bond Limited simply vanished, taking Bitcoin worth more than $5 million with it.

On the good-news front, in July a project was initiated that linked Bitcoin with M-Pesa, a popular Kenyan mobile payments system, that promised to spur virtual online payments throughout Africa. In October, the first Bitcoin ATM was launched in Vancouver, British Columbia. And during the course of the year, several online and real-world merchants and services began accepting Bitcoin for payment, including OkCupid, WordPress.com, Reddit, Foodler, and Overstock.com.

Bitcoin was in the news again in October, when the FBI seized roughly 26,000 BTC from the Silk Road website. This was part of an investigation into Silk Road’s alleged illegal activities; the site was well known as a marketplace for illegal drugs, with the virtually untraceable Bitcoin as the currency of choice. It wasn’t the best kind of publicity for the fledging virtual currency.

Also not good was the news from China. On December 5, the People’s Republic of China announced that it was prohibiting Chinese banks from using Bitcoins, and that Bitcoins could not be used as legal tender. It didn’t ban individuals from trading Bitcoins as a commodity, but it did impose new reporting constraints.

All that said, the biggest Bitcoin news of 2013 had to be the huge increase in value at the end of the year. The exchange rate was approximately $140/BTC at the beginning of October, hit $200/BTC on November 3, skyrocketed to $900 on November 19, and hit an all-time high of $1,216/BTC on November 28.

That looked like a bubble, and it was. In December, the price crashed down to $600/BTC, rebounded back to $1,000/BTC, then fell again to $500/BTC, and ended the year in the $650/BTC range. If you held any Bitcoin during that period, it was a wild ride.

2014: Mt. Gox...and Beyond

The Bitcoin exchange rate remained volatile during the first few months of 2014, rising to $1,000/BTC in January, sinking to the $600/BTC range in February, and then hovering in the $400 to $500/BTC range for the next several months.

This volatility was due in part to the problems befalling Mt. Gox, once the largest Bitcoin exchange in the world. Continued issues with the U.S. government hindered its operations, as did poor business practices and ongoing technical and security issues.

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Mt. Gox’s website, in better days.

On February 7, 2014, Mt. Gox announced that they were halting all withdrawal requests while they obtained “a clear technical view of the currency processes.” On February 10, the company stated that the current issue was due to a “bug in the Bitcoin software that makes it possible for someone to use the Bitcoin network to alter transaction details to make it seem like a sending of Bitcoins to a Bitcoin wallet did not occur when in fact it did occur. Since the transaction appears as if it has not proceeded correctly, the Bitcoins may be resent. Mt. Gox is working with the Bitcoin core development team and others to mitigate this issue.”

To give you an idea of the magnitude of Mt. Gox’s problems, a February poll indicated that 68% of the exchange’s customers were currently awaiting funds they had requested withdrawn. The median waiting time was between one and three months, with 21% of customers waiting for three months or more. (Imagine waiting three months for your local bank to process a withdrawal!)

On February 23, Mt. Gox’s CEO resigned and the company deleted all posts from their Twitter feed. The next day, Mt. Gox officially suspended all trading and, just hours later, its website went offline. Then the bomb dropped: On February 20, Mt. Gox filed for bankruptcy protection. It listed its liabilities at 6.5 billion yen (approximately $64 million), and its assets at just 3.8 billion yen.

As to the cause of all these problems, the company claimed to have lost close to 750,000 of its customers’ Bitcoins, and 100,000 or so of its own store. The “lost” Bitcoins were worth around $473 million—not an insignificant amount.

What happened to all those virtual funds? Mt. Gox released a statement that said, in part, “The company believes there is a high possibility that the Bitcoins were stolen.” By hackers, presumably. The company’s recently resigned CEO said that technical issues opened the door for those fraudulent withdrawals.

(Keeping up-to-date, on March 20 the company reported that it had found some Bitcoins, worth around $116 million, in an old digital wallet from 2011. That reduces the number of total Bitcoins lost down to around 650,000.)

Obviously, hacks and fraud can totally destroy any unsecured Bitcoin exchange; that’s why we have regulations and insurance for traditional financial institutions. Mt. Gox is the biggest example of this type of value-destroying fraud, but not the only one. Witness the Bitcoin exchange Flexcoin, which was hit by hackers on March 2, 2014, smack dab in the middle of the whole Mt. Gox thing. The hack—and resulting losses—forced Flexcoin to shut up shop just one day later, stating, “As Flexcoin does not have the resources, assets, or otherwise to come back from this loss, we are closing our doors immediately.”

March also saw the Internal Revenue Service rule that Bitcoin is not a currency, but rather an asset. This means that Bitcoin transactions should be taxed as capital gains, the same as stocks and other securities. This ruling could be troublesome for those wanting to use Bitcoin as a currency rather than an investment.

That said, the IRS ruling obviously had little impact on a Bitcoin start-up named Circle that launched on May 16. Circle’s website enables consumers to purchase Bitcoin in any amount they choose and then spend their Bitcoin on online shopping and at real-world merchants and restaurants. Even better, Circle’s Bitcoin exchange services come with all the safeguards that protect traditional currency transactions in the real world—and with no fees for deposits, withdrawals, or Bitcoin storage.

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Circle—a new way to trade Bitcoin?

The same week, Halsey Minor, the founder of CNET, launched another new Bitcoin market dubbed Bitreserve. Funds held by members are backed by a full reserve of real-world currencies, including dollars, euros, yuan, yen, and pounds. The goal is to give members all the traditional values of a virtual currency but with more security and less value-destroying volatility.

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