Bitcoin is a virtual currency that surged in popularity in 2013. Bitcoin are mined by computers solving complex financial puzzles. Bitcoin production is limited to 21 million and at the end of 2013 there was an estimated 12 million Bitcoin in circulation.
Bank of America Merrill Lynch strategists, David Wo, explains Bitcoin this way:
Bitcoin is a digital currency designed by Satoshi Nakamoto, a pseudonym, in January 2009. Bitcoin allows users to send payments within a decentralized, peer-to-peer network, and is unique in that it does not require a central clearing house or financial institution clearing transactions. Users must have an internet connection and Bitcoin software to make payments to another public account/address.
Satoshi is the smallest unit of Bitcoin; 1 Bitcoin contains 100 million Satoshi. By design, the supply of Bitcoins cannot exceed 21 million Bitcoins (2,100 trillion Satoshi). The total amount of Bitcoin in circulation will increase predictably, based on its underlying code, until reaching the cap in 2140. The current supply is 12 million Bitcoins or 57% of the eventual total (Chart 2). A public history of all transactions is continuously updated and verified by "miners" who gather batches of new transactions into blocks and attach these blocks to the end of the "Blockchai"n. This public history forms a ledger of transactions where every single Satoshi is tracked from its first owner to the present owner. Having the full history publicly available guarantees that a buyer actually owns the number of Bitcoins he or she wants to spend, preventing fraud.
Bitcoin supply is increased with every new block of transactions added to the public history (i.e. Blockchain). The verification of new transactions by miners is relatively easy and many transactions can be easily compressed in a single block. However, there is a computational task for each block of a high degree of difficulty designed to constrain the increase in the money supply, no matter how slow or fast the overall mining network is. If no external transactions are outstanding, a block with a single transaction to pay the miner would be produced. Indeed, the first several thousand blocks simply paid the miner and contained no other transactions (presently blocks contain a record of hundreds of transactions). This way the initial seed currency was distributed to miners who bore the speculative risk in the Bitcoin's success.
As a rough analogy, suppose competing journalists (miners) are asked to document the national news on each given day for the National Archives. The journalist is asked to write down the events (transactions) in a book (block) and the Archive will eventually buy one such book for a fixed fee. To determine which of the books the Archive will buy the archive has an additional requirement for journalists that the book contains the fingerprints of 10 people whose birthday was on that particular day. Note that the list of people isn't related to the national news (transactions) but is simply meant to control the supply of books coming out per day. As more journalists collaborate to find people, the Archive increases the number of fingerprints required.
Exchanges allow the conversion between real-world fiat currencies and Bitcoin. The participation in exchanges requires consumers to take on credit risk by transferring Bitcoins from a personal account to a third-party's account, which is similar to entrusting real-life cash to depository institutions. However, unlike banks, Bitcoin third-party accounts are not regulated nor do they provide FDIC protection. While personal accounts are easy to secure, start-up exchanges in overseas jurisdictions with online digital wallets are often targeted by hackers. Exchanges also have some risk of the operator absconding with the money before the currency conversion is completed. Major exchanges ordered by volume are BTC China (CNY), OkCoin (CNY), Mt.Gox (USD, EUR, GBP, JPY, AUD), FXBTC (CNY), Bitstamp (USD), Bter (CNY), BTC-E (USD), BTCTrade (CNY), VirtEx (CAD).
Bitcoin as a medium of exchange, distinct from speculative transactions on exchanges, initially gained popularity with companies involved within the Bitcoin ecosystem. For example, miners can purchase specialized chips with Bitcoins. To facilitate transactions, payment processors such as Bitpay provide software to merchants, and absorb FX volatility risk by guaranteeing exchange rates and sending daily bank payments. Since April 2013 significant investment was made into start-ups that develop and promote Bitcoin as a means of exchange for merchants (as opposed to speculation investment on the exchange). For example, CoinLab has received seed money to incubate other Bitcoin start-ups like mining companies and exchanges. The most notable company to accept Bitcoins may be Baidu, a major Chinese portal, which began accepting Bitcoin for its online security services in October 2013.
The rapid rise in BTC prices (292% a year) has generated a comparable exponential growth in mining revenue, which in turn has attracted large capital investment. Indeed, the number of computations has grown 521% a year, requiring expensive, heavy-duty Bitcoin-mining chips. The competition for revenues has taken away the low-hanging fruit and each dollar mined is now hundred times "deeper". Electricity costs are also going up as miners use more computers.