Bitcoin roller coaster: What's the buzz about?

Satoshi

Is an algorithm the future of currency? That's what anyone who's curious about Bitcoin is trying to figure out. The digital money has piqued the interest of many, mainly due to its complexity as a technology and its meteoric rise in value in recent weeks.

What is Bitcoin?

Bitcoins are like the U.S. dollar in that there's almost nothing you can't buy with them. It exists in a digital form and is bought and sold using software -- through peer-to-peer networks. But there are a few things that set Bitcoin apart.

For starters, it's not just currency. It's also a technology and platform. Bitcoin is built with an open-source code that has essentially de-centralized transactions. The software uses a network of people's computers to manage "blockchains" -- a transaction log that the entire system relies on. Every transaction made with bitcoins is logged on block chains. There are no exceptions. Instead of having a central bank where money is kept, the block chain organizes who officially owns bitcoins.

New bitcoins are "mined" or generated by computers. They get harder to generate all the time, which means the inflow of fresh bitcoins keeps falling. There are about 8 million bitcoins in circulation today, and the maximum that can be generated is 21 million. By 2032, 99 percent of those will have been created.

There are a few ways to interact with bitcoins. Its intended use is as a virtual currency to make purchases. While using Bitcoin is not anonymous, there are several tools online that make it possible for users to hide their identities and computer's IP address. Bitcoins have been used to purchase illegal items from black market websites and fund hacker activists.

Bitcoin users are also treating the currency like an investment. Some are holding on to bitcoins, which drives up their cost on the market. Bitcoins doubled in value over the last week -- and then took a massive dip Wednesday. On April 1, bitcoins were valued at about $102. That number rose to $266 in 10 days and plummeted to close to $100 before recovering.

Who owns Bitcoin?

Technically, no one person owns Bitcoin because new bitcoins are generated by a network of computers and traded on peer-to-peer networks. The bitcoin protocol was introduced in 2009 by a developer or group of developers who use the pseudonym Satoshi Nakamoto. Several attempts have been made to reveal Nakamoto's real identity, but there has been little success.

Why did its value spike?

Many speculated that the nature of a bank that has no nationality and a finite number of "coins" that can be released was especially appealing to people during the financial crisis in Cyprus. According to Bloomberg Businessweek, Spanish investors turned to Bitcoin out of fear that the Cypriot government would raid domestic savings accounts to pay off the country's massive debts.

Is that dangerous?

The meteoric rise in value is also linked to what some economists say is the biggest problem with the currency: that the supply of bitcoins increases only slowly, at a rate that's coded into the system.

That's a contrast to a regular paper currency like the dollar, whose supply is managed by a central bank like the Federal Reserve. The Fed engineers the dollar supply to increase slightly faster than the growth of the economy, which means that the value of the dollar falls slightly every year, in the phenomenon known as inflation.

Since the supply of bitcoins grows so slowly, any increase in demand leads to higher prices. That's known as deflation, and it's widely seen as a disaster when it happens to a real-world currency. As money becomes more valuable, our incentive is to hold onto the money instead of spending it - slowing down the economy.

"What we want from a monetary system isn't to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that's not at all what is happening in Bitcoin," Nobel Prize-winning economist Paul Krugman wrote in 2011.

When the supply of money is fixed or increasing only slowly, deflation can feed on itself. Investors will look at the rising price of the coins, and conclude that they're set to rise further. So they buy more, sending the price even higher. This goes on until the market is sated. In the ideal outcome, the value of the currency then stabilizes at the new high level. In the worst case, the value plunges.

This boom-bust cycle has already happened once before for Bitcoin. It hit nearly $31 in June 2011, then crashed, hitting $2 five months later.

In essence, Bitcoin is similar to the "gold standard," the monetary system in force before modern central banking started to take root in the 1930s. Under the gold standard, each unit of currency was worth a certain amount of gold, leaving governments few means to increase the amount of currency in circulation.

No country uses the gold standard today, but some libertarians want to revive it, and see Bitcoin as a modern-day alternative or complement.

"If you wipe away the misguided economics courses that we have, deflation doesn't have to be a negative," says Jon Matonis, a board member of the non-profit Bitcoin Foundation, created last year to foster and protect the system. "It's not a bad thing when a citizen's purchasing power increases."

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